As they say, every new beginning is some other new beginning’s end.
That phrase, popularized by that 1990s tune “Closing Time,” is attributed to Roman philosopher Seneca the Younger, who lived large as the son of a rich man and worked as a trusted adviser to Emperor Nero. Having navigated the brutal politics of Rome, he retired on good terms to a plentiful country estate. Things were looking pretty good until, in the wake of a conspiracy against Nero, he was forced to commit suicide by cutting his veins and taking poison.
Something similar, if much less dramatic, is about to happen to the stock market as the Federal Reserve, after years of nursing the financial markets with a steady drip of cheap-money morphine, is about to pull out the needle.
It’s anyone’s guess what happens after.
It seems nearly everyone is still in denial that anything is about to change. Just look at the market action on Wednesday in the wake of the release of the Federal Reserve’s latest meeting minutes.
In it, policymakers confirmed that the current “QE3″ bond buying program will end in October, that they are concerned about evidence of investor complacency in the market, and that the end of the year will be dominated by chatter over the pace, timing and form of policy tightening in 2015.
Yet after an initial knee-jerk reaction lower, the market seemed to dismiss all of this as mere bluster. Stocks rebounded. Treasury bonds rebounded. The U.S. dollar cratered. And precious metals took flight. The Dow Jones Industrial Average tried desperately to retake the all-important 17,000 level but failed.
All are indications that investors believe the Fed will drag its feet on ending its six-year-old run of near-0% interest rates despite indications it should’ve already done so (using a simple Taylor Rule analysis).
The job market has already tightened, with the unemployment rate at 6.1% (just three-tenths away from full employment) and the job openings rate increasing to 2007 levels. Inflation also is on the rise with the Consumer Price Index growing at a 2.1% annual rate with more expected as food, fuel, medical costs, and shelter all go up in price.
Moreover, the folks at the Bank for International Settlements, the central bank of central banks in Basel, Switzerland, recently warned in their annual report that the Fed and other central banks were increasing the risk of financial turmoil later by resisting the need to shock the markets out of the complacency that has resulted from years of cheap money dependency.
But now, to maintain its credibility, the Fed is being forced to acknowledge — despite its desires to keep the cheap money flowing — that the situation has shifted.
Should inflation continue to rise and the unemployment rate continue to fall, as is widely expected, Fed chairman Janet Yellen will have little choice but to acknowledge it at the upcoming events including an appearance in front of Congress next Tuesday, the release of the next Fed policy announcement July 30, and the annual Jackson Hole symposium in August. When that happens, investors will find it more and more difficult to ignore the inevitable: Money, either via higher inflation and/or via Fed policy tightening, is about to become more expensive.
The stock market could shrug this off, as it has during all but one Fed tightening cycles since 1970. The exception was the aftermath of the June 1999 rate hike, which pricked the dot-com bubble and sent the S&P 500 down more than 15% over the next 21 months.
We could very well see the Fed prick is latest, much larger stock market bubble as a rise in bond yields (and a drop in bond prices) slams the brakes on the real driver of the higher share prices over the last few years: debt fueled corporate buyback programs.
Researchers at TrimTabs note that announced buybacks this quarter have slowed to levels not seen since early 2012 at a time when new shares are being issued at the fastest pace since last fall. Moreover, the Financial Times reported this week that, out of desperation, companies are increasingly using secured bank loans to fund buybacks — subordinating all its bondholders to benefit stockholders.
The result is that corporate cash relative to debt has fallen to the lowest level in 15 years, making income statements more and more sensitive to the business cycle. With elevated debt levels and leveraged balance sheets, the next recession is going to result in a flood of corporate defaults.
Think about that, as well as the specter of higher inflation, before you buy that AAA-rated corporate bond yielding just 4.2% on average — lows last seen in the early 1960s.
For now, I continue to recommend investors maintain a focus on precious metals as an inflation protection strategy. Examples include the leveraged ProShares Ultra Silver (AGQ), which is up more than 24% since I added it to my Edge Sample Portfolio back on June 5.
For individual stocks, candidates include NovaGold (NG), which is up 22.6% since being added on June 5.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he had recommended AGQ and NG to his clients.