By John Richardson
The above chart is the most important indicator about why the current rally in equity markets is at high risk of a sharp correction.
Volumes in European markets (the blue line) and US markets (the red line) are significantly below levels in 2006-2012.
High volumes are always a bullish indicator as it means lots of people are involved; low volumes means movements are taking place without real conviction.
Low volumes encourage a trading mentality, as financial players need volume and so rumours start very easily.
Another concern is that in today’s markets, interpreting complex political issues has become very difficult. As a result, different interpretations add to the volatility.
A further factor behind the volatility is the increasing role played by high-frequency traders.
The stock markets have also changed their focus. They no longer see their main role as being to provide capital for companies.
As Bill Gross of Pimco, the world’s largest bond fund, has sad: “Credit is now funnelled increasingly into market speculation (instead of) productive innovation”.
Central bank intervention, through stimulus packages, has provided great support for these speculators via ample and very cheap financing.
We discussed in chapter 3 of our e-book, Boom Gloom & The New Normal, how earlier price rallies in crude occurred because of some of the speculative factors listed above.
Everyone then sought to find a reason to justify increases in oil prices based on supply and demand when they had, in fact, been driven by speculation.
We are worried that history is in danger of repeating itself.
Today, the “real world” after-the-fact justification for rallies in equity markets, in commodities including crude and in chemicals pricing, is lagging economic indicators.
For instance, an increase in US government defence spending ahead of the presidential election and China’s equally politically motivated stimulus package in May-October 2012 helped boost growth in the fourth quarter.
In the case of China, money from the stimulus package is still sloshing around its economy.
But post-Lunar New Year, stimulus seems more likely to be withdrawn as China has to rebalance its economy and deal with inflation problems.
As for the US, the 1 March sequester, which would involve deep cuts in defence and other spending, threatens renewed recession.
Numerous other negative macro-economic events could be the trigger for a significant correction in equity and commodity markets.
The risk for the customers of chemicals companies is that they are once again trapped in the cycle detailed below, because of rising raw material costs:
*Manufacturers cannot adjust their prices on a daily basis to reflect higher oil prices. They are locked into fixed price contracts with their end-user customers, often for six months or more.
* When oil prices start to rise, they cannot simply sit back and allow future margins to disappear. Instead, they are forced into the market to stockpile raw materials before prices rise.
* This process continues until it becomes apparent that prices have plateaued. Then companies seek to destock again, but find this difficult as their immediate customers are also destocking.
*End-consumers have all been reducing their purchases, due to the loss of discretionary income resulting from high oil prices. This creates a double whammy for profit margins.
As we keep stressing, please, please be careful out there.