John Mauldin's Outside the Box: The Mirror Cracks

This reminds me of something else I was thinking about this morning. I was trying to think about a good analogy to the way the markets currently seem so dependent on Fed action/intervention. The thing that came to mind was Taleb’s turkey problem….for 1,000 days a turkey gets fed by a butcher. Every day that goes by the turkey gets more and more confident that this butcher is nice and is looking out for its well being. Until day 1,001 (a few days before Thanksgiving) when the butcher kills the turkey. The turkey was most confident in the thought that the butcher would always feed it and do good for it at the point just before the butcher delivered the Black Swan to the turkey (Black Swan for the turkey, not a Black Swan for the butcher). The markets seem to be acting similar to the turkey in response to the Fed, its equivalent of the butcher. The lesson: Don’t be a turkey.

Michael Lewitt is one of my favorite credit analysts. If I want to know what is happening in the credit markets, one of my first calls is to Michael. He has been doing deep dives into some rather esoteric markets as well as traditional bonds over the course of his career, and he really understands what is happening under the surface.

In the latest issue of The Credit Strategist, which Michael has given me special permission to pass on to you as today's Outside the Box, he gets our attention right off the bat by comparing the recent big move in the benchmark 10-year Treasury yield to a comparable two-month move in 1994, a year that, as he says, was "generally viewed as Armageddon for bond investors." But in percentage terms, the 1994 move was only 20% over that period while the recent move was 40%.

And what caused that move? Ben Bernanke blinked, that's all. It's high time, says Michael, for investors to prepare their portfolios for the eventual termination of the Fed's monetary fun and games, since:

The comparison between the recent interest rate spike and 1994 underlines just how Fed-dependent markets have become and how incredibly difficult it is going to be for Mr. Bernanke and his colleagues to alter policy without causing serious market dislocations…. 

Mr. Bernanke is creating the conditions for a violent market reversal. As I wrote last month (“Delusions of Stability”), the dependence of markets on the continued beneficence of the Federal Reserve is profoundly unhealthy.

Then Michael takes us straight into the nitty-gritty of how to put in protection. Read and learn – then act while the acting is good.