For the past few months, the markets have risen back to highs made earlier this year as traders attempt to front run potential EU and Fed intervention. Federal Reserve Chairman Ben Bernanke and his counterpart ECB Chairman Mario Draghi have used almost every arrow in their quiver in an attempt to juice the markets higher over the summer.
We have been told that the Federal Reserve stands ready to act, the ECB would do whatever it takes, and that the ECB stands ready to enact a policy of unlimited bond purchases and/or sovereign debt yield targeting in an effort to prop up the markets.
The problem with promises of intervention is that once the markets have front run the targeted asset classes there is little left for investors. For example, the S&P 500 (NYSEARCA:SPY) now trades for 16 times earnings, an expensive multiple when one considers that earnings growth in the second quarter stumbled into the single digits and the third quarter little or no growth is expected. At the beginning of the year, earnings growth was expected to be in the low teens indicating that the global economy is slowing more than anyone expected.
The question now becomes what happens if the Central Banks do or do not deliver on their promises?
The ECB has already poured cold water on the idea of granting the ESM a banking license making the idea of targeting sovereign bond yields impossible at best unless they want to become the only buyer in town. This solution would create more risk and open the door to moral hazard as the affected governments would have no incentive to fix their structural problems.
The idea that targeting sovereign bond yields can stem the crisis in the European bond market harkens back to the LTRO which was effective until it ran out of funds. The LTRO helped plug holes in Spanish banks during bank runs earlier this year, but in terms of bringing an end to the European crisis, it has been a failure.
Initially, yields fell but then rose once the money ran dry. A similar situation may be occurring now as European leaders put the finishing touches on a new bond purchase program. Traders are front-running the program, buying up as much sovereign debt as possible in the hopes that they can flip the bonds to the ECB. If the program does not appear, look for a swift selloff as the trade quickly reverses itself. If the program does appear, look for yields to fall initially as traders stuff the ECB full of debt they purchased earlier only to disappear once the program is full sending rates higher. One huge risk of targeting sovereign bond yields is monetizing all debt from Spain and Italy as the markets will test the cap repeatedly until the limit is found.
In this environment, investors should be taking steps to protect their portfolios against the coming selloff. Stocks like Coca-Cola (NYSE:KO) are extremely overvalued in this market climate, trading for 20 times earnings while giving investors 4% growth through the first six months of this year. No one denies that they are a one of a handful of global brands whose logo is recognized anywhere in the world, but there is the question of how much premium that brand commands in this economic environment.
The old Wall Street adage of buy low and sell high applies here. Stocks are overvalued and trading near yearly highs, while Gold (NYSEARCA:GLD) and Silver (NYSEARCA:SLV) have spent the better part of the summer tracing out bottom formations, setting the stage for the next move higher.
In either case, intervention or no intervention, gold and silver will move higher after a short pullback. Intervention means that gold and silver once again will take on their roles of safe havens in an uncertain environment. If there is no intervention, that means the inevitable has been delayed, giving investors the opportunity to buy in before the storm hit.
Disclosure: I am long DGP. 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. I am also short SXPS.