When will the market face reality?

Oil prices are soaring, inflation is raging, a recession is taking hold, and Wall Street continues to pretend the worst is over. But these problems won't just disappear.

By Bill Fleckenstein

Recently, I remarked that the stock market action has been echoing a familiar theme, whereby nothing seems to matter except the action itself. Some days, near euphoria on the part of bulls has trumped negative macro/corporate news and, more importantly, an economy that struggles as a result of the burst credit/housing bubble.

For a sense of that fantastical thinking, look no further than the recent spirited action in tech stocks. Their upside performance, as I have noted often, suggests a resurgence of the all-will-be-well mind-set.

Or, consider how all dips in oil inspire spikes in equities generically. Last Tuesday, as oil dropped a dollar to $134 a barrel, one would have thought -- judging by folks' giddiness for buying stocks -- that oil was closer to a six-month low than to an all-time high.

Eventually, though, reality will hit the stock market hard, just as it has hit the real- estate market, after much denial. When that happens, the market will head lower -- just how much lower is impossible to predict but certainly below the lows for the current cycle set in March.

Paper-trained bulls

Perhaps part of the strength in equities stemmed from folks' belief that the Federal Reserve will not tighten interest rates after all. (In last week's column, I noted that the chance of higher rates was essentially zero.)

No fewer than four newspapers ran stories midweek to the effect that the Fed is unlikely to tighten at its meeting this week -- unless, to quote The Wall Street Journal (subscription required), "the inflation outlook deteriorates considerably."

Of course, when you look not at inflation but the "spun" version of inflation that's championed by the Fed, you can always find a reason to avoid raising rates. It continues to boggle my mind how anyone can think the Fed is serious about fighting inflation.

The central bank is trapped -- unwilling to raise rates even as inflation ratchets higher-- because it (rightly) fears what higher rates would do to a weak economy.

Likewise, I find it stunning that anyone would take any prognostication by Alan Greenspan or Ben Bernanke, on any subject, as worthy of consideration, given that the past and present Fed chiefs, respectively, apparently understand nothing about what has been the engine of the economy for more than a decade -- that is, speculation.

Muzzle the (never-wuzza) maestro

Just last week, Greenspan could again be heard shooting off his mouth. He now sees the reduced possibility "of a deep recession" and said, regarding the mortgage crisis, that "the worst was over or soon would be" (as paraphrased by Bloomberg).

What really made me burst out laughing was this headline (again on Bloomberg): "Risk managers should learn from market turmoil." What's so ironic is that the man who created the turmoil is the one person who has never seemed to learn anything.

Meanwhile, one can only wonder if any Fed heads (they, of the inflation-ex-energy-and-food camp) have gassed up their cars in the past several months. Of course, the bullish contingent still wants to believe that somehow the Fed will make inflation go away without raising interest rates and that somehow oil will trade lower -- thereby sustaining the fantasy that our economy will have a Goldilocks outcome.

Recently, a friend shared a noteworthy statistic: An oil exchange-traded fund is among the most heavily shorted ETFs in existence. In the first five months of this year, as oil rose 33%, the short interest soared 140%. Parenthetically, I might point out that another heavily shorted ETF happens to be SPDR Gold Shares (GLD, news, msgs).

As I have noted many times, the people most likely to call the recent action in commodities a bubble are the same ones who did not see the equity bubble or the housing bubble as such.

Meanwhile, the always insightful Jim Stack (in his biweekly InvesTech Research) compared the charts of the Internet index, the housing-bubble index and crude oil. Both the Internet and housing-bubble indexes have eerily similar charts, with each experiencing gains of about 1,400% during their four- to five-year upside runs. Thus far, crude oil has rallied "only" about 400%, and the energy-stock ETF that Stack uses for comparison has gained a more modest 200%.

Oil shorts, cavort with care

Based on Stack's data, the move in oil would place it about where stocks were during their bubble around mid-1998 and would put housing-stock prices about where they were in 2003. If oil were to experience the same sort of move that those two did, it has a lot further to go. That is just an observation, not a prediction. As noted often in my daily column on my Web site, I just don't have an opinion about energy due to all the factors that to me seem impossible to analyze.

Nonetheless, it would seem that the majority of folks who do have an opinion believe that the price of oil is too high. They continue to bet against it -- and continue to engage in wishful thinking, hoping that inflation and high oil prices will somehow just disappear.

At the time of publication, Bill Fleckenstein did not own or control shares of any fund mentioned in this column.

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