Some thoughts on stock and bond markets

The biggest story this week has undoubtedly been the big falls in the stock markets. The Dow Jones Industrial Average index fell by more than 1,000 points for the second time this week on Thursday. Similar sharp declines have been evident in other major global indices. Friday was no different as the major European indices sold off across the board this morning, before bouncing back a head of the US open. It all started last week as good economic news was treated with negative reaction in the stock markets. Investors are worried about several factors that could weigh on stock prices going forward, not least the extremely overstretched valuations. But from a macro perspective, the big worry is the withdrawal of monetary support from major central banks, which is what helped to fuel the rally – or dare I say, the bubble – in the first place. As global monetary policies are tightened, and QE reduced or withdrawn completely, bond prices may fall further as speculators front-run central banks. As a result, yields look set to rise further, which in turn may reduce the appeal of other higher-yielding assets on a relative basis, such as equities. This trend could continue for a while yet if investors’ worry that inflation might rise quicker than expected is realised, as this will actually lead to faster interest rate rises. Indeed, the Bank of England has become the latest central bank to warn about the prospects of faster rate increases, when the central bank delivered its inflation report on Thursday. Prior to this, the European Central Bank had hinted that the era of extra-ordinary loose monetary policy is basically over. The Bank of Japan recently reduced the pace of its purchases slightly. The Bank of Canada has raised interest rates a few times now. But it is the US Federal Reserve which is leading the pack as it is already reducing its balance sheet after ending QE and then raising interest rates on over the past couple of years. So, you get the picture: monetary conditions are tightening.

How long can the sell-off last?

That is the million – if not billion – dollar question. No one can say for sure, but things don’t look pretty out there given that the sharp falls haven’t been bought this time around. So, things could get ugly really quick. But ahead of the weekend, will the shorts take some profit and cause the indices to push slightly higher? Or will more longs rush for the exits, fearing the markets could gap lower next week? From a purely psychological point of view, the emotion of fear is always greater than that of greed. So, on that basis, we think more losses could be on the way ahead of the weekend. But what about the long-term? What IF this turns out to be THE top? Previous sell-offs haven’t felt this bad, and markets were able to regain their poise really quickly. Not this time. Even if it is not THE top, the markets will need a lot of time to base before pushing higher. So, this could last several weeks, if not longer. Indeed, there are a lot of similarities between this down move and the falls in other markets in recent past. For example, when gold and silver were rising rapidly back in 2011, no one believed the top was in after the initial big sell-off. Both metals rallied hard a few weeks later, which gave the bulls’ some (what turned out to be) false hope, before selling off again. That weakness lasted for several years. I see a lot of similarities in bitcoin and now maybe the stock markets, too. A lot of people will not want to believe or even entertain the idea that the markets may have peaked, merely because of the past sharp gains. One has to remember that a lot shrewd fundamental analysts were surprised with the Dow at 15K and then at 20K, let alone 25K. They thought that valuations had already stretched to the limit and that a sizeable correction was imminent. Yet the markets kept on pushing higher and went almost parabolic. So, if Dow at 20k was expensive, and very expensive at 25k, why can’t it fall back down to 20k? How about 18k? Anything is possible. Indeed, it can even rally to 30K for all I know. The point I am making is anything is possible and we should fixate our minds based on what has just happened. But overall, I feel that this weakness could last for a while yet. Granted, we may get short squeeze bounces every now and again, but ultimately the tide may have turned. Be careful out there.