Risk of a 1987 style sell off?
On Friday last week (23/03/18), I circulated a note entitled ‘Expect the S&P to retest its 200dma’. A link to the original article can be found here: https://www.mwcmgroup.com/expect-the-sp-to-retest-its-200dma/
The surprise for me, was how quickly it re-tested – with the S&P finding support at its 200dma that very evening.
While I noted in Friday’s ‘Insights’ that, ‘the current business cycle is long in the tooth’, it is ‘not necessarily over’. I continued: ‘We are not yet forecasting an imminent crisis, for the simple reason that while malinvestment is high, the central banks are still very committed to keeping things moving. And don’t forget the tax cuts and increase in fiscal spend in the US, which are positives on the short and medium term. Yes, a trade war is damaging longer term, but will not cause a major correction in the market near term’.
My concern here is that, while its relatively easy to protect capital in a 2000 or 2008 scenario, by reducing exposure based on technical factors, it’s a lot harder to protect capital in a 1987 style sharp down move.
The market fell just over 22% on Black Monday 1987.
While technicals are not a perfect science in any way, I would be concerned if the S&P falls through its recent support of 2540. A near-term break below that could lead to a further down move.
Why the concern at this point? While the underlying economic growth is improving, the current rally in the equity market is long in the tooth and there is a confluence of factors, investors will be increasingly concerned over. Let’s go through a few of these:
The S&P is still significantly above its longer-term mean.
The chart below highlights how small the recent move is relative to the up move we have seen over the past 6 years.
Valuations are also rich for the S&P.
The chart from DShort, who does a terrific job aggregating valuation and other market and economic data, provides an excellent snapshot of the S&P in terms of its longer term valuations and also against its mean.
Goldman Sachs has also highlighted the S&P looks rich against history.
Besides valuation, there are a few other factors to consider:
Margin debt is well above the peaks we saw at prior tops.
While this is not evidence of a turning point, if those using margin start to sell off to cover, it can waterfall very quickly.
Funding costs have, and are, rising.
See the LiBOR-OIS spread which has materially widened.
The Fed balance sheet is contracting.
We are seeing a similar trend to normalise by the central banks globally. Given that the central banks have pumped some USD 12 TRL+ into the markets through quantitative easing, a reversal of these policies, is effectively a form of severe tightening.
Unemployment in the US is at 4.1%.
Yes, the participation rate has come off and has room to expand, so the pressure on wages may be a little further out but, as I have raised in past Insights, further falls will likely drive wage inflation higher.
The chart below also does a terrific job to highlight how long in the tooth this economic expansion is. Unfortunately, a bust always follows a period of improving employment.
Source: Federal Reserve Bank of St Louis
So, in summary, rising rates and yields, rising LIBOR, quantitative tightening, a new Fed chair, continuing weak money supply and velocity, trade wars and twin deficits are all factors that could and will put pressure on the market.
A key positive, however, to consider on the flip side and that does support the market, is the fact that earnings growth has really picked up. As the chart below highlights, earnings growth is a key driver of the equity market and we have seen a nice pick up here more recently.
Unfortunately though, the tax cuts in the US are a key driver of this growth and this is a one-off impact.
The increased fiscal spend will also be supportive, but then one also needs to consider the consequences of such a policy. Firstly, it will increase the deficit at a time when the US is already at over 110% debt to GDP.
Secondly, it is coming at a time when the economy, from an employment standpoint, is already fairly hot, and could put pressure on inflation. Of course that’s what policy makers want, but the market is, and should be, forward looking.
There are sufficient data points that one should be cautious in the current markets – particularly in equities and high yield. While the Emerging Markets offer better valuations, any trade war will impact negatively and they are never the place to hide in a developed market sell off.
I am not advocating that we will have a 1987 event. I am advocating that one should be aware of the risks and invest accordingly.
I hope all of the above is food for thought. Pls share this article.
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