Monetary Inflation Becomes Less Supportive of Asset Prices
We have recently discussed the sorry state of the junk bond market, as well as the noteworthy decline in the annual growth rate of US money supply aggregates. The latter has finally manifested itself not only in terms of narrow monetary aggregates like M1 (see chart) and AMS (“Austrian money supply”, a.k.a. TMS-1, the narrow true money supply), but also in the broader true money supply aggregate TMS-2.
Photo via klyker.com
As a reminder, here is the most recent chart of the year-on-year growth rate of TMS-2 :
Below is a chart of the annual growth rate of narrow money AMS from the transcript of the October advisory board meeting of the Incrementum Fund. US money AMS is calculated by Dr. Frank Shostak. The chart shown below originally appeared in his AAS Economics Weekly Report of October 5, 2015.
As you can see, the growth rate of the narrow true money supply has fallen off the proverbial cliff recently. It is fair to assume that it will continue to be a leading indicator for the growth rate of TMS-2. Steven Saville of the Speculative Investor has recently mentioned that the sharp growth in euro area money supply (a chart of the growth differential between US and euro area AMS can be seen here) could well help to keep asset prices up longer, by offsetting the slowdown in US money supply growth to some extent.
This idea certainly has merit, as there exists empirical evidence to this effect. However, the US stock market will likely continue to be the leading international stock market. Should leveraged positions in the US market run into trouble, it will affect “risk asset” prices nearly everywhere. The danger that this could soon happen is clearly growing:
A Look at Leverage in the Market
Given the less supportive backdrop from money supply growth and corporate debt markets, it is probably a good time to take a closer look at leverage and positioning data that relate directly to the stock market. We have discussed all these data points before, so this is essentially an update that shows where things currently stand.
The most obvious data point worth considering in this context is margin debt. There is pretty convincing empirical evidence that the level of margin debt tends to peak a few months prior to the stock market topping out (this divergence is less noticeable near lows, as stock market peaks tend to be more drawn-out affairs, whereas lows are often made in the form of spikes). Given the deteriorating monetary backdrop, we would expect to see something like this to happen at the present time as well. This is indeed the case. Below is a chart of nominal margin debt since 1982 illustrating the situation.
A long term chart of nominal NYSE margin debt via sentimentrader. We have highlighted the major peaks in margin debt expansion observed since 1999/2000. Since margin debt is currently off 11% from its all time high recorded in April 2015, we can by now state that a major trend change warning is in place. Only if margin debt were to quickly rise again and exceed its previous peak would the warning signal be invalidated – click to enlarge.
Next we show two additional charts of margin debt from Doug Short/ Advisor Perspectives. On these charts, the growth in margin debt and the SPX are “inflation adjusted”, i.e., adjusted by CPI. The message remains however the same: every consecutive market top involves higher levels of margin debt, and the recent peak in margin debt and the subsequent decline are highly reminiscent of what could be observed at previous turning points.
Also included is a chart showing the net worth of investors. At the recent peak in margin debt, investor credit balances reached a record low in spite of the fact that asset prices have concurrently reached a record high. In other words, near what has been the market’s price peak to date, investors were prepared to take on an unprecedented level of leverage – not only in absolute, but also in relative terms. This leaves them woefully unprepared and exposed should the market actually suffer something worse than just a run-of-the-mill correction.
Growth in margin debt and the SPX, adjusted by inflation. The decline since the April peak in margin debt is very similar to what has occurred in the years 2000 and 2007. Will this time be different? We wouldn’t bet on it – click to enlarge.
NYSE investor credit balances have turned negative to an unprecedented degree. It takes quite a bit of bullish unanimity for investors to take on such outsized risk in one of the most overvalued markets ever. Evidently the idea that central banks will have their backs if anything untoward should happen is by now deeply ingrained. Many will be surprised when it turns out that central banks have actually no real control over asset prices (this doesn’t mean that their actions don’t influence asset prices, but “influence” and “control” are not the same thing) – click to enlarge.
Other Long Term Positioning Data
Similar to margin debt, other long term positioning data also tend to make peaks or troughs ahead of the major market indexes. An important detail are the extreme readings reached ahead of and in the vicinity of the turning point, as well as the persistence of these extremes. The bigger they are and the longer they persist, the more severe the next bear market is likely to be.
Two of these long term indicators are the mutual fund cash-to-assets ratio and the ratio of retail money funds to the market capitalization of the S&P 500 Index shown below:
The level of mutual fund cash relative to total assets since the early 1970s. This illustrates that mutual fund managers were far more cautious ahead of and during the secular bull market of the 1980s and 1990s than they are today. These extremes have partly to do with the fact that interest rates are now so low that cash holdings no longer provide a decent return. However, this is just another way of saying that extremely low mutual fund cash reserves are indicative of bubble conditions – click to enlarge.
This indicator shows that retail investors are by no means any more cautious than professional investors. Their cash holdings are likewise extremely low relative to the market’s capitalization – click to enlarge.
Lastly, here is an update of the positioning of Rydex traders. While these funds are primarily designed for short term speculation, the signals given by Rydex ratios historically appear to have long term rather than short term significance – this is to say, similar to the indicators shown above, they are probably not really useful for short term timing purposes, but should be seen as long term risk metrics.
This Rydex combo chart shows Rydex money market fund levels, the pure bull/bear fund ratio and the total assets held by bearish Rydex funds. In recent years never before seen extremes have been reached in all of them – these readings are lately beginning to falter, but remain at historically quite elevated, resp. suppressed levels – click to enlarge.
The leveraged Rydex bull/bear asset ratio, which isolates the assets held by leveraged strategies, shows similar extremes, which have lately begun to falter as well. What is interesting here is that the willingness to take on extreme risk was at its highest after the market had already advanced by more than 200% from its lows, i.e., at a time when market risk in terms of valuations was actually far higher than previously.
From a seasonal perspective it is unlikely that the market will make any big downside moves near year-end. In fact, it is usually more likely that there will be some additional strength, although the upcoming December FOMC decision represents something of a wild card this year.
However, the data above – especially the data on margin debt – suggest that we could see a big increase in market volatility next year. The decline that occurred seemingly out of the blue in late August is best seen as a warning shot in this context.
Long term risk has increased quite a bit, no matter which data points one happens to consider. Whether one looks at valuations, market internals, leverage or positioning, there are now more warning signs than ever. With the support provided by strong money supply growth declining as well, it becomes ever more likely that these potential dangers will actually materialize. It is an accident waiting to happen.
Charts by: StockCharts, SentimenTrader, Doug Short / AdvisorPerspectives, Frank Shostak / AAS Economic Report