Top Reasons Why We Believe a Near-Term Correction is Inevitable – Introduction
After the 2008/09 financial crisis, the global financial markets have surged. As we speak, all the major indices in the United States are near an all-time high. The same is true in several European countries where the DAX touched an all-time high last week. In the United Kingdom, despite the current Brexit issue, the FTSE 100 is also at an all-time high. The same is trend can be seen in other countries as well. Amidst all this, I believe that the market is headed for a near-term correction. In this article, I will highlight key reasons why I believe this.
The chart below shows the performance of the S&P 500, Dow, and the DAX after the financial crisis.
To have a better understanding of this, you need to understand the reasons why the markets have trended upwards after the crisis. After the recession, central bankers in the developed markets wanted to stabilize the markets. To do this, they brought their benchmark interest rates down. The United States Fed brought it to 0%. In addition to this, they started large-scale asset purchases. This program was known as Quantitative Easing (QE).
In QE, these banks print money and buy assets which are mostly treasury bonds. As they carry on their asset purchases, their prices rises. As we speak, the central bankers balance sheets are at their highest level ever. They own stocks and bonds worth more than $20 trillion.
Last week, the federal reserve chairman, Janet Yellen stated that the Fed was close to starting a program of reducing its balance sheet. The same sentiments were echoed by Mario Draghi of European Central Bank. His statement led to an immediate fall on the pound.
The end of Quantitative Easing program will without a doubt lead to a short-term financial markets correction. In fact, some people believe that the end of the program will lead to a recession while others argue that it could lead to a depression.
During the presidential debates, Donald Trump stated that the continued state of low interest rates was creating a bubble which would pop after the rates started to go up.
The fundamental question that all investors should ask is this. If the quantitative easing was so good for the financial markets, why will tightening not do it harm? I mean, the famous law of physics states that for every action, there will be a reaction.
Some so-called experts have argued that the current bull market will continue because it has been fueled by corporate earnings. In normal market conditions, this could be true. However, they forget to mention that low interest rates have made money/credit readily available in the market. With the money, people have been able to buy cars, houses, and other discretionary items. What will happen as the fed starts to raise rates? I believe their spending will decrease which will affect the earnings.
Another reason I believe the rally might soon come to an end is the companies that are fueling the rally. Companies valuations are currently overstretched. We have a situation where many companies with no history of earnings are doing very well in the stock market. Consider a company like NVIDIA that creates graphic cards for gamers and bitcoin miners. The company has annual revenues of $5 billion in 2016 is currently worth more than $110 billion. Tesla, a company with annual revenues of about $7 billion is currently worth almost $60 billion. Tesla is currently worth more money than General Motors and Ford. This market cap is also close to that of Volkswagen, one of the best developers of cars in the world.
I believe that investors will soon come back to their senses. Remember, during the dot com bubble, investors believed that the dot com companies would become mega companies. Companies like Cisco had market capitalizations of more than $500 billion. Many companies collapsed.
All this should not worry traders. In fact, they should embrace the new normal. They should know that contrary to long-term investors, they are not much at risk. This is because they will make money whether the current market trajectory continues or whether a down-turn happens. The secret or the rule of the game should be to always remain hedged.