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.

Gold’s 2015 performance in various currencies (chart)

The Brazilian Real was walloped and the dollar was clearly a standout winner. Gold’s relative underperformance shows against US dollars that the US dollar is still seen as a safe haven currency.

Until that changes gold will underperform as measured by US dollars. I think we’re closer a that point in time when we see positive price action then we were a year ago, but I can’t say for certain if the markets will agree until stocks move in to a bear market.

As seen in the start of 2016, when stocks were out of favor, gold caught a bid and moved higher each day stocks were sold off. Now that stocks are catching a bid, gold is selling off.

Whether or not 2016 is the year that stocks enter a bear market remains in question. I am inclined to think that we have only seen a prelude for the downside in stocks that could occur this year.

S&P 500 may hit 1,000 before it makes a new high

Deflation is in the air. It’s gutting the prices of raw materials, emerging markets, junk bonds and starting to catch up to equities.

It’s going to get ugly

The journey up was fast and fortuitous, without the structural economic improvements that should accompany such a prolific bull market.  And more importantly, with enormous leverage and speculation driving prices.

The mini-panic on August 24, 2015 showed us that the market is capable of wild swings, and likely enormous drops.  In 2008 we saw the stock market lose more than a quarter of its value in days.  This sort of action is not only likely, but I expect it.

Why 1,000? 

This level puts the index back to major area of psychological support and also seems to complete what may be a head and shoulders pattern forming on the S&P 500 back to the base of the left shoulder.

1,000 is a level where the market was before the latter incarnations of QE wildly distorted prices higher. I believe that the beneficial effects of QE were overestimated and that the detrimental effects underestimated.

The gross distortion of prices has destroyed many price signal indicators.Adding to that the lack of interest bearing savings account has forced savers to speculate, hoping for a gain.

spx

Buyback backtrack?

The stock market’s valuation has largely benefited from corporate buybacks.  Now corporations possess an enormous amount of debt.

Additionally, corporations tend to get cold feet as the market is volatile or when prices decline quarter over quarter.  That means less buybacks should occur as fear overtakes greed.

Have some cash set aside

Right now my own inclination is to make a wish list of stocks to own and an idea of what prices make sense to buy them.  Then wait for prices to come to me.

Rather than chasing prices or settling for buying something that may be overvalued I think it makes sense to set cash aside and buy in at lower prices.  In all likelihood they are coming soon.

US stocks reverse gains to close in red

Reversals lower from a morning that began green often portend to more selling pressure in the coming days.  Today was such a day in the US stock market.  Prices opened strongly higher and closed decidedly in the red.

Reversals show a sentiment change

When buyers pile in the morning and exit with prices lower at the close than they were the previous day’s close, that indicates a change in investor confidence.  Selling pressure exhausted the bid from buyers to the point that many buyers became net sellers.  As a result equity markets went from being positive, to neutral and finally settling decidedly negative from the previous day’s close.

When this sort of change in confidence occurs it is often a multi-day or week event, rather than a one off.  With the much cited Federal Reserve interest rate policy decision just about a week away, there is the potential for increased anxiety across multiple interest rate sensitive asset classes, including stocks.

Bears growl, bulls hide

For the first time since the correction of 2011 the markets are not seeing an immediate buy the dip rally that sustains itself to new highs.

Bears are wrestling for control over price direction with bulls.  Each have differing opinions on stock valuations and are expressing them with their trades and investments.  Where prices ultimately go will depend on whose convictions prove to be correct.

For now the bulls are retreating as the bears show their teeth.

Quick thoughts on 2015

This is likely going to be a year of reckoning for overvalued equities and corporate bonds.  The credit markets have already begun their contraction, but equities hold on to the promise of earnings expansion, while only truly achieving multiple expansion.  Stocks are far too rich in price vs. the underlying economic global backdrop.  I expect a significant correction, and I expect it to occur during (or before) Summer.

Thoughts on equity, energy and metals markets

At this point there is some distortion between energy and metals which have a direct relationship as energy must be expended to mine the metals. usually the ratio is 10x the price of a barrel of oil for an ounce of gold, but now it’s been in a range of 12.5x-15x.

Either oil is very undervalued (which is unlikely) or gold is overbought at these levels.

Today’s close of the stock markets and oil seems to indicative of a risk repricing that began last week.

960 (around the 50 day moving average) on the S&P 500 and $65 a barrel on light sweet crude are my downside targets short term, but if either breaks we could trade to much lower support levels.

In addition, when examining the huge sell off in natural gas prices, it’s near certain that energy has more negative catalysts than positive because industrial utilization continues to lag despite the green shoots propaganda that we keep hearing.

Finally, there are a growing number of bears calling for a shake out of March’s lows coming this fall because of a new leg down in commercial real estate that will bleed liquidity out of the equity markets and REITs.