Which Jenga Piece Will Topple The Market?

January 15, 2014

Here we are in 2014, just 5 years from the infamous 2008-2009 market crash bottom. The question on everyone's mind is, "Are we there yet?"

 

The "there" they refer to of course, is another market top, similar to those of 2000 and 2008. In both cases, those tops were followed by dramatic market losses.

 

The short answer to their question right now, is that "no", we are not there yet. However, should the right Jenga block get pulled, we could see a top form very quickly.

 

Jenga, for the uninitiated, is a game of stacked blocks wherein each player removes one block from somewhere within the stack during each turn. A player, who ultimately pulls a block that causes the stack to collapse, loses. Early in the game, it's easy to pull blocks without affecting the stack, but as the game progresses, each block removed can start the whole stack wobbling.

 

It's been five years since previous market highs, and in both 1999 and 2007, markets showed gains of better than 50% before markets reversed. Astoundingly, markets are now up 175% off their 2009 lows, and that's precisely why everyone is getting worried.

 

Historically though, time in the bull market and the percentage it advanced weren't two Jenga blocks that caused markets to wobble and ultimately fall. It was something else.

 

The Jenga block that has mattered most is labeled "Treasury yield". That block is central in the stack, and when it is metaphorically pulled, the whole market stack is going to collapse. It's demise will take just about every stock with it when it goes.

 

Treasury yield is considered something of a market fulcrum. When yields are low, big money (institutions) prefer to take risk for bigger gains and shovel money into stock markets. Low rates help companies grow by providing capital that is generally easy to pay back. But more importantly, it makes little sense for institutions to gain 1-2% on their money when the average return for being in stocks has been 12% since 1926.

 

That's why markets keep rising in a low interest rate environment, and why companies keep showing better quarterly results.

 

But everything changes once rates start to top 4%. That's when the guaranteed return and principle of Treasuries begins to look viable. That is especially appealing to institutions following many years in a bull market when prices for stocks are starting to look too expensive.

 

When money that would have gone into the markets starts going into treasuries, markets begin to wobble. They often temporarily recover, but as rates continue to climb, more money comes out of the markets until the whole stack finally collapses.

 

With current yields below 3%, markets will remain bullish. But as those rates climb, look for volatility that says the top is starting to form. It doesn't happen overnight, but as rates keep climbing lower highs will start to signal the end of the bull, and the beginning of the bear.

 

The Fed is in charge of which blocks get pulled. Keep an eye on their hands.

 

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