Friday, January 17, 2014

The Good News

Before the "crisis of confidence" arrives, conditions are in place for the greatest asset bubble in history, thanks to the Federal Reserve.

Good News No. 1: The Fed can't raise interest rates, and that will fuel soaring asset prices.
To put it simply, the Federal Reserve will not raise interest rates through the year 2015. The central bank actually told us so..
.
In December, it said it won't raise interest rates "as long as inflation isn't forecast to rise more than 2.5% in the future and as long as unemployment remains above 6.5%."

Fed Vice Chairman Janet Yellen followed up the statement by saying those numbers are just "thresholds for possible action, not triggers... When one of these thresholds is crossed, action is possible but not assured."

The consensus from economists is that inflation will stay tame, unemployment will stay high, and the economy will slowly start to grow:

Inflation (Core-PCE)
Unemployment
Real GDP
2013
1.3%
7.4%
1.7%
2014
1.6%
6.8%
2.6%
2015
1.9%
6.2%
3%
Data Source: Bloomberg consensus forecasts

This means low interest rates for a long time – through at least 2015. That will fuel the great asset bubble that I see coming – the Bernanke Asset Bubble.

The Bernanke Asset Bubble is the simple idea that assets (like stocks and real estate) should soar to unimaginable heights, as Fed Chairman Ben Bernanke has promised to keep interest rates at zero for longer than necessary.

Right now, I believe real estate, stocks, and precious metals are very cheap. I expect these assets will soar in price over the next three years.

Good News No. 2: The bizarre election-cycle indicator that says stocks could soar through 2015.
Over the last 80 years, stocks have not had a losing year during the third year of the election cycle. It's hard to believe, but the typical stock market gain during the third year of an election cycle is 29% (including dividends). Take a look...


The next third year of the election cycle starts next September. And the tailwind it will create will fuel real estate and stock prices through at least 2015.

When I first heard of a presidential cycle for stock market returns, I thought it sounded absolutely ridiculous... But then I crunched the numbers – and it turned out to be way more accurate than I ever imagined. Take a look:

Year
Return*
%of losing years
1
-0.7%
50%
2
-2.9%
50%
3
26.2%
5%
4
6.9%
20%
* Not including dividends

The first two years have no return. Then the numbers get silly...

All of the return from the presidential cycle really happens in the massive third-year gains, with a decent fourth-year gain. It sounds crazy. But it is true.

It turns out, since 1932, the return during the third year of a presidential term was negative only once... and it was a loss of less than 1%. If you add in dividends, we haven't had a single negative Year Three since The Great Depression in 1932!

I credit Jeremy Grantham (www.gmo.com) with figuring this out... Grantham starts his number-crunching at the end of the third quarter of the election year.

Could stocks soar from during the next Year Three of an election cycle? Absolutely!

Good News No. 3: Stocks are an incredible value... And they could lead us to a 2000-style stock market boom

Even though stock prices are moving higher today, we still have great value – especially on a "relative" basis...

A key reason why stocks are so cheap today is the "earnings yield." Going forward, I expect the earnings yield will explain why stocks today are cheap relative to other investments – and could easily double from current levels.

The term might sound fancy – but it's just the price-to-earnings (P/E) ratio flipped over. Instead of the P/E ratio, earnings yield is the E/P ratio. And right now, the gap between the earnings yield on stocks and the return on everything else is too wide. It has to close...

On an absolute basis, stocks are fairly valued at a P/E of about 17 today. That means the earnings yield on stocks is around 5.9%... But government bonds pay less than 3% today. Safe corporate bonds pay around 4%.

So on a relative basis, stocks are dirt-cheap relative to bonds and just about everything else.
I believe we'll hear about all these factors in the coming years to explain why the market can soar through 2015.

The Federal Reserve has already promised plenty of times that it won't raise interest rates until it is too late. It will purposely wait for the economy to overheat to make sure the recovery is in place before it starts hiking rates.

In the meantime, the Bernanke Asset Bubble will continue… and stocks and real estate should be good places for your money through 2015.

I believe the stock market will reach "bubble territory," and it will feel like the 2000-Internet boom all over again.

By 2016, it may be time to tighten your trailing stops and batten down the hatches.

What Happens Next?

When will the great boom of 2015 end?

My guess is that it will a peak in late 2015/early 2016. But where do we go from there?

One simple yardstick to follow is when inflation hits 5%...

History shows that once inflation hits 5%, central bankers get worried it could spiral out of control. So they finally act.

Take a look at what happened in the 1960s and 1970s: Each time inflation ticked above 5%, stocks dropped…


I believe that day is long way away... years away, actually.

Bernanke's goal is to save the economy. Higher stock prices and higher housing prices are a part of the prescription. The Fed has repeatedly said the goal of its actions is to create a wealth effect by pushing up the prices of risky assets.


But what happens when inflation hits 5% and the Fed is forced to act?

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