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 11:47AM
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 I'm 65 and my entitlement " handouts" are sacrosanct says Ryan himself. So convince me why I have skin in the game. Right now I'm for whatever curbs inflation and a poor economy will do just that..Then  again inflation will make my gold go up so I can't lose no matter what
 If the REST of the Middle Class is dumb enough to go back to the Bush economics, oh well! YOUR problem, not mine YOU will have made your bed, so lie in it and don't come back for my vote in the future
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 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 11:42AM
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cramer's headlines are like a short skirt on a hooker ......all designed to draw you in .......monday he will mention Romney or President Obama .......
Oct 19, 2012 11:39AM
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If mitt wins you will be able to get high again for a couple of years as trust me he ain't cutting anything except to those who can least afford it .........he and his zillionaire buds will finally get that 0% tax rate they yearn for once capital gains tax is abolished and you the masses will have to pay extra (via the removal of deductions) for all the services the govt.  provides ......

Also let's not forget mitt owes some of his wealthy backers a war with Iran so warn your kids who are in their teens to get prepared......mitt's clones .....oops I mean kids will not have to worry of course as mormons "object" to war --- well that's not true - it's ok as long as other peoples kids do the fighting and bleeding.
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 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 11:32AM
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It took bush and his cronies 8 years to bury our economy sadly it will take longer than 4 years to fix it ....going back to romney is like having a party for 8 years ....living with the hangover for 4 years and as the pain starts to subside you decide to start drinking again ......
Oct 19, 2012 11:29AM
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If the Dow drops to 13,000 buy with both hands.A year later you`ll be kicking

ypurself if you don`t.

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 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 10:19AM
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Market collapse October 2012 ! TAKE YOUR MONEY AND RUN  !
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