Erik McCurdy's  Instablog

During the past several years, the Federal Reserve has engaged in a historic market intervention through its quantitative easing (QE) programs. Early on in the process, Federal Reserve Chairman Ben Bernanke indicated that the intent of the intervention was to inflate the stock market and thereby spur a "virtuous cycle" through which the economy would be reinvigorated. Predictably, the economy has failed to respond meaningfully to QE as it continues to be constrained by excessive debt. However, the stock market has responded to artificially low interest rates and the cyclical bull market from 2009 has accelerated into a highly speculative advance that exhibits the characteristics of a prototypical bubble.

 

 

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As an academic, Chairman Bernanke has exhibited the tendency to expect markets to behave rationally throughout his career. For example, many years ago, he argued that excessive debt would almost certainly not become a problem in the US because allowing debt to reach excessive levels would be irrational. Yet, here we are. Similarly, he probably did not expect the recent QE programs to create a speculative bubble in the stock market, but that is precisely what has occurred. As with all such highly speculative advances, the inevitable correction will be equally violent in character. It is only a question of when.

Additionally, it is important to reflect upon the extremely difficult task that will face the Federal Reserve when the time comes to reverse the QE process. How will this historic amount of monetary stimulus be withdrawn from the system without engendering significant economic disruptions? In a recent weekly commentary, fund manager John Hussman reviewed the unpleasant consequences of Federal Reserve policy that will need to be addressed after QE ends.

Over the past three years, the U.S. economy has repeatedly approached levels that have historically marked the border between expansion and recession. There is little question that massive quantitative easing by the Federal Reserve has successfully nudged the economy away from this border for a few months at a time. But as I've noted before, the belief that monetary easing solved the 2008-2009 financial crisis is an artifact of timing. The Fed was easing monetary policy throughout 2008, and while it is tempting to view the recovery as a delayed effect, the more proximate factors were a) the change in FASB accounting rules to dispense with mark-to-market accounting, which relieved banks of insolvency concerns even if they were technically insolvent, and b) the move to government conservatorship and Treasury backstop of Fannie Mae and Freddie Mac, which reduced concerns about default risk among mortgage securities.

The Pavlovian response of investors to monetary easing - as if it has anything more than a transitory and indirect effect on the economy - fails to distinguish between liquidity and solvency; between economic activity and market speculation; and between investment value and artificially depressed risk premiums. The economy is not gaining anything durable from these policies, and the conditions for the next bear market are already established. Meanwhile, the chart below updates the extreme that monetary policy has already reached (data points since 1929).

 

 

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The 3-month Treasury yield now stands at a single basis point. Unwinding this abomination to restore even 2% Treasury bill rates implies a return to less than 10 cents of monetary base per dollar of nominal GDP. To do this without a balance sheet reduction would require 12 years of 6% nominal growth (which is fairly incompatible with sub-2% yields), a more extended limbo of stagnant economic growth like Japan, or significant inflation pressures - most likely in the back half of this decade. The alternative is to conduct the largest monetary tightening in the history of the world.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

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

Our computer models analyze a large basket of fundamental, technical, internal and sentiment data in order to calculate our Secular Trend Score (STS) and our Cyclical Trend Score (CTS). The historical data used by our models extend back to the market crash in 1929 and have enabled our STS to correctly identify every secular inflection point and our CTS to correctly identify more than 90% of all cyclical inflection points during the last 84 years. Additionally, when analyzed together, these data identify extremes in the risk/reward profile of the stock market from an investment perspective. Since early February, stock market investment risk has remained in the highest 1 percentile of all historical observations, joining a select group of five time periods that include the long-term tops in 1929, 1973, 2000 and 2007.

 

 

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As always, this particular measurement of investment risk is not a top call or an indication that a severe market decline is imminent. Overbought rallies such as this one can remain overbought for a long time as speculative momentum carries prices to higher and higher extremes. What the current investment risk/reward profile tells us is that a severe market decline will almost certainly occur after the current cyclical bull market terminates. At a current duration of 50 months, the bull market is long overdue for termination and the next cyclical top could form at any time. Additionally, the rally has taken the form of a prototypical speculative advance as modeled by a log periodic bubble. This mathematical formula replicates market behavior extremely well during unsustainable advances and the following chart from a recent weekly commentary at the Hussman Funds website displays the high degree to which the current stock market rally is exhibiting the classic characteristics of a bubble in its final stage.

 

 

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The most recent uptrend from November has moved higher at an unsustainable rate, gaining nearly 22 percent during the past six months and becoming extremely overbought on a short-term basis.

 

 

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Any breakdown could signal the development of the latest cyclical top, so it will be important to monitor price behavior closely during the next several weeks. Now remains a time for extreme caution and we remain fully defensive from an investment perspective.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

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

As we note often, context plays a vital role in the development of reliable market forecasts. Short-term price behavior only has meaning when analyzed in the proper context afforded by the long-term view, so all investing and trading strategies should begin with a thorough understanding of the current secular environment. There have been five secular trends in the stock market since the crash in 1929, three downtrends and two uptrends.

 

 

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The current secular bear market began in 2000 following a speculative run-up during the second half of the 1990s. As usual, market behavior clearly signaled that a secular inflection point was approaching and our Secular Trend Score (STS), which analyzes a large basket of fundamental, internal, technical and sentiment data, issued a long-term sell signal in December 1999. At the time, our computer models predicted that stocks would enter a secular bear market that would last from 10 to 20 years. Following the topping process in 2000, a prototypical secular downtrend began that continues today.

 

 

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Severe secular bear markets such as this one are nearly always accompanied by extremely weak economic activity and the first decade of this century was characterized by the lowest real GDP growth since the Great Depression.

 

 

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Stock market secular trends typically last from 10 to 20 years, depending upon the nature of underlying structural economic trends. Since we are currently in the final stage of a debt expansion cycle that began 60 years ago, it is highly likely that the current secular bear market is still several years away from its terminal phase.

 

 

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The STS supports the hypothesis that this secular downtrend is far from over as the score has yet to return to positive territory following the sell signal in 1999. Secular inflection points develop slowly, usually over the course of 6 to 12 months, so the STS will provide plenty of advance warning when the next true investment opportunity develops in the stock market.

 

 

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Secular trends are themselves composed of cyclical subcomponents, and the current cyclical uptrend began in March 2009. When they occur during secular bear markets, cyclical rallies have an average duration of 33 months. At a current duration of 50 months, the bull market from 2009 is long overdue for termination and it will likely be followed by a violent overbought correction. The long-term uptrend will remain healthy as long as it continues to hold above support at the lower boundary of the power uptrend from November near 1,571. However, a weekly close well below that support level would predict a quick return to support at the lower boundary of the rally from October 2011 currently near 1,470 and signal the likely development of a cyclical top. A subsequent weekly close well below uptrend support near 1,470 would effectively confirm the formation of the overdue cyclical top and predict a relatively quick return to bull market support currently near 1,281.

 

 

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The final phase of the previous cyclical bull market from 2002 was easy to identify as it developed in 2007. The measured move higher from 2004 until 2006 was followed by speculative blow-off rally that terminated the advance in prototypical fashion. The historic amount of Federal Reserve stimulus introduced during the last four years, targeted directly at risk assets such as stocks, has created massive market distortions, causing the current cyclical bull to be characterized by violent moves in both directions. However, the last advance off of the low in 2011 is rising at an unsustainable rate, suggesting that the rally has entered its final phase.

 

 

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Another way to model an unsustainable advance is via a log periodic bubble. This mathematical formula replicates market behavior extremely well during highly speculative uptrends and the following chart from a recent weekly commentary at the Hussman Funds website displays the high degree to which the current stock market rally is exhibiting the classic characteristics of a bubble. Therefore, the next cyclical top is almost certainly imminent and it could form at any time.

 

 

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Additionally, it is important to remember that stock market investment risk continues to hold near the highest level ever recorded. Anything can happen over short-term time periods, but the key to having consistent success over the long run as an investor and a trader is to stay aligned with the most likely scenarios and protect yourself from the unlikely ones. There will come a time when the risk/reward profile of stocks is once again favorable and the judicious study of market data will signal when that next long opportunity develops, just as it did in March 2009. However, now is a time for extreme caution and we remain fully defensive from an investment perspective.

We will identify the key developments as they occur in our daily market forecasts and signal notifications available to subscribers. Try our service for free.

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