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.

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.

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.

Has gold finally bottomed?

Let me start by saying I think it’s hard for anyone to call a bottom.  Many experts do, and often they do so with the guidance of charts, fundamental analysis and other informed speculation.  I am no expert, but I do think we’re finally seeing a turn in the precious metals markets based on two critical factors.

The US dollar and gold have rallied together as of late.  This doesn’t often happen, especially at multi-year highs in the dollar.  But it has for the past couple of days.  And during very large US dollar rallies.  As you can see in the chart below, for the past six months when the US dollar rallied, gold and silver were sold.

US dollar chart

This is a convincing indication that the precious metals markets are looking beyond the myopic view of the US dollar index (which really only measures the Euro and Yen weakness/strength vs. the US dollar) and seeing that rising risks demand a safe haven.  It may also indicate that the US dollar rally is beginning to lose its luster.

We also saw that the tax loss selling last year did not push gold and silver to new lows, or break down the miners further.  This is a very powerful indication that sentiment bottomed out in the October/November bloodbath that was likely a capitulative event.

I am not ready to say that we are turning right now, but I do think that there is a good chance of it.  In essence, if the precious metals markets can look beyond the dollar, or better yet, the dollar can begin to give back its rally from late 2014, we will be in for a year of renewed strength in precious metals, and their miners.

US dollar short vs long

The US dollar trade is as crowded as a trade can get and so many are short Euros and Yen that any unexpected surprises will roil the forex markets.  But gold and silver are telling us that doesn’t matter.  That they can look beyond forex and see that the risks are strong enough to warrant a significant bid (and most likely short covering — we’ll see the COT tomorrow).

Gold chart (daily)

From a technical standpoint I’d like to see gold trade above $1,260.00 on a sustained rally (closing the week on Friday above that level would be critical).  Ideally this price action would occur by the close of the second week of January, 2015.  After that I believe we’ll see some short covering and less aggressive posturing from the sellers counting on another waterfall capitulation in prices.

If gold can make its way back to $1,400 by the end of the first quarter of 2015, then I do believe we’ll see the momentum chasers come back to the table and start driving prices higher through leveraged speculation.  This may also renew the appetite from Asian buyers for physical bullion as the low prices have turned from a positive to a perceived negative as of late.

Is the rally topping out or just starting?

We’ve seen a significant gain since the bottom in March of 2009, up about 80% since those 666 S&P 500 lows.  Now the market is facing significant resistance, even after the massive $600 billion QE2 plan to inject more liquidity.  The resistance comes both in the US dollar beginning to find trend line support and the S&P 500 showing potential resistance at what could become a double top formation.

First let’s have a look at the long term dollar chart:

US dollar long term chart

It’s clear that the US dollar, despite a large drop in recent months, is beginning to find support at the trend line formed from previous lows. If this trend holds it could bolster the ailing US currency and provide room for not only a short term reversal, but some significant appreciation on the back of Europe’s woes and a correction in the commodity currencies. On the other side, the dollar is seeing significant headwinds towards sustainable appreciation because of the unsustainable forward looking debt load of the US government combined with the massive stimulus and easing programs.

Now let’s have a look at the S&P 500 chart:

We see the potential for a double top formation in the index around 1220. If this level can not be broken to the upside then we have some serious downside potential to contend with in the US stock market. The rally of around 15% over the last two months indicates that many are confident in putting their money in to equities, rather than bonds, and with that a lot of speculative stocks have seen impressive gains. But another side of this rally is that it has largely been supported by extremely loose monetary policy, a “Bernanke put,” is what many are calling it, meaning that there’s no reason to buy protection (or put options) on your investments because the Fed will be there to prop up the market.

This is an inflection point. It has the potential to decide the direction of where many different markets, including currencies, commodities, equities and bonds, will be trading for the next several months ahead. Should the dollar fail its trend line support and the S&P break to the upside of the resistance around 1220 we’ll see a massive rally in other currencies, commodities and equities. If instead we see the dollar hold firm and appreciate against other currencies, reinforcing the trend line support and the S&P breaks down at the aforementioned resistance level then we could see a daunting correction in other currencies, equities and commodities.

All we can do now is watch, wait and act accordingly…

Feeling frothy?

As the rally appears to be running on fumes at this point, I’d like to say that I was a little early saying to sell it before, but one never can trust a bear market rally.  That’s what it still seems like we’re dealing with, too.  The technicals were powerful during the 8 week surge, but we do not yet have a Dow theory buy signal (need a close above 9125) or a break above the 200 day moving average on the S&P 500.  Now the charts are beginning to look more exhausted as the overbought conditions are worked out.  Longer term the trend remains down as we seem to continue with the 10+ year double top formation playing out on the S&P 500.

Banks led the rally up and now they are beginning to give way as fundamentals point to a more pessimistic picture than the prior trading action of their equities might suggest.  While I do feel that the substantive cash injections, ZIRP cheap liquidity and stimulus have filled part of the vacuum left by the implosion of Lehman and the deleveraging process, there is simply too much enthusiasm around when this alleged recovery is due to transpire.

We are quite literally in the midst of a complete reinvention of how the world does business and in that process there likely will be further dislocations and market abberations before settling in to a U or L-shaped recovery — either economic destiny will be determined by the shape of fiscal policy and whether insolvent institutions are infact allowed to fail or continue indefinitely as “zombies”.  Unregulated derivatives markets must be brought in to the light and fully regulated in order to prevent credit default swaps and other leveraged contracts from contributing to widespread system disruptions.

This turning point has been marked by the downfall of the US as the financial capital of the world.  A slow unwinding process that in the decades to come will be much more apparent than it is now.  This is the unfortunate consequence of being the largest debt bearing nation in the world whose currency is quickly losing popularity as reserves for central bankers around the world.  The unraveling is going to degrade the quality of life for Americans and boost domestic inflation considerably.

If nothing can be done to restore confidence by regulating the shadow markets and unraveling the insolvent institutions, then this trying period shall last quite a while.  At this point I don’t feel the actions of the US government or the Federal Reserve have been constructive to that end.  That is why I feel the rally is largely unsustainable and right now we are in a frothy period where short positions in equities and long positions in foreign currencies may be appropriate to consider putting back on the table.

Disclosure: Short US equities, long foreign currencies