Red Alert

JM Keynes_No more crashes

This is the March 2017 update on the ‘red alert’ article that I’ve been running for some time.

In stark contrast to the calming words of J.M Keynes (in 1927!)  – now, the ‘experts’ are putting out red alerts

In an excellent article (FT, October 14, 2016) Gillian Tett relayed some ideas about what’s really shaping markets now.

The ideas (from Axel Weber, head of UBS and former head of Germany’s Bundesbank) include a big concern that

markets are not true (free) markets now.

Well of course they’re not.

The world’s central banks have distorted them for years now.

The trouble is  – we’re only now waking up to the RISKS in what the central banks have done.

One big problem is that holding DOWN the price of money (interest rates) simply pumps UP the price of other assets – whether they’re houses or stocks

‘To my mind’, says Gillian Tett, ‘this point needs to be proclaimed with a megaphone’

Well, I’m glad to hear that, because it’s an issue that many of us have warned about for years !

The sad thing is that the authorities have let this game run on for too long . . .

The bankers know that there's big trouble ahead as the game unwinds. So they're queuing up to give warnings nowClick To Tweet

Also in October 2016, Murray Gunn, the head of technical analysis for HSBC, said that based on the price action of stocks over the past few weeks he was on “red alert” for an imminent sell-off in stocks.

So, does technical analysis offer reliable forecasts?

Well, I’m not aware of any evidence that it does – at least not consistently.

And clearly that call has been wrong so far.

Indeed, I’ve seen plenty of evidence of ‘technical analysis’ giving the wrong signal – and costing people a lot of money!

But if a major bank issues such a warning, perhaps we should take a look – to see if there’s any cause for concern.

Gunn also said (in September) that the stock market’s moves looked eerily similar to those just before the 1987 stock market crash.

And in case you’re not familiar with that one . . .

. . . that was when the FTSE lost around 35% of its value in one month.

Tom Fitzpatrick (from Citi Bank) has also talked recently about the parallels with 1987.

But short-term technical analysis aside, is there any cause for concern?

Well yes, I think there is . . .

And this stock market indicator has been flashing red for some time.

This stock market indicator is flashing RED right nowClick To Tweet

Actually, this indicator started flashing red around 2013!

And I guess that proves, as with earthquakes, we simply cannot predict when the trouble will strike.

What we do know, however, (as that 1987 example proves) is that markets do fall very hard very quickly from time to time.

And those falls normally come after a lot of buying pressure has built up – to take the market well above it’s normal valuation range.

Earthquake

Incidentally, the frequency and size of stock market moves are actually very similar to those of earthquakes and we’ll come back to that another time.

But for now – let’s look to see if there’s been a pressure build up – to at least give a clue as to whether a big fall might be coming.

Please note:

The indicator we’ll look at here is not about market ‘value’ – and that’s really the best place to start.

So if you’ve not read about my favourite market value indicator – the CAPE – I’d urge you to read that Insight before this one.

You can read about the CAPE here.

Okay, so what is this red alert about?

Well, it’s about investors who borrow – to invest!

And this excellent chart (from Doug Short at Advisor Perspectives) tells the story.

NYSE margin debt vs S&P 500

You can find more of Doug’s Insights here

And don’t worry if  you don’t like charts – there’s a very simple but powerful message here as I explain below.

Still with me?

Great, so take a look at how that blue line (of the US stock market) has a nasty habit of overheating (ramping up) and then crashing.

And notice also how the overheating happens when there’s a lot of borrowing (the red bars) by investors.

Right, so investors have borrowed heavily in recent years?

Exactly right – and who can blame them?

I mean, interest rates have been at all-time lows. They’re at many percentage points below what anyone would describe as ‘normal’

Borrowing has been mega cheap – whilst the return on your money left in the bank has been mega awful!

There has been a double incentive to borrow to invest!

Okay, but why highlight ‘has been’ ?

Surely, rates are still low.

That’s true – and they might stay low a while longer.

But most informed commentators expect interest rates to start moving up again quite soon now.

And as that happens, the mood music will change dramatically, if it hasn’t already.

Then, with rising costs of borrowing and better returns on money at the bank, that double incentive goes into reverse.

And these investors will likely cut their borrowings.

Indeed, you can see from the chart (red bars, right hand side) they started doing exactly that last year.

But they’ve since gotten excited about the prospects for even more gains – and have started borrowing again – to buy back in.

Perhaps these speculators think that Mr Trump can help the stock-market ‘defy gravity’ for a little longer.

Okay, but so what?

Well, notice how the big market crashes tend to come, when those borrowing investors ‘cash out’ of their shares to pay back their debts.

Oh wow, so this is potentially a nasty situation?

Well, potentially, yes but then big risks exist at all times in stock markets – and some never materialise.

This is just one key indicator that’s not looking good right now.

By the way, if you’re not yet a ‘lump sum’ investor – and like many younger people, you’re saving regularly over the long term – then this issue may be lot less important to you. I’ll explain why at another time.

The fact is that markets (in stocks and property) worldwide have been ‘propped up’ (and boomed) because of the crazy low interest rates we’ve had for many years now.

Such ‘asset price parties’ always end eventually . . .

. . . and with the ‘experts’ now questioning the wisdom of this party, I suspect that the end of this one might be sooner rather than later.

The US stock-market is up by more than 250% (including reinvested income) since March 2009.

The UK stock-market is up over 180% on the same basis.

These are incredible returns compared to what you’d have earned from money at the bank.Click To Tweet

Which is all very nice for those lucky enough to have been fully invested over that time. But the key question for investors is . . .

Can such returns be repeated from now?

Well, as you may have guessed, I’m in the camp of people who think that’s unlikely.

Yes, it’s possible but it seems very unlikely given how ‘stretched’ the valuations are today.

See that CAPE Insight for more on that.

Or, if you want a deeper dive into the prospects for markets, check out the quarterly letter from GMO here

So what does this all mean for your money?

Well, you have to decide, with or without guidance, what to do.

My general guidance is very clear and it’s this.

The right answer depends completely upon your personal circumstances.

Like so many complex questions, there’s no silver bullet and no single investment to suit everyone’s situation.

We really are all different.

What you need to understand is your own personal ‘appetite for investment risk’.

And, more importantly, your personal ‘capacity for loss’ on each of your investment goals.

Only when you know these things can you invest intelligently.

And here’s a final ‘red alert’ to watch out for.

A lot of financial advisers ignore market valuations in giving advice.Click To Tweet

They will tell you that markets are priced perfectly – and that they will always produce good long term returns, regardless of when you go in.

Now, that’s not clever advice.

And if you’re unlucky enough to receive it at the wrong time it could be very damaging to your wealth.

So be careful how you choose your adviser/wealth manager. And if you need guidance on that I’ll write some.

Just let me know in the comments.

Final thought – and I’m grateful to my friends at Money Week for this one . . .

. . . Samuel Lloyd, an English financier, once observed that:

No warning can save a people determined to grow suddenly richClick To Tweet

But that’s not going to stop me from issuing these warnings . . .

. . .  so take care out there.

Paul

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Discuss this article

  • Cwijetunge

    Great article. I’ve been assuming interest rates would rise for years… still waiting! What do you think would trigger a rate rise, given that even the decline in the pound hasn’t seemed to have had an impact…

  • Great question Caroline – and one that’s worth a fresh Insight. I’ll write one and let you know when I’ve posted it 🙂

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