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Stock market musical chairs

April 15, 2013

The stock market has gotten a lot of media coverage recently, setting a series of all-time highs and sparking a debate about whether we’ve finally reached a meaningful economic recovery. Driving that debate is the increasingly obvious disconnect between Wall Street profits and the sense that, outside of the financial markets, the situation remains somewhat lackluster. There is a sense that the rising markets are a little bit too good to be true, and that we are due for a reality check.
 

Guess what? There are very good reasons to believe exactly that. The biggest reason to be dubious about the state of the stock market is the continuing policy of quantitative easing (QE) being pursued by the Federal Reserve. Essentially, the Federal government is artificially propping up the market by buying up bonds and introducing more cash into circulation. This isn’t just a U.S. phenomenon: similar policies are being pursued around the world, most notably (and worryingly) in Europe. We don’t need to be an economist to see the correlation between these policies and an inflated stock market. Both rounds of Quantitative Easing (QE 1 and QE 2) sent the market up, only to see it fall back somewhat when the buying stopped.

The problem with that pattern is what happens when the government stops buying bonds.

While the Fed recently announced that it plans to keep moving forward with additional QE until unemployment is reduced to 6.5%, at some point the Federal Reserve will cut us off and the market will fall—perhaps significantly. We’ve all played musical chairs—the game where there is one less chair than there are players—and we all know what happens when the music stops. The upshot of this is that you’d better find a chair!
 

Recognizing that we have just hit an all-time high in the stock market, and understanding that much of that is due to a temporary, unsustainable and artificial stimulatory policy from the Fed, you would be wise to be very wary of leaving yourself overexposed in the current market (especially if you are approaching retirement). They say to buy low and sell high, and we are at the highest we have ever been: plan accordingly!

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