Effective Federal Funds Rate chart 1954 - 2014

Stock Market Risk – The New Reality Part 1

Investors are expecting far too much return from their investments, and far too little downside potential, as of today. These expectations rest on two faulty ideas:

  1. Expecting the next five years to mirror the past five.
  2. Belief in the power of the Federal Reserve, and central banks everywhere, to ensure economic growth.

But, the Fed’s primary policy tool of quantitative easing (QE) has started to lose support, partly because it’s not an effective long term solution. I will point out several items that suggest that the stock market risk is high at current levels, even if central banks continue to pump QE; and, should a new paradigm come into play with respect to currency management, the risk has scarcely been higher. And, more importantly, what does an investor do as a consequence of this risk?

The Problem

“We will not have any more crashes in our time.”John Maynard Keynes 1927
“Stock prices have reached what looks like a permanently high plateau.”Irving Fisher, U.S. economist Sept 5, 1929
“… the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”Ben Bernanke May 17, 2007

Making market and economic forecasts is tough business. And, while we have the benefit of hindsight exposing the absurdity of the first three prognostications, I have my own forecast on the next two: There’s a 0% chance of them being correct.

“the FOMC’s outlook…foresees a gradual return over the next two to three years…[to] its mandate [5% unemployment and 2% inflation].”Janet Yellen April 16, 2014

Fed Funds rate forecast is, “3% at the end of 2015, and 4% at the end of 2016”Charles Plosser, Philadelphia Fed President March 25, 2014

Fed policy makers have a terrible track record forecasting future developments from their policies. The trouble with the two quotes above from notable Fed heads is that they are based on the two faulty assumptions at the top: “that current trends will continue,” and “their overinflated belief in themselves.” And, keep in mind, Fed policies have always generated unintended consequences that they will have to deal with.

Chart of FRED 1954-2014 in percentage
Economic data by: Federal Reserve Bank of St. Louis
Stock Market Risk, Bond Market Risk, 0% on Cash

Today, the unintended consequences of six years of the Fed’s unprecedentedly loose monetary policy (see Effective Federal Funds Rate chart above), and the U.S. government’s unprecedentedly loose fiscal policy, leave most asset markets at unattractive valuations. I offer the following:

Table with the Dow Jones Industrial Average components' P/E and divident yield1. Stocks are richly valued – The Dow Jones Industrial Average is trading at high valuations because of 0% rates, not because they’re worth current prices – the average P/E is 17 and the divident yield 2.5%.

2. Bonds are overvalued – Bonds are trading at high valuations (low yields) because of 0% rates, not because they’re worth current prices.

3. Cash is unattractive due to its negative 4-5% real rate of return (return – inflation).

4. Inflation is high – CPI is 2%, but using pre-1990 methodology, inflation is over 5%. Using pre-1980 methodology, inflation is even higher. Check John Williams’ ShadowStats website.

I’ve made a fairly controversial statement, “The Dow Jones Industrial Average is trading at high valuations because of 0% rates, not because they’re worth current prices.” So, let’s examine that. The argument in favor of these lofty valuations is something along these lines, “Yes, valuations are high, but bonds and cash are unattractive, due to inflation, and companies at least can raise prices to insulate themselves from inflation.” A reasonable point if rates remain at 0%, and there are no external shocks. But, what if there are some external shocks that would remind investors that despite, “pricing power” and “dividends” that stocks can actually fall 30-40% over a given 12-18 month period?

Coming up in Part II

In Part II of the Markets’ New Reality, we will cover some potential external shocks, and what to do about them. Here’s a sneak peak at the points we will cover: Japanese government debt downgrade, debt defaults as result of separatist movements, the new currency paradigm and new strategies.

The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.

About The Wolf

Twenty years is a long time to be involved in the trading business. Through many battles in every asset class known to man, knowledge has been gained; and, this project is a way to share that knowledge. The Wolf is a big fan of repeatable market work, or the creation of a “process.”

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