Great Unwinding creates Great Divergence in financial markets
on December 2, 2015

Index Dec15

Most traders prefer to be with the crowd – then, at least, they can’t be personally blamed if things go wrong.  Instead, they can claim that “nobody could have seen the change coming”.  So as we approach year-end, many traders are becoming very nervous as the Great Unwinding of policymaker stimulus means that markets start to go their own way:

  • As I discussed on Monday, US 10-year interest rates have seen a major increase, even though the US Federal Reserve has kept short-term rates at zero
  • Even worse, German interest rates have continued to fall as the European Central Bank keeps buying: the 10-year yield is just 0.48% and the 5-year yield actually negative

The same worrying pattern can be seen within the US S&P 500 itself – the world’s major stock market index:

  • It is only up around 1% on the year, but the FANG tech stocks are living in their own bubble
  • Facebook, Amazon, Netflix and Google are up around 60% as a group

This divergence is very typical at the end of a major market move.  Momentum wanes, and trading becomes concentrated in just a few areas.  Traders rush to be part of the remaining action, creating a bandwagon effect on prices. In the end, of course, the bubble can often then burst with a bang.  Shanghai provided a spectacular example in the summer, when it fell 45% between mid-June and late August.

What happens if a Shanghai collapse happens in the West next year?  As we all know, the Chinese government rushed to protect their market, just as Western governments rushed to protect markets in 2008.  Would they, could they, do this again?  This is the question explored in an excellent Financial Times analysis by John Dizard last week:

We now have a bit over 14 months until a new US president and Congress are sworn in. Until then, the national policymaking process will not be functioning. If a decision on financial laws or regulations has not been made yet, it will be on hold until early 2017….That means that you will have to come up with your own contingency plans for rescue from systemic risk…This is why those better-informed or better-connected large institutions are setting up credit lines and access to collateral in advance. Unless you move relatively soon, rather than wait for actual trouble to develop, that is credit and collateral that you will not get.

“I am quite confident the banks will stay open. What about your portfolios? Will they be open?”

The uncertainty means that even major companies are showing signs of strain.  US banks have had to postpone the planned $5.5bn sale of debt to back Carlyle’s leveraged buyout of Veritas from Symantec. And giant telecoms company Vodafone was forced to withdraw a planned 30-year bond issue.  Nobody is suggesting Vodafone is going bust – but their problem in raising cash from the market is a warning sign of potential problems ahead.

It is not difficult to make the case that a false market has been created in the S&P 500: 

  • 70% of all US trading is now being done by the high frequency traders, and these modern-day highwaymen have no interest in providing liquidity if markets do start to close down
  • Equally worrying is that earnings have been been supported by record levels of share buybacks, usually aimed at boosting the value of CEO’s share options
  • The Wall Street Journal says buybacks are “up more than 80% from a decade ago“, whilst Marketwatch has reported:

“The sums involved are staggering. In 2014, S&P 500 companies bought back $553bn in shares, in addition to paying shareholders $350bn in dividends. Total returns to shareholders equalled $904bn, a bit shy of reported earnings of $909bn.”

The chart of the Boom/Gloom Index above confirms that market confidence has dropped sharply since the beginning of the year – it is currently almost half its January peak.  And there are clearly headwinds for earnings and buybacks:

  • Earnings are already being hit by the strength of the US$
  • Buybacks have often been financed by borrowing, which is more expensive at today’s interest rates

What we know is that the first 3 phases of the Great Unwinding are now underway:  the fall in the oil price, the rise of the US$, and the rise in US 10-year interest rates.  Only the 4th is still to come – the bursting of the S&P 500 stock market bubble.  And as I will discuss on Friday, political risk is rising at the same time.  It could be a difficult 2016.

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