Financial Smash-Up Heading Our Way?
Could the least expected outcome, a financial smash-up be on the cards?
The idea that stocks are heading for a melt-up, that trillions of dollars of liquidity will gravity towards stocks away from bonds makes sense in a world of functioning market dynamics and where price discovery, the fundamentals dictate price. But the post-2008 financial crisis tipped markets out of their usual orbit. Asset prices have since been orbiting around the central bank’s liquidity. Almost a decade of unprecedented monetary easing which involved a near-zero interest rates policy and trillions of dollars of liquidity flooding the markets through the central bank’s bond purchase program (known as quantitative easing QE) has created the bubble of bubbles.
Post-2008 financial crisis and the fundamentals have become irrelevant, the stock market became the central bank’s perpetual motion machine. The central banks kept the bulls charging by injecting more liquidity in the market. So it was this coordinated effort by the major central banks that have thus far been successful in preventing a financial meltdown (there is no fear of bank runs) but it also created a fake bull market in stocks, bonds, real estate and even alternative assets.
But take the funny money out of the equation and what is left, a melt-up or financial smash-up?
There is no relationship between corporate earnings and ever-increasing stock prices.
S&P’s 12-month P/E is now at an all-time high of 22.88.
Why then would stocks melt-up due to rotation of capital out of bonds into stocks, bearing in mind that the S&P’s 12-month P/E suggests that stocks are already too expensive.
Moreover, an emergency monetary policy has debased the central bank’s fiat currency. Put another way the central banks can’t continue with another round of massive easing without further debasing the currency and creating a monetary crisis. So it is no surprise that the central banks are eager to shrink their balance sheet and raise rates.
The current era of monetary policy is monetary normalization with central banks retreating from QE and near zero rate interest policy. But how will investors make up the shortfall in liquidity, thereby keeping the upward trajectory of asset prices going forward?
So perhaps it is not so far-fetched to think that we could see a financial smash-up (correction) going forward, bearing in mind that imminent crash indicators are starting to flash red.
Take investors’ cash levels which have reached an all-time low
This is an indication that every leveraged investor and his dog are already riding this fake bull market. The era of funny money QE has created a generation of complacent investors-everyone is all in, after all its a stock bull market by default.
Think about it. A financial smash-up, a correction usually occurs when the herd is taking one side of the trade and the herd mentality (which is what top investors try to avoid) is currently too bullish. The bulls are betting that this market will be the greatest of all time.
The CBOE Equity Put/Call Ratio is at five year low (more bullish bets than bearish ones) at 0.49%, as of January 26.
More investors are betting that stocks are heading for a melt-up rather than a smash-up.
Whats more there is no fear in this market. The CBOE Volatility Index is at ten-year historic lows as it hovers around 11.50 range.
So the majority of investors are all in, betting bullishly on stocks and they don’t fear a correction coming. But contrarian investors would take the other side of the trade, they would bet on an imminent financial smash-up-a correction and if their call is bang on the money that is how the tiny few make spectacular profits from the losses of the many in this zero-sum game.
The financial smash-up would take the air out of the bubble in everything and we could see going forward falling bonds prices (soaring yields-this is already playing out), crashing stock prices, real estate, and alternative asset prices.
Already we are seeing signs of a market top in bonds. Bond prices are currently tumbling and their corresponding yields are soaring (as I write this piece). The bond market appears to have had its last dance. Regarding real estate, many of the metropolitan cities from London, NewYork, Paris, Sydney are now registering price falls in real estate, particularly at the top end of the market.
In the alternative market, the value of classic cars and fine art are also all tumbling.
So already a correction in asset prices at the top end of the market is in play
As the market adjusts to a tighter liquidity environment. Moreover, this trend of tumbling prices is likely to filter down to other asset prices.
The BofA believes that a financial smash-up is heading our way.
The next crash “is coming between Thanksgiving And Valentine’s Day” according to BofA’s chief investment strategist Michael Hartnett.
So the consensus a goldilocks macroeconomic environment (that completely discounts a looming trade war with China) and the forever Fed that keeps liquidity on tap means that the majority of traders are bullish. Everyone is betting on a melt-up.
But could this be another classic contrarian trade where betting against the herd, betting on financial smash-up yields big profits?
Over to you.