The Party is Over

I.C. Angles Investment Post…

We are entering a new era for central banking, where the freedom to pursue the easy money policies of the past are receding. To the degree cheap money has fueled the global economy and market rise since 2009 this development is particularly worrisome for the near term. Conversely, insofar as central bank policies have created market imbalances and stood in the way of needed structural reforms this will be a long-term positive over the coming decades. In short the easy money party is winding down. And that means stock market risk is higher now than at any point since 2007.

The Federal Reserve, Bank of Japan and other central banks are entering an era, where their previous actions combined with market forces, significantly constrain their policy options. This shift is revealed in three key drivers of the current global market sell off in equities, bonds and commodities—worries that: the U.S. Federal Reserve will begin to reduce its quantitative easing program, China’s tightening of credit amidst a real estate bubble will significantly decelerate global growth and Japan’s experiment in very aggressive monetary accommodation is already hitting a wall.

To paraphrase a famous saying the job of central banks is to take away the punch bowl before the economic party gets out of hand. Unfortunately central banks have failed in that job time and again. Like any good bar tender, central banks aren’t supposed to allow liquidity binges that incapacitate participants. But even worse than that, central banks have over the past few years imitated the worst bar tenders who themselves get drunk on the job. Today the focus of dangerously leveraged debt is the central banks themselves, holding trillions of dollars in bonds on their own balance sheets as a result of quantitative easing programs. The laws of economics have finally seen enough. Not only will the punch bowl be taken away, but the long process of revoking these central bankers’ liquidity licenses has begun.

Market realities are beginning to place restrictions on the Federal Reserve. There are only so many Treasury bonds the Fed can purchase before reducing needed availability of these securities for institutions, such as pension funds, while falling government deficits ironically reduce this supply. There is also growing reason for the Fed to worry that both quantitative easing policies in general, as well as purchases of mortgage bonds in particular, are fueling more speculative behavior. In other words the Fed may be running out of securities to buy, assuming it even wants to continue its aggressive program of quantitative easing. With the economy doing better and the financial sector healthier the Fed may want to back away, since evidence increasingly points to this policy as creating the worst of both worlds. A low velocity of money has meant Fed policy has largely been pushing  on a string in the context of the broader economy, while signs of speculative behavior can be seen in the recent run-up in stocks and resurgence of real estate in markets at the center of the last bubble.

The current sell off of course began before those Fed comments. The market peak was more linked with Japan’s central bank than that of America’s. The correction in the Nikkei has been in no small part driven by investor concerns that Japan’s extremely aggressive central bank policy may hit the wall of driving up borrowing costs and risking government insolvency before it increases compensating economic growth and tax revenues. With massive debt levels, multiple popped asset bubbles, huge infrastructure investments of the kind advocated by modern Keynesians, and now extreme monetary policy aimed at pursuing money creation around inflation targets, it may well prove that Japan led the way into the ongoing malinvestment cycle and will also lead the way into a final bottom, as its own debt servicing issues now constrain its policies.

Although Japan has certainly experienced multiple asset bubbles from real estate to the stock market, the most massive present bubble is clearly China’s real estate market. And that may have started to unwind. The policies of China’s central bank that can attract hot money by fixing the currency value of the yuan have also not helped matters. There is now noticeable economic weakness and signs of credit contraction in China. The sell off in emerging market stocks and commodities is linked to concerns of decelerating growth in China’s economy. I’ve been worried enough about the impact of China on the global economy to write about China’s risks. Its real estate bubble and bad debts throughout its financial system may finally also be constraining China’s monetary policy options.

None of this means there is a certainty the stock market is entering a bear market. But these and other factors do mean it makes sense to be worried about the market’s prospects and take a more cautious approach around stock allocations. Even if this market reverses its recent descent and heads higher, it will do so in a risk environment that warrants caution. For reasons I’ve covered in other posts I believe we are still in a secular bear market, and simply breaking into new all time highs is concerning, since based on the admittedly limited historical data a secular bear market should at this point not see meaningful higher highs and higher lows from the levels set in the past. Yet, a dramatic decline from here would fit the pattern nicely. Beyond this, the very nature of a secular bear market argues for a more cautious approach to investing than would otherwise be warranted, especially when the market is nearing or making new secular highs and the last bear market was less than a decade into the current cycle.

Since writing this blog I’ve also been consistent in pointing to 2013 as a point where stock market risk would rise, and called for the first time since starting this blog in 2010 for investors to raise some cash at the beginning of this year and then called at what so far has been the height of the market’s advance in 2013 for investors to take some profits and raise more cash. Over the years of the current bull market the contrarian in me has commented to colleagues that we should start to worry about the market when we begin hearing comments from the Federal Reserve that they’ve been so successful in saving the economy that some reductions in their quantitative easing program are warranted. As of last week we’re hearing those comments.

At the beginning of the year I noted several reasons to become more cautious, but to recap just a few of them: this economic recovery is still more notable for its weakness than strength, global risks are growing and this bull market has run long enough for a bear market to become a real possibility based on typical market cycle durations. Given everything, now is a good time to take another hard look at stock allocations and triggers for future reductions, whether new fundamental negative developments arising or technical tests of levels such as the 200-day moving average. Asset bubbles involve leverage, and with the amount of leverage on central bank balance sheets it is not surprising to find them at the center of the current sell off.

Portfolio construction and management does not lend itself to simple pronouncements. However, I am currently about as bearish as I can be without technical confirmation in the wake of a bigger  move down. In my view capital currently allocated to stocks and involving a 3-5 year time horizon should be pulled out of the market until a 40 percent or greater decline presents an opportunity to redeploy such funds or until underlying fundamental conditions improve significantly. In any portfolio it’s time to reassess stock allocations. On one last note the contrarian in me finds the extreme sentiment around the perceived ability of central banks to provide significant liquidity, which has driven the 2013 rally to itself be worrisome, especially given my view that this paradigm is now shifting. Adjusting to that new reality could be a long ride down.

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