IS STOCK MARKET LIVING ON BORROWED TIME ? / BARRON´S MAGAZINE

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Is Stock Market Living on Borrowed Time?

LBO king Wilbur Ross and Prem Watsa, the “Warren Buffett of Canada,” have their concerns.

By John Kimelman 

Nov. 17, 2014 6:07 p.m. ET


The Standard and Poor’s 500 gained a mere 0.07% Monday, but any positive movement in the benchmark would have been enough to set yet another record close for the benchmark.

Earlier in the day, however, Wilbur Ross, Jr.., a shrewd investor known for turning around failed companies, went on CNBC to say that “markets are living on borrowed time.”

And an article in Street Authority profiled the cautionary views of V. Prem Watsa, the CEO of Fairfax Financial (ticker: FRFHF), a Toronto-based insurance holding company often compared to Berkshire Hathaway.

Watsa contends that stocks could suffer as economies enter into a period of deflation which will be aided by central bank money tightening. The executive is playing this theme through derivatives that pay off should consumer prices decline.

Like Watsa, Ross, in his CNBC appearance, also mentioned his concerns about deflation, as well as geopolitical risks as the catalysts can drive stock prices downward.

Thus far, the stock market has weathered various geopolitical concerns arising out of the Ukraine and the Middle East fairly well. But Ross told CNBC views that “I do think the big worries are geopolitical worries, that’s one of the things we’ve been very concerned with all year and I’ve some concern about deflation becoming anew problem.”

He added: “We have been a seller on balance, not because we think a terrible crash is coming but we need to sell opportunistically because we tend to have relatively large stakes in relatively thin securities so we have to sell when the markets are very strong.”

Meanwhile, the Street Authority piece does a nice job of profiling the contrarian views of Watsa, an Indian-born executive who hopes to profit grandly should stock markets head south.

“On the surface everything looks rosy,” writes Street Authority’s Jody Chudley. “Underneath, though, Watsa warns of serious trouble brewing. In Fairfax’s most recent investor conference call, Watsa referred to the fact that current levels of inflation are now at 60-year lows. That by itself is somewhat alarming, but remember that those low levels were reached despite the fact that the United States and almost the entire world has been engaged in easy-money policies on an unprecedented level.”

As Watsa sees it, once quantitative easing is completely ended, he says the United States and the entire world are in great danger of facing a long period of deflation. In fact, several countries in Europe are already facing a deflationary environment.

Deflation, the article points out, is bad for stocks because lower prices can translate to lower profits for corporations, which leads to cost-cutting, lays off and rising unemployment.

“To understand the severity of deflation and its effects on a market, simply look at Japan, which experienced a prolonged period of deflation, from 1990 through today,” Chudley writes. “If Watsa is correct, then investors should be reducing their exposure to equities immediately. I think that isn’t a bad idea even without deflationary concerns when you consider that the market is at all-time highs and is six years into a bull run.”

The article is bullish on shares of Fairfax Capital itself because it nearly $7 billion of cash and short-term securities ready to be invested in opportunities that might arise in a big market selloff. “Additionally, Fairfax owns more than $100 million in derivatives that are set to generate big profits should the consumer price index (CPI) decline -- which is what will happen in the event of deflation,” Chudley writes. “Those CPI-linked derivatives would be worth billions if deflation actually occurs as Watsa has forecast.”

Of course, it takes opposing views to make a market. And a thoughtful piece on the Reuters Website by columnist Anatole Kaletsky makes the case while stocks can continue to “melt up.” Interestingly, Kaletsky thinks that low inflation will remain a stimulus and not sink into a debilating deflation as Ross and Watsa fear.

His bullish arguments follow. “First and foremost, the worst financial and economic crisis in living memory has ended, and most parts of the world economy are enjoying decent, if unspectacular, growth. Second, economic and financial policies around the world, though far from perfect, are highly predictable and therefore unlikely to cause further market disruptions.

Third, technology is continually advancing and innovation is creating new products, services and processes that stimulate both investment and consumer demand. Finally, inflation is almost nonexistent, at least in the advanced economies, meaning interest rates are guaranteed to stay low for a very long time,” Kaletsky writes.

To be sure, he writes, minor corrections and panics are bound to happen. “Financial markets always move in boom-bust cycles, as greed alternates with fear. We saw this in early October, when Wall Street fell by 10% in three weeks and equity prices in Europe plunged by almost 20 percent in relation to the U.S. dollar. Such setbacks, however, actually reinforce the uptrend if the fears that triggered them turn out to be illusory — or less daunting than they first appeared.”

Only time will tell those aforementioned fears prove to be illusory or something quite real.