How High Is ‘High’

April 6, 1998 – Ever since the Dow Industrials Average made a new record high in early February, I have been warning that one should play the market from the long side, or don’t play it at all. It is now very apparent what I meant and why I was making this warning. The Dow has surged higher, and though there have been some scattered pockets of weakness, over the last couple of months and 1000 Dow points the short sellers have for the most part been massacred.

Even though it seemed clear to me that stocks were headed higher once they broke into new record territory earlier this year, I have not recommended any trades to buy stocks during this surge. I didn’t think it prudent to do so. And though stocks are probably headed higher still, it still isn’t prudent to jump aboard in my view. The opportunity to participate in this advance is one best left for traders, not investors.

Given the outrageous valuations on stocks (as measured by book-to-market, high P/E’s, low dividend yield, and all of the other valuation methods that have proven their worth time and again), stocks have little fundamental reason to be trading at the prices they have reached. Therefore, the market is a high-risk proposition at the moment.

Consequently, the stock market is highly vulnerable, which means that this recent uptrend clearly has the potential to turn on a dime into a nasty downtrend. Therefore, because I like to sleep peacefully and without worry at night – and presumably subscribers to this letter share this very sane objective – I prefer the safety of the sidelines. I’ll leave the high-wire act to the nimble and fearless traders, and put my trading capital in the safer play – like buying the precious metals. Nevertheless, even though I have chosen not to play this latest rally in the Dow, it will be useful to share some of my thoughts on where the stock market is headed from here, particularly because some of you may be surprised to learn how much higher I think the Dow has to travel.

My conclusion about the heights yet to be reached by the Dow have little to do with American economic prowess. But it does depend upon the manipulation and debasement of the US Dollar.

I have discussed this point many times before, most recently in Letter No. 219. I noted that because of the loss of Dollar purchasing power, it may prove to be beneficial to own stocks rather than Dollar denominated instruments like T-Bonds, bank time deposits, T-Bills and the like. And in recent years it has indeed proven beneficial – stocks have clearly outperformed bonds. But there is also another factor at work, causing the Dow to plow ever higher, and it is one point I have not yet discussed in these letters.

The Dow has become commoditized. Stocks are trading more and more like commodities trade, and this result is the direct consequence of one element introduced into the stock market in recent years – the use of leverage. It is leverage that explains why commodities are viewed to be such a dangerous game.

For example, it was a very big deal for crude oil to have moved from $18 to $13 earlier this year, a decline of 28%. However, it is a frequent and regular occurrence forany one stock to move from $18 to $13, or vice versa. In reality stocks regularly demonstrate much greater volatility than commodities, but until recently, stocks did not offer the leverage available when trading commodities. Consequently, stocks were viewed to be the safe play, while commodities, even though they exhibit less price volatility when compared to stocks on a non-leveraged basis, have been considered the risky play. These labels need to be switched because of the leverage now being regularly used in stocks.

The leverage has slowly crept into the stock market in a number of ways. These include the increasing use of: options on stocks, futures contracts on stock indices, and options on stock index futures contracts.

Leverage is also coming into the stock market in more traditional ways – through debt. Reports show that home equity loans are being used to finance stock purchases. There are even reports that some wild-eyed individuals who do not understand the risks are using credit card debt to purchase stocks.

Regardless how this leverage manifests itself, the result is dangerous. The result is too much money chasing stocks. What is worse is that these conditions are being fueled by an ever docile Federal Reserve, which has apparently turned a blind eye to the obvious speculation going on around it. The Fed continues to open wide the monetary spigots. I estimate that the 12-month growth in M3 ending March 31st is 9.8%, the highest rate of growth in money since 1985! In contrast to the 1970’s when newly created money was used to chase ever higher the prices of tangible assets, today’s newly created money is going into the stock market, chasing ever higher the prices of stocks.

The result is that the stock market mania will end much like the mania in a commodity market ends – with a ‘blow-off’ top. A good example of a blow-off top was Gold’s memorable climb from $430 in September 1979 to $850 in January 1980, nearly a 100% advance in less than five months.

Am I suggesting that stocks are about to repeat Gold’s performance and nearly double within the next five months? Well, I won’t say it will happen, but then again, I surely won’t say that it will not happen. My point is that anything is possible from here!

Stocks are entering a blow-off stage. There is a lot of momentum behind the stocks market. Money is being created at a blistering pace, and this money is fueling the stock market advance.

It’s outrageous. It’s insane. It’s high risk. But it is a blow-off, and crazy things happen when a blow-off occurs. Just think back to Gold and those last few months in 1979 as an example of what may lie ahead for the stock market.

So how high do I think the stock market is headed? My best guess is that the Dow has the potential to reach 12,000 to 14,000, and to get there sometime within the next six to nine months. Thereafter comes the bust, and the inevitable reality.

Stocks don’t go up forever. Just like every other market, and particularly leveraged commodity markets, the stock market is not a one-way street. It never has been, and it never will be.