December 15th, 2015

'The largest asset bubble and disconnect from the economy ever': A widely followed market strategist outlines the negative side effects of Fed intervention — and shares the 2 signals he's using to monitor the situation

Sven HenrichCapital Traders Ltd.

Summary List Placement

Sven Henrich wants to make one thing clear: He is not a perma bear. He's just trying to keep it real. 

The outspoken founder and lead market strategist at NorthmanTrader is known for his technical and macro analyses of global equities and widely followed for his bearish warnings about the Federal Reserve, stock market, and US economy on CNBC and Twitter. 

"There's this perception about perma bears and being permanently short the market. This is silly," he said in an interview. "I don't know anyone that does that realistically."

But Henrich's criticism of the Fed has been long-standing. His main complaint is that the central bank has overstepped its original mandate. 

"I'm not blaming central banks for everything in the world. But over the years, they've adopted an attitude to intervene all the time, at every sign of trouble," Henrich said. "By always being beholden to markets and by always needing to intervene, they are creating the largest asset bubble and disconnect from the economy ever."

Since the onset of the COVID-19 crisis in March, the shutdown of business activities has ravaged the economy but the stock market has reached all-time highs after an initial plunge.

Many attribute the market exuberance to monetary policies of the Fed, which has cut short-term rates to near-zero and purchased massive amounts of securities from Treasuries to junk bonds. As a result, the central bank has created a debt-dependent financial system that never gets cleansed out, according to Henrich. 

"By constantly intervening and saving everybody or trying to save everybody, the system never cleanses itself and the economy zombifies itself," he said. "We're all sitting on this big asset bubble and hope it doesn't pop. Because now it's gotten so big that all central banks are terrified that if this ever blows up on them, that's when you're really in trouble."

No crash, but probably a realignment 

Despite his strong opinions about the Fed pumping up the stock market, Henrich is not sure if we will see a full-on market crash in the near term. 

"Personally, I would like to see some sort of realignment," he said. 

He uses the famous "Warren Buffett indicator" that looks at the percentage of total market cap to US GDP to gauge the current market valuations and likely returns. 

Historically, the percentage has been 65% to 80% but it shot up to 150% during the 2000 tech bubble before falling to 75% in 2002 after the Nasdaq crash. During the 2007 housing bubble, the ratio ran up to 130% to 140% again before reverting to 50% after the 2008 recession, according to Henrich. 

"We have these vast excesses of GDP and then we had the reversion back to some sort of cleansing process," he said. "In February this year, with the repo of the Fed and the three rate cuts in 2019, we got to 158%. That was higher than the 2000 dotcom bubble."

He continued: "There are some people that say because we have these big mega-cap tech stocks and they're acting globally, therefore they're capturing a portion of global GDP, maybe that ratio should be higher than it historically has been… But should it be at 158% in February? Clearly not, because the market reacted to this brutally with the 35% crash that we had."

Ominous still, this ratio reached 187% in September. 

"You are still dealing with a market cap to GDP ratio in excess 160%, which means we're still sitting at the highest valuations in history," he said. "To my mind, it's dangerous."

2 key indicators on his radar

As a deft market technician, Henrich is always looking for signals to align for either a buy or a sell in the markets. 

Since late August and early September, he has been watching the dollar and its relationship to the stock market

"Right now the market is very much short the dollar, it is assuming that the dollar is going to continue to get crushed because the Fed keeps intervening and so forth," he said. "If people are too loaded up in one direction, long or short on something, that can always spell trouble. Doesn't mean it must, but it's very much possible."

He explained: "What the dollar is doing right now is it's still playing with what is called a potential bullish cup and handle if it makes a high and low here in October. And if it were to break above the September high, that pattern has quite a bit of punch in it and that may spark a very large dollar rally, which would be not very positive for equities, assuming that the current correlation continues to hold very closely. 

Another key indicator on his radar is the value line geometric index.

Wall Street has talked up a rotation trade from growth into value in recent months but a lot of such attempts have failed this year, Henrich noted, adding that the zero earnings growth in 2019 and the negative earnings growth in 2020 have made it so that the entire price equation in 2020 is supported by multiple expansion.

"It's been making lower highs, lower highs, lower highs," he said of the index. "However, this October rally here has brought it back to the June highs. That either means it's going to be some sort of double top or we break through. If we break through the June highs on the equal weight, that could be bullish for this entire rotation trade argument." 

Be flexible and be realistic 

While Henrich does not usually give investment advice, he stresses the importance of being flexible and realistic about the markets.

"Don't be dogmatic about anything, have a view of what the technical signals tell you," he said. "If you are blindly bullish or if you are blindly bearish, I think you're going to get hurt one way or the other, so you got to be flexible."

But investors should definitely be more vigilant.

"Everybody should take a closer look over the last three years and note that markets have become ever more extreme to the upside and to the downside," he explained. "That's not a sign of stability in the system at all, they become ever more extreme and they become ever more disconnected. That to me is a sign of fundamental instability in the system and we should just be mindful of that."

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