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Storm in a tea cup

 

FTSE heads for the highs

As it turned out, Storm St Jude was a damp squib, at least compared with its famous forebear. And, in line with my forecasts, stocks in the US, UK and Germany have kept gusting upwards. The S&P 500 and DAX 30 are now are fresh record highs. The FTSE is not far off its all-time peak and even nearer to its bull-market highs of earlier this year.

Nevertheless, it is a good moment to go back to the risk of the big slump in shares that I discussed back in March of this year. My article then was prompted by a piece by James Mackintosh in the FT, which drew parallels between conditions then and now. The fundamentals were - and still are - somewhat like those in 1987: bubbly stocks, rising bond yields, a recovery in its fourth year, and similar valuations.

 

Now and then in the S&P

Back in March, I said I thought the comparison between then and now was overdone. The bull-run back then had travelled 231 per cent over 60 months, whereas today the S&P is up by 165 per cent over 55 months. As a result, the market was looking far more stretched back then. At the August 1987 peak, the monthly relative strength index (RSI) was 80 per cent, compared with 75 per cent today.

 

Overbought, 1980s style

On the face of it, today's RSI reading is not that far off that seen ahead of the 1987 highs. The key difference for me is that the market had spent much longer back then in an overbought state. From November 1985 to August 1986, the monthly RSI was above 70 per cent, getting up as high as 83.8 per cent. As such, there was negative divergence between the price and the RSI going into the crash. Today, this is not the case.

 

No divergence now

The lesson I draw from this is that markets can remain very overbought for quite some time. In late 2013, there is a good reason why they might do so again, in the form of quantitative easing. There is now a widespread belief that the Federal Reserve will not start cutting the flow of money-for-nothing perhaps until April next year. In the meantime, the odds are that the stock market will continue to puff higher towards overbought extremes.

As I said back in March, the longer that this goes on for, the bloodier I believe the end will be. I believe that the Wall Street's valuation is far more estranged from fundamental reality in the present than it was in the late 1980s. Speculative booms driven by cheap money seldom last long and after that fuel runs out.

For now, I therefore look for further gains in the near term. I expect the FTSE 100 to join its peers at fresh record highs above 6951 before very long. To address my longer-term concerns, I intend to research technical strategies for surviving big slumps.