Everyone “knows” that the Fed will never let markets fall – and that China will never burst its real estate bubble

Our pH Report Sentiment Index has been a very reliable guide to the S&P 500 in recent years, as the chart shows – on the upside, and downside. Now it is suggesting a major downturn may be underway.

Of course, “everyone knows” this cannot happen. If the market does continue to fall, then the Federal Reserve will simply rush to its rescue, as it has done for the past 15 years. But just suppose, for a moment, that the Fed’s policy has changed:

  • Jay Powell has only recently been reappointed as chair, and he has been under major attack for his inflation record
  • US inflation is now 7%, its highest rate for nearly 40 years – and there are midterm elections coming up in November
  • Investors assume that President Biden will want to support the market – but his record suggests this is unlikely 
  • Given that Powell wants to keep his job, it seems quite likely that he may reposition the Fed to focus on inflation

Of course, the central banks deny there is any link between their stimulus and the stock market. If you show them my chart from last week, they claim it is just “coincidence” that any market weakness led to more stimulus.

But investors have focused more on what they “do”, than what they “say”. And one of the most profitable trades for the past 10 years has been to “buy on the dips”. The idea is simple – wait for the market to fall, monitor the increasing panic in the Fed, and then invest as much as you can afford.

The problem, as they say, is that “to ASSUME can make an ASS of U and ME”. History is full of examples where everyone believed markets could never go lower – but they did – as the chart shows:

  • The issue is that these false assumptions turn into “false dawns”
  • In the 1928-32 collapse, it took more than 2 years to go from peak to bottom (blue line)
  • In the 1998-2003 collapse, it took almost as long from peak to bottom (green line)
  • In the 2005-10 collapse, it still took a year to reach the bottom, despite major stimulus (black line)
  • Just maybe, this month saw the start of a new collapse (red line)

And certainly bond markets are taking the risk very seriously. The benchmark US 10-year bond yielded just 0.66% in March 2020. But on Friday it closed nearly 3x higher at 1.78%. Higher rates, and much higher energy prices, are a potentially lethal cocktail for inflation, corporate earnings and stock/house prices.

But, of course, it is also true – as discussed here 2 weeks ago – that China’s real estate bubble has been the main source of central bank stimulus . And most commentators still argue that “China will never let its property market collapse”.

Unfortunately, as the chart for Evergrande’s US share price suggests, this assumption is well past its sell-by date. It is now the world’s most indebted property developer, having launched its US IPO at $15 in March 2015:

  • The stock raced to a peak of $102 by November 2017
  • But then President Xi began to suggest “houses were for living in, not for speculation
  • Since then, there have been lots of “false dawns”, but the share closed at $5.40 on Friday

The latest news from China suggests President Xi has no intention of changing his mind. As Reuters reports:

“A growing number of Chinese construction and decoration companies are writing off assets or issuing profit warnings as debt woes at China Evergrande Group and other property developers debilitate their suppliers.”

We cannot know today whether the Sentiment Index is right to be bearish. Nor can we know (yet) whether Powell will continue to refocus on inflation, and President Xi to burst China’s real estate bubble.

But we may well be seeing the end of the stimulus programmes. The cheap money they provided sent stock and home prices to record levels. Now our Sentiment Index is suggesting we may be at the start of a major downturn, rather than another opportunity to “buy the dip”.