Watch out, danger's about

Historically, the stock market generates more positive than negative annual returns, so an equity investor is better off being optimistic. Does that mean we can simply throw what the pessimists and doomsday merchants are saying out the window? Of course not: that would be far too naïve. It always has been and always will be our intention to give you realistic expectations.

Even so, we would be the first to admit we are stock market optimists. You've probably worked this out by now for yourself. History tells us that those who invest in European equities have seen a positive return in 32 of the last 42 years. This is why we feel it is unwise to bet against the stock markets, although this does not prevent us having realistic expectations.

Occasionally, there are difficult periods in the stock markets, and a number of indicators have recently shown up that might be pointing in this direction again.

Today, we will look at monetary policy and, in a future article – coming soon – we'll take a closer look at the yield curve trend.

The past decade has seen a very flexible monetary policy. During and after the 2008 financial crisis, Western central banks pumped huge amounts of liquidity into the financial and economic system. What was their goal? To keep interest rates as low as possible and keep economic growth at the same level. And yes, part of this "capital injection" has indeed found its way into the financial markets, which has caused the major global stock markets to rise in recent years.

Figure 1 shows us the very high correlation between the total balance sheets of the central banks and the trend in the US S&P 500 index. The liquidity injected by the central banks implies higher total assets on the balance sheet, because the central bankers mainly buy bonds and then hold them on their balance sheets.

Figure 1: S&P 500 vs Western central banks' total assets

Source: Crescat Capital

A diverging trend now seems to be emerging. Central bankers are pumping less money into the economy today and seem to be focussing more on reducing the level of their total assets.

Will this curb the upward trend of the S&P 500 and other stock markets?

As you know, we are not fond of making predictions like this, but we will certainly be a little more wary. In the same way that higher long-term interest rates have made bonds more attractive once again, the equity markets will also have to find a new equilibrium point. Adjustment periods like this can often bring with them an increase in volatility. The fact is that the era of ultra-low interest rates now appears to be history.

Conclusion

Over the last 15 years, there has been a close correlation between the ultra-flexible monetary policy (and its massive cash injections) and the equity markets.

As this period now seems to belong primarily to the past, the risks are growing for equity investors. In other words, it is best to start keeping a closer eye on the 200-day moving average of the major indices right now. Spotted a downward breakout in these averages? This might be an argument to reduce your equity exposure.

Another parameter to look at could be the total return of a major equity index (such as the S&P 500 or the MSCI Europe index). If we assume that these figures are falling into the red over 12 months, this could also be a signal to slow down investment in the stock markets.