While We Were Talking About Bubbles...

Includes: DIA, IWM, QQQ, SPY
by: John M. Mason


Concern with a stock market bubble grows.

BIS is now warning about excessive risk in the market due to Federal Reserve behavior.

Seth Klarman warns of a stock market bubble.

It seems as if there is a growing concern over credit bubbles these days. My last post discussed the subject of bubbles and how bubbles might occur more frequently because investors learn … especially wealthy investors … from the behavior of policymakers and then act on this behavior to pull down lots and lots of profits.

There were several articles last week that pointed out how private equity "kings" benefited from the actions of the Federal Reserve. The subtitle of an article in the Financial Times reads "Leading private equity firms are making record profits, partly on the back of the Fed's quantitative easing program."

How nice!

In my post mentioned above, I wrote:

"The New York Times reported that, 'One private equity chief went so far as to publicly thank Ben S. Bernanke, the Federal Reserve chairman until last month, whose program of extraordinary economic stimulus has helped push stocks higher, feeding the private equity machine.

'Thank you, Ben Bernanke. I saw him last Thursday, and I thanked him,' Mr. Schwarzman of Blackstone said during a conference in December.'"

Even economists at the Bank for International Settlements issued a warning last week, "Efforts by the major central banks to spur an economic recovery by providing guidance on what will happen to interest rates could endanger the global finance system."

Going further "Investors are being encouraged to load up on risk because they believe that forward guidance will warn them about impending rises in interest rates."

Furthermore, "It could also result in rates remaining too low for too long because central banks fear the reaction of markets to any rate rise, fueling riskier behavior."

The BIS economists go on "that a more worrying development would be if guidance made central banks so concerned about investors' reaction that they delayed raising rates."

Oh, my

And, now, Seth Klarman, the head of Baupost Group a $27 billion hedge fund, now raises the possibility that there exists an asset price bubble in the stock markets. Klarman is a "value investor" who wrote an investment book in 1991 (now out of print) that, on Amazon (NASDAQ:AMZN), fetches a price for a "new" copy of $3,575 or you can obtain a "used" hardback copy for $1,600 or a "used" paperback copy for $1,999.

A letter to clients, revealed in the Financial Times, "said that investors were underplaying risk and were not prepared for an end to central banks reversing a five-year experiment in ultra-loose money."

Although Klarman cannot predict the point at which the market will turn, he wrote "When the markets reverse, everything investors thought they knew will be turned upside down and inside out … Anyone who is poorly positioned and ill-prepared will find there's a long way to fall. Few, if any, will escape unscathed."

He adds, "Any year in which the S&P 500 jumps 32 percent and the NASDAQ 40 percent while corporate earnings barely increase should be a cause for concern, not for further exuberance."

Sounds like something I have posted along the way.

But, Klarman continues, "On almost any metric, the US equity market is historically quite expensive. A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla Motors."

The Federal Reserve continues to "pump" away although it is tapering its purchase of securities. Still, reducing its purchases $10 billion on a monthly basis will still result in the Fed injecting $320 billion of new reserves into the banking system. This is over one-third of the total Federal Reserve balance sheet six years ago. It's not the $1.02 trillion pace that was occurring last year.

The stock market "rally" could continue on for some time given this injection of funds. Still, that would just mean more "nosebleed stock market valuations". The stock market can continue to rise but there still is little expectation that corporate profits will show much gain. How long this disconnect can go on is the question. How long can asset bubbles last.

Which leads to the point that I have been making for the past six months. That point is that the future course of monetary policy is one of the greatest uncertainties in the economy at the present time. Never has the Federal Reserve … or any central bank for that matter … faced such a situation at this Federal Reserve now does. There is really no telling what is going to happen over the next six months … one year … or two years … and beyond … given the situation in the world today. It is hard to comprehend what a path back to "normal" would look like.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.