Yesterday, Mario Draghi, President of the European Central Bank, unveiled a potentially limitless bond-buying initiative aimed at supporting the euro. Later in the day, the S&P 500 index surged by 28 points, reaching its highest level since Lehman Brothers collapsed. You can interpret this news as you wish; however, from our perspective, it signals another impending disaster.
Just like a broken clock is accurate twice a day, we believe the stock market is on the brink of a crash. That’s our view, and we stand firm in it.
On July 20th, we published an article titled, Get Ready for a Massive Stock Market Selloff. This piece cautioned that a combination of insufficient monetary easing, a faltering economy, and a deadlock in Congress would inevitably lead to a significant stock market decline.
To be frank, we anticipated a downturn by now. We expected the market to cease its upward trend and instead start to decline. Surprisingly, since July 20th, the stock market has risen, not retreated. In fact, the S&P 500 has increased over 5 percent during this time.
Given this recent upward momentum, does it imply that we are now investing in stocks? Absolutely not. The fact that the S&P 500 has risen 5 percent in the past 54 trading days and 30 percent since the interim low on October 3, 2011, only strengthens our bearish outlook.
Why a Major Downturn Is Likely Before Year-End
It’s no secret that markets often behave irrationally. As Keynes famously remarked, “Markets can remain irrational longer than you can stay solvent.” Yet, something will inevitably have to give.
At Economic Prism, we firmly believe that something significant—and negative—will occur before the year concludes. With each passing day of stock market gains, our conviction grows: a substantial selloff is imminent.
Why do we feel this way?
Market veterans assert that the stock market is a forward-looking entity, pricing future events before they transpire. However, what happens when it inaccurately anticipates positive events that ultimately fail to materialize?
Currently, Wall Street is betting on additional quantitative easing being implemented before the year ends. They also presume that Congress will manage to devise a last-minute plan to halt the automatic tax increases and spending cuts kicking in on January 1st.
We contend that both assumptions are misguided for a couple of straightforward reasons: (1) Federal Reserve Chairman Ben Bernanke cannot justify printing more money while stock prices approach record highs and oil is priced at $100 per barrel. He must first allow asset prices to decline before injecting more liquidity into the system. (2) Congress is too fractured, and the politically charged atmosphere of an election year inhibits any potential compromises before year-end.
Once Wall Street realizes either of these truths, panic will ensue. But that’s not the only issue on the horizon…
Providence Is With Us
As the nation plummets off the fiscal cliff, resulting in immediate tax hikes and drastic spending cuts, unemployment will rise sharply, corporate profits will plummet, businesses will fold, and consumer spending will dwindle. The economy could quickly spiral into chaos.
At this juncture, there will be little that politicians, the government, or the Federal Reserve can do to avert disaster. Once economic stagnation sets in, the onset of a new recession will be unavoidable. In truth, a recession is necessary to eliminate bad debt and rectify misallocated resources, returning assets to their genuine market values—free from government intervention.
Historically, the Federal Reserve did not prevent the dot-com bust, nor was it able to avert the housing market’s collapse. Its role has been primarily to create vast amounts of credit and channel it into the economy. However, the ultimate destination of this money lies beyond the Fed’s control.
Sometimes, it contributes to rising stock and property prices. Individuals typically respond positively to this kind of asset inflation, feeling wealthier, more intelligent, and rejuvenated. This can lead to increased spending and an economic upswing—something Alan Greenspan dubbed the “wealth effect.”
Yet, there are times when the Fed’s new capital stimulates hikes in oil, food, and consumer prices. This type of inflation is far less welcomed—especially when economic stagnation has already devastated jobs and housing. Ultimately, with all the existing debt and flawed currency in circulation, any new fiscal and monetary stimulus could further debase what’s left of the dollar.
“Providence is with us,” proclaimed President Obama during his speech at the Democratic National Convention last night.
This prompted a fit of laughter from us.
Sincerely,
MN Gordon
for Economic Prism