Hyper-Speculation, Hyper-Inflation, Interest Rates and the Several Potential Catalysts for a Correction in the Financial Markets

2021 has been a hectic year for financial markets. From watching indices such as the Dow, Nasdaq Composite, S&P 500, as well as smaller indices such as the Russell hit all-time highs, to hedge funds being torn by retail investors, 2021 will certainly go down in financial market history. 

This being said, there are certainly several catalysts for a potential pull-back in financial markets. The first and foremost indicator of potential pullback is the factor that this market is eerily similar to that of the 1990’s tech bubble. Speculation is at all time highs. Here is a chart of Penny-stock interest, and liquidity in penny stocks:

Similarly to 1990, people are buying companies with no intrinsic, deep, or any kinds of value and driving them up 100-200% even 1000%. Here is another example with international Cyclically Adjusted P/E or CAPE ratios compared to the United States:

PE ratios in the United States trade significantly above those of the United States, another indicator for a potential downturn in financial markets. Furthermore, if you have ever read any Benjamin Graham you may recall that if indices such as the Dow or SPX reach a pe ratio of 22 or above, they tend to underperform over a 5-10 year period, returning an average of 2-5%. Right now the dow jones trades at a PE of 32. Another indicator of potential pullback is investor’s confidence in financial markets. When JP Morgan surveyed clients on what they thought equity markets would return in the following years they all believed that they would return 15% or higher:

Finally options. The most entertaining of all markets, has reached an all time high in speculation, with its inflow being greater than that of other equity markets: 

The second, and less obvious until recently catalyst is inflation. This is something that I have covered in the past, and the potential for inflation is a theme that has been looming in my head for some time. As it has been established for some years now, the Federal Reserve, along with the Bank of Japan, the European Central Bank, The Bank of England, and several other central banks around the world have engaged in Quantitative Easing (Quantitative easing is a monetary policy where central banks purchase at scale government bonds or other financial assets in order to inject money into the economy to expand economic activity). While quantitative easing can be helpful in stabilizing financial markets, it can also pose a threat to currency and comes with several tradeoffs, such as potential inflation or hyperinflation if it isn't controlled properly or misused.

Hedge Funds, Investment Banks, and other institutions are starting to catch onto this idea of inflation and modern monetary theory. People have been buying gold and silver and large quantities to protect themselves against inflation. 

My final potential catalyst for a potential downturn in financial markets is bond markets and the movement of interest rates in the near future. As you may recall, interest rates have been trading near 0 during the pandemic, but until a couple of days ago, they have started to ramp up again, with hedge funds, quant firms and CTA firms shorting and selling bonds short actively. “While the biggest driver of rising nominal yields in the past year has been the surge in breakevens - buoyed by rising commodity prices and, more recently, surging CPI, in the last week the market has also started watching real yields, which strip out inflation and are seen as a purer read on the growth outlook.” If yields do shoot up, that is generally bad for stocks and the economy, it means that people will generally spend less because it costs more to borrow or the consumer price index to fall. The good news is that it will cause inflation to fall. 

There are certainly some potential catalysts that hint towards there being a potential correction in financial markets. Regardless of whether we see a correction or not, these are certainly some aspects to monitor in the near future of financial markets to better understand what is happening in financial markets.