Why are stocks selling off?

First let’s dive in to the mechanics of what’s changed. We were accustomed to a market where there was practically no volatility. Complacency was high and on a technical basis the Dow and S&P were more overbought than at any period since perhaps 1929. In essence euphoria and perhaps even blind optimism were becoming extreme. That condition quickly and violently reversed as more than five trillion dollars of market capitalization have been wiped out by selling since January 26th, 2018.

Volatility has returned

We’re now seeing volatility pick up and equities give back much of their gains over the past several months rapidly. Downward moves are generally faster paced and more intense than moves upward. Easy come, easier go.

That relatively uneventful journey up in most of 2017 is part of the problem with markets right now. During the rise in prices equities didn’t consolidate or correct which led to almost no technical support for buyers.

This is important because when there is volatility, market participants often utilize charts and technical patterns to determine areas of support. But in moves that are parabolic there generally aren’t such areas of technical support on the chart to rely on. So buyers (both human and bots) are more shy to put a bid out.

Fear is a powerful emotion

When volatility picks up and losses accumulate, speculators that used leverage (debt) to buy equities are often hit the hardest, forced to liquidate their positions. When this sort of activity crescendos with other investors panicking we typically see a capitulation selling event. I’m not certain we’ve seen that event as of yet, though. The market will have to demonstrate whether or not it has buyers here.

An example of how powerful fear can be is how inverse volatility index (VIX) ETFs have imploded in the wake of volatility returning to markets, meaning buyers who bet against intense trading price ranges were essentially wiped out. This trade worked well for years — until one day it didn’t.

These dislocations are not enough to create a full on selling panic on their own. Instead they are representative of instruments that were too heavily bought in to on the long side unraveling as the markets normalize to higher levels of volatility.

Bots are not buyers during sell-offs

High frequency trading bots have overtaken humans as the largest component of buying and selling volume for US equities. That seems efficient in theory, but the problem we see is when the selling intensifies the bots stop bidding. That allows declines to intensify as those wishing to exit will be fighting against a larger spread and less buy-side liquidity.

Indeed, during the last week we’ve seen situations where smaller lots were moving markets up and down by handles, rather than ticks. That’s the sort of activity one expects in an illiquid and immature market. Yet we are seeing it on a continuing basis here in the US with its extremely deep and previously liquid stock markets.

Technically speaking

Zooming out to a 30,000ft perspective, we haven’t seen any truly significant selling. Even though many points have been lost on major indices, this selling event is relatively normal. The pace of it is a bit intense, but for a maturing bull market one should expect increasing volatility along with leadership consolidation.

S&P 500 technical analysis

The S&P 500 appears to be hitting a lower area of support. Watching to see whether cautious buyers come in for a move more substantive than a “dead cat bounce” is crucial in determining whether or not the downward move is ending or if there is more to go. If we move meaningfully down from here across the US equity indices I believe we are going to see much more significant selling pressure and volatility.

It’s almost entirely about rates

The selling intensity and loss of confidence in bidding up equities seems to be tied to increasing rates on the longer end of the yield curve. Related to that development is that inflation expectations are beginning to change and concerns are rising. That is to say, bond buyers may be questioning whether a 10 year bond at 2.851% is a fair interest rate or if perhaps a higher rate is justified based on what the rate of inflation may be over the next 10 year period. If buyers commit to an interest rate that is lower than inflation they walk away with a loss when the coupon matures.

While the yield curve has had a flattening spread for several years — it is beginning to steepen again. Higher interest rates are also inducing higher borrowing costs for mortgages, margin debt as well as other variable rate debts and could compress consumer spending as well as market buy-side participation. Borrowing costs are one of the most important factors in market psychology as well as interest earned on presumably safe government bonds.

That means if the 10 year bond continues higher, say at 3% or more, then many equity participants may re-balance their portfolio away from equities and more towards US Treasury bonds. Assuming other shorter dated bonds were not as well bought, that change would steepen the yield curve which would also potentially assist lenders in capturing a larger interest rate delta between the short term borrowing they engage in vs. the long term lending at higher rates.

On the other side of that, if yields peak and meaningfully decline then there is a fair chance that a bid returns to the equity markets and they move meaningfully higher. Whether or not stocks are able to make a higher high in prices is the most important technical consideration for maintaining a healthy bull market uptrend.

Economic development trajectory

If economic data begins to slow meaningfully, which it may with higher rates, that is another area where weakness may be demonstrated as a result of reduced economic participant confidence. Such slowdowns often happen as rates increase and borrowing costs rise at the end of a business cycle. The most leveraged companies, states, cities and private debt holders are hit the hardest.

Closing thoughts

As I told a friend, the “crisis” now is that there is a lack of a crisis to keep crisis-level accommodations flowing. In essence the central bank liquidity spigots are slowing and commercial lending is taking a breather. The Fed has also recently made it clear that the “Powell Put” is at much lower price levels.

These developments impact both equity markets and real-world economic activity.  I’ll be watching the economic data releases, interest rate complex, especially 10 year yields and junk bonds, to see where equities may go from here.

Are emerging markets a good bet right now?

US equities have a smoothed P/E of approximately 24 whereas emerging markets average P/E is 16. Combine that with the potential of the US dollar uptrend (which started in summer of 2014) unwinding (adding emerging market native currency appreciation potential) and higher yields in emerging markets (an average of about 6.5% based on my math).

It seems like there is an opportunity here, if even only for normalization of valuations. I would suspect that liquidity would continue to be drawn, perhaps at an even faster pace, to EM equities and bonds (as it has been since early 2016) as the US dollar rally unwinds.

Full disclosure: I have been investing in EM equities and bonds since January, 2016 when I felt an enormous opportunity was on the horizon.

A stronger dollar means a weaker everything else

As the dollar surges past 97, toward 100, the rest of the market seems to be catching on that this is a risk off signal. Just about every asset class is selling off today as a result. There’s no single catalyst for the stronger dollar. More a myriad of micro-catalysts:

  • The assumption that the EU, UK, Japan and others will continue QE and ZIRP/NIRP as the US Fed raises rates.
  • The notion that the US Fed will raise rates at a faster pace (than they have in the last 3 years of jawboning about it).
  • The structural economic problems in other economies (making ours seem like the least bad of the bunch).
  • Weakness in demand for assets in Japan and Europe.
  • Brexit and the follow-on economic impact on UK.

With all of that in mind, I believe that the current leg of the US dollar rally is becoming problematic for the goals of the US Federal Reserve. Indeed, a strengthening dollar on top of rising US Treasury yields is in a way a de facto tightening. Liquidity tightens and lending/margin speculation decreases.

Should the rally strengthen I believe it will create a significant downside catalyst for a multitude of other asset classes. And there is some small chance that it could spiral in to a deflationary headwind should the situation grow out of the control. My opinion is that the dollar strength could be utilized as an entry point in to beaten up asset classes, especially commodities and emerging markets.

Let’s watch carefully and see where the market takes us from here.

Liquidity is not solvency

Apparently this is not a very well understood concept among the financial elite. Or perhaps they understand it all too well and are milking every incentive and easing measure for all of the salary, stock options and bonuses they can provide.

Not much has truly changed

Other than transferring an enormous amount of risk from the financial system in to the hands of central banks and governments, the underlying fragility of the financial system remains. Further, because the lenders of last resort are now burdened and their arsenal of financial ammunition near empty, there are not many options for the next economic hiccup.

With both US equities and bonds expensive by most measures, the logical alternative for most value conscious investors is to search for value in other asset classes: emerging markets, commodities, foreign exchange and real estate in distressed markets. But these options don’t come without risks of their own as their fates are tied to that of the US dollar (read more below).

With a great rally comes a greater upset

The last 7.5 years have been very generous to equity and bond investors. Perhaps too generous if current valuations are of any indication. What many are not prepared for based on current sentiment readings is a sustained downturn. Yet at the same time expectations of interest rate hikes by the Federal Reserve continue to rise (as they have in fits and bursts since jaw boning about such tightening began in 2013).

When rates rise, lending conditions tighten. And as that happens margin levels shrink, leverage is reduced as the cost of holding positions rises. This means that most of the time a series of rate hikes, as is being priced in to Fed Funds Futures, is the beginning of the end for modern bull markets in equities.

Yet stocks don’t seem to have received the memo. And they usually are last. 10 year Treasury Bonds, however, have seen yields rise from a paltry 1.3% to nearly 1.75% over the last few months. This may be more than just smoke signals as there are many foreign sovereign investors lightening up on Treasury Bond positions over the course of 2016, including China.

King Dollar’s mighty move

The US dollar has been rallying as of late on interest rate expectations as well. This has knocked down many commodities, outside of the energy sector, and caused renewed pressure on foreign currencies. Dollar strength should be watched carefully. If the dollar continues to rally (the dollar index is now testing 97) then we may see a renewal of equity selling as rate hike fears begin to permeate the US stock market.

Fears of the Fed are foolish

They say don’t fight the Fed. But what if the Fed is all talk? Over the last three years, there’s been a lot of talk of higher rates, even normalization. But what we have after all that talk is one lonely rate hike that is almost a year old now. The market seems to key in on every word every Fed official says, almost as if their words were seen as valuable insights.

But if each speaker’s rate forecast, economic forecasting track record and previous speeches are carefully examined the inconsistencies and inaccuracies accumulate. My opinion is that many of these officials, while they probably mean well, don’t have the requisite tools to forecast something as complex and intricate as the US economy. Why? Because no one does. Such tools do not exist.

But one thing is certain…

With a track record as dismal as Fed officials seem to have, their forecasts and banter about tightening should be taken with nothing more than a grain of salt. They don’t have a magic ball  and they can’t see in to the future much more than any other market participant, economist or statistician.

These are the same minds that brought us such failed monetary experiments as quantitative easing, which had the effect of redistributing middle class wealth to the already very wealthy, and bank bailouts which enabled more systemically reckless gambling.

As if flooding the system with credit would resolve the underlying structural solvency problems that our financial system and our government suffer from (hint: it made these issues worse by failing to address them in any meaningful way).

In conclusion, and I’m talking to you Mr. Market, let’s try not to take the hot air too seriously. After all, the people making it don’t seem to recognize the difference between liquidity and solvency.

Seesaw market creates opportunities in volatility

There is a lot of emotion charging the market, creating exaggerated moves both up and down.  One day everything is fixed, the next everything is broken.  Manic depression wouldn’t even begin to describe the back and fourth being witnessed.

But with chaos comes opportunity.  And the opportunity here is finding beaten up, misunderstood and frankly cheap assets.  Right now the areas that seem to be most attractive are commodities, commodities companies, energy and energy companies.

The global markets are pricing in worldwide depressed demand.  Oil producers are pumping at frantic rates, more concerned about the flow of cash than the margin on each sale.  This has created a glut of energy supply — and with little demand oil prices have crashed below $30.00 to about $28.00 a barrel for West Texas Intermediate Crude (WTIC).

Consider the following opportunity: The US dollar has had a rally which induced a de facto tightening even before the US Federal Reserve raised interest rates.  As such, one can reasonably expect that the actual pace of interest rate tightening, with the backdrop of a softening US economy, will likely be subdued.

Markets have priced in a more aggressive interest rate hiking cycle, which is putting pressure on everything that’s priced in dollars.  Even stocks.

I think that we’re getting ahead of ourselves here.  The Federal Reserve is unlikely to let this situation turn in to a full blown 2008 panic again, unless there is a desire to bring back all the calls to audit the Fed and the political upheaval that protests and social unrest would bring.  Instead, especially given that it’s a critical election year, I believe the Fed will tap the breaks and ease off the gas, leaving interest rates at 0.25% and possibly cutting them to negative levels if the global slowdown increases in momentum.

This time it’s different

The last time the market crashed, commodities were booming until they weren’t — and then equities tanked even more.

This time commodities are ahead of the business cycle as represented by equities.  At least in the US.

It seems as though we are confronting a new era. One where many other asset classes, including commodities, credit (bonds) and foreign currencies may be first in line to suffer from headwinds in global economic growth.

But that doesn’t mean that stocks will lag too far behind.  It just means that investors have been given every single warning indicator possible that something is amiss.  The question is, will anyone pay attention?

Fedflationary fabrications

These press conferences with Federal Reserve Chairman Dr. Bernanke are becoming more amusing as of late:

“We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation [..]” – Ben. S Bernanke

Really?  On what basis of calculating inflation can one say with a straight face that over the last 30 years inflation has been tame or for that matter stable?  Let’s take a look at the 30 year chart of the CRB index, which represents a broad view of commodities as priced in US dollars.

30 year CRB index chart showing high inflation and unstable prices

30 year CRB index

Clearly inflation is not under control.  However, if the above chart is not enough to make one skeptical of the Fed’s latest remarks, then here’s a 30 year chart of the US dollar index, the currency in which prices are set for all the items we purchase in the United States (and other countries using or pegged to the US dollar).

30 year US dollar index chart

30 year US dollar index

What one can gather from these charts is that we’re experiencing 30 years of a weakening dollar and extremely volatile commodities prices.  Our central bank has the audacity to tell us that inflation is under control, and that in essence one should ignore gas prices, food prices and the prices of other goods which have surged over the last few decades (because all of the official inflation statistics ignore said prices).

I’ve always been a skeptic of the Fed’s press releases and these conferences, but this statement alone is enough to make one’s head spin when put in to context with the charts above.  I believe instead that the Fed is claiming inflation is under control as a guise to give them the flexibility to perform more easing should the European contagion come home, or if our own sovereign debt issues begin to become more apparent to bond investors.

Without quantitative easing, twisting (and lots of shouting) our markets would likely have higher Treasury yields, lower equity prices — but people would be enjoying lower prices on food and energy.  With the labor market stagnating and the overall economic picture still quite dismal, one has to wonder whether the Fed’s dual mandate of encouraging employment and maintaining stable prices has been abandoned in favor of recklessly supporting the financial system at large, and more specifically US Treasury bond and equity prices.  It certainly seems to be the case when objective data is reviewed from a macroeconomic perspective.

Why fixed income investing is on life support

The current financial paradigm is crumbling beneath us.  This is not a temporary disruption, it is a meltdown.  All of the mechanisms that drive paper markets are being eroded, and more and more market participants are being, quite literally, robbed — and without consequence.

Income generation through investing comes down to a troubling set of problems, because revenue comes from the interest yield on various debt-based instruments.  Which debt does one buy during a credit crisis?  Obviously not European debt.  Corporate debt is suspect — and when the market is this high if it takes a turn for the worse corporate debt could easily take a 30-50% haircut overnight.

US debt has incredibly low yields and has been in a 30 year bubble, suggesting that it could collapse if inflation becomes a problem.

Other countries currencies seem dangerously manipulated by central banks, so it is hard to build a portfolio of high yield currencies without risking a monetary crisis wiping a large portion of the value out.

That leaves high dividend stocks, which are, just like every other paper asset, overvalued, dangerously dependent on the stock market continuing to move forward — and what would cause the stock market to continue to move higher here?  The only thing that could is a large scale global bailout which would be highly inflationary and bad for all debt (income) instruments — with the exception of a select few Euro bonds.  Bonds so toxic that they blew up MF Global and caused a global liquidity vacuum.  And let’s not forget about Dexia, who also had a lot of Euro debt exposure.  This highly rated European financial passed all its stress tests and subsequently collapsed, needing a bailout.

Any investment in ‘income’ instruments is highly speculative and dangerous.  Look at the charts for varying income instruments: sovereign bonds, corporate bonds, junk bonds, high dividend stocks, high yielding currencies — then tell me if based on just the technical analysis, they seem like good investments.

Then add to it the macroeconomic foray.  The likelihood of either a global banking system disruption or a highly inflationary bailout are both negative for most income instruments.

If we have a disruption, income instruments will crash in value very, very quickly.  No stop loss order will adequately protect against a waterfall collapse.  If instead we have a global bailout, money will rush out of income instruments in to speculative assets.

Most retirement age Americans are struggling with this problem.  Millions are unable to get yield, which forces them in to dangerous assets.  Investors have to be patient and wait for the opportunity to come — rather than get destroyed by the rush to the exits that is almost certain at this point.

Fed Wednesday – Policy Outlook

I don’t want to be right about my of my dire predictions, but all signs point to a significant global slowdown:


The Fed is coming out at 2:15 pm to announce the results of their policy meeting.  Many expect a variation of the 1960s “Operation Twist” where they sell their short-dated maturities and buy long-dated maturities:


If they were to do this, it would actually hurt the large and regional banks because they would be borrowing at a higher rate and lending at a lower rate — but it may help the consumer, at least short term, buy making mortgages and revolving debt less expensive:


They downside is that any more monetization of debt will likely be perceived as inflationary and send speculators in to commodities (including energy and agriculture) which could cause a rise in consumer prices.

I think they may even have to perform some more aggressive monetary policy measures given that the US dollar money market funds in Europe are drying up — and the EU banks are in bigger trouble than our banks:


If they announce nothing new, which is in my opinion extraordinarily unlikely given that this is a longer than usual Fed meeting (something we hadn’t seen since the last rounds of QE) I think there will be a significant market sell-off and a head and shoulders topping pattern may play out:


Whatever is done by the Fed is only a short term piecemeal solution to a broader, more structural problem with bank and sovereign balance sheets — and in my opinion it only delays any real resolution.