The Stock Market's Addiction to This One Drug Could Kill the Bull Market, Doug Kass Explains –

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I long have said that the ready availability of cheap debt, the abusive use of debt and the emergence of a new marginal buyer of an asset class that stems from the aforementioned availability of debt are the historic preconditions of the sort of speculation that leads to the end of bull markets.

Sometimes it is simply the extension of margin debt as occurred during the boom, but the dramatic end of bull runs usually occurs from the trigger of rapidly rising corporate or mortgage debt levels.

It should follow that, in this cycle, today’s concern should be associated with the grand monetary experiment and the record level of sovereign debt and expanding government indebtedness.

Zero and even negative interest rates and central banks’ quantitative easing are raising risks that the current debt cycle is no different than past boom-ending cycles.

The new paradigm to the bullish cabal is that the global economies will grow their way out of this risk. Skeptics, however, see an aging economic recovery absent the needed growth and a reduced chance of fiscal, tax and regulatory initiatives out of Washington, D.C.

There are other ways for mushrooming government debt to be eradicated, such as deflation leading to default or inflation leading to currency debasement; both can lead to market chaos.

At the least, the ebb of outcomes may lead to episodes of crises and rising volatility.

A Changing Investment and Economic World

The market and economic guidelines and relationships of the past seem different than today.

These changing conditions — the disruptive upending of long secular trends — could lead to larger-than-average, crisis-induced corrective periods ahead.

We do know and can be certain that human emotions and psychology, which commonly reflect the extremes of fear and greed, will not change. These factors have contributed and will contribute to extreme behavior.

The introduction and dominance of quantitative-trading strategies and the popularity of ETFs are new factors that are likely to add to rather than subtract from the extremes. We vividly saw the potential exaggerated market impact, disorder and response to Portfolio Insurance/quant strategies in the forced selling experienced in 1987 and 1998.

A False Sense of Security?

After eight years of rising equities, higher valuations and declining volatility, it can be argued that we are developing a false sense of security about ETFs and stocks.

The same can be said for bonds, which are in an even lengthier bull market of 27 years.

Extremes in popularity or unpopularity usually lead to extremes in views, pricing, valuation and media coverage.

From my perch, in all likelihood the setup is for a rise in volatility.

Though the “when” can be debated and being too early can be costly, mean reversion seems inevitable.