Bubble Trouble?

The stock market loves to confound most participants. Almost no one predicted the vicious bear market of the past three years. And few expected the 2,000-point rally we caught after the war began.

The vast majority of players now think that the market will mark time. The “too far too fast” crowd, those who believe that the stock market exceeded some nonexistent speed limit, expect stocks to do nothing or maybe trade down a bit. Others, sensing that Iraq will start taking its toll on a president popular on Wall Street for his low capital-gains and dividends taxes, believe the market could have a nasty sell-off based on political uncertainty.

Lately, though, I have come to believe that the single most unlikely scenario, the one nobody’s predicting, might be about to occur: the massive melt-up, the upside blow-off that lifts the Dow a thousand points between here and year-end.

No one’s predicting it because the possibility of such bullish action after three years of a horrid bear market seems almost inconceivable. Yet, I think we could have an exact repeat of the astonishing melt-up that preceded the start of the bear market of 2000 because the conditions for such a rally now seem in place.

Consider these five factors that could combine to cause an upside conflagration:

One, the Federal Reserve said recently that it was going to leave interest rates at record lows to be sure the economy wouldn’t falter. This, despite the fact that the economy just grew at 7.2 percent and is accelerating, not declining, from here. That relatively foolish and potentially politically motivated easy-money policy at a time when it is obviously no longer needed could fuel a synthetic rise in prices. If the Fed were at all prudent, it would make a preemptive move now, to forestall the speculation that has become rampant on Wall Street, but Alan Greenspan was blind to it last time and he will be blind to it again. Gee, is it ever time for him to go?

Two, most hedge funds have radically underperformed the averages because they have stayed way too short and not believed in the rally. Now the end of the year is coming and the rich people want their money back. They don’t need to pay the hedgies steep fees to underperform the market. So, the hedge funds will have to bring in their shorts, particularly their market shorts, or bets against the S&P and the NASDAQ, to meet the redemptions. That means the pressure will be on the upside, as short-covering always drives up markets quickly. We saw a similar dynamic in 1999 when a couple of large hedge funds played catch-up with the market, reversing direction by buying the overextended favorites of the dot-com era. These hedge funds, notably the giant one then steered by George Soros, contributed mightily to the inane rally that brought us the crash. A repeat seems almost preordained given the need of the hedge funds to grab some quick performance before they lose too many assets.

Three, there simply aren’t enough market-shaping events between here and year-end to change the market’s course. We are in a period when few earnings reports come out and the broad data look to be positive relative to expectations. It is, in other words, a remarkably benign moment, one where the last data points, the spectacular earnings that were just reported, will continue to buoy the market. I know a lack of data points doesn’t seem much to the uninitiated, but if you are running money and you know there are no “big days” with major earnings or economic reports looming, you tend to grow more confident, and more long, by the day.

Four, we’ve had a marked return to speculation already, and it wouldn’t take much to accelerate from these levels to the outlandish activity of 1999. Trading in the NASDAQ Bulletin Board stocks, the so-called Pink Sheets, the lowest of the low in terms of quality, has reached frenetic levels, exceeding trading on the Big Board, exactly as it did at the height of the boom. The use of margin, or borrowed money, to buy stocks, akin to using gasoline to start a grill, is also on a rapid rise and in a few months at this trajectory could return to the heliumlike levels that overinflated the bubble that just burst. You’d think that someone would have learned from the pasting the public took just a few short years ago, but that’s just not the case.

Five, and this is the wild card that could ignite the market in a way that would seem like a frightening re-creation of the boom-and-bust cycle at the turn of the past century: Google’s going public! The market is as ill equipped to handle a big, popular dot-com deal as it was in the last go-around. Retail investors will no doubt once again use market orders to buy stock, institutional shareholders will exert pressure on their brokers to give them as much stock as possible, and the result could be a stock that goes to wild overvaluation from the get-go, perhaps as much as a $50 billion market cap. If a barely profitable Google is worth $50 billion, then think about all the unprofitable pieces of dross that the brokers can bring public for a twentieth of that. Google could trigger another iron-pyrite gold rush of acquisitions and IPOs that would get going the speculative juices of every little investor with a cable modem.

For some, the prospect of a melt-up seems downright bountiful. My partner on CNBC’s Kudlow & Cramer, Larry Kudlow, for example, cheered when I recently suggested that we are on the verge of such a move. For him, higher prices, no matter what, are a win.

Not me. I know the way the market reacts in the wake of a melt-up. Like the blow-offs in 1987, 1991, and 1999, the aftermath is always ugly. If the Fed maintains its oblivious posture initially, it will no doubt take rates up dramatically after the run-up, killing both the rally and the recovery with it.

That’s why as much as such a move could trigger tremendous short-term excitement, it’s the last thing a long-term bull should ever wish for. As recently as six months ago, I would have said that the possibility of a melt-up was less than one in ten. Now, looking at the landscape, with only Iraq going wrong, and with everything in the economy going right, I put the melt-up odds at 50-50. Strap yourself in and get ready for the ride, but don’t forget to hit the eject button the moment we get there. Sticking around almost always leads to a crash, and last time, the market’s air bags failed to inflate. This time will be no different.

Bubble Trouble?