When Will The Markets Stall?

Overnight, Citibank said that they see the potential for a 25 percent fall in global equities. They based their view on the global unwinding of monetary stimulus, which has helped to fuel the current rally in global equities.

As you can see by the below chart, as the US monetary authorities accumulated financial assets (primarily treasury securities), it helped to push share markets higher. Similar asset buying programs were also enacted (and are continuing) in Europe and Japan.

Now the US Federal Reserve has started to unwind its balance sheet, and the concern of Citi strategist Matt King (and indeed, many others) is that this could lead to a huge correction on global stock markets, in a manner similar to the impressive rally that we have witnessed.

In addition, Japan has started to reduce its own bond purchases and the Europeans are expected to follow suit. Mr King believes that "these policies are additive", and that the results of an unwind "will be much greater than central banks imagine".

Such a sell-down of Central Bank assets could take years to wash through to equity markets, a may need some sort of a catalyst to trigger share price depreciation.

Indeed, the traditionally bearish Society General also believe a pullback is likely, although they come at it from a different perspective. Soc Gen has been looking at US equity volatility data, and according to analyst Praveen Singh, US equities are "now entering dangerous volatility regimes."

Soc Gen found that the current low level of volatility is incredibly rare, and that on the occasions that volatility has reached these levels, it has gone on to rise by 3 points over the following twelve months.

Apparently Soc Gen’s view is share by a host of hedge funds and investment managers, because according to Bloomberg “Brevan Howard Asset Management, 36 South Capital Advisors, One River Asset Management and at least three other firms are rolling out new funds designed to protect investors from rising market turbulence.” I.E they are rolling out long volatility funds.

This is also a view on share market falls, as volatility is usually inversely correlated with price movement; if volatility were to meaningfully increase, it would mean that share prices are broadly falling.

The view is also share by our most recent Nobel laureate in economics, Richard Thaler, who stated a few days ago that “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”

It is impossible to argue that US (and global) equity valuations are cheap by historical standards. In fact, by most measures, US stock valuations are heavily stretched; and will eventually pull back. Keep your eyes to the markets, because I feel it is not too far off.