Central Banks Have Made a Mess

Photo from CNBC.

Central banks around the world have been unable to advance economic growth and raise inflation in the last five years despite declining interest rates and added stimulus to their national economies. Their egos fail to recognize that their monetary policies and actions have a smaller impact on real-world economics. Individuals still cannot get loans because poor economic conditions disallow many to qualify. And housing inflation skyrockets as speculators re-enter the market. This has created an environment not unlike 2008 that could lead to another stock market crash in the very near future.

Continued pessimism with regards to the economy is justified by falling corporate earnings and low GDP growth. The US market has now had four consecutive quarters of falling earnings - termed an earnings recession. Just this month, we have seen three behemoth technology stocks that rule the world, Apple, Microsoft, and Google disappoint followed by significant reductions to their market capitalization. Yet, the stock market maintains its current valuations propelled by low interest rates.

Low interest rates has been the culprit for the extension of the bull market. With no other assets to invest in that can yield significant returns, investors are forced to turn to the equity markets where dividend yields are relatively higher than bonds. During a time of significant pessimism, this can be dangerous when smart money pulls the trigger and starts selling the moment the Fed raises rates as it will have to do if inflation starts to rise. This rate hike is predicted for June 2016 unless conditions worsen, a truly lose-lose situations for main street.

In December, the market fell 8 per cent when the US Federal Reserve moved to raise rates a quarter basis points. It was the first rate hike in a decade. It was concluded that the stock market was in a fragile state for a rate hike because of its significant correction, but four months later, the stock market is right back where it was. With little options, as discussed, the flow of money continues to drive the market higher while the Fed remains hesitant on its second move.

The second component of this rally may be corporations buying back stock. Large names like Apple, Starbucks, etc. are borrowing billions of dollars, instead of using their cash deposits, to buy back stock. An interest payment on a bond would be less than the dividend payment owed to investors because yields on the safer bonds are often lower than equities. This creates a situation that may be arbitrage and allows corporations to boost earnings per share without having to increase revenue and net income.

The conditions created by low interest rates will only cause another fallout. A housing bubble is being created by the few speculators that have access to low-cost money. The UK posted in December 2015 that housing inflation was at 7 per cent, exceeding both inflation and wage inflation. Housing now costs 10 times the earnings of first-time buyers versus 2.5 in the 1990's. As of March 2016, the Canadian housing index is up 7 per cent year-over-year as well, also exceeding the consumer price index average of 1.5-2.0 per cent.

Sweden, one nation with negative interest rates, recently posted a significant growth in its GDP. It is heavily debated whether it is a direct result of negative interest rates, but the main concern now is the significant amount of consumer debt that has been created. Housing has risen 11 per cent as more people take on mortgages fueled by low interest rates and this may be an unhealthy as it creates a bubble.

Central banks do not get it. They have pumped trillions of dollars in international economies over the last half-decade and lowered interest rates to record lows, some nations at negative interest rates, with very little to show. This is because the average individual has not prospered through some trickle down economics. Jobs are still as scarce as ever and housing prices are beyond the affordability of most people. Stability in the market is uncertain and GDP growth in first world nations will not reach 2 per cent for another decade. The law of big numbers, an idea that as a company or entity gets bigger its rate of growth slows down, has now hit world economies. Japan went through a decade of tepid growth and our world is near its peak, but it is still a shining example of innovation and the envy of many.

Perhaps we have entered a new economic environment that does not prosper as it once did, but maintains small growth equal to inflation. All I know is this. Economics and business analysts are concerned. Central banks continue to believe their stimuli will work. They will continue to delay and prolong an interest rate hike and it will allow the stock market to soar, but when they realize it has failed and its decisions are less effective, it will pull the carpet from under investors in the stock market and the average person will see another crash. It is only a matter of time.

Read:Bank of America believes not investing equal to investing in 2016

Stock Markets Decoupled From the Economy?

The stock market wants to crash, or at least correct, but there is something that has not allowed this event to take place. The stock market is supposed to be a barometer for the health of a nation's economy. Its value derives from the expected future earnings of all companies it is comprised, and when we examine the US economy, there has been a major decoupling from wall street and main street; regular folks have not seen the same prosperity.

The bull market rally is now seven years old and has seen equities triple in value. Over the last three quarters, we have seen an earnings recession, that is, year over year returns in the negative. The upcoming earnings season expects companies to see earnings fall 8 per cent from last year's first quarter, but the stock market maintains its valuation. The reason: low interest rates.

We have now entered a global economy where many nations are at zero or negative interest rates, which has never happened in history. And as a result, trillions of dollars invested in low-yielding assets seek better returns in the stock market. This massive demand for higher yielding assets outpaces the selling pressure that traditionally occurs in an earnings recession. Money needs to grow and it needs to grow more than inflation, but dozens of top-tier nations have bond yields that can barely match inflation ten years out. The 10-year Canadian bond rate is 1.23 per cent. The 2015 inflation, according to the CPI, was 1.13 per cent. The Bank of Canada targets inflation of 2 to 3 per cent. In the US, the 10-year bond is yielding 1.69 per cent and its last inflation rate was calculated at 1.00 per cent. The US Fed also aims for about 2-2.5 per cent inflation.

We are days away from Alcoa (AA) earnings, which is traditionally the first day of earnings seasons, but we are just a few short weeks away from the April Fed meeting. Which set of events will impact the stock market more? On days with an FOMC meeting or the release of minutes, the stock market has major volatility in every case. Whether it be dovish or hawkish, the markets rise and fall according to what Yellen and her colleagues do. That is a cause for concern. Whether it be computer traders or money managers, their reactions set a significant tone for the remainder of the week or month. And it also re-affirms the impact an interest rate decision has. The trillions of dollars that have entered the stock market because they cannot make money outside will leave when interest rates rise. And how much of the stock market's value is at a premium because of low interest rates?

The historical price-to-earnings ratio of the S&P 500 is around 17. It is currently estimated at 22.8. If the market were to head to its historical valuation, that would see a market reduction of almost one-quarter. Startling and not unrealistic. We have already seen two corrections in the last 9 months, and unsurprisingly, both corrections recovered within weeks, but if there is a third correction and it is triggered by an interest rate rise, it could be the start of the end of the bull market rally.

Other reasons to support the theory that the market will fail in 2016 comes from its technical patterns. Weakness in many indicators, such as the MACD and OBV, and overbought conditions measured by the RSI, as well as failed attempts at ceilings, could signal the start of another leg down. Cheap option prices have created a great opportunity for investors to protect their necks. The implied volatility of an option rarely favours the long straddler, but we have seen consistently oscillations that make option sellers reluctant to take positions.

On April 6, 2016, an analyst for Bank of America-Merrill Lynch was on CNBC's "Fast Money" and said that the S&P 500 would outperform other benchmarks, which we believe included the STOXX 600, NIKKEI, and other international indices. That's great news for North American investors, however, she also mentioned that their firm believes there is an equal chance that being in cash will outperform the S&P 500.

Let that sink in for a moment. BAC believes that not investing for 2016 could be more profitable than investing. That is not often a phrase said by a firm, especially when firms only make money on transactions. When a firm backs that capital preservation is equal to owning stocks, that raises some red flags. It might just be one rogue analyst whose views don't add up to much when the rest of the industry says otherwise, but it could also be the one rogue analyst who decides it is time to make bolder predictions that do not profit the firm and help the investor.

The truth: we could be wrong. Every trader and doomsday predictor could be wrong. But the idea of selling your stocks if you have owned it through any or all of this extended rally is not wrong. And taking profits is always a good idea when analysts, professionals, money managers, historical trends are all uncertain as to what investment decisions are best for 2016.