The Only Way is Up, Baby!
Since President Trump’s inauguration the S&P 500 Index has soared 17.3%. It seems the U.S president single-handedly suspended gravity. Otis Clay released “The Only Way Is Up” in 1980 and it seems Otis can’t be proven wrong. Ladies and Gentlemen, we proudly present the latest “theory” on why the only way continues to be up: The “Melt Up” hypothesis.
What is a Melt Up?
Google Trends demonstrates that users have searched frequently for this topic lately:
Investopedia defines Melt Up as “a dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy.”
Rationally speaking, Melt Up has been occurring in almost all asset classes globally since at least February 2016. As we will see, the primary driver has been worldwide Central Bank market distortion through limitless supply of liquidity for years.
Professor Shiller’s Price Earnings Ratio reflects the increasing confidence investors “feel” about the market and is a quantitative measure of how much Melt Up has been occurring compared to historic averages.
We have now reached a point where only once in the past 150 years stocks were more overpriced: During the Tech Bubble of the late 1990s.
In case you are gathering comfort from the fact that markets have been even crazier one time in the past 150 years, don’t be lured into a false sense of security: At the time in the late 1990s, we had to deal with only one major bubble, which was the one in equities.
Now, however, there is Melt Up everywhere: Be it housing prices in Canada, Germany, Australia or the U.S., digital cryptocurrencies, unicorn tech companies, fine wine, classic cars or equities around the globe – almost any asset enjoys a seemingly inexorable bid. After all, that freshly minted money has to go somewhere!
The craze now extends to credit markets as well. While stocks were more expensive in the late 1990s than today, US 10-year treasury bonds paid a respectable 6.7% interest rate then. For investors who recognized the perilous nature of American stock prices, there was a viable alternative to park their money elsewhere.
Nowadays, however, that option is gone. The Melt Up effect has spread everywhere. US 10 year treasury bonds yield just 2.3% today. If investors are lucky, maybe rates will keep up with inflation. Bonds certainly are not a viable alternative to stocks. Don’t bother looking overseas either. Interest rates are even lower in many other countries. 10 Year Bonds of Germany and Japan are almost at zero, i.e. you are being punished for not running towards the cliff with the crowd.
What is driving the Melt Up effect?
Central banks are the main factor here. It’s important to realize that it is not just Janet Yellen at the US Fed causing this. The three most important central banks have all inflated their balance sheets to unprecedented levels with the supposed goal of boosting inflation and employment growth in the wake of the worldwide slowdown between 2008-12.
We mentioned February 2016 above, since that is right about when the Bank of Japan and European Central Bank both started revving up the money supply growth again, taking over the monetary expansion role as the Fed backed off:
You may recall that the S&P 500 Index experienced its last meaningful correction at the start of 2016. As soon as the Bank of Japan started exponentially ramping up its balance sheet, however, equities stabilized and then rallied again globally.
China also faced a significant credit squeeze at the end of 2015, contributing to that equity sell-off. At the beginning of 2016, China’s central bank intervened heavily to shore up their economy.
This brings us to the first major catalyst that may put the breaks on the Melt Up. China’s central bank president warned recently about excessive optimism. He suggested that the bank will take action to prevent a so-called Minsky Moment – a point when enthusiasm turns to a sudden bust. Presumably, China will slow or halt money supply growth as part of its efforts to curb excess speculation in their economy.
With the printing press of the Fed turned off and China about to pull the plug, investors’ irrational exuberance now relies on the Bank of Japan and the European Central Bank to keep the party going.
Can the BoJ and ECB carry the weight of investors’ hopes?
Investors betting on more Melt Up better hope the answer is yes. While the verdict is out, a few factors are stacking up to spoil the fun: Unfortunately, the Fed, which has already stopped all net asset purchases in 2014, may swing to outright balance sheet shrinkage once a new chairperson takes over, and another rate hike in December is a foregone conclusion at this point.
Still though, why not enjoy a few more quarters of Melt Up before taking a more defensive posture? What could go wrong? For one thing, the Melt Up bet is a crowded one. Look at hedge fund positioning over the last 20 years; we’re almost off the chart bullish now:
Ultimately, hedge funds aren’t bullish because their managers think the party will continue forever. They are bullish because their investors can’t bear the pain of missing out and managers do not want to lose clients.
Additionally, the U.S. equity volatility index has been hitting record-low levels. It almost never spent time below 10 prior to this year. Before 2017, the last time the VIX hit the single-digits was at the end of 2006, and the next year mortgages started going bust.
For 2017 to date, the S&P has only dropped 1% four times; the fewest number since 1964 if the year were to end now. The current streak of trading days without a 3% correction is now the longest ever. Investors feel invincible as the Melt Up powers on.
But with market participants already almost all-in betting on a further rally, it will not take much to tip things in the other direction. The fact that central banks are rather strongly pulling back liquidity creation should be a clear signal to you to start thinking defensively now.