Stock Market Russian Roulette

by: Eric Parnell, CFA

"One shot, one shot."

--Michael Vronsky, The Deer Hunter, 1978

Investing in the stock market has become both an exhilarating and dangerous game. Each and every trading day, the markets open and the chamber spins. And as the monetary stimulus flows, the money changes hands and the trigger is pulled, the stock market surges higher seemingly each and every trading day. That is until one day it all finally takes an inevitable and tragic turn. The game is over, the blood is strewn and the irrevocable damage done.

Unfortunately, such is the path that the stock market finds itself on today. There is no telling exactly when this day will come. It could be tomorrow, a month from now, a year from now or longer. It may have even already occurred on Monday with the news out of Cyprus. At this point, we do not know. But when this fateful day does finally arrive, the aftermath is sure to be ugly.

"Oh, I'm so glad you're alive. I'm so happy. I really don't know what I feel."

--Linda, The Deer Hunter, 1978

The fact that the stock market has performed so well over the last several years has been a relief to many and equally puzzling to others.

Of course, it has been and continues to be the actions of global policy makers more than anything else that has propelled stock prices higher these last few years. Fiscal and monetary officials have repeatedly scrambled to try and fix the problem by deploying vast quantities of vital resources a desperate attempt resuscitate economic growth. These efforts have certainly yielded some meaningful positives, for not only did we recover from the brink of a full-scale global financial meltdown, but we also have returned to an environment market by steady albeit sluggish growth and corporate earnings that have returned to pre-crisis levels.

But despite these short-term positives over the last few years, we are far from a circumstance today where all of the negatives have been fully cast aside. For what plunged the global economy into crisis in the first place was the fact that too much low quality and speculative debt had been recklessly accumulated and distributed like poison throughout the financial system. Since that time, much of this toxic debt still lingers, only in different and arguably far more dangerous and mutated forms.

"This comes every month from Saigon. I don't understand. That place is going to fall any day now...Where is a guy like Nick getting money like this?"

--Steven Pushkov, The Deer Hunter, 1978

Looking forward, the worry remains that all of these efforts will have been in vain in the end. For along the way, global governments have accumulated massive sums of debt in trying to fix the problem that at a minimum will serve as a heavy weight on future growth and at worst will end up never being paid back. And global central banks have printed so much money trying to keep interest rates low and stock prices high that they may end up at a minimum being forced to drain liquidity before achieving sustainable economic growth and at worst will end up destroying the fiat currency system as we know it. In the meantime, conditions have once again been set to promote the inflation of new asset bubbles.

Perhaps everything will simply work fine in the end, but all of these substantial long-term risks represent a meaningful threat to financial markets. And exactly if and when one of these threats will begin to fully manifest itself only remains to be seen. It could be today, next week, next month, next year or longer.

"We don't have much time, Nick"

--Michael Vronsky, The Deer Hunter, 1978

In the meantime, the money changes hands, the chamber spins and the trigger is pulled. And to this point, the fatal bullet has yet to be discharged on the stock market.

Sure, we've certainly had a number of near misses that rattled the markets along the way. These included but were not at all limited to:

  • The Latvian financial crisis in early to mid 2009
  • The Dubai World debt crisis on the day after Thanksgiving in 2009
  • The flash crash on May 6, 2010
  • The Greek debt crisis and bailout in May 2010
  • The Ireland debt crisis and bailout in November 2010
  • The dawn of the Arab Spring in December 2010
  • The outbreak of civil war in Libya in February 2011
  • The Japanese earthquake and tsunami on March 11, 2011
  • The Portugal debt crisis and bailout in May 2011
  • The U.S. credit rating downgrade in August 2011
  • The spike in Spanish and Italian bond yields in 2011 and 2012
  • The Spanish bailout in June 2012
  • The Cyprus bank rescue and deposit tax in March 2013

The bullish among us might look at all that has unfolded over the last several years and marvel at the resilience of the global economy and its financial markets. Of course, one could also watch The Deer Hunter and think "wow, that Nick must be one heck of a Russian roulette player given all that money sent in the mail to Steve". And perhaps this stock market game will continue, no harm will come to its participants and the money will continue to flow.

The more bearish among us might view all that has unfolded to this point and see a worrisome trend. Building on the example above, another viewer watching The Deer Hunter might reflect on Nick's experiences earlier in the movie and think "something must really be unraveling with Nick if he's sending all of this money in the mail to Steve". For the one fact that cannot be ignored is that the size and scale of the problems that continue to erupt are becoming increasingly larger. Four years ago it was Latvia and Dubai. Today it is potentially Italy, Spain and all of Europe not to mention the unsettling realities that continue to haunt places like China, Japan and the United States.

Until we see a reversal in this trend where problems are becoming smaller instead of bigger, and until we see policy makers comfortably withdrawing stimulus instead of frantically injecting it, we will remain perilously close on any given trading day to that one fatal shot that unravels the stock market all over again.

"One shot."

--Nick Chevotarevich, The Deer Hunter, 1978

Was Cyprus over the weekend that one shot? It remains to be seen, for stock markets do not plunge into darkness in a single trading day. An often-overlooked point about the outbreak of the financial crisis in 2008 is that the stock market did not immediately plunge following the Lehman bankruptcy. In fact, the S&P 500 Index (NYSEARCA:SPY) was actually higher from where it started five trading days later. It was only after a few weeks and subsequent events unfolded that the market began cascading lower. Thus, we should not conclude that we have the all clear just because the market reaction has been generally muted thus far.

Beyond the current issue with Cyprus, the far more important point to consider is the following. The market has been caught up in a catatonic state over the last several years. Aggressive monetary and fiscal policy has helped mend the physical wounds to the financial crisis, but deep emotional scars remain. All along, the stock market has been generally placid, almost too much so at times with the VIX not far above historical lows today. But every now and then it shocks violently awake with a sharp and staggering plunge, only to drift back into another monetary policy induced stupor.

This leads to the following critical questions. Exactly what event will finally cause the stock market to awaken from its catatonic state? And once it awakens, at what moment will it react violently to the still deeply unsettling realities all around it? And will this bleeding play out slowly over time or be done as quickly as the click of a trigger? Perhaps it will be the events out of Cyprus. Perhaps it will be something different later this year, or the next, or a few years down the road. Or perhaps the global financial system will find a way to miraculously heal itself with little to no repercussions for the financial system. It is on this last point I am far less optimistic.

In the meantime, we are left to trade in the market we have before us. Recognizing that stock market stupor may soon return at the moment policy makers potentially throw additional money at the Cyprus problem, it is reasonable to maintain an allocation to stocks. I should note that I was already in the process of scaling back my stock allocations prior to the Cyprus news. This included the sale of all beta allocations with the focus instead emphasizing quality through positions like the S&P 500 Low Volatility ETF (NYSEARCA:SPLV) and McDonald's (NYSE:MCD). As for the reallocation of these stock sale proceeds, I intend on holding it in cash at least for the moment until some clarity is gained surrounding the events in Cyprus and across Europe.

In the meantime, these latest events highlight once again the importance of diversification across asset classes that have a low to negative correlation with stocks. High quality bonds such as Build America Bonds (NYSEARCA:BAB), U.S. TIPS (NYSEARCA:TIP) and Investment Grade Corporate Bonds (NYSEARCA:LQD) have surged back to life in recent days after edging lower for most of 2013 thus far. And the recently battered precious metals market including gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) has discovered a new found resurgence after what was a difficult stretch in February. While the events unfolding in Cyprus once again highlight the advantage of owning the physical metals, those interested in holding such allocations in an investment account are best served by positions such as the Central GoldTrust (NYSEMKT:GTU), the Central Fund of Canada (NYSEMKT:CEF) and the Sprott Physical Silver Trust (NYSEARCA:PSLV).

Wednesday will bring yet another trading day. A fresh new dose of monetary stimulus will flow into markets, money will change hands, the chamber will spin and the trigger will be pulled. And whether the fatal bullet has already been fired or still resides in the chamber simply remains to be seen at this point.

Disclosure: I am long SPLV, MCD, CEF, GTU, PSLV, BAB, TIP, LQD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.