The Real "Pin" That Could Pop the Stock Bubble

Nothing goes up forever. Not the Federal Reserve's balance sheet, not global debt levels, and not stock markets... even when governments don't shut down.

Precisely because the Fed's balance sheet ballooned from $869 billion in August 2007 to over $3.6 trillion (and counting) today, and in spite of ballooning U.S. and global debt levels, U.S. equity benchmarks have been inflated to precarious heights.

"Houston, we have a bubble."

While the sky-high Fed balance sheet and rising global debt levels are their own bubbles, when they diverge - meaning, when the Fed starts to taper as global debt inflates - look out.

If the Fed-induced pump priming of financial assets isn't backstopped by strong and real global GDP growth, the increasing debt burden of the world's citizens will act as the ultimate pinprick that explodes the United States' inflated financial assets bubble... and other global bubbles.

So here's what's really happening, how to prepare for the eventual correction (or possible crash), and - more importantly - how to make money from it...

Up to 40% of Your Gains Aren't Real

The credit crisis that crescendoed in the autumn of 2008 was called a "credit crisis" because banks stopped lending overnight to each other, and short-term financing markets effectively shut down. There was no credit.

The Fed had to intervene and aggressively lubricate seized-up liquidity conduits, not just for banks, but for insurance companies, money markets, and corporations. And not just here in the United States. The Fed facilitated massive global liquidity vis-à-vis currency swaps and other dollar liquidity mechanisms.

Since the Fed's primary constituents are America's biggest too-big-to-fail banks, and because America's biggest banks are all interconnected (see "The Mother of All Bubbles") with banking behemoths across the globe, the correlation exposure faced by the world's biggest banks required a concerted effort to save them all.

The Fed, having the biggest capacity to expand its balance sheet (given the de-facto backing of the U.S. government and American taxpayers), took the lead, and central banks around the globe stimulated with gusto.

Because the credit crisis morphed into the Great Recession, the Fed, in the face of a dysfunctional and denuded American Congress, continued a zero-interest-rate policy (on overnight and short-term loans) to flush banks with cash in an articulated "wealth effect" policy aimed to pump up financial assets.

The wealth effect is a project to elevate devastated pension and retirement funds and invigorate consumer confidence by virtue of a rising stock market.

By pushing investors out of low-yielding fixed-income assets and into equity assets, the Fed engineered a rising stock market. Record-low interest rates further invigorated the stock market, as corporations have been able to borrow cheaply in the bond market to mainly execute stock buyback programs, lifting their own shares and the market to boot.

According to some estimates, as much as 40% of the rise in stocks over the past three years can be directly attributed to share buybacks funded by bond-market borrowing.

We have the Fed to thank for all that. But now we have the problem that markets, drunk with the Fed's Kool-Aid, are facing the prospect of the punchbowl being removed.

And it's a very big "problem."

The Global Debt Bomb Is 61% More Explosive Now

Tick... Tick... Tick... 

* Aggregate debt of advanced economies (AE) is expected to increase from $22 trillion in 2008 to $36 trillion in 2013. The corresponding numbers for emerging markets (EM) are $4 trillion and $7 trillion, respectively.

* The ratio of aggregate debt to aggregate GDP for AEs goes from 54% in 2008 to 81% in 2013. The corresponding ratios for EMs are 26% and 27%, respectively.

* The average per capita debt in AEs is $35,300 in 2013 and expected to be $41,500 in 2018. The burden of debt for U.S. citizens is $45,600 in 2013 and is set to rise to $55,100 by 2018. The debt burden for Japanese citizens could hit $73,200 in 2018, the highest level in the world.

* Among the peripheral European economies, the debt burden in 2013 ranges from $23,800 in Spain and Portugal to much higher levels in Italy ($36,000), Greece ($38,100), and Ireland ($51,200).

* Average per capita debt for EMs should rise gradually to $1,700 in 2018, far lower than AE levels. In 2018, the debt burden will be $1,400 for China and $1,100 for India.

* The U.S. accounts for 42% of the increase in global debt and 17% of the increase in global GDP from 2008 to 2013.

Source: International Monetary Fund

The Fed's pronouncements in June that they would start to consider cutting back their $85 billion-a-month bond purchases spooked markets domestically and globally.

So, the Fed walked back its "tapering" rhetoric and, when given the chance last week to execute an "our-word-is-good" reduction in their bond-buying binge, instead relented, leaving the markets to rally in the hope that QE4 would indeed last fourever.

But all that liquidity, from the Fed and central banks elsewhere, flushed global economies with debt, too, since there was money available to borrow, and low rates made borrowing palatable.

How bad is the global debt picture? It's frighteningly bad.

According to data from the IMF's latest Fiscal Monitor, global debt has exploded. (See the sidebar on the right.) And will continue to explode into the foreseeable future.

Aggregate net government debt in the world is expected to rise from $26 trillion in 2008 to $42 trillion in 2013 - a 62% increase.

The ratio of world net debt to world GDP increased, too, from 46% in 2008 to 61% in 2013. Of course, the debt-to-GDP ratio depends not just on debt dynamics, but also on economic growth. "Advanced economies," according to the IMF's report, "account for the bulk of the increase in global public debt since the financial crisis, both in absolute levels and relative to GDP."

There is an even sharper contrast between Advanced Economies (AEs) and Emerging Economies (EMs) when we calculate the debt burden of the working-age population (ages 15-64).

Among AEs, average debt per working-age person is expected to rise to $64,600 by 2018. Japan tops all countries, and the United States will move into the second spot by then. U.S. debt per working-age person goes from $37,700 in 2008 to $85,300 in 2018. For Japan, it more than doubles, from $56,100 in 2008 to $123,100 in 2018.

The IMF calls its data a "sobering picture of worsening public debt dynamics."

It claims rising debt servicing burdens will reduce expenditures on education, health, and infrastructure. "It will also raise social tensions if the result is a combination of low growth, high unemployment, and increasingly threadbare social safety nets."

"With little progress on much-needed structural reforms, this has put the burden of sustaining recoveries squarely on monetary policy. This combination of policies does not bode well for sustainable growth."

Now put the Fed's eventual "tapering" into that context...

It's Been 55 Months

First of all, that's why they didn't begin to taper. But eventually they will have to. Their ballooning balance sheet is giving rise to concerns that the Fed is so beyond insolvent that it couldn't possibly offer the confidence in its liquidity measures and the backstop of its balance sheet in the event of another global crisis. For that reason alone, it has to reduce its inventory of bonds.

And when it does, if there isn't strong and real global growth to support inflated equity prices, a correction or a crash is a real possibility.

With mounting global debt as the trigger, if the United States doesn't raise its debt ceiling and doesn't find a palatable way to continue to fund the government and reduce debt significantly in the foreseeable future, equity market investors might just start taking their chips off the table while the markets are at near-new highs.

Charles Payne of Fox, and Stuart Varney of Fox's "Varney & Co.," call me the "reluctant bull" with good reason.

I believe we're in the midst of a generational bull market, but that doesn't mean it's going to be a one-way ride to the stars.

A look at the Dow tells me we're facing a possible double-top in technical terms. A look at ongoing private sector consumer deleveraging and surging public debt is a clear sign that low interest rates won't benefit consumers on account of the crowding-out effect public sector debt will have, which will eventually cause rates to rise and consumer confidence to plummet.

It's time to take profits off the table and put on some defensive positions, as well as outright bets that a correction is looming. It's been 55 months since we've had a meaningful one.

Nothing goes up forever.

Next from Shah: "There Is a Better Way"

The problem with the U.S. government's stimulus efforts to create jobs, and the Federal Reserve's quantitative easing to foster full employment, is that banks are the only direct beneficiaries. There's just no good pool of jobs being formed from the trickle-down effect that first bathes bankers in bonuses and then showers shareholders with buybacks and dividends. There is a better way... Full Story

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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