Yesterday’s post started making the case for whether the key economic indicators are turning around. My hypothesis is that we’ve seen decent numbers in certain instances but all represented a seasonal or temporary trend rather than anything sustainable. For the most part, however, the key indicators like consumer credit, employment, and housing remain abysmal. The question is whether these facts are being reflected in capital markets and how my various forecasts will impact them. Let’s explore…
If the only economic news you’ve been tracking (and many people do) is the stock market, you might think we’re in the next boom of a lifetime. From the bottom in March to the top, the S&P 500 grew by a whopping 67%. This type of growth in less than a year’s time has only occurred during the Great Depression. Lately, however, there have been some hiccups in this run-up story…
As you can see from the graph, the latest dip has been the biggest since March and reflects a slowing trend in the overall appreciation. After price growth of this magnitude in the absence of any good news, a slow down was inevitable. The question from here is whether we see another big correction similar to 1931 or a square root shape. My bets are on the former.
First let’s explore why we saw such a quick and exaggerated growth pattern. Undoubtedly, we saw the stock market collapse far further than its true valuation and thus a quick correction back to more reasonable prices was easy to predict. To understand why this was so sudden requires brainstorming how our investment system works. Long only investment advisers typically got hammered in 2008. Retirement accounts were taken to the cleaners at the critical time before Boomers were set to retire. Pension funds were in crisis as their obligations were already underfunded. Big investment houses or hedge funds were under pressure to maintain the high returns of the 2000s. Since this makes up the majority of the market, there was significantly urgent need to see a major correction in the stock market. Hence we saw everyone get into the “cheap” market at once and continue bidding it up, often through leverage. There wasn’t much concern about risk or whether the stock appreciation was fundamentally supported because everyone required a certain rate of return and would chase it at any cost. Since housing didn’t supply these returns and the government flooding Big Finance with free money, everyone powered into the stock market at once and went back to 2006 leverage. This was able to produce a dramatic run despite a complete lack of economic support.
Eventually these things must come to an end and a dramatic buildup usually results in a painful crash. Quantitative easing is over, all the buyers are already in the market, and leverage is as high as can be. After a year without good economic news, people are starting to get impatient with the so called recovery. Massive bubbles in the biggest recovery areas like China and Brazil, so called immune countries like Australia and Canada, and bonds everywhere are becoming glaringly obvious. Big default implosions in smaller markets like Greece/Portugal/Iceland/Dubai/Latvia/Ukraine/Lithuania/Ireland/Spain/Italy/Argentina/Venezuela/Mexico are popping up and drawing international attention. This is leading to increased scrutiny of Japan, Russia, UK, and the United States (especially the states). With these factors dominating public attention, the market appears to have hit its top.
Compounding these trends are the behavior of bond market indicators. First let’s look at the US Treasury yield curve…
For all the talk of a recovery, the bond market just isn’t buying it. Short term Treasury bills are still hovering at nearly 0%. Longer term bills and bonds are still at low rates and are now exhibiting a downward trend as the dollar strengthens. With all the excess reserves and government liquidity floating around, yield would be through the roof if the bond market was anticipating any type of recovery. Instead they’re far below average yields and pushing downward even further. Since the bond market has historically been a much better economic indicator than stocks, it foreshadows negativity ahead.
Next let’s take a look at the overall risk in the market…
This is probably the best sign of the market as it currently sits. Even the most bullish economist would admit there’s still a lot of risk in the business world today. With credit declining, banks failing at record rates, and budget problems apparent everywhere, we hardly seem to have a favorable business environment. If I were to lend money to businesses rated riskier, I’d demand a much bigger return premium than almost any other time in modern history. Not the case as the chart above illustrates.
Except in the best of times, Baa corporate bonds require at least 7% yields and are often higher than this. In today’s climate, you sure wouldn’t expect to see 6.25%. You also wouldn’t expect to see a spread over 10 year Treasuries approaching levels as low as the height of the boom. This chart indicates there is a nearly unfathomable level of risk in capital markets today. This cannot be sustainable, especially without improved economic conditions. With commercial real estate in the midst of a complete collapse, another huge wave of foreclosures on the horizon, pension disasters popping up everywhere, and losses prepared to come from the bubbles listed above, I don’t think this level of risk (without the proper yields) is justifiable for much longer. All it will take is one major event (which we may see in Greece or Portugal very soon) to cause the House of Cards to come toppling down.
My theory is we’re in for a very tumultuous year and it will have severe consequences for capital markets. Like it did in 2009, it’s entirely possible the bubbles continue to inflate. It’s also possible we see stagnation rather than rocky behavior. I think this is unlikely due to a financial system with the same structural problems as last year, massive leverage everywhere, and the inability of most governments to operate as a backstop for losses.
Very soon, I will be unveiling a new feature on this website to strategically monitor this theory. My intention is to lay out the facts and my interpretation here and let all interested parties prepare accordingly. We’ve already seen the initial stages over the last two weeks of a new bear market. We’re seeing worse than expected economic reports. We’re seeing negative reaction to positive economic reports and earnings. We’re seeing big sell-offs at the end of each day’s market session. We’re seeing the news being dominated by more negative stories that have been brewing for a long time out of the mainstream eye. We’re seeing a return to the dollar/stock/commodity correlation and most people seek the light to safety of the dollar. I personally have taken note of these trends and reacted accordingly. I suggest everyone else examine their own situation carefully as well.
are you suggesting that the stock market run up was the result of investor leverage………….that’s the first I heard of that analysis. please explain.
No, I’m not suggesting that was a sole cause… just one of the many ingredients that helped push it as high as it was. You have hedge funds and prop trading firms using significant leverage the same way they did pre- recession. I don’t have any proof these levels have increased but you know they’re chasing returns to make up for shortcomings in previous years. Zero interest rates allow speculation without as much risk. You even have various pensions trying to chase unrealistic return targets through leverage because they’re so dangerously underfunded. You have the growth in popularity of these leveraged ETFs. Any time bubbles appear in the absence of corresponding fundamentals, you can guarantee there is leverage behind the curtain. It’s not the driver of the trend but the fuel to keep the fire in expansion.
I just don’t know where you got the stat that funds were returning to pre recession leverage levels to fuel stock acquistions. It was my understanding that they had plenty of cash on hand after going to the side lines.