“Just when you think that you are safe, you are most vulnerable.”
-- The Seven Samurai
As we approach the end of the year it appears that equity markets are still content to pursue their upward path, with U.S. equities setting all-time records along the way. At the same time the CBOE Volatility Index (VIX)--which market participants look to as a gauge to measure fear in the market--remains low. In addition, since as far back as 2009 investors seem to have been rewarded for “buying the dips” and adding to their equity holdings during equity market downturns.
Even at these high levels of traditional valuation, the case for further appreciation in the equity markets could be supported by a continuation of the following conditions: continuing synchronized global economic growth, positively-sloped yield curves, benign global inflation, narrow credit spreads and a low real (inflation-adjusted) cost of capital which contributes to higher valuations of future earnings streams.
At 3EDGE we remain at or near our maximum equity ranges across our strategies. However, this is certainly no time for complacency. We remain vigilant and on the lookout for any potential canaries in the coal mine that may provide evidence of an impending market correction and perhaps even the onset of a Minsky Moment. A Minsky Moment is a crisis named for famous economist Hyman Minsky, who argued that oftentimes a lengthy period of market stability tends to breed complacency resulting in a build-up of excesses and imbalances, sowing the seeds of the next period of instability.
We have been talking for a while now about such a scenario in terms of the potential for an equity market melt-up which could occur when the remaining market skeptics capitulate and the fear of missing out on additional appreciation in the equity markets becomes overwhelming. The remainder of cash on the sidelines then pours into the equity markets causing an almost parabolic rise in equity prices. This situation often presages the onset of one final push upward and then a sudden reversal, followed by a major, oftentimes painful, market correction.
Another potential headwind on the horizon for the markets could arise from a shift in central bank policies. President Trump has nominated Jerome Powell to succeed current Fed Chair Yellen when her term expires in February and current market consensus is that Powell’s approach could be similar to Yellen’s – more dovish than hawkish. However, after almost a decade of unprecedented monetary stimulus on behalf of all the world’s major central banks, we seem to be entering the beginning phase of monetary policy normalization, the unwinding of quantitative easing and increasing short-term interest rates. The U.S. Fed was the first major central bank to move towards normalization of monetary policy and while it is unclear when the other major central banks may follow suit at some point other of the world’s major central banks will move towards normalization and begin to unwind their own versions of quantitative easing. As more attention is paid to liquidity being extracted from the markets there is a risk that at some point market participants conclude that more widespread central bank tightening is going to become a reality and will prove to be counter to higher equity prices going forward. Given the strong sustained market momentum currently helping to drive equity markets to new highs, a correction triggered by a perceived shift in central bank policy could be further exaggerated to the downside as the momentum that is helping to drive the equity markets higher could then begin to work in reverse.
So, with equity markets in the U.S. hovering around all-time highs and volatility remaining low it is important to remember the words of the Samurai from the movie The Seven Samurai -- just when you think that you are safe, you are most vulnerable.
DeFred G Folts III
Chief Investment Strategist
3EDGE Asset Management
*The quote at the beginning of this commentary comes from one of my favorite movies, The Seven Samurai which as directed by Akira Kurosowa who is widely regarded as one of the most important and influential filmmakers in the history of cinema. Released in 1954 the film is over three hours long and filmed entirely in black and white - what’s not to love? The story takes place in 1586 and follows the story of a village of farmers that hire seven Ronin – master-less samurai to combat bandits who regularly return to their village after the harvest to steal their crops. Since its release, Seven Samurai has consistently ranked among one of the greatest films in the history of cinema. The film is also the model for the movie The Magnificent Seven a 1960 American Western.
DISCLAIMER: The opinions expressed above are those of DeFred Folts of 3EDGE Asset Management and are subject to change without notice. These opinions are not intended to provide personal investment advice and do not consider the unique investment objectives and financial situation of the reader. Investors should only seek investment advice from their individual financial adviser. These observations include information from sources 3EDGE believes to be reliable, but the accuracy of such information cannot be guaranteed. Investments in securities, including common stocks, bonds, commodities and ETFs, involve the risk of loss that investors should be prepared to bear. Past performance may not be indicative of future results
© 3EDGE Asset Management
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