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Confidence – it's the trick at the core of all Ponzi schemes

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AT their last meeting of 2013 the Federal Reserve finally commenced its plan to "taper" the amount of dollars flooding the system. They announced a $10bn (€7.4bn) taper. Last week they added to that with a further $10bn.

It should be noted, in the original plan tapering would actually have been completed by now, rather than starting, but the Fed has been so worried regarding the strength of the US economy it was afraid to act sooner.

The markets reacted with euphoria in December after the Fed meeting – not because of the taper but instead because of the additional promises that came with it. At previous meetings the Federal Reserve has indicated that they may need to raise interest rates (maybe in 2015) in the future when employment reached certain levels.

At the December meeting they indicated that even if their thresholds were met they will delay any interest rate increases for many years.

What is curious is that the Fed felt they needed to promise additional support for the market even when announcing a minuscule taper. They were so petrified of a bad reaction when announcing any type of taper that they felt the need to sugarcoat the announcement.

The short-term result is another sharp move higher in equity markets until early January.

Since then the sentiment indicators have been flashing red. As we should all know sentiment indicators are reverse indicators.

More than 20 different sentiment indicators have reached record highs recently. In back-to-back weeks of December 4 and 11, Investors Intelligence reported that only 14.3 per cent of stock market advisory services were bearish. This is the lowest percentage in more than 25 years – lower than at the highs of 2000 and 2007.

In fact the last time numbers were lower was before the 1987 crash.

The daily Sentiment Index reported 93 per cent bulls twice, on November 15 and 22. Two readings this high are a rarity. Many other indicators showed extreme optimism and epic complacency.

In March 2009, the low of the market, the daily sentiment index reported an all-time low of two per cent bulls, meaning 98 per cent of S&P traders thought the market would go lower. Now after five years rallying, 93 per cent of them think the market can only go higher.

By keeping the Fed funds rate near 0 per cent and increasing its balance sheet to nearly $4trillion, the Fed pulled out all the stops in 2013 to keep stock prices rising. They say their policies were intended to boost bank lending and investment but instead they boosted speculation in highly risky debt.

One thing is clear, these indicators are suggesting that at the very least the market will have a very large and aggressive correction – and soon.

We've seen the start in the last 10 days. If that occurs, it may lead to a further move higher – or maybe not. But if these indicators are worth anything they tell us 2014 is going to be an extremely volatile year.

The week before last the Dow lost 579 points (3.5 per cent) to 15,879 – its biggest drop since May 2012. The S&P 500 fell 2.6 per cent to 1,790. All 10 main groups in the S&P 500 retreated as materials producers lost 4.5 per cent and industrial stocks declined four per cent. Last week there was more intense selling early in the week, but by Thursday the markets had regained some momentum with some reassuring Q4 GDP numbers for the US showing the economy grew by 3.2 per cent.

Let's get this clear: for all of 2013, the US economy expanded 1.9 per cent after a 2.8 per cent increase in the prior year – some recovery.

Asian markets have fared even worse, with intense turmoil in equity and currency markets. Last week both South Africa and India put up interest rates to defend their falling currencies.

Chinese stocks fell to five-month lows while the Nikkei has fallen 1,200 points from the recent high. The Turkish central bank raised its overnight lending rate to 12 from 7.75 per cent and the overnight borrowing rate to eight from 3.5 per cent.

For Irish investors, one sector of interest and concern is the consumer staples and consumer discretionary stocks which have been pushed up to very high valuations on a global recovery or as a "safe haven" bond substitute dividend play.

Unilever, for example, had a profit warning in October and is now trading 17 per cent below its high and has given back all stock gains of 2013. Similarly, last Thursday, Diageo surprised the market with a profit warning. The stock is now also trading lower than it did at the start of 2013 – even though 2013 was an incredibly strong year for the stock market as a whole.

There are no safe havens if you bought when valuations are very high.

Janet Yellen starts her reign at the Fed by receiving the biggest hospital pass in history. The entire system is riddled with distorted prices, especially the price for risk.

The recent turmoil may dissipate quickly by more central bank action – don't be surprised if the ECB hits the printing presses later in the year – but Bernanke's bubble is the biggest bubble the financial markets have ever witnessed and investors should be fully prepared for a very volatile year.

It has now been 530 trading days, more than two years since the market suffered a 10 per cent price drop – the common definition of a "correction". The S+P has not had a 10 per cent dip since August 2011. That's 27 months ago.

Everybody is confident this is a blip – but confidence happens to be one of the crucial elements of a Ponzi scheme.

Paul Sommerville is CEO at Sommerville Advisory Markets (www.sam.ie). Paul.sommerville@sam.ie

Irish Independent