This is not a repeat of 1987, but it’s still dangerous times for markets – Nigel Dunn

JOHANNESBURG — With the Dow’s biggest ever daily point plunge on Tuesday, many will be remembering just how risky the markets can be. It’s unclear which direction global markets will veer towards as a result, but, in this piece, Nigel Dunn outlines several key risks facing markets currently and the factors that traders and investors should have in mind as part of their strategies. – Gareth van Zyl

By Nigel Dunn*

Stock market expert Nigel Dunn

I have been warning for some time via Alternate Thoughts that these are very dangerous markets for several reasons; valuation being the most obvious; but there are a lot of others that concern one; namely:

Short volatility: short volatility was the most crowded trade in the world in January; most of those invested in the trade being unsophisticated retail investors lured in via Exchange Traded Funds, (ETF), and Exchange Traded Notes, (ETN) on the basis Central Banks had your back; things were going swimmingly well and would get markedly better on Trump’s tax cuts.

Some of that euphoria has been dampened somewhat; Figure 1 shows the VIX; some people are immeasurably poorer than they were a week ago.

I won’t go into derivative detail; but with moves like, this many banks VaR models, (Value at Risk), are going to have to be reset across all asset classes, the knock on effects of which will be seen in the coming days and weeks.

Figure 1 (Source: Market Master)

Leverage: the extent of leverage in the market is at unprecedented levels via products like CFD’s, (Contract for Difference), SSF, (Single Stock Futures), and others. These products gear an investor’s exposure to the market by factors of 6 – 10 times. A sharp fall in a share price and margin needs to be deposited the next day by the investor to maintain his/her position; failure to do so and the bank/broker will sell the share out
with scant regard to price.

I have included a graph of EOH for December: two investors/speculators could not meet margin calls; Figure 2 shows the result; a fall from 7000c to an intra-day low of close to 2400c. Broad based sell-offs like we are currently witnessing are going to affect a lot more than two investors; the rebounds might not be as quick and marked as they were in the case of EOH.

Figure 2 (Source: Market Master)

Exchange Traded Funds (ETF): The large number of ETF’s; have introduced a level of risk many choose to ignore; because they are not mandated to hold cash; any redemptions force the issuer to sell the underlying in the market. Given the extent of losses in the two most popular trades of the retail investment community; being short volatility and Bitcoin; many will be forced to sell other investments to make good

ETF’s have become the investment vehicle of many as they are cheap; expect some ETF liquidation and the knock on effect it will have.

Liquidity: Contrary to popular belief; I believe the proliferation of high frequency trading has drained genuine liquidity from the market; the net effect will be the losses on bad days are magnified as those needing to exit will find fewer bids a lot lower than hoped for.

US economic data: much has been made of recent US GDP data; a gain of 2.6%; unfortunately less has been made of its make up; strip out the effects of repairing the damages inflicted by Katrina and other hurricanes, and people pushing personal savings close to record lows; and 2.6% morphs into less than 1%!

Some bulls are pointing to the recently released US Atlanta Fed now forecast of 5.6% growth this quarter; assuming it is correct; a big assumption given a broad range of economists are expecting 2.5% to 3%; it implies the Federal Reserve are years behind the curve re normalising rates; 5.6% and long rates should be well above 4%, rather than below3%.

In an economy that is not indebted; +4% would not be an issue; in an economy with record levels of debt at all levels; a 100bps point jump in rates will carry negative implications for all; Government; corporates and individuals alike. This is 1987 again: I would caution those believing this narrative; there are some stark differences; debt was markedly lower; rates were falling; growth was better and valuations were not stretched. The Cold war era was drawing to a close; at present geo-political tensions are rising on all fronts.

Is there some hope? From a purely technical perspective one might say yes; there is an open chart gap in the Dow Jones just below 26500, Figure 3; chartists will know that gaps have a habit of being filled. Looking at the last financial crisis in 2007/08 one will find that when the market initially fell, there were no gaps at all; one did
appear once the sell-off was well under way; however it was closed, before the market resumed its down trend.

Figure 3 (Source: Market Master)

In summary: this may be a warning shot across the bow; short volatility; Bitcoin and record retail inflows into ETF’s in January are all the signs of a top, at best an impending top, as the inflows were from unsophisticated retail investors who have a long history of getting in at the top and out at the bottom.

Rather than listening to, and watching what the likes of Buffett do, most prefer to follow the mainstream financial media and other equally less qualified investors.

Looking at Buffett’s words and actions:

  • Berkshire has record levels of cash on their balance sheet; over $100bn.
  • Buffett when interviewed late last year said; “markets are fairly valued given the prevailing level of interest rates.” He did not say they were cheap as many of the financial media reported. Rates have risen significantly since he gave the interview; reread what he said and equities have gone from fair value to embracing expensive; that is the only conclusion you can logically draw.

The inescapable fact is the world is more indebted than it has ever been; rates are at record lows; Central banks are devoid of tools with which to fight another crisis; leverage is extremely high, valuations are amongst the most expensive in history; trade barriers/protectionism are coming back and the geo-political situation is
worsening not improving. This is not the most opportune time to be embracing risk; on the contrary it is worth looking at one’s portfolio; especially for companies carrying high levels of debt; that is what is driving this sell-off; rising rates.

  • After graduating with a B Com Honours, Nigel Dunn moved into stockbroking close on three decades ago. He has been a registered member of the South African Institute of Stockbrokers since 1994. He started his career in 1987 advising individuals, moved to research, company specific and of a strategic nature, before settling in fund management, both for private clients and pension funds. He was a partner of Anderson Wilson, subsequently acquired by Standard Bank, where he became a director of Standard Equities. Thereafter he moved to Investec Securities where he managed funds for private clients, family trusts and helped on the corporate broking desk. Most recently he has been managing discretionary funds for clients, proprietary trading in addition to generating his own corporate research. Of late he has started to write articles of a market related nature intended to stimulate thought and debate.
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