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I Ain’t Scared

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    May 10, 2014

    Since the beginning of this year, the markets have really not gone much of anywhere.  As shown in the chart below, the S&P 500 has remained confined to a tight trading range between 1850 and 1890.  The good news is that this range has been held despite the ongoing traction of the Fed’s liquidity supports.  The bad news is that the Fed is extracting their liquidity supports.


    As I have discussed previously, there is little doubt that the Federal Reserve’s ongoing liquidity programs have lofted asset prices far in excess of economic value.  Furthermore, the move by the Fed to artificially suppress interest rates to abnormally low levels, in hopes of stimulating an economic recovery, has led to the “great yield chase”as investors seek to garner a return on cash.

    This chase for yield, combined with the Federal Reserve’s “support” of the financial markets, has led to an excessive level of “greed” within the financial markets.  This is clearly shown in the next chart which shows near record levels of asset prices, margin debt or “leverage” and near record low yields on “junk bonds.”


    As shown, such a mix of “greed” and “complacency” by investors never ends well. The cause of the reversion is never known beforehand.  Economists and analysts routinely come with a variety of metrics as to why current levels of market valuation are reasonable. It is only in hindsight that the culprit is revealed and is usually something the markets were completely unaware of.

    The current decline in interest rates suggests that the economy is indeed weaker than current economic reports suggest. The majority of the recent upticks in economic data is due to an inventory restocking cycle after the drawdown in the first quarter.  More importantly, for investors, the decline in rates is not supportive of higher asset prices currently.  The chart below shows the divergence between stocks and bonds.


    Both cannot be correct and the gap will eventually be filled as it has in the past. The important question for investors is whether it will be a sharp rise in interest rates or a decline in stocks? We are likely to have a resolution sooner rather than later as slip into the dog days of summer.  (Read “Sell In May?”)

    With the markets near their highs for the year, and no technical violations of key support, complacency remains high. That complacency has been emboldened, as Idiscussed recently,  each decline has been met by Federal Reserve intervention to inject liquidity and stem selling.

    “Is it “actually” the Federal Reserve’s actions that are supporting the financial markets? To answer this question I examined the weekly changes to the Fed’s balance sheet as compared to the S&P 500.”


    “As you can see, through the majority of 2012 the market struggled to advance as the changes to the Fed’s balance sheet limited overall balance sheet increases.  However, beginning in December of 2012, as the Federal Reserve fully implemented the current QE program, asset prices begin to surge.  Furthermore, as I have highlighted with vertical lines, market declines were halted as large rounds of asset purchases pushed liquidity into the financial system.”

    There is currently no reason to reduce portfolio allocations at the current time. However, the rising risks do have my undivided attention. With the Federal Reserve continuing to reduce their support, and eventually end it altogether, there is a rising degree of uncertainty whether the markets can continue to interpret “bad news” as “good news.”With both the S&P 500 and Wilshire 500 indices extremely deviated from their long-term(36 month) moving averages the risk of a significant “reversion” has increased.


    At some point, a negative catalyst will overwhelm the bullish consensus creating a stampede for the exits. I do not know when that will happen or what will cause it, but I do know that it will occur. As I stated above, the markets have not technically done anything wrong as yet, however, there are plenty of reasons to be scared. History is replete with the “blood baths” that have occurred from a combination of excess complacency and overconfidence. This time is unlikely to be any different.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.


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