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.

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.

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.

The Fed has zero credibility until it raises rates

A lot of hot air, but no substance. That’s what’s been emanating out of the mouths of Federal Reserve officials over the two years about the direction of interest rates — with no follow through of taking rates higher.

As a result the Fed has no more credibility left.  When Fed officials talked about moving rates in the past markets would move with their chatter.

Not so much recently.  Market participants are squelching out the talk and waiting for the Fed to walk the walk.

Bernanke’s Bubble in Stocks and Bonds

Summary

Six years after the height of the financial crisis, we may be living in one of the most prolific financial bubbles in recent history.  Under Dr. Bernanke’s guidance the US Federal Reserve system expanded its balance sheet to about 4.3 trillion dollars, with asset purchases creating a disproportionate wealth effect in equities and debt-based financial instruments.

Despite this massive injection of liquidity, by and large the US economy has not significantly recovered. Yet the US stock market (with the exception of the NASDAQ) is at all time highs. This disconnection in equity prices vs. measurable economic recovery is the primary reason that I believe a bubble exists. In addition, the artificially low interest rate environment (see: ZIRP and QE) has also created an enormous bond market bubble as reflected in US treasury bond yields.

LFP Participation

The US workforce is languishing 

A quick glance at the US Department of Labor’s recent U3 unemployment data would have us believe that almost as many Americans are employed as had been before the Great Recession.  Unfortunately the Department of Labor’s U3 unemployment rate is based on the amount of Americans currently on unemployment benefits — not the number of Americans out of work.

The US Labor Participation Rate is at its lowest levels since 1978, indicating that US job creation is not sufficient to support widespread employment. In addition, the quality of new jobs being created is equally deficient, with lower pay being a prevailing theme.  One of the Federal Reserve’s mandates is maximum employment.  A mandate they seem to be failing to uphold when utilizing more objective measures of employment.

cci

Raw materials are rolling over

While equity markets re-test all time highs, commodities are sinking fast.  Traditionally weakness in industrial commodities and energy prices signal global economic weakness.  Since July we have seen that weakness accelerate as the sell-off in commodities prices took the CCI (a broad measure of commodities prices) to multi-year lows.  This is a powerful sentiment indicator.

Optimism about global growth would be expressed in higher commodities prices — as more orders for raw materials would increase demand.  Another mandate of the Federal Reserve is stable prices.  A cursory glance at the above chart shows we certainly don’t have stable prices.

usd

Stronger dollar, weaker world?

Part of the recent decline in commodities prices has been attributed to recent strength in the US dollar index, which is in its most basic form, a measure of the dollar’s spot value vs. the Euro, Yen and GBP.  There are other currencies in the basket, but none are quite as influential.  In essence, the US dollar currently signals that it is more favored than the Euro, Yen and GBP through its ascent towards 87.

As commodities are priced in dollars, it is expected that some weakness will occur if the US dollar strengthens, especially under the back drop of softening global demand.  But one must also question the utility of the current US dollar index structure — and whether or not such an index is relevant in a world that seems to be increasingly moving away from the dollar as the primary trade currency.

spx

Stocks surged on stimulus. Now what?

With the S&P 500 back above 2,000 and optimism among fund managers back to similarly lofty levels, it may be time to examine the US stock market with a degree of skepticism. There exists a very high probability that we are in a bond and equity bubble that was fomented by the US Federal Reserve system. And traditionally these bubbles deflate when policy makers begin to head for the exits.

With QE3 over, and no immediate sign of further stimulus in sight, as well as the Fed signaling that rates are going higher in 2015, perhaps we are closer to seeing this bull market mature.  After all, it’s been largely driven by liquidity injections and those have since ended.

sp-500-vs-federal-reserve-balance-sheet1

A direct connection: Fed assets and stock prices

The correlation here is uncanny. QE’s various incarnations have an incredibly potent effect on boosting US equity prices to all time highs.  Just about every dollar the Federal Reserve has injected in to the US bond and mortgage market has found its way in to US equity markets directly or indirectly.

Now that QE3 has ended, what policies will be utilized next?  Is the Japanese QE-to-infinity program going to be enough to generate a new carry trade that pops US equities higher?  Or are we finally witnessing the tail end of one of the biggest financialized bubbles in US history?  One that has brought bond yields to the lowest levels in decades whilst simultaneously inflating mortgage-backed securities (lowering interest rates) and equity prices.

treasury

Is this bond bubble ready to bust or is it signaling something worse?

Bond yields are an inverse indicator of the underlying asset price. That is to say, the lower the bond yield, the higher the paper price to buy that bond.  This chart illustrates US Treasury bond bubble in no uncertain terms.  With US government debt exceeding GDP, whilst simultaneously at all time low yields, there is something wrong with this picture.

Typically the higher the debt level, especially as it exceeds the GDP of a country, the worse its debt outlook becomes.  The only exception we’ve seen to this rule has been Japan, which has ‘enjoyed’ a 25 year economic malaise that was culminated by their very own real estate bubble.  The deflationary forces at work there have been keeping bond yields and economic activity pinned down for a quarter century.

Reading the tea leaves of macroeconomic data

Signs seem to be pointing to an intermediate term deflationary bias.  It’s likely that this situation will be greeted by more quantitative easing from central banks of developed countries around the world. Signals include a rocketing dollar, collapsing commodities, the Bank of Japan already engaging in record QE and the weaker EU countries slipping back in to recession or worse.  In addition, China’s miracle growth story seems to be concluding with a not so happy ending.

m2

Velocity of money sinks to lowest level on record

Worse yet, with all of the Fed’s easing and stimulus, the velocity of US money has been collapsing.  This is an indication of economic activity insofar as how fast money is changing hands. Generally during periods of strength the velocity of money will increase.  What we’ve seen since about 2002 has been just the opposite.  A marked decrease in the velocity of money across all measures to the lowest levels ever recorded.

NYSE-margin-debt-SPX-since-1995

Leverage and levitating stock prices

Margin debt on the NYSE (see above chart) is at record highs, and similar leverage is being employed across many equity and bond markets around the world.  That means that the level of debt-based risk taking now exceeds what we saw during previous bull market peaks and as such a reversal in psychology would be even more dangerous to stock prices.

A replay of 2008’s volatile panic selling of various asset classes is quite possible.  The level of complacency and leverage in financial markets is similar to where we were in the fall of 2007 before the financial system began to collapse.

Conclusion

Watch these trends carefully.  Further deterioration of M2 stock velocity, commodity prices and increased dollar strength will signal the increased potential for a renewed deflationary global recession.  If such a situation unwinds, and if equity prices are dragged down in sympathy, then I do believe the Federal Reserve will begin to reinvigorate its stimulus programs and we could see the pendulum swing back towards a more inflationary bias.

What remains a mystery is how the Fed will do so when it already possesses the biggest balance sheet in its history — and has largely failed across many metrics to remedy the economic problems that face the US.  Alternatively, if Bernanke’s Bubble is allowed to burst, the consequences will be catastrophic, not the least of which for the Federal Reserve and its balance sheet.