An optical illusion like a mirage can lead you to believe in something that doesn't exist. In contrast to a hallucination, a mirage is a real phenomenon that can be captured on camera. Yes, it is possible to 'prove' the existence of something fake.
Logical thinking often enables one to discern a mirage while wishful thinking - like the proverbial oasis in the desert - tends to fuel unfounded hope.
With elections coming up, the government certainly has a vested interest in creating a make believe environment where stocks are in a bull market and the economy is improving. Votes are power and every political party wants power.
If the mirage of an economic recovery starts to fade, the Fed 'will employ its policy tools as necessary to promote economic recovery and price stability'
As investors, we are caught between a rock and a hard place. It doesn't take an economist to see how bad things are, but there's also the old adage, 'Don't fight the Fed.' So what is one to do? This article will take a look at both sides of reality; the one we see and the one the government wants us to believe in.
Don't Fight the Fed
The U.S. administration has put together a nifty cycle of (never ending?) 'get out of jail free cards' for big Wall Street players. Big banks and financial institutions are allowed to benefit at tax payers' expenses.
Here it is: In 2008, the Federal Reserve cut its interest rate to 0.25%. If you have any credit card debt, car or other loans, you know that the 0.25% doesn't apply to you, but it applies to banks.
Banks can borrow at 0.25% and buy Treasuries. Banks make money on interest rate spreads. The current spread between money borrowed at 0.25% and the 3.75% that long-term Treasuries pay, is 3.5%, risk-free.
But wait, there is more. Via its permanent open market operations (POMO), a mechanism designed to control interest rates and money supply, the Fed has and continues to buy back Treasuries from the banks. TLT is up more 21% year-to-date.
Banks get to pocket the profits (interest rate spread and capital gains) and invest in more Treasuries (to keep the cycle going) and buy high-beta stocks like Apple and broad market indexes like the S&P 500 SPDR
Perhaps this explains why a 'risky' sector like technology has been a performance frontrunner in a time when the economy just can't recover. It also explains why banks aren't lending. They simply don't have to.
Don't Fight the 'Mirage Truth'
Most investors have forgotten by now, but there is such a thing as toxic assets. Toxic real estate related assets were a problem too big to solve. As it turns out, a problem doesn't need to be solved as long as it's covered up properly.
One simple accounting rule change (rule 157) allows banks to value a home at what it might be worth in a decade or two, rather than what it's worth right now.
If the average homeowner applies at any bank for a new loan or refinance and claims that the home's value will recover to 2006 levels within the next 20 years or so, the bank would laugh while pulling out the 'loan denied' stamp. Yet, when preparing their financial statements, banks are allowed to do just that.
Fantasy vs. Reality
A strong case can be made, however, not to fight the Fed. A quick glance at a basic chart quickly shows that the Fed wasn't able to prevent the 2000 and 2007 crashes.
In September 2008, the ETF Profit Strategy Newsletter brand marked the financial sector as a 'downward spiral with no stop-loss protection' and recommended to load up on short positions. These positions were covered on March 2nd and replaced with long and leveraged ETFs like the Ultra S&P ProShares , Direxion Daily Bull 3x Shares and others.
Corporate, Public, Financial - Bad, Bad, Bad
From the corporate sector we hear that CEO's are more cautious about sales and hiring. A recent survey shows that CEO's of large U.S. companies have become less optimistic since June.
Regarding the private sector, we read that nationwide household income fell 2.9% while the number of households receiving food stamps surged by more than 2 million, and the population living in poverty increased by 3.5 million. This is despite a new record in government transfers (government support like unemployment, etc.).
Even though it's not front page news regarding the financial sector, we are aware that federal regulators took over three corporate or wholesale credit unions. Corporate credit unions provide wholesale financing and investment services for the more than 7,000 U.S. credit unions.
The government will take over the three wholesale unions and their $50 billion worth of toxic assets. With this move, the government earned the distinction of controlling about 70% of the total assets of corporate or wholesale credit unions.
To 'deal' with the colossal financial hole and to help rescue the battered industry, the National Credit Union Administration plans to issue $30-35 billion worth of government guaranteed bonds. In addition to the government guarantee, the bonds are backed by shaky mortgage-related assets.
Is it surprising that a simple accounting maneuver can't do the trick? Apparently, when the rubber meets the road and cash runs dry, financial engineering doesn't work. That explains the 128 failed banks in 2010. At the same time in 2009, 'only' 96 banks had failed.
The bad news is that the reality isn't pretty. The good news is that with the help of the government, Wall Street hasn't had to face it yet. How long will the denial approach last?
October Crosscurrents
October is a tricky month. On one hand, it has an 'October phobia' type of reputation and has kicked off crashes such as in 1929, 1987 and 2008. On the other hand, it has killed bear markets such as in 2002 and has a stellar track record, particularly in midterm election years.
After bouncing on top of the much-publicized 1,040 - 1,130 trading range for several days, the S&P (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) will probably show their true intentions sometime in October. Of particular interest will be the performance of the higher beta Nasdaq; strength or weakness in the tech-heavy index will likely spill over into the broad market indexes.
No doubt, the market will have a few more surprises and fake breakouts - to the top and the bottom -before settling on a trend.
The ETF Profit Strategy Newsletter provides a bi-weekly Technical Forecast. This forecast is designed to take the emotion out of investing and focus on the market's internal signals. As such, it provides target and safety levels that aid in narrowing down the market's direction early on.\
Dow Jones Industrial Average
(DJI: ^DJI)| Index Value: | 10,967.65 |
|---|---|
| Trade Time: | 4:02PM EDT |
| Change: |  22.93 (0.21%) |
| Prev Close: | 10,944.72 |
|---|---|
| Open: | 10,936.79 |
| Day's Range: | 10,918.57 -10,974.16 |
| 52wk Range: | 9,596.04 -11,309.0 |
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