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Dangers signs from the current share rally
If someone had said 12 months ago that a deadly virus would infect more than 7m people worldwide causing a global lockdown, resulting in the worst economic contraction and unemployment since World War 2, you probably wouldn’t have expected to see the S&P 500 index trading 12% higher today at 3,232.
If investors are genuinely worried about the economic impact of coronavirus, unemployment, a wave of corporate defaults and the rising risk in equity and bond market valuations, they have a funny way of showing it.
The answer to this mother of all conundrums is, as usual, central banks. The world’s central bankers decided in March to go all-in supporting markets by announcing coordinated global action to provide a ‘liquidity backstop’.
Since then, they have announced the purchase of corporate bonds, including high-yield or ‘junk’ bonds, exchange-traded funds (ETFs) and even shares in order to prop up financial markets.
For their part, after years of trying to box clever, professional traders have given up trying to ‘fight the Fed’ and have taken to front-running it instead, buying the same assets that the world’s central are targeting.
Last month the Bank of England cut its key lending rate to a record low of 0.1% while injecting £645bn of liquidity into markets.
At its next monetary policy committee meeting in a week’s time, it is likely that all nine members of the committee will vote to leave rates where they are.
With almost no interest on their deposits, and companies having slashed their dividends this year to preserve cash, the only option for investors is to pursue capital growth by chasing share prices higher.
Market commentators are spinning the narrative that we are ‘looking through’ this year’s earnings dip to a recovery next year, with no certainty that there will be a recovery or what shape it might take, in order to justify the continued upward price spiral.
With the death toll rising and economic damage worsening, this may not feel like a normal bubble, but so far nothing about 2020 has been ‘normal’.
In the US, small investors have chased up S&P 500 call options – giving them the right to buy the index at a specified price within a specific time period in the future – by a record amount.
Historically this level of speculation has led to negative returns for the index over the next 12 months, making small investors a reliable contrarian indicator.
Essentially, we are witnessing a ‘bigger fool’ rally, where investors think they can continue making money buying and flipping stocks to the next credulous buyer before the music stops.
You might want to review your portfolio and lock in some profits on more speculative investments now, thereby providing cash to invest on the dips should there be another market sell-off.