Market conditions are ripe for a bad storm - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 22 August 2013
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Baltimore, Maryland

Our operating hunch is that all major markets have turned around. After 33 years of falling yields, bond yields are now going up. After 2 years of correction, gold prices are going up again. After 5 years...or 12 years...or 31 years - depending on how you count it -- of rising stock prices...stock prices are falling.

It's still summertime. We don't expect much action in the next few days. But already, kids are going back to school and parents are getting back to work.

And pretty soon, investors could notice that Mr. Market is taking over from the Fed. Mom & Pop are back in the stock market. Sentiment, prices, margin debt - all are at extremely high levels. (Margin debt, for example, is back at levels not seen since 2000 and 2007.) Take away the jive profits of the financial industry and real earnings are weak. And the relationship between Fed policy and stock prices is weakening too. John Hussman:

    ...our estimates of prospective risk are surging...

    At present, we have what might best be characterized as a broken speculative peak, in that market internals (particularly interest-sensitive groups), breadth and leadership have broken down uniformly following an extreme overvalued, overbought, overbullish syndrome. If you recall, the market also recovered to new highs in October 2007, weeks after the initial, decisive break in market internals at that time. Presently, we're looking at the same set of circumstances. On some event related to tapering or the Fed Chair nomination, we may even see another push higher. It isn't simply short-term risk, but deep cyclical risk that is of concern.
What's the 'deep cyclical risk?' It's the risk of a market that has been bubbled up by too much cheap credit. Like any bubble, it floats around until it finds its pin.

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This leads us to do something we do rarely: today, we're hoisting our black and blue, tattered 'Crash Alert' flag over our Diary headquarters here in Baltimore. Watch out.

Not that we know anything you don't know. We gave up trying to predict the future long ago, after we realized we were no good at it. Our 'Crash Alert' flag is not a forecast. It is a like a tornado warning: market conditions are exceptionally ripe for a bad storm.

Yesterday, the Dow fell 105 points. Gold barely moved. Bonds kept going down.

Markets move in long cycles of trust. They begin tentatively, with investors unwilling to pay more than 8 or 9 times for a dollar's worth of corporate earnings...and too scared to lend money without at least 10% interest coming their way.

Gradually, as things improve, they become more confident. Soon, they are buying stocks with P/E ratios of 12 to 15...and borrowing at only 5% interest.

Then they become convinced that the good times will last forever. Doubts are put aside as they find reasons to believe that what never happened before is now guaranteed forever. Ordinary people come to think that Wall Street is there to help them make money. Progress, prosperity, and rising asset prices...now and everlasting. Amen.

These beliefs are tested. There are setbacks. Shocks. Brief corrections. But if these are overcome quickly enough, a kind of blind faith takes hold. Investors begin to believe the impossible. Now, for example, investors think the Fed 'will not allow' a serious correction.

It should be pointed out, tout de suite, that the Fed can influence the markets. It cannot control them. And the more it influences them, the harder they are to control. Why? Investors test the Fed to protect their money...just as the Fed makes their investments less trustworthy. Because the more influence it exerts, the farther they go away from where they ought to be. If the Fed offers too much credit, for example, stock prices adjust...and soon become higher than they should be. At some point, they are so high...and so far removed from solid values...that the proud tower wobbles...and then collapses, regardless of what the Fed is doing.

And based on what's happening in the bond market, it appears that the Fed has already lost control.

Ah yes, dear reader, that is one of the curious, always-fascinating feedback loops that keeps life on planet earth 'normal.' Whenever things get too weird, something intervenes to make them less weird. And one of those things is a certain Mr. Market.

It's all very well for investors to believe the Fed won't allow them to lose money. That's what makes it possible for non-delusional investors to make a lot of money. Again, John Hussman:
    Collective belief can create its own reality, and at least for the past few years, collective belief is that Fed actions simply make stocks go up, and so they have. The problem is that this outcome is based almost wholly on perception and confidence bordering on superstition - not on any analytical or mechanistic link that closely relates the quantity of monetary base created by the Fed to the equity prices (despite the correlation- presumed-to-be-causation between the two when one measures precisely from the 2009 market low). Some of the deepest market losses in history have occurred in environments of aggressive Fed easing. Markets move in cycles, bear markets wipe out more than half of the preceding bull market gains, and this one is likely to be no different.
Mr. Market is watching. He allows bulls to make money. He allows bears to make money. He allows smart people to make money. And dumb people too.

But at some point, Mr. Market gets tired of watching people make money. He likes to see them all lose money too.

This could be one of those times.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "Market conditions are ripe for a bad storm"

Amir Lakhani

Aug 23, 2013

fantastic! Absolutely down to earth.haven't read anything like this in long time

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