The warnings about the US stock market are everywhere. Bloomberg has several columnists, including normally bullish analysts, writing that investors should be prepared for a correction. Paul Farrell of the Dow Jones Market Watch service, who has been consistently bearish, issued his 17th warning that the Dow Jones index is almost certain to fall back to its 2009 low of 6,600 from its record setting high this week of 15,600. It takes guts to issue your 17th warning, because millions of investors are now aboard the Bernanke express train to the moon, and they are obliged for their own peace of mind to make mockery of anybody who dares question the power of the Federal Reserve to sustain this market bubble.
That there are professional analysts and writers questioning just that is what makes this market so unusual. At major market tops, such as the ones in 2000 and 2007, there were hardly any public warnings. You had to go to a place like The Agonist to find any clue that a housing bubble existed. In 2013, when the professionals are fleeing the markets, you have got to wonder who is out there pushing the markets to record highs.
The Blow-off Top
The professionals always preface their remarks with the statement, “In my 20 (or 30) years in the markets, I’ve never seen anything like this.” What they are talking about is the incontrovertible evidence that the stock market is in a blow-off top. There are ways to measure these phenomena, and since the last major correction in 2011, the major stock indexes in the US are in classic compliance with the shape, dimension, and timing of a blow-off top. The recovery from a correction starts slowly. Set-backs to the advance occur with relative frequency, but the market regains its strength and goes even higher. Then the set-backs become less frequent and shallower, the recoveries quicker and with greater confidence. At the blow-off climax, there are hardly any set-backs (rarely less than a percent or two), and they last a day or so. At this point the market is repeatedly off to the races, moving almost straight up. Because each advance after a set-back is at a slightly higher trajectory – initially a 5% move up, then a 7%, then a 10%, etc. – the mathematical picture that is being formed is of an exponentially rising growth rate that looks like its heading to the moon. Sometimes it does, as with the NASDAQ tech and dot.com bubble of 2000 from around 2,000 to 5,000 in the index, but that just makes the collapse of the bubble even more ferocious and dramatic (the NASDAQ subsequently lost 70% of its value).
Blow-off tops are common in commodities and emerging markets equities, where volume is thin, but are rarely seen in major stock indexes, the NASDAQ being a particular exception, more than doubling in value by 2000. The Dow Jones index was at 6,600 at the market bottom in 2009, and it has more than doubled since then, as has the S&P 500 index, a broader measure of the stock market. The S&P 500 just set a record high at 1700 this week, a far cry from its 2009 low of 666, so it is even more over-extended than the Dow. How much more so is easy to measure, one common yardstick being the relationship of today’s price to the average of the last 200 days of prices. That moving average is currently at 1300, so there is a 400 point spread between the average and the current price of 1700. That measures out at nearly a 4 standard deviation divergence from the average, meaning such a gap has been seen far less than 1% of the time in over 100 years of data for the index. Usually, when the gap reaches 2 standard deviations, red warning signs are going off that a snap-back to the average (or reversion to the mean) is coming straight ahead. These warning signs are always worth heeding; markets not only eventually revert to their mean, they overshoot it on the downside. Paul Farrell’s warning that we are going to get back to 666 from 1700 now suddenly makes more sense. To put this in perspective, at the market top in 2007, the S&P 500 index peaked at 1550, and the moving average was about 1250, or a 300 point spread. From that warning sign, the market dropped to 666. It could easily overshoot even that low this time.
A Sure Thing
Bubbles are always accompanied by the perception the market can only go in one direction. There is a frenzy of buying because profits are guaranteed by some paradigm shift that makes it appear as if the laws of gravity have been repealed. In the housing bubble, it was the belief that since prices in the US had never gone down in 100 years, they were guaranteed to go up. As they did so, the collateral value in homes kept increasing, leading to even more lending and an expansion of the bubble. This time it is faith in the Fed that is feeding the stock market bubble. The Fed is printing money to the tune of $85 billion a month through Quantitative Easing. Supposedly it can keep doing this forever, and since there is no sign it will stop, and this money is being funneled into the stock market, the stock market can only go up.
That QE money is finding its way into equities is easy to establish, partly because it is certainly not being used by the banks to lend money into the economy. Instead, it is being lent out by banks through their brokerage subsidiaries to investors wanting to leverage up and buy even more stocks in such a sure thing. It is a repeat of the housing bubble, in which each increase in an investor’s stock market portfolio value induces the investor to borrow more money to buy more stocks. This was the undoing of the 1929 stock market bubble – it was fed by margin loans. We see the evidence in New York Stock Exchange margin data, which is reported through three statistics: the cash value in investor’s accounts, their market gains on their portfolio, and the level of debt they have taken on through margin to buy that portfolio. At the 2007 market top, investors had around $120 billion collectively in cash in their brokerage accounts. They had borrowed $375 billion through margin, and had amassed $210 billion in mark to market (unrealized) profits on those loans. They had, in other words, $330 billion in total asset value to support $375 billion in loans, and that meant only one thing: to protect themselves, the brokers had no choice but to liquidate assets, cash in the profits, and repay the loans they were owed, when the market started heading down. This forced liquidation of investor stocks through margin calls (give us more money now or we will sell your stocks) is what led to the snowball decline in the markets from 2007 to 2008.
Fast forward to today. Investors once again are holding around $120 billion in cash in their accounts. They just tied the old record in 2007 for margin loans of $375 billion. That alone is a classic warning sign: when margin loans get to such high levels, a market top is not far behind. This time, however, mark-to-market profits on these leveraged assets are only $165 billion, compared to $210 billion in paper profits five years ago. How could that be if the markets are at record highs? This time the brokerages are taking on more risk, giving themselves and their customers less room to maneuver when (not if) prices start heading down. They are doing so through new products that give investors 2x or even 3x leverage, which investors love because they have to put down less cash to buy the product. Because there is less cash and paper profits to support the loans, the snowball down is going to be bigger and quicker – an avalanche of margin calls is going to drop the stock market like a stone.
The Fed Never Sees it Coming
If it is all so obvious to some astute and experienced investment professionals what is going to happen to this market, why doesn’t the Fed recognize the risk as well? Alan Greenspan famously said that it is impossible to recognize a market bubble until after it has burst. That is true if your only experience is as an academic, professional economist, or career central banker; in other words, if you have never worked a day in your life in the financial markets. That, unfortunately, is the job resume of every member of the Fed board and the Open Market Committee – not one of these people has any practical, real world market experience. They wouldn’t recognize a market bubble if it slapped them in the face, or to use Greenspan’s observation, they can only recognize a market bubble after it has slapped them in the face.
That they were just given that awakening was obvious in late spring, when Ben Bernanke hinted – merely hinted – that Quantitative Easing might be reduced a bit. He called it tapering down from the $85 billion that the Fed is currently spending every month in monetizing the deficit. The markets went haywire. The bond market asked the obvious question: what is the market-clearing interest rate for Treasury bonds if rates were left purely to the market, without any Fed interference? To use the 30 year bond as an example, the market decided yields shouldn’t be 2.46% – they should be at least 3.75%. That leap up in yield in the space of one month was one of the largest ever experienced so quickly in that market, and it caused massive losses for bond investors as well as upheavals in stock and bond markets around the globe.
The Fed panicked. Several governors and district presidents came out immediately and said poor Ben Bernanke was misunderstood. Bernanke then went before Congress and backtracked on his comments completely; tapering if it ever happened would depend on lots of improvement in the employment picture, and oh by the way, interest rates would stay at zero percent for years to come. Stock markets recovered instantly on this happy news, but the bond markets not so much. The losses to bond investors were so big that many institutional buyers have hesitated to load up on more bonds. Long term rates therefore remain at their late spring highs, which is hurting the baby bubble that was developing in the housing market in the US.
The Curtain is Slowly Being Pulled Back
Most observers are now understanding that the Fed is trapped. It is petrified of bursting the stock market bubble, so it does nothing. The stock market acts as if everything is back to normal – the Bernanke put remains in place, and it is therefore impossible to lose money in stocks because Uncle Ben is there to cover any losses, prevent any declines, and keep throwing $85 billion every month into the markets. Besides, humans no longer make the day to day decisions in the stock market. Three-quarters of all transactions are done by computers, and they are programmed to keep buying as long as the trend remains in place. They are not programmed to recognize bubbles, nor to do anything but sell if it looks like the trend has reversed. They too will join the brokerage firms in creating a market crash when every investor is huddled to one side of the boat, causing it to tip over.
If you think the Fed is all-powerful, and has unlimited money-printing capabilities that will never allow for a crash, then you weren’t watching what happened to gold. Like stock investors, gold traders thought they were on to a sure thing in 2011. Quantitative Easing scared them because all that money pouring into the economy was bound to cause inflation sooner or later. That is what happened to every country that has tried excessive money printing by their central bank. Consequently, inflation or even hyperinflation was guaranteed as long as QE continued, and so traders bid gold up all the way to $1900/oz., because gold is always a safe haven during inflationary times. Then in 2011 the price of gold suddenly collapsed. Nothing had changed. QE was not only going strong, it was increased. It was merely that every investor was all one way – long gold – and crowded into one side of a boat that was beginning to take on water. One day, the boat capsized, and gold is now trading near $1300/oz.
We are very close to the point where the stock market ship of state is about to capsize. It can happen when every last buyer gets on board. There could also be some news or development that causes every investor to rush all at once to the other side of the boat, causing it to tip over. That could be any number of things. Investors might realize that the nay-sayers are right, and the Fed is not omnipotent and able to stave off a correction forever. The bond market may continue to tank, and send 30 year rates from 3.75% to 4.75%, which would pretty much kill the economy and devastate the government budget when interest costs explode. Even worse, money markets might push short term rates from 0.50% to 1.00%, forcing the Fed to abandon its Zero Interest Rate Policy. The Fed might be forced to taper down QE anyway because it now owns over 30% of all 10-year and 20-year Treasuries, which has caused a dangerous shortage of collateral in the markets. An oil shock could push prices up from $105/bbl to $145/bbl. President Obama could decide to appoint a certified incompetent like Larry Summers to be Ben Bernanke’s replacement as Fed Chairman.
What’s an Academic to Do?
What the gold price collapse taught us is that if the markets get over-extended, it is irrelevant how much money the Fed is spending to prop up the markets. The boat will capsize, investors will flee, quite a few will drown, and a lot of the money the Fed put into the markets will evaporate in the twinkling of an eye. That’s always the problem with money printing; you have to be careful how the economy invests the money. If the banks had put all this Fed money into loans to companies with sound business investment prospects, most of it would get paid back. Instead, the Fed has sat back gleefully if not stupidly and watched its money printing go into highly speculative investments like stocks. In fact, it did this on purpose. It said it wanted stock market prices “to be higher than they otherwise would be”. The Bernanke Fed is a big believer in the wealth effect theory, that higher stock market prices inspire consumers to spend some of the paper wealth, causing the economy to expand. There is no evidence this theory is valid. Worse still, it was developed by Alan Greenspan, which ought to be a warning sign from the start.
Remember, though, nobody at the Fed understands the financial markets. They understand theories and models, and they put great faith in these tools. They don’t appreciate that a year or two of Quantitative Easing money could disappear in a few weeks in the form of market losses of $1 trillion or more from a stock market crash. This is why so many market observers describe the current Fed policy as the greatest economic experiment ever conducted by a central bank.
If a private individual were to conduct an experiment like this, causing investors to pour their money into an investment with a guaranteed high return that could only truly be paid out if the market continued to go up and only up, it would be called a Ponzi scheme, and that individual would go to jail. If a central banker does the same thing, it’s called a maladjusted policy when it blows up, the central banker gets to retire with a nice pension, and he writes a book explaining how no one could possibly have seen the market crash coming.
That’s about the only sure thing you can count on from the Fed. You are guaranteed that in a few years Ben Bernanke will be selling a book asserting that no one saw the stock market crash coming. It was completely unexpected, and came out of the blue. No model could have predicted such a thing. He’ll believe everything he’s written, because that’s how central bankers think. If they didn’t, we wouldn’t be facing the crash coming soon to a stock market near you.