Fundamentals Rendered Irrelevant by Fed Actions: Probability Based Option Trading

The fundamental backdrop behind the ramp higher in equity prices in 2013 is far from inspiring. However, fundamentals do not matter when the Federal Reserve is flooding U.S. financial markets with an ocean of freshly printed fiat dollars.

As we approach the holiday season, retail stores are usually in a position of strength. However, this year holiday sales are expected to be lower than the previous year based on analysts commentary and various surveys. This holiday season analysts are not expecting strong sales growth. However, U.S. stocks continue to move higher.

Earnings growth, sales growth, or strong management are irrelevant in today’s stock market. In fact, the entire business cycle has been replaced with the quantitative easing and a Federal Reserve that is inflating two massive bubbles.

Through artificially low interest rates largely resulting from bond buying, the Federal Reserve has created a bubble in Treasury bonds. In addition to the Treasury bubble, we are seeing wild price action in equity markets as hot money flows seek a higher return. Usually fundamentals such as earnings, earnings estimates, and profitability drive stock prices. However, that is not the case lately. 

Chart by www.zerohedge.com

The chart above illustrates that fundamentals are becoming irrelevant. What matters most is the flow of fresh liquidity out of the Federal Reserve and into the banking system. This process fuels more risk taking and pushes money into high risk assets.

The chart below, from Thomson I/B/E/S, demonstrates that the future outlook is not any better.

As can be seen above, over 90% of the S&P 500 companies have already reported negative 4th quarter 2013 pre-announcements. Essentially, these companies are warning equity investors that earnings expectations are going to be lower than expected.

Normally this would be seen as a headwind for equity prices particularly because the ratio is the worst on record. However, equity prices have rallied straight through the dismal earnings data.

In addition to earnings, global leading indicator analysis from Goldman Sachs is also issuing warning signals. The Global Leading Indicator Swirlogram is showing decisively that global leading indicators are slowing down and moving toward possible contraction.

On top of consistently lowered earnings estimates and forward guidance in S&P 500 companies at the worst levels on record, we are seeing evidence that suggests the global economy is slowing down. So how can risk assets be rallying?

The weekly chart of the S&P 500 Cash Index (SPX) going back to the beginning of 2012 tells a rather compelling story. The S&P 500 Index in that period of time has rallied by more than 43% as shown below.

However, the past 6 – 8 weeks have seen prices move higher. In fact, the last time the S&P 500 Index had 7 consecutive weeks of higher prices was back in 2007. In light of the negative fundamental data, this is the price action we see.

Prices could go higher and likely will go higher if the Federal Reserve continues to accommodate the U.S. capital markets. However, as prices move higher and bears continually get run over at some point a correction or possibly worse could begin. Clearly a bubble has formed in Treasuries, but if this type of price action continues a bubble will form in equities as well. Several financial pundits are beginning to discuss this possibility.

Financial pundits and asset managers are beginning to come forward to discuss their views that equities are at full value and are forming a possible asset bubble. Famous investors and portfolio managers like Larry Fink and Carl Icahn have stated recently that they believe the U.S. equity market is moving into dangerous territory where large corrections could be looming.

Furthermore, in a recent interview with Fox News, renowned economist and political pundit David Stockman made the following statements:

“This is the fourth bubble the Fed has created through easy money and printing press expansion.”

“The Fed has taken itself hostage.”

“This is a destructive poisonous monetary medicine that is being put into the system that is distorting all kinds of economic mechanisms with mal-investments on a massive scale.”

Stockman concludes that “its like 2007 – 2008 all over again.” Whether the bubble exists in the Treasury market or in U.S. equities is hard to say. In fact, we maybe witnessing bubbles in both asset classes and history says the endgame will likely end badly.

I want to be clear that many times bubbles are viewed in hindsight and we may be months or even years from the top. The Federal Reserve has a horrible track record. They have dramatically reduced the U.S. Dollar’s purchasing power and reduced stimulus too late since their inception. 

While prices may continue higher for months or years, history suggests the endgame will be ugly for those who chased the speculative bubbles.

In closing, I will leave you with a quote from a recent interview with legendary investor Jim Rogers, “The Fed will self-destruct, before the politicians realize what is going on.”

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This material should not be considered investment advice. J.W. Jones is not a registered investment advisor. Under no circumstances should any content from this article or the OptionsTradingSignals.com website be used or interpreted as a recommendation to buy or sell any type of security or commodity contract. This material is not a solicitation for a trading approach to financial markets. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This information is for educational purposes only.