April 29, 2010

Why Bernanke's Comments Are Suspicious

Until stock prices drop, it doesn't matter whether the rally is real or fake. But once prices drop, a fake bull will give way to a meltdown.

Part of a Federal Reserve chairman's job description is to be positive. Can you imagine the effect a panic-stained comment from Bernanke on the market?

Perhaps that's why neither Bernanke nor Greenspan openly admitted the sub-prime mortgage debacle until it was too late. Even in 2007, Mr. Bernanke stated that the Fed "does not expect significant spillovers from the subprime market to the rest of the economy."

As of recent, the tone has changed a bit. Even Mr. Bernanke has admitted to serious problems albeit in a subtle way. Below are some excerpts from the most recent Fed meeting along with out-of-the-box explanations.

Fed statement:

"The staff did make modest downward adjustments to its projections for real GDP growth in response to unfavorable news on housing activity, unexpectedly weak spending by state and local governments, and a substantial reduction in the estimated level of household income in the second half of 2009."

Reality:

GDP was lowered from its initial projection once again. Real estate remains the troubled sector and housing income is not recovering. Private sector spending remains muted.

Much has been written about strategic mortgage defaults lately. Bank of American is fielding more than 125,000 calls a day from people seeking mortgage help. Hundreds of thousands haven't made a mortgage payment in more than a year.

That is hundreds of thousands of home-owners who decided that they won't pay the mortgage on an underwater home. The only way banks (KBE) could motivate mortgage holders is to reduce the loan principal. If banks were to do just that, they'd have to report some $500 billion in losses, so they don't.

Meanwhile, the banks can successfully hide a big black hole, called shadow inventory while home-owners spend their mortgage money on the new iPad or flat screen TV. How does that affect GDP?

Fed statement:

"Real disposable personal income in January was virtually unchanged from a year earlier and would have been even lower in the absence of a substantial rise in federal transfer payments to households."

Reality:

Despite massive government stimulus and billions of dollars freed up via strategic defaults, disposable income is the same as it was in January 2009. We look at the GDP and wonder how much of it is based on real economic growth?

By extension, it would be prudent to ask how much of the 75 percent gain in the S&P and many other indexes is based on real growth? How much of the profits that financial corporations' are reporting are "true" profits?

Fed statement:

"While recent data pointed to a noticeable pickup in the pace of consumer spending during the first quarter, participants agreed that household spending going forward was likely to remain constrained by weak labor market conditions, lower housing wealth, tight credit, and modest income growth."

Reality:

Even Mr. Bernanke expects household spending to remain constrained by weak labor conditions. The employment picture is the lynchpin for the U.S. economy. Without jobs, consumer spending won't see real growth, real estate will continue to fall and banks will continue to hoard money rather than lend money.

The tale of the artificial bull

Fool's gold and real gold look the same and until you use it as payment it doesn't matter whether you have the real or fake stuff in your vault. The same is true with rallying stocks. Until prices drop, it doesn't matter whether the rally is real or fake. But once prices drop, a fake bull will give way to a meltdown, while a real bull will recover and move higher.

Valuations are one way to distinguish a real bull from a fake bull. The ETF Profit Strategy Newsletter offers a detailed analysis of trustworthy and commonly used valuation metrics - P/E ratios, dividend yields, Dow measured in gold - and compares today's prices with valuations seen at historic market bottoms.

Having a positive attitude is not an investment strategy. It's simply an approach that renders you a genius in a bull market. But what happens when the market turns? Do you remember 2008?

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