Calm Before the Storm

The comments above & below is an edited and abridged synopsis of an article by Peter Schiff

Investor anxiety usually increases when markets get to extremes. Greed is supposed to be counterbalanced by fear, so this relationship should not be surprising. But sometimes the formula breaks down and stocks become expensive as investors become increasingly complacent. History shows that periods of optimism have often presaged major market corrections. Current data suggests that we are in such a period.

Schiff discusses the Cyclically Adjusted Price to Earnings ratio (CAPE); the VIX (fear) index; the idea that stock investment entails risk; the Fed and its willingness to use its toolkit in extraordinary ways; the QE program; delayed interest rate hikes; the relationship between the VIX and the CAPE showing misplaced optimism; and the Fed’s inability to limit the damage this time.

Interest rates are now at just 1.25%. If the stock market were to fall again, the Fed could do little. It could cut rates to zero and then launch another round of QE bond buying to flood the financial sector with liquidity. But propping up overvalued stocks, many of which have nothing to do with the financial sector, is a far more difficult challenge than the mortgage debt of 2008.

Since the 1990s the Fed has inflated 3 stock market bubbles. As the prior 2 popped, the Fed inflated larger ones to mitigate the damage. The extra liquidity sent prices back to new highs and emboldened investors to downplay the risks and focus on potential gains.

But investors may be overestimating the Fed’s ability to blow up another bubble if the current one pops. Since this one is so large, the amount of stimulus required to inflate a larger one may produce the monetary equivalent of an overdose. It may be impossible to revive the markets without killing the dollar in the process. The potential currency crisis might prove more destructive than the repeat financial crisis it’s hoping to avoid.

The writing is on the wall and all investors need do is read it. It’s written as plainly as the gods of finance can make it. Should the current bubble pop, it won’t be third time’s the charm, but three strikes and you’re out.