The larger they are, the harder they fall
The chart below – of the FTSE – does not look healthy to me…
We are currently facing a lot of downside pressures, with the FTSE breaking below 7000 and pushing back up twice in the last few weeks.
This gradual probing is worrying and it’s not really being spoken about too much.
Let’s face it, we’re currently off the highs up at 7800 by 800 points. This has been a gradual grind down over the past few weeks.
Why? Well I have one main reason…
Time to unwind?
The Fed is unwinding their balance sheet.
We have to remember that a huge amount of the FTSE is denominated in USD, since many sales are done in the greenback.
This therefore, has a direct correlation with Fed tightening monetary conditions – one component of that is shedding the huge $4.2tn balance sheet that they have acquired over the last nine years through quantitative easing.
No more will firms be able to stay afloat by cheap credit.
No more will retail investors be able to hold as cheap margin positions on US equities, and more specifically, products such as $SPY, an ETF that tracks the SP500.
The former has a direct effect on the financial fundamentals of a firm…
If a firm’s price has been propped up for nine years through cheap credit, buybacks and corporate bond purchases by the central bank, and these are all of a sudden removed, investors will see this as a negative price effect.
This has a knock on effect on FTSE firms, not only purely from an investor standpoint, but the BoE tends to follow the Fed’s Mon Pol signalling.
The overarching mechanism here is something known as equity risk premium compression – there has barely been an attractive risk-free rate for such a long time, investors have been looking for yield as if they are jacked up on testosterone.
This chart shows it in clear view…
What is hugely dangerous about this current market cycle is that only 9% of the price increase of the SP500 on the past bull market is due to earnings growth.
The majority of this cycle has simply been caused by low rates.
And now that rates are increasing, I see the most violent move to the downside that we have ever seen occurring when the Fed, and consequently the BoE, begin to really shed the assets off their books.
In fact, I believe that the Fed are only increasing rates to accommodate when another crisis hits.
It is easier in terms of economic confidence, to lower from $4tn to $2tn than to increase balance sheet holdings to $5/6tn when the inevitable occurs.
I drew up the chart below a few months ago of the USD…
And this is the chart now…
The Fed has been hiking, which should mean a bullish dollar.
But the dollar has been falling.
For me, this signifies a lack of confidence in the US economy, where we are reversing the 2014 move i.e. the end of the balance sheet increases.
As the old adage goes, the larger they are, the harder they fall.
I’m not advising to do anything, but if I look at the probabilities and where the easiest money will be, I’d be looking to get short on the FTSE (or long GBP/USD as an easier trade, although with that method you’re more susceptible to price shocks).