Why Equity Markets are going to be tested in the coming months?

In the last 5 days, the Dow Jones Industrial Average has corrected by 2.24% while the figure for the S&P 500 is 1.63%. At first glance, it seems a market pullback is a normal dip before another rally starts in the prolonged bull market. But apart from extreme valuations according to some metrics, fear of tapering has markets on the edge, that a deeper correction might be in the offing. Some analysts think that it might not even be a deeper correction, but a prolonged flat market where returns are hard to come by. In either case, the FOMC meeting on 21–22 September would hold very important clues. Just to show how extreme valuations have turned, I looked at the ratio between Market Cap(Wilshire 5000 Broad Index as proxy) and Nominal GDP over the last 2 decades. It is one of the favourite ratios of Warren Buffet to ascertain the valuation state of the markets. Historically, a value of 1 or 100% is considered to be fairly valued, where the market usually reverts back to. Below is the chart for the same:

The ratio is currently between 180 to 200, the highest level ever. Let us look at the chart, and see if there is a pattern to it. Starting from 1989, the 100% level was crossed in 1997 and reached a high of around 130% before the dot.com bubble hit. Then it continued to come down reaching a 70% level before another uptrend started which ended when the financial crisis of 2008 hit. But it seems there was no bubble in 2008 because the ratio was sitting around 100 only when the world economy got hit. It was more a result of risk mismanagement, which caused that crisis. After that Fed started Quantitative easing, and the ratio has refused to come back below 100 since then.

Now for someone who thinks it is a bubble it is a great visual, pointing towards an over expensive market. Growth and Tech stock backers might say that in the last decade technology innovation has shifted the markets fundamentally and such ratios are no longer relevant.

It is not a surprise that the contribution of Technology companies to the economy has increased manifolds in the last decade with smartphones, apps/social media, storage solutions(cloud) becoming a necessity. But is it right to say that the ratio has broken, humankind has been making technological progress since the start of civilization, it is not like we were not progressing in the 80s,90s, or 2000s?

One of the analysts from Bank of America defined S&P 500 as a 36 year zero-coupon bond, which I think is a very scary description. The description itself shows how much growth is being factored into the market plus the market would be very sensitive to any adjustment in interest rates towards the upside.

I wanted to look at another ratio that might hold relevance in a liquidity-pumped environment. A school of analysts in the current market environment are of the opinion that Fed’s Balance sheet expansion is responsible for the bull run that has ensued since last year. I looked at the ratio of Market Cap/ Fed Total Assets ratio, to see if we can find a pattern or a mean-reverting value.

* Fed total assets (in billions ) vs Wilshire 5000 index

We observe that for the better part of the decade ratio has actually hovered around 5, except for the 2017 to 2019 period when the ratio ran up to 8, then violently readjusted itself to a value near 5 in a matter of a quarter. Currently, the ratio is near 5.6–5.7 which could mean a 10–15% correction, and maybe more if tapering proceeds at an accelerated rate, though the ratio can still run up higher before any major correction if liquidity doesn’t dry up.

Another factor that I think would change the current market dynamics in the coming days would be how retail investors react to a market dip or a flat market. Some have touted 2020 as an evolutionary year in terms of retail investors’ risk appetite, they not only participated in the equity segment but also in the derivatives segment. With the market pointing upwards, the confidence to take risks has only gone up. Until now retail investors have been buying the dip, but if the market fails to move despite that they might lose the interest and patience to keep doing that. They might be a small investor group in terms of value traded each day, but retail investors have been the ones who have supported IPOs(sometimes overpriced) and stocks like Tesla, Gamestop, AMC. According to Morgan Stanley in June 2021, retail investors contributed to 10% of the US market, after peaking at 15% in September 2020. It is not only the drop in trading activity that will impact the market, but also the fact that small-cap companies whose shares have grown multifold on the back of retail interest can experience extreme volatility.

I believe it is time to prepare for a bumpy ride in the markets for the next couple of quarters, to keep an eye on macro trends. The recovery phase of the economy might be coming to an end, as new narratives pick up and the markets look for cues in the corporate earnings data.