Podcast: Play in new window
- Volatility (VIX) Has Largest Move In History 117%!
- Nomura Bank Offers 4 Cents On The Dollar To Those Who Bet On No Volatility
- Sentiment Changes: Once Complacent Investors Now Jumpy And Nervous
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“I say balderdash. The price absolutely matters. The price you pay determines what your ultimate rate of return is, and if you’ve come into the market in a period of time when interest rates are low, inflation is low, valuations are high, you’re locking in long-term losses for your portfolio – that’s what history says, that’s the trouble you have. It’s not stocks for the long run, it’s losses for the long run, if you’re willing to play in this market today.”
– David McAlvany
Kevin: Dave, a couple of days ago on Monday you were on a plane while the stock market was taking, oh, I don’t know, a little over 1,000-point drop, the Volatility Index was going through the roof. It made me remember Alan Greenspan, when the stock market was crashing back in 1987. He wasn’t on the ground, he was in a plane. He only got off the plane afterward and said, “How much did it fall?”
David: (laughs) Exactly how I felt because from Vancouver to Denver things changed materially. We were down 300-400 points when I got on the plane and by the time I checked into the United lounge we were down 1500 points. Then of course we closed the day at 1175 down for the day.
Kevin: If you had stock that you wanted to sell you couldn’t have done it, but if I remember right last week you gave everyone advice while the market was peaking to go ahead and sell.
David: Should have taken my advice last week and closed out your year in January if you’re trading stocks. You had a handsome annual return in the first four weeks. Unfortunately, between Friday and Monday, most of that return is gone.
Kevin: One of the things that we have been lamenting, Dave – one of the beautiful things of the market is volatility. When you can see something go up and down based on people making new decisions as to valuations of things – what is valuable, what is over-valued, what is under-valued? That is a wonderful thing, yet for the last several years you have made the comment that we have virtually no volatility in the market. We have almost a positive sure thing every day. And that removes volatility. That changed Monday while you were on the plane.
David: And we’ve said for some time now that it has been well over a year since we’ve had even a 3% correction, so the volatility, we may say it doesn’t exist. It has just been unidirectional volatility. So people don’t mind volatility as long it is going up, and that trend has certainly been challenged.
Kevin: And the VIX is how it is measured.
David: That’s right. A ratio between puts and calls, the way people are either hoping to benefit from an increase, or hedge their positions using puts, we saw the VIX spike probably the largest percentage move on record, I think about 117% in a day. So the favorite trend of late has been to short volatility on the belief that volatility would basically go to this flat-line state, where there is no volatility, there is only market bliss.
Kevin: Right. But shorting volatility is taking a bet on things staying completely consistent and not rising or falling too dramatically.
David: And there being no need to hedge what you have, and there has been that tremendous complacency in terms of zero hedging in the marketplace. So the popularity of that short volatility trade in this last week – it’s game over for someone. If you recall our discussion of the VIX, at less than 10, I think the low was 8.56 – the 52-week low – and now with highs registered Tuesday early at 50.3, that sets up for a very significant reversal.
Again, you can read the charts, it’s not secret knowledge that we have, but if you read the charts in a way that doesn’t prove what you want to prove, you look at low volatility and one thing that you know, looking back and anticipating the future, low volatility precedes high volatility, high volatility precedes low volatility. There is still some cyclicality in the market. A single-digit read day after day sets you up for a spike, and we hear, lo and behold, we’ve gone from less than 10 to over 50.
Kevin: I want to point out, too, you have brought this up over and over. You have said now that we are less than 10 you can count on a spike, and it may be historic.
David: In the meetings that I have had with a local college here in Durango and the committee that manages the funds for the local college here, the big question on the table last week was this – are we taking enough risk? Because we were under-performing the market. The S&P was up 22% and the funds were up slightly less than that, and the question tabled was, “Are we taking enough risk?” And I said, “In fact, we should be taking risk off of the table. We should be raising cash. We should be increasing a gold position.” By the way, they did liquidate 100% of their gold position, which is roughly 10% of the portfolio, at $1050, about 30% ago they picked the low, and I’m sure they will be back for a gold position at some point, at significantly higher prices.
Kevin: I’m just wondering if there is a reason you are there because they ask your opinion and then they do the opposite.
David: I think I’m supposed to be the tenth man, the person who offers an opinion that is completely unpopular. And at least in that culture the advice is not going to be taken.
Kevin: So they sold gold at the bottom, and they wondered if they should be taking more risk last week right before the 1,000-point drop.
David: That’s exactly right. But I’m not trying to make fun of anybody here, it’s to say that people don’t realize how emotional they are and how tied to emotions they are. They believe that they are objective, they believe when they look at a chart that they are seeing something objectively when the reality is, nine times out of ten, if a market practitioner is not careful, he will be seeing what he wants to see, not necessarily what the picture is accurately projecting, and that is, I think, an important clarification.
Kevin: It is amazing that you can make an investment out of anything. Recently these “short the VIX” types of funds are basically betting on complacency and putting a high bet, sometimes a highly margined bet, on pure complacency.
David: If you were taking the critical view, it would be a bet on continued complacency. But I think what they are betting on, in their minds, is the continuation of calm in the marketplace, and they wouldn’t see it as something that ultimately has a reversal, they would say, “this is well in hand, the central bank community has tamed the market beast, and therefore we have nothing to worry about.” But complacency, in a historical sense, sets the stage for panic. It always has and I think it always will. There is nothing new here. The tools to short volatility and to press it lower, frankly lower than any reasonable mind would expect, those vehicles are new, but we are talking about ETFs that allow for a huge number of investors that wouldn’t have had the sophistication or the tools or the skills to do that trade before.
So what does that mean? It means that there is a longer line of lemmings. The lemming line isn’t new. That’s not new. But the length of the line surely is, and this week we see what they were lined up for. How is the news media going to conclude this, what is their take going to be on it? “Look, we’ve got a technical glitch. This deals with computer trading models and they got out of hand. It’s volatility. It’s computer trading which is overdone. Move along.”
Kevin: So in other words, “Move along citizen, there is nothing to see here.”
David: “Nothing to see here, moving back to Dow 30,000, supported well by the growth in the global economy, here we are.”
Kevin: Yes, but somebody has the other side of that trade. You have counterparty risk. Not everybody just gets to lose 1,000 points and everything is fine. You have counter-parties in this trade.
David: That’s right. So the VIX explodes higher in the context of that very popular trade short VIX, which means a bunch of people who were short the market just got hammered. Nomura, the Japanese bank, had sent clients Tuesday morning a notice that what they had invested, several hundred million dollars, was being paid out at four cents on the dollar. And the structure of that product was basically, if you had volatility of greater than 80% that the product was liquidated and the proceeds returned to clients.
So that is what happened. They had volatility of greater than 85% and lo and behold, the difference between Friday and the open on Tuesday in Japan is that the clients are handed back four cents instead of their original dollar. A fascinating turn of events for people who were certain that nothing could go wrong.
Kevin: Not just the Japanese. Look at Credit Suisse. They had exposure, as well. And I think what this points out is that when you see a 1,000-point, or a 1500-point drop in Dow, and you look at it percentage-wise you think, “Oh well, that’s not that big a deal.” But because of leverage in the system, that can take a dollar investment and turn it into four cents in one day.
David: Right. So what you’re talking about is the potential of wiping out the annual earnings of a company, or multiple years of earnings. If Credit Suisse makes a couple hundred million bucks a year, then you can wipe out those earnings in one day, or multiple years’ worth of earnings. Now, to be fair, in most instances, investment houses, and Credit Suisse would be included in this, they hold assets on behalf of clients. So do they have direct exposure, what is their dollar exposure, will they take a big hit? It is more likely that their clients will take the big hit and they face some degree of reputational risk.
But you’re really talking about not just the 3½ billion dollar trade which was short volatility, but there are other ways of playing short volatility simply by owning bonds. There are other ways, you might think, well, that’s not directly being short volatility, but is the equivalent of an ancillary trade. So, you’re actually talking about probably somewhere in the neighborhood of seven to ten billion dollars implicated in this short volatility trade. Now, again, will we see dominoes fall in other areas as a consequence of those losses? One thing is for sure. We know that there is margin debt which is at the periphery here, and this kind of volatility certainly makes those who are margined out their ears lose a little sleep.
Kevin: It’s good to go back and remember. Let’s just remember last week’s show. We had record dollars coming into the stock market. We put that on one of our three points for the show for people to see what the show was about. We said, “Look, this is usually the beginning of the end before you see a break.” Now, the other thing that has been on record is margin debt – the amount of money that people are willing to borrow to go do exactly what this college board asked. “Do we need to be more risk-exposed?”
David: That’s right. And you’re average professional manager today – well, this goes back, say, 30 days, actually – was over 105% allocated to stocks. In other words, they were using margin to get greater exposure to the stock market because 100% was not enough, and to keep up with the Joneses, that is, their competing management firms, and to not under-perform the index or a competitor, they were adding leverage to the portfolio. It’s individual investors, as well, and you’re right, that’s what brings us to record balances on margin debt. If you remember that margin debt is at all-time highs, Tuesday morning was a wake-up call for people who were, to use a ski analogy, way too far out over the tips of their skis.
What happens Tuesday and Wednesday is forced liquidations as their margin balances get out of whack in light of the diminished equity value in their accounts. And if they don’t make arrangements immediately and choose what is sold, then the house gets to choose the assets that are forced to be liquidated to cover that margin debt. So it is not unlikely to see, in the next few days, and even through the end of the week, again, the cascade effect of margin liquidations. One of our concerns through 2017, we have been saying over and over again, 2007 and the year 2000 were also years when we were setting records for margin debt.
What does it speak to? It speaks of over-confidence, number one. It also speaks of a ticking time bomb within the equity market. Why? Because there is a date that those funds have to be paid back, or an arrangement has to be made when there is a decline in price to bring in more cash, more capital into those accounts. So you have what is a very foreseeable liquidity event. When you start stacking too much margin into the system, you’re tempting fates with a liquidity event, and that is something that ultimately exaggerates or exacerbates a market decline.
Kevin: The longer I do this, the more these crashes look the same, right up to the point that they crash – 1987, 2000, 2008 – they all were proceeded by some of the same indicators.
David: There is no doubt there will be some rallying back in the equities markets over the next several weeks. The question is, has confidence been damaged sufficiently to move into a real bear phase. John Kenneth Galbraith wrote a book in the early 1990s called, A Short History of Financial Euphoria, and he is looking back in time. It is fascinating to me that you see virtually all the same elements today as he saw in the early 1990s. Not only reflecting on the market mood then, but also from a historical perspective, he says, “They (the speculators) are in to ride the upward euphoria. Their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues. They will get out before the eventual fall. For built into the situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants, the new era believers, and the superficially more astute in the speculative situation, are programmed for sudden efforts at escape. Something, it matters little what, although it will always be much debated, triggers the ultimate reversal.”
Kevin: Here is what is different about the early 1990s. Actually, I got to hear John Kenneth Galbraith speaking at a financial convention one time saying something very similar to that in the early 1990s. What he is saying we say every week, yet one of the questions that I asked you last week was, now that we are in an algorithmic world, John Kenneth Galbraith made that comment about human action during a time when the markets were mainly human actors in the early 1990s. Now we have over 70% of the market that is just robo-trading.
Another element that we have is robo-brokers, where you place your trade, either buy or sell, with a machine that knows nothing about what you’re doing. Now, on Monday there were a number of people who were trying to sell who could not get into their robo-broker, and we asked the question also last week, “What does a robo-trading algorithm do when it sees human action that is has never programmed into its algorithm?”
David: Again, algorithms are for normal circumstances, things that happen within one, or even two, standard deviations of some behavior in the stock market, or the bond market, or the assets markets, which is considered to be normal. If it begins to move beyond those parameters, if you get outside of a normal trading band, then you have, again, rules that get placed, and it is on an automatic basis. So it actually is very similar to the kind of internal market dynamics that we saw with portfolio insurance back in 1987. Portfolio insurance was a total oxymoron. That was a derivative exposure which caused an increased selling when the market was in decline and exaggerated that trend. We had a 22% down day in October of 1987 because of “portfolio insurance.” But again, we have 70% of New York Stock Exchange volume. It’s not just the volatility trade we’re talking about, which is implicated in Monday’s decline, but we’re talking about 70%…
Kevin: That are robots.
David: Which is happening on an automatic basis. When trends begin to reverse and move beyond the pre-determined parameters your automatic buys turn to automatic sells. Those kick in, and all of a sudden that trend, the downtrend, becomes self-reinforcing. A part of the safety net within the trade has been having market-makers who will take on and moderate what they are willing to inventory in terms of shares. And they are in it for the long haul. And there are guidelines, but not so many rules, for a market-maker. When you move to black box algorithm trading, now you have rules, not guidelines. And gone are the rational appraisals.
Remember last week we were talking about the ability for someone to judge or discriminate in the market what they are going to do next. “Do I participate, do I not participate? What is happening? What is not happening? Do we have a clear understanding of what is happening? Is there a headline that we are reacting to, or over-reacting to? Or is this just simply gravity?” And that is gone. 70% of the volume on the New York Stock Exchange now trades in a way that is consistent to exaggerate trends, as we saw yesterday. That is not going away.
Kevin: It reminds me of the movie, 2001, when Dave needed Hal to open the pod bay doors. And people calling on Monday wanting to sell, or do whatever they could with their portfolios, you have robots that have shut this thing down and robots that are doing their own trading. It reminds of when he said, “Open the pod bay doors, Hal.” And Hal responds back, and he says, “I can’t do that, Dave, the mission is too important.” So what happened was the rules, what you’re talking about – rule-based trading – the rules overpowered human discrimination. So in a way, it’s like being trapped in a ship that is controlled by robots at this point.
David: That’s right. But it’s only partially controlled by robots because you have the inputs which are still committee-determined, whether it is the European Central Bank, the Bank of Japan – all these monetary committees meet and determine what the headlines will be that those trading algorithms trade off of. And by the way, the headlines are written in a way that communicates a message, not necessarily the message of the committee, but that is often what happens.
Kevin: Look at Bloomberg. We brought up Bloomberg in the past as far as not only writing the algorithms and selling them to the trading platforms, but also writing the news.
David: Exactly. If you go back a week, you can read any number of articles from Bloomberg which would have said that the market was not over-extended and valuations were in line, particularly if we’re looking at forward price-earnings multiples, and that was what Bloomberg’s message was. Now, Bloomberg can’t say it enough. Why are markets selling off? The market was extended, valuations were high. It’s mind-boggling to see the same thing from the same news source, just separated by days. The real explanation is actually quite simple. Gravity ultimately catches the arrow in flight. There is nothing that you can do to suspend the laws of nature. Gravity ultimately catches the arrow in flight.
There was a Bloomberg article that particularly irked me earlier this week. What on earth happened to stocks? Here is where to cast blame. First of all, the title frustrated me because casting blame – what does that mean exactly? Trying to understand causality is one thing – casting blame? That is, to me, twisted. That is absolutely twisted. If you own this market at current valuations, the blame rests squarely, if only partially, on your shoulders, because how are prices at these levels? Through your participation, and other people playing that game of the greater fool theory – someone else will come in and pay an even higher price. Bloomberg has been quoting the Shiller PE as showing over-valuation in the market, and yet just ten days ago the Bloomberg shills were making fun of the Shiller PE as out of date and useless, as telling us nothing. “Forward, PEs are the only way forward. The Shiller PE is anachronistic and needs to be thrown away. It is as worthless as the gold standard.”
Kevin: Sometimes we can be very narrow-focused as Americans. We can look at the stock market and say, “Okay, well, because the U.S. economy is improving, because of Trump’s State of the Union address, and because of the successes of the tax cut, then I must stay in the stock market.” How does that fly when the rest of the world is also coming up with the same kinds of downturns?
David: I think there are a couple of things that are going to take us by surprise. One, you’re seeing more come out about election issues – the Senate Judiciary Committee, the FBI, the Department of Justice, perhaps corruption at the highest levels at the DOJ and FBI. And I frankly am not getting into the weeds on that, but what is interesting is the parallel to the stock market and to the cryptocurrencies. If you damage confidence in the powers that be, what you are doing is adding to a negative social mood. And adding to the negative social mood is consistent with entry into a full-blown bear market. Because a bear market is determined by psychology. A bear market is determined by sentiment, by people saying, “Uh-oh,” instead of “Oh yeah.”
And as those words begin to transform the mind and take hold as fear in the mind of the average investor, their behavior shifts pretty radically. You have to love the financial news. “Don’t panic, stay in. The economy is supportive of higher prices.” Yet, what we see is this uniformity. In recent weeks we’ve talked a lot about uniformity of markets going up. 97% of the world’s stock markets also moved down. And I don’t think that this has to do with the U.S. economy supporting the global stock markets. There is something that is more universal here than U.S. economic growth that has taken all assets on a global basis and driven them higher.
Kevin: Your point last week was, from 1966 to 1981 we had one of the worst stock-performing decades-and-a-half in history, yet the economy was growing at almost a 10% clip, the GDP was.
David: Every year.
Kevin: Yes, so it’s not really about the U.S. economy, is it?
David: No, it’s a credit issue. It never was about the U.S. economy. And if you’re thinking that the stock market is high because of the U.S. economy, you don’t understand what is driving stocks, or what has ever driven stocks. That may be a supportive element, but it is only one of five or six other much more important elements, and I think credit remains the biggest issue. Global expansion of credit equals global expansion of asset prices, driven by – back to psychology here – over-confidence.
Confidence has been built on a self-perpetuating trend of momentum investing and immediate gratification in a variety of speculative trades. So you have the cryptocurrencies which have given you that, you have biotechs which have given you that, you have the NASDAQ which has given you that. You have even blue chip companies – let’s pick on Boeing – everyone is a friend, and every price of every stock is going up. And again, is it on the basis of a discriminating view as to what good value looks like?
Kevin: I can tell you, confidence is frail. It changes very quickly. The other night I was out walking the dog like I do every night, in the dark. You know me, I love the stars, so I keep the flashlight off, and I’m looking at the stars. And I never see anybody on our dirt road. We have a dirt road that is about three-quarters of a mile long that several houses are on. I was just walking, comfortably, confidently, as always, and about 15 feet from me was a man, standing. He was standing waiting for a ride on this dirt road, in the dark. Granted, we had a little bit of a moon, but I’m telling you, my voice went up about 15 notes, more than an octave. “What are you doing here? Hi!” (laughs) But see, my confidence changed. And what is interesting is, the last few nights when I’ve been walking, even though this was an unusual event, he was waiting for a ride, someone actually did come and pick him up while I was out there.
David: Previous weeks you didn’t have the same internal experiences you have in the most recent nights after this experience.
Kevin: But I’m telling you, I’m jumpy. I am jumpy. At this point, I’m looking around. Now see, for the last three to four years, no one has been jumpy. They’ve been out walking the dog, knowing that everything is going to be completely fine. There is no one out here, it’s just fine.
David: And if they’ve been jumpy, they’ve become embarrassed, and they’ve joined the FOMO crowd, the Fear of Missing Out crowd, and they’re now joining in. Again, we were talking about the short VIX trade, and those people joining the lemming line, there are plenty of people joining the lemming line in the stock market, too. Confidence is always frail, even when it seems invincible. Why? Because it is circumstantially informed. Change the circumstance and the sentiment which was pervasive and running forward like a rhino in all its power and strength, has now reversed course and the energy looks like a flock of scared barnyard chickens running in every direction. You don’t have the rhino and the clear direction forward, it’s just, “Aaaa! Gotta get out of here!”
Kevin: People always ask us what timing is going to be and they’re always looking for a trigger, and I think that’s the wrong way to go, because there is always an inflection point or a trigger. But usually, you can look at it and say, if you’re just looking at valuations of things, they’re overvalued. Something is going to happen. Now, we now there are inflection points or triggers in all markets that will reverse them. Let’s just look at it. They are always points that you love the most. It is when you want to be there the most, right before things change.
David: I had some great skiing this weekend, and one of the things that brings me great delight is hearing things explode up in the mountains because it means they’re blasting fresh powder, and they’re making the conditions a little bit safer. Imagine doing something completely different. Instead of mitigating that potential disaster, being swept off the mountain in avalanche debris through the use of explosives, whether it’s a howitzer or dropping bombs onto the hillside and forcing the slides, imagine if your solution was to add more powder to the hillside and then go ask children to play on it.
Kevin: Which is sort of what the markets have been doing.
David: And that is kind of what the markets have been doing. Rather than mitigate, they have been exaggerating and encouraging people to play in a dangerous environment. So you’re right, timing is something that people get fixated on. When? When? Because they want to maximize every penny. The reality is, if you understand the context, you know that there are certain times that you just need to be grateful that you’re not on the hillside (laughs). Or in the market.
Kevin: It reminds me of the time that you and a good friend were climbing Mt. Rainier, and you had really put quite a bit of investment of time and money to be there, but you felt the snow shift. And within a week there were several people who were swept off the mountain and killed. You guys got off the mountain. It’s like a valuation decision because you said, “You know what? This mountain is overvalued in snow.”
David: I don’t need to get to the peak. I don’t need to be the person that summits. I can come back on a better day. So, a winter ascent to the peak – yes, there is danger involved. And the higher you go, the more danger there is. And you have to be mindful of the risks and the risk elements there. And if you’re not mindful of it, you can get into real trouble.
Kevin: And that takes incredible discipline because it’s so disappointing.
David: But this is the issue. ETF investing, and the idea of moving to autopilot buying of the indexes, we’re talking about a complete lack of mindfulness. Look, we have inflection points that, to us, are an indication of where you are. They are telling you the context that you are in, and they set the tone for what people love. Do you know that people who love to ski love to ski in deep powder? But it is also the most dangerous thing to ski in. If you have steep hillsides and deep powder, you have all of the engineering there, you have all the mechanics, for a slide. That goes with the territory.
The same is true, but for the skier, that is the ideal place to be, although it is the most dangerous. So if you consider what the ideal place to be is in the stock market, you have the market which is reaching inflection points, volatility reaches all-time lows. You tell me. Do investors love low volatility? Absolutely. And does the stock market absolutely feed on low volatility? Yes it does.
Kevin: Same thing with interest rates.
David: But you reach an inflection point with volatility, and it always feels best just before there is a reversion – again, that inflection point. Volatility reaches an inflection point, rates reach an inflection point, inflation reaches an inflection point, consumer confidence reaches an inflection point. Consumer confidence was at a peak in 1968. It was at a peak in 1973. It was at a peak in the year 2000. It was at a peak in the year 2007. And it is as a peak at present.
Kevin: Which were prior to stock market crashes.
David: Right. So it feels best the day before. This is where, again, Nassim Taleb has talked about the happiest day in the turkey’s life is the day before he is slaughtered. Why? (laughs) Because he is being stuffed for the slaughter. All he knows is, looking back and up to the present moment, that he has never had it so good. So how do you judge the future by the present when you’ve never had it so good? What I’m saying is that when you’ve never had it so good, you ought to consider yourself – you ought to look in the mirror and consider whether or not you are the turkey.
Kevin: I think what makes it so difficult, Dave, is exactly what you’re bringing out, and that is, bear markets don’t start when there is bad news. Bear markets start when it’s only good news. And it is amazing, that was actually the phraseology that was coming out over the last week. “We have a tidal wave of good news.” That was in the press.
David: That’s right.
Kevin: Strangely enough, the market didn’t think so.
David: Yes, well a tidal wave of good news, we weren’t reacting to bad news. Yes, you have bear markets which, you are right, don’t begin in the context of bad news, they begin in the begin in the context of the best news imaginable. Why? Because that’s where you get every last buyer into the market. Everyone who has been sitting on the sidelines, everyone who says, “All right, all right, fine, fine, I’ll put my last $10,000 in.” They only end – this is a bear market – they only end when bad news falls on deaf ears and you’ve run out of sellers.
So again, we’re back to what creates bull markets and bear markets. Bull markets end when you run out of buyers, bear markets end when you run out of sellers. We have loads of sellers today which are still available. We have not seen pain thresholds, and we probably won’t see those pain thresholds in the next few days. It may take months, or even years, for people who have come into the stock market to finally capitulate, throw in the towel, and walk away with disgust. Those are the emotional and psychological characteristics of a market low.
We have the exact opposite of that today. Everyone and their brother is saying, “Look, aren’t you glad you can buy it at 2,000-3,000 points less? We heard the same thing – “Bitcoin at $19,000, now it’s $17,000, you can get it on sale for $17,000. Now it’s at $15,000, you can get it on sale at $15,000, you can get it on sale at $12,000.” You can get it on sale, as of this week, at $5900. Will it go back to $19,000? I have no idea. In all likelihood it will. I have no idea.
But what we do have, again, is emotions, and the dialogue, the chatter in people’s brains, which convinces them to do one thing or another. And again, you come back to confidence or lack thereof, which defines the market trend, and we are a long way off from calling a bear market low, and we are a lot closer to a bull market high, given the amount of confidence that has been in the stock market. And again, what have we been talking about? We’ve been talking about VIX, we’ve been talking about interest rates marking zero concern in the stock market for a rise in credit concerns, a rise in inflation concerns, etc. These are all very, very relevant factors in the end.
Kevin: The excuse that is being used, though, is that we do have economic growth. But if you go back and really look, aren’t secular cycles and stocks driven more by inflation, interest rates, those longer-term – if we’re going to look at fundamentals, it’s not economic growth of a particular country that adds or detracts from the stock market, it’s really inflation, interest rates – the long cycles.
David: Yes. I hope we don’t lose our listeners here, but multiple expansion and multiple contraction, if we go back to PEs and other measures of value for equities – if inflation is falling, multiples expand. Multiples expand, stock prices tend to rise, as long as inflation isn’t falling into outright deflation. So just a steady trend of declining inflation, very positive for stocks, very positive for multiple expansion, so you get to high PE levels. But if inflation begins to rise, multiples begin to compress, stocks prices fall. This is the nature of secular bull and bear markets. Inflation trends are far more important than economic growth to values in the stock market.
Kevin: Right. And the question is, are we going to see inflation again?
David: Yes, is that what the global bond market has been signaling? If you look at the moves off the September lows, both in the global bond market, but in the U.S. treasury markets, you are seeing things that would indicate, not only carry trade dynamics, borrowing short to lend long. But you are also seeing, again, something of a change in feel within the bond market. Inflation, is that it? Will stocks gradually reflect this by selling off? Listen, this does not happen over days. When you’re talking about the compression of multiples, the shrinkage of price earnings ratios, you’re talking about something that takes years.
Kevin: Interest rates, Dave – 30-35 year cycles. We’re talking long cycles here, so you can’t just turn the news on and say, “Gosh, was it interest rates changing that did that?” Bill Gross, two weeks ago, said that once we pass that 2.66 mark on the two-year bond, we were seeing the reversal of the interest rate market. Now, it may still drop down below that, but he really called it at that time and said that that was the end of the long, long – three decade long – bull market in bonds.
David: Yes, what he is saying is, the tide is going out. Now, there may be sets of waves that someone can take – if you’re thinking about an analogy to surfing here – you have short-term volatility within interest rates. The reality is we have seen such a strong move from September to present, it wouldn’t surprise me to see interest rates drop here in the short run. But what he is suggesting is getting above that threshold of 2.6% on the ten-year, you’ve crossed the Rubicon in rates. You’ve crossed the river. There is a secular trend change like the tide going out.
So if the tide is going out, U.S. interest rate history, bear in mind the shortest trend – 22 years. The longest – about 37 years. But you’re talking about long-term trends. Now again, you’re talking about tidal trends as opposed to short-term sets of waves coming or going. Those tidal trends are very significant because what do they do? They ultimately impact the cost of capital, they ultimately impact companies’ earnings and profitability, and they ultimately set the stage for what happens in terms of the price action in the stock market.
So far more interesting are the interest rates, and the inflation concerns, rather than looking at economic growth. Do we have economic growth? Absolutely. And you are absolutely correct, point back to 1966 to 1981 and you have a period of radical economic growth, and it did not matter one iota. It was inflation and rates which determined the course of the stock market, not growth in the economy.
Kevin: We talked about inflection points, and you can expect when something is hitting new highs, as far as volume, that you are probably close to an inflection point. Volatility – should we expect extreme volatility at this point? That confidence – that guy that I saw 15 feet away on that dark road – I’m now a little jumpy. That would be volatility in the market.
David: That’s right. I think you could expect extreme volatility. Investors who poured into ETFs in the greatest numbers on record in the last two weeks now have to ask themselves about their true level of conviction. Did they do their homework, or was it a bandwagon momentum trade? I’m listening to Jeremy Siegel on Bloomberg who wrote Stocks for the Long Run. In his interview he says, “Look we have a lot of momentum, people coming in late.”
There is an acknowledgement. The pros know that things are too high, but they’re not willing to speak against it. By the way, he created the Wisdom Funds – these are also ETFs – which have benefitted massively from an influx of capital. The last thing he wants to do – this is like Warren Buffet. Warren Buffet stops talking about the Buffet indicator at the highs. Why? Because he doesn’t want to speak against his book. He owns a bunch of companies that benefit from people believing that tomorrow is going to be better than today.
Kevin: Professional traders have been selling into the market for the last month. The professional traders need a buyer. When you have those volumes coming in, of course they’re not going to say that they are selling.
David: Do you remember three weeks ago on the Commentary we talked about a particular chart formation where the market opens up, closes down for the day, and do you remember what we said? We said, “This is an indication of professionals going fishing for a market top.”
Kevin: Selling to lemmings.
David: That’s right. They’re trying to figure out, “Is this going to hold? Should we stay, or should we go?” And for it to trade higher, but end lower for the day, again, is suggestive, in terms of the trading behavior, that professionals want out and they are experimenting with how much farther the market can go. That was three weeks ago. Look, four to six weeks – that’s right – professional traders have been wanting an out and the public is only too eager to enter the market here in what would be considered the ninth inning of the game. It’s sad, but it’s true – the general public comes in late and always gets caught holding the bag.
Repetition in the markets is predictable because people don’t change through the ages. We’re talking about greed, which erases memories that would otherwise provide wisdom, and even restraint, and I think you would see a lot of people avoiding these markets if they had recalled what mania looks like – they’ve participated before and somehow they can’t keep themselves from participating in it all over again.
Kevin: Last week we asked the question, is passive investing creating a bunch of idiots as far as investors that don’t know what to do? I’ll tell you, the big pink eraser of memory is the Federal Reserve’s reaction to these things. The Federal Reserve, generally, will just pump money into something that they want to buoy.
David: Yes, just as a recap, you have the Fed monetary policies of the 1990s which gave us the tech bubble. The aftermath of that was a tech wreck that took the NASDAQ down 80%. The Fed’s monetary response to the tech wreck, the easy money accommodations that they gave us following the tech wreck, gave us the real estate bubble. It was a credit binge first, and a housing and mortgage finance bubble second. Wall Street figured out how to finance the easy money and make the flows expand considerably, structuring various products, and they did it very, very well. But it started out as a credit binge. When that bubble burst, the Fed monetary policy included measures that we had never seen before. Euphemistically, what do we call them? Quantitative easing. In the old days they just called it outright money printing, and everybody knows that money printing as a way to save the economy is not a good idea, has never worked in the past. But if you change the name of it, still is money printing, but call it QE – somehow it’s going to be different this time. By design, the latest iteration of quantitative easing was to boost asset prices – to boost them and to trigger a wealth effect, and the assumption was that that would induce consumer spending and the economy would recover on the basis of consumer spending as a result of the wealth effect.
Kevin: We saw three very deliberate quantitative easing installments here in the United States, but we’ve passed the baton off. The baton was passed to the Bank of Japan, it was passed to the European Central Bank. Quantitative easing has continued through this whole period of time, really, from about 2010 on.
David: Right – with Monday’s announcement from the Bank of Japan that they are willing to buy an unlimited number of bonds to suppress bond yields. So they’re looking at bond yields going higher and they’re saying, “Wait a minute – wait, wait, wait, wait. You don’t understand. We, of all people, are running debt-to-GDP figures north of 200%, closer to 250%. We cannot afford to have rates go higher. We will monetize debt like nobody’s business.” Everyone seems to have forgotten, Kevin, that it was monetization in the 1970s that spurred massive rates of inflation. And as we discussed last week – the concerns of inflation.
So if the central banks are willing to monetize any quantities of debt, and we are willing to call it monetization rather than quantitative easing, now we’re back into the brains of investors, brains that are having to process this information and say, “Huh, well let’s see, maybe my future expectations of inflation will be higher than they are today.” Shift the inflation expectation, shift bond yields higher. Shift bond yields higher, and you are crucifying the stock market.
That is why what the central bank has done over the last several years has been so potent in terms of manipulating the mind of the market, and convincing people to be unconcerned with inflation. If anything, they should be more concerned with deflation. Remember, last week we said that the deflation bogey-man has been in the haunts of the central bank community. What they cannot afford is for the inflation specter to enter the minds of investors because that will radically alter the prices of assets. And I think that is what we are beginning to see today.
Kevin: Could that be what they are trying to do at this point? Are they meeting the inflation genie at this point with a shift toward quantitative tapering – QT instead of QE?
David: They’re behind the curve. They’re late. They should have been tapering, and they should have been doing quantitative tightening several years ago, but they didn’t want to risk the nascent growth, the low levels of growth in the economy. They finally have growth in the economy, but with it they now have an asset bubble all over again, and they know the consequence of popping the bubble is to undermine growth in the economy. So they are now really on the horns of a dilemma because they have shifted toward QT, that is, quantitative tightening, which is the opposite of QE.
And should we be surprised by the market’s response? One, that is, quantitative easing, inflates asset prices. The other – is quantitative tightening supposed to inflate assets prices as well? I don’t think so. So you have the ECB which has already begun its monthly cuts. You have the Fed, which has announced a balance sheet reduction of 60 billion in the first quarter, 90 billion in the second quarter, 120 billion in the third quarter, 150 billion in the fourth quarter. If you are looking for a cause of stress in the financial markets, look no further than the quantitative tightening.
Kevin: How would you like to be Jerome Powell right now?
David: Normalization has a high cost, and Jerome Powell is right in the middle of this where he is going to have to weigh whether or not he wants to follow through with pre-announced reductions in the Fed’s balance sheet which will have an impact in the asset markets. He is going to have to endure that market pressure. But more than that, he is going to have Trump breathing down his neck because political pressure will be mounting to reverse course to not reduce the balance sheet, in fact, maybe even instigate another round of quantitative easing if we see the stock market roll off any more.
Now for the economic reality connected to balance sheet reduction, this is what really stinks. Every tightening cycle, let’s say 95% – almost every monetary policy tightening cycle has caused a recession. There is no reason to believe that this episode in history is different. It starts with a financial issue, migrates to the economic. The fact that you have a broader conversation about this after this week, with some volatility coming back into the market, is helpful. But I think what you are going to see is a lot of lemmings still lining up as we come into the end of the week, saying, “Look, Jeremy Siegel says I should buy stocks for the long run and it doesn’t really matter the price that I pay.”
I say balderdash. The price absolutely matters. The price you pay determines what your ultimate rate of return is, and if you’ve come into the market in a period of time when interest rates are low, inflation is low, valuations are high, you’re locking in long-term losses for your portfolio. That’s what history says, that’s the trouble you have. It’s not stocks for the long run, it’s losses for the long run, if you’re willing to play in this market today.
Kevin: Lest we sound like we’re repeating ourselves, back in December Goldman-Sachs warned that valuations were at their highest since the turn of the century – not the turn of this century, but 1900. So we’re talking 118 years, stock valuations were the highest. That includes 1929, Dave. That includes 1987, that includes the year 2000 – the stock valuations were the highest. Last week you brought out that the birthplace of a bear market was exactly these things.
David: That’s right – low volatility, high valuations, low rates, low inflation, high assets prices. All of those elements are enjoyable. They’re fantastic. They do not signal stress. But they do precede it. They are positive elements, but in a sequence, they have invariably led the market lower. When things are as good as they can get, then a reversal is in order, just as when you experience peak pessimism, the lows have put in. Again, you’re dealing with, this is not my perspective, this is history. You get to peak pessimism and you’re at a market low. You get to peak optimism and you’re at a market high.
It’s going to take more than a day or two, and a few thousand points, to find peak pessimism – valuation compression, rates moving higher as they have in recent weeks. They’re telling us a lot. The market sees a move away from price stability. Do I know if we’re going to have rampant inflation or deflation? I don’t know. I do know that the market sees a move away from price stability, whether it is 1930s style deflation or an era of inflation – price stability is the key. In either case, you’ve unhinging market participants who have been dependent on a constant for their assets to appreciate.
Kevin: One of the things that we assume is that rates can be controlled by the central banks, but rates are rising globally.
David: Yes, the central bank community can do what they want to intervene, but it’s awkward to do so when you already have half of the global stock markets trading at all-time highs in the last 30 days. So, intervene for what? You’re supposed to save some powder. You’re supposed to be able to intervene and keep a little bit of ammunition for when the chips are down. We’re talking, in terms of percentiles, about being in the 99th percentile of returns and valuations over a 200-year period, if you’re looking at global markets. This is as good as it gets.
Does that mean it can’t go higher? Of course it could go higher. But the issue here is the central banks have no justification to step in and support the markets because you have a hiccup in price by a few, 2,000, points off of an all-time high. They have to wait. The problem with waiting is they have no idea the power of the avalanche of selling that comes through the ETF universe. We have moved to an autopilot investing world. We’ve moved to no professional management, by and large, and we have no idea what the consequences are. We are facing one of the greatest market liquidity events in stock market history, and it’s going to be 21st century.
Kevin: We have the Mighty Mouse of the markets. You know, “Here he comes to save the day.” The President’s Working Group on Financial Markets is what we call the Plunge Protection Team. I remember they intervened back in 1987. They intervene when they need to. Now, I don’t know that we saw any intervention over this last few days.
David: Again, it’s just tough to argue for it. The Dow has risen over 50% in the last 14 months since his election. Intervention? On what basis? Normal stock market correction of 20% – that would take us to 20,800. That’s a normal correction. No reason to be concerned about a move from 26,000 to 20,800. From a historical perspective, that would be a healthy correction. There is a lot of pain and heaps of doubt from current levels to 20,800. And I think traders around the globe went into liquidation mode this week. Why? Do they need a reason? Does an avalanche require a rationale? When it slides, it slides, and traders know to get out of the way or they will see their P&Ls decimated.
Kevin: Earlier in the show we were talking about, stop looking for the trigger, stop looking for the inflection point, and actually be positioned in the right value. Now, retail investors, those who called their live broker if they had a live broker, this week, the normal Wall Street broker is going to tell them the same thing, and that is, “Hey, we’re in this for the long term.”
David: “Stay in. If you had stayed in in 2008 and 2009, ultimately, you would have been fine.” It’s the retail investor that in the last six months has gone all-in, and actually can’t afford a 20%, 30%, 40% loss. If that is normal, just remember what your cost basis is. You can afford stocks for the long run if your cost basis in the Dow is 6,000, 5,000, 4,000. If you truly are a long-term investor with a 20-year time horizon, but to stay invested now, with valuations being what they are, you’re assuming that you have 20 years for things to catch up to current levels. I’m not sure that the valuation studies would support that.
No, an independent person investing in ETFs, yes, that has become the rage. But you know what you pay for now – the real price of independence? Do you know what the heck is going on? You took on the responsibility, now it’s up to you to figure it out. It’s up to you to take action. What is the action going to be? Are you going to flip-flop? Are you going to be whip-sawed by the market? We could finish the year at 30,000. Valuations studies say that over the next 10-12 years your average rate of return is going to negative, but that doesn’t mean that we don’t finish this year with a windfall from current levels, and then spend the next 9-11 years suffering. It just says that we know what the averages are.
So sure, the market is going to bounce, but it’s not prices you need to worry about. It’s the shift in sentiment. Let me say that again – it’s the shift in sentiment. If it occurs, then short-term price improvement is going to catalyze a massive selling – a 50-60% decline in equities from peak numbers, seeing us back at 14,000-15,000 on the Dow, virtually retracing 60-75%, maybe even 100% of the move from 2009 to present. That is the stuff of a secular bear market.
Now, it’s all down to sentiment. It’s all down to whether or not the Fed can keep people in the market, can keep people thinking positive thoughts, can keep the consumer’s sentiment, in this case the average investor, and how they feel held together. You break the psychology, the bear market becomes secular, not cyclical, and you’re looking at five years of hell.
Kevin: One of the things that I love about Doug Noland – and we don’t just see him when we’re working with him, Dave, but we see him all over the media, he is being republished everywhere – Doug has always looked at credit as the driver of knowing where the markets are going to go. When we have a crash, it is always about credit excess – too much borrowing. It sounds like an idiot kind of statement – “You know, well, anybody knows that.” Actually, they don’t.
David: I have been underground in the Middle East and seen the remains of Roman aqueducts. These are things that were built to last. I have been in Europe, and still, things that have been sitting there for 1600 years, 1800 years, constructed by the Romans, are there. What we have today in terms of a financial market is a leveraged system, financially speaking, built like a house of cards, not some master Roman architecture to last through the ages. What has been built was meant to last for seconds, so that someone could profit in the here and now with no respect for the future.
That is the nature of leverage – you are sucking growth from the future into the present. You’re building something that is actually to the detriment of the future, rather than building something for the future. We understand the backdrop from the perspective of credit excess and an unwind of risk. In some instances, a forced unwind is what we are likely to see. We look at the leverage in the system, and again, we see that as a financial structure like a house of cards. Leveraged trades, based on the assumption of perpetual growth and credit.
I fully believe central banks can open up liquidity lines. They will open up liquidity lines, and it will flow to your commercial banks. But when sentiment shifts, you’re talking about people who have to be willing to continue to take risk in the marketplace. And when that willingness to take risk goes away because sentiment has shifted, it doesn’t matter how much liquidity is flooded into the system, now central bank liquidity, although it may be good for commercial banks and their liquidity problems, you are dealing with an unresponsiveness at the level of market practitioners.
Kevin: Right, and that sentiment can shift in a nanosecond. Central bank liquidity is good for commercial banks, but it doesn’t always drive the public. Central bank liquidity doesn’t necessarily even make it to guys like us.
David: No. You look at the amount of lending that is in the system today. The Chinese have expanded from 4-5 trillion dollars circa 2008-2009 to a banking system that has 34 trillion dollars of credit sloshing around in it. They recognize they have too much credit in the system, but they can’t control the shadow banking which is off-market lending. We can’t in our universe, either.
We have so much leverage in the financial system today, Kevin. That is really where the weakness lies. At the end of the day, I look at gold and silver – they have been in a stealth bull market for two years. If equities begin to trade lower, for a longer period of time, you have your catalyst for U.S. equity buyers to join the global trade in gold and silver purchasing. I think 2018 to 2020, under those circumstances, could be a few of the very best years on record for gold. So as for Grant’s recommendation, which we said two weeks ago was a good possibility, that gold outperforms bitcoin in 2018.
Well, gold is out-performing, but we’re only in the second month of the year. Anything can happen between here and the end of the year. I think this is one of those times where if you have not placed your conservative hedges in place, you had better get it done. You had better get it done, whether that is raising cash, reducing equity exposure, reducing bond market exposure, increasing an allocation to gold and silver, having a short overlay which protects the long exposures that you have so that you can maintain lower cost basis positions – legacy assets.
Figure out now what you are going to do. Because again, this all comes back to sentiment. You shift sentiment and you’re talking about five years of hell.
