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Is a 'Melt-Up' Back in Play?

4 reasons why stocks are soaring...

As a BAD PENNY returns to its sender, or a dog returns to its vomit, investors are returning to the stock market, writes Brian Maher at The Daily Reckoning.

"All in" these gentlemen and ladies are going (or at least the computer algorithms that set market pace).

Lance Roberts of Real Investment Advice:

"With cash levels at the lowest level since 1997 and equity allocations near the highest levels since 1999 and 2007, it suggests investors are now functionally 'all in'."

You may recall sharply unpleasant events subsequent to 1999 and 2007 – after investors had become "all in".

Now that they are once again marshalling their poker chips...and shoving them out onto table's center.

Will Mr.Market break them once more – or do they possibly play a lucky hand this time?

First this question:

Why are these gamesters going "all in" now?

We believe we have the answer, revealed anon.

We first note the stock market has once again scaled the impossible heights.

All three major US indexes have recently established fresh records. And so the market has scaled its cliff face of worry.

Trade war, impeachment inquiry, a fading global economy, Brexit, the devil and any number of impediments...it has clawed above them all.

Affirms analyst Andrew Brenner of National Alliance:

"Brexit, impeachment, budget deficit, lack of a budget – none of those things are affecting the market at this point."

It is – in the parlance of the trade – "risk on".

Our spies even report fresh speculation about a possible "melt-up".

A melt-up is the glorious terminal phase of a bull market, when stocks reach fever heat – before melting down.

Melt-ups have preceded some of history's greatest collapses.

In the 18 months prior to the Crash of '29, for example, the stock market nearly doubled.

And the Nasdaq rocketed 200% in the 18 months before the dot-com mania peaked in 2000.

Yet that is a topic for an altogether different day. Let us instead concentrate our focus on this early November day...

Why are investors rushing back in now?

Several reasons suggest themselves...

Reasons 1: The Federal Reserve sliced interest rates last week – the third occasion this year – and for a total of 75 basis points. And as explains Raymond James:

"Over the last 30 years, when the Fed has implemented an 'insurance' rate cut policy of 75 basis points, the equity market has been 'lights out' as the S&P 500 has posted a 12-month forward return of about 23%, on average.

Reasons 2: Markets are again hopeful the United States and China will come to terms on trade.

Commerce Secretary Wilbur Ross announced yesterday the combatants were making excellent progress toward a "phase one" trade accord.

A successful resolution would lift tariffs on some $156 billion of Chinese exports, presently scheduled to enter force Dec. 15.

(Negotiations appear to have faltered somewhat today...for what it is worth.)

Reasons 3: Corporate stock buybacks this year – despite recent slackening – should nonetheless turn in their second-largest year on record.

Reasons 4: Stocks as a whole are surpassing earnings estimates.

These reasons and more we can cite.

But do they haul the full cargo of explanation?

We are unconvinced.

Is the primary reason the stock market once again scales record heights...and that poker chips are piling up on the table's center...

...because the Federal Reserve has been slyly hosing in floods of liquidity?

The short-term lending market nearly seized in September as liquidity ran dry.

The Federal Reserve's New York command center therefore grabbed the hoses...and gave the "repo" market a good soaking.

A temporary expedient, they labeled it.

But long experience teaches that nothing can be so permanent as a temporary expedient.

Furthermore, these same hoses will pump "at least" through next year's second quarter, says the Fed.

Jerome Powell insists these "open market operations" are not quantitative easing.

Apologists claim they are merely plugging a leak within the financial plumbing. And in detail, they may well be correct.

But these operations have expanded the Federal Reserve's balance sheet...precisely as if they were quantitative easing.

The balance sheet expanded over $50 billion in the first week of November, and exceeds $4 trillion.

"The Fed can deny that they're doing quantitative easing," argues permanent bear Peter Schiff – who styles current operations QE4.

He adds: "But they can't hide the numbers. They can't hide their balance sheet."

Is QE4, as you style it, even larger than QE3, Mr.Schiff?

"The Fed is expanding its balance sheet right now at about twice the pace that it was expanding its balance sheet when it was doing QE3. So QE4, whether they admit it or not, is much, much bigger than QE3, and it's going to continue, and it is going to accelerate."

And is QE4 responsible for the latest stock market spree?

"And that is what is driving the stock market...They're doing quantitative easing, and they're going to print as much money as they have to keep the markets going up and to keep the economy propped up."

Just so.

But stocks are vastly expensive by history's standards. By some measures today's valuations rise even above 1929's and 2008's.

Will today's lemmings make much money in this stock market – as they go hoofing for the cliff?

The odds strike us as...slim.

That is because the higher things rise, the further they fall.

Assume today's obscene valuations. From these heights, history argues the Dow Jones may plunge some 35% next time.

Meantime, we understand that options traders are lowering their guard of late.

These fine folks take out "call" options in anticipation market gains. They conversely take out "put" options to insure against losses.

When the number of calls runs too far ahead of puts, it is evidence the guard is down. And a lowered guard invites a blow.

That presently appears to be the case.

The last occasion the ratio of calls to puts attained current highs was on Jan. 23, 2018 – immediately prior to a market thumping.

We must assume investors presently streaming into the stock market will come ultimately to grief...as they did in 2001...and 2008.

When precisely, we do not know.

But "experience keeps a dear school," as Benjamin Franklin affirmed two centuries ago – and "fools will learn in no other."

Formerly an independent researcher and writer, Brian Maher is managing editor of The Daily Reckoning, the contrarian investment email launched in 1999 and now read by over half-a-million people worldwide each day.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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