The stock market is enjoying its best start to a year since 1987. But according to several strategists, the rally is carrying symptoms of a sharp reversal — one they expect to soon follow.
Thanks to the Federal Reserve’s change of tune, investors turned around the correction that ensued late last year, confident that the central bank would not allow high interest rates choke the economy.
Despite this powerful catalyst, strategists including Societe Generale’s Albert Edwards have identified worrying traits of the rally that portend danger ahead.
In a recent note to clients, Edwards stacked himself against other experts who are betting that the rally is a precursor of a continued melt-up that could accelerate if the ongoing earnings season outperforms expectations.
For those who would rather dismiss Edwards’ ideas as the ramblings of another perma-bear, he reminded readers of a few prescient calls he made over a decade ago. He said central banks would be forced to lower interest rates to zero in dealing with the next recession, and that they would have to buy bonds to keep borrowing costs low.
Edwards is once again throwing his forecasts out there, drawing on research from other colleagues on Wall Street. Below are four things he would have investors keep in mind:
1. The ‘dumb money’ is too bullish.
This refers to the retail investors — usually placed in contrast with the ‘smart’ institutions on Wall Street — who wait until a rebound is well underway before mustering the courage to buy stocks.
In other words, the dumb money gets exuberant and buys at the top for fear of missing out.
If the so-called Dumb Money Confidence Index is any indication, the stock market could be at another inflection point, according to Edwards. The index, compiled by Sundial Capital Research, is at its highest level since 2010. And according to the firm, the S&P 500 has seen a negative return within 2 to 8 weeks of similar readings over the past 20 years.
2. Volatility is extremely low.
The lull doesn’t only exist in the stock market, where it’s gauged by the CBOE Volatility Index. Volatility in the dollar, treasuries, and high-yield debt is also near historic lows.
But what makes stocks different from other asset classes is that periods of low volatility are usually followed by market declines — and these sell-offs tend to be more violent than upswings.
Edwards’ point does not even factor in the market’s constrained liquidity, which could amplify the losses suffered during a surge in volatility.
3. Some economic data are still lackluster.
Edwards pointed out that stocks are rallying despite the decline of manufacturing data in developed countries including the US and Japan. Also, global trade volumes are slumping.
His explanation for why these trends run counter to the rally is that investors believe the Fed is now on their side — no longer raising rates on autopilot, but willing to slam the brakes if need be.
4. Stocks can rally — and have rallied — leading up to recessions.
“Traditionally the equity market rallies after the final rate hike and any rally should be sold into if you believe the economy is headed into recession,” Edwards said.
He continued: “The problem is that no-one ever forecasts imminent recessions. The closely followed BAML Global Fund Manager Survey shows that in April 70% of investors surveyed expect a global recession to start in H2 2020 or later and most shocking, 86% believe yield curve inversion does not signal an impending recession! So are you going to pile into equities along with the ‘dumb money?'”