Keep safe distance from frothy markets - Outside View by Chirag Mehta

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Keep safe distance from frothy markets
Sep 12, 2014

People's expectations of future returns are often just extrapolations of the recent past. This behavior is described as trend following. For e.g.: equity markets have been surging and hence are on the investor's radar as of now. Is this trend investing any good?

There is a saying that these trend investors consciously or subconsciously seem to believe- "The trend is your friend". (Believe me, most of the investors fall in this category where investors are seen chasing recent good performances.) However, in real world, this adage seems to be only the half truth. The phrase needs to be modified to "The trend is your friend, until the end when it bends."

Sometimes the underlying structure of the world changes rapidly with disastrous consequences for trend-following investors. Especially markets plagued with intervention are artificially supported and when that support goes off, it all comes down like a house of cards. This is because it's not supported by a fundamental foundation. What seems like a strong structural surge is many a time just liquidity propped up market. When you dig deeper into the underlying factors, it will be apparent that it's a bubble waiting to burst.

The underlying structure of the world seemingly changed 2010-11 onwards. The aghast / risk averse state of markets suddenly changed to a fearless, aggressive, risk loving by the magical wand of central banks that opened the taps of liquidity. Apart from rates gravitating closer to the lowest levels in close proximity to the zero bound, there were a series of additional monetary infusions taken by central banks across the globe that reignited the appetite for risk.

Table: Liquidity measure by major central banks since 2010
Period Central Bank Liquidity Measure Amount
May-2010 ECB Securities Market Programme (SMP) €220 billion
Oct-2011 Bank of England QE £75 billion
Oct-2011 BOJ Asset purchase program 5 trillion
Nov-2011 ECB Covered Bonds Purchase Programme (CBPP-2nd) €16.4 billion (announced target was €40 billion )
Dec- 2011 / Feb- 2012 ECB LTRO €1 trillion
Feb-2012 Bank of England QE £50 billion
Jul-2012 Bank of England QE £50 billion
Sep-2012 ECB Outleft Monetary Transactions (OMT) Nil -Announcement was enough to change market behavior
Sep- 2012 / Dec- 2012 U.S Federal Reserve QE3 $85 billion per month
Apr-2013 BOJ Asset purchase program $1.4 trillion
Source: Bruegel, Wikipedia

If you notice, there were a series of quantitative measures aka money printing programs intiated by major central banks around 2011-12. The liquidty propelled a move towards risk and a search for yield. And this is exactly the time when gold topped and started correcting as a result of movement of money towards risk assets.

The comparison of asset markets and unprecendented advances seen in Fed balance sheet provides a strong evidence of the great rotation marking a move towards risk assets (represented by US equities).

Chart: Equities, Gold and the Fed balance sheet
Data Source: Bloomberg

A closer look from 2012 onwards shows the lockstep movement in Fed balance sheet expansion and the surge in equity markets.

Chart: Equities, Gold and the Fed balance sheet
Data Source: Bloomberg

Going forward

Equities are increasingly getting expensive by the day increasing the probability of a correction hitting soon. Asset markets which have risen on the back of liquidity infused by central banks will feel the impact of lower money on the table as the U.S QE finally tapers and finishes likely by October, 2014. The markets have been reactive of geo political developments across the globe. Any flaring of these issue or any surprises from the upcoming US bi-elections in early November this year could potentially serve as the tipping points for any ensuing correction. Weaker prices in equity markets could trigger some renewed investor buying in gold.

Investors would do well by not chasing markets just by looking at recent performance of a particular asset. Trending markets on the back of liquidity are nothing but frothy markets which will sooner or later bend and turn into a nasty correction. It will be advisable to remember the full quote "The trend is your friend, until the end when it bends." Long term investor should consciously try and avoid chasing markets that are not backed by strong fundamentals and are rising just on back of sentiment / investors piling along. The low interest rate backdrop is forcing investors to move out in search of yields and in turn take more risk. The moment the liquidity tap slows, it could spell disaster for such asset markets.

Chirag Mehta is Fund Manager, Commodities for Quantum Mutual Fund and manages the Quantum Gold Fund ETF and the Quantum Gold Savings Fund among others.

Disclaimer:

The views expressed in this Article are the personal views of the author Chirag Mehta and not views of Quantum Asset Management Company Private Limited(AMC), Quantum Trustee Company Private Limited (Trustee) and Quantum Mutual Fund (Fund). The AMC, Trustee and the Fund may or may not have the same view and DO not endorse this view.

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