Regular readers of my blog know that I consider current economic conditions as well as the stock and bond market rallies since 2009 to be highly artificial due to the unprecedented and extraordinary Federal Reserve intervention supporting them. That view doesn’t make the rallies and today’s economic circumstances any less real; they are what they are. The resultant debt and related market and economic dislocations, however, make today’s condition highly unstable and dangerous.
At the first hints in May that the gravy train might be slowed – far from stopped, stock and bond prices fell aggressively. Many subsequent calming words from a variety of Fed spokesmen prompted a recovery bounce for stock prices. Bonds, however, did not benefit from a similar rally. In fact, the price decline has been so severe that since Bernanke’s May outline of a tapering scenario, most bonds have lost all interest and capital gains of the past two years. Most bondholders have never experienced such losses. They last occurred more than 30 years ago.
There is no way to measure how durable is investor confidence. Stock markets have historically been far more volatile than bond markets. Should today’s confidence disappear, stocks could similarly give back years of gains more quickly than most investors can imagine, given the lack of sound fundamentals beneath today’s market prices.
The behavior of both stock markets and currencies of emerging countries has sounded an ominous note. In a matter of just one month, the threat of slowing worldwide liquidity precipitated a nearly 20% equity price drop among the emerging countries considered the new engine of the world economy. Such action might have been largely disregarded in decades past, but with emerging nations now comprising about half of the world’s economy, their cumulative impact could prove a determining economic force in years ahead for developed and emerging nations alike.
It is possible that the central planners occupying the top seats in the major world central banks may yet orchestrate a successful exit from the most massive monetary policy experiment in history. On the other hand, a successful exit is far from certain, and initial reactions from stock and bond markets around the world certainly don’t reflect confidence in such an outcome. Maintaining large, essentially fixed allocations to either stocks or bonds in this uncertain environment is to invite serious losses should an exit from the great monetary experiment prove less than successful.
Especially after extended market rallies, it’s important to recognize that what investors get to keep is what’s left in portfolios at market bottoms, not market tops. The key to success is not to give back any appreciable amount during significant market declines.