Reflecting on The Seven Samurai* – This is No Time for Complacency.

“Just when you think that you are safe, you are most vulnerable.”
The Seven Samurai

At 3EDGE Asset Management we remain vigilant and on the lookout for any potential canaries in the coalmine that may provide evidence of an impending market correction and perhaps even the onset of a Minsky Moment1.

As we continue into the fourth quarter of 2017, it appears that equity markets are content to pursue their upward path, with U.S. equities setting all-time records along the way. At the same time the CBOE Volatility Index (VIX)–which market participants look to as a gauge to measure fear or complacency in the market–remains low.  In addition, since as far back as 2009 investors seem to have been rewarded for “buying the dips” and adding to their equity holdings during equity market downturns.

Even at these high levels of traditional valuation, the case for further appreciation in the equity markets could be supported by a continuation of the following conditions: positively-sloped yield curves, benign global inflation, narrow credit spreads which signal that the market believes there is no recession in sight, low real (inflation-adjusted) cost of capital which contributes to higher valuations of future earnings streams and signs that the global economy continues to grow faster than expected.

At 3EDGE we remain at or near our maximum equity ranges across our strategies.   However, this is certainly no time for complacency.  We know that we need to remain vigilant and focused on any potential canaries in the coal mine that may provide evidence of an impending market correction or even perhaps a Minsky Moment.

Another potential storm cloud on the horizon could come from the possibility of a shift in U.S. Federal Reserve policy, along with the possibility of a new Fed Chair coming on board soon.  After years of unprecedented monetary stimulus on behalf of all the world’s major central banks, we seem to be approaching the beginning phases of monetary policy normalization, the unwinding of quantitative easing and increasing short-term interest rates.  The U.S. Fed could be the first major central bank to move towards normalization of monetary policy while the European Central Bank may be next in line to begin unwinding their own version of quantitative easing. These potential developments can create a great deal of uncertainty and there is a risk that at some point market participants may interpret the Fed’s intentions and change in leadership as being counter to both lower interest rates and higher equity prices going forward.  Given the strong sustained market momentum currently helping to drive equity markets to new highs, such a correction triggered by central bank uncertainty could be further exaggerated to the downside as the momentum that seems to be helping to drive the equity markets higher could then begin to work in reverse.

So, with equity markets in the U.S. hovering around all-time highs and volatility remaining low it is important to remember the words of the Samurai from the movie The Seven Samuraijust when you think that you are safe, you are most vulnerable.

DeFred G. Folts III
Chief Investment Strategist

1 A Minsky Moment is a crisis named for famous economist Hyman Minsky, who argued that oftentimes a lengthy period of market stability tends to breed complacency resulting in a build-up of excesses and imbalances, sowing the seeds of the next period of instability.  At 3EDGE we have been talking about such a scenario in terms of a potential equity market melt-up which can occur when the remaining market skeptics capitulate and the fear of missing out on additional appreciation in the equity markets becomes overwhelming.  The remainder of cash on the sidelines then pours into the equity markets causing an almost parabolic rise in equity prices.  This situation often presages the onset of one final push upward and then a sudden reversal, followed by a major, oftentimes painful, market correction.

*The quote at the beginning of this commentary is from one of my favorite films – The Seven Samurai. The film was co-written, edited and directed by Japanese screenwriter and director Akira Kurosowa who is widely regarded as one of the most important and influential filmmakers in the history of cinema.  Released in 1954 the film is over three hours long and filmed entirely in black and white – what’s not to love?  The story takes place in 1586 and follows the story of a village of farmers that hire seven Ronin – master-less samurai to combat bandits who regularly return to their village after the harvest to steal their crops.  Since its release, Seven Samurai has consistently ranked among one of the greatest films in the history of cinema. The film is also the model for the movie The Magnificent Seven a 1960 American Western.

DISCLAIMER: The opinions expressed above are those of DeFred Folts of 3EDGE Asset Management and are subject to change without notice. These opinions are not intended to provide personal investment advice and do not take into account the unique investment objectives and financial situation of the reader. Investors should only seek investment advice from their individual financial adviser. These observations include information from sources 3EDGE believes to be reliable, but the accuracy of such information cannot be guaranteed. Investments in securities, including common stocks, bonds, commodities and ETFs, involve the risk of loss that investors should be prepared to bear. Past performance may not be indicative of future results.