There’s a problem with the stock market…

Investors are “drunk.”

Let me explain…

The prevailing sentiment among economists is that the U.S. Federal Reserve Bank should, metaphorically, take away the punch bowl when the party gets started. 

The metaphor comes from the Fed chairman William McChesney Martin, Jr. in a speech he delivered in 1955:

“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects… Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve… is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

This means that, if the economy or financial market looks like it’s growing (or “inflating”) too fast, then the Fed should enact policies to restrict this growth.

But if we’re going to extend this metaphor, right now the U.S. financial markets seem to be an “all you can drink” open bar for any investor or business looking to take speculative risk. 

That’s because investors know that the Fed is propping up asset markets by providing unlimited liquidity.

What does that mean?

Well, the internet joke is that the Fed has turned on the “money printers.”

This is a kind of oversimplification of a few dozen financial interventions specifically targeting big businesses and what are called “primary dealers”--that is, large commercial banks that help the Fed implement monetary policy. 

Big institutions and investors and regular folks feel, as a result, that they can buy assets with minimal risk.

This has led to something that has concerned me since September 2020…

A massive asset price bubble. 

As the National Interest put it:

“Through its truly massive bond-buying program, the Federal Reserve has created and continues to create asset and credit bubbles that are bound to pop eventually.”

They point to the fact that, adjusted for inflation, the price of homes has reached its previous peak in 2006, the height of the last housing market bubble. 

In terms of stocks, today’s valuations are more than double their long-term average. We’re seeing valuation levels that we’ve only experienced once before in the last 100 years (a crash followed soon after).

So logically, if this asset bubble was created by Fed policy that floods financial markets with money… 

Then the Fed withdrawing support might lead to a correction or, worse, a crash in the markets. 

As one of the major Fed officials recently said:

“As the economy continues to improve, and we see it in the data, and we get closer to our goals… we’re going to have discussions about our stance of policy overall, including our asset purchase programs and including our interest rates.”

The Fed withdrawing its support of financial markets is called “tapering.”

When this tapering causes a shock or correction to asset prices, it’s sometimes called a “taper tantrum.”

For instance, on May 22, 2013, the Fed chairman, Bernanke, said the Fed was considering tapering its asset purchases following the 2008 financial crisis. 

Note the distinction. He didn’t announce tapering. The Fed had not begun tapering. 

Bernanke simply said tapering was being considered at some point in the future.

Bond and stock prices dropped and continued to drop for the next month, as you can see on the chart: 

Ultimately, the expectation of tapering caused a serious market decline and also stalled the U.S.’s economic recovery. This is a “taper tantrum.”

It wasn’t until December 17, 2013, that the economy and markets were stable enough that the Fed reduced the pace of its monthly asset purchases by about 12%. 

We might see a similar situation occur in the coming months.

In the recent meeting, held June 18, 2021, the Fed directors began discussing the possibility of tapering its stimulus. One official stated:

“The taper discussion is open and the chairman [Jerome Powell] made that very clear. But it’s going to take several meetings to get organized on all these different points.”

Immediately after that meeting, I believe we saw the beginnings of a “taper tantrum.”

According to MarketWatch, “the Dow Jones Industrial Average [posted] its biggest weekly decline since October on worries the Federal Reserve might begin lifting rates sooner than previously expected.”

And today, on September 17, Reuters reports:

World shares fell on Friday after a week of mixed economic data and fears over the stability of growth and Asian markets put the focus on the U.S. Federal Reserve's timeline for tapering asset purchases. Investors hope the Fed's meeting next week will yield more clarity on its plan to slow down asset purchases, and when it might raise interest rates.

If the Fed announces, next week, that it will begin tapering its asset purchases, I would expect to see some volatility and a decline in the markets in the weeks and maybe months ahead.

However, if the Fed plans to continue suppressing interest rates and maintaining its ongoing policies until 2023, as some have guessed…

Then I’ll wager the party will continue.

For reasons I’ve detailed in recent issues and will explain in the Chart of the Week, I don’t consider this a “risk on” market…

Meaning, now’s not the time to be buying, in my opinion.

Now’s the time to be holding or selling a bit to get some of your money out of play.

I’m telling you this so you can position your investments accordingly…

While we’re in a bubble, there’s no way to know what will cause it to collapse. Or when.

This “taper tantrum” could have short-term effects, or it could be the beginning of a more serious downturn that lasts for a few months or years.

Regardless, prepare yourself for the possibility that your stock investments will go down in value. 

Shore up your cash position so, if a crash does happen, you’re free to buy more shares of high confidence, quality growth stocks and index ETFs on the dip. 

In the coming months, I will let you know if conditions change in the economy, if the bubble begins to burst, or if my future outlook changes. 

In the meantime, please be careful in the stock market.