Category: rationalizations

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.





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

Latest fad: buy the dip

Now that the S&P 500 has had all of a 3.4% correction, rationalizations for dip buying are coming out of the woodwork.  E.g., the latest headline from Yahoo Finance: “Fear not. The VIX is flashing a buy sign.”  Seriously?

VIX - 140805


There are better indicators of bullishness:

Rydex bear fund assets


“Spikes in the VIX tend to indicate heightened investor fear,” said Ari Wald, head of technical analysis at Oppenheimer. “From a contrarian standpoint we use that as ‘buy’ signals, and the numbers agree.”

We wholeheartedly disagree.  Investment professionals have adopted the Orwellian logic that up is down, black is white, stimulus is sustainable, and bravado is fear.  The true contrarian position is to raise cash, get short, and fasten the seat belt.

Addendum: Recent quotes from some of our favorite talking heads:

This is not a weak economy, it’s a pleasantly strong economy.  This is a nicely strengthening economy.  This is a very well demeanored economy.  It’s not an excited one.  It’s one that’s doing quietly better…  Let’s all be calm and not be panicked at this point.  I turned from being quite bullish of stocks to being neutral early last week and I have to tell you, I never thought we’d see the market fall several hundred Dow points in the course of three or four days.  I got very lucky, and I’m going to turn back to being bullish again.

~ Dennis Gartman, as appeared on CNBC, August 4, 2014

Tony Dwyer


Where are the ominous headlines?

Biotech Index - 140413


The momentum stock bubble burst last week, with highflying stocks showing significant declines from their February/March highs:

  • brokerage stocks: -10.8% (high set on March 20)
  • housing stocks: -9.4% (February 27)
  • Internet stocks: -17.1% (March 4)
  • biotechnology stocks: -21.1% (February 25)
  • Tesla Motors: -20.0% (March 4)
  • Netflix: -28.2% (March 4)
  • Twitter: -45.4% (December 26)
  • 3D Systems: -50.1% (January 3)

Yet a brief scanning of the financial headlines shows little concern:

  • – “Stocks fall as volume rises, but here’s why not to worry”
  • The Wall Street Journal – “Stock-Market Jitters Put Investors at Ease; Recent Turbulence Is Seen as a Healthy Sign”
  • CNBC – “Last week’s big selloff ‘probably over': Pro”
  • – “Don’t let these stock market gyrations scare you; It’s likely that we’ve seen the end of recent declines”

The common theme among pundits is that the momentum bust is isolated, contained, healthy, and even predictable.  CNBC quoted Jonathan Golub, chief U.S. market strategist at RBC Capital:

“I think the selloff is probably over.  If you look at the economically sensitive stuff in the market, it’s not really selling off. It’s tech. It’s bio-tech [which makes up about 10 percent of the market.]  The other 85 to 90 percent is in perfectly fine shape.

This weekend Barron’s patted itself on the back for predicting the tech bust several months ago:

In November, when pundits began to natter about a stock market bubble, we pointed out in a prescient cover story that it was a tech bubble, not a market bubble.  Our advice has paid off handsomely.

Barron’s quoted perma-bull Jim Paulsen, chief investment strategist at Wells Capital Management:

My guess here is that we’re having a valuation adjustment in one small part of the market, in the highflying momentum stocks that got ahead of themselves and are now correcting.  I think this is more of a buying opportunity.

The article concluded:

All this suggests that despite some ominous headlines, the stock market’s health is still good. [emphasis added]

Where are the ominous headlines?  We don’t see any.  We see complacency as far as the eye can see with the assuredness that the momentum stock bust is “contained.”  We heard these same words in April, 2000 after the dot-com bust and March, 2007 after the subprime bust… early warning signs that were overwhelmingly ignored.



Bullish rationalizations from a Wall Street market strategist

'Bear Market Checklist' Goes a Perfect 0-for-6

According to CNBC staff writer Jeff Cox, Morgan Stanley chief investment strategist David Darst is “a realist – cautious but not cowering, optimistic but not overzealous.”  Says Darst:

“The market’s running.  When cookies are passed, grab the cookies and realize they may not come back around again, and it’s not always going to be thus…  Nobody is buying stocks, and they will someday.  There will be a coil-spring reaction.”

Apparently, such commentary passes for restraint these days.  Further, Darst maintains a bear market checklist:

  1. Is the Federal Reserve tightening monetary policy?
  2. Are stock price valuations stretched?
  3. Is investor euphoria present?
  4. Are bond spreads widening?
  5. Is there a recession looming?
  6. Are transportation stocks, small caps and bank stocks retreating?

“Right now we are 0-for-6 in the bear market checklist.”

In addition to the ubiquitous complacency after a 4-year 140% rise in stock prices, what caught our eye is rationale #3 to which Cox added his own journalistic license:

“In spite of the seemingly easy path to more gains for the stock market, which is up the more than 20 percent from its last low required for a technical bull market, there is still plenty of fear in the market…  This year has seen the first consistent inflows in stock-based mutual funds since the financial crisis began, but investors are still cautious and pouring just as much cash into bond funds.”

Fear?  Let’s go down our abridged investor sentiment checklist:

  1. Rydex bear fund assets: 16.9% of bull + bear fund assets (93rd percentile of bullishness)
  2. Rydex money market fund assets:  19.9% of bull + sector fund assets (97th percentile)
  3. 3-month VIX contract: 16.45 (80th percentile)
  4. Equity fund cash levels: 3.7% (73rd percentile)
  5. MMF assets: 17.2% of mutual fund + ETF assets (record low, 99th percentile)
  6. Investors Intelligence poll: 19.8% bears (87th percentile)

Incidentally, I am not just cherry picking statistics to make my case.  These all have proven long term track records as contrary indicators.  Such an analysis is admittedly quantitative and never perfect.  For a qualitative view on sentiment, simply turn on CNBC.  95% of the pundits are bullish, many of whom justify their optimism because they sense “fear” amongst investors.  This is quite delusional behavior, classic of manias – what I refer to as the “double contrary.”

They’re back!

Don’t look now, but those masters of the universe who arrogantly whistled past the greatest credit bubble and bust in history are again gracing the covers of popular business magazines. For example, the October 12 issue of Barron’s featured none other than Bill Miller “riding high again as one of America’s top fund managers.” Yes this is the same Miller who beat the S&P 500 15 years running, was named “Fund Manager of the Decade” by in 1999, and anointed “greatest money manager of our time” by Fortune in November, 2006.

To say Bill Miller didn’t see the financial train wreck of 2007-2008 coming is an epic understatement. For the 18-month period ended this March, his Legg Mason Value Trust lost 72%, wiping out a decade of gains. When the first subprime cracks appeared in March, 2007 he thought Countrywide Financial would be a long-term beneficiary. When the Fed began easing August 17, 2007 he chose not to fight the Fed:

“We bought financials after the Fed [first] injected liquidity. That’s what you do in a liquidity crisis… This turned out to be a collateral-driven crisis caused by underperforming debt… We’ve analyzed that mistake and tried to make adjustments to risk management and the portfolio-construction process.”

Besides Countrywide, his fund’s investors were buried in Bear Stearns, Lehman Holdings, Fannie Mae, and Freddie Mac. He even had the audacity to blame the government for his mistakes:

“Lehman was investment-grade Friday and worthless short-term paper on Monday,” Sept. 15, 2008, Miller notes. Miller blames the feds for the Lehman debacle, saying their “pre-emptive seizure” of Fannie Mae, another ill-fated Value Trust position, and Freddie Mac caused the other financial dominoes to fall. “It was a gratuitous wiping out of equity capital,” says Miller, referring to the preferred shares issued by the mortgage giants as their troubles grew. The government, he adds, “told them to sell capital.” He bought the stock because they both met capital requirements and Fannie had been bailed out once before. “I expected forbearance like in the early 1980s, but they didn’t do it this time.”

Like at least 90% of those in the investment industry, Bill Miller expects – no, demands – that government to step in and backstop his risk taking. When the feds are powerless to do so and overwhelmed by market forces, he whines like a baby. When he rides a wave of artificial stimulus (Value Trust is +37% year-to-date) he attributes his oversized gains solely to his guts and acumen.

What does Miller like now? More than 25% of his portfolio was in financials as of June 30, 2009 and positions included State Street, NYSE Euronext, and Goldman Sachs.

Bear markets do not end until behavior changes and the necessary lessons are taught. By all appearances, this process has been subverted by trillions of dollars in bailouts, stimulus, credit backstops, and injections of liquidity. Old habits die hard…, i.e., the secular bear is still a cub.

More kind words for the U.S. dollar

We feel too many people are leaning the wrong way with the dollar. Mr. Market is set up to drive the most people crazy. If so, the scenario that drives the most people into a padded cell is inflation in the things they buy and deflation in the things they own on margin (although goods inflation and asset deflation could be relative). A credit crunch would bring this about and the knee-jerk reaction would be to get liquid, i.e. raise dollars.

Year-to-date, the vast majority of mutual fund flows are going into global funds, the Bullish Consensus on the dollar index is at 19%, Canadians are coming over the border to buy cheap American goods, and dollar bears like Peter Schiff are strutting around like peacocks. Though there is plenty of froth in the U.S. equity market, the real froth is in emerging markets (especially China). We think the idea that global markets escape the U.S. storm for the first time in modern history is pure fantasy, particularly with their best customer – the U.S. consumer – going into a coma. A good old fashioned contagion would squeeze out these excesses, returning the dollar to its original safe haven status, at least for awhile. Finally, the latest Grant’s shows Federal Reserve Bank credit growing at a 2.3% annual rate in the last 3 months and 3.6% in the past year. Meanwhile, European Central Bank assets grew at a 21.0% rate in the last 3 months and 12.3% in the past year. Why the ECB’s rapidly inflating fiat currency is head and shoulders above the American brand is beyond us, yet the vast majority of investors remain convinced.

The exception to being bearish on foreign currencies is clearly the Japanese yen (Bullish Consensus = 49%). 2-year government paper in Japan yields a miniscule 1.32%, not exactly a haven for investors. In fact, by some estimates, speculators have borrowed upwards of $1 trillion in the yield-challenged yen to lever up into higher yielding currencies like the Euro (93% BC), British pound (89%), Canadian dollar (93%), Aussie dollar, and New Zealand dollar. If, in fact, the great unwind is underway, this massive carry trade will largely liquidate itself to the yen’s advantage. Bank of Japan assets have actually contracted 4.5% over the past 12 months, although the BoJ has exanded its balance sheet at a 36.0% annual clip the last 3 months.

Over the weekend, the G-7 meeting failed to produce any political support for the dollar. Yet, after an initial drop, the dollar is rallying – perhaps a sign that the dollar pessimists have largely exhausted themselves.

Goldman’s secret sauce?

The October 5 issue of Grant’s Interest Rate Observer had this interesting tidbit about Goldman Sachs, et al.:

How is it, Jim Chanos had asked, that the big broker-dealers can show consistently high returns on equity when their own star alumni, once transplanted at hedge funds, so often struggle to earn a half or a third of what their alma maters manage to produce, “no matter how leveraged they are or what bets they have on?”

There seems to be a remarkable difference between the public and private sides of Goldman Sachs. Very bright people work in both, yet the results of the former are mediocre while the latter are stellar, bordering on statistically improbable. Is it possible that their secret sauce is friends in high places and an opacity that allows them to trade on inside information? And does the SEC enforcement of insider trading laws for the rest of us give them a further unfair advantage?

If our hypothesis is correct, Goldman’s private investment/trading strategy amounts to “don’t fight the Fed” with the advantage of knowing the Fed’s next move(s). Such a strategy worked to maximum benefit in August and September. It will become less effective as the credit drug wears off. In fact, during a bursting bubble (a likely scenario) the best strategy is “fight the Fed.” In that event, Goldman’s goose would be cooked, regardless of how many friends it has in high places. Echoes of Enron?

Going going gone

Shoppertrak has issued the following warning to its clients (Note: Shoppertrak permits reprinting with acknowledgement of themselves and their “National Retail Sales Estimate” as the source):

Following an eight-month trend of slumping total U.S. retail foot traffic so far in 2007, ShopperTrak RCT, provider of the National Retail Sales Estimate (NRSE) and ShopperTrak Retail Traffic Index (SRTI), is advising retailers that this trend could indicate that an industry-wide drop in sales will follow in the near future.

While retail sales have remained positive, posting a year-over-year increase in 33 out of a possible 36 weeks in 2007, total U.S. foot traffic has slumped seven of eight months so far throughout the year:

January -4.0
February -5.0
March +2.9 [due to an early Easter]
April -13.0
May -3.9
June -3.7
July -6.2
August -1.7

This downward traffic trend represents the lengthiest ShopperTrak has seen since the company began collecting traffic data nearly ten years ago.“Historically, … after a sustained period of time, retail sales ultimately can begin to reflect the traffic decline like the one we’ve been monitoring throughout 2007, which suggests retailers could experience an industry-wide dip in sales in the coming months.”

Martin continued: “… we could see retail sales declining as early as the first quarter of 2008….”
Martin clarified that this trend does not indicate gloom and doom for upcoming holiday shopping season.

“We anticipate that purpose shopping will remain reasonably strong during the holidays, just as it has during the recent back-to-school and Easter shopping seasons,” he said.

My comments: It appears Goldilocks has unexpectedly caught the flu. Someone please inform Larry Kudlow.

Study says don’t fight the Fed

Last Friday, John Waggoner, in a USA Today article, “Rate cut could skew investing path toward stocks, gold,” re-hashed the nearly universally accepted wisdom “don’t fight the Fed.”

Credit expansion, the opposite of a crunch, is good for stocks. When the Federal Reserve pumps money into the financial system, it makes more money available to lend, driving rates down. Lower interest rates stimulate the economy, lower companies’ cost of borrowing and make stocks look more attractive in comparison with bonds and bank CDs.

Waggoner cited a study by a group that represents certified financial analysts:

A recent study by the CFA Institute found that tweaking your investments according to the Fed’s monetary policy can be highly beneficial. The stock market averaged a 12% annual return from 1973 through 2005. When the Fed has pursued an expansive monetary policy and lowered short-term interest rates, the stock market gained an average 17.41% a year. When the Fed was raising rates, the stock market gained an average of only 5.34% a year.

The other lesson, buy cyclicals:

You could have substantially improved your record by investing in the correct sectors. Analysts have long divided the market into cyclical stocks and non-cyclical stocks. Cyclical stocks fare well during an economic expansion. Non-cyclical stocks, such as health care, tend to hold up well when the economy is faltering.

The study found that cyclical stocks gained an average of 20.27% a year when the Fed was lowering interest rates. When the Fed raised interest rates, cyclical stocks gained just 2.25%.

My comments:

  1. Long cyclical stocks (materials, tech, industrials, energy) is a crowded trade.
  2. After at least 25 years of “successful” crisis intervention, the mainstream financial community is convinced the Fed is omnipotent.
  3. It is not.

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