War complacency

With investor complacency already high (65% of the sub-10 VIX readings since 1993 took place in the past 3 months), it should be no surprise that the escalation of tensions with North Korea would be met with a yawn.

At 2:21 PM E.T. yesterday (with the S&P 500 down 0.87% on its way to a 1.45% loss), MarketWatch columnist Mark Hulbert published an article advising investors to remain calm:

If war breaks out with North Korea, we’ll have bigger things to worry about than our portfolios.  But that’s OK, because doing nothing is almost always the best investment strategy during a geopolitical crisis.

That is the clear conclusion to emerge from an analysis conducted by Ned Davis Research of the most momentous geopolitical crises of the last century. The firm found that far more often than not, the stock market, as measured by the Dow Jones Industrial Average strongly rebounds from its post-crisis panic low — so much so that within six months it is actually higher than where it stood before that crisis erupted.

The research report covered 51 events from 1900 to 2014, including the bombing of Pearl Harbor and JFK assassination.  Of note: the average stock market drop during each crisis was 17.5%, so the positive returns came after a fair amount of pain.  With stock valuations broadly at record high valuations, it is not difficult to envision a much larger correction if war breaks out with North Korea.

One problem with these sorts of back tests is that economic and market events can’t be replicated in a lab.  History doesn’t repeat, though it often rhymes.  To unravel this complicated puzzle, let’s look at three variables: valuations, sentiment and economics.  From a valuation standpoint, there is no way to compare past crisis lows to today’s twin asset bubbles in both stocks and bonds (at the lowest yields in 5,000 years of recorded history).

As for sentiment, a bit of history:

  • After WWI there was a sharp but brief depression in 1921.
  • After WWII, economists predicted another depression.  Instead we got a two-decades-long boom.
  • Initially, in the early-1960s there was complacency about the Vietnam conflict.  That eventually ushered in the intractable inflation of the ‘70s, which helped trigger (along with Watergate) the worst bear market in stocks since 1929-32, in real terms, from 1972-74.
  • The Gulf War brought back memories of the quagmire in Vietnam and was widely anticipated.  Stocks sold off in late 1990 as a result.  Operation Desert Storm began mid-January of 1991 and was over in a month.  There was no quagmire.
  • In 2003, the Iraq War was widely predicted to be brief, but it turned into quagmire.  Fortunately for stocks, they were 3 years into a burst tech bubble and prepared for bad news.  An aggressive Fed fomented the housing/credit bubble of the mid-2000s.

The lesson of #4 and #5 was that war – brief or quagmire – leads to bull markets.  Investors constantly fight the last war.  The complacency regarding North Korea is a direct reflection of recent past war experience plus an 8-year bull market where buy-the-dip behavior has been constantly reinforced by central bank asset purchases.

Lastly, let’s take a look at economics.  With the onset of war, we can expect the following to occur:

  1. The war economy is engorged while the real economy (or consumer economy) is drained.  GDP growth is highly misleading during wartime.  The consumer is worse off as resources are siphoned off to be destroyed (see chapter 3 of Henry Hazlitt’s Economics in One Lesson, “The Blessings of Destruction“).
  2. The immense costs of war are paid for through government borrowing and inflation.
  3. Government, aka the public sector parasite, is ratcheted up during war, but doesn’t relinquish all of those gains after the war (see Crisis and Leviathan by Robert Higgs).

Imagine these maladies foisted on an economy struggling to grow (the most anemic recovery post-WWII) and wheezing under record debt levels including $20 trillion of government debt (having doubled the past 8 years), $1.2 trillion in auto loan debt, $539 billion in margin debt, etc.  That debt has remained manageable thanks to miniscule interest rates, but a wartime economy would threaten this state of nirvana.

Moral of the story: act before the crisis.  With stocks and bonds priced for perfection, ignore impending danger at your peril.

Is new ETF to track ETF industry another sign of an ETF bubble?

Burton Malkiel, early influence (along with Eugene Fama) on Vanguard founder and indexing pioneer John Bogle, has been hired to join the investment committee of the Tosoro ETF Industry Index.  This index guides the ETF Industry Exposure & Financial Services ETF (TETF) recently unveiled on June 26th.

Adding irony to the launch, there appear to be flaws with index construction, not uncommon for ETFs.  The companies in Tier A, which make up 50% of the index and have “direct financial impact” from the ETF industry, are equal-weighted.  That means BlackRock (BLK), with a $71 bil market cap, has the same weight (6.25%) as Wisdom Tree Investments (WETF) with a $1.43 bil market cap.

One dirty little secret of the ETF industry is that there is no such thing as a “passive” index.  Otherwise, why the need to hire an investment committee to decide components and weightings?  The timing of a new ETF is another matter, and almost always a backward look on performance and forward look on what will entice investors.  These are not impartial decisions made by machines, but value judgements made by humans.  Value, as any Austrian economist knows, is always subjective.

Canaries in the coal mine

  1. Several debt-fueled roll-ups have unraveled
  2. U.S. middle class consumer under stress
    1. Trump populism a symptom
  3. Creative destruction adding to woes of retailers
  4. State government finances under pressure
    1. Connecticut, Illinois, Kansas
  5. 35-year bond bull market ended a year ago

 

Is Mario Draghi pulling away the punch bowl?

“Draghi hints ECB may start winding down QE,” read the MarketWatch headline this morning:

European Central Bank President Mario Draghi hinted on Tuesday that the ECB might start winding down its large monetary stimulus as the eurozone economy picks up speed, even as he warned against an abrupt end to years of easy money.

The comments, at the ECB’s annual economic-policy conference in Portugal, come as investors watch closely for a sign that the world’s second most powerful central bank is preparing to withdraw controversial policies such as its EUR60 billion ($67.52 billion) a month bond-buying program.

Mr. Draghi said the ECB’s stimulus policies are working and will be gradually withdrawn as the economy accelerates. However, he warned that “any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.”

With the Fed now talking about contracting its balance sheet and the BOJ and ECB doing the heavy lifting, this seems like a big deal, yet equity markets have barely noticed.  The Euro Stoxx index was -0.13% while S&P 500 futures are currently -0.07%.  3-month VIX futures (Oct contract) stand at just 14.25. The eurozone sovereign debt markets are a different matter:

Germany 10-year = -0.56% (0.32% yield-to-maturity)

France 10-year = -0.59% (0.69% ytm)

Italy 10-year = -0.80% (1.98% ytm)

“Today Draghi moved his first step towards indicating that ECB monetary policy will become less [stimulative] in 2018,” said Marco Valli, an economist with UniCredit in Milan.

Mr. Valli said the ECB might reduce its monthly bond purchases to EUR40 billion in the first half of next year, followed by a further reduction to EUR20 billion per month in the second half of the year. That would be a slower pace of stimulus reduction than many analysts had been expecting.

Keep in mind, the ECB and Bank of Japan have been doing the heavy lifting as year-over-year growth in total assets shows:

Fed = 0%

ECB = +36.7%

BOJ = +20.0%

The bond markets are starting to pay attention (though still wildly delusional). Perhaps the equity markets should as well.

Traders buy the dip as Trumphoria begins to fade

There were two headlines about bearish sentiment on CNBC and Yahoo Finance this week that were classic.  CNBC claimed the fear gauge was “breaking out.”  Yet the VIX still shows plenty of bullishness (62nd percentile 10-year reading).  I pay little attention to the VIX: it’s mostly noise.  Far more important are the VIX futures 3 months and out.  The 3-month VIX closed the week at a 95th bullishness percentile.

 

Earlier in the week, this Yahoo Finance headline read: “By one measure, investors have almost never been this nervous about stocks.”  Reading the fine print, their methodology is flawed, even admitting that the cost of downside protection is cheap.  Delusional!

 

Buy-the-dip is so ingrained by 8 years of bull market behavior, hardly anyone sees any downside.  The crowd is rationalizing their behavior with talk of “fear” and “cash on the sidelines.”  All nonsense, of course.  This week assets in Rydex MMF dropped 13% to an all-time low $457 mil.

 

This all took place while the averages were breaking down with financials leading the way (XLF -2.63%).  On Fast Money at Thursday’s close, the fast monkeys were all foaming at the mouth to buy bank stocks!

Market timers remain all-in.  The NAAIM Exposure Index jumped 19% to 86.7%.  Among assets in Rydex bull and bear funds, just 7.6% are positioned for the downside, weighted for leverage.

 

I realize we shouldn’t get overly infatuated with market timing, but this “what, me worry?” behavior struck me as noteworthy.  So far, at least, this is very different from the breaks in August 2015 and January 2016 in which Rydex MMF balances and 3-month VIX futures spiked.

The bear crying wolf

A perennially bearish hedge fund manager with an Austrian economics bent recently appeared as a guest on the Tom Woods Show.  Tom Woods opened the discussion with:

What do you say to somebody who says, “The trouble with you Austrian-influenced financial guys is that you’re always bearish, so of course you’re going to be right when things go wrong.  Why should I listen to you now?”

Great question.  Are we Austrians eventually right, but always early?  Is this one “big, fat, ugly bubble” that, when it bursts, will vindicate all of us?  Are we just flat wrong?  Is Austrian Business Cycle Theory (ABCT) out of touch with reality?  Or are we stopped clocks, right twice a day, but miss out on a lot of opportunities the rest of the time?

For the full article by Kevin Duffy, see here.

Predictions for 2017

Those who have knowledge don’t predict. Those who predict don’t have knowledge.” ~ Lao Tzu, 6th century BC poet and father of Taoism

It appears Lao Tzu anticipated the accuracy of our 2016 predictions twenty seven centuries ago.  While we got a few right (rebound in gold mining and Brazilian stocks, the demise of Valeant Pharmaceuticals, and 50/50 chance Trump would be the next president), we got plenty wrong, most notably a 25% bear market in stocks.

Bloodied, but unbowed, here is our short list for 2017:

1) The Trump honeymoon is short-lived, doomed by absurdly high expectations, faulty economics and political expediency.

– positives: Sanctions against Russia end as the Cold War thaws.  Regulations are cut, especially in the energy sector.  U.S. corporate tax rate is cut to 25%, bringing it more in line globally.

– negatives: Obamacare is not repealed, but instead replaced with a watered down version, dubbed “Trump Care.”  The debt ceiling is raised in March and federal spending continues to grow unchecked, even adjusted for inflation and population growth.  Trade tensions increase.  Common Core is not repealed.

2) Global economy officially enters recession.  China, the Euro Zone and U.S. all join the fray.

3) Global backlash against the political establishment continues.  Populist parties do especially well in Europe.  French, German and Italian bonds suffer.  Heading into 2018, a breakup of the EU looks like a serious possibility.

4) Most global equity markets enter bear market territory.  The S&P 500 ends the year down over 20% (below 1800).

– worst performers: financials (global banks, investment banks, auto finance, bond insurers), REITs (retail and office), technology, industrials, Chinese financials

– best performers: discount retailing (Wal-Mart, Dollar Tree), food-related, fertilizer, genomic sequencing (Illumina), cancer drugs (Bristol Myers)

5) Inflation begins to become a concern.  Gold and gold mining stocks do very well.

6) U.S. dollar peaks, losing ground to the Swiss franc, euro, British pound and Japanese yen.

7) China cracks widen.  Bonds extend losses.  Equities fall over 20%.  Yuan experiences at least one official devaluation, even though the Chinese sell over $200 billion in U.S. Treasuries to shore up their currency.  Trump cries fowl, labeling China a “currency manipulator.”

8) Official U.S. deficit for fiscal year ended 6/30/17 exceeds $600 billion.  Talk of future trillion dollar deficits becomes more commonplace.

9) Active investing makes a comeback.  BlackRock is a notable underperformer.

10) Global free market reforms are a mixed bag.  Brazil makes progress, India regresses.

Fedaphobia…

Fedaphobia

[fed-uhfoh-bee-uh]

noun

1.  fear of irrational Fed easing doing irreparable harm to a rational short selling strategy

A central banker fesses up (almost)

William White, the Swiss-based chairman of the OECD’s review committee and former chief economist of the Bank for International Settlements (the central banker’s central bank), recently made some frank statements about future debt defaults from Davos, reported here by Ambrose Evans-Pritchard.  We parsed his comments and responded with a few of our own:

“The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up,” said William White.

Their ammo is used up.  That may be a good thing since all the central bankers can do with their interventions is cause mischief.  That won’t prevent them from trying.

“Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief,” he said.

“It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something,” he told The Telegraph on the eve of the World Economic Forum in Davos.

All enabled by Central Bankers Gone Wild.  Since 2007 the Fed’s balance sheet quintupled.  The rest of the world’s central bankers followed suit.  The debt followed: cause and effect.

 “The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly. Debt jubilees have been going on for 5,000 years, as far back as the Sumerians.”

It will be disorderly and there is nothing the central bankers can do to stop it.  Year-to-date action in financial markets has been very orderly.  That will change.

The next task awaiting the global authorities is how to manage debt write-offs – and therefore a massive reordering of winners and losers in society – without setting off a political storm.

No!!!  The next task should be to shut down the entire central banking operation.  I guess we’re going to have to endure even more pain as the central banks compound their mistakes… once again.

Mr. White said Europe’s creditors are likely to face some of the biggest haircuts. European banks have already admitted to $1 trillion of non-performing loans: they are heavily exposed to emerging markets and are almost certainly rolling over further bad debts that have never been disclosed.

We agree.  Deutsche Bank is this cycle’s Lehman Brothers.  We are heavily short.

The European banking system may have to be recapitalized on a scale yet unimagined, and new “bail-in” rules mean that any deposit holder above the guarantee of €100,000 will have to help pay for it.

Get ready.  The euro zone is headed down the bailouts-for-banks path.

The warnings have special resonance since Mr. White was one of the very few voices in the central banking fraternity who stated loudly and clearly between 2005 and 2008 that Western finance was riding for a fall, and that the global economy was susceptible to a violent crisis.

What a telling quote!  Correct, these guys do not see around corners.  Nearly all of them failed to anticipate the 2008 meltdown.  Even when the subprime cracks appeared, nearly all thought the cancer was contained.  It wasn’t just 2008.  Interventionist economists missed the 1929 crash and 1970s inflation, failed to identify the 1989 Japan bubble and 2000 tech bubble, and thought the Soviet economy was exemplary before it collapsed in the late 1980s.

Mr. White said stimulus from quantitative easing and zero rates by the big central banks after the Lehman crisis leaked out across east Asia and emerging markets, stoking credit bubbles and a surge in dollar borrowing that was hard to control in a world of free capital flows.

The result is that these countries have now been drawn into the morass as well. Combined public and private debt has surged to all-time highs to 185pc of GDP in emerging markets and to 265pc of GDP in the OECD club, both up by 35 percentage points since the top of the last credit cycle in 2007.

“Emerging markets were part of the solution after the Lehman crisis. Now they are part of the problem too,” Mr. White said.

Spot on.  My jaw is on the floor.  I can’t believe any central banker would admit how much they screwed things up by trying to prop up the financial system in 2008.

Mr. White said QE and easy money policies by the US Federal Reserve and its peers have had the effect of bringing spending forward from the future in what is known as “inter-temporal smoothing”. It becomes a toxic addiction over time and ultimately loses traction. In the end, the future catches up with you. “By definition, this means you cannot spend the money tomorrow,” he said.

True statement.  There is a reason people defer spending: so they can invest today and have more in the future.  Central bank suppressing of interest rates breaks the regulator on this behavior, encouraging more spending today.  People are under the illusion that they can have their cake and eat it, too.  Unfortunately, there are no free lunches in economics.

A reflex of “asymmetry” began when the Fed injected too much stimulus to prevent a purge after the 1987 crash. The authorities have since allowed each boom to run its course – thinking they could safely clean up later – while responding to each shock with alacrity. The BIS critique is that this has led to a perpetual easing bias, with interest rates falling ever further below their “Wicksellian natural rate” with each credit cycle.

This is central-banker-speak for “moral hazard.”  Thank you very much Alan Greenspan for inventing the “Plunge Protection Team.”  Also, thanks to Robert Rubin, nicknamed “Mr. Bailout” (for good reason).

“Responding to each shock with alacrity?”  This is an understatement.  With each crisis the response has been exponentially greater.  The 2008 variant saw global central bank balance sheets probably go up 3-4 times and interest rates taken to zero for 8 years!

 The error was compounded in the 1990s when China and eastern Europe suddenly joined the global economy, flooding the world with cheap exports in a “positive supply shock”. Falling prices of manufactured goods masked the rampant asset inflation that was building up. “Policy makers were seduced into inaction by a set of comforting beliefs, all of which we now see were false. They believed that if inflation was under control, all was well,” he said.

This is a muddled statement, but revealing.  China joined the world economy in the 1990s, an unmitigated positive.  And yes, this extra supply masked underlying inflation.  But who caused that inflation?  Central bankers, of course.  Were they “seduced into inaction?”  Well, not exactly.  They were doing what they normally do: suppressing interests below the market level.  They should have gone to inaction: let interest rates rise to their natural level.  The revealing part of this statement is that central bankers are always fighting the bogeyman of deflation.  This is dangerous and what always give them an excuse to meddle.  Btw, if we’re going into debt defaults and asset declines, central bankers will have plenty of excuses to “fight deflation.”

Btw, a similar mistake was made in the mid to late 1920s when the Fed tried to “stabilize the price level.”  With electrification, new inventions and productivity gains, consumer prices should have gone down.  However, the Fed would not tolerate the dreaded “deflation” so they printed money.  Consumer prices were strangely (and unnaturally) flat during the second half of the 1920s.  In retrospect, most of the Fed’s inflation went into asset prices, blowing a great bubble.  This didn’t end well, if my recollection of history is correct.

 In retrospect, central banks should have let the benign deflation of this (temporary) phase of globalisation run its course. By stoking debt bubbles, they have instead incubated what may prove to be a more malign variant, a classic 1930s-style “Fisherite” debt-deflation.

Correct.  I doubt they’ve learned the lesson.

Mr. White said the Fed is now in a horrible quandary as it tries to extract itself from QE and right the ship again. “It is a debt trap. Things are so bad that there is no right answer. If they raise rates it’ll be nasty. If they don’t raise rates, it just makes matters worse,” he said.

Checkmate.  The best they can do is shut down the operation and do something productive, like work as greeters for Wal-Mart.

 There is no easy way out of this tangle. But Mr. White said it would be a good start for governments to stop depending on central banks to do their dirty work. They should return to fiscal primacy – call it Keynesian, if you wish – and launch an investment blitz on infrastructure that pays for itself through higher growth.

Bad idea!!!  More government “stimulus” can only make matters worse. If Mr. White is so concerned about high debt levels, why is he encouraging even more government debt?

 “It was always dangerous to rely on central banks to sort out a solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and now we are hitting the limit,” he said.

No, all they can do is wreak havoc.

Predictions for 2016

“It’s OK to forecast the end of the world, but don’t ever give a date.” ~ Burton S. Blumert, 1929-2009

 

With that sage advice as a caveat, our thoughts on how 2016 might play out:

1) Global economy will be in full blown recession by the end of the year.  China leads the way, but the Euro Zone and U.S. not far behind.

2) Global equity bubble bursts, with the S&P 500 down over 25%.

– Worst performers: financials (global banks, auto finance, asset managers like BlackRock), technology (including highflying “FANGs”), REITs (especially those with exposure to shopping malls and NYC real estate), health care (heavily leveraged serial acquirers like Valeant, pharma companies with dubious patent protection, health insurers gaming Medicare), Chinese financials and real estate-related

– Best performers: Wal-Mart, food-related, fertilizer, defensive/consumer staples stocks in beaten down markets like Brazil

3) Euro zone bonds decline (yields rise), reflecting too much debt and too weak economies to service that debt.  German, Italian, French, Spanish bonds all decline.

4) U.S. dollar peaks

– Japanese yen surprise winner as speculative carry trades unwind; Swiss franc reemerges as safe haven – Gold holds up well and gold mining stocks outperform as costs decline (but sticking to high quality companies and royalty companies that control their owns destinies and don’t depend on rising gold prices); platinum and silver also do relatively well

5) A Republican wins the 2016 election as Dem experiment of last 8 years is discredited (50-50 chance it’s Trump).

6) Optimism and dip buying remain intact; Jim Cramer still working for CNBC; no more than 1 or 2 short selling hedge funds are launched.  Denial is still the order of the day.

7) Fed raises rates no more than 2 more times, then does an about-face.  The world’s central bankers begin to lose credibility and swagger (though still early in the process – no “Wizard of Oz moment” yet).  (Yellen & Co. may not even raise at all.)

8) Biggest winners in 2016: short sellers (though they are still treated by the mainstream financial press like pariahs).

Happy New Year, everyone!

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