A Potent and Combustible Combination

First 10 minutes of Wall Street Week episode from Friday October 16, 1987 just prior to the market crash on black Monday. 

I’m not the only bear in town of course. Most market professionals quietly agree that the market has been pumped up to unsustainable levels and most expect it to self-correct in the traditional way. The only disagreement is over the timing and amplitude of correction. I’m using the cluster of unusual turn dates during this current period to identify it as a period of vulnerability for equities but with valuations and sentiment stretched to historic extremes, a catalyst could come at any time and in any form from Q1 earnings, a Grexit scenario, conflagration in the Middle East with the Saudi’s being drawn into Yemen, a cyber event and so on. 

US investors are especially low on ammunition. The NYSE available cash figure has dropped to one of its lowest levels. The last time it was near this level shares struggled for the following two months. Also, the ratio of assets in equity mutual funds to assets in safe money market funds has reached a new high. Shares have struggled to make fresh headway when the ratio has previously been close to the current extreme. 

These cash levels have been abnormally low by historic standards for a while now, perhaps reflecting what the crowd has come to believe is a “new normal.” It’s clear that managers are not looked upon favourable either by investors or their own management when not fully invested. Nobody wants to be Tony Dye. The result is a heightened state of collective market complacency.

The comfort there is the belief that “if we fall we all fall together.” We can cut and slice this with a number of other measures such as money market holdings of mutual fund investors as a % of the S&P or the percentage of cash in mutual fund investors portfolios, (2.45%) but we come to the same conclusion.  

Sentiment surveys for investors, advisors and managers are all at extreme levels. The 52 week average of the Investors Intelligence bull/bear ratio hit 3.35 last week which exceeds every reading for 35 years. These readings can of course continue to reach even greater extremes but they are telling us that markets are on borrowed time.

Concurrent with that margin debt has been contracting since Feb 2014, (a traditional warning signal), when it reached an all time high of $466bn. Margin debt peaked in front of the four greatest corrections of the past 50 years, 1973, 1987, 2000 and 2007. Note too that the level of debt in February last year expressed as a percentage of US GDP is bang in line with ratio levels at those previous peaks.

The madness abounds in bond land too. You are now guaranteed to lose money on nearly €2tr of Europe’s sovereign bonds if you buy now and hold to maturity. Bloomberg noted that the German 30 year yielded just 0.66% and if that yield rose to 1% in the next year the price of the bond would drop by 10%. Time for investors to acquaint themselves with duration and convexity perhaps. The environment is so too-good-to-be-true that a growing number of US corporations are traversing the Atlantic to issue Euro denominated corporate bonds. In fact, its been the busiest start to the year for Euro bond issuance since the currency’s introduction.

Collectively, it all creates a potent and combustible combination to trigger a bear market. In fact, it’s difficult to think of how to improve it as a bear set up.

Technically, most equity indices are in the final stages of their respective rallies. Pullbacks to date have been quick and shallow. The “buying the dip,” mantra has become so rewarding its become an automatic reflex. Overall momentum however is declining while volatility spikes are becoming more frequent. Investors at this stage of bull market maturity should be treating each decline as if it is the start of a major correction. You may be wrong once, twice, five, ten times but you only have to be right once. That’s an oft quoted mantra of would be tech millionaires but actually, I think the tables have turned.