JOHN TAYLOR: Is Our Version Of The 1987 "Can't Lose" Paradigm Melting Down?

Over the past few days Bill Gross at PIMCO made some noise within the financial community comparing the “Bernanke Put”/QE-infinity currently propping the markets to the mid-1980’s concept of ‘portfolio insurance’. Of course, we all know the end result of this failed attempt at investment utopia as portfolio insurance was a primary cause of the 1987 stock market crash for both psychological and practical reasons. We agree in principle with Mr. Gross, and actually made a similar argument last year ahead of the summer meltdown in pro-risk assets. We find it funny and a little sad that so many professional investors now scoff at the notion. Is this time really that different? Is it really that far fetched to believe that the “can’t lose” aura that propelled equities higher over the first half of 1987 is precisely the exact same one that has seen pro-risk markets levitate ever higher since David Tepper made his infamous “win-win” speech on CNBC way back in September of 2010? However, here we are more than two years later and only one of Mr. Tepper’s “wins” has actually come to fruition as despite policymakers best efforts their impact is clearly having less and less impact. How long will free market forces allow this to go on? How long did institutional equity investors give firms like LOR (Leland O'Brian Rubinstein Associates, Inc) in those dark days of October 25 years ago before throwing in the towel in their trust of portfolio insurance and admitting they were not invulnerable investors? Are the markets today heading towards a similar revelation?

The price action over the past few weeks in the wake of the markets getting more from the Fed than they could have ever expected heading into an election is a clue that the times indeed could be a changing. The 1987 paradigm underwent a similar period of choppy trade before melting down. Of course, crashes by their nature are a rare breed and the probability of one occurring is astronomically low. That said, should the S&P 500 fail to hold the 1400 level over the next few days (especially on a closing basis) we wouldn’t wait around too long in anticipation that the modern day version of LOR will save the day. The chart makes it clear that quantitative easing has diminishing returns.

John Taylor, FX Concepts Founder Chairman & CEO, is recognized as an expert in the management of foreign exchange and a pioneer in the analysis of cyclicality of foreign exchange and interest rate markets.