The Federal Reserve’s balance sheet has begun to show the effects of the Quantitative Easing unwind. To date, approximately $375 billion has been removed from the Federal Reserve Bank assets. It should be noted that this reduction is a small fraction of the liquidity that was pumped into the financial system since the global financial crisis. The removal of Fed liquidity is one key reason the credit and equity markets have become unsettled over the past two months. The ongoing liquidation of the Fed’s balance sheet will continue to pressure equites.
It’s Déjà vu all over again!
Levered loans are back! Ever since the global financial meltdown, levered loans have been on the rise. Loan issuance is now near the highs of the last peak.
Before the market imploded.
This is a serious warning sign not to be ignored. Why? Because leveraged loans are a type of loan extended to companies or individuals that already have considerable debt. Or, these borrowers have a poor credit history.
Leveraged loans carry a higher risk to the investor. As an indicator, this chart also should help visualize that we are in a very heated environment and that has allowed debt to pile up. The tipping point is unknown. But, the other side will be particularly ugly.
In a word…default. Lots of them.
Recent data released also showed that 80% of borrowers who refinanced in the third quarter chose the cash out option and was the highest since the start of 2007.
So, more and more people are pulling cash out of their house to fund their lifestyle. In a normalized environment, economic activity wouldn’t benefit from this artificial demand created by increased cash outs.
When this comes to an end, and it will, we will see a slow-down. Defaults will also rise because people are way out over their skis.
We saw this movie before 10 or 12 years ago. It’s a horror movie. It doesn’t end well.
After all, whether it’s research or advice, those folks are all about making money… for themselves.
They’re not looking out for the little guy. By the time the little guy knows the ship hit the iceberg and is sinking, Wall Street has padded its pockets. Joe Six-pack is scrambling for a life-vest.
And nobody does the time for their white-collar crimes.
However, once in a while, from that abyss comes a little gem that sheds interesting perspective on the market. That’s what I discovered in a recent release from Goldman Sachs…
And it’s a bright, red warning sign…
Take a look at this chart:
This aggregation of several indicators – including valuation, inflation, and the yield curve – shows that we’re in the danger zone. But we’re not in just any danger zone: We’re in a generational danger zone.
The market hasn’t been this risky on these measures since the late 1960s.
The beauty of this indicator is that it’s objective. There’s no fuzzy math.
We can make plenty of qualitative statements to justify why the line on the chart is where it is and that this time around it won’t amount to a hill of beans. Name the narrative: “Tax cuts”… “Buybacks”… “Divided government”… “Gridlock”… “War”… “Peace”…
Yada, yada, yada…
The fact is that risk is high. In the past, that’s meant zero returns going forward. Until the market corrects. Scary.
It is particularly scary this time around, because we’re dealing with a historical bull market. That means that the coming bear market – and there will be a bear market again – is likely to overshoot on the downside, too. There’s lots of excesses to work off.
So, what to do?
For one, pay attention. It’s been very easy to buy an index and make money in the market over the last 10 years. Even if you had your head in the clouds but suffered a momentary lapse of reason and bought an index fund, you’ve done well.
But more and more stocks are falling by the wayside – among them a few monster names that hold the market up these days. Indeed, even Amazon.com (Nasdaq: AMZN) and Netflix (Nasdaq: NFLX) got smoked in October.
That could be just a start.
Recent volatility is a warning sign.
There are more days in a bear market when the market is up 2% than in a bull market. Why?
Well, my own theory is that more people try to call “bottoms” than “tops.” It’s easier to buy the dip rather than add money into a blue sky high.
But the market has a perverse way of luring you in at just the wrong moment – usually after a few 2% “up” days – only to reverse course and pick your pocket.
So, it’s time to pay attention – real, close attention. Tighten your stops. And think long and hard about where and when to commit new capital.
Zero percent returns – which is what history tells us follows with markets at these type of levels – don’t sound attractive to me.
The chart from chartcraft.com below shows that stocks comprising the NYSE composite have been in the midst of a selling climax. That historically indicates that they are set for a rebound, at least in the short-term. Why? Selling climaxes occur when stocks make a 12-month low but then close the week with a gain. That indicates the stocks are being accumulated and buyers are out numbering sellers, driving prices higher. Conversely buying climaxes occur when stocks reach a 12-month high but close the week lower, indicating the stocks are headed down.
How do we know this is important news for investors? Chartcraft.com says its studies indicate buyers into a selling climax and sellers into a buying climax are right 80% of the time after four months of time. In other words, odds are the recent selling climax should be good news for bulls in the short-term.
Although important technical and economic factors make us extremely cautious about the equity markets longer term, we’re looking at some shorter-term indicators that tell us the markets could experience profitable upward bounces during the rest of 2018. For one thing, as illustrated by the second chart below, most public companies can once again buy back their own stock after emerging from blackout periods that suspend buybacks before quarterly earnings announcements. Indeed, the fact they couldn’t buy during September and October may have exacerbated the recent sharp market declines.
Another positive is that the Ned Davis short-term sentiment indicator is at only 20% bullish, the lowest level of the year. That means there’s a huge amount of bearish sentiment out there. And that’s positive news from a contrarian point of view since historically investors are wrong about market direction.
More good news for the remainder of 2018 is that a lot of mutual funds and the like subject to the 1940 investment company are done with the tax selling of the last two months that helped depress the markets. So that adds even more liquidity for upward market momentum this year as these investment companies initiate buying programs to maximize annual returns after flat to downward performance for the first 10 months of the year.