Why this time is different

We are living within an incredible monetary policy experiment. One the likes of which has never been embarked upon in human history. Therefore the results are difficult to forecast. However, I do believe we are in the initial stages of a bear market and that the next central bank monetary policies and their impacts will be different than those of the last several crises.

We have seen the last three bull markets catalyzed largely by loosening liquidity conditions during the bear markets that preceded them by central banks — in more and more of a globally coordinated fashion. This has led me to believe that the expansion of liquidity is the primary driver for consistent risk asset upward price revisions (aka bull markets). More than economic developments, earnings or political discourse.

As a result it is crucial to realize that the ‘punch bowl’ of quantitative easing, the veritable liquidity spigot that juiced markets higher over the last 9.5 years, is not only running dry, but going in reverse (taking liquidity from markets).

The impact of this reversal cannot overstated. It will be the primary catalyst that drives this bear market in equities lower. Only a reversal of tightening liquidity conditions will drive risk assets higher again in my view.

Below I will discuss, in summary, my view of how future crises may be remedied by central bank monetary policy, and how the law of diminishing returns may not deliver a buoyant bull market as we saw from early 2009 to mid 2018.

Markets:

  • The evolving variable for each crises’ remedy is lower and lower interest rates; then QE and finally direct future/stock buying. See Bank of Japan playbook for the ‘end game’.
  • As a result it is reasonable to expect the next crisis will result in not just QE, but likely direct future/stock buying in US markets.
  • Further, there are fewer listed shares now and the listed shares have been shrinking their floats as a result of share buybacks, exacerbating both upward and downward moves.
  • Adding to that, HFT algorithms do not tend to bid during downward moves, causing the smaller floats to experience outsize downward volatility on any liquidation. Next major crash could be significantly exaggerated as a result.

Macro:

  • $1 of US GDP growth now costs $4 of debt, and is only growing as we push on the string of debt to borrow forward demand to today.
  • US now has $200 trillion of unfunded liabilities over the next 10 year period.
  • Debt monetization isn’t just important, it will become a necessity. Otherwise rates normalize and the party ends in a very bad way (insolvency and/or extreme austerity measures).

Broader takeaway:

  • Muted returns for US equities over next 5-10 years (unless next crash corrects more than 80% of gains during this cycle).
  • Growing risk of protracted rolling global equity bear market as compression in economic activity, earnings — and the all important liquidity spigot (QE becomes QT) slows and reverses.
  • Future monetary policy easing will have a diminished impact on equity prices due to enormous expansion of multiples during this business cycle. If one discounts QE and share buybacks stocks are about 70-80% overvalued.
  • Next bubble will likely have to be in sovereign debt, aka US treasury yields approaching zero. Out of necessity to keep the gov’t open. Other assets may benefit as well. Especially if US dollar is debased to support forward liabilities.
  • Social factors will prevent future large scale bail-outs of Wall Street such as those that we saw in 2008. Unrest has grown as wealth disparity between working and wealthy grows to record levels.
  • I don’t expect US equities to perform as well in that environment, but do suspect strong headwinds against US dollar; emerging market / commodity outperformance. Largely due to the prospect that the US dollar is significantly overvalued based on economic fundamentals when netting out gov’t debt expansion (doing so shows we’ve largely been in a recession since 2008).
  • Emerging markets also have much more realistic valuations, better yields, lower nominal debt levels and the share buyback activity has been muted so EPS distortions are minimal.

As we can see, over the last several decades the primary trend in US interest rates has been lower. Countertrend rallies revert to the larger primary trend of lower lows in interest rates. Should this trend break down and rates normalize, we would see significant delinquencies emerge across corporate, financial and household variable rate debt markets. The US government would struggle to pay the interest on its longer dated treasuries.

While past is not prologue, it is reasonable to assume that the path of least resistance for interest rates is lower. Perhaps as low as 0% or even negative as we’ve seen in massively mispriced debt markets in the EU and Japan.

The larger underlying theme being that monetary policy authorities see massive distortions in asset pricing and capital misallocation as a lower risk than a sovereign debt insolvency. Therefore it is also reasonable to assume that they will do whatever is necessary to accommodate that trajectory over the longer term. That is to say, each subsequent business cycle will see lower nominal interest rates until we reach the mathematical limits of ZIRP/NIRP policies.

Eventually, with zero to subzero interest rates, sovereign debt becomes less attractive to hold (outside of regulatory mandates for financial companies). But before such an occasion arises, there is plenty of room for interest rates to keep going down — following a well established trend.

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.

US economic and precious metals outlook

I remain reluctantly bullish on gold, silver and platinum (and bearish of palladium). I fear we are entering a time of turbulence via geopolitical events, monetary policy tightening (during the greatest policy experiment perhaps in human history); a national, state and city debtastrophe, retail implosion (in a sector that employs millions) and an increasingly gig-oriented job market — that provides quite poorly for its paycheck-to-paycheck participants. The housing bubble 2.0 is beginning to sputter with almost as much leverage as 2007 in the speculative areas (flippers especially).

Further, I fear that the economic recovery did not manifest as hoped, and instead we’re seeing fudged metrics across the board (whether it is labor statistics that are double and triple counting the aforementioned gig jobs as separate people each getting a new job — when it is a single person with 2-3 jobs). We see funny data coming from Facebook where they are saying they have more users than the US census says we have population. We see enormous misallocations of capital as a result of these and other fuzzy numbers. At the end of the day we have a weak economy that is limping along, despite the record setting stock market saying otherwise as its returns grace the headlines on a near daily basis.

GDP growth has largely been predicated upon expansions in cost, not true increases in activity. Medical costs being one of the primary drivers, which are now rising at about 200% the rate of inflation by conservative measures. Compounding that problem is the fact that the FIRE (finance, insurance, real estate) component of the economy continues to occupy an outsized portion of GDP, creating a situation that has changed the lubricant for the engine of economic growth in to a drag.

So much wealth has been transferred vis-a-vis QE and this ongoing monetary policy experiment, from the working and middle glass to the very wealthy. This further creates an enormous strain on the largest input of US economic growth — consumption. Combining that with the overhang of student debt which is now approaching or exceeding $1T depending on the measure. We have a growing swath of consumers that can’t afford to engage in their namesake activity. And we just broke through record credit card debt in the US. So it’s safe to say we’ve pushed a lot of consumption forward without the means to keep that pace going.

Shifting gears to the central bank conundrum, a Warsh appointment at the Fed doesn’t do much to resolve the largest quandary in the institution’s history: how to unwind a 4.5 trillion dollar balance sheet before the next crisis — without causing the next crisis? Warsh’s own WSJ op-ed opined about his remorse and skepticism regarding QE. Will he be capable of unwinding what he admits he (and others at the Fed) barely even understand? It will be fascinating to watch. Makes buying VIX long dated calls look tempting if he is appointed and such an endeavor is undertaken. The current unwinding of the balance sheet is unrealistically slow unless they never intend to normalize.

What are the odds that this equity bull market, the second longest in US history by my calculation, continues unabated? I would imagine further strength in equities is required to keep the Fed determined to raise interest rates — and significant weakness could pause the tightening or even reverse it. Even if Warsh is at the helm, he would be under massive pressure from the administration to keep the economy looking better the closer we get to re-election.

That all said, I think we are navigating one of the most fascinating markets in my lifetime. It has evaded almost all logic and reason. So many much more gifted investors than me have missed a lot of this rally having been extremely skeptical of its durability and potential.

At this time I don’t see a lot of value in the US markets. Valuations feel stretched and equities priced to perfection. I’ve been allocating more capital in to emerging markets where the yields are higher, the valuations are more fair and there is some potential for hedging against US dollar weakness — which still concerns me over the intermediate to long run.

I plan to increase my own exposure to high quality silver miners based on my thesis that silver industrial usage will increase with larger demand for solar power, communications, computers, mobile devices and weapons systems (such as drones and missiles). Unlike gold, silver is used and quite hard to reclaim. Silver investing may also grow in time, but that isn’t the center of my thesis with silver. I suspect, instead, that investment will remain flat and the outsized portion of increased utilization will be non-reusable applications. That, and the fact that silver is generally mined as a secondary metal (incidentally rather than purposefully) at most mines, makes the opportunity a bit more bullish for me than gold.

It’s a very difficult metal to analyze, though. Thinly traded, often beaten up by large banks in concert (silver price rigging investigations have proven that several of the largest banks in the EU and US were working together covertly to suppress prices — and they saw minimal consequences for this activity).

Trading silver is not for the faint of heart, either. I spent a few months trading small lots of silver mini contracts and found the volatility very difficult to execute against because the bid would just dry up during times of high selling pressure. Most of the silver miners are much more liquid than the futures, which is a bonus. But there are very few of them to choose from and even fewer worth investing in.

As always I hope my commentaries are constructive to those who make their way through them!

Full disclose: Long positions in emerging markets bonds, stocks, precious metals mining companies; short position against NASDAQ 100.

It’s not just Amazon gutting retail

There’s so much talk of Amazon bringing doom to all things retail that I think it’s fair to take a step back and look at the bigger picture. A massive downsizing of US retail was inevitable. We have 600%+ more retail space in shops, malls and megastores than any other first world country. That’s a big tell.

Adding to that, as Americans we tend to overspend, beyond our means, and use debt to drive that consumption forward. That is to say, we can’t collectively always afford what we’re buying, so we tend borrow to buy. That cycle of debt-driven overconsumption did not end well in 2007-2008. Since then we’ve seen mid-tier and low-tier discretionary spending trends at many retail stores flat to down as consumers try to deleverage.

It’s also becoming more obvious that online shopping is driving sales away from brick and mortar companies who haven’t had the wherewithal to create a cohesive online shopping experience — or who have failed to effectively solidify customer loyalty. Further, as companies like Amazon grow and offer a sort of “Walmart of the Internet” approach to allow someone to do most of their shopping on a single website, ill prepared stores will suffer, losing more sales and customers.

But I feel that there are much bigger catalysts at work here as well. We’re confronting a generational shift from tangible consumerism to intangible consumerism. Retail stores have trouble selling intangibles. An example of that would be GameStop, who should be flourishing in the age of electronic sports and online gaming, but is instead collapsing in on itself due to its inability to execute online. Meanwhile, companies like Activision Blizzard, Valve, EA Games and others have created extremely lucrative online game distribution platforms, tying together the purchasing, social and gaming experience.

The same is true of application spending. Surely no customer is going to trek out to a store to download an application on to their phone, tablet or computer. That used to be the case, however, as software was too bulky to download and vendors were cautious to distribute online for fear of piracy. But much has changed since the early days of software distribution.

How we buy, what we buy and whom we buy it from are all changing. This appears to be a generational shift perhaps almost as much as it is a correction in retail overabundance to more normalized levels.

Full disclosure: Short the NASDAQ 100.

Trump threatens government shutdown over wall

First we were told Mexico would pay for it before the project started. Then we were told they would pay for it later after it was built. Now we’re told that our government will be shut down if we, the American tax payers, don’t fund this ridiculous and counterproductive project.

I don’t tend to post political content on here often, but since this administration seems dead set on creating intractable political turmoil I believe some attention is warranted.

President Trump has, at least in the initial 6 months of his presidency, provided a positive catalyst for US equities. Whereas the underlying theme was deregulation, tax cuts, corporate favoritism (as if we needed much more of that) and a promise of infrastructure spending.

Thus far just about none of that has materialized in any meaningful way. In fact, I think it’s fair to say that the US equity, bond and global forex markets are beginning to realize this as volatility ratchets up.

I fear that President Trump has set the stage for a steep decline in equities due to the market disappointment of having his policies unrealized combined with the realization that in all likelihood he is unable to effectively execute his duties as President.

Full disclosure: Short NASDAQ 100.