Don’t Fight The Dow

Those who forget History are fated to relive it, goes the saying.

Financial markets, prone as they are to swings between boom and bust, are a particularly good case.  Reasons for this reach at least as far back as Adam Smith’s “animal spirits”, and probably even further to ancient Mesopotamia and Man’s first go at organized agriculture.  I bet the connection between water flow in the Tigris - Euphrates  rivers and grain productivity soon became obvious to a few smart farmers. Ditto cornering the market.  A few thousand years later, Egyptian bureaucrats kept accurate records of the Nile’s seasonal ups and downs.

                                      The Palermo Stone, Egypt circa 25th Century BCE

Fast forward to the Fed as keeper of the floodgates.  The chart below shows Fed Funds rates and recessions (shaded grey).

Every time the Fed starts tightening from a seminal low stocks drop and a recession follows.  It’s not rocket science: interest rates are simply the price of money and as it goes up the marginal demand for investment goes down. Hence, Don’t Fight The Fed.

Presidents absolutely hate to be caught in the middle of a tightening cycle because they, at least, never forget that people vote with their wallets and Mr. Trump is no exception (except that his mouth and Twitter run faster than his common sense).

Ok, nothing new in all of the above, of course.  Or.... is there?

In my opinion, there is. Rates bottomed out at 0%, an unprecedented low in history, and the Fed has ALREADY raised rates 9 times, succeeding - as it always ultimately does - in abating the market’s animal spirits.  After the worst December since the Great Depression, IN JUST ONE MONTH!, stock indexes are now officially in bear market territory.  Never mind Mr. Trump’s rantings, the Fed cannot but take heed of the direct connection between markets and the “real” economy, a connection that has only become stronger and more direct in the last 30-40 years.

In other words, yes, don’t fight the Fed - but the Fed increasingly understands (I hope) that it cannot and should not fight the Dow.  As I have put it in several older posts, the tail (markets) wag the dog (the economy).

The Grinch That Stole Christmas

Merry Christmas everyone... except if you are long stocks in which case Santa most certainly put a lump of coal in your stocking making it the worst December in a very long time.

So, who is to blame? According to Mr. Trump, the Fed Chairman is guilty of “not understanding markets” and would love to boot him out as he did with more than a dozen other top officials in his administration. Needless to say, I strongly disagree; the Fed’s independence is crucial if the dollar is to remain the global reserve currency. Nevertheless, yes, the Fed is probably raising rates a bit too fast given the health of the global economy, which is not quite robust (Europe is struggling and China is ramping down its growth).

Then again, with US equity markets previously showing every sign of “irrational exuberance”, it was the Fed’s duty to take away the punch bowl before the prom turned ugly. Let’s not kid ourselves: rates were raised mainly to bring down stocks and cool rampant speculation, not because of higher inflation concerns. Given that Mr. Trump’s sole presidential claim to fame was measured by the Dow, his anger is understandable.

So, yes, Mr. Powell is the Grinch. Then again, this is precisely what he should be doing.

                                                 The Donald And The Grinch

It’s Just Too Perfect...

Technical chart analysis can often produce useful insights.  Patterns such as Head and Shoulders are considered powerful predictive tools by technical gurus.

The following chart of S&P 500 exhibits a picture-perfect top Head and Shoulders pattern, confirmed by the lower readings of the Relative Strength index and the sharp breakdown below the “neckline”.

*****Updated Chart*****


A technical analyst would have little to argue with such a pattern and would very likely recommend getting out of stocks and/or shorting.

However... it just looks “too perfect” to me. Obviously, I’m not the only one looking at this picture and I bet a lot of the recent extreme bearishness emanating from market analysts is already incorporated in this chart.

So, here’s a lesson I’ve learned in my 35 years in the business: if something looks obvious AND everyone agrees.... it is highly likely to not happen.

******UPDATED DEC. 22.... the breakdown continues below the neckline.  The speed of the decline is the fastest since the 2008 plunge.*****

Stocks vs. Bonds

The chart below from Yardeni Research is one of the most interesting I’ve seen in a long time.

The gap between stock earnings yield (=the inverse of the P/E ratio) and Treasury bond yields is quite wide, meaning that stocks are still significantly more attractive than bonds.BUT.... it also shows how low bond yields are, historically.

That’s why stocks are swooning every time bonds twitch...

Populism, Explained

Yellow Vests are storming the Bastille, Trump is playing to the discontent of the working poor, ditto the Brexiteers, Germans are voting down mainstream parties in record numbers, stocks around the globe are tumbling, ditto commodities.

IMHO they are all connected and explained by the chart below from a World Economic Forum publication.   (https://www.weforum.org/agenda/2016/01/3-charts-that-explain-global-inequality/)

The chart is from an Oxfam report on global inequality:  According to the report, 62 billionaires own the same amount of wealth as 3.5 billion people who make up the poorest half of the world’s population. In a dramatic widening of inequality, this number has fallen from 388 in 2010, and is set to become just a handful of super rich by 2020.

Apart from ethical, societal, etc concerns there is a “technical” story here, one that concerns stocks: the market has become very narrow, fewer people own a larger proportion of shares.  This means that volatility goes up and, inevitably, downturns can become crashes as the number of potential buyers is now smaller. Looking at it another way, the ultra wealthy have painted themselves into a corner.

Backpedaling At Tour de France

Faced with massive violent protests in Paris and across France President Macron has been forced to backpedal on his previously announced economic policies. Unfortunately, it’s too little, too late.  Leaders of the popular Yellow Vest uprising (revolt?) have already decided they are not satisfied;  it seems that only Macron’s resignation will do.

But France is only one hotspot of many.

There is a deep malaise in many EU countries: France, Great Britain, Italy, Belgium, Austria, Hungary, Greece, Poland, Slovakia are gripped in some form or another of reactionary populist politics.  The proximate issues may be varied but the root cause is the same: economic underperformance and slipping of living standards for the shrinking middle class.  Macron is the poster boy of a privileged urban yuppie who ignores the plight of the poor citoyens trying to make do in La France Profonde.

It is becoming increasingly clear that the response to the Debt Crisis of 2007-2010 may have saved the financial “system” but it did so at a severe societal price. State bailout costs were passed to the taxpayers, particularly those who were used to a kind, gentle and generous Nanny State. But Nanny’s economy could no longer create the necessary wealth to support them so it started cutting corners.

To use a TdF analogy, cycling downhill makes everyone look like a champ. But once you hit the infamously steep and long cols (climbs) of the French Alps it is only those who train hard that make it. Oh, sure, doping may carry you through for a while but eventually you are either caught or it kills you.  Just like too much debt....

Margin Debt As Percentage Of Wiltshire 5000

From Yardeni Research comes the following chart: margin debt as a percentage of total market value of Wiltshire 5000, the broadest equity  index in the US (data go up to October)

At 2.1% it is (surprisingly) at the lowest level since late 2006, just before the Debt Bubble blew out to great proportions. However, they are at the top end of the Dotcom Bubble.

Despite my blog’s title, these days I don’t see debt as a serious threat to markets.  Instead, I’m really worried about ugly populist politics around the world.

More on another post.

May You Live In Interesting Times

The post’s title is a well known Chinese curse.  For financial markets, the equivalent (and ambivalent) saying is “May you trade in volatile markets”. Remember, it’s a curse not a blessing.

Long term equity investors hate excitement and love to be bored. They buy, they hold, they prosper. For them "interesting" is synonymous with fundamentals and value;  their heroes are Graham, Dodd and - above all - Buffett.

Traders, on the other hand, love excitement - known as volatility in markets. They buy, they sell, they short, they cover, they scalp. For them "interesting" is the equivalent of precipitous declines followed by massive rallies, preferably within the same day.  Their heroes are the anonymous designers of black boxes and whoever can get their network nodes as close as possible to the exchanges' transaction mainframes.

Up until the start of 2018 US markets were "boring" in the sense that buy and hold, the trend is your friend type of strategies worked best.  Score one for Buffett and cohorts.

The rest of the year, however, has been heaven for the practitioners of the Dark Arts.  So much so that it was actually trades on first and second derivative volatility indices (VIX and VVIX) that drove markets into several tailspins (see VIX chart below). Game and set, so far, to the Bad Boys.  The match is still undecided, but it increasingly looks like they will win this one.

VIX - S&P 500 Volatility Index 

Back in 2006 I started this blog because I saw the threats posed by the Debt Bubble and its derivatives which had expanded and permeated the “real” economy to an unprecedented extend, particularly in the real estate sector.  What followed nearly threw the global economy into a new Great Depression, averted only because central banks and governments were willing to employ unconventional weapons in the battle against asset deflation.: Quantitative easing, zero or even negative interest rates, massive bailouts for the financial sector. In some ways we are still relying on them, albeit to a significantly lesser extent than previously.  If nothing else, it is now a commonly held belief that the powers that be will always be there to rescue the system.

I beg to differ.

Oh, bankers and most politicians may wish to repeat the process when the need arises again - and it always does - but I'm not at all sure that they will be allowed to do so.  I interpret the rise of populism and right wing political activism to a strong undercurrent of anger amongst the former middle class, now relegated to "working poor" status.  Basically, they now see financiers and bankers making billions after they were bailed out with public money, while they themselves struggle to make ends meet.

So, another volatility index which is today even more significant than VIX is PAX, i.e. Political Anger index, shown graphically below.... it's from the Yellow Vest turmoil in France, but we are also seeing similar anger simmering just under the surface in Great Britain (Brexit), Italy (Five Stars), Germany (AfD), and of course the USA (Trump).

Interesting times, indeed...

Travails Of A Bond Blogger

What am I supposed to do, huh?

I mean, I am a blogger who specializes in writing about debt. You know, A Merchand Of Venice kind of deal... does “a pound of flesh” ring a bell? As in if you don’t repay your debts WITH INTEREST the lender will have your arm. Maybe your leg, too.

But, in the decade-long aftermath of the Big Dip the world of finance has gone topsy-turvy. You now have to PAY borrowers to lend them money. As in, here, please borrow my money and when you return it I’ll give you MY arm. Crazy stuff.

For example, Germany charges investors -0.589% annually for the (extremely dubious) privilege of holding their money for 2 years. Yup, you give the Germans 100 euro and two years later they give you 98 point something back, all is square. Sort of..

Germany 2-Year Government Bond Yield

Going on a bit longer with the Shakespearean analogy, Bassanio keeps the loot, snags Portia, buys a luxury caravel and they sail off to party in the Bahamas, while poor Shylock goes bankrupt. Moral suasion goes waaaaaay out the window.

Willy would be floundering today, probably penning something like The Playboy Of Venice.

What am I trying to say? That I am confounded, dear reader. I was raised in a world where one pays for the privilege of using something - even fiat money.

Ahhhh... but... when things don’t make any sense it is time to sense that a change is coming.  Just as a change was coming back in 2006-07.

The EU: Beggining Of The End Or End Of The Beginning?

Where to EU?  What started as a lofty and noble idea to establish an enduring  peace in the continent most guilty of global blood letting is turning into a low, cheap and acrimonious scuffle about Polish plumbers and Italian bravado.

Cheap it may be, but the current fight amongst member states is, nevertheless, dangerous.  And the reason is not what the fight is about, but because of what is missing at the very foundation of the EU. To wit, a common fiscal policy mechanism and a common defense structure.

What are the two most important elements of an empire?  A strong global currency and a strong military with global reach.  The EU seemingly has the first, but in the absence of a common fiscal policy structure it actually doesn't, and has zero common military.

Therefore, if the EU is to survive and even thrive it urgently needs:

1. A European Department of Treasury / Ministry of Finance AND
2. A European Army

Just think of Rome without its legions and aurii or the British Empire without a pound sterling and the Royal Navy.