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CITI: The end to the 'greater fool' theory that has driven markets means 2016's rout could intensify

BZ Falls, WA – JULY 19: Kelly Liles drops into the 30′ Big Brother Falls on July 19, 2002 during the the Extreme Kayaking Finals of the Ford Gorge Games in BZ Falls, Washington. (Photo by Jonathan Ferrey/Getty Images)

Stock markets in the US had another night to forget Friday with the Dow down 391 points and the S&P 500 losing more than 40 points to close below 1,900.

Crude oil crashed again, losing more than 5% and closing under $30 a barrel for the first time since 2003.

Locally, the Australian dollar, one of global financial markets’ best indicators of growth, risk and sentiment, has opened the week at 0.6832, just a little above Friday’s low and now almost 9% lower than where it closed out 2015.

But while traders and investors wonder where the circuit breaker might come from for this current sell-off, Matt King, an analyst in Citibank’s global research team, highlights that rather than slow, the current selling could actually intensify.

King’s warning, and the article he wrote about the current market funk, was the most read research report published by Citibank in the past week, the bank said.

Two main points stand out in King’s summary of the current situation.

First, central banks don’t have the ability to act as a safe haven and suture the market’s wounds. Second, King says, is that the end to the “greater fool” buying – where traders and investors buy assets in the belief that they will have someone else to sell to at a higher price later – means an unwind of this trade could accelerate the selling in a negative feedback loop.

Here’s the key excerpt which highlights the transmission mechanism which could make the selling worse in sessions to come(our emphasis):

Last year’s near-zero returns across asset classes, and the difficult beginning to 2016, are more than just the direct consequence of EM and commodity weakness. They are a sign that central banks’ power to stimulate risk-taking in markets is waning. In principle, that should imply reversion to fundamentals. While corporate leverage is at non-recessionary highs, spreads already price this in. Likewise, US HY pricing is already consistent with defaults rising to 7%.

If only traditional notions of value were to apply, things should stabilize. But those fundamentals are themselves liable to deteriorate if the sell-off in markets continues. Markets are never just reflective of the economy; they also influence it. But record debt-to-GDP and record wealth-to-income ratios make that feedback loop much stronger than usual.

When so much buying was based purely on “greater fool” theory, there is now a very real risk that selling begets more selling.

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