Eleven months ago, I talked about four classic canaries in the investment mines: (1) commodities, (2) high yield bonds, (3) small-cap stocks, (4) emerging market stocks. I explained that when all four of those canaries stop singing, riskier ETFs usually break down.
Indeed, in September of 2014, commodities were tanking, high-yield bonds were plunging, small-cap stocks were faltering and emerging market stocks were plummeting. The canaries were losing their voices.
Not surprisingly, the broader U.S. markets eventually followed suit in rather dramatic fashion. In fact, everyone’s favorite large-cap benchmark (S&P 500) had nearly pulled back 10% from a record high.
Then came the 16th of October. Stocks had coughed up yet another 1% through mid-day. With the broad-market benchmark pushing the 10% correction level, the president of the St. Louis Fed, James Bullard, suggested that his colleagues at the U.S. Federal Reserve could always rethink the use of additional bond buying with an extension of quantitative easing (QE). And at that time, Bullard talked about worldwide economic uncertainty being a reason for continuing “QE3.”
Here’s what happened next:
Today, the “Bullard Bounce” still reverberates off the walls and ceilings of the New York Stock Exchange. Why? Investors believe the Fed is willing to do whatever it takes to preserve higher stock prices.
Keep in mind, in an effort to boost the U.S. economy, the central bank of the United States has used higher stock prices as a weapon of perceived wealth creation. When you pressure investors to take on risks that they would not normally have taken by pushing interest rates to ‘rarely-before-seen’ lows – and when you entice consumers to finance gratification through credit rather than through savings – asset prices rise precipitously. Higher home prices and higher stock prices make people feel wealthier.
Here’s the downside. When you implicitly and explicitly suggest that rates will remain lower for longer, people begin to count on risky assets being safer than they are; similarly, the size of debts can become so large that those who trusted the policy makers lose the ability to service the debt (let alone pay it back) when borrowing costs go up.
Now let us tie together last year’s four classic canaries with the subsequent Bullard bounce and today’s financial markets. PowerShares DB Commodities (DBC) has accelerated its decline since July and currently seeks depths that haven’t been seen since the heart of the Great Recession. That’s one canary that cannot sing. Meanwhile, high yield bonds via SPDR High Yield Bond ETF (JNK) is accelerating its decline that began in June. Canary #2 has a bone its throat.