Tim Price: God tapping us on the shoulder
Comment of the Day

November 11 2013

Commentary by David Fuller

Tim Price: God tapping us on the shoulder

My thanks to the author for his ever-interesting letter, published by PFP Wealth Management. It is posted in the Subscriber's Area but here is a brief sample
It may be all but impossible to forecast a crash, but it is surely easier to identify the sort of conditions that might give rise to one. Such conditions might include, for example, specifically in the context of the US: an overbought stock market; high optimism and / or complacency among investors; historically low volatility; a deteriorating bond market and rising interest rates; a climate of panic / euphoria driving precious metals and resources markets. It would be superfluous to cite the apparent deterioration in geopolitical stability, beyond questioning the possible impact of worsening trade or political tension on the US dollar - as opposed to the price of gold or oil.

David Fuller's view Crashes are relatively rare but they are preceded by a number of reoccurring characteristics.

Most will include these points cited by Tim Price in his paragraph above: "…an overbought stock market; high optimism and / or complacency among investors; historically low volatility; a deteriorating bond market and rising interest rates".

I would add that irrationally high optimism in an increasingly overextended market is always accompanied by high anxiety, not least among the more experienced participants. They know, and many others will intuitively sense, that the trend is too good to last. However, it is so profitable that no one who is long wants it to end. They become like junkies - give me one more new high, and when that has occurred they will hope for another, at least until the inevitable reality of a sharp pullback brings them back down to earth.

Bubble markets are fuelled by excess liquidity which the USA's Federal Reserve or central bank in any other country can take away by tightening of monetary policy. Central banks have inflated and then killed off far more bull markets than any other factor.

Bubble markets usually have themes. Considering the more recent ones, in the build-up to the 1987 crash the theme was "portfolio insurance", meaning the theoretical ability to instantly hedge against downside risk by shorting Wall Street's new stock market futures contracts. That was supposed to mean that shares could safely trade at higher valuations. The trouble was, every institution tried to hedge at the same time. Consequently, a number of stock markets had to be closed because of a sudden avalanche of sell orders. They reopened at considerably lower levels, triggering a further crash.

The late 1990s theme was "the new economy", a reference to the proliferation of technology stocks which were regarded as considerably more sexy and promising than "old economy" stocks, even though many of them had no earnings. The bursting of that tech bubble in 2000 ended Wall Street's last secular bull market which had begun in 1982.

In the build-up to 2008's bear market the "commodity supercycle" was a contributing factor, especially the spike in oil prices. Historically, accelerating energy costs have been an important factor in a number significant bear markets, including the 1973-1974 slump.

Clearly, we need to recognise significant bubble conditions which are followed by bear markets. However, it is even more important to understand that every market crash presents an excellent buying opportunity, although most people do not believe it at the time. This is especially true if they have sold out in the latter stages of the bear market decline. For them, even buying near a recognisable market trough will feel equivalent to rushing back into the burning barn from which they recently escaped.

Today, do we have bubble conditions on Wall Street and in some other markets? Yes, although they are nothing like 2000 or 2008, in my opinion. Nevertheless, an increasing minority of serious international investors have begun to express concern about bubble characteristics created by quantitative easing (QE), which after all, was introduced to boost confidence by lifting share prices. It has succeeded, although the knock-on benefits have been modest by comparison.

My concern is that the Federal Reserve risks creating a more significant bubble which would be destabilising, not least for investors. Meanwhile, emboldened by QE, a majority of investors are still pushing US equity indices upwards, evidenced by the progressions of higher reaction lows on weekly 5-year charts of the DJIA, S&P 500, NASDAQ 100 and Russell 2000. Setbacks have become unsustainably smaller, with the exception of the DJIA. Breaks in the progressions of higher reaction lows would suggest at least mean reversion towards the rising 200-day moving averages.

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