Stock markets are rising, economic statistics are improving and economists are rushing to proclaim the end of a recession that, compared to recessions past, is quite long in the tooth. While some quibble with the official dating of the recession to the fourth quarter of 2007, if one takes that as the starting point, the recession is now seven quarters long and the longest in the post WWII period. In my opinion that is an optimistic account of the post 2000 period. The reality is that the performance of the US economy has been subpar for quite a bit longer than most are willing to admit.

Much of what we think we know about the markets and the economy is an illusion. As an illustration of what I mean, consider the recent revelations regarding the use of high speed data connections and computers to facilitate what is known as High Frequency Trading (HFT). I won’t go into a detailed explanation of the inner workings of HFT, but what it amounts to is what we once called front running. Front running refers to having advance knowledge of incoming orders for a security and trading on that information to book a riskless profit. HFT works by allowing a few select firms to see incoming order flow a fraction of a second before everyone else. Using high speed data connections and computer algorithms, these favored firms are able to place orders before the information is available to the public.

HFT is said by some to account for as much as half the volume in US stocks and proponents claim that it adds liquidity to the markets, but the way it is practiced provides nothing more than the illusion of activity.

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

Scalping a few pennies from every stock transaction while providing no benefit to the market (on the contrary, causing real harm) does not enhance the economic well being of the US. Much like government taxation, it merely transfers wealth from one group of citizens to another. The fact that the transfer is from the general public to the shareholders and employees of Goldman Sachs, JP Morgan and a few others should not surprise anyone after all that has happened over the last two years. 

So, HFT provides an illusion in two ways. First it creates the illusion of activity in the stock market, rendering useless the volume statistics provided by the various exchanges. Second, it creates the illusion of wealth creation at the various entities using the practice. These banks and hedge funds aren’t creating wealth anymore than a bank robber creates wealth by liberating the contents of a bank vault for his personal use. Of course, like the bank robber, the recipients may spend their ill gotten gains thereby converting savings and investment into consumption and perpetuating another illusion.

Like HFT, the economic statistics released so regularly onto the unsuspecting investing public provide an illusion of activity masquerading as economic recovery. The statistics that feed into the calculation of GDP tell us quite a lot about the quantity of activity in the economy. They tell us very little about the quality of that activity. We know that money creation by the Federal Reserve can produce economic activity. The steadily rising GDP of the middle part of this decade is evidence of that, but does anyone still believe that it was real growth? Does anyone believe it was productive activity? Did we really need all those vacant houses now residing on the balance sheets of the nation’s banks? Does anyone still believe that real wealth can be manufactured by the Federal Reserve? 

Wayne Angell, a former Federal Reserve governor, recently said on Larry Kudlow’s show that monetary policy always works and I guess to some degree he is right. The artificial suppression of interest rates and the creation of new money does work in the sense that it creates economic activity. But we now also know, or should know, that there is a price to be paid for growth generated through such means. We have had two market bubbles and two spectacular crashes in the last ten years. If that isn’t enough to convince us that we are doing something wrong, I don’t know what will.  

Apparently, for stock market participants, the quality of the recovery is irrelevant at this point. A recovery in activity, even if caused by the inflation of the Federal Reserve, moves earnings and earnings move stocks. The expansion of the Fed’s balance sheet is not likely to show up in the official inflation statistics anytime soon, so as activity rises so will GDP. But make no mistake, this inflation is no different than the last one created by Bernanke and while he laid out his “exit strategy” in the pages of the Wall Street Journal last week, anyone who believes he can execute that plan with perfect timing and/or scope has a faith in his abilities that I can’t muster. I also don’t believe in unicorns or altruistic politicians.

True growth and wealth creation are not a product of monetary policy or government spending. Wealth is created as a nation in the same way it is produced by individuals. It cannot be conjured out of the illusions presented to us by politicians and central bank governors. What happened last fall was an attempt by the market to unveil the wizards of monetary policy for the frauds that they are. That Bernanke has managed to close the curtain again does not mean that the illusion is real. Economic growth is produced by the savings, investment and productive activity of individuals pursuing their own goals. Until we remember that, we will continue to live in a world that is nothing more than a grand illusion.

The economic statistics released last week were generally supportive of GDP growth. Leading economic indicators rose for the third straight month. Mortgage applications rose again even with higher rates. Jobless claims rose but less than expected. Claims are still being distorted by seasonal adjustments, but that is nearing an end so we’ll get a better picture over the next few weeks. Continuing claims fell, but I’m a bit wary of calling that a positive since a lot of people are just moving from state rolls to federal for extended benefits. There are roughly 3,000,000 unemployed who have exhausted state benefits and are now receiving extended benefits from the federal government. Existing home sales also rose and inventory fell. The housing market is slowly getting back to balance but with inventories still over 9 months worth of sales, there is a long way to go.

The stock market continued its winning ways last week as earnings continued to come in better than expected. It may be an illusion, but for investment managers who have remained in the bear camp all year, that is irrelevant. Lagging performance in a bull market is the stuff pink slips are made of, so the bears are feeling the pressure to participate right now. The S&P 500 moved to a new high for the year as the previous resistance at 950 gave way to the bulls:

I don’t know (and neither does anyone else) how much higher the market can carry, but I suspect it will be quite a bit higher than most expect. Earnings estimates are probably still too low and market sentiment is still too negative. Critics have complained that cost cutting is the source of higher earnings and therefore can’t be duplicated, but my guess is that these same critics are probably underestimating the effects of monetary and fiscal stimulus. GDP growth coming out of this recession, for a variety of mathematical reasons, is likely to be much better than expected. In the past, recoveries have been symmetrical with the depth of the recession and I see no reason to believe this time will be any different. So, I’ll go way out on a limb here; my target for the S&P 500 is  1100 - 1200. That doesn’t mean we won’t get some corrections along the way, but the trend is up and technically that is the next logical target.

Keep your eye on the Treasury market this week. Longer term Treasuries have been in a bear market all year and next week brings the auction of roughly a quarter trillion dollars worth of new supply. Increasing supply and declining demand is a recipe for lower prices:

IShares 7-10 year Treasury ETF

Corporate bonds, investment grade and high yield, remain in the bull camp. Frankly, I’m a little nervous about these markets as everyone seems to love them, but for now buyers have the upper hand. As Treasury yields rise and corporate yields fall there will come a point when this no longer makes sense, but apparently we aren’t there yet:

IShares High Yields ETF

IShares Investment Grade Corporates

If you would like to receive this weekly update by email, click here.

Significant Earnings this week:

Monday: Amgen, Honeywell, SL Green Realty, Verizon

Tuesday: Agco, Banco Bilbao, BP, Deutsche Bank, FPL Group, Potlatch, Rockwell Automation, Teva Pharma, US Steel

Wednesday: Aetna, Agnico Eagle Mining, Arcelor Mittal, Banco Santander, Cerner, Conoco Phillips, Daimler, Equity Residential, General Dynamics, Goldcorp, Hartford, Ryland Group, Sanofi Aventis, Time Warner, Vale, Visa, Wellpoint, Oppenheimer Holdings, Taiwan Semiconductor, The Travelers

Thursday: Alcatel Lucent, Apache, Astrazeneca, Cigna, Colgate Palmolive, Cummins, Exxon Mobil, Goodyear, International Paper, Kellogg, Mastercard, Metlife

Friday: Autonation, Chevron, MDC Holdings

Selected charts:

As I predicted last week, commodities recovered quickly. :

The dollar is barely holding support. It will be interesting to see if the bulls can mount a rally here with massive Treasury supply hitting the market:

Gold had a decent week, but remains in the previous range bound trade. If the dollar finally breaks down, gold may finally be able to break out above the $1000 mark:

Natural gas may be trying to make a bottom. I tried calling a bottom once earlier this year and got stopped out, but it is very cheap now relative to oil, so either oil is coming down or nat gas is going up. Maybe a little of both:

I still favor foreign stocks over US. Some favorites are Hong Kong, Brazil, China, South Korea (which reported good GDP numbers last week),  and Taiwan:

Hong Kong

Brazil

China

South Korea

Taiwan: