Phony Rallies in an Unreal Market

11/12/2009 2:24 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

It’s hard not to be impressed by the blow-out rallies we’ve seen since March. Global stocks, commodities, and corporate bonds have all soared in the eight months after we stared financial Armageddon in the face.

And to be sure, the market’s moves appear to have anticipated significant rebounds in the world’s economy. Much of Asia and Europe are out of recession, and the latest quarter’s gross domestic product reports show even the troubled US economy recovering—despite lingering high unemployment.

But I, like many investors, remain suspicious.

Too much of this rally has been driven by “liquidity”—trillions of dollars pumped out by government printing presses. Too many asset classes are moving together, just as they did in 2007, propelled by massive speculation via the so-called “carry trade”.

These forces have distorted markets so dramatically that I wonder how much the markets accurately convey value any more.

No wonder individuals have avoided this rally in droves. As the markets move higher and higher, they’ve been wisely reducing their stock positions and have poured money into bond funds instead in a search for yield. Only in gold do we see any sign of a retail mania—and trust me, that will end badly for too many people, too.

That’s why it’s crucial that individual investors ignore the so-called “seers” who predict certain markets will soar much higher and it’s time to get on board before the train leaves the station. The risks are getting much, much bigger, too, and too many investors just can’t afford to get burned again.

Of course, the three-ton elephant in the room is the money governments have pumped in to save the global financial system. I’ve seen estimates of anywhere from $12 trillion to $14 trillion, roughly one year’s US GDP.

A lot of that money is being used to “backstop” various financial institutions through loans, preferred stock, and other direct investments. But hundreds of billions are going directly into purchases of government bonds and mortgages, rebates on auto and home purchases, and various stimulus packages around the world.

And don’t forget “quantitative easing”—money printing—by the Federal Reserve, the Bank of England, and other central banks to keep rates artificially low and get the economy moving again.

Sure, central banks will start withdrawing that money as economies recover, but a chunk of it already has made its way into various assets, raising fears of yet another “bubble.” It has encouraged risk-taking beyond what you’d expect at this point of an economic recovery.

“The real danger is these levels we’re observing are artificial [because of] government involvement in the markets,” says Brian Battle, vice president of Performance Trust Capital Partners in Chicago.
 
And it may be creating an artificial boom in some assets at the expense of others as hedge funds and huge institutions resume a massive “carry trade”—this time, with the US dollar as their target.

These speculators have borrowed or sold short the greenback to invest in riskier assets, like emerging markets and commodities. That has once again driven up the correlations between assets such as oil and the Standard & Poor’s 500 index, suggesting speculative money is flowing into both areas.

"It tells me that all assets are driven by the giant dollar carry trade," Dean Curnutt, president of Macro Risk Advisors, told the Financial Times.

Added Amin Rajan, chief executive of Create Research: "The recent market buoyancy is driven by momentum traders and professional traders; it is not sustainable in the view of many investors."

And Nouriel Roubini himself—the permabear who predicted the whole housing and financial crisis—is now warning against “the mother of all carry trades.”

“Traders are borrowing at -20% rates (including profits from short-dollar positions—Editor) to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade,” he wrote in the FT.

“In effect, it has become one big common trade–you short the dollar to buy any global risky assets.”

Especially gold. The yellow metal has soared to over $1,100 an ounce, and gold bugs are predicting it could go much, much higher. Even as demand for gold jewelry drops dramatically throughout the world—especially in India, the largest market—small investors are scooping up gold bars and coins like there’s no tomorrow.

In the second quarter of 2009, gold jewelry sales fell 20%, while investor demand skyrocketed 51%, according to the World Gold Council.

The rationale: Inflation is just around the corner, and the US dollar is toast because of our huge deficits in the future.

Our deficits are bad, of course, but the UK’s are much worse, and yet the pound has rallied strongly against the greenback in recent months. That shows this has much more to do with the speculative carry trade than the relative strength of different currencies and economies.

Which makes the recent upsurge in demand for gold all the more striking, as this report from The New York Times shows: "Everyone and their grandmother has a sign out saying, We buy gold,’ said Ron Lieberman, the owner of Palisade Jewelers in Englewood, NJ. He estimates that ten times as many people come into his store to sell gold now as when the metal was selling for $300 an ounce at the beginning of the decade. ‘I hear people come in and say gold is going to $2,000."

And Harrods, the venerable London department store best known for its food halls selling a dozen different pates and rooms full of tea, chocolates, and biscuits, has gotten into the gold business, too. “The response has been astounding,” Chris Hall, head of Harrods Gold Bullion, told the Times.

Does that sound like the proverbial bell that rings at the top of a market?

“I think there’s a retail tulip-bulb phenomenon in gold,” says Brian Battle.

So, what could send this all in reverse? “The day the Fed hints, indicates, or actually raises interest rates,” he says.

And Roubini writes: “At some point [the dollar] will stabilize; when that happens, the riskiness of a reversal of dollar movements would induce many to cover their shorts, [triggering] a dollar rally at a time when huge short dollar positions will have to be closed.”

That would clearly jolt people—and the markets—back to reality, which is why I wouldn’t be jumping on these bandwagons any time soon.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.

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