Ouch! That hurt

For some time I have been warning that the end of QE could mark the end of the current stock market rally. 

No new money for banks to lend to speculators would bring an end to buying pressure. Also the actual mechanism which the Government uses to print money will begin the process of pushing up interest rates on bonds.

How’s that? The Government buys its own bonds from financial institutions and pays for them with freshly printed money, money from nowhere. The effect on the bond price of this massive buyer of Government securities is to drive up the price. A high bond price means a low interest rate. (A bond costs $100 and yields 2%. If the price now rises to $125 the yield falls to 1.6% [$2 return on £125 equals 1.6%]. Conversely if the bond price falls to $75 the yield rises to 2.67%). That is why we have had those low bond yields for so long. The Government has been driving the yields down by its bond buying activities.

As I explained yesterday, low bond interest mean that that the dividend yields on shares look very attractive and create a demand for shares so the stock market rages on upward.

And then when, as yesterday, the Government announces it is all going to end it begins to look ugly. Bernanke and the minutes of the Federal Reserve Committee both indicated that “tapering of the monetary stimulus” (a new bit of vocabulary to describe the end of the road for free money) was being considered as early as June.

The chart I showed yesterday which indicated that sharp rise in bond yields was all too prescient. The market knows, you know. Before any of the rest of us.

I should have heeded that warning. Instead I went on buying shares and through the morning and afternoon it looked as I was doing the smart thing. Then Bernanke spoke and it all fell apart. So here I am 75% invested and the rug gets pulled out from under me. 

There will be those saying we knew it all along. But they are mostly the stopped clock merchants who have been warning of disaster all through this stock market bull run.

In one way they are right. The economy says no. The euphoric rise is misplaced. But the markets are driven by the cash available to invest and the relative attraction of the returns different markets offer. When the Government messes with them we face the chickens coming home to roost.

A moment more to think about those chickens. The US Government has been borrowing money like there was no tomorrow – literally since there was no way they could ever pay it back.  So out there, there are bonds worth trillions of Dollars. Wouldn't it be great if those bonds suddenly fell in value. Higher interest rates will push down their resale values. But the holders have the option of waiting till they are due for redemption and get paid full value. Unless!  Inflation reduces the cost of redeeming those bonds in real terms. (Remember those days when we could borrow money to buy houses easily and inflation meant that it cost us a lot less to pay back our loans. We were left with a huge profit on the value of our home. Same thing will happen here.) So my prediction is that not far down the line Governments will allow inflation to rip in order to burn off the cost of redeeming all that debt.

That leaves me with an immediate dilemma. Having been sucked into the market what do I do? My carefully laid plan to sell when support is broken by x% would cost me a lot of cash which I cannot afford. Do I stick with that idea, or do I cut my losses in the face of what looks like a steam roller coming my way?

On the chart it does not look quite as bad as my losses in cash do. I guess I have till this afternoon to contemplate what to do. 

Unless I start with a little dabble in the gold market.