zaterdag 24 juni 2017

Citi; "Is The Equity Market Irrational Yet?"

One of the bigger mysteries plaguing sellside analysts in recent weeks has been the seemingly inexplicable divergence between the euphoric market which keeps making new all time highs, and the expectations that global central banks will soon start reducing their balance sheets. it is this divergence that prompted Citi's popular strategist Matt King to predict that he "expects markets to flounder as central banks try to exit"...


Prompted JPM's famous "quant wizard", Marko Kolanovic to warn that central bank balance sheet unwind will be the catalyst the leads to "market turmoil", to wit: Risky assets have been rallying for years, and market volatility is near record lows. Valuations are high, arguably supported by low interest rates and record pace of central bank monetary expansion. However, this may change in the near future. In the US rates are rising and monetary accommodation from the ECB and BOJ is expected to recede. Medium term, this is likely to lead to market turmoil, and a rise in volatility and tail risks...


Yet with the upcoming central bank "turn" so obvious, not only have risk assets failed to price it in, but stocks stubbornly refuse to drop even fractionally, as nobody wants to be the first to sell. Discussing this phenomenon, King recently mused that central banks have broken the market to such a degree it no longer can discount the very event that could be its doom: our models suggest markets are unlikely to react until the reductions in purchases are actually implemented. This is in stark contrast to the widespread presumption of immediate and full discounting. Asset prices have rarely been able to pre-empt future changes in the pace of purchases, even when these have been announced in advance, over the last seven years. We think this is unsurprising when one set of buyers is so completely distorting the market. This in turn has prompted a bigger debate: has the equity market become irrational? To Matt King the answer, at least in part, is yes. Meanwhile, in a separate discussion on Citi's equity side, strategist Jeremy Hale asked the very same question in the context of whether traders are now confined to an "irrational, end-cycle" market.
As Hale writes, "we watch corporate leverage trends closely to asses where we are in the credit cycle, which is often a good indicator for the economic cycle. We have recently been highlighting the slowdown in commercial bank credit/loan creation and also the Fed Flow of Funds report which suggested corporates’ borrowing via credit market instruments had slowed significantly. As a reminder, when both these series turn decisively, grey shading can often be seen in the charts, recessions follow...


This, of course, is something this website has also been closely following, and as we warned two weeks ago, at the current rate of loan contraction, the US economy may have just a few weeks left before it slides into outright recession. Hale continues: We would need a sustained uptick in borrowing in order to be convinced that the credit cycle hasn’t turned just yet and that time is ticking in our approach to endcycle. Sure, Trump could still come with the much needed adrenaline shot, the Citi base case is for fiscal stimulus to still emerge eventually, which might well buy us another year or two. But, if not, the case for overweight cash/ FI and underweight equities would rise. Which bring us to the key question: "Is The Equity Market Irrational Yet?"
# Here is the answer from Citi, or rather equity-City; we already know the answer from debt-Citi (and the subsequent warning). Another way of looking at this debate is via the question of whether the equity market is behaving irrationally, as it sometimes does towards the very end of the cycle. In trying to answer this, we looked at many intra-equity market correlation, dispersion and breadth measures for both price and earnings series. The bottom line is that we didn’t really find a holy grail to be used as the end-cycle indicator to follow. Conditions are just too different across history, and passive investment trends are influencing some of these calculations this time round. As one would expect, there never is an explicit answer to whether the market is "acting irrationally", especially since one man's irrational is another man's "perfectly rational" source of wealth effect. Still, Citi did share one particular chart of interest, which we present below: it shows the pair-wise correlation measure of the price action among S&P 500 sectors.
Here Citi finds that as the cycle matures, pair-wise correlations drop. When the cycle turns and stock markets drop, correlation picks up rapidly as investors “sell what they own”. In 2000/2001 and 2006/2007, this correlation indicator fell to around 20% before markets peaked out. As Hale concludes "we are currently at 30%. Perhaps not quite in the “danger zone” but definitely worth keeping an eye on"....