Warning from a Central Bank

The S&P500 was almost unchanged last week on light volume. Volatility also barely moved. It felt as if the equity markets were in a holding pattern waiting for greater clarity on the US fiscal cliff stand-off which showed no signs of getting resolved. Breadth was modestly positive—the percent of stocks above the 50 and 150 day moving averages inched slightly higher.

The US macro data were mixed. While ISM manufacturing stunned everyone with a shocking collapse below 50, the ISM services index beat expectations. Factory orders also beat expectations. Initial jobless claims are settling in at a level far higher than they averaged earlier this year, but at a level below 400,000. And the payrolls results also appeared to beat expectations; both payrolls and unemployment came in better than expected. The problem is that the only reason the unemployment rate appeared to improve is because more folks left the labor force than were actually hired. In fact, there were fewer people actually working (on payrolls) in November than there were in October. Not good. In terms of the payrolls beat, if the economy is really slowing (and most of the new orders and inventory sub-components of the national surveys suggest that it is), then today’s payrolls “beat” will be revised lower, just as the payrolls for October and September were revised much lower on Friday. Finally, consumer sentiment badly missed expectations.

Technically, the uptrend on the daily charts is losing momentum, but it is still in effect. Amazingly, without any resolution to the huge fiscal uncertainties—the same fiscal uncertainties that crashed the S&P500 by 20% in the summer of 2011—the S&P today is holding out hope that things will turn out just fine, and that the stock markets will continue on their merry way into year end and beyond, climbing without any serious setbacks.

Speaking of levitating stock prices, the Bank of International Settlements (the central banks’ central bank located in Switzerland) just issued a warning that asset prices (especially stock prices) have risen to levels not seen since the credit boom peaked about five years ago.

In its report, the bank stated that “asset prices appeared highly valued in a historical context relative to indicators of their riskiness”. In other words, prices are losing touch with economic reality.

This bank, a respected financial institution, has a strong track record for issuing accurate warnings. It was one of the few institutions that warned of a global debt crisis in the months before the Global Financial Crisis broke in late 2007.

Today, specifically, it points out how unusual it is for asset prices to rise in the face of a deteriorating global economic outlook. GDP growth forecasts are falling, corporate sales and earnings are dropping, and bond defaults look like they’re set to rise. Yet stock prices are booming.

This is an institution with a record of getting it right. It’s a group without the bias that afflicts most of Wall Street—the need to peddle products no matter how inappropriate the price.

Wisely, the BIS did not issue a date by which prices will correct. Nobody can predict with certainty when valuation reality will return to markets.

But this is a warning that should not be ignored. Sadly, just as it was ignored by most in 2006, this warning will likely be ignored by most folks today.

Odds are high that most of these folks will get hurt…..again.

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