IN THE CENTER - I've talked quite a bit about US equities in recent months, not only because of my short exposure but also because of the importance of this market as it relates to the global economy. This is the market that has been at the center of central bank strategy to stimulate the global recovery since the financial markets crisis of 2008. The strategy has been simple. Lower rates to the point where money is free and buying stocks becomes the only attractive play in town. This way, sentiment is elevated and that positive sentiment ideally dominoes into a productive momentum that trickles into the real economy. But I think it's also become quite obvious that there are dangerous risks associated with this strategy and we still don't know how it will all play out.
FALSE SENSE - The biggest risk to this strategy is that it creates a false sense of things, with prices deviating a great deal from fundamentals. The market basically buy stocks less on the underlying fundamentals and more on the incentive to buy. Of course, buying something because it's cheap only makes sense if you believe in what you're buying. Ultimately, this takes us to a place we've already been at for some time, which is a place where it no longer matters what happens out there. Soft economic data? Political risk? Global terror? It doesn't matter. All that matters is that there are no other places to put capital to work and investors starved for yield in a yieldless world continue to push the market higher.
BUBBLES - So big deal. What's so bad about a false sense of things? Well, when stocks keep driving the way they have been, you get a bubble and we all know what happens when bubbles burst. It's pretty scary to think the very institutions responsible for ensuring safety and security have come up with a strategy that has pushed markets into excessive risk taking to the point where these same institutions are at risk of being responsible for the next big collapse in the market. I have said for many months that the reversal of Fed policy would trigger the end of this unprecedented run in stocks. And yet, we've seen the onset of policy normalization and the market is still pushing higher. So what's going on?
THREE THINGS - It comes down to three things for me. The first is that the rate increases that we've seen from the Fed thus far haven't been enough to make a dent as far as forcing investors to reconsider their equity exposure. So while rates have moved up by 50bps, they're still ridiculously low enough to make these equity valuations compelling for investors. The second is the fact that the market has yet to see a Fed that actually follows through with its forward guidance. And in recent days, calls from the Fed for two more hikes this year have come back into question. So as long as the Fed keeps backtracking, the market will be happy to keep buying. Finally, the moves we've seen have also been helped along by the emergence of quantitative funds making up a huge part of the market these days (nearly 30%).
NUMBERS GAME - What do quantitative funds have to do with higher stocks? A lot. With the discretionary component all but removed from these strategies, it becomes a pure numbers game that is broken down into the simple fact that the market is trending up and so long as it continues this way, the buying will persist. There is no worry with these funds that the market has moved too far. Worry is not a part of these models. They are built to push and buy dips until proven otherwise. But once again, this means there is also no sense of caution when markets get to levels that scream caution. The trouble is, there's only one exit door when the time comes to get out and with all of these players heading for that door at one time, it will get real ugly, real fast.
FOLLOW THROUGH - I believe the big collapse will come when the Fed actually follows through with its guidance and starts delivering more consistent hikes. So if the Fed follows through with two more hikes this year, all of a sudden, those valuations aren't looking cheap and those models will be running to book profit. And what's even more disturbing than everyone heading for that exit at the same time is the fact that no one will be looking to come back in right away. So that buy everything on dips bid will be removed and there will be very little supporting the market on the way down. This is why I've been calling for a 20-30% correction. Of course, those things the market wasn't caring about (geopolitical risk etc) will start to have an impact and only intensify the liquidation.
PERSPECTIVE - But with all that said, it's also important to understand we still could head higher. The possibility for a move into the 2465-2485 is real, at which point, that top may finally be in place. Here's a closer look at those SPX500 levels and dates I'm talking about which suggest we could see another jump, but also make a very strong case that a top is imminent and could be in the 2400s. Take a look at the tweet below for more color.