We have previously shown the chart below on countless occasions, so we are content to see that increasingly more banks are showcasing it as the biggest potential threat to the future of the market’s artificial levitation. Here is BofA’s Martin Mauro explaining why “investors may be well served by locking in some profits in US stocks.”
Central banks turning off the liquidity spigot: Among the most striking market developments in recent years has been the coordinated efforts by the world’s central banks to supply liquidity by purchasing financial assets. Investment Strategist Michael Hartnett points out that since the collapse of Lehman Brothers in 2008, central banks have bought $10.8 trillion in assets, and that liquidity has propelled financial markets all over the world.
That phase, as Citi’s Matt King warned two months ago, is ending.
Now it appears that we are on the cusp of global synchronized monetary tightening, according to Hartnett. Central banks in the US, Canada and China have raised rates this year, while the Bank of England has stopped asset purchases and the European Central Bank is on track to end its asset purchases in 2018. Moreover, the reduced pace of re-investment that the Fed has outlined would reduce the size of its balance sheet by $2 trillion by the end of 2022.
BofA’s conclusion: “The unwind of the balance sheet could impose a strain on financial assets” and as a result BofA now believes “that investors may be well served by locking in some profits in US stocks.”
And while the unwind of the global central bank balance sheet will certainly have a dire effect on global risk assets, no matter what Bullard, Kocherlakota or the rest of the peanut gallery says (or rather, precisely because they deny it) a better question – one which Matt King asked two months ago – is whether this broken market can no longer execute its primary function: discounting the future:
… central banks still cling to the textbook model in which the market discounts all available information ahead of time, meaning that by the time they actually come to do their reduction, provided they’ve telegraphed it beforehand, the effect is already priced in. Unfortunately they seem to have neglected the textbook footnote that states that markets function this way only when they are deep and liquid. That might have been a reasonable description of pre-crisis markets; it seems a deeply unreasonable assumption for post-crisis markets in which leverage is constrained and one set of buyers have come along and absorbed virtually all of the world’s net new issuance.
The above is a major issue for Janet Yellen because while the Fed may hope the market is only “modestly” broken, and can fix itself when the liquidity support is yanked, if the market is too broken to realize that it is broken, and just keeps grinding – or surging – higher and higher, the Fed will soon have a major problem on its hands as it will have no choice but to actively intervene in equity markets on the short side, a skill which none of the Fed’s traders have after nearly a decade of only buying.
But before that, it will be the bears that will be carted out first, because even though we are late, late, late into the cycle, the following table shows the S&P returns in the year just prior to every previous market peak:
Although we are getting more cautious on equity markets, we note that some of the best returns come at the end of a bull market, which makes the case for maintaining some presence in the market. According to Subramanian, in the 12-month period preceding prior market peaks, the historical total return has average 25%. The S&P 500 is up 16% over the last 12 months, suggesting that some of those gains may have already been realized.
Good luck timing the crash.