The terrible reason stocks are soaring now

Since the market bottom of March 2009, U.S. stocks (as defined by the S&P 500 index) have nearly doubled – up 95%. Soaring stock prices translates into a $28 trillion increase in U.S. equity market capitalization. This is the biggest two-year increase in stock prices since 1955. The march higher has been nearly straight up – stocks have risen 18 of the last 24 months. Without a doubt, stocks have been the place to be for the last two years. If you'd put $1,000 into a global stock index fund (MSCI All-Country World Index) two years ago, you would have a little more than $2,000 today. Making the same investment in commodities would have left you with $1,593… Global corporate bonds would have left you with $1,277… and U.S. Treasurys would have only gotten you $1,044. And the rally probably isn't over yet, either…

There are good reasons to expect stock prices will continue to move higher. Stocks really aren't that expensive, when compared to earnings. The S&P 500 is trading at 15.5 times reported earnings, compared to average bull market peak valuations of 19.7. Earnings will almost surely continue to grow rapidly. Bloomberg reports consensus estimates of Wall Street analysts showing average earnings growth of 17% in the next 12 months. Stocks are also cheap relative to interest rates. The earnings yield of the S&P 500 (6.4%) is still substantially above the yield of benchmark (10-year) U.S. Treasury bonds (3.5%).

This all sounds like good news, doesn't it? But here's one fact you probably won't see reported anywhere else: The entire rise in U.S. corporate profits came from the financial sector. That is, the earnings growth driving our current bull market in stocks is coming exclusively from the financial sector. The nonfinancial sector of our economy actually saw profits fall in last year's fourth quarter. Today, financial sector profits make up more than 30% of total domestic corporate profits. That's the same level we saw in 2006 and 2007… just before the financial crisis.

What's behind the surge in financial sector profits? You already know, dear subscriber…

You already know the Federal Reserve has been shoveling out as much money as the banks want and charging nothing for it… You already know the Fed has lowered interest rates for member banks to almost nothing. But how does this impact the real world of finance? Let's look at Annaly Capital Management (NLY) to find out.

We like to use Annaly as our window into the secret world of the big banks, because we're familiar with the company (having watched closely for the last decade) and its business model is Banking 101: Annaly borrows money at a privileged rate and lends it safely via the government-guaranteed mortgage market. At both ends of every deal, Annaly enjoys the warm, loving embrace of our sovereign nation. It takes advantage of the Fed's interest-rate manipulation at the short end of the curve (where it borrows) and the Treasury's backing of Fannie and Freddie at the long end of the curve (where it invests). Playing the government's game is unbelievably profitable…

At the end of 2010 (the most recently reported quarter), Annaly paid only 1.8% to borrow money – and it could have as much as it wanted. It turned around and "lent" those same dollars out at an average rate of 3.65% via investment in Fannie- and Freddie-backed mortgage securities (which are guaranteed against any credit loss). In this way, Annaly earned a "risk-free" profit of 1.85% on each dollar it touched. Annaly's total portfolio grew to $75 billion – meaning its net interest income was almost $400 million in the fourth quarter alone.

Now, let me ask you a few simple questions about all this… Does it seem reasonable that a banking institution with only 114 employees and no branches should earn a risk-free $400 million in one quarter? That implies annual profits of much more than $1 billion. What did it do to earn these profits? Nothing more than pose as a buyer. I say "pose" because Annaly borrowed nearly all the money it used in these purchases and never assumed any risk whatsoever on the things it "owned." Does this make sense? Does it make sense that we, as a society, should trade $1 billion or more for this "service"?

I admire the men who built Annaly and run it today. They found a simple – and wildly lucrative – way to take advantage of the absurdity of our banking system. Annaly's roughly $400 million in profits make up a tiny fraction of the $400 billion-plus profit generated by the financial sector last quarter. But they represent perfectly how these dollars were "earned." In almost every case, the money wasn't earned at all – it was simply manufactured by a charade just complex enough to fool the press and the average debtor.

But what about the parts of the economy where profits can't simply be manufactured with fiat money? How's that part of the economy growing? It's not. Whoops.

Given these facts, I would suggest investors pay close attention to the government's ability to maintain its paper charade. The prices of gold, silver, oil, and most other major commodities would seem to indicate this process of printing money and paying bankers $400 billion a quarter to move it around isn't productive. Instead of producing wealth, we're only producing debt… which is getting much harder to afford, thanks to inflation… which is a terrible side effect of using monopoly money and allowing the government to play the game's "banker."

Here's another interesting fact… Stephen Moore in the Wall Street Journal today writes:

More Americans work for the government than work in construction, farming, fishing, forestry, manufacturing, mining and utilities combined. We have moved decisively from a nation of makers to a nation of takers. Nearly half of the $2.2 trillion cost of state and local governments is the $1 trillion-a-year tab for pay and benefits of state and local employees.

Forgive me for being cynical… but it seems the only sector of our economy that's growing is the banking sector, which manufactures profits via a paper currency regime that's stoking a massive inflation and remains threatened by a growing banking crisis in every developed country. Meanwhile, the banking system is being held together by our government, an institution that's bankrupt on any conceivable scale – to the point that the world's largest bond investor (PIMCO's Bill Gross) has sold every single U.S. Treasury bond and is publicly calling Congress a house full of "skunks." The government has also become the largest employer, the largest source of union members, and the single largest customer of almost every company in the United States.