Watch out for a Wall Street sneeze

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  • Saturday, 04 Aug 2018

Narrow market: Signs for the New York Stock Exchange hanging above the trading floor. The gains seen among the FAANG stocks this year shows that the S&P 500 does not have a healthy breadth as gains of the index is primarily contributed by just about 10 stocks. — AP

I MUST admit I am an avid follower of Twitter under the handle @happypankaj – it’s a handle I created to depict my emotions on the market, i.e. to be happy when markets are up, for a simple reason that I will be making money, and to also be happy when markets are down for another simple reason i.e. I will be able to buy stocks cheaper than they were before.

In one of my twitter feeds recently was an article titled “US Household Debt is in a Bubble – Part 2” that I came across and was written by Jesse Colombo, an economic analyst and Forbes columnist, who posted the article in blog. Jesse, in his article published on July 25, highlighted few undeniable facts and his main concern was the repercussions if the current financial markets were to reverse course.

In summary, his article pointed towards one thing, that we are in an “everything bubble” phase, measured in multiple ways. Other than the jaw dropping 300% gain that the S&P500 has made since March 2009, Jesse pointed out that the Fed’s action and the long periods of low interest rates have indeed fueled markets. Interestingly, investors’ margin financing activities too have peaked up considerably while retail investors’ allocation towards stocks have risen to 70%.

With the exception of the extreme volatility of the US markets in early February this year, the US market in general has been trading in relative calm waters with the CBOE Volatility Index (VIX) at relative low levels, and similar to the levels we saw before the Global Financial Crisis of 2008, which we all know was led by the housing market bubble.

Six charts captured my attention the most in Jesse’s article. First was his chart related to the cyclical adjusted price-to-earnings ratio (CAPE) which basically showed the market is now more overvalued than it was in 1929, although still lower than levels seen during the dot-com bubble. The second chart related to the current market capitalisation to GDP of the US stock market, which at 1.4x is at its highest point ever.

The third chart was in relation to the current S&P500 dividend yield which is now at below 2% while the scariest chart of them all is none other than the chart that showed how FAANG stocks (Facebook, Apple, Amazon, Netflix and Google combined) have reached unprecedented levels, with Apple rising by over 1,000%, Amazon up more than 2,000%, and Netflix rising by more than 6,000% since March 2009.

The gains seen among the FAANG stocks this year shows that the S&P 500 does not have a healthy breadth as gains of the index is primarily contributed by just about 10 stocks, including the FAANG stocks.

The fifth chart that showed markets are in bubbles were none other than the impact of interest rate increases that had typically led to a recession in the US while the final chart is the risk that an inversion is likely to take place as the short term yield is rising faster than the longer term yield. This was depicted by Jesse in a chart that showed the 10-year and two-year US Treasury spread is now in “recession warning zone”, i.e. between 0% and 1% and will be in “recession zone” if it falls below zero.

While Jesse was not able to pinpoint exact time and manner how the bubble will burst, which nobody could really tell in any case, we all can agree that the signs are indeed there and when the Fed continues its monetary tightening stance for the rest of this year by another 50 bps and perhaps by another 75 bps in 2019, markets at one time or another will react or will finally realise that valuations no longer justify due to rise in interest rates as well as bond yields.

With the Fed also reducing the size of its balance sheet, taking away liquidity along with it, markets may be in for a tough time ahead.

What Facebook showed us last week following its disappointing second quarter report card with misses at both the top line as well as active global daily users is just perhaps an excuse for investors to take profit. Having lost almost 24% in market value since its peak, Facebook is now giving investors a negative return year-to-date as it is now down 3% in price.

Will other tech stocks follow suit or will the markets still hold to the year-to-date gains despite the lofty valuations that we have seen?

Perhaps the old idiom that when Wall Street sneezes and everyone catches a cold cannot be ruled out as history has proven that other the Asian Financial Crisis of the late 1990s, most market crisis were led by Wall Street.

In the meantime, I definitely will check out Jesse’s next article on markets on my twitter feed to see whether they are more telltale signs that markets are indeed overbought or overstretched.

Pankaj C. Kumar was formerly a director of investment & corporate strategy, chief investment officer and head of research.

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