The US markets are closed on Monday, and many parts of Asia will continue to celebrate the Lunar New Year.  The economic schedule is fairly light, and market psychology appears fragile after the dramatic activity in equities and what appears to be shifting macro-relationships. To help navigate the challenging investment climate, we identify four “numbers” that can illuminate the path ahead.  

1. The equity market is center stage. The key number here is 2743. It is the 61.8% retracement of the S&P 500’s recent sell-off from record highs on January 26 near 2873. If last week’s impressive recovery, the largest weekly advance in six years, is “dead cat bounce” from the sudden drop, then this area should hold.It was teased before the weekend, but the S&P 500 closed below it (~2732).

In the starkest terms, the issue is whether the drop in equities was the beginning of the end of the bull market in equities. Many observers and analysts seem to think it is and welcome the increase in volatility is chiefly a beneficial development. The argument is that the capital markets have entered a new era, and many seem to attribute it to the end of the extraordinary monetary policies of central banks.

We have offered an alternative hypothesis. Yes, the equities were stretched, with a substantial rally in the first several weeks of the year. The correction was overdue, which again underscores the hazards of market timing. However, that is all it was, and even that may have been exaggerated, we suggest, by the new products that profited from the continuation of low volatility.  An echo-chamber was created that amplified the drop but the underlying drivers are still in place. 

Rather than seeing the historical precedent for the stock market action in 2000 or 2008, we suggest it is 1987. US equities lost a quarter of their value in a single day. Coincidentally, a new Fed chief (Greenspan) had just taken his post. There was no recession, and the stock market did not see those October 1987 lows again. Then it took two years for the S&P 500 to make new highs, but if our hypothesis is correct, new highs will be seen much sooner. 

More broadly, the consensus narrative puts the central banks at the center of its explanation for low interest rate environment and the elevated valuations in the equity market and low volatility. We respectfully demur. While recognizing an important role for central banks, the huge pools of capital that do not find a sufficiently profitable outlet in production remain in circulation and park in financial assets. Financialization is one of the key developments in the past generation, and the source of it is not central banks per se, but surplus capital.