For the last few months, we have repeatedly warned about the mounting risks which were being ignored by an increasingly overly complacent, overly exuberant market. Doug Kass had a good compilation of those concerns on Friday:

  • The Fed Chairman seemed more hawkish in tone recently
  • Rising interest rates provide an alternative to stocks and reduce the value of long-dated assets.
  • Higher inflation (input costs) will pressure corporate margins and profitability.
  • A pivot in global monetary policy towards constraint from easing.
  • Policy risks.
  • Midterm election uncertainties.
  • Fiscal policy that has trickled up (not trickling down).
  • Our Administration’s trade policy and (as expressed in my missives this week) reversing the post-WWII liberal order holds multiple social and economic risks.
  • Increasingly leveraged public and private sectors.
  • A leveraged and dangerously weak European banking system who’s left-hand side of the balance sheet is loaded with overvalued assets (like sovereign debt).
  • Submerging emerging markets vulnerable to large U.S. dollar-denominated debt that will be difficult to pay off.
  • China’s economy is faltering – and its financial system is too leveraged.
  • Investor complacency – not a soul in the business media (save the Perma Bears) has warned of a large market markdown since the January highs. 

    • Of course, the sell-off last week was simply more evidence of the influence of “algos gone wild” when technical levels are broken and the robots all hit the “sell” button at the same time. It was also further acknowledgment of the lack of liquidity due to the surge in ETF issuance which has now created a massive amount of overlap risk in the markets.

    “When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.” – James Rickards

    The same was noted by portfolio manager Frank Holmes as well:

    “Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro-strategist at INTL FCStone.

    If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares.“ – Frank Holmes

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