SEC will be market's undoing

Another crash is inevitable, and it'll likely be because of high-frequency trading, not Fed policy.

By Jim Cramer Oct 19, 2012 9:08AM

TheStreet.com LoGo Image Source SuperStockAre higher stock prices bad if they occur partly because the Federal Reserve is wrecking the competition in the financial supermarket?

 

On the 25th anniversary of the 1987 crash, we are going to hear a lot of bubble talk. It's natural. We are reading not only about how it can happen again but that it has to happen again. We are reading, moreover, that this may come about because the Fed is facilitating a stock market bubble with easy money.

 

First, I agree that another crash is inevitable. But I don't think it will be because of the Fed. I think will be because the stock trading system is too fragile, lacking in any serious regulation, and because the sacrifice of integrity for speed seems to have been blessed by the Securities and Exchange Commission.


It is almost as if the SEC has decided that we have a need for speed, like the big video game I have at home in the basement, even as there is no definable benefit from speed to capitalism or capital formation and preservation. This speed altar, on which we sacrifice regular investors, is a vestige of a previous administration that thought volumes would be endlessly growing and that speed could only make things fairer.

 

Instead it has dramatically unleveled the playing field and helped destroy the image and respect of an asset class.

 

What makes a crash inevitable is the unwillingness of the SEC to even question the notion that financial innovation could be malevolent, especially as it applies to something that speeds up trading.

 

Everything happens too fast for humans to stop it, yet the benefits of the speed simply aren't there. Go ask anyone involved in Thursday's Google (GOOG) release. Speed overwhelmed the system and the company, and neither was ready for it.

 

We have unleashed the Terminator, and we know it, because the government simply supported endless, mindless innovation to benefit a few well-capitalized hedge funds -- innovation that will lead ineluctably toward a second, more lasting flash-type crash.

 

Ironically, as it's known by people who remember and traded through the crash 25 years ago, that one was artificial, too. It was caused by a belief that the S&P 500 ($INX) futures could be used as insurance to hedge what had been bountiful gains. When the selling in those futures engulfed the market, it simply wasn't big enough to handle the blitz of orders all coming in on one side of the ledger.

 

It was, in some respects, a flash crash of its own. We just didn't know it. I regard it as a flash crash because it ended up having nothing whatsoever to do with the economy.

 

That brings me back to the Federal Reserve and the so-called pumped-up positions of stocks in this market. I would never disagree with the notion that the Fed has robbed us of a chance to invest in fixed income, because interest rates are just too low to generate an acceptable and responsible return. However, the notion that stocks are somehow pumped up en masse by the Fed seems far-fetched to me.

 

Here's why. Despite the endless attempts to aggregate values of companies by lumping them together in the S&P, an amazingly precise valuation process of individual stocks is occurring.


The ones that give you good quarters are getting revalued higher. The ones that give us bad quarters, like Google, IBM (IBM) and Intel (INTC), are going down -- although, despite endless negative chatter here, I wouldn't count them out.

 

If the Fed were pumping up all stocks, you wouldn't see that bifurcation. It couldn't exist. All boats would be lifted by the fire hose in the lake.

 

Second, if you insist that we look at the market in aggregate, when the market went into the crash of 1987 it was selling at 29x earnings, in part bid up not by the Fed but by the Japanese, who used to buy U.S. stocks without any price sensitivity. It was, alas, insane, and it was one of the chief reasons my hedge fund had been in 100% into the crash. Boy, was it hard to find anything that didn't trade at a high multiple in the teens.

The S&P now sells at 14x earnings, less than half of what it did in the 1987 crash -- hardly dangerous historically, especially when you consider the return of fixed income. That is why I think the next crash will be precipitated not by the Fed but by machines that are indifferent to valuations.

 

In the S&P, as with any average, there are some stocks that pull the averages up, even as there are others that sell well under the average. So the question is: Are the ones well above the average "crashable," so to speak, because of their valuations?

 

There are two groups of stocks that are jacking the averages higher: dividend stocks and tech stocks, the latter which account for about 20% of the S&P. That is, by far, the largest segment of the average, although 5% of the whole S&P is Apple (AAPL).

 

The dividend stocks might genuinely be inflated to some degree because of a desire to get an above-average dividend, courtesy of the Fed's plan. The real-estate investment trusts, for example, have been bid up endlessly in a reach for higher yield, and they are no longer acceptable as a way to beat fixed income. But before we finger that group as a potential catalyst, we have to remember that the REIT sector has outperformed the averages every 10, 20, 30 and 40 years -- the only group that can claim that record of outperformance -- so I am reluctant to trash it. That's too good a record.

 

Consumer packaged goods and drug stocks have also given above-average yield at a higher-than-average price-to-earnings multiple. But be careful about betting against them. Their consistency in a low-growth environment causes money to go into them anyway, and that's more important than any yield competition that the Fed has engendered.

 

Then there is tech. That's the segment that's wrong, even as Apple itself, the stalwart of the group, trades at a market multiple. That's the segment that's been exposed this quarter as the S&P's soft underbelly, as we saw Thursday from Google. The company missed numbers for multiple reasons having to do with a shift from desktop to mobile, and from a failure to deliver what its advertisers wanted.

 

Of course, Google is hardly emblematic of the group, even though its performance Thursday sure had been. The sector is led by semiconductors, which sell on average at a too-rich 20x earnings. Sorry -- I think after the events of the past few days tech can have another step down before it can find its footing. It's just too overvalued as an entire chunk of the S&P.

 

But how about the huge number of stocks that trade below the market multiple? Those are led by the underowned banks and industrials. Both are undoubtedly undervalued if housing is indeed coming back, which it sure seems to be. After all, the current rate doubles the number of homes built from just a couple of years ago, and China looks to be coming back, judging by the numbers we saw this week.

 

Yes, there is plenty of evidence that China is turning, from the rise in materials prices to the increases in Baltic Freight. Don't believe the bears. China is bottoming, and the "China plays," after two seasons of swooning, are now in ascendance.

 

So while the Fed has forced money into the market, you have to look at individual sectors and individual stocks. When you do that, you will be pleasantly surprised to see that the groups, other than tech, can't be called historically overvalued at this point in the economic cycle.

 

Despite a desire by so many people to point to a Federal Reserve-inspired bubble that must lead to a crash, the valuations point to anything but such an elevation. Nonetheless, I expect another crash to occur because of the SEC's laissez-faire attitude toward markets that can hurtle down in the blink of an eye because of high-speed trading.


But given the earnings I'm seeing, and the immense profitability we're getting from companies away from tech, you'll want to buy that crash when it occurs. That's because it will have been inspired by the federal government, just not from the branch you expect.

 

Here's the bottom line: Indeed, on the 25th anniversary of the crash, I certainly expect another one to occur. But I don't think the Fed won't be on the hook. That crash will be all on the SEC.

 

Jim Cramer, thestreet.com 

 

Jim Cramer is a co-founder of TheStreet and contributes daily market commentary to the financial news network's sites. Follow his trades for Action Alerts PLUS, which Cramer co-manages as a charitable trust and is long GOOG, IBM and AAPL.

 

 

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166Comments
Oct 19, 2012 11:43AM
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The SEC has totally given up any pretense at regulating the markets to maintain a level field for ALL investors. The SEC does not care about investors...they only care about traders.

The leadership of the SEC belongs in prison, as they are far more corrupt than Bernie Madoff!

Oct 19, 2012 11:47AM
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Btw don't people ever wonder why these pundits and CNBC folks are always praising CEOs who take "$1" in salary like they are martyrs...

Rarely mentioned is the fact that they get most of their compensation in stock options which are taxed at 15% now and 0% under romney .......they are gaming the Govt (that's you and me) out of payroll, social security taxes etc etc etc ...

Why can't we have a 2 tier capital gains tax......if you use your own money for investment and make a profit ZERO CGT but if the options are compensation in lieu of salary tax it at 35% ....
Oct 19, 2012 12:35PM
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Look The economy collapsed for one reason.   People gambled in real estate with BORROWED money.   

We need a simple rule.  No Federally insured bank may make a real estate loan without 25% down.  We have margin rules for stocks and commodities, why not real estate?  

Had we had this rule many deadbeats would have been kept out of the real estate market. Canada has such a rule, and they have not experienced any real estate melt downs.

Until we have such a rule in place we have the potential for another speculation bubble.  
Oct 19, 2012 11:35AM
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high speed trading is the way they make money now.  catch a few billion pennies every 5 minutes.  it's a classic engineering response equation now.  hardly means a thing about fundementals of the company values.  just quick in and out's
Oct 19, 2012 11:39AM
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The reason we even have the market where it is now is the present administrations decision to infuse money to maintain a false sense of confidence.  Picture this folks.  Free trade is like going and giving blood.  You know how you have a needle in your vein and your heart pumps YOUR blood into a vial intended for someone else. The present trade policy of our elected politicians is designed to do exactly the same. The American citizen is sending his/her money overseas and to those holding stock in International Corporations. That same citizen as a group can not by design ever be able to replace that money/blood and in time will expire.  The unemployed and the pressure to reduce American workers salaries guarantees this expiration.  The transfer of American wealth to the richest folks in America and the citizens of other countries willing to accept a lifestyle less than ours is where all of our lifeblood is and is intended to go.  Like it or not this is the reality of our time.  When a certain amount of American blood is gone and the transfer reaches a certain level the America we know will  die and the Corporations in this market go with them.  Seems soo simple and sooo certain.
Oct 19, 2012 12:34PM
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The SEC as a regulatory agency tasked to protect the public is WORTHLESS ! The head of the SEC belongs in Federal Prison along with Jon Corzine, Jamie Dimon and LLoyd Blankfien( I AM DOING GOD'S WORK) Goldman Sachs GANG !  Let Bernie out he has done 6 years and put these 3 Criminals in to replace him !
Oct 19, 2012 11:24AM
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High speed trading and computers lack on of the most important parts of there programming and that is common sense!!!
Oct 19, 2012 2:07PM
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The stock market is a wage-busting ponzi scheme.

And the futures market..

40% of the price of gasoline at the pump is caused by speculation and the speculators that work the market.

40%.


Oct 19, 2012 1:03PM
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The SEC is a toothless tiger. It has the power but not the resolve or congressional support to do their job. Congress does not want to bite the hand that feeds them. As a result the SEC is significantly underfunded by intention and unable to perform their duties in an effective way. The staff at the SEC has been demoralized for years knowing that their leadership is recruited from Wall St. who are sympathetic to those they are charged to oversee. Hence, with limited resources and a hostile congressional attitude the SEC only pursues high profile cases hoping that their actions will serve as a deterrent. If you want real SEC oversight, it needs leadership not related to Wall St and a doubling of staff and hands - off policy by congress.
Oct 19, 2012 11:50AM
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 I think will be because the stock trading system is too fragile, lacking in any serious regulation,

=======================================                                       ********************

 

My God Cramer, the "R" word...regulation.....worse yet, serious regulation.....just to protect people from abuse, you must be a commie liberal Marxist!  The GOP/TP will be after your job now.

Oct 19, 2012 1:31PM
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I found it rather odd we sentence a couple Koreans to prison for attempting to price fix the flat screen TV market.  How about the big bankers fixing LIBOR?  Lets see some prison sentences for the price fixing of LIBOR by all those big bankers.  Bring about some parity in the manipulation of all markets.  Put some big bankers behind bars. 

 

We have some real panty waste prosecuters who are controlled by big banks.  Don't forget most end up employed in that private sector.

Oct 19, 2012 12:06PM
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 Jim became a Democrat when he announced to the world on CNBC that his own DAD was not going to be able to vote in PA thanks to the new voter ID law. Oh the irony of it all
Oct 19, 2012 2:11PM
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This isnt the big fall alot of people know is coming but its a very small taste of it.

 

Oct 19, 2012 2:43PM
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Bye Bye Wall street and the stock market, I will not miss you at all. The U.S would be better without you. The rich will be a little pissed off, because they won't have the inside edge anymore, and might have to get a 9 to 5 job. Oh No!!!
Oct 19, 2012 11:57AM
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 Th computer has made a LOT of professions obsolete. What's a few more
Oct 19, 2012 10:19AM
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Market collapse October 2012 ! TAKE YOUR MONEY AND RUN  !
Oct 19, 2012 1:30PM
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Every significant move in the market these days is generated and exaggerated by computers using so-called smart technology.

 

Here’s an analogy to think about. The next time you’re driving down the road at 65mph, and for some strange reason your GPS tells you to take a left turn in 30 feet, imagine what would happen if it took control of your car and actually did it.

Oct 19, 2012 11:06AM
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Well here we now have it friends......Housing really down, earnings down, no jobs, stock market down. Now we are seeing the truth! We cannot afford another 4 years of  Obama! He is totally out of touch with reality, OR he IS just untruthful!!! GO ROMNEY GO!!!!
Oct 19, 2012 12:28PM
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 Cramer knows nothing?? He was pushing Apple BIG TIME when it was at 200. Could have more than TRIPLED your money fast if you had listened to him, huh
Oct 19, 2012 2:28PM
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The whole wall street is corrupt! They probably taught Bernie Madoff!
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