Despite numerous warnings from various experts, our stock market continues to reach unprecedented highs.
The Dow Jones stands at another all-time high of 21,891. And so does the S&P500 at 2,470. We’ve talked previously about how the Shiller Ratio which measures cyclically adjusted price earnings ratio, is at the same level as 1929; second only during the dot-com bubble of the late 1990s.
Yet despite all these warnings, we appear to truly be in a ‘Teflon’ market. The Wall Street Journal recently noted that the major stock market benchmarks in the US, Europe, and Asia have had zero pullbacks in 2017. A pullback is a 5% decline from recent highs, and no major index has gone a calendar year without any pullbacks for at least 30 years.
The last pullback our market experienced was over a year ago during the Brexit referendum, which saw a 5.2% pullback. Not quite a full calendar year, but the zero pullback streak we are currently on is the longest streak going back to 1996.
So what’s keeping the stock market so inflated?
It can’t be just irrational investor confidence, although that certainly plays a part. Is the market really just that strong and resilient?
The real answer is that the stock market is being artificially pumped up from the excess liquidity tap. And this is very dangerous. This means that unless the Federal Reserve keeps the excessive liquidity flowing with asset purchases and an accommodating fiscal policy, the stock market bubble will burst. But before it does, the bubble will just keep getting larger and larger.
And there are already signs that this liquidity tap may dry up soon. As we have seen, the Federal Reserve has been steadily raising interest rates, a sign of tightening fiscal policy. And now, the Federal Reserve also wants to shrink its $4.52 trillion balance sheet.
The rate hikes plus a shrinking balance sheet could put a quick and sudden end to our fairy tale stock market.
And the United States isn’t alone in facing this dilemma. Consider the ECB, the European Central Bank. Hamstrung by the less economically successful EU countries, the ECB has almost had no choice to but to step up their quantitative easing program, pumping more and more liquidity into the markets.
And what’s worse is that the assets the ECB are purchasing is becoming of increasingly low quality. When the ECB first began buying corporate bonds in March 2016, its stated policy was that it would only purchase investment grade rated debt.
However, when questioned about what would happen if any investment grade rated debt it held was downgraded to below investment grade, the ECB replied that it was “not required to sell its holdings in the event of a downgrade”.
So how does the ECB’s corporate bonds balance sheet look like now? Well, not good.
Out of a total of 981 corporate bond issuances which the ECB has bought, 34 are rated BB+, below investment grade, and 208 are not rated at all. That means that 24.7% of its total corporate bonds balance sheet is nothing but junk bonds!
The ECB has now become a ‘bad bank’ loaded up with bad credit such as corporate junk bonds and toxic sovereign debt from the Euro-periphery countries. And if global economic conditions take a turn for the worst, all that bad debt will be the first to implode.
There is little we can do as individuals to influence the course of the economy or the actions of global central banks. All we can do is to be prepared. That’s why intelligent investors are diversifying their portfolios into hard assets such as precious metals. Precious metals serve as a hedge against the economy as a whole; when the crash comes, would you rather be holding paper stocks or gold?
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