Friday, the fat lady sang

I didn’t see this rally coming. Neither, it seems, did a lot of the institutional investors who missed out on the all-important initial stage of the rally, which is typically where 50 percent of the gains are made. And, like a lot of bears, I got hammered when the expected snap-back didn’t happen in late March, then again last week, when despite the indicators turning south, the final blow-off top drove inexorably upward for an almost unprecedented 11 days out of 12.

But I’ve been wrong before and if there was no risk, there would be no reward. What’s important is to realize that there are two possibilities from this point. Scenario A is that the CNBC cheerleaders are right to be jumping up and down, excitedly waving their pom-poms, and the October lows mark the start of a new bull market. Their arguments are that inflation and interest rates are low, the economic indicators, while negative, are not worsening at the same pace as before and are therefore positive, and that corporate earnings will increase dramatically in the fall thanks to the economic growth that is just around the corner. This will justify the optimistic pro-forma earnings-based valuations, which in Generally Accepted Accounting Principle terms again exceed those of pre-crash 1929.

This scenario is not only rosy, but is about as likely as monkeys flying out of Alan Greenspan’s beknighted butt. I’m down with Scenario B, which is that this is just another bear-market rally – the sixth since the bear first growled in early 2000.

While the impressive scope of this rally, 27.71 percent on the S&P 500 in 61 days, exceeds the average bear rally, (24.10 percent in 28 days), this only indicates that the present rally is a rather labored one due to collapse of old age and exhaustion. And despite taking more than twice as long to reach these heights, the Dow’s peak is still .29 percent short of average, and the Nasdaq-100 is 11.61 percent short.

But averages only indicate probabilities. What is perhaps more important is to understand the actions of the market makers. You see, when the Fed talks about its fears of deflation, it is not talking about deflation in the general economy, it is talking about deflation in the asset markets, since by any reasonable measure, the U.S. economy is in the deadly grips of massive inflation. Inflation is when the money supply increases faster than the economy grows – it is not, as most people think, an increase in consumer prices as measured by the CPI – and the Fed’s three measures of money supply have all been growing around 13 percent, far faster than the feeble 2 percent increase projected in the GDP.

So, until recently, have the Fed’s market operations, which is the money it loans out to banks that use it to buy stocks or currencies, then sell them and repay the Fed, usually the very next day. It’s worth noting that in the last two weeks, the Fed has reduced this liquidity pool by 40 percent. This isn’t a definitive sign, but in conjunction with the rally’s age and performance, it suggests that the Fed feels that it has done its job of stabilizing the situation and can safely allow the market to decline for the next two or three months without fear of a terminal crash.

This isn’t conspiracy theory – the Fed openly manages the bond and mortgage markets, so why would one believe the equity markets are magically off limits? Especially since there’s nothing the least bit unusual or illegal about the central bank lending money to its member banks in the first place. Remember, since the Fed is considered responsible for managing the economy, it would be downright derelict in its duty if it simply ignored one of the more important markets.

Finally, for those who only pay attention to price action, last Friday was truly intriguing. Just as on Dec. 2, 2002, the Nasdaq-100 raced up more than 2 percent at the start, only to reverse abruptly and finish well below its peak. The significance is that Dec. 2 marked the end of the last rally, so if we see a similar 9 percent decline in the Nasdaq this week, that will be all the confirmation we’ll need to know that, on Friday, the fat lady sang.