Batten Down The Hatches - Stormy Markets Ahead

Includes: DIA, IWM, QQQ, SPY
by: Michael Blair


Indices at record highs.

Fiscal and debt issues unresolved.

China growth slowing.

Hard to see upside value from here.

There is a French expression "Plus ca change, plus c'est la meme chose!" It seems most appropriate to the current state of the market and the economy.

The United States got itself into a bind only six or seven years ago when individual debt rose to an unmanageable level with mortgage loans the worst culprit. The tipping point came when adjustable mortgage rate (ARM) loans reached reset point; NINJA (i.e., no income, no job) borrowers were able to get credit but unable to pay when due; and, investors took a bath on inane paper Wall Street created when I packaged up toxic debt into so-called "Collaterized Debt Obligations" or CDOs, although there was no shortage of other acronyms. Mortgage brokers made a killing originating loans that had no hope of ever being repaid and the financial industry had a field day collecting fees for selling the junk to clients to whom they arguably owed duties of care. When the party ended it left most party goers with more than headache.

You would think the public would have learned their lesson from the 2008-2009 debacle but I will argue not. Take a look at household debt. It is back to levels first touched in 2007 and is growing. Mortgages remain 70% of household debt.

On the government side, government debt to GDP has not fallen but continues to rise and now stands above 100% of gross domestic product.

To put that into figures an ordinary person can understand, the national debt is now $17.5 trillion or just over $57,000 for every man woman and child in the country.

Source: Dave

Over $5 trillion of the U.S. debt is owed to foreign investors with China and Japan making up half of that amount.

Source: Dave

There has been substantial progress in bringing the fiscal deficit under control over the past few years. The debt now stands at a modest 2.8% of GDP or about $500 billion, well down from the trillion dollar figures a couple of years ago.

A lot of that progress relates to the massive intervention of the central bank to force down interest rates to historically low levels. The lower rates have actually lowered the amount of interest the government pays on its debt obligations to $415 billion in 2013, an less than the interest payments in 2008 when the debt was half the current level. America has enjoyed a fairly long expansion since the 2008-2009 collapse, now in its fifth year. Stock markets are at historic highs; unemployment is nudging its way down to about 6%; and, the central bank is easing its way out of the quantitative easing program in a process eloquently described as "tapering". By the winter, the Fed will no longer be buying treasuries.

What happens then? It is anyone's guess. We like to believe the Fed can control interest rates and there is little doubt it can when it is buying bonds at a rate greater than the issuers of those bonds are supplying them, leaving institutions with a legal need to hold bonds forced to also bid up bond prices to round out their portfolios. That process will end, indeed, must end. And, when it does, world economic forces will overpower domestic ones as I see it.

A new recession could be devastating to the U.S. stock market. One seems unlikely at present but it would not take much to set one off. A steep decline in Chinese economic growth; a major banking crisis in Asia; or, a war between Russia and its former satellites would very likely be enough. Alternatively, we could see a rise in inflation that requires a shift in monetary policy to keep under control.

There have been few signs of inflation to date, but inflation can emerge quite stealthily. An interesting chart was published by Barclays' in Business Insider showing that rising wages at the production level are being masked by slower growth in pay at the supervisory level. Labor is the biggest factor in costs for pretty well every company and higher wages necessitate higher prices over time.

Market tops are hard to time but have always had the same characteristics. These include:

  1. Record prices for the major indices
  2. Low interest rates
  3. Low unemployment
  4. General optimism about the outlook for the market and economy
  5. High levels of merger and acquisition activity
  6. Some really stupid deals and bad practices

I see quite a bit of evidence that most of these characteristics are present. Certainly the stock markets are at record highs and interest rates at record lows. Unemployment approaching 6% is pretty low although there is a debate about the quality of the measurement. Most investors appear bullish. There is a lot of M&A going on. And there have been a few really bad deals like the insane purchase of WhatsApp by Facebook (NASDAQ:FB) for $19 billion and the front running by Bill Ackman's fund in the Allergan takeover proposal. The high frequency trading disclosures just add fuel to a smoldering fire that the retail investor has little chance. Muppets, I think they are called at one of the big investment banks.

I think smart investors move to higher ground, increase their cash holdings a bit, and stay away from anything valued by price to sales owing to a lack of earnings. Twitter (NYSE:TWTR) recently demonstrated how quickly you can lose your shirt in 140 characters or less.

Good luck investing.

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.