This bull market increasingly looks scary. Setting new record highs and extending deep into 2013 only makes it look more worrisome. It was only a little more than a year ago I recommended investors keep stocks as the largest portion of any long-term investment portfolio. But that advice came with the caveat that market risk would rise in 2013, and indeed I have become increasingly nervous about stocks this year. Although I have yet to declare a market top, and will not call a bear market until important technical levels are broken, I have not hesitated urging taking profits and raising cash levels by selling stocks as this market has set new record highs this year. Pictures can often convey more than words, and in this post I am going to highlight a few notable and scary charts related to the current stock market.
To believe that the stock market will rise significantly from its recent August highs, when the S&P 500 reached over 1,700 points or not revisit near its lows, is to bet that it is different this time. The famous declaration of legendary investor, Sir John Templeton, that, “The four most dangerous words in investing are, it’s different this time” has over the past few months become particularly pertinent. The secular bear market that began in 2000 (when investors believed it was different that time and the Internet had fundamentally changed the nature of the stock market removing the risk of a major bear market) would need to have ended in the 2009 bottom for the stock market to now rise significantly higher or not fall to around previous lows. But there is little reason to believe this time is different, that stocks entered a new secular bull market in 2009, well below the typical duration of a secular bear market and that the odds now favor a heavy allocation to stocks.
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.
Major central banks of the world have set in motion a chain of events likely to result in their own decline and the eventual demise of fiat money. Of late there has been growing concerns about the risk of bankruptcy to central banks, due to the trillions of dollars in debt instruments being carried on the balance sheets of the Federal Reserve, European Central Bank, Bank of Japan and Bank of England. Recently the chairman of the Federal Reserve for the United States had to answer a growing number of questions about how he could exit these immense positions, which are poised to grow beyond four trillion dollars on the Fed’s balance sheet alone. Ben Bernanke’s responses should give no one comfort. Yet focusing on the risk of bankruptcy to central banks, actually ignores the real risks around the demise of the world’s fiat money system. Nor are market observers appreciating how the current central banking conundrum is likely to eventually give rise to a return to hard money.
The balance sheets of the major central banks of the world are in a dangerous state. In the United States, the European Union and Japan they have basically printed money to buy debt, counting the debt securities purchased as an asset and the money paid for them in the liability column. Despite many mistakenly believing China’s central bank must be in good shape with all the U.S. government debt held in its asset column, this overlooks its liability column. Reviewing the magnitude of central bank liabilities, the implications on future policy and potential economic challenges, arguments can be made that central bankers are either wisely learning from history or the equivalent of fools playing with matches in pools of gasoline of their own pouring. Unfortunately their lackluster track record argues more for the latter than the former.
The Federal Reserve has painted itself into a corner, where there is no easy way out. The current global monetary system is headed for trouble. Dangers around rising inflation coupled with a weak employment environment, aka stagflation, are building. America already has the weak job market, and now as my previous post pointed out there are warning signs that the Fed’s latest policy moves are translating into inflationary forces. Having already focused on some of those signs, I am going to take a moment here to describe the dynamics of the problem. Although the leaders of the Fed not surprisingly argue there is nothing to worry about, there are three compelling reasons to believe otherwise.
There has been a lot of worrying in financial markets over the past few months. In fact quite a long list of looming disasters has been assembled. Will destabilization in the Middle East, especially if unrest reaches Saudi Arabia, send oil prices skyrocketing and the global economy spiraling? Could this wave of unrest spread to China? Will the earthquake in Japan trigger a financial crisis in that country, as more debt is added to an already formidable mountain of debt? Is Bill Gross signaling a debt crisis in the U.S. is eminent, as he pilots the world’s largest bond fund out of U.S. Treasuries? Irrespective of the U.S. Treasury market is a wave of defaults on its way in the municipal bond market? And what about real estate—are we now on our way to a second bottom with prices headed for a 20 percent or greater decline?