These Signs of Market Trouble Are Looming

Editor's Note: By now you're familiar with Michael E. Lewitt of The Credit Strategist. We  love his work. Today, he has a special report on current, troubling conditions  at this late stage - and a dire warning for investors who may be unprepared.  Here's Michael... 

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"Markets are priced to perfection. 

Signs of late-cycle behavior and thinking are abundant. 

The latest example came from BMO's strategist Brian Belski, who published a report arguing that the bull market in stocks will continue for another ten years with annual gains of 10.5%. 

This is the type of report that appears at market peaks. Despite the fact that it was dressed up in statistics and produced by a respectable brokerage house, this isn't a serious piece of research; it is nonsense and anyone who takes it seriously and invests based on its conclusions deserves the losses that will follow."

The above is excerpted from a recent report I produced for my Credit Strategist readers. I wanted to share with you some of my thinking on rapidly coalescing signs that point to growing cracks in the façade of a healthy market...

Be Wary of "Growth" in These Propped-Up Indices

Too much of today's market forecasting is focused on the wrong data, and even more is just outright bad analysis as we saw above with Mr. Belski's report.

We may not be looking at a nominal-value market bubble, but there are signs valuations are out of touch with realities in the credit markets and relative to our managed interest rate environment. The combination spells losses for investors who don't, or won't, prepare for changes ahead.

Here is why I'm concerned about the "everything is rosy" scenario, and what I want you to do to protect yourself when the music stops.

Still, the epic stock market rally continues to churn. Year to date...the S&P 500 is up over 7% ...the Nasdaq Composite Index is up 6.3% and the small cap Russell 2000 index is ahead, despite some serious noise around the rally:

  • The situation in Iraq and Syria continues to deteriorate, yet investors remain squarely focused on supportive monetary policies around the world.
  • Investors believe inflation is not going to be a problem even though it already is in the real world outside official government statistics, and that corporate earnings will continue to rise on the back of low borrowing cost, low effective tax rates, weak wage growth and stock buybacks, and other non-organic factors.

Stocks remain, on the face of it, far more attractive than other asset classes such as bonds, but relative value does not equate to absolute value.

How Will Your Investments Respond to "Normalizing" Interest Rates?

The first half of 2014 has seen a historic rally across all asset classes. Six important gauges of world stock, bond, and commodity performance are headed for gains for this period, the first time that has happened since 1993. Through July 8, gold was up 8.8%, the Dow Jones UBS Commodity Index 5.5%, the MSCI World Index of developed world shares 4.8%, and the MSCI Emerging Markets Index just over 3%.

Not every market in the world is up - the Japanese stock market is down a few percent. But for the most part all asset classes have rallied as a result of unprecedented stimulus efforts by global central banks.

The question, of course, is how long those efforts will continue and what happens when they stop. So what's the catalyst for a change?

Recently, Bank of England head Mark Carney signaled that his bank may raise rates sooner than expected in order to stem a sharp rise in British housing prices.

Meanwhile, Chinese authorities have been taking steps to deal with a housing bubble as well.

In contrast, European and Japanese central bankers have been doubling down on efforts to stimulate their economies.

The Big Kahuna, of course, is the U.S. Federal Reserve, which is reaching the end of its tapering of bond purchases and will be out of the market by November. The Fed, however, has made it clear that it will not be raising rates for the foreseeable future although markets reacted badly when St. Louis Fed President James Bullard (a non-voting member of the Federal Reserve's Open Market Committee this year) warned that rates could be raised sooner than expected.

The Fed faces the dilemma that the benchmarks it has set for raising rates - a 6.5% unemployment rate and 2.0% inflation - have either already been breached (unemployment) or are about to be breached (inflation). At the same time, it realizes that heavily indebted private and public sectors would react badly to any normalization of interest rates.

As a result, the Fed is going to face a test of its credibility as it fights to keep interest rates low in the face of evidence that the rationale for doing so is wavering.

Investors should be preparing for the day when rates rise, which could come sooner than expected. Now, not later, is the time to prepare.

Bolster Your Portfolio... with This in Mind

Even if it doesn't come as early as 2015, which is not priced into the market, investors should focus their investments on those that will be able to withstand a gradual rise in rates. This will include value as well as growth stocks, event-driven, floating rate and short duration (rather than traditional and long duration) fixed income investments, and gold.

Trees don't grow to the sky and neither do stocks. At the very least, investors should avail themselves of the low cost of insurance and Money Morning's oft-recommended trailing stops to protect the gains that they have enjoyed during this epic five-year bull market run.