This week, Mario Draghi, the head of the European Central Bank (ECB), (the equivalent to Bernanke and the Federal Reserve Bank here in the U.S.), shocked markets to the upside when he made the comment that the ECB was prepared to make “unlimited” bond purchases in sovereign debt. Markets around the world hungry for more stimulus, exploded to the upside on Thursday, pushing U.S> stock markets to multi-year highs. The reason markets reacted so aggressively is that central bankers don’t make crazy comments like this, ever. Central bankers are conservative – they are guarded with their comments, and are very careful not to say anything that can be misconstrued. Draghi’s comments are completely irresponsible because the reality is that it is a functional impossibility for the ECB, or any central bank, to make “unlimited” purchases. There is a strict limit to the amount of money the ECB (or any central bank) can spend buying bonds, or doing any kind of stimulus. In the case of the ECB, they are more limited than many because they have already been forced to provide previous stimulus for bailouts and other bond purchases.
The reason central bankers don’t make these kinds of comments is that they don’t want to put themselves in a position where they cannot deliver on what they promise. In Draghi’s case, he has placed himself in the ECB in a position where they are guaranteed to disappoint world markets. Just as markets rallied big on his comments, they will get hammered when the realization of the ECB’s limitations are revealed.
The reaction this week to Draghi’s comments also underscores the continuing fact that small investors drive markets, and small investors are almost always wrong. Another recent statistic released this week is that cash levels in investor accounts are at a 15-month low of 18.1%. This means that, on average, investors are more heavily invested (bullish) than they have been in 15 months. Keep in mind that this bullishness and this week’s rally on the Draghi comments, comes at a time when the U.S. stock markets are already at recent highs. We are now well above the previous highs set in early April, just before an 11% correction. Valuations are even more expensive today, because corporate profits are fading, and economic growth has slowed. This means that the risk of a short-term correction is even more serious. Couple these facts with the time of year – September and October are historically bad for stocks, and the elections in November, and you have the potential for heavy losses in stocks.
I am maintaining significant cash balanced and remain very cautious.