5 Danger Signs that the Stock Market may be in Trouble

The post Brexit stock market rally is a familiar story for this economic cycle:

"Ah sharks! Things are turning bad! Nevermind! The central bankers will save us again! Buy buy buy!"

The stock market recovered sharply from the Brexit shock and in some markets, are trading in record territory. Other than the strong optimism that the central bankers will flood the market with cheap money again, there is another strong reason explaining the recent rise in the stock markets. 

In a world whereby yields are negative or close to zero for most of the low risk assets, investors have been forced to chase for yields in higher risk assets pushing the prices of risk assets into dangerous bubble zones. A combination of irrational optimism and chase of yield in higher risk assets have put the world financial markets in a precarious state.

And there are 5 danger signs that this rally may not be sustainable.



Danger Sign 1: Dangerous Valuation

In US, the stock market is rising on factors that are absent in a typical stock market run. US corporate earnings are not strong and US stock valuations are hitting a dangerous zone. Base on a research done by Goldman Sachs, the current P/E expansion cycle is now one of the largest in history. Since September 2011, S&P 500 forward P/E has grown by 75% (from 10x to 18x). This expansion has only been surpassed twice since 1976, when the multiple rose by 111% from 1984-1987 (ending with the 22% Black Monday collapse) and by 115% from 1994-1999 (ending with the Tech Bubble pop).

In China, parts of the country that are manufacturing oriented has lapsed into a recession, while prices of properties coastal cities are shooting through the roof again as a result of a low interest rate and lack of investment options.

Danger Sign 2: US Bond Yield at Record Low

Low yields in bond equate to only one thing, that institutional investors are so uncomfortable with other higher risk asset classes that they are willing to earn close to nothing for the safety of bonds. Historical, bond yields and stock prices tend to follow the same direction and bad things often happen when the trends of these two diverge.

Danger Sign 3: Rising Yen

The Yen has been rising despite the central bank unleashing rounds of QE and pushing negative interest rates to the negative zone. All these efforts should have weakened the demand of Yen and yet global investors are flocking to this safe haven currency despite losing money as a result of a negative interest rates. Global investors do not volunteer to put their money into a money losing investment unless the alternatives offer an even worse scenario.

Source: CNBC

     

  Danger Sign 4: High Investor Complacency 

 The VIX index, which is a measurement of investor's complacency via options traded in the open market, hit a 2016 record low at the end of July. The value of VIX indicate the amount of fear in the market and the higher the value, the more fearful investors are. It seems like investors are pretty fearless right now despite signs of a slowing global economy. The last time VIX hit that low was in July 2015, just before the crash of the energy and china stock market.

Source: CNBC

Danger Sign 5: Rising Gold, Falling Oil

With all the fuzzy data from China, investors have turned to oil prices as one of the forward indicator of the Chinese economy. The first oil correction from $90 to $60 in 2014 is later followed by the Chinese government sharply revising their growth expectation downwards. The second crash which started in May 2015 from $60 to $35 was followed by the Chinese stock market crash and the Chinese government intervening with fiscal and monetary policies to ensure that the economy does not crash as a result of the stock panic. Oil prices have stabilized, but it seems like the story has not ended yet as oil price once again, started to trend down again. Gold prices as we all know is a safe haven commodity. Gold prices has risen sharply this year from $1000 to $1300 

 If institution investors are rushing to buy all the 3 safe haven asset classes, there is a strong probability that something sinister is going to happen just around the bend of the road. What is holding up the financial market at this moment in time is the optimism that the central bankers will once again step in to save the world again. So what are the central bankers saying?

US Central Bank: "Things doesn't look that bad. We might raise interest rates!"

Japan Central Bank: "Sorry to disappoint but we are running out of ammunition!"

China Central Bank: "There are bubbles everywhere in China, so we will keep monetary policy prudent."

All eyes are now turned to the Europe and the eye of the Brexit Storm.

Portfolio Strategy

 

On Hindsight, I must admit that I am wrong about the potential impact of Brexit. The market recovered strongly post Brexit and we missed out on a good chunk of the recovery returns. My plan was to exit European equities, should that in the unlikely scenario that the Brexit should occur. Investment management is about planning for unexpected scenarios and successful investors stick to their game plan based on their investment principles whether the result turns out to be in their favor or not. My principle of capital preservation is that it is better not to make that 5% potential return than to potentially lose 20% as a result of a potentially unknown and catastrophic financial event. In any case, based on the lengthy analysis I have done on the post Brexit financial environment, you can see that the risks of the financial markets are approaching towards a perfect storm. At this moment in time, holding on to a conservative portfolio seems to be the best thing to do in this irrational market environment.