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Kass: Prepare for a Minsky Moment

Stocks in this article: SPY

There are times when the market gives the impression it is fading into nothingness. Volume becomes very low, trading ranges become very small, volatility becomes very low. Also, there is very little change in market levels, and day-to-day fluctuations are minimal. Looking back at history, when that happens, it is almost always a sign of a market high point.

-- Dick Arms

For over five years the Fed and other central bankers around the world have backstopped markets with nearly free money and through quantitative easing.

The U.S. stock market has benefited from accommodative monetary policy, and the S&P 500 has tripled since the generational bottom of March 2009.

To some degree, central bankers' efforts have prevented natural price discovery in many asset classes, and their actions have caused investors to lower their guard, adopting something of a false sense of security that the market downside is limited.

Optimism and Complacency Rises

Fueled by new highs and easy money, market observers are now growing more optimistic. Sentiment measures are at or are approaching five-year highs.

But consensus views are often notoriously wrong-footed. As an example, find me the forecaster who called for a 2.50% yield on the 10-year U.S. note and 1905 on the S&P 500 this year, and you would have found a liar.

Over history, a Minsky moment -- that is, market turmoil following an extended period of speculation and/or unsustainable growth -- sometimes occurs when complacency sets in, as stability is often the prelude to instability.

Particularly worrisome is that we might have entered one of the great bull markets in complacency, with enthusiasm rapidly building (as it typically does in a maturing and eventually vulnerable stock market cycle).

As the Past Is Forgotten

Regardless of the direction of the news flow of fundamental economic or corporate profit data, the markets have moved ever higher over the past few weeks.

Furthermore:

  • The VIX (and other fear gauges) have dropped consistently.
  • The Investors Intelligence bull/bear spread has rapidly expanded.
  • IPO activity is back.
  • M&A activity is soaring -- the number of deals worth $10 billion or more are higher than both 2000 and 2007.
  • Share repurchases have accelerated -- again, thanks to easy money and the funding of equity buybacks by bond borrowings).

All of the above conditions are back to 2007 high levels.

Memories of the last down cycle (and lax lending standards) have grown faint, as evidenced by the quality (and coverage) of the leveraged buyout deals in 2014 having deteriorated, with 40% of private equity leveraged buyouts being done above 6x earnings before interest, taxes, depreciation and amortization and, again, at the highest since 2007. Investment-grade and junk spreads have plummeted, and bond yields have declined to fresh 2014 lows.

Meanwhile, in the land of technical analysis, we are experiencing divergent internal group action, relative and absolute weakness in small-caps, strength in defensive sectors, shrinking new highs, (again) anemic volume and large reactions in the growth leaders -- all of which have been historically associated with overall market weakness.

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