Is the Wall of Worry Becoming Vertical?

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The melt-up, and break-out, in the U.S. stock market recently is a classic case of the market once again climbing the wall of worry in a convincing fashion. Political and economic uncertainty has surged. Trump is now real contender, the Brexit limbo persists, Italian banks are on the brink, and Turkey is wobbling. But the mighty S&P 500 has no time for such petty headwinds, as low yields press investors to seek returns in the equity market. We have seen this movie before, and it ends badly eventually, but it could go on for a while. This is especially the case if investors are starting to discount that EU politics are about to get really ugly. 

The Brexit vote and rise of Trump effectively are proxies for the U.S. and the U.K. turning their backs to Europe. This entails a number of unpleasant consequences if taken to its extreme. The U.S./U.K. will not go to war with Putin over the Baltics, Europe’s soft underbelly vis-a-vis the Middle East and Turkey will become further precarious and unguarded. In the end, this could lead to disintegration on the EU continent. This, admittedly, is a “glass is half-empty” view of the world, though. Other scenarios are possible. It could herald a move towards unconditional integration. Germany gets control over the economy, and France gets its EU army. If individual countries don’t want to play along, they can leave. It will be interesting to see where the pieces land once the dust settles in Europe.  

Meanwhile, our most trusted indicators suggest that investors fade the rally, reduce their exposure or even short U.S./global equities outright. This message is clearest by looking at at dynamic valuation scores, which point to falling returns soon. In addition, a very low put/call ratio which points to complacency.

Other indicators, however, give room for pause. Global real M1 growth point to a surge in the MSCI World, and breadth in the U.S. has improved strongly, which suggests that the rally has “good internals.”


This divergence is not unusual, and essentially is a question of difference in time horizons. What it does indicate, though, is that if the sell-off comes soon, it is unlikely to be the gut-wrenching 50%-to-70% decline the uber-bears are waiting for. Plus ca change. 

Bonds remain very expensive with the main consequence that they are unlikely to protect investors if risk assets sell off. Finally, macroeconomic leading indicators point to lower global growth, but no recession. GDP growth in the U.S. probably rebounded in Q2, while it slowed in the Eurozone. Amazingly, though, leading indicators point to a relatively resilient EZ economy despite the towering political uncertainty. In the U.K. the initial evidence suggests that the economy has fallen off a cliff in the immediate aftermath of Brexit, but it is too early to say for sure. In addition, the economy should rebound quickly from a short-term slowdown driven by a spike in uncertainty unless underlying fundamentals deteriorate.