Are We Due for a Crash?

Regular readers know that I have been skeptical of this equity market rally (see examples here and here). My opinion is confirmed by many commentators that I respect.

Jeremy Grantham of GMO wrote in his 2Q letter that their estimate of fair value on the S&P 500 is slightly south of 880 and the index could move to between 1000 and 1100. In addition, reports of high levels of insider selling is not comforting for the bulls.

On September 9, long time chartist Richard Russell indicated that he saw a rare “double non-confirmation” [emphasis mine]:

We may have seen a rare "double non-confirmation." On August 27 the Dow closed at 9580.63, a new Dow high for the rally. On the same day the Transports closed at 3714.63, which was not a new high -- in so doing, the Transports failed to confirm the Dow. Today the Transports closed at 3806.75, a new high for the ]Transports. But today the Dow closed at 9547.22, below their August 27 close -- in doing so, the Industrials failed to confirm the Transports. This is what I call a rare "double non-confirmation". First, the Transports were weak in that they could not confirm the Industrials. Today the Industrials were weak in that they could not confirm the Transports. These rare "double non-confirmations," in the past, have tended to signal the top.

Bespoke also pointed out that the S&P 500 is now 20% above its 200-day moving average, the first time this has happened since 1983. This suggests that the market is very overbought and due for a pullback.

Art Cashin recently piped in and said this market reminded him of 1987:

There’s just some eerie things about this—it’s reminiscent of spring and summer of ‘87 when nobody believed the rally and it kept going up despite skepticism, people shorting into it. It ate them alive until it suddenly turned.

Could the market crash?
Are we in for a repeat of the Crash of 1987?

Possibly. I have heard anecdotally that hedge fund leverage is now back to pre-Lehman levels, indicating a high level of systemic risk. William Pasek at Bloomberg wrote the that the US Dollar is now the preferred source of funding for the carry trade, which puts risk levels in context [emphasis mine]:

Now imagine what might happen if the world’s reserve currency became its most shorted. Carry trades are, after all, bets that the funding currency will weaken further or stay down for an extended period of time. It’s also a wager that a central bank is trapped into keeping borrowing costs low indefinitely…

Three-month London interbank offered rates, or Libor, for dollar loans are at a record low and fell below those for the yen on Aug. 24 for the first time in 16 years.

Think about the turbulence that would be unleashed by the dollar suddenly shooting 5 percent or 10 percent higher with untold numbers of traders around the globe on the losing side of that trade. It could make the “Lehman shock” look manageable.

Watching the bearish tripwires
Remember that in 1987, the stock market didn’t just spontaneously decide to crash in a single day. Before the October crash, the market had topped in August and was steadily declining before it took the ultimate plunge.

Today we have the combination of over-valuation and high risk behavior, but these things have a way of not mattering to the market until they matter. I respect Barry Ritholz’s comment that the current rally could very well be in the 6th or 7th inning.

The key to timing any potential downdraft is to watch the bearish tripwires.

Sentiment tripwires
Here is what I am watching for.

One is investor sentiment. James Grant, who could usually be counted on to be not just bearish, but apocalyptic, has become a bull. Despite this sign of bearish capitulation, the chart below of public sentiment, as measured by the AAII survey, is not excessively bullish. [click to enlarge images]

Watching the risk trade
As I pointed out in my previous post Risk on, the risk appetites are still rising. For the bear to truly come out of hibernation, investors have to show signs that their taste for risk is becoming sated. The chart below of the euro/yen cross, a measure of the risk trade, is still trending upwards.

Euro/Japanese Yen

If the USD is now the preferred currency of choice for the carry trade, then let’s look at some emerging market currencies against the greenback. The chart below of the Hungarian Forint against the Dollar remains in a healthy uptrend.

Hungarian Forint/U.S. Dollar

The Turkish Lira is also in an uptrend against the Dollar.

Turkish Lira/U.S. Dollar

Commodity prices, which is an indication of the progress of the reflation trade and risk trade, are also in an uptrend.

Until these bearish tripwires are crossed, the path of least resistance for equities is still up. My inner trader tells me it’s too early to get outright bearish. The 50% Fibonacci retracement level for the S&P 500 is roughly 1120 - and under the circumstances that may be a realistic short-term target.

On the other hand, the trigger for the 1987 decline was the Fed's August decision to raise interest rates. While I have expressed my doubts about the willingness or the ability of the Federal Reserve to effectively implement its exit stratgies, the FOMC statement on Wednesday bears watching.

Comments

[Andrew Butter:]

Interesting quote you had there:

Now imagine what might happen if the world’s reserve currency became its most shorted.

There is a theory that the reason for hyperinflation in Germany in 1920 to 1923 was foreigners shorting the currency.

Sep 21 05:11 AM

[Fabien Hug:]

Agree with you. All up then all down is too easy. It's going to be trickier than that.

Sep 21 08:44 AM

[Albertarocks:]

I was surprised and puzzled by Jim Grant's view. To be quite honest, I can't understand it. Normally he makes a lot of sense and has his cute way of making his opinions in a somewhat humorous manner. I have to say it... I think Jim Grant is wrong this time, and I'm right. lol

It looks to me like we're going to see one more thrust into the end of Sept., and that should be it. The U.S. federal gov't's fiscal year end is at the end of Sept. I believe, and I can see them keeping the ship afloat until then. But I see a lot of arrows pointing to a top in the next 10 days or so. It's gettin' real spooky out there.

Sep 21 06:14 PM

[Mad Hedge F...:]

nbc The autumnal equinox is tomorrow. That is the day when the sun crosses the equator headed South, and daylight equals darkness. I know this because I am so old that celestial navigation with a sextant was a requirement to get a commercial pilot’s license. That means that I can shoot an angle off of the North Star and tell you your latitude, the same method used by Christopher Columbus to first cross the Atlantic. Now that’s old! Moving on to navigation of the financial sort, many long in the tooth, grizzled old veterans insist the movement of the sun, moon, and stars, as well as sun spots, have a major impact on the markets. History is certainly replete with financial disasters this time of year, most recently in 2008 when Lehman went under, almost dragging the entire banking system with it. These were easily explainable a century ago when 50% of our GDP came from agriculture, and the harvesting of the fall crop placed huge trains on a then nascent financial system. But today, less than 2% of the economy comes from Green Acres. So maybe history is not repeating itself, but rhyming, or reverberating. Certainly everything good, from currencies and commodities, to energy, emerging markets, and private and public debt, need a rest and are overdue for a pull back. The short term risk/reward for everything is not good here. Watch the run up to end Q3, when the fireworks may begin.

Sep 21 11:48 PM