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January 13, 2011

Muni-bond Panic to Weigh on Stocks

Despite the stock market's seemingly inexorable rise, clues to a coming crisis continue to build, promising not only to bring down equity prices sooner than later, but also to make the correction much more severe than most expect. As readers of my Member Letter know, I have been anticipating a dollar crisis to visit markets sometime in the first half of 2011, spurred by an exodus from bonds as the Federal Reserve continues its malfeasant policies. In now seems the dollar crisis will be paired with a panic in the municipal bond market.

Municipal bond index breaks down

The Illinois legislature's decision to raise taxes as a means to fill its budget gap sets an ominous tone for the municipal bond market. The message is clear: politicians will attempt to drain taxpayer resources rather than control outrageous spending habits. In other words, the root of the budget problem will be ignored. This direction is bearish not only for munis, but also for the economy.

A muni bond meltdown will be detrimental to the dollar in more than one way, not the least of which comes from the dollar's chief persecutor, Ben Bernanke. Despite Bernanke's persistent denials that the Fed would step in to bail out a state government, pressure will grow on him to do so as the crisis worsens. It will be interesting to see if his political will fails him again.

Higher interest rates from bond markets... both municipal and Federal... will do no favors for the stock market. In fact, a sense of crisis will exacerbate an equity decline. I have proposed to readers that when this crisis hits, stocks will fall in tandem with the dollar rather than being supported by its decline. That period of positive correlation may be just in front of us.

The stock market itself is looking quite exhausted. According to my cycle analysis, equities are due for a dive into a yearly low. Several market indicators also suggest the time is ripe for stocks to roll over.

stock market indicator shows exhaustion

stock market indicator shows thin participation

stock market hits major resistance

Consider also that the respectable work performed over at shows several sentiment extremes... all bearish for the equity outlook... including a very large gap between smart money and dumb money confidence. The stage is set for a significant stock market correction, and this week's breakdown in the muni bond market may provide the needed catalyst.


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