The US equity market suffered its worst weekly performance since the China inspired sell-off into January 2016, falling by about 6% over the five days. Although the focus may well have been on Facebook and other Technology companies that would be vulnerable to greater scrutiny, we think there are other bearish forces that contributed. The sell-off was broad-based and no region was spared with European stocks falling by over 4%, UK stocks by 3.4% and Asian markets mostly around 3% to 4% (Japan by over 5%).
Strangely, although the price action of the last two months has only increased our conviction that we have entered a multi-month topping process that will ultimately give way to a vicious bear market, we are not sure that markets are headed directly lower in the short term. If they do head immediately lower, it could be in a cascading fashion that the media would probably label as a crash, but we think the odds of a relief rally starting at some point are probably higher.
As well as pressure on the Technology stocks, we look at the Fed as being modestly hawkish at last week’s meeting, continuing on our theme of them heading directly into policy error territory. We also look at the European and US data indicating a softer start to the year; perhaps the synchronised global growth witnessed in 2017 is as good as it was ever going to get? The continue rumbling around tariffs and trade wars has a bearish bias, as does the general tone in the geopolitical arena.
As well as the above headwinds, there are two other observations that we think are worth making;
- Corporate share buybacks, which likely hit a record in February and helped save the day as the volatility blow-up impacted markets, will ease off as companies enter their closed periods when they are not allowed to buy back their own shares around their quarterly results schedule. Without this support, the immediately bearish case for equities remains a valid path.
- Bonds have barely held their ground during periods of falling equity prices, and have not fulfilled their safe haven role. In fact, equity and bond markets are both down year to date in most regions – a worrying correlation that we have warned about before.
We pointed out recently how European stock markets have a different look to the US, and in relation to our topping theme, European stocks appear to be very much in this zone whereas the US market trend can still just be viewed as bullish. Viewing all this via the MSCI World Index (heavily weighted to the US), as shown in chart 1, the market has declined to the still rising 40 week moving average. That said, the correction of recent weeks may very well be the opening move in our multi-month topping theme.
Chart 1 – Weekly chart of the MSCI World Index (with 40 week moving average in red)
In thinking about the anatomy of a multi-month topping phase, we would point out that it is the most speculative/popular areas in financial markets that top out first. Looking back at the last 18 months or so, what is interesting is that although mainstream equity markets were generating strong returns for shareholders, some investors just could not help themselves in chasing even greater returns. Some went well off-piste and started speculating in Crypto currencies, some stayed closer to their equity bias but significantly overweighted the so called FAANG stocks, and some decided to try and enhance their returns by systematically selling volatility. These are all the types of actions seen in a speculative environment.
One by one, these more speculative areas are biting the dust. Crypto currencies topped in December (Bitcoin is some 55% below its high). Volatility products literally blew up in early February and many holders lost close to 100% of their money. And now last week, fears of greater regulation of Facebook and other Tech stocks has caused the largest correction in the FAANG stocks in over two years, as shown in chart 2.
Chart 2 – Weekly chart of The FAANG Index
Key to the anatomy of a topping process is the clear ending of the speculative frenzy surrounding the most flaky or esoteric corners of the bubble, and we think we are there. Next comes the growing realisation that despite strong memories of the preceding bull market (promoted by the ever bullish sell side firms and finance channels), investors are no longer making money. Chart 3 below shows the MSCI World ex. US. What intrigues us is that collectively non-US markets have still not recaptured the pre-crisis levels seen in 2007, and no progress has been made since mid 2014, more than three and a half years ago.
Chart 3 – Weekly chart of MSCI World Excluding the US
The next phase of the topping process will be a period of range trading that probably lasts 6 months or so. If we are correct that this process has begun in Q1 2018, then we should expect it to end in Q3 or Q4 this year. By later this year, the Fed will be further along their path to raising rates and reducing their balance sheet, and financial conditions will be a good bit tighter than they are now.
Our view remains very much that the Fed are on the path towards another major policy error that will end in recession and a financial crisis, but this is a 2019 story. Before we get to that stage in the process, we need to see a more progressive unwinding of the financial excesses in recent years, including a marked deterioration in high yield bonds.
As noted a few weeks ago, the spread between high yield bonds and US Treasuries has been in a tight range for the last year or so. The poor performance in equities last week was accompanied by wider spreads, but at 348 basis points, there is no obvious sign of immediate stress in this segment of the markets, and probably won’t be until we see the spread exceed 400 basis points.
Chart 4 – High yield spread over USTs and the S&P 500
So, our big picture view remains the same; we have likely entered a multi-month topping process that will ultimately yield to much lower prices in many areas of the financial markets. After a bad week and a lot of obvious bad news, it is very easy to be bearish. However, we are sticking to our theme that it is unlikely that broad equity indices head straight lower from here. That said, the real story here is a changing market psychology which we believe translates for investors into a new narrative of selling rallies rather than buying dips.
Stewart Richardson
RMG Wealth Management
