A key driver of rising stock prices is the psychology of aggressive speculators. They act as pioneers to push up prices and frequently take on far too much risk with high risk, junk quality, small cap stocks that are in highly cyclical industries like oil. In late 2014 some of these stocks plummeted 50%, a few are down 75%. Since aggressive speculators often use margin that means some could have been completely wiped out in terms of their equity in the worst performing stocks. As the markets shifts from high risk stocks as the fastest appreciating to just a few giant companies then more numbers of aggressive speculators may get burned out or stopped out or run out of cash and then there will be less momentum in stocks. It may end up that this year is like the great top of 2000 where the market that year was in a trading range instead of appreciating. But inside of that range some investors bought at the top and got burned and as they withdrew then the market weakened even though a few large caps stayed high and made the broad indexes look good.
Once the aggressive speculators have been driven out then there will be an imbalance of sellers over buyers. Add to that the end of Quantitative Easing and the result may be that gravity finally starts to affect the stock market. Intrinsic value based on stock price to sales, price to earnings ratio, price to GDP all imply roughly a 50% price cut is needed for stocks to reached equilibrium which would make the SP drop to about 1,000.
The combination of increasing disinflation and maybe actual deflation plus rising distress in the Eurozone will help bond prices. The bottom may be reached when the EU decides to breakup and each country gets its old currencies back and then devalues as needed. If that should happen at the same time that Japan realizes that QE doesn’t work and decides to switch to an aggressive tax cutting and regulation cutting then a lot of progress could be made towards fixing the global economy. However when the initial EU and Yen devaluations take place that could induce a shock that would temporarily make things worse until they get better.
The conditions in southern Europe for young job seekers is simply unbearable with 25% to 50% unemployment and as a result there will be growing dissent and ungovernable parliamentary elections with no majority in parliament, making things more volatile. Eventually the mild mannered, overcautious bureaucrats of Europe’s establishment will be pushed aside by those seeking to take drastic action and the Euro currency will be dissolved. Even more massive write offs of the southerner’s debts will need to occur. With no ECB after dissolution to buy sovereign debt at par value then that debt will trade at defaulted debt prices.
With the risk of increasing market volatility from problems in the EU, China and Japan now is the time to reduce global investment risk and have as small as possible positions in risk-on assets.
Taking on duration risk in U.S. Treasuries when yields are so low seems to risky so bond portfolios should try to keep duration roughly the same as yield just in case inflation comes back. I feel strongly that a near zero inflation rate and low bond yields will be what happens this year but one must try to hedge against the risk that they could be wrong, so avoid loading up on duration. The one exception, based on a risk to reward ratios is that perhaps duration risk in Muni bonds is OK as long as it is a modest portion of one’s portfolio and one has no plans to sell those assets to meet a sudden need for funds. Munis can’t or shouldn’t be bought by foreigners, pensions, retirement accounts and are illiquid making the price lower and the yield higher. This makes them more attractive than other fixed income. This is even more true now that some high income Californians may be in the 56% tax bracket. A 3.4% California Muni yield in a mutual fund holding investment grade bonds for a high income California taxpayer would be roughly a taxable equivalent yield of 7.7%, far above the yield for corporate investment grade bonds. Of course there is risk that if one stays in a bond portfolio too long then eventually inflation will come back and devalue bonds so one should be on the lookout for this.
Investors need independent financial advice about the risk of a stock crash. I wrote an article “Stocks look increasingly riskier”.