Don't Let Market Bubbles Hurt Your Portfolio

The guitar has always been abused with distortion units and funny sorts of effects, but when you don't do that and just let the genuine sound come through, there's a whole magic there.
     - Jeff Beck

Extraordinary Commitment

Since the financial crisis, The Federal Reserve, along with other central banks, have taken coordinated action to support growth. While asset prices have certainly recovered, one wonders what long-term outcomes might be in light of the fact that relaxed monetary policy is not likely to solve structural problems within the global economy or resolve significant debt problems. The Fed's balance sheet has grown to $4.2 trillion, an increase of +$1 trillion year-over-year! Here is a chart that illustrates the actions of central banks impact on stock prices.

fed market bubbles

Discussion continues about the rate at which the Fed should or shouldn't taper or reduce its bond purchasing. Refer to our piece, "Is Fed Chair Janet Yellen Tapering Fast Enough?" Just a few days ago, Yellen said, "I think this extraordinary commitment is still needed and will be for some time, and I believe that view is widely shared by my fellow policymakers at the Fed." Many believe that we face a potentially volatile market backdrop with the possibility of asset bubbles.

Be On The Lookout For Market Distortion

Definition of 'Market Distortion' (Investopedia)

An economic scenario that occurs when there is an intervention in a given market by a governing body. The intervention may take the form of price ceilings, price floors or tax subsidies. Market distortions create market failures, which is not an economically ideal situation.

fed market bubbles

Quotes from the past 18 months:

"...market distortions and acting on bad incentives are becoming more pervasive. I fear that we are feeding imbalances similar to those that played a role in the run-up to the financial crisis."
     - Federal Reserve Bank of Dallas President Richard Fisher

"All the money printing in the developed world is causing distortions everywhere including China."
     - Jim Rogers

"We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances."
     - Kansas City Fed President Esther George

"There are extreme market distortions occurring due to the unusual monetary policy."
     - Lawrence Goodman, former director of Quantitative Policy Analysis at the U.S. Treasury

"Markets are highly connected and highly interrelated so a severe spell of financial instability obviously would be much broader than the markets in which we are making the purchases."
     - Dennis Lockhart, president of the Atlanta Fed

"The distortion last year was in the long-end of the curve. Now the distortion is in the front end of the curve."
     - Rick Rieder, chief investment officer of Fundamental Fixed Income for BlackRock

"The Bank of Japan’s massive bond-buying binge is creating all sorts of market distortions. The latest: the rate in one funding market fell briefly below zero."
     - WSJ

Tread Wearily

We know from past experience market bubbles that burst can significantly hurt your investment portfolio and savings. The internet/tech bubble (1999), the US real estate bubble (2005-2006), the commodity bubble (2011-2012), and the bond bubble (2011-2012). Even if central banks' actions continue to drive stock prices in the near-term, eventually risk outweighs potential reward. It just might be a good time to mentally prepare yourself and keep some cash available that can be redeployed at lower prices. Asset Protection 101: Enhancing returns with a prudent bear market strategy

Morgan Housel authored an excellent article at Motley Fool entitled, "Why Markets Will Always Crash." In it, he reminds everyone:

Markets crash all the time. You should, at minimum, expect stocks to fall at least 10% once a year, 20% once every few years, 30% or more once or twice a decade, and 50% or more once or twice during your lifetime. Those who don't understand this will eventually learn it the hard way.

HIring an Advisor Checklist

Are you bullish or bearish on the stock market in 2014? Are you concerned about bubbles or market distortions?

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About the Author: Andrew Wang

Andrew Wang

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