The last two years have been extraordinary. The stock market has surged higher as corporate profits continued to climb and the Federal Reserve’s aggressive QE3 bond-buying program, which was announced in September 2012. Charted side-by-side, the relationship between higher stock prices and cumulative Fed bond purchases mirror each other closely as the S&P 500 has gone on to gain more than 40 percent.
Aside from the magnitude of the market gains, the smoothness of the rise has been noticeable as the steady flow of cheap money squeezed out volatility. The S&P 500 hasn't even touched its 200-day moving average since November 2012. That's a streak of consistency totaling 464 trading days and counting. That type of consistency has only been seen three other times since World War II: In 1998, 1965 and 1956.
Have things gone too far? And are they set to change?
Related: What Happens When the Fed Stops Propping Up Stocks?
This is the warning coming from the Bank for International Settlements, the Basel-based institution that's the central bank of global central banks. This is a sober institution that courtesy of former fixture William White (now chair of the Economic Development and Review Committee at the OECD), was critical of central bank policy during the run up to the housing bubble. He was one of the few voices sounding a warning about the risks of overly lax monetary policy, the rise of subprime lending and the risks of a collapse should home prices weaken.
As an aside, it's worth noting that William White is once again sounding the alarm as well. In a paper from 2012 before the Fed embarked on QE3, he warned that "easy monetary policies threaten the health of financial institutions and the functioning of financial markets, which are increasingly intertwined." He continued, "[It] can lead to moral hazard on a grand scale" — excessive risk taking driven by the idea that the Fed will bail everyone out if it goes sideways.
Related: Instead of QE, the Fed Could Have Given $56,000 to Every Household in America
We've seen that before. We saw it with China bailing out troubled bond trusts earlier this year. And we're likely to see it again in the future.
In its latest Quarterly Review paper, the BIS notes that we've been in the midst of unusual tranquility supported by easy money policies that are "fostering risk-taking and the search for yield." The result has a drop in market volatility — not just in stocks but in other assets such as bonds, currencies and commodities — to historic lows at or below the 10th percentile.
This encourages a positive feedback loop, since lower volatility raises the value of assets and collateral held by financial institutions by lowering the risk discount as measured by the VaR or "value-at-risk" calculation. As the BIS explains: “As market participants further revise down their perceptions of (market) risk, they may be inclined to take larger positions in risky assets, boosting prices and pushing volatility even lower."
This is not dissimilar to the dynamic that powered the housing bubble higher. Or any other bubble, for that matter. Higher prices begat higher prices, be it shares of South Sea Company or rare varieties of tulips or shares of Pets.com.
We know things are approaching the danger zone because we have price-to-earnings valuations at levels that have only been exceeded in 1929, 2000 and 2007. Confidence is at such high levels that bearish sentiment has dropped to lows not seen since before the 1987 market crash, and an options market that is betting on a "Black Swan" type market wipeout on a scale not seen since 1998 (tied for the second highest level since 1989).
How do we know the fever dream won't simply continue?
Maybe it will. But the problem is, the conditions fostering this positive feedback loop are about to change. The Fed's bond buying is set to end next month and policymakers are preparing to embark on their first tightening campaign in more than 10 years, one that threatens to put an end to the three-decade bull market in bonds.
Also, as I explained in a recent column, the debt-fueled share buyback mechanism that was translating the Fed's low interest rates into higher stock prices is set to slow as corporations near the limit of what they can borrow without damaging their debt-to-equity ratios and putting their credit ratings at risk.
Related: 3 Steps to a More Fed-Proof Portfolio
All of this will result in higher volatility, which in turn will lower risk-adjusted asset valuations, and put stock and bond prices at risk. While the S&P 500 maintains a devil-may-care attitude, the same can't be said for the junk bond market, which is testing down to its August lows again. A big break of the 200-day moving average by the iShares High Yield Bond Fund (HYG) could very well be the catalyst that changes the positive feedback dynamic, returns cross-asset volatility to historic norms and ends the current period of calm in the financial markets.
In response, I continue to recommend investors prepare for higher rates via leveraged inverse Treasury bond ETFs such as the ProShares UltraShort Treasury Bond (TBT), which will rise along with interest rates. You can also bet on higher stock market volatility directly via the iPath S&P 500 VIX Short-Term Futures (VXX).
Disclosure: Anthony has recommended the TMV and TVIX to his clients, more aggressive variations of the investment ideas discussed above.
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