Why the volcano could wake investors up to risk again

Back on 6 April, Alan Brierley of Collins Stewart sent out a note warning of the fragility of markets. The markets he said, are in “good news is good news, bad news is good news” mode. So, despite the “far from sanguine news flow”, global equity markets have seen strong gains in the first quarter – albeit on thin volume.

Brierley, like everyone else, was loath to call the top, given the “wall of liquidity pouring into risk assets” (the result of fast-running printing presses and low interest rates). But he did say that if you were still dancing in the markets, he would advise you to dance near the door, given that “someone has built the dance floor on top of a volcano.”

At the time he wouldn’t have been thinking of the Icelandic eruption – it hadn’t happened yet. Instead he was thinking of a variety of negative market factors.

First up was the “exit strategy” – the implications of the withdrawal of fiscal stimulus and higher interest rates across markets. Next, the fragile state of the US housing market, where new home sales are at a record low. Then the lack of resolution around the Greek crisis, the high oil price and the rising risk of a hung parliament in the UK.

And finally there are valuations. Very few valuation methods have any established history of actually working. The cyclically adjusted P/E ratio (CAPE) does. No one has the numbers for this for the UK, but in the US the CAPE is now knocking around 22 times. That’s 30% above its long-term average of 15 times. That doesn’t mean markets will fall 30% any time soon but, as CAPE’s main analyst and supporter Andrew Smithers points out, it has to be seen as something of a warning signal.

The question now has to be what might push the market over from its “all news is good news mode”. That’s a tough one to answer, but we may get some hints this week: it is going to be pretty hard to convince anyone that the Goldman’s news is likely to do much for the financial sector. And it might just be beginning to dawn on people that the real volcano under Iceland’s dance floor may turn out to be more than just a minor inconvenience.

Anyone not yet convinced might like to read this article from the Guardian. Turns out that an Icelandic volcanic eruption 200 years ago disrupted the Asian monsoon cycle “prompting famine in Egypt”. It also caused such disruption to the economies of northern Europe, where sulphur clouds confined ships to ports, that it can be considered to have contributed to the causes of the French Revolution. Sometimes bad news really is bad news.