Beware the Raging Bull?


As I type this blog post, US and Canadian stock markets sit at or near all-time highs. A little over a week ago North American markets briefly sold-off on news that the Coronavirus, originating in China, was not contained and may very well reach pandemic proportions. Chinese stock markets had initially escaped the damage, having been closed for the week due to Chinese New Year but were set to play catch-up (or rather catch-down) once they opened the following week. In an effort to preemptively minimize the damage, the Chinese Central Bank announced a liquidity injection of $173 billion (all numbers in USD) into the economy. On Feb 3rd, the Shanghai Composite index opened down over 9% but stabilized thereafter, closing down only 7.7% on the day. Although it was a very large single-day drop, the liquidity injection largely succeeded, with Chinese markets rising for the remainder of the week.


At the same time as China was announcing its stimulus measures, the US Federal Reserve's ongoing repo operation was two times over-subscribed (again), at $59 billion. What began in September as temporary measures to provide liquidity to institutional investors, the repo has now been extended well into February. Given that this was supposed to be a transitory policy response, a person could be forgiven for speculating on whether there aren't deeper problems beneath the surface.


Regardless of what the end game is for the most recent stimulus measures, it should be noted that the initial repo operations were introduced during September's market swoon. In the interim since the liquidity injections began, US markets have been on a near-vertical rally. This makes it over a decade that this bull market has remained intact, arguably enabled by central bank interventions along the way (several QE's, operation twist, and now the temporary but ongoing repo operations). This euphoria has trickled into Canada's market as well, with tech stocks, utilities and other large caps having recently been on a tear.


As an investor, I am enjoying the ride but I can't help ask myself where we go from here. Given the parabolic nature of US markets and near record valuations (by most metrics), one has to wonder if we are entering a final blow-off phase where everything goes vertical? Or alternatively, it could be argued that the vertical run has already occurred and the ongoing emergency repo measures are the proverbial canary in the coal mine, indicating that something is about to break in our highly leveraged financial system.


In support of the bull case, the conventional economic indicators (unemployment rate, GDP, etc.) remain strong, especially in the US. Although these are often lagging economic indicators, the forward case being presented by the Federal Reserve and the financial media is currently a bullish one. A second bull argument is that Central Banks have shown that they are prepared to provide support to the economy and financial sector on a near permanent basis. This formula has worked well for over a decade, so one could ask "why can't it continue?" Cheap money has meant that borrowing for share "buy backs" is commonplace and can continue to provide support for the markets. Other reasons cited for a continued bull run include better than expected corporate earnings and progress on trade talks between the US and its trading partners.


So given all these positives, is there really anything to be worried about? Let's dig a little deeper. I have already mentioned the record valuations but let's take a look at a chart of the NASDAQ for some visual perspective.

Looking at the chart, it should be noted that the Federal Reserve reversed course on normalizing interest rates in December 2018 and since that time the index has gained 56%! The recent repo operations have only accelerated the advance, giving this chart a parabolic appearance. The exponential growth in share prices can certainly continue for a while but I don't think I need to tell investors how market parabolas typically end. Perhaps this time it will be different.


In conjunction with current market dynamics we need to consider the record levels of debt across all facets of society. Currently the US government is running deficits of a trillion dollars per year, with this projected to continue until at least 2030. North of the border, Canadian consumers currently hold $1.74 in debt for every dollar in household income. And this week it was revealed that Canada's consumer insolvencies are approaching record levels. Further highlighting that challenges faced by consumers, a recent poll by BDO Canada Ltd found that close to half of Canadians are living paycheck to paycheck and a third have no retirement savings. At the same time, corporate debt levels in both Canada and the US are at record highs. I don't know about you but these do not sound like healthy economies to me.


Meanwhile all of this is occurring in concert with a backdrop of euphoria emanating from financial market participants. The financial media continue to advocate the perspective that central banks will keep the party going and are recommending that we continue to "buy the dip". Facebook investment groups and internet discussion boards are rife with retail investors looking to load up on stocks (like Tesla) that have risen over 100% in mere months. Others are waiting patiently for the badly battered marijuana industry to begin another bull phase merely months after the over-hyped sector collapsed in spectacular fashion. In the tech sector, I am even starting to hear "it's a new era" comments in reference to the obscene valuations that currently exist. Many investors are too young to have ever experienced a bear market and it seems that they are now clamouring to go "all in" on the latest "feel good" story. In my investing life, I have never experienced a more universal enthusiasm for investing.


And this brings us back to the Coronavirus. Are markets discounting the economic impact that will result from this "yet to be contained" pandemic? Even if the virus remains largely contained to China, this is a nation that produces much of what the world consumes. Home to seven of the ten busiest shipping container ports on the planet, if China experiences any meaningful disruption in its supply chains, the world economy will feel it. Recent reports indicate that Coronavirus related shipping challenges in China are already significantly disrupting global trade. And this is occurring a time when the Baltic Dry Index (a measure of global shipping) is already sitting at three-year lows. In light of this, it is quite possible that the impact of the virus on trade is being underestimated.


So where does this leave us now? I know better than to make a prediction on market direction in the short to medium term. It is entirely possible that North American markets continue their parabolic rise. But it is becoming increasingly evident that our economies are experiencing significant structural challenges and an immediate headwind in the form of the Coronavirus. I do believe that caution is warranted moving forward.


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