Long ago, life for the canary bird in a coalmine was described as short but very meaningful.  Used to detect deadly gas build up in mines, canary’s were caged and brought down into the mine. When the chirping stopped, it was time for miners to get out fast else they ended up like their small-feathered companions.

Today we say that to be a canary in a coal mine is to be a warning to others. I couldn’t imagine a more fitting analogy then to say Japan is the canary for the U.S. And, fellow coalminers, Japan has stopped chirping.

In the last two weeks Japan’s major stock index, the Nikki Index, is down over 17%. This puts Japan’s Nikki Index in negative territory for the year and in the correction category of more than negative 10%, putting the market into a bear market. It’s time we realized that the U.S. is in the same “mine” as Japan and we need only look to its fall as reason for us to get moving!

Why would we say that we are in the same “coalmine” as Japan? A few facts make it pretty clear. First, Japan and the United States have undergone unprecedented government driven monetary easing. As shown by last week’s performance, the honeymoon is over for Japan’s Prime Minister Shinzo Abe’s excessive quantitative easing program.  His attempt to end two decades of stagnation with unprecedented monetary easing, increased government spending, and reforms to make the world’s number three economy more competitive is failing. 

There are three developments that we find disturbing, none of which bode well for the U.S. economy. First, we are concerned with the recent May 23, 2013 flash crash in which the Dow Jones Utility Average plummeted down -12% shortly after opening. Like the June 6, 2010 “fat-finger” crash, this May 23 incident should be viewed as a precursor to trouble ahead for the U.S. markets.

Second, we are going to face the same problem here in the U.S. as Japan. To see why, simply take Shinzo Abe and swap in Ben Bernanke.  The only difference is that the U.S. markets are not showing up negative, yet, and despite all reasonability. The Federal Reserve’s balance sheet is now leveraged 60 times, up from 21 times in 2008.  The Federal Reserve has a borrowed balance sheet of $3.34 trillion on capital of just $55.2 billion. History has shown us what happens when markets are over-levered.  Lehman Brothers at their time of demise was leveraged 44 times.  Bear Stearns at their time of demise was 33 times leveraged.  So leverage less than what the Federal Reserve is carrying was able to knock these two firms out of existence despite their significant presence in the market place. What will happen to the Federal Reserve when it comes to pay the price for this abuse of financing?   A mere loss of 1.7% on the Fed balance sheet could wipe out its equity.  So if it wouldn’t take much of a U.S. bond market decline to render the Fed bankrupt, I’m wondering if the Fed voo doo economists have ever considered that it would be risky to leverage the Fed to infinity with QE?

The final troubling development is the rise of the U.S. stock market. For the last few months the U.S. stock markets have powered ahead as if guided by magic, not logic or facts. Underlying financial trends at the U.S. largest public companies are sadly reminiscent to the early 2000s. During this bear market time equity prices ultimately fell 50%.   According to Global Equity Analytics and Research Service, sales growth fell at 2/3 of the companies in the Dow Jones Index in Q1 of 2013, which is not good.   Capital weighted average sales growth for Dow Jones Total Market Index fell for a fifth straight quarter and in Q1 of 2013 to 3.1%.  At the same time, average profits of these Dow companies stocks had their deepest declines in 20 years. 

The message in the negative corporate earnings data and the Japanese markets is that the gig is up. The turmoil of the Japanese financial market is merely a prelude to things to come in the U.S. Japan is setting the stage for what will be happening in the U.S. financial markets. The question is whether or not we have time to respond to the Japanese-canary, or whether the chirping ended far too long ago for hope of our salvation.

Dawn Bennett is Co-Portfolio Manager of Bennett Funds and CEO and Founder of Bennett Group Financial Services.

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