- New Science in old markets -

2016 and beyond in equities and bonds

To look forward we must look back a little. Financial markets have been range-bound in recent months and we have seen compression signals at longer time frames almost everywhere. This continues today as we can see from these two American examples at year-end, in both stocks and bonds:

S&P & Bond weekly comps

Here are two European examples, both in equities. Only UK Gilts are compressed at a weekly scale (not shown) among European bond markets but other bond markets are poised to generate weekly compression signals too.

FTSE & CAC wkly comps

There have even been a few compressions at a monthly scale, but none yet in the major markets. The fact that they are happening at all, even in the smaller markets such as these Dutch equities is a sign that pressure is so bottled-up that it is now extreme:

Dutch ETF monthly comp

All this means that a sudden jump in volatility is coming and probably a big move in prices. The underlying bull and bear arguments are unusually profound and they are these:

Bearish - all asset prices have been inflated by Central Bank activity (QE) and the true value of financial assets is much lower than current price levels. The Federal Reserve's recent first step along the road to restoring 'normal' conditions will remove this underpinning and a steep drop in prices will result.

Some detailed forecasts have concentrated on the risk to the indebted of any rise in interest rates, arguing that 'zombie' banks, companies and individuals have been kept alive by the actions of central banks (QE and low rates) and that bankruptcy is their destiny. This is a more detailed version of the same argument - that the end of loose money will bring down the house of cards.

Low prices for commodities and particularly for energy are seen as a risk to all the capital invested and loans that have been made to the resource sector. Shares in mining and energy companies have indeed been in sharp decline in response to falling prices for their products. The question remains - will they go lower yet as even a cheap stock can halve in price.

Trouble in some emerging economies (mainly caused by those low commodity and energy prices) poses risks to the overall growth of global economic activity (see recent IMF forecasts) and particularly  to banks who have exposure to these countries. There could be another 'Lehman moment' with further consequences.

Bullish - asset prices have indeed been inflated by QE but there has been some genuine economic activity created by it too. All that is required is some restoration of confidence from business folk and consumers  and the resulting surge in investment will ensure the resumption of 'real' economic growth. There is plenty of money in corporate accounts - it is just not being spent at the moment.

QE still continues in Europe and Japan, is being held in reserve in the US and China and so the risks of a sudden reversal in policy are small. The US has effectively been tightening (albeit from an ultra-loose position to merely 'accommodative') since the end of their QE bond-buying in October 2014 and asset prices have held up well (although they have broadly not gone higher) - the small rise in rates is part of a gradual trend that already exists.

Some think that the Fed should have been quicker to tighten and that they are now 'behind the curve' of market sentiment. Any fresh burst of enthusiasm for US equities or real estate now could see a bubble phase of this bull market develop in which quick further increases in interest rates are made impossible because of the damage they would cause to the 'real economy'. Such a bubble could be very big and it could inflate in a matter of a few months. This is both a bullish and a bearish argument but initially bullish - we give it quite a high probability.

Low resource prices, especially for energy are bullish, not bearish. In this view, the fast short-term harm done to the resource sector is all now discounted in the prices for energy and mining companies. The slow longer-term benefits to consuming countries (mainly the US, Europe, China and India) will now take over and create a benign environment for growth and profits. The losers will be Opec and the other mineral-dependent countries. The general benefits will far outweigh the short-term damage and the growth stimulus will be far greater than that from QE.

Choose - the outcome will determine what this next year or two looks like and the markets are poised to start their move now. The compressed conditions shown above that have been building up in the longer-term time frames mean that trading ranges will not last much longer and that it is now risky to keep 'playing the range' as we have been advising in US equities.

We will not anticipate which of these fundamental arguments will win the day but instead we will wait and 'go with the break'. Please note that a return movement after the initial break of these compressions is always likely (see page 5 of our main userguide for more) so there will usually be a second chance to catch the move if you miss the initial break.

As usual we will try to provide usable advice at all the relevant time frames but our writing will seem to concentrate on the shorter term (up to a few weeks) merely because there is a lot more to see and do when we analyse daily data than when we analyse the weekly or monthly versions.

There is more to say on the longer-term prospects for other markets that we will write soon.

Happy New Year