I spent the last three days in New Zealand talking to investors and financial advisors about global investing, and the most frequently asked question is “do you think Wall St will have a correction?”

My answer is “yes”, but of course “timing” is everything. You don’t want to be the boy who cried “wolf”.

With US equities trading on a five P/E point premium to the rest of the world, and US equities now representing 54% of the MSCI World Equity Index (yet US GDP only represents 16% of world GDP) it would appear valuations and positioning are now very stretched in US equities.

It’s also worth noting that S&P500 price to sales ratios are now the highest since the 1999 tech bubble. This confirms share prices in the US are now broadly expensive.

S&P 500 prices to sales ratio

Of course valuations and positioning can remain stretched for a long time (the old ‘markets can remain irrational for longer than you can remain solvent’ theory), but that can change very quickly if an unexpected catalyst comes along that triggers investors to lock in some of the huge profits they have generated in US equities since the US Presidential election.

My view is a pullback on Wall St is much closer than most people realise. In fact, if you look at the bond markets, they have started getting less optimistic about US growth and President Trump’s ability to execute on his ambitious plans. Bonds have started rallying, which to me is a warning signal for US equities in the shorter term, remembering that it has been rising bond yields and reflation expectations that have driven the financial and cyclical leadership of Wall St.

The table below shows you the correlation of US equity sectors to moves in the US 10-year bond yield. The red line is post the Presidential election and confirms correlations have rapidly risen for all sectors (up and down) to movements in 10-year bond yields since the election. Quite frankly, if you want to forecast the near-term direction of Wall St, you should look at the bond market first.

The chart below shows US 10-year bond yields (white) and the S&P500 index (orange). Rising bond yields have led US equities higher, but you can see in the last few weeks that falling US 10-year bond yields have halted the S&P500’s advance (orange line).

Clearly a couple events have taken some of the heat out of the bond market. The first was the “dovish hike” from the Federal Reserve. The second was Trump’s inability to get his healthcare bill through congress.

Both these events will have ramifications for US equity sentiment as the equity market is very optimistically priced on expectations of rapid fire regulatory and legislative change that is pro-growth from the Trump Administration.

You should be in no doubt that US equities are currently pricing in substantial tax cuts, large scale infrastructure spending, tax breaks on cash repatriation, lower regulation and higher long-term interest rates.

Wall St had been led by financial companies because they are seen as the biggest direct beneficiaries of all of the above. However, as you can see below, the largest US financial sector ETF, the XLF, has started correcting (-6.4% from recent peak) after a monster rally.

This US financial sector performance will be the key to Wall St’s near-term performance. If I am right and investors start losing patience with the Trump Administration’s ability to execute in the timeframe they currently expect, then you will see Wall St correct -5% in quick-time due to the fact cash levels and short positions are currently very low.

This is a simple “expectations” versus “reality” arbitrage. Trump may well deliver on his promises, but in my view it will not be in the timeframe that ultra-short sighted markets are currently pricing in. There will almost certainly be a “this is going to take longer than we thought” pullback on Wall St, led by financial stocks. This has already started in the bond market.

The clear problem is “positioning” had become extreme (very crowded) in the short bonds/long cyclicals/financials trade based on “Trumpflation” expectations. It would appear that just about every hedge fund in the world was/is short bonds and long financials and cyclicals. My point is when we get to this degree of “crowding”, it’s almost impossible for the respective investments to continue to perform (in the short term). What usually happens is a short, sharp, correction in the trade to wash out all the “fast” money.

The table below shows “net speculative positioning” in the US 10-year bond market is currently 3.3 standard deviations short. That is “off the chart” and the key reason we expect short-covering in bonds (i.e. lower yields) and profit-taking in yield sensitive US equities such as financials and materials. We also think the US Dollar will fall in this scenario.

Similarly, analysis of 3-month forward returns in bonds when net speculative positioning gets this extreme shows bonds do the complete opposite of what the speculators want in the next three months. The return in bonds has been +6% in terms of capital gain (lower yields) historically when speculators were this short previously.

All in all I strongly believe the so called “Trump trade” will come under pressure in the next three months and I fully expect a pullback in US equities. The Trump Trade has already started to come under pressure in the bond market and I am expecting that pressure to move across to US equities. You can see that pressure has already started in US financials.

As I said, this is just an expectations versus reality correction. It’s simply that expectations have gotten way ahead of reality in terms of timing. It may well prove a dip to buy in US equities, but I am waiting for that dip over the next three months.

Remember, when Trump was elected, US equity futures went limit down (-5%) on the day. Don’t be surprised how quickly sentiment and prices could turn against him again. This is particularly so when US equity valuations are so stretched.

I am invested more in Asia and Australia, feeling the worst value and biggest downside risks lie in the USA. If you benefited from the Trump trade, I’d consider taking some profits and moving to the sidelines for a few months. A better buying opportunity will almost certainly present itself.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.