Is this the start of the next great bear market?

Are we looking at the start of the next great bear market in equities? Simon Caufield investigates, and looks at where three of the best bear market signals are pointing right now.

The FTSE All-Share Index has fallen hard recently. And most experts are blaming unexpectedly weak economic data or the debt crisis in Europe. Could this be the start of the next great bear market? Not quite yet is my best guess. I have three bear market signals that I follow closely; inflation, profits and bond yields. What are they telling us right now?

Well annual US consumer price inflation (CPI) jumped to 3.6% last month. That's up from 1.1% at the end of last year. As I recently explained to True Value readers, 4% CPI triggered the lastsix bear markets.

But higher inflation usually triggers interest rate rises. This time, the Fed is watching core inflation excluding food and energy. And that is just 1.5% although it's creeping higher.

Neither of the other two signals is flashing red. Company profits are still rising. Government bond yields are falling. And I also suspect investors are still holding a lot of cash. They don't really want more. So they're not selling much.

Don't get me wrong. I expect volatility a lot of volatility. But I think the next bear market won't start for a while yet.

How Mr Market could upset everything

But then we should always be prepared for surprises. As Bill Bonner wrote in The Daily Reckoning last month, "you can't second guess wily Mr Market. He will always do what you least expect the very thing that will cause the most amount of pain and suffering".

That's why he got them all into stocks in 1999 and housing in 2006, at the end of bull markets lasting two decades. Mr Market is a malign character - someone who is constantly looking to exact pain from complacent investors.

Now, Mr Market is a fiction of course. But it's a fiction worth indulging. Because I find that picking apart his motives can help you fathom even the most complex risks in the market.

How could Mr Market surprise us this time? Well Bill looked to the bond market to maximise investors' pain this time. And he could be right. The bull market in bonds has lasted 30 years. And the US ten-year government bond now yields less than 3%. But most people now expect higher inflation. nd that should mean higher bond yields.

So Bill asked what Mr Market might do. He won't do the obvious while everyone's expecting it. He might grind yields down to prolong the bull market a bit longer. He'll wait until the bears give up and buy back in. Then, and only then, he'll smash them.

Readers of my True Value letter will know that overvalued stock markets are being held up by low bond yields. So I worry about Bill's scenario. Today, I want to tell you my version of Bill's story. I want to explain why I think stocks could be very volatile in the months ahead. And how Mr Market could be setting the scene for another banking crisis in 2012.

How Mr Market could clean out bond investors

Mr Market knows that bond markets are a bit different to most other financial markets especially today. So what could his plan be this time? Well I think he'll take advantage of a few obvious weaknesses

1.The stock of bonds is still growing

As you know, governments are spending way more than they're taking in tax revenues. So they're issuing bonds in record amounts to fund the deficits. While the stock of outstanding bonds is still growing fast, Mr Market might be inclined to wait. He can cause more pain later. There's a huge stock of commercial property and bank bonds that needs to be refinanced over the next few years. That's a legacy of the credit boom which peaked in 2007. And most corporate bonds arefive to sevenyears. If Mr Market waited until late 2012 or early 2013, banks and property companies might not be able to roll-over their bonds. Mr Market could sink the commercial property market. Perhaps he could cause another banking crisis.

Remember too that November 2012 sees the next US presidential election. Investors will want to know about the candidates' plans to reduce the deficit. Whoever actually wins, Mr Market may not want to risk that the new administration actually does the right thing. If they develop plans to cut the deficit, his chance might go. Surely he must be tempted to strike before the new president's swearing-in in January 2013.

2. The bond market is dominated by dumb money

Most bond buyers are dumb money. Insurance companies and pension funds don't buy bonds because they think bonds are good investments. They buy because they have to. They buy whatever the price. Their regulators tell them to match assets and liabilities. The liabilities of pension funds are future income payments to their members. Bonds are a perfect match.

Dumb money is silent. You don't ever see pension fund managers on Bloomberg TV talking about whether bonds are overvalued or not. No, the bond investors you see on TV are smart money - like Bill Gross of PIMCO, manager of the world's largest bond fund. Gross recently sold his US government bonds. He thinks yields don't compensate for stubbornly high inflation. And he told the world on TV. So it's easy to think that all bond investors think the same way. They don't. Most, dumb money, are still buying.

Gross has not gone short US government bonds yet. And Mr Market won't want to give him the satisfaction of being right. Mr Market could play the long game like Bill suggests. But at current yields, the shorts can't lose much money. Bond yields can't go below zero. So Mr Market might try something different.

Say he arranged a nasty slowdown in early 2012. That would force down yields, shake out the shorts and sucker in the last of the buyers. But Mr Market wouldn't leave yields low for long. Once they've levelled out, the smart money would go short again. He'd be tempted to strike before that happened - saysix to nine months after the slowdown.

3. The largest US bond investors are the Federal Reserve and emerging market central banks

More than ever, the bond market is dominated by dumb money. The two largest owners of US government bonds are the US Federal Reserve and emerging market central banks, especially China. Neither buys because they like the price. The Fed buys as part of quantitative easing to boost the economy. The People's Bank of China (PBOC) buys to keep its currency down.

How Mr Market must be tempted to make fools of the Fed and PBOC. If Mr Market could force the Fed into QE3, it would buy more bonds at even more ridiculous prices. That means he needs a US recession.

The PBOC is going to be more difficult. Chinese inflation is getting out of control. And China is trying to move away from its export-driven growth strategy. It wants future growth to be based on consumption. But if Mr Market could engineer a slowdown in China as well, the PBOC might be forced to boost exports one last time. It would buy even more US treasuries to keep the Chinese yuan down.

Above all, then, Mr Market needs a recession in the US and China. Ideally, he'd like it to be a surprise. So he'd like first to lull us into a false sense of security.

Mr Market's three-step plan

If I were Mr Market aiming to cause as much damage to investors as possible, I'd use the following three-step plan.

Step 1 create a false sense of security for the rest of 2011

For maximum effect, Mr Market wants the economy to pick up for the rest of 2011. Three factors suggest that it's already on the cards. Japan's recovery should take hold in the second half. It is the major supplier of important components in the automobile and electronics industries. Shortages have forced factory closures and short-time working. That's created pent up demand from end users. A Japanese recovery should provide a big boost.

Second, the Middle-East unrest in spring caused a jump in oil prices. That hurt consumers' disposable incomes. But it's now reversing at least in part.

Third, the US government extended the so-called Bush tax cuts last November. The legislation included tax incentives for companies to bring forward investment spending from 2012 to 2011.

According to Lombard Street Research (LSR), it makes sense for companies to bring forward short-life assets (software, for example) by aboutsix months. Long-life assets should be brought forward by about a year. LSR expects US GDP to be boosted by 1% in the third and fourth quarters - equivalent to 4% on an annualised basis each quarter. That's a veritable boom.

Step 2 Engineer a sharp slowdown in early 2012

This too should not be hard. The investment tax incentives run out at the end of the year. Obama may try to extend them to help his re-election. But the Republicans think he can't get re-elected if the economy is bad. So they'll resist any extensions. If LSR are right, the US economy will take a hit of 4% in both Q1 and Q2, which more or less guarantees a recession.

China could easily have a recession all of its own making. It's always difficult to arrange a soft landing when fighting inflation.

Then there's Europe. The Greek government is close to losing control of Athens' streets. So surely it can't be long before a credible politician, with an eye for the main chance, suggests that it can't be worse to default and leave the euro.

That would be enough to cause another banking scare. And it could send US government bond yields tumbling in a flight to safety. It could be the final, blow-off leg of the 30 year bond bull market.

Step 3 QE3

Any one of these three shocks should be enough for the Fed to start QE3. So Mr Market would get his way and have the Fed buy more bonds. And any slowdown in the West is going to make it tough for China to avoid recession too. So it'll buy bonds to help the US to keep buying its goods. Chris Whalen, of International Risk Analytics, thinks we could get QE3 even if the Fed does nothing. Low interest rates have been good for the banks so far. They borrow money for short periods of time at variable rates of interest. They lend for long periods. Low interest rates boost profit margins at first.

But soon the loans start to mature. And the banks can now only replace them with lower yielding assets. So their profit margins start to shrink. If the economy is doing badly, there aren't many good lending opportunities. Thanks to QE2, the banks own over $1 trillion dollars of reserves at the Fed. hat's the cash the Fed paid them for their bonds. And it's not earning much interest.

So the banks must be tempted to use their reserves to buy US government bonds. And they could even borrow against the reserves to lever up their returns. After all that's what modern banks do.

And that would be QE3 led by the private sector. So the Fed looks virtuous. Mr Market would love it. It would cause a massive increase in the supply of broad money. And that virtually guarantees higher inflation. And much higher bond yields.

So what should you do?

If Mr Market follows my three-point plan, stocks will be volatile. A stronger economy in the second half of 2011 should send them higher. Then a recession in the first half of 2012 would push them back down. They might rebound on QE3 only to enter my terrifying bear market when bond yields start upwards.

That's going to be too difficult to navigate safely even if my scenario proves accurate. And there's a further complication.

As you know, stock markets anticipate the short-term future. So how much of my scenario is built into prices already? Surely not the ultimate jump in bond yields. Neither, I suspect, QE3. But the market should know all about the effects of last November's investment tax credit. And the mini boom and bust it should set-off in the next year.

Now this scenario is a fiction, of course. There are so many ways that Mr Market may damage bond investors. And there's no way to know what the ultimate trigger might be. I just find it very hard to imagine that the bull markets in stocks can last much beyond the end of 2011, and in bonds beyond 2012.

My advice: cut your equity exposure. And get ready for some rocky months ahead.

This article is taken from the free daily investment email The Daily Reckoning. Sign up to The Daily Reckoning here.

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