Running Off a Cliff

The stock market at the moment reminds me of those old-time cartoon characters, who would run off a cliff and keep running on thin air—only falling when they eventually noticed there was no ground beneath. In terms of valuations, U.S. stocks are sky high, when measured by methodologies that are actually correlated to future returns. Both this bull market and economic recovery are well past typical lifetimes, and due for a fall, based on history alone. In fact as we move into 2015, there are worrisome signs that an economy many hoped was gaining strength, and would allow stocks to grow into their valuations and find more support, might instead be weakening. We are also experiencing divergences in the stock market and other markets of the type you would expect to find as market participants awaken to the reality that the solid ground they thought was beneath them is not.

Maybe we keep running on air for the foreseeable future, as earnings per share are supported not so much by profits, but by using debt for stock buybacks to decrease the share count at the expense of corporate balance sheets, and central banks prop up markets by leveraging their own balance sheets to buy government debt. But at some point I expect the basic laws of economics are going to win out and stocks will fall back to earth. That is a ride investors should do their utmost to avoid taking. All of the reasons enumerated here caused me to recommend long-term investors take a defensive stance in regards to stocks last October, and I remain bearish for these reasons. I want to emphasize that these reasons alone are enough to warrant a cautious allocation to stocks. But I do have my own personal view on the road that has taken us to this point.

Roadmap to Ruin

Since starting this blog in 2010, I have often focused on negative dynamics around the stock market, including my view that we remain in a secular bear market that will likely only end after a third, still-to-occur major bear market. But that doesn’t mean I have been negative on stocks. In February of 2011 I even wrote a post “Don’t Fight the Fed” about despite my concerns about overly accommodative policies I thought it was a near term positive for stocks, which were a good value in a still young bull market with room to run. In May of 2013 I recommended investors take some profits, and, despite voicing a lot of concerns, it wasn’t until June of 2013, when I advised short-term investors, who might need their money in 3-5 years to not hold stocks. Then it would be more than a year later in October 2014, when I finally recommended long-term investors underweight equity exposure.

The last several years proved my view to remain in stocks, despite real worries, was a money maker. The next few years will now prove whether my advice to exit and underweight will also be rewarded. But my overriding view has not changed over the years. I still believe we are in a secular bear market, where one last bull market (the one we are presently riding), will set the stage for a major recession and particularly nasty bear market in stocks, before the next true secular bull market begins. In my view, this secular bear market has been characterized by overly accommodative monetary policy. Such easy money policies fueled the dotcom bubble top in 2000. Then on the theory that two wrongs make a right, another round of accommodative monetary policy fueled strong, unsustainable economic growth around consumer spending and a global residential real estate bubble, before topping in 2007.

Now we are working on the dubious theory of third time is the charm, as even easier accomodation in the form of zero interest rate policies and quantitative easing, has pushed money into the stock market and helped fuel a new round of debt binging. As I covered in my February 2012 post “China’s Economic Dark Side” and recently written about by David Stockman, the epicenter for this latest debt binge is China, where to reignite global growth the Chinese inflated their own massive real estate bubble. It was back in October 2013 that I wrote about how Chinese growth was hitting a wall. It was only when I perceived that monetary policy was increasingly pushing on a string and unable to generate much growth on a global basis in 2013 that I moved to a more cautious outlook on stocks, and not until the fourth quarter of 2014 as I began to see signs of this impacting capital markets, when I finally moved to urging a defensive stance on stocks.

The same dynamics that drove this stock market to highs few could imagine, will in my opinion also push it to depths difficult to envision–we’ve run up a mountain of debt, off a cliff, and we’re going to fall at some point. I don’t think we can run on air for too much longer, no matter how fast we furiously turn our legs. Asset bubbles are easy to inflate. But reflating them or controlling their deflation for a soft economic landing, is a far different matter. I don’t think governments are going to find much success, even with aggressive quantitative easing programs, zero interest rate policies or even negative interest rates we’re seeing in some countries. Such policies buy time, but not sustainable growth that in my opinion would require structural reforms and productivity-enhancing technologies of a level not currently present. Like gravity, the laws of economics eventually assert themselves, and if you borrow money to build unproductive assets, unsustainable growth will eventually give way to disruption and contraction.

That’s been my view when I was positive on stocks on the way up, and it’s my view now as I look at what could be a long fall below. At the same time, I have a stronger conviction on my diagnosis of the problem, than my timing. But given my view on the magnitude of the danger, I am seeing more than enough evidence of risks of a top to become defensive and remain so on stocks. So, far things are unfolding far too much with how I would expect a global recession triggered by the burst of the latest round of asset bubbles to transpire for me to be comfortable owning stocks with sky high valuations and lots of room to fall.

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