This Market Rally Is an Illusion: Two "Magic Tricks" Pushing Stocks Higher

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Stocks have been on a tear. After looking weak in February, when the bottom could have fallen out, stocks have soared close to 13% in a matter of weeks. We’re finally here: positive for the year, above the market’s important moving averages, above resistance, and just plain sitting pretty.

So why does it all feel like a magic trick? Why isn’t the market rally giving investors any solid feelings? Why is everyone so nervous?

The reason it’s hard to get a handle on the market is because the old free market is gone. The free market isn’t free any more.

There are two major forces manipulating markets right now – but it’s nothing more than smoke and mirrors designed to push stocks higher and give the illusion of healthy markets.

I’ll tell you what’s going on, who’s responsible, and what you need to do now.

Let’s get started…

The Manipulation Is Worse Than You Think

market rally
Of course, any discussion of market manipulation has to begin with the U.S. Federal Reserve.

Everyone knows the Fed and other central banks have been manipulating the markets for years through artificially low interest rates, quantitative easing experiments, and more.

But here’s something you might not know…

Instead of just buying sovereign bonds, central banks now buy everything from mortgage bonds to stocks. They’re even contemplating creating their own exchange-traded funds (ETFs) to sell to the public so they can then buy them back. Some central banks have even pushed interest rates into negative territory, which is itself proof positive they are completely out of control.

The manipulation is so deep, they’re so out on a ledge, all central banks can do to keep from losing control of markets and global economies is to keep manipulating in the desperate hope that global growth will bail them out of the holes they’ve dug for markets and themselves.

Here’s something else you probably didn’t know.

The real reason the Fed didn’t raise rates at the last FOMC meeting, even though the Fed’s all about being “data dependent,” and the data they’ve been looking for to start “normalizing” rates has been filling up their inboxes, is because they ran into a big problem.

The Fed conducts its “open market operations” – all the buying and selling of securities and bonds they do – through a group of 22 primary dealers – a bunch of big banks that includes Bank of America Corp. (NYSE: BAC), JP Morgan Chase & Co. (NYSE: JPM), and Goldman Sachs Group Inc. (NYSE: GS).

Well, last month those primary dealers got a ton of U.S. Treasury bonds dumped on them and could have lost billions of dollars if the price of those bonds tanked.

As primary dealers, they have to buy and sell Treasury bonds to maintain prices, keep markets trading, and to facilitate the Fed’s operations.

They ended up with over $121 billion in bonds last month, almost double the average of the past five years. Primary dealers had to buy those bonds mostly from foreign central banks and sovereign wealth funds who were dumping Treasuries to raise money to support their currencies, meet budgets, and liquidate assets they knew wouldn’t go down too much in price as they unloaded them.

If the Fed raised rates while its primary dealers were sitting on all those bonds, the price of those bonds would have tanked and the dealers would have lost billions in an instant. And that would have devastated the $13 trillion Treasury market.

Of course they weren’t going to let their bank constituents lose that kind of money. So they punted on raising rates.

There’s another reason the Fed didn’t raise rates… and it just happens to be the other force that’s goosing stocks at the moment.

And that’s not a coincidence.

These Numbers Are Hiding the Truth About Earnings Growth

Last week, I told you how trillions of dollars of corporate buybacks have boosted stock prices by creating the temporary illusion that earnings per share are increasing, which is what investors want to see (and is something the Fed would like to see before raising interest rates). But those gains are far too often temporary measures to manipulate stock prices higher so executives can cash out their fat options awards.

But there’s more to earnings manipulation.

There’s GAAP (Generally Accepted Accounting Principles) earnings and non-GAAP earnings.

I’m not an accountant, so I have to ask myself, and you have to ask yourself, if GAAP is based on accepted accounting principles, why would companies use non-GAAP accounting methods, which are by definition not generally accepted as being principled?

Because it makes their earnings look better…

Basically, non-GAAP accounting lets companies exclude certain losses from their accounting because they’re supposed to be one-time charges.

Most of these are related to items like costs of a merger or acquisition, restructuring charges, writing down goodwill, asset impairment charges, and other supposed one-time charges.

Of course, there’s a problem with principles when one-time charges keep recurring, as they tend to do too often under non-GAAP accounting.

The difference between GAAP and non-GAAP earnings is material.

For all of 2015, S&P 500 non-GAAP 12-month trailing earnings, also known a pro-forma earnings, came in at $118. GAAP earnings, however, were $87 for 2015.

That’s a huge difference.

Looking at non-GAAP earnings, investors would say earnings have been growing nicely. The truth is that GAAP earnings in 2015, after a seven-year bull market, are only about $5 higher than what they were in 2006 before the meltdown.

This is key – because even as the Fed talks up the “recovery,” such as it is, there’s no real, principled data underpinning the surge in stocks and the supposed growth in earnings. It’s all cooked up by creative accounting – and if the Fed were to raise rates in this environment, the entire house of cards would come down.

Want more proof?

The fourth quarter of 2015 saw non-GAAP earnings of $29.49, while GAAP earnings were $19.92. If that’s not manipulation, I don’t know what is.

One Thing You Can Do Now

An increasing chorus of analysts, from Societe Generale’s Andrew Lapthorne, to Deutsche Bank’s David Bianco, to Warren Buffet in his latest Berkshire Hathaway shareholder letter, are worried about the distorted view of earnings investors are being subjected to.

It’s no wonder investors aren’t sure the market rally is real.

They should be worried – and you should be, too.

The best thing investors can do right now is to contact your broker (or hop online if you manage your own investments) and put down stop orders to get out of your winners if a reality check knocks the market back down to earth.

And since the manipulation isn’t going to stop any time soon, and the market can be manipulated even higher, enjoy the ride as long as it lasts.

In the meantime, just keep raising your stops so you can take profits when the markets head back down.

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Why This Rally Reminds Me of 2008: It seemed for a minute that reality would bring some semblance of market-pricing to U.S. and global markets, because it’s much needed. But then central banks stepped in… again. Their blatant market manipulation is shocking, but these conditions have created some big opportunities for investors…

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