An ageâ€old debate centers on how effective markets are at predicting the future. Those who
believe in the efficient market hypothesis (EMH) are convinced that the markets accurately discount all available information, thus making the current price a true reflection of a stock's fair value. Others take the view that irrational human behavior causes prices to swing to such extremes that they offer little predictive value.
I have never been a true believer in the strict view of the EMH. While markets generally do an
excellent job of discounting information, at times prices reach irrational levels. However, the duration
and extent of these moves are so hard to judge that investors looking to profit from irrationality face a difficult challenge. Instead, we should assume markets are properly discounting future events and
challenge that view only when we have compelling information that points toward inefficiencies.
Hopefully the markets are now approaching a period of irrationality. If not, they paint a dire
While academics will spend years explaining what triggered the current bear market and
assessing whether or not policy decisions were appropriate, we know a few things for certain. As
markets collapsed into March, fear of future deflation was widespread. In a deflationary environment,
prices collapse, assets lose value, and economic activity ceases. After all, if something will be cheaper tomorrow, why buy it today?
Federal Reserve (Fed) chairman Ben Bernanke and many others believe deflation extended the
Great Depression and that by preventing it now we could stave off economic Armageddon. Their answer has been to spend money recklessly and expand the Fed's balance sheet in hopes of facilitating credit expansion. On March 18, the Fed began directly buying bonds and leaped down the path of quantitative easing. Immediately, commodities skyrocketed and the dollar weakened. Bernanke, who felt that printing money would thwart deflation, was pleased with the market's reaction.
Now times are changing. The inflation trade which had worked so well in the beginning is now
collapsing. Stocks and commodities are falling while the dollar and bonds rally. The broadâ€based
Powershares DB Commodity Fund (DBC) is 16% below its recent high and is showing signs of imminent collapse. Lowry's buying index, a measure of stock market demand, is below the level at which it traded when stocks bottomed in March. With demand waning and prices collapsing, the market is telling us that the Fed's attempt to create inflation has failed.
If this interpretation of the market's reaction is correct, we should be fearful. The Fed has lent or
guaranteed nearly $14 trillion. The Obama administration is pouring trillions more in deficit spending
into the economy to help jumpstart economic recovery. If these dollars are spent without achieving the desired effect, what is next?
The Fed has indicated it will not stop until inflation is created, but there is an eventual limit to its ability to manipulate the markets. It's now looking like we have reached that point and investors should prepare for the worst.
Bear markets never truly end until the last bull has been slain. The recent sharp rally from the
March low was atypical of a true bottom and instead presented itself as a tradeable rally. As deflation
fears reemerge, prices should work lower. I do not expect the ultimate bottom to occur until the
majority of investors have been forced from positions and abandon hope. At that time, those who have remained disciplined and hedged their risks appropriately will be positioned to seize the opportunity and buy stocks at very low levels.
Like all bear markets, this one will eventually end. By preparing for the future, we can act when
the time is right.