• The US economy will pay for years of cheap money and a low exchange rate. This has created an unsustainable asset bubble.
• Economic activity will drop as European and Chinese economies stumble.
• Low volatility and technical indicators point to a market nearing the top.
There is no shortage of articles predicting a correction or even a crash in the near future. The author usually highlights a couple of persuasive arguments or specific signals that proves their case such as the threatening "death-cross" of the Russell 2000 showing the 50 day moving average falling below the 200 day MA as noted in Marketwatch.com today . Individually, I believe that the points forecasting a correction are worthy of note but they are not necessarily convincing. If we bring them all together, the argument is quite compelling. As a hedge fund manager, I usually focus on analysing forex and commodities however after a period of market analysis, I have become convinced that a correction is not more than 3 months away. I'm going to step outside my noted area of expertise and explain why traders should prepare for a correction that is more than 10% and at the very least a near-future pullback of 5%.
The Asset Bubble
The most obvious cause for a correction is that we are witnessing the end an era of access to very cheap money. It is widely believed that asset prices are elevated due to ultra loose monetary policy implemented by almost all the main global reserve banks, specifically the US Federal Reserve. The Fed is on course to bring its bond buying program to a close in October and is expected to begin raising rates next year with many analysts predicting that it will occur sooner rather than later if Yellen's employment dashboard gives her the green light. However it would seem the market is giving us indications that while employment is a serious factor in the Yellen's decision making process, pressure coming from other members of the fed might cause Yellen to view her dashboard with less immediate importance as the US economy fires all pistons and almost all other economic indicators are overwhelmingly positive. It is possible that cooling the US economy may be of higher priority than waiting for US unemployment to fall further (which is certainly improving anyway).
It's irrefutable that company valuations have soared and some of the largest corporate acquisitions ever have been made over the last few years; a financial period that is and will be characterised by cheap money producing inflated asset prices or an asset bubble (in my opinion the acquisitions of Whatsapp (NASDAQ:FB) and Minecraft (NASDAQ:MSFT) and the IPO of Alibaba (NYSE:BABA) are evidence of irrational exuberance). Since the dissipation of the credit freeze that characterized the GFC, companies have been allowed to borrow at a very low rate and have been exporting products at an historically favourable exchange rate since 2004. Risk-off precious metals and bond prices have plunged as risk-on equities increased in demand, supported by value seeking investors who have disregarded the natural economic cycle but have sought a place to park their funds in well-oiled market; stock price indices are at record high and have risen continuously without a serious pause since 2011.
Following the GFC, corporations have been the main beneficiary of QE while the private sector has yet to really feel the benefit of the Fed's moves and perhaps this is the reason why Yellen is so cautious to see employment rise before lifting rates. It is the private sector that is really the driver of demand in the economy and as it stands, there is noted slack and unused capacity. Current company valuations seem to be based on profit potential and low borrowing expenses rather than current income and this will surely translate to a massive problem when the age of low interest rates come to an end and all of a sudden acquisitions have become far more expensive. As a young stock analyst I was always taught to evaluate a company based on its fundamentals but it almost seems as if nobody really pays attention to that anymore. Ultimately, as Sam Zell says the stock market is at an all time high, but economic activity is not and noted that ""every company that's missed has missed on the revenue side, which is a reflection that there's a demand issue; and when you got a demand issue it's hard to imagine the stock market at an all-time high." It is understood that before 2008, the private sector was addicted to credit, it may be that in 2014 it becomes apparent that it was the corporate world that bit off more than it could chew.
I think it is quite telling that voting Fed member Stanley Fisher has been tasked with leading a committee to assess whether or not an asset bubble exist and yet he is considered a hawk. If there is an asset bubble you can be sure he would be making convincing arguments for raising interest rates following his successful leadership of the Israeli Reserve bank during a period of a good economic growth and relatively low employment participation rates. It' a different ballgame sure, but the similarities are there.
The US Dollar has been trading at historical lows for much of the last decade helping to keep the economy afloat during the tough times earlier this decade. China grew steadily during the worst of the GFC with annualised growth hitting double digits year on year but now we can be assured that those days are well over, and it has been predicted for years as such a rate of growth was not sustainable. There are serious concerns for the Chinese economy with its balance of trade rising to record levels and it's rising debt. Any stimulus the Chinese government injects into the economy is not guaranteed to perk up the economy. China is the US's four largest importer and any reduction in demand is a big deal.
It is worth noting that crude oil has fallen recently to its lowest level since April 2013, despite the well-known geopolitical risk. The market is flooded with oil and this is this a terrible indication of the global economic activity. The increase in US crude oil supply could not have come at a more inopportune time and supply far outweighs demand.
Imports to Europe are falling as the region's fortunes become apparent that is tied to the crises in Ukraine and its ability to fight deflation. The possibility that it might fall back into recession is real and that the Ukrainian crises will exacerbate - a likely scenario considering Putin's unpredictable and obdurate attitude. The Euro will likely fall to its lowest point since 2012 and that will make US exports expensive.
When market volatility is low this is often a sign of complacency but it is also a warning light that perhaps the market nearing the top and that it's hard to see how much more value can be added to stock prices (on the other hand it may also be a sign of overconfidence where downside risk is overlooked). Market consolidation usually follows with a sudden and rapid movements in either direction. With the stock market already considered expensive, it's hard to see how that rapid movement will be upward.
BIS says it best "Financial markets have been exuberant over the past year, [...] dancing mainly to the tune of central bank decisions. Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks."
Technical Indicators show overbought prices
Looking at the Nasdaq 100 chart (NASDAQ:QQQ), we come to the conclusion that certainly stocks rose quickly over the past 6 years and that we may be overdue for a correction. September is historically the worst month for stocks and the biggest market crashes occurred in October and therefore I would consider going short over the coming months to offer a good risk/return ratio. Certain technical indicators show that the market is overbought for an overbought market and that even a small correction is probable. It might be that the first drop will be to the middle of the linear regression. The next target would be the bottom of the linear regression channel. The final target (but not guaranteed) would be the upward trending long -term support line.
There are many big names traders including Soros are preparing for a market correction. The retail market on the other hand seems oblivious to what the experts are doing by jumping on hyped up IPOs and that's a mistake. Winter is coming and investors should take notice and be looking at the warning signs. Even if you're a doubter of the pending market correction, consider the fact that in the last 52 weeks alone, eight of the ten major S&P sectors have retreated more than four percent at least three times each. Nine sectors - all except technology - have had at least a 6.9% drop. Consequently it might therefore be a prudent decision to short indices highly consisting of technology stocks such as the Nasdaq 100.