Thursday’s pre-holiday surge by the Dow Jones Industrial Average over the 17,000 level — a level it had been pawing since early June — on a better-than-expected June jobs report has sent investors into full-on eyes-bleeding, foam-at-the-mouth euphoria.
The economy added 288,000 positions (mainly part-time) as the unemployment rate fell to 6.1%, which was the Federal Reserve’s year-end 2014 forecast.
These folks look more and more like zombies instead of bulls, mindlessly repeating predictions like the Dow tagging 20,000 by year end ignoring a growing list of problems. Like the fact investor positioning and sentiment is at extremes. Or that stock valuations have returned to peaks seen in 1929, 2000, and 2007. Or that the Iraqi government is in stalemate as Sunni extremists capture more territory. Or that breadth in this latest push has been terrible, a sign of narrow buying interest. Or that the market hasn’t had a meaningful correction since 2012.
But above all, folks don’t realize that the tightening of the job market, while being wonderful news for middle-class families, threatens the Fed-fueled liquidity bubble that’s been boosting the market in the first place. Here’s why.
The Economic Fantasy
Like the all market bubbles throughout history, whether Dutch tulips or shares of Pets.com, the latest one features all the telltale signs: A suspension of disbelief, greed compromising good stewardship, and the subscription to the maxim that this time is truly different.
This time, it’s the belief that the Fed and other central banks will always support markets. No matter what. And that interest rates will stay low for longer — maybe forever, if former Fed chief Ben Bernanke is to be believed.
That’s a great fantasy. But it’s exactly that: A fantasy.
Because despite man’s best efforts, we’ve yet to tame the business cycle. Instead, the Fed’s efforts to control the economy over the last 20 years have merely exacerbated it in a series of booms and busts that are growing in magnitude and the resulting fallout. The Fed held interest rates too low for a time in the late 1990s, blowing the dot-com bubble. It did it again, but more aggressively, in the early 2000s to fuel the housing bubble.
And now, the Fed has been doing it since 2008 to fuel a bubble of unprecedented size and scope.
It’s not just stocks that are overvalued, but bonds as well. You can see this in the way stocks are no longer responsive to downside earnings revisions and in the way bond yields no longer respond to increased corporate leverage at a time of peak stock valuations and very compressed bond spreads.
In other words, fundamentals don’t matter at a time of very high prices. Like when Las Vegas condo prices were justified by “home prices never go down” as mortgage affordability was plummeting. Or when money-losing tech IPOs were justified in the 1990s by the “Internet changes everything” meme.
A simple Taylor Rule analysis considering slack in the economy (which is narrowing as the unemployment rate falls) and inflation (with consumer price inflation already at 2.1% and rising) suggests the Fed should have already raised short-term rates to near 2% from 0% right now.
Put simply: Out of fear of pricking its massive financial bubble, the Yellen-led Fed is falling behind the curve. That will encourage further inflation gains. And inflation is ultimately the kryptonite that will end this fiasco. Because once inflation is unleashed, the Fed will have no choice but to smash its bubble to maintain faith in the U.S. dollar and prevent a catastrophic bout of “stagflation” — the combination of inflation and economic stagnation — of the type seen in the late 1970s and early 1980s.
Thursday’s job gains only make this worse be further narrowing the slack in the economy. The Congressional Budget Office estimates that “full employment” is currently at 5.8% — only 0.3% away from where we are now. At the current pace, we should hit that level by September or October.
When that happens, wage pressures will build and further lift inflationary pressures. And while that’s great news for working folks, it’ll force the Fed to acknowledge that it’s running out of justifications for cowardly holding interest rates too low for too long. Not only that, but a rise in labor costs will put pressure on corporate profit margins as well.
Remember, the Fed’s QE3 bond buying program is on track to end in October. Should inflation surge, as I expect, we could see the first interest rate hike much sooner than folks anticipate. Analysts at JPMorgan today moved up their rate hike estimate by three months from the end of 2015. But that’s still too optimistic.
The Fed could very well be forced to act by the end of the year.
The silver lining in all this is that the inequality gap between the wealthy and everyone else should finally start to normalize as corporate profits as a share of GDP normalize from record highs and labor share of income pushes higher.
My hope is that any stock market turbulence caused by the deflating of the Fed’s liquidity bubble doesn’t jeopardize this.
Click to Enlarge For now, I continue to recommend investors prepare for the tailwind of inflation with a focus on one of the few areas of the market not stupidly overvalued: precious metals and the related mining stocks.
Examples in my Edge Sample Portfolio include the leveraged ProShares Ultra Silver (AGQ) and NovaGold (NG), which are up 24% and 27%, respectively, since being added in early June.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he had recommended NG to his clients.