I like to imagine worst case scenarios. If you can imagine the worst case and it comes to be it’s much easier to deal with than if it catches you by surprise. And if it doesn’t become reality, and it rarely does, then everything’s really just peachy in contrast.
Bear with me for a minute because I’m just thinking out loud here. I’ve been writing about risks to both stocks and long-term bonds lately. It’s mainly technical factors along with some fundamental and sentiment clues that lead me in this direction so I start to imagine what sort of macro issues might validate these factors. Then I can try to assess how likely these scenarios are and adjust my overall thinking accordingly.
So what would make stocks and long-term bonds decline simultaneously and dramatically? The first answer that comes to mind is a loss in confidence in the Fed.
The Fed’s M.O. for years now has been to pin rates down very close to zero. A big, clearly intentional byproduct of this is to boost risk assets – kick investors out of safer bonds that pay next to nothing and into riskier assets that do more to promote economic growth: junk bonds, stocks, real estate, etc.
“Quantitative easing” has been very successful in this regard. Risk assets have risen dramatically in the wake of the financial crisis and the Fed may have, in fact, staved off a depression in the process.
The process itself, however, may have given birth to a new breed of investor who depends completely on the Fed’s largesse for their own confidence in investing in risk assets. I’d call this breed of investor a patsy. After all, in this scenario Bernanke is a confidence man and investors are his mark.
What I worry about is that should the patsies ever begin to lose confidence in the Fed – maybe because risk assets reward them less with every new QE program – this marginal demand that has powered the bull markets in both stocks and bonds could evaporate very quickly.
I’m not ready to batten down the hatches just yet but I’m keeping a very close eye on the markets and especially their reaction to Fed news for clues about investor confidence. Should stocks and bonds begin to fall in tandem I’ll have to give this scenario more credence.