Genie Is Out of the Bottle

Haven't you wondered how the market could keep going up for four straight years, with barely a correction? No, you haven't. I understand, you've just been riding it. No concern about risk. Heck, you wouldn't even recognize stock-market risk if you saw it walking down the street.

I'm here to tell you that the risk genie has been let out of its bottle. Risk is back in the market, and at some point fairly soon it's going to be realized. You better start preparing now.

By lowering the Fed funds rate to 1%, the Fed allowed the risk in the stock market to be bottled up. Low rates let you borrow money to invest in long-term debt, which provides the collateral to let you sell short-term debt. You make the difference between the long-term debt you buy and the short-term debt you sell. Arbitrage allows you to deny the effects of risk for a period of time. When the arbitrages unwind, look out below.

Here's an example. The muni-bond market has been crushed. Funny, you'd think that investors would be running to those low-risk, no-tax funds as risk has increased. But it turns out that many funds were buying long-term munis so they could sell short-term collateralized debt obligations (CDOs). Now these funds can't sell short-term debt, so they don't need (and can't afford) the long-term debt. Down go munis.

Muni-bond sellers are telling you that munis are a bargain now. Some muni yields are higher than treasury yields. Muni-bond sellers are telling you that the market is somehow wrong. Who do you believe, the muni pushers or the market? The market is telling you to watch out. States and municipalities issued a record number of munis last year, 25% above the previous year's rate. In areas where foreclosures are highest, municipalities are cutting back on services left and right. You don't get paid enough by munis to take the risk of default. Stay away from munis at least until you start hearing about muni-bond defaults coming out of California.

Munis deserved to plunge, because the riskless arbitrage play that was responsible for at least part of their increased values no longer exists. That's a fundamental change to the value of those entities. Now you have to evaluate the securities based upon their own merits. And them merits are looking worse and worse each day.

Same thing is going to happen to stocks. The funds tell you it's a liquidity situation -- if we had more money (or could borrow more money), we'd support these prices. Money's gone. There is no more. So they're selling the things in their portfolio that have value right now. We see it differently. Risk is now seeping back into their portfolios, so they no longer are able to leverage their positions to the hilt. Banks see the risk, and they won't lend them the money.

As risk seeps back into the market, it will cause a repricing of assets going forward. And they won't be pricing these assets higher. Time to shake hands with the genie.