Financial markets feel impact of the Great Unwinding

Economic growth

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Index Jan16Its not been a great start to the year for those who have trusted in conventional wisdom:

  • Western stock markets have been reeling, with the US S&P 500 Index down sharply since Monday
  • It has been the worst opening for world stock markets since 2008 – not a good year for investors
  • China’s currency has been under major pressure:  its stock market closed “limit down” on Monday and Thursday
  • Oil prices have broken through the critical $36.20/bbl support level

This is the Great Unwinding of policymaker stimulus in action.  As I highlighted last month, it is very likely that companies and investors will end up paying the price for policymakers’ refusal to accept the simple fact that ‘demographics is destiny’:

What we know is that the first 3 phases of the Great Unwinding are now underway:  the fall in the oil price, the rise of the US$, and the rise in US 10-year interest rates.  Only the 4th is still to come – the bursting of the S&P 500 stock market bubble.  And political risk is rising at the same time.  It could be a difficult 2016.

This month’s IeC Boom/Gloom sentiment Index highlights the change underway as the chart above confirms:

  • The Index has fallen back to levels that suggest a major downturn is close
  • In the past, this led to major new stimulus efforts from the major central banks
  • They have poured in $tns at similar moments since 2009
  • But with China now moving in its New Normal direction, it is hard to see how they could do this again

Instead, markets are starting to rediscover their true role of price discovery based on supply/demand fundamentals.

Doug Short Jan16The major bubble today is clearly in Western stock markets, which have been convinced that central banks would never let prices fall.  The charts above from Advisor Perspectives highlight the extreme level of over-valuation that have developed as a result for the S&P 500:

  • The 10-year price/earnings ratio is at its 92nd percentile in terms of the historical context
  • It was only higher ahead of the 1929, dot-com and subprime crashes
  • Similarly, the amount of stock bought on margin is at all-time highs
  • The amount of debt adjusted for inflation is higher than in 2000 or 2007

Further signs of likely problems are obvious in the popularity of the so-called FANG stocks (Facebook, Amazon, Netflix, Google/Alphabet).  These were up around 60% in 2015 as a group, even though the wider market ended marginally lower.

Divergence between a small group of shares, and the wider market, is a very typical way for bubble markets to end.

And it is very significant that these 4 stocks have been so successful – investors have wanted to travel in hope, rather than analyse today’s reality.  Thus they have preferred to follow the “greater fool theory” and chosen to invest in the belief that all 4 companies have developed fabulous new ways of making money for the future.

History therefore suggests that markets may have  a very long way to fall, if central banks fail to rush to their rescue.

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