On Friday, the Dow suffered its worst one-day percentage decline since November 2011. The index plunged by nearly 2%.

The S&P 500 didn’t fare much better. It plunged by 2.1% – its biggest one-day percentage drop since June 2012.

So far in 2014, the S&P 500 has lost 3.1%. And the Dow is down 4.2%.

Mainstream pundits say the big fall in US stocks had to do with China. Or with the Fed’s tapering of QE. Or with bad labor reports… a slowdown in capital spending… or the drop in foreign trade.

Take your pick.

Does this mean the bull market is over? Is it time to sell stocks? Or should you buy the dip?

A Troubling Place

We never know what markets will do next. And now, we are in a particularly troubling place.

Never before in the history of the world have markets and economies been the subjects of so much experimentation and innovation.

Thanks to the Fed, the Bank of England, the Bank of Japan, the European Central Bank, the Swiss National Bank, the People’s Bank of China… and every other central bank bent on “fixing” what ails their economies… every price in the global capital market is now manipulated, twisted, tortured and distorted.

We live in a bubble of faith in central banks, where nothing is quite what it seems. Trying to fashion a coherent economic view or an enlightened investment strategy has never been so difficult.

And remember, no paper currency has ever survived a complete credit cycle.

What will happen when interest rates revert back to their historic norms? We don’t know. But when it comes, we doubt you will be happy holding a portfolio concentrated around US stocks and bonds.

What will happen next?

We’ve tried to figure it out. Inflation? Deflation? Hyperinflation? Boom? Bust? Bubble? Our guess is that we will see all those things… in good time.

In the meantime, not having much to guide us, we fall back on old formulae.

“Buy low, and sell high,” for example.

So forget buying the dip. US stock prices would have to be almost cut in half before they were really attractive on a valuation basis.

And as for selling, that is what you should have done last week, last month, last year – or whenever was the last time we recommended it. Still, it’s not too late. This market could go a lot lower.

Why Stock and Bond Prices Will Fall

Here is all we know:

First, sooner or later the price of debt and equity in the US (and most major economies) will have to come down.

To make a long story short, today’s prices depend on real growth rates that haven’t existed since the early 1980s.

Second, when asset prices begin to fall seriously, the Fed will stop talking about tapering QE.

The Fed has broken the stock and bond market. Now, it owns it. Its meddling in the Greenspan and Bernanke years caused a big run-up in prices. It stands to reason that if the Fed stops meddling, prices will go back down to where they ought to be.

The resulting “poverty effect” will be even more unpleasant than the “wealth effect” was pleasant. Janet Yellen won’t permit that. She will add stimulus, not remove it.

But we will have to wait to see how this little selloff develops. Stay tuned this week for more on that…



Market Insight:

Did the Fed Inflate a Bubble in the Emerging Markets?
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

It’s not just in the US that stocks are tanking…

Emerging markets are taking it on the chin, too.

Over the last two trading sessions of last week, Turkey’s benchmark stock index dropped 4.4%. Brazil’s Bovespa dropped 3.1%. And the iShares MSCI Emerging Markets ETF (NYSE:EEM) – which tracks the performance of over 800 highly-traded stocks in the emerging world – plunged 5%.

And Friday also saw a big rout in emerging market currencies, with sharp selloffs in the Turkish lira, the South African rand and the Mexican peso.

This is part of a longer-term trend.

As you can see from the chart below, the MSCI Emerging Markets Index (red line), priced in dollars, is roughly where it was in May 2010, despite plenty of volatility. The S&P 500 (blue line) is up more than 50% in that period (and has trended higher with much less volatility).

One problem is slowing economic growth – particularly in China, where worries remain over the government’s ability to rebalance the economy away from cheap exports and toward greater domestic spending.

Another problem for the emerging world right now is that the Fed’s EZ credit policies helped inflate a speculative bubble in emerging market bonds.

Facing the Fed’s artificially low bond yields in the US, yield-hungry investors piled into emerging market bonds (often denominated in US dollars). These investment inflows helped mask trouble in emerging market currencies.

But since the Fed announced its intention to cutback on QE in May 2013, this trend reversed course.

Emerging market currencies have been tanking since. A Bloomberg index of the 20 most-traded emerging market exchange rates is down by 9.4% over the past year. This has helped pull down emerging market stocks, because underlying earnings are priced in currencies that have been weakening sharply versus the dollar.

But crashing emerging market stocks could spell opportunity for patient investors with an eye for value…

Stock market valuations are already on the floor in the many parts of the emerging world.

The Chinese stock market, for instance, trades on a trailing P/E of 6.7 and yields 4.6%. And the Russian market trades on a trailing P/E of just 5.9 and yields 3.3%.

That compares with a trailing P/E of 18.4 and a yield of 2.3% for the S&P 500.

That means expensive US stocks are more vulnerable to a reverse in sentiment than relatively cheaper emerging market stocks.

I’d steer clear of pricey US stocks. But I wouldn’t bet the farm on emerging market equities right now, either. There’s plenty of turbulence ahead for the emerging world.

But judging by the single-digit price-earnings multiples in places such as China and Russia, much of that turbulence is already priced into equities.

That gives you the opportunity to follow the golden rule of prudent investing, which is to buy low and to sell high.

Gradually ease into positions in discounted markets. This is the safest way to play the current set-up.