Big boys firing warning shots... yes, again

ref :- " Investment Banks Turn Sour on U.S. Equity Outlook ", Bloomberg Markets

A couple of points to make straight off the bat:

Regulars will know that we find ourselves saying "We've been here many times before" quite a lot, and today could easily be another occasion when it would be sensible to remember that phrase. People have been trying to pick a top in rampant US stock markets almost since they began their spectacular upward surge after the pandemic-driven crash of March 2020, and certainly since they passed pre-Covid levels in August of that year. There have been occasional breathers for sure, but any look at a longer-term chart would tell you that they amounted to little more than blips for anyone other than short-term traders. FOMO (Fear of Missing OUT), unprecedented waves of retail investors, lack of credible alternatives and of course levels of stimulus (both monetary and fiscal) have contributed to making those urging a re-think look a bit silly. Is there any reason to believe this time is any different?


By the time most of you read this, the ECB will have announced its decision on future monetary policy and some are expecting them to cut back its emergency bond-buying programme by as much as €20bn per month to €60bn. Whilst they face broadly the same issues there are differences between the situations in the Eurozone and the US. Former ECB boss Jean-Claude Trichet said yesterday that they operate in a different universe, particularly when it comes to inflation. That may be overstating things a tad, and no one would expect the Fed to be led by what the ECB does, but should the latter take a bold path it will inevitably be grist to the mill to those at the Fed arguing that it should follow a similar route... and soon. U.S. investors will be at least taking note, and so should we all.

Anyway, that said... Bloomberg tell us that no lesser lights than Goldman Sachs, Morgan Stanley and Citigroup have all issued warnings about the "potential" for some sharp reverses. That's not the same as saying they will happen of course, but you wouldn't expect that. The growth of the delta virus, flagging global growth and moves by central banks to withdraw pandemic-era stimulus are all identified as reasons for their caution, though of course one could argue that the first two factors might postpone or at least water down moves on the third.

With doubts clouding the horizon, it's not at all surprising that the issue of overstretched valuations is a key contributor to some new-found caution. In old parlance, and using elements of market logic that don't always apply in this strange new world, the markets are "overbought"... big time. When valuations are this stretched, and especially when a significant proportion of the impetus behind them comes from smaller retail investors, those valuations are extremely fragile and vulnerable to bad news. Stats on current market positioning on speculative positions on the S&P500 reveal that the number of longs outstrip shorts by a ratio of almost 10 to 1, and half of those (weak?) longs would be losing money if the index reversed by just 2.2%. If that should happen, and if the longs are as weak as implied, then we could well see a rush for the exit. As Citigroup say, what would otherwise be a small correction could be "amplified" by forced long liquidation - and given the well-documented lack of liquidity in markets when things go pear-shaped, the move could be exaggerated into something pretty serious.

Both Morgan Stanley and Credit Suisse have turned "underweight" on U.S. equities, with the former highlighting a growing risk to growth brought on by the spreading Delta variant and the latter citing those overextended valuations and... a new factor here... regulatory risk. Presumably (we confess to not having read CS' missive to clients), they refer to the chances of Pres. Biden appointing a new Fed Chairman not keen on following current Chairman Powell's intentions of loosening some of the banking regulation brought in after the financial crisis.

Time for a bit of perspective... We cannot argue with the reality of any of the dangers brought forward in the Bloomberg piece, though without any inside knowledge whatsoever we would consider a change of Fed Chair at this time to be unlikely. Yes, valuations are overextended... very... and many of the investors who have brought that about are indeed on the "flighty" side, shall we say. And yes, it is very likely that growth data over the next couple of months (say) will be adversely affected by Delta, itself exacerbated by the return to schools. And yes, slowing growth or not, the Fed is likely to begin to reduce its levels of monetary stimulus by tapering its asset buying sometime soon (November?). But even if all these ominous stars align, how severe will the reaction be?

Let's be clear... no one that we have read has suggested a ruinous sell-off. Given the nature of today's markets (high valuations, positioning, lack of liquidity during stress and the like), one might expect any reversal to be sharp but not necessarily long-lived. Would it be ridiculously naïve to suggest that when the Fed does begin to reduce stimulus, as long as the process is gradual and well-communicated in advance, the markets, even these markets, might be able to handle it... well, within reason, anyway? And above all perhaps, if the walls of money that are being pumped into equity markets are withdrawn, where exactly are they going to go? Like it or loathe it, we are still in the arms of TINA (There is no Alternative) - an acronym that effectively says "I'll buy stocks because I don't know what else to do with my money". It doesn't sound like a very well-thought out trading strategy - it's not, but no less real for that.

On balance, we'd agree with all the esteemed institutions mentioned in the Bloomberg piece in that there are some very real dangers lurking, and that it might be wise to prepare for some rocky times ahead, But a melt-down? That's something else... we hope.

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