Sovereign Debt Risks Grow as Stimulus Pumps Asset Prices

Paul Farrell provides ten worthwhile observations in his forecast of a coming banking crisis. Essentially, he argues against buying stocks in an environment where market indices are about 70% off their lows. He sees two stock markets in America — one for the rich and another for everyone else. He explains how Wall Street skims from Main Street, rigs markets, and grasps vast winnings from socially worthless activities. He worries, for good reason, that Wall Street may yet turn Social Security into a casino. Finally, he predicts another Wall Street crisis no later than 2020 and probably well before. He worries that the crisis might come quickly enough to catch many people off guard.

While Dr. Farrell’s concerns and observations are valid, the success of the recovery so far must not be overlooked. All of us must think flexibly. For example, I was in the bear camp from June 2007 through early March, 2009. However, in mid-March 2009 I noticed evidence that big hedge funds were covering shorts and getting long exposure. In the process, short-term bear trend lines were broken in stock market indices. Consequently, on March 26, 2009 I published an essay noting an increased possibility that the DJIA would work its way back above 10,000 in less than 18 months — the Dow index well under 8,000 at the time and investor fear still thick in the market. (See: “Evidence that the Current Rally is a Mega-Bear Bounce.”) I wrote, “...the bull move underway now could evolve into one of the most consequential transient bulls of all time.”

Forecast Revisions Required

Around the same time Paul Farrell made a similar forecast — both of us among the earliest Marketwatch bears to predict a substantial turnaround in stock pricing. (See, “Forget Robini: I’m the New Dr. Boom,” Paul Farrell, March 31, 2009.) Tellingly, Marketwatch audience sentiment said Paul was wrong by a ratio of about 5 to 1. Paul had his own reasons for believing the turn was real...but not permanent. My expectation that Dow 10,000 would be breached was based upon hedge fund activity plus a 50% price retracement model that technical analysis supported, assuming robust Fed stimulus. Thus, I expected a cyclical (temporary) bull market in the context of a secular bear market that would end in a sovereign debt crisis.

Little did I realize that the stimulus plans the Fed would concoct would dwarf every other example of stimulus in our historical models. Consequently, historical patterns of recovery were made obsolete. Thus, when the Dow reached 10,000 I updated my projection in a published essay on October 15, 2009 (See: “What Does the Return of Dow 10,000 Really Mean?”) My revised projection suggested that the DJIA would approach 11,700 in the cyclical bull — an index price level that equates with a 75% retracement (falling from a 13,500 trading range in late 2007 to around 6,600, then recovering 75% of the loss to around 11,700). This 11,700 updated projection was made with an eye to the creation of a 12 to 15 year head and shoulders pattern in the Dow, the left shoulder being placed in the 11,400 to 11,800 range from 1999 to 2002. At the time there was good reason to believe that massive Fed stimulus would create a right shoulder to offset the left shoulder prior to stock prices tumbling back toward 6,600 in a sovereign debt crisis.

The circumstances of the last few months make it appropriate for me to revise my update. While we have breached 11,400 as expected, it no longer looks likely that the Dow Jones Industrial Average will top out around 11,700 to form the right shoulder of a technical formation. The Federal Reserve was very tactical in jawboning investor sentiment to make sure the stock market did not have a weak September/October in conjunction with the market’s historical tendency. The Fed is now preparing to maneuver monetary conditions and investor sentiment so that it will be very difficult for a right shoulder to form in the Dow — thus converting the rally from a cyclical bull into a full-fledged secular bull market.

The Fed's Path To Debt Crisis

If Bernanke can induce stock prices to blow through technical resistance that would otherwise create a right shoulder formation for index chartists, this might allow stock prices to challenge all-time highs in a burst of speculative energy. This view is consistent with the theory that the Fed hopes America can be burdened with two more years of excessively large fiscal deficits before the nation’s sovereign debt crisis arrives on behalf of a game shift to democratic plutocracy. Such a scenario puts the national debt at well over 100% of GDP by the time the big breakdown gets underway.

My updated forecast is for the Dow to get into the range of 13,000 to 14,000 within the next 18 months, topping out short of its all-time high of 14,164. This forecast depends upon the realization of Bernanke’s assertions that the Fed has the wherewithal to hold down interest rates well into the future. If, however, bond market vigilantes are able to price debt risks in the U.S.A. the way they have in Ireland, Portugal and Spain, it may not be possible for Bernanke to drive equity prices higher than a technician’s right shoulder formation in the Dow. Indeed, signs are already appearing that the impending tax giveaway might force bond prices higher. Therefore, any forecast must be conditioned upon stable interest rates and reasonable geo-political conditions. If rates stay low the Dow should move above 13,000 largely on the basis of trend momentum, fund flows, and conditions that allow corporations to temporarily increase profits.

In the event that Bernanke succeeds in getting stock prices above 12,000, the shock and awe will drive many people back into stocks during a time when stocks are overpriced in light of approaching dangers. For example, high quality manufacturing stocks that I applauded in early 2009 such as Caterpillar, John Deere and Parker-Hannifin are already nearing or above their all-time highs. By the time the Dow approaches its all time high, many stocks will be substantially overpriced, index averages held back by lagging stocks that remain in financial trouble.

Cautious Market Recommendations

If people would have followed Paul Farrell’s advice in early April, 2009 they could have re-entered the stock market near the bottom. Now that the Dow is up over 70% from its trough, Paul rightly advises people to be cautious about buying in high. However, I think this market will lurch higher still. Agile but late buyers may be able to build positions at the dips and still exit safely before America’s sovereign debt crisis blocks many exit doors. On the other hand, Europe’s sovereign debt woes are serious enough that contagion could erupt unexpectedly and spread fast. Just as the financial crisis of 2008 caught big banks off guard, the Fed’s best laid plans might go awry and create a new series of surprises. People who think that a Dow rally past the 1999 to 2002 left shoulder necessitates a challenge to its all-time highs don’t understand the fragility of the system. The Fed may aim to take us there but that is no guarantee.

Many members of the Marketwatch audience, myself included, have a different take on what thinking Americans should do with good portions of their investable capital. Just because the stock market is rising does not mean that money should be invested in stocks. After all, the purpose of Wall Street is to exploit America — just as the good Dr. Farrell explains. Many patriotic people are boycotting Wall Street even if it costs them capital appreciation. It is a new angle on “socially responsible investing” based on the biblical adage, “Where your treasure is, there will your heart be also” (Matthew 6:21). Instead of sending their money to Wall Street or putting it under their mattress, thousands of insightful Americans are investing in local businesses, trying to do for their own communities what Wall Street refuses to do. What these good Americans need is recognition and support from the big conservative radio personalities, some of whom have become too complacent in touting stock market resilience.

People who realize that a sovereign debt crisis will roil the financial markets before 2020 should be careful to recognize the Fed’s aptitude in using extraordinary measures to keep the asset price recovery marching upward. As long as unemployment remains stubborn and asset inflation does not spill over into consumer price inflation, the Fed can continue playing its game. After all, the U.S. Congress has left the Fed’s money creation powers intact.

Both parties need the Fed to maintain easy money policies to pay for continuing tax cuts and entitlement agendas. Notably, the tax deal just struck by President Obama and the lame duck Congress is expected to add another trillion dollars to the national debt in fiscal years 2011 and 2012. Fiscal policy is now dependent upon the Fed’s tacit pledge to supply money for a continued recovery. Interestingly, the decision to accelerate the rate of increase in America’s sovereign debt burden comes less than a week after the National Commission on Fiscal Responsibility and Reform released a politically contested plan to cut $4 trillion from federal deficits by 2020.

Ben Bernanke’s insistence that heavy deficit spending be addressed but not until an economic recovery is adequately in place creates a danger for people like Dr. Farrell who see a huge crisis coming. What if the recovery continues to build momentum for awhile, most notably over the next couple years of monetary and fiscal stimulus? Competent watchmen who are too focused upon near-term risks may be written off for crying, “Wolf, wolf!” Where’s the wolf when stock prices are climbing? Where’s the wolf as long as investors’ concerns about sovereign debt risks are sufficiently subdued to keep rates low? Sovereign debt additions work until they don’t work. The Fed knows it has time. If the Fed gets its way at least $2.5 trillion of new debt will be added to the national debt before the wolf appears at the door.