Is the Stock Market About to Go Bust?

05/15/2013 9:00 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Probably not as long as investors are sure central bankers will keep pumping money into the financial system. But keep an eye on fixed-income markets for signs that such confidence is waning, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Are we in bubble territory again?

The talk that financial markets have created or are creating another bubble has become louder with every upswing of the Dow and the S&P 500. We're in uncharted, all-time-high territory, and that has increased worries that we're about to see a replay of the busts of 2000 and 2007.

How worried should we be? I think worries about the stock market, in particular the US stock market, are overstated at this point. That doesn't mean, however, that we shouldn't worry about certain parts of the financial market.

In particular, I'm worried about parts of the fixed-income market where traders and investors seem willing to overlook risk if they can just pick up a bit of yield.

Growth is indeed anemic in the much of the world, and China doesn't look like it is willing to step up its economic stimulus program to return to the days of 10% annual GDP growth. (That's a good thing, by the way.)

But as long as the world's central banks keep pumping money into financial markets, I think equity prices have decent support at recent levels.

I wouldn't call anything cheap here; some individual stocks are overvalued, and I think that some technical measures are close to calling this market "overbought." But I don't see anything like the mania of 1999, when analysts fell over themselves to see who could raise the target price for Amazon.com (AMZN) the most for that day.

As far as hype goes, this is still a relatively subdued market: At the May 10 closing price of $26.68, Facebook (FB) is still more than $11 below its initial public offering price of $38.

To get a 2000- or 2007-style bust, we'd need to see central banks go from net providers of cash—rally enablers—to net withdrawers of cash—rally killers. I just don't see that yet, even in the United States.

However, saying that we're not likely to see another stock-market bust of the 25% or more variety doesn't mean I think we won't get a more modest pullback. The US stock market is on the verge of moving into overbought territory and looks increasingly vulnerable to a mild 3% to 7% retreat.

The European stock market seems on shakier footing. European stock markets have rallied recently, even though many of Europe's biggest companies have reported disappointing first-quarter earnings and guided investors to expect lower revenue for the rest of 2013. Expectations were low going into the first quarter, but still 59% of the companies that have reported so far have missed consensus projections.

Looking ahead, Siemens (SI) and Alstom (ALO.FP in Paris) have cut forecasts for 2013. Alstom, for example, cut its forecast for three-year sales growth to 5% from an earlier 8%.

This week, data from Eurozone economies is expected to show that GDP for the group dropped in the first quarter. That would mark the sixth consecutive quarter of contraction.

On the equity side, though, I think the risk profile is highest for stocks in emerging markets. That's not because these economies are showing particularly lackluster growth (well, Brazil is), but because, on recent form, when investors get nervous about risk they sell emerging-market equities first.

In any stumble in the US or European markets or economies, the biggest damage to stocks is likely to be not in those markets—in fact, US stocks could climb on a rise in worries about global growth, because the US markets and the dollar are the safe havens of the moment—but in such markets as Brazil, China, the Philippines, Indonesia, and Turkey.

As perverse as it may seem, if you're worried about a dip in US markets, you should probably start thinking about what to sell among your holdings in emerging markets. (And given that these stocks are likely to fall hardest in any US dip, emerging markets should be at the top of your list for buying once fear has taken its toll.)

As I said, however, my biggest worries aren't on the equity side. If you're looking to make an argument for a bust (and not just a dip), I think you have to look at the fixed-income side.

I'm not worried about such deep, plain-vanilla markets as US Treasuries. In fact, recent news suggests that Treasury prices at the short-end of maturities might be set to rise over the summer months.

Forecasts from the Congressional Budget office say that, due to spending cuts, tax increases, and a recovering US economy, the 2013 budget deficit of $845 billion will be the smallest since 2008. That's likely to lead to a reduction in the amount of notes with maturities of five years or less that the Treasury offers for sale.

The reduction, if there is one, could come as soon as the July auctions. Fewer Treasuries for sale at a time when global investors are looking to buy dollar-denominated assets would likely result in higher prices (and lower yields) on Treasuries.

I'm not even especially worried about Eurozone bond markets, where yields for Italian and Spanish debt have held steady in recent auctions. A few more editorials by German finance minister Wolfgang Schaeuble like that in Monday's Financial Times might change that.

In the piece, Schaeuble argued that the treaties governing the Eurozone are not sufficient to support current plans to create a Eurozone-wide authority to rescue or shut down weak banks.) However, as long as the financial markets believe that the European Central Bank guarantees the euro, I don't think these markets are likely to see a spike in yields and a collapse in prices.

If you're looking for danger in the fixed-income markets, I think you need to look at far less-liquid markets where prices are far more volatile and are near historic highs.

The most obvious danger here is in the junk-bond market, where yields for the riskiest corporate bonds have tumbled to historic lows—and prices have moved up to historic highs.

B-rated US corporate bonds, near the low end of the quality ladder for this market, are yielding just a little over 6%. That's the lowest yield on record. Higher-quality junk bonds yield even less. The Barclays high yield index, which covers a broad range of the market, yields less than 5% for the first time in the history of the index.

At this level, the junk-bond market is pricing in a virtual impossibility of default: It's okay to reach out for a 6% yield on a B-rated corporate junk bond, because these bonds are close to risk-free at the moment, the thinking goes.

That reminds me of the argument in the run up to the US mortgage crisis: that reaching for yield by buying mortgage-backed securities created out of the riskiest tranches of subprime mortgages was OK because they were risk-free.

Right now, there is some evidence that junk bonds are less risky than they've ever been. Defaults on junk bonds peaked in this cycle at 7.4% in 2009, and hit a low of 0.5% last year. (The long-term default rate back to 1983 is 5.3%.)

Recent junk bond issues have been for long maturities, too, so that issuers have until 2016 or 2017 or 2018 to fix any problems before their debt comes due. That gives extra protection against a turn in the business cycle that might reduce cash flow.

Ultimately, though, it's the Federal Reserve that is supporting the junk-bond market. As long as the bond market believes the Fed will keep interest rates low and will continue to pump $85 billion in cash a month into the financial markets, there's no reason to question junk-bond prices. Just pay up and collect your 5% or 6% risk-free yield.

The junk-bond market isn't central enough to global or US financial markets, in my opinion, to lead to a general market bust if bond buyers did decide that they could no longer trust the Federal Reserve to play Daddy Warbucks. The market is relatively small, and I don't see the kinds of interconnections among institutional players in this market that turned the mortgage-back securities bust into worldwide financial crisis.

Instead of a cause for any general bust, I see the junk-bond market more as a indicator, the proverbial canary in the coal mine that warned of a dangerous buildup of combustible gases by falling over dead in time for the miners to flee the coming explosion.

A rout in the junk-bond market would be an early warning sign that the financial markets have lost faith in the ability/willingness of the world's central banks to support asset prices.

And since that is the key to current highs in asset prices, I think that canary would be well worth heeding. Financial markets are all dependent currently on central bank cash flows. Not an especially comforting thought, but a reasonable assurance that we're not headed for another bust quite yet.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund's portfolio here.

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