Terror shocks Big Ben

30th May 2013

The four year equity bull market has been fuelled by a mass of liquidity around the world created by central banks. The US Federal Reserve was the early advocate of this policy with the UK happily tagging along. The Eurozone was more reluctant. Also late to the liquidity party, but now making up for lost time following the change of government last December, was Japan.  More sceptical investors believe this last leg of the equity rally is completely out of touch with the pace of economic growth and a reality check is required.

A crude, yet effective check on any stock, sector or index in the case of equity markets can be gauged by reference to the 200 day moving average. Whilst writing, the FTSE 100 Index is hovering around the 6,800 level whereas the average closing price of the past 200 trading days is around 6,100. So the market is trading around 10% above the moving average, typically perceived as a significant overbought position. The more serious technicians of Technical Analysis would calculate the standard deviation of the gap between the current price and the moving average, seeing significance greater than one standard deviation. For me a simple chart of these two indices tells me all that I need to know - and currently, I agree with the sceptics.

The calculation of the moving average supports the theory of mean reversion, the investment industry's answer to Newton's Law of Gravity, although in this theory when the current price is either above or below the moving average it will eventually fall or rise. Typically there are two ways to achieve this, either a short sharp market correction or a sideways moving market which allows the two lines to converge. I don't believe that the current overvaluation will lead to a 10% fall in the FTSE 100 Index, more likely a gradual convergence over the next few months. The UK equity market remains relatively good value on historic terms, whereas government bonds are not.

The US equity market, (I use the S&P 500 Index), was, before Ben Bernanke's recent testimony, around 12% overvalued on a 200 day moving average basis. No doubt his testimony caused some panic last week near this peak. Supporting asset prices has been a clear strategy since the credit crisis to sustain an economic recovery. Mean reversion is a powerful force, as investors witnessed when QE ended in 2010 and 2011. When the time comes to start withdrawing liquidity Bernanke would obviously prefer a less violent reaction to those previous occasions. Last week he hinted at slowing down QE as the economy recovers.  The market reaction must have petrified him and his colleagues on the Fed. Weaning a market addicted to central bank liquidity was never going to be an easy task.

One last observation on moving averages - I calculate that the current gold price in US dollars is nearing 20% below the 200 day moving average. With inflation being the long term threat, perhaps this could be a buying opportunity.