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Time To Be Cautious On The Markets.

  • Market is starting to look expensive from a chart and P/E perspective.
  • Market Making restrictions on the market might give stamina to the price action as liquidity has been reduced in bonds and stocks.
  • The fall in stocks is just a matter of time, perhaps the FED will give it a reason.

Mr Market is not cheap..

We have been experiencing a parabolic bull market since the 2009 lows in the former years, with gains of 164 % in the S&P500 and a 162% in the Dow Jones Industrial Average. One would assume this is perfectly normal given the fact that the market overreacted during the financial crisis.

Long term charts in almost every major index tells us this party can be over soon. No matter if you look at the FTSE, N225, HSI etc. The question to be asked is not IF a market correction is to be expected, but when will it start to happen.

To keep this text short, I decided just to include the S&P500 and DJIA Historical Logarithmic Charts to support my point, you can check all the other indexes that I have mentioned if you wish.

S&P500

DJIA

Scary Right? Now lets assume that we are completely bullish and that this price growth is based on the premise that companies are doing very well, and profits have been the main driver of stocks.

To prove or disprove the former assumption; we must look to the Shiller P/E Index in order to see where are we standing relative to what should be the basic principle of a stock price; Profits.

Shiller`s P/E Index is at 27.1, the same level we saw in 2007, and in 1929. The only time that we surpassed those levels was during the dot-com bubble. If we consider a regular P/E of 21; we could see valuations going south around 20% without changing the fundamentals of the market.

Therefore, either we see a 20% increase in worldwide profits during the next 2 or 3 years, or we should expect valuations to adjust through stock prices. IMHO, this is the most feasible scenario, given the fact that most developed economies have injected billions of dollars, and part of it has flooded to the stocks and bonds. One day, all that money will be taken away from the financial system when QE programs end.

With the Great Recession of 2009 came not only QE, but a regulatory change in banks and financial institutions, all of them aimed to address the "to big to fail program". That sounds great, but with all the restrictions to market making, we have passed that risk to the market itself. This has been talked about by The Economistand the WSJ regarding the limited liquidity that bond markets are going through.

If all people rush into or out of a particular market and asset and you have no market-makers in the hood.. What happens? Well, you get very aggressive ups and downs in prices as all investor flee in or out a particular market.

I am starting to read many people telling that since China`s growth is stalling (at 6.5%), we can expect further liquidity measures from the Chinese central bank. That would maintain a good level of liquidity in the markets and will sustain current asset valuations for a while, delaying the market to adjust..

The problem with this theory is that it does not takes in account that we are starting to see the end of near-zero rates. As soon a the Fed increases rates, we will see a slow but steady "fly to quality". Resulting in less cash available for bonds, stocks, derivatives, etc.

Conclusion

I am not trying to be pessimistic, I am just saying that an asset revaluation is due, and lets just see what detonates it, the FED raising its interest rates, or the end of China┬┤s economic measures (if it does happen)

IMHO, FED rates will detonate the return of assets to "normal measures of value" and we could easily see a 20% drop from current levels... If I were an option trader, I think that long term puts on the market would be a very wise investment strategy.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Any trades are your sole decision, this is not an investment advise.