ICangles Investment Post…

The financial markets at the start of 2013 remind me of a giant game of Jenga, where players build a tower out of wooden blocks and then take turns pulling out blocks until the increasingly unstable structure eventually collapses. Today, the stock market is climbing towards new highs on a foundation of cheap money that is anything, but stable. Unfortunately, all that cheap money means investors have little choice, but to play this game. The term of the moment to explain the recent rally in the stock market is “moving out on the risk curve.” As central banks have embarked on a new round of money creation to purchase bonds and push yields down, investors are being driven into selling bonds and CDs to buy riskier stocks. Participating in the stock market rally has become one of the only viable options for investors to keep up with inflation, as central bankers try to force money to flow into more risky investments associated in their minds with driving economic growth. In the process the government is doing retirees no favors.

A Shaky Structure

In August 2011 my “Market Malaise” post urged investors to heavily weight stocks over other investments in their portfolios, explaining some of the fundamentals still in play making other investment options, including cash, bonds, real estate and commodities, less than ideal. The forces pushing investors out on the risk curve have been in play for a while, and today I would still overweight stocks over other investments. However, given the current state of the stock market there is merit presently in doing some selling if necessary to build up a minority cash position that can be deployed in the event of a major market downturn to buy stocks. In other words I wouldn’t put everything in stocks.

I am not forecasting an imminent bear market for stocks, but nor am I as bullish as I’ve been previously. Cheap money forcing investors out on a risk curve, in order to play what I am terming Financial Jenga may be a reason to buy stocks, but it is not a particularly confidence instilling one. A better one would be if we were residing in the early stages of an economic recovery and bull market. But that isn’t the case, as this bull market is now entering its fifth year. It would also be nice if there were strong economic, productivity and income growth unfolding, but that also isn’t the case. This recovery remains notable for its weakness and high unemployment.

Nor is it the case that growth is weak because debt is being paid down. Unfortunately, government debt is growing, while central bank balance sheets are leveraged with growing amounts of government debt. People may have celebrated the deal in the United States to raise the debt ceiling and keep the government borrowing or the European Union deal with the government in Greece. But both deals merely amounted to successfully pulling some blocks out without the tower collapsing in the process. Neither deal shored up the financial structure of the United States or Europe. It continues to get shakier instead, and just because enough time has passed that talk of a double dip recession has died down, doesn’t mean this rickety structure will forever avoid another economic downturn.

Last year I also drew confidence from the government transitions in the United States and China, as any dramatic changes that could negatively impact financial markets was unlikely to happen until afterwards. Now with the communist party transition in China over and the elections in the United States held, chances are greater for destabilizing policy changes being embarked upon. I will be keeping an especially close eye out for changes in monetary policies. In fact one such change has already transpired with Japan’s new government embarking on radical, expansionary monetary policies that have given rise lately to concerns of currency wars breaking out.

On the topic of wars, the world isn’t exactly getting any safer either. Iran and North Korea continue with their nuclear weapons programs. The Arab spring is looking positively chilly, with a full-blown war in Syria and growing unrest in Egypt. Meanwhile, China is now officially embarking on one of the riskiest phases in economic development of transitioning form an export-driven to a consumer-driven economic model, with the government weary of a misstep sparking unrest. Although representing little risk of destabilizing violence, the European Union project of continental integration appears increasingly shaky, as Northern members push for austerity, Southern members for more borrowing and the major center powers of France and Germany take the lead in crafting one short term fix after another.

Calling the current market a game of Financial Jenga might seem overblown, but in my mind the unstable, growing tower of debt that represents the current global monetary system is destined to collapse. Instability and volatility are likely to be characteristics of this market for years to come. However, it should be noted that the 20^th century witnessed the remaking of the global monetary system twice with Bretton Woods and Bretton Woods II. Neither the demise of either of the previous monetary systems represented the end of the world. Rather any major market downturn, whether driven by the collapse of the current monetary system or not, would in my mind represent a buying opportunity.

With all that said this game could go on longer than seems possible, arguing for holding stocks. Per my last post a move to tightening monetary policy is the most likely action that will end this bull market and there is no signs of that yet happening. There is a very good chance we will be into 2014 before any such action is seriously considered. At the same time, having some cash on hand to be able to take advantage of a sudden buying opportunity also makes good sense. The “fun” of Jenga as the game gets later is that no one knows exactly when it will crash down.