INSANITY:  Doing the same thing over and over again and expecting different results.  That quote has been attributed to both Benjamin Franklin and Albert Einstein, but it doesn't really matter who said it.  What matters is that our government, the Fed, and Wall Street all are insane.

Yesterday the market rallied on a decline in the ISM Services index.  The reason stated by most traders was that it not only means that the Fed will continue with QE2 through the end of June (despite rumblings from some Fed governors that they should stop it sooner to fight inflation), but many now believe that QE3 will follow sometime this summer.

When we released our most recent economic update yesterday, I pointed out that most Wall Street firms have lowered their GDP forecast for both the 1st quarter and for 2011.  It seems that a weaker economy is thought to once again be a positive for the stock market.  The reason of course is that since the market bottomed in 2009 there has been a strong correlation between the Fed's Balance Sheet and the stock market.

The fact that the economy is growing much weaker than the historical average means nothing right now.  The Fed is getting what they wanted -- people moving money from low risk assets to higher risk assets.  We've already mentioned that pension funds appear to be a big reason behind the underlying bid in the market (see Who is Buying Stocks?)  Following the steep sell off in the aftermath of the Japanese Triple Disasters, I think I have identified another source behind the run-up in the market -- insurance companies.

The week following the disasters in Japan saw the biggest outflows from high yield bonds.  Several traders have said that insurance companies were freeing up cash in anticipation of some large claims.  A very large source of revenue for insurance companies is the way they invest their "float".  When rates are so low, they of course seek out higher yielding investments.

The sell off did cause our Income Allocator system to hit the first sell threshold that week, but as the money started flowing back into high yield bonds causing the market to stabilize, we have put that money back into the high yield bond market.

As you can see from the chart below, the rise in high yield bonds has been phenomenal. 

In hindsight, it would have been better to not make any trades since 2009.  Of course, we cannot use hindsight in our trading.  We can only stick with the trading systems that have made Income Allocator one of the top performing fixed income programs in the country for over 18 years.  As we saw in 2008, when you have insurance companies investing in riskier assets, once the economic reality sets in that printing money and using debt to stimulate the economy isn't working, the sell off in high yield bonds could be unprecedented.  Luckily for Income Allocator clients we have several buy & sell thresholds, so our sell signal last week was for only 20% of the overall holdings.

My April Fool's joke on Friday was supposed to point out the absurd, but as long as the market believes the Fed can bail out the economy via forcing assets into riskier investments it may be a logical strategy-for the short-term.  The problem will be when market forces (like inflation or a sell off in US debt) cause the Fed to pull back that stimulus.  One thing I asked a prospect the other day that told me the market was a great value was this -- if the government had a balanced budget and the Fed was not printing money, would the economy be able to stand on its own? 

We already know the answer.  It is barely able to stand on its own with the government spending money without a budget and the Fed printing new money every single day.

That game will in and when it does it will be ugly.  For now, our programs are participating, our ENCORE models are at or within a fraction of a percent of all-time highs, and we have our finger on the sell button.