Flatliners – Dead Market Walking
In the movie Flatliners aspiring medical doctors tried to unlock the mysteries of death by, well, killing themselves. It was meant to be a controlled death of course, to flat line on the heart rate monitor for a few minutes to find out what wonders where to be found “on the other side” only to then return safe & sound thanks to medical intervention. Well, they soon found out the other side wasn’t everything it was cracked up to be and the main character soon got regular beatings as the sins of his past came back to haunt him.
In my view markets find themselves in a very similar script. The promise of investor nirvana where the pains of real life no longer matter. If you only pay attention to the record highs headlines it all looks rather fantastical these days.
Prices only go up no matter what time frame you look at.
And still central bankers can’t find any evidence of inflation. Funny.
Indeed all risk has been flat-lined in this grand central bank experiment as the following chart of the $VIX shows:
Oh I’m kidding of course, but any trader staring at the tape knows that we find ourselves in the most compressed price environment in history.
This is not normal, there’s no heartbeat:
As I’m writing this I’m fully aware I may be viewed as the bear who cried wolf. After all I’ve been outlining structural risk factors for a while and markets have moved past my technical risk zones of 2450-2500 and most recently 2530. That’s what bubbles do. They blow past anyone’s expectations, they make believers of the unbelievers, make bears look like idiots and the most reckless look like geniuses.
But an extreme market that only becomes more extreme is not any less extreme, it is just more extreme. As no risk is apparent these extremes are then dismissed as the new normal.
Yet momentum driven price appreciation has absolutely zero predictive value of future price appreciation, it only appears as such at the time.
Here’s the $NDX leading up to the 2000 top:
It looked fantastic.
It meant absolutely nothing:
For traders of course the key is how to trade set-ups (I’ll post more on this in the near future, but I’ve talked a bit about it in The Relevance of Technical Charts) and for investors it is a matter of how to take advantage while at the same time know when things change.
At this time I want to document a bit of what I see here in markets and the structural world as I don’t want anyone to be surprised when the flat risk line we currently see brings about those nasty consequences.
Let’s be clear.
We find ourselves in a very unique point in history and in a world dominated by false narratives. It is a challenge to keep an analytical grip on reality, but I’ll try to tie a few threads together here to put everything in a macro context.
Firstly the underlying base reality: Free money, easy money, whatever you want to call it, permeates everything we see in financial markets. Indeed I would argue price appreciation has been paid for with unprecedented and, in my view, unsustainable volatility compression.
A couple of charts really highlight this.
Most clearly perhaps is the precise trend line tagging we can observe in the correlated picture of price appreciation and volatility compression since the February 2016 lows:
The $VIX’s corollary, the inverse $XIV, embarked on an explosive near one way journey since the US election coinciding with over $2 trillion central bank intervention in just the first 9 months of 2017:
And it has continued to this day and just made another all time high this past week on a massive negative divergence. It is the magnitude of this volatility compression that explains the current trading environment we find ourselves in.
Aside from the obvious artificial liquidity avalanche we’ve had speculated about the driver of all this and the answer may simply be the promise of even more free money, specifically tax cuts.
As some of you may recall from my analysis over the past year I’ve been very clear that math ultimately will bring out truth in any narrative. In this case that notion that tax cuts pay for themselves is a fantasy. It always has been. Can it result in a short term bump in spending or even growth? Yes it is possible, especially if structured right. But any historical analysis will show you that tax cuts, especially already coming from a relatively low base, will just add to debt via larger deficits.
Recently the White House budget director finally acknowledged this very reality:
“a tax plan that doesn’t add to the deficit won’t spur growth”
My criticism has been that all this marketing talk is simply a lie and will structurally put the country further at risk of trillion dollar deficits and a massive debt explosion that is already baked in even without tax cuts.
Indeed the further one digs through the details the bigger the expense of these tax cuts become:
“We have a lot of businesses… I don’t think any of them are non-competitive in the world because of the corporate tax rate,” Buffett, the chairman and CEO of Berkshire Hathaway Inc told CNBC.
Fink said a corporate rate as high as 27 percent could satisfy U.S. businesses’ need for tax relief, while avoiding an increase in the federal deficit.
“What is being proposed is a pretty large expansion of our deficits,” Fink told Bloomberg TV. The plan contains up to $6 trillion in tax cuts, according to independent analysts.”
I bet you if you ran these tax cuts through a budget that accounts for a recession case somewhere in the future this entire budget would be an utter disaster and they could never sell it. And this is why you won’t see a stress tested scenario, all you will see is happy steady 2.9% growth projections in perpetuity. Nonsensical. Unrealistic. And frankly intellectually insulting to anyone that insists on any base line of intellectual veracity to any budget process.
Running the numbers it’s clear who actually benefits:
So I ask, how will any of this change this trend?
The answer is it won’t despite public narratives to the contrary. People will choose to believe what they want, but math is independent of beliefs and the math is very clear on this.
Put this proposal in context of standing trends:
Real disposable personable income growth remains meager at best:
Debt expansion at low rates continues to sustain the illusion of real prosperity for the 90%:
A meager set of rate hikes is already putting pressure on revolving credit obligations and personal interest payments:
Why does all this matter for us here?
Look no further than to the earlier quoted Warren Buffett who may have explained much of the reason we see no sellers in these markets currently:
“Buffett also said he would wait to see how the tax push played out before doing any significant selling of Berkshire Hathaway stock to avoid paying unnecessary taxes on his gains.
“I would feel kind of silly if I realized $1 billion worth of gains and paid $350 million in tax on it if I just waited a few months and would have paid $250 million,” Buffett said.”
I get it, why sell anything if you can save on taxes and while central banks keep pushing markets higher with record liquidity? Steady as she goes after all.
And we have to acknowledge that the combined effect may be here to stay until clarity has emerged. If current legislative efficiency is any indicator then this may drag on for months with perhaps nothing accomplished.
Health care? Still nothing has happened. And let’s be clear: Not a single health care proposal (and there have been multiple efforts) have had anything to do with health care. They have been proposals that would have knocked millions off health care coverage and financially benefitted the 1% in form of tax reversions. That’s the analytical reality.
I don’t know why anyone still believes this administration will implement anything substantive to help the middle class. Previous administrations (both Democrat & Republican) have failed miserably on the wealth inequality front. And this administration looks no different and perhaps only worse. Every proposal looks to disproportionally benefit the top 1% and this latest tax cut proposal is no exception. Every analysis I have seen shows disproportionate benefit going to the wealthy. And how will that stimulate growth for the middle class? Or the bottom 50%?
And don’t think I’m alone bemoaning wealth inequality & associated inbred dynastic economic structure as an increasing drag on society and its future prospects.
Here’s Buffett himself again:
Ironically it is those 400 that would benefit the most by getting rid of the estate tax that is currently proposed as part of the tax cut package.
Bottom-line, it’s all tied together in a package that promises more and more debt.
Central banks do whatever it takes to keep reality at bay:
And hence I’ve called this entire central bank talk of “normalization” a fantasy. They can’t do it, they’re trapped and even the quants at JPM are out in force warning of it:
As central banks begin shrinking their balance sheets, they risk triggering another financial crisis, something that may be sharpened by the shift away from active investing, JPMorgan’s top quant strategist has warned.
“Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis,” said Mr Kolanovic (who, it is worth noting, has issued such warnings before). “The timing will largely be determined by the pace of central bank normalisation, business cycle dynamics and various idiosyncratic events, and hence cannot be known accurately.” Mr Kolanovic pointed out that “this is similar to the 2008 [Great Financial Crisis], when those that accurately predicted the nature of the GFC started doing so around 2006.”
“The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns,” Mr Kolanovic said. He added that the move towards passive and momentum strategies, where traders chase market cues as opposed to company fundamentals, has “eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption.”
And this is precisely why we won’t see any real normalization ever again. Or perhaps only after a massive reset in the financial system.
This new administration wants massive tax cuts. This year the military budget was already increased by $80B to $700B. The costs of the recent hurricanes are providing the perfect excuse for running larger deficits and you can already see the narrative creeping in:
“I hate to tell you Puerto Rico, but you’ve thrown our budget a little out of whack,” said Trump as he introduced his budget director Mick Mulvaney.
Not the $80B increase in military spending of course.
Look, I can read between lines with the best of them and the message is clear.
Low rates are here to stay and the administration needs low rates to keep it all going and justify tax cuts.
The writing is on the wall, no, actually it is coming to you courtesy Jeffrey Gundlach:
“Bond King” Jeffrey Gundlach has an unusual pick for who President Donald Trump will choose to be the next Federal Reserve chief.
“I actually have a very non-consensus point of view. I think it’s going to be Neel Kashkari,” the the CEO of DoubleLine Capital told the Vanity Fair New Establishment Summit on Tuesday in Los Angeles. “He happens to be the most easy money guy that’s in the Federal Reserve system today and that’s why he may win.”
Kashkari is the president of the Minneapolis Fed and happened to say Monday that the central bank is making a mistake by continuing to raise rates, comments Gundlach referenced as helping him possibly get the job.
“I think there is no chance that she wants to be chairwoman, nor do I think the president wants her to be,” said the manager of $109 billion.
Gundlach said that Trump needs someone who will keep rates low in order to keep his populist reputation and help his base voters and that’s why he’ll pick Kashkari.
“A stronger dollar is not good for achieving that agenda,” he said.
And there you have it. We need an easy money guy. Now I don’t know if Kashkari will be it, but it’s pretty clear Yellen is toast and some version of an easy money guy is coming and the Fed’s balance sheet reduction plan may be out the window shortly after February.
But that’s the combined message, massively more debt is coming, normalization is at best a marketing ploy, and easy money will continue to be part of the equation with perhaps more coming in form of tax cuts.
So yes, I get and receive comments about how it’s different this time, how price discovery as we know it may be a thing of the past.
An asset price inflation world, without core inflation, where valuations don’t matter and debt flows continue unabated and consequence free…
…and market caps rise in asymptotic fashion every quarter, month and week:
The end result: The $SPX is now 18.8% above its annual 5 EMA:
As far as I can tell this is the largest, or one of the largest disconnects ever.
And I’ve shown the chart of $MSFT as an individual stock example of how historically extreme the current disconnect is:
$MSFT is now 35% above its annual 5 EMA. There’s been only 1 year prior to 2017 when it did not touch its 5 EMA: 1999. Did it have any predictive value of future price appreciation? Nope.
Speaking of 1999: Greed is back with a vengeance.
It is all around us:
Central bankers have flat lined risk and investors have crossed to the other side expecting nirvana & free money forever.
So far so good it seems. Just remember in Flatliners the allure of nirvana turned into a running nightmare:
What would be signs of nirvana turning into a nightmare?
Keep an eye on this thin red line:
It will get tested again. Currently the trend line is barely 2% below current prices and it is rising steeply.
When price breaks below this line it’s time to return to real life.
After all you do want a heart beat:
Don’t you? I know I do.