Last week, the Dow (DJI) and S&P 500 (^GSPC) both beat their all-time closing highs set back in 2007. In a Sunday New York Times op-ed, David Stockman, President Reagan’s budget director and former Republican Congressman, writes “instead of cheering, we should be very afraid.”
Stockman goes on to lay out a case for his prediction: “This latest Wall Street bubble, inflated by an egregious flood of phony money from the Federal Reserve rather than real economic gains, will explode” in the next few years.
(His concern over Fed-fueled bubbles is one theme from his new book The Great Deformation: The Corruption of Capitalism in America.)
Stockman tells The Daily Ticker that “the bond market, stock market, all risk assets - they’re totally driven by the Fed."
He argues that the Fed is largely responsible for the market’s trajectory. This comes in the context of measures of overvaluation such as Robert Shiller’s CAPE ratio, which shows stock valuations are similar to where they were in 2007, but far from the levels reached in the late 1990s. Also, Warren Buffett’s purported favorite valuation indicator has not reached the levels seen in late 1999 or 2007.
Related: 3 Market Rally Risks
With the Fed leading the charge, he suggests the result is a mispricing of risk.
“I think the markets are not discounting risks, the real economy, the headwinds coming at us from the world,” he says. These headwinds include China’s construction boom ending, Japan falling into “old age bankruptcy,” the Eurozone crisis, and baby boomers retiring in the U.S.
“When the Fed loses confidence in the market I think that will be the beginning of the end,” he notes, “and it will start in the bond market."
Yet, when it comes to the bond market, it’s been remarkably resilient in the face of $16 trillion public debt. Yields for the 10-year Treasury have been hovering near historic lows. Stockman argues it’s a result of the “market front-running the Fed.”
Stockman advises people in his op-ed to “get out of the markets and hide out in cash.” But this isn’t the first time he has issued a warning like this. Last March, for example, he was quoted in an interview talking about the dangers of the stock market and saying he had his money in cash. However, if you had followed his recommendation, you could have missed out on some solid stock market gains. Total returns for the S&P 500 were close to 14% in the last year.
In that context, stocks seem like a pretty good place to be.
“That’s what they told me in late 2007 and early 2008,” Stockman says in response. “About seven months later people had lost 45% to 70% of their net worth. If you were in the Russell 2000, which is where Bernanke wants you, you were crushed – it dropped by 60% within 15 trading days.”
As for his advice to hide in cash he says, “I would rather have capital preservation, be safe. I don’t think another two, four, 10 percent is worth losing 50, 60, 70 percent when the crash comes.”
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