Deutsche: "We Are Almost At The Point Beyond Which There Will Be No More Bubbles"

Whereas many Wall Street strategists enjoy simplifying their stream of consciousness when conveying their thoughts to their increasingly ADHD-afflicted audience, the same can not be said for Deutsche Bank"s Aleksandar Kocic, who has a troubling habit of requiring a background and competency in grad level post-modernist literature as a prerequisite for his articles among the handful of readers who don"t already speak exclusively in binary. Here is an example of Kocic"s "unique" narrative style:

Volatility is a consequence of speed and speed is the result of fear. Acceleration of movement is a defensive maneuver, a tool of retreat -- high speed and high volatility represent sophistication of flight (flight to quality is an example of the speed event). However, absence of volatility is not necessarily synonymous with absence of fear. Volatility is low not only when things become predictable, but also if the distribution of risks causes paralysis, when the state of no change, regardless how uncomfortable it might be, becomes the least undesirable of all alternatives.

While a passage like that is far more likely to have been taken from a book by Lacan, Derrida, Deleuze and Guattari, Foucault or any other prominent POMO-ists, in this case it comes from Kocic" year end outlook which encapsulates many of the themes we have covered recently, most notably his recent take on the interplay between volatility and leverage, a topic which anyone who has read Minsky is quite familiar with, yet which Kocic decided to give it his unique post-modernist spin with the following "spiraling leverage" chart from one month ago...

... which he described as follows: "spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes -- and we believe that moment is now – the market is facing a following dilemma."

• Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice [ZH: hey, one can just blame the Russians, right?]


• Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.


• Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.

The Deutsche Banker"s conclusion was stark and certainly dramatic:

"The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive."

Of course, Kocic could (far simply) have said that it takes more and more debt to kick the can, and keep the world"s biggest asset bubble ever created - with the explicit backing of central banks - from bursting. This is precisely what Bank of America"s Barnaby Martin did in far less words one month ago:

"the irony in today"s world is that central banks are maintaining loose monetary policies to generate inflation…in order to ease the pain of a debt "supercycle"…that itself was partly a result of too easy (and predictable) monetary policies in prior times."

* * *

In any case, fast forward one month later when Kocic picks up where he left off on his favorite "spiraling leverage" diagram, and decides to once again paraphrase Minsky"s conclusion that "stability is destabilizing" using just a few hundred extra words than is necessary, although since he does so in a "cool", Pomoist way, here is the paraphrase:

Persistent low volatility is like a sirens’ song. Low uncertainty engenders high leverage which leads to compression of risk premia and further buildup of risk, which, in the long run, destabilizes the system causing ultimately volatile deleveraging. This is generally harmful for the economy and requires stimulus injection in order to create an economic turnaround leading to subsequent decline in volatility and gradual releveraging as the system recovers. When described in terms of leverage and volatility, economic trajectories exhibit quasi-periodic pattern. These dynamic are shown in the Figure as trajectories in the vol-leverage plain across several “cycles”.

 

Starting with the internet bubble in 1999, we reach the 2001 recession and subsequent recovery on the back of the real estate boom (2003-2007). The figure suggests that after each volatile deleveraging (e.g. 2000 and 2007), subsequent sweep leads to a bigger bubble. After each sweep, amplitudes grow bigger and the damage more substantial, requiring a heavier hand in terms of policy response as crises they create become deeper and recoveries longer and more difficult.

Kocic then reuses the same chart he showed back in November to indicate the four distinct endgames should the leverage cycle be pushed into one of four final states of "instability."

Where the narrative differs from last month, however, is in the slight but perceptible shift to Kocic" conclusion: he now appears resigned that the current twist of the vol spiral is also the last one, beyond which the current financial and monetary system will no longer exist, something his just as gloomy colleague Jim Reid concluded not too long ago and which we described in "This Is Where The Next Financial Crisis Will Come From."

Here is Kocic explaining why we may be approaching the end of financial history (at least as we know it):

It is clear that the spiraling trajectory cannot continue indefinitely; it has to stop at some point beyond which there will be no more bubbles. In many ways, it looks like the post-2008 represents the last lapse. A new game has to be reinvented for the old future to materialize, or a different paradigm altogether has to take over.

As to what happens next, after the two sweeps of the spiral, both of which culminated with crashes, Kocic reverts back to his forecasting self and writes that "we arrived at the juncture point (2017) from which four possible trajectories emerge, none of them are looking very attractive at this point." For those who may have forgotten the November report, here they are again:

• Throughout the post-crisis period, policy response has been designed around an attempt to avoid the lower left corner of low volatility and low leverage. It is safe to say that we have been able to stay clear of this outcome.


• At this point, with regulated financial sector and restricted leverage, we have found what appears to be a “reasonable” base case trajectory – a middle ground between Japanese style liquidity trap and repeat of the same mistake of the previous lapse -- with regulated markets, lower leverage, and subaverage growth (a.k.a. Permanent state of exception).


• Alternatives represent risk scenarios and correspond to volatile outcomes. The lower right corner is the policy mistake territory of forced deleveraging (without inflation) triggered possibly by overly aggressive Fed.


• The most acute risk is associated with the path leading to the upper right corner where possible deregulation and reckless fiscal spending could trigger rise in inflation leading to stagflationary outcome with potential currency decline and forced unwind of the bond trade. Both of these trajectories represent high risk alternatives to be avoided.

Unfortunately, as recent social events have demonstrated, the current "reasonable base case" of a "permanent state of exception" is becoming increasingly improbable because the forced surreal financial relationships are starting to tear apart the social fabric itself. Not only that, but the fact that the "stability" has only been bought thanks to some $15 trillion in central bank liquidity is lost on only the biggest fools, and socialists, pardon - MMTers - in finance. Here again is Kocic:

As much as the base case trajectory appears as “reasonable” and a worry-free choice, its biggest problem is its legitimation. Easy money provided by central banks to restore growth was easy for capital, but not for labor. Policy response to crisis added further to inequality by blowing up the financial sector and inviting speculative rather than productive investment. The Keynesian bond which ties profits of the rich to the wages of the poor seems to have been severed, cutting the fate of the elites loose from that of the masses and the well-being of the economy. 

Confused? You can thank Bernanke and Yellen for president Trump. Anyway, Kocic continues:

 With subaverage growth and highly skewed wealth distribution, the economy is converging towards what for a growing majority increasingly resembles a zero sum game. To the vast majority, that is saying that the best days are behind us. This is the most difficult aspect of the base case scenario: There has been no political system in modern history -- inclusive, exclusive, democratic or oppressive, all the same – that has promised anything but better future to its constituents. For any ideology the gradient between the present and the future has always had to be positive. It is difficult, if not impossible, to conceptualize any political narrative capable of making the reverse acceptable. And in a context where economic growth is a universal metric of progress, problems  with the base case become even more acute. The legitimation of the base case will continue to define the populist narrative as a voice of change. Politics will be shaped along the lines of looking to disrupt the status quo with quick short-term fixes, which could emerge as outright triggers of stagflationary trajectory.

Well, considering that years and decades of endless political lies that "the future is brighter" is the reason why the world finds itself on the edge of a social, political and financial catastrophe, and which has made a handful of people richer than their wildest dreams while pushing the vast majority of the population into considering that socialism - and even communism - may be a wise alternative to capitalism, perhaps it is not so bad that for once the truth will be told and someone will have the temerity to admit that no, the future will not be better, especially when one admits that after the next crash - and the wars that follows - the future, or as it will be known then, the present, will be the worst since the world wars.

And finally, for those who lament the disruptions to the status quo by populist elements promising "short-term fixes", well just look where said status quo got you: a world where the markets have to close their eyes and pretend they can exist forever in the artificial, central-bank created "permanent state of exception."

Which, thankfully, is impossible.

Eric Peters: Today"s Opportunities Include Negative Convexity, Complexity, Illiquidity, Leverage, Or All The Above

From the latest Weekend Notes by Eric Peters, CIO of One River Asset Management

Anecdote

“What are the odds we come across an opportunity in the coming 4yrs to earn 20%?” the investor asked his team.

“High,” they answered. “The odds are 100%,” he said, having seen this movie a few times. “So our cost of capital is 5% per year (20% divided by 4yrs), plus the 1% we earn on cash,” he said. His team nodded.

“Under no circumstances should we deploy capital unless it earns well more than 6% per year from here on out.” It made sense.

“What do we see that earns more than this hurdle?” he asked. His team’s list was as short today as it was long in 2016, 2011, 2009, 2003, 1998, 1997, 1994, 1992, 1990, 1987, etc. Today’s few opportunities have much in common with previous peaks: negative convexity, complexity, illiquidity, leverage, and/or all the above.

“Investors confuse a 7.5% average annualized return target with a 7.5% annual return target,” he explained. “They’re entirely different things.”

Targeting average annualized returns allows you to accept what the market gives you, while targeting annual returns forces you to leverage investments near peak valuations to hit your bogey. “Typical pension and endowment boards want incoming investment returns to consistently exceed outgoing flows.”

So most investors attempt to produce the highest return every year, no matter what it takes. “But that’s the wrong objective. Never underestimate the value of cash and patience in achieving the real goal; superior returns over the complete cycle,” he explained.

“Markets tell you what to do if you listen,” he said. “Near the highs, few opportunities exist to earn substantial returns, so you should take little risk. Near the lows, opportunities to earn attractive returns are abundant.” You should take a lot of risk. “This sounds simple because it is. It’s obvious. But obvious is not easy.”

The Seven Questions Goldman"s Clients Have About "Rational Exuberance"

In mid-November, just days after Barclays released its 2018 equity outlook with the title "Rational Exuberance"...

... Goldman"s David Kostin decided that imitation was the sincerest form of unveiling a non-contrarian year-end forecast, and in presenting his revised S&P price target for 2018 of 2,850 - which accounts for GOP tax reform - "borrowed" the Barclays title for his own year ahead preview...

... despite admitting that valuations have never been higher, thus suggesting that contrary to the title, the exuberance is anything but rational.

To be sure, despite their hyperbolic titles, both Barclays and Goldman simply went with the sellside flow: in fact, in addition to Barclays and Goldman, Wall Street strategists polled by Barron"s said they expect about a 7% S&P gain for 2018 same as basically every single year, according to Sentiment Trader who points out that "they"re not stupid, they go with the base rate." Indeed, there is power in numbers, because if everyone is wrong about the year ahead, it is the same as nobody being wrong, something Wall Street discovered in 2007.

And yet, with not one but two banks mangling Alan Greenspan"s infamous words to justify their late cycle bullish outlook which both admit is not deserved on a fundamental basis, Goldman"s clients remain confused, and in his Weekly Kickstart, Goldman"s chief equity strategjst David Kostin writes that he has spent the last two weeks meeting with investors to discuss his outlook for US equities in 2018, including the impact of tax reform.

"Our Nov. 21 report, entitled Rational Exuberance, describes our expectation that 14% EPS growth, driven by healthy economic growth and a 5% boost from tax reform, will lift the S&P 500 index to 2850 by year-end 2018 (+8%)."

While it will hardly come as a surprise, Kostin confirms that as we reported last week most investors remain exceptionally bullish despite the all time high in the S&P and despite record valuations, instead betting that the Fed will always step in to keep the upward mometum in risk assets; still while "most clients agree with our bullish sentiment but they questioned several of our specific views."

Below Kostin addresses seven of the most common investor questions prompted by his forecast, or specifically the things Goldman"s clients think is irrational about "rational exuberance.":

1. How can you be “rationally exuberant” about the path of US stocks in 2018 when equity valuations are so high? Although the median S&P 500 stock trades in the 99th historical valuation percentile, valuations are typically poor indicators of short-term returns. Moreover, in contrast to the “irrationally exuberant” market of the late 1990s, today’s equity valuations are justified by a macro environment of extremely low rates, modest inflation, high corporate profitability, and a stable economy. Nonetheless, earnings growth, rather than higher valuation, drives our 2018 forecast. 

 

 

2. If the out-of-consensus US Economics forecast for the Treasury yield curve is wrong and rates stay low in 2018, could equity valuations rise further? The “melt-up” scenario of a forward P/E that rises to 19x or 20x is possible, but unlikely. Our forecast for a stable 18x forward P/E multiple at year-end 2018 assumes the economic expansion continues, ROE rises, and the equity risk premium (ERP) narrows. However, in contrast with market pricing (2 hikes) and almost every client we have met (2 or 3 hikes), our economists expect the Fed will raise rates four times next year as the labor market tightens and inflation firms. A rising term premium should lift the 10-year Treasury yield to 3.0% and restrain further P/E multiple expansion.

 

3. Why did you downgrade the Information Technology sector when it has twice the sales growth and twice the margins of the rest of the S&P 500? The Tech sector’s low effective tax rate (19% vs. 26% for the S&P 500) means it has little to gain from tax reform. Recent performance supports our view. Regulatory risk is another reason for our downgrade. However, we recommend a Neutral weight (24%) in the sector due to strong fundamentals. Investors with sufficiently long investment horizons may find policy-driven weakness an opportunity to add to positions in the sector’s strongest secular growth constituents, which we believe remain attractive. We recommend overweight positions in Financials and Industrials. Both sectors pay above-average effective tax rates and are likely beneficiaries of tax reform. In addition, each sector has fundamental tailwinds such as deregulation and rising capex spending that should boost earnings in 2018.

 

4. Following value stock outperformance during recent weeks, do you still recommend growth as a style in 2018? Concentrated positioning and correlation with the Technology sector are clearly short-term headwinds to growth stocks. In fact, the  acceleration in already-strong US economic activity should have led value stocks to perform even better than they have during the past several months (Exhibit 2). However, our economists’ forecast of 2.5% US GDP growth in 2018 portrays an economic environment typically conducive to growth stock outperformance and suggests that our sector-neutral growth factor should fare well during the course of the year.

 

 

5. Is the equity market already pricing the full impact of tax reform? The prediction market shows roughly 80% odds of passage. Equity market indicators such as Altaba (AABA) and our High Tax Rate basket (GSTHHTAX) send broadly similar signals. However, lingering uncertainty regarding both the provisions that will be included in the final legislation as well as the potential impact of several proposals, such as limiting interest deductibility and the treatment of cross-border transactions, suggest more rotation at the industry and stock levels remains in store.

 

 

6. What does the Senate proposal to delay the tax rate cut until 2019 mean for S&P 500 earnings and performance? The delay in rate cut until 2019 will save roughly $140 billion in government revenue but weigh on 2018 EPS as firms face several base-broadening provisions without the offsetting benefit of the rate cut. However, we expect the net 5% boost to future earnings will be unaffected, as would our 2019 EPS estimate of $158. The likelihood that companies pull forward capex and other expenses into the higher-tax year of 2018 may even boost economic activity and provide a net 2019 earnings benefit to S&P 500 companies beyond our current f orecast. In total, particularly against a backdrop of low discount rates, we expect little impact on stock performance from a potential delay in tax cut.

 

7. How big a risk to EPS is the Senate’s proposal to limit interest deductibility at 30% of EBIT? The proposal would have a minor impact on S&P 500 firms but pose a greater risk to more highly-levered small-caps. Consensus 2018 estimates show 5% of S&P 500 constituents but 15% of the Russell 2000 paying interest expense above 30% of EBIT. However, the proposal suggests incremental downside risk to buybacks and credit issuance as companies adjust corporate structures in response. In addition, the pro-cyclical proposal would have a much greater potential effect on US firms in environments of higher rates or weaker earnings; the current ratio of S&P 500 interest expense to EBIT is nearly the lowest in at least 35 years.

 

Finally, for those who have missed the barrage of year-ahead outlooks from Goldman in the past two weeks, here is a summary of what the world"s most influential bank believes will happen in the next 12 months: "We forecast the S&P 500 index will rise by 8% to 2850 by year-end 2018. EPS will benefit from tax reform and climb by 14% to $150 while the forward P/E multiple remains stable near 18x. Growth style will prevail over value and Industrials and Financials will outperform while Consumer stocks lag. Thematically, we prefer firms that prioritize investing for growth via capex and R&D. Most clients agree with our bullish sentiment but they questioned several of our specific views. Investors have a less hawkish view than Goldman Sachs economics on the bear flattening of the yield curve and implications for equity valuation and continue to focus on the implications of tax reform."

Six Ways US Stocks Are The Most Overvalued In History

Submitted by Mish Shedlock

US large cap stocks are the most overvalued in history. Let"s investigate six ways.

Crescat Capital claims US large cap stocks are the most overvalued in history, higher than prior speculative mania market peaks in 1929 and 2000.

Their 25-page presentation makes a compelling case, with numerous charts. It"s worth your time to download and investigate the report.

Six Ways Socks Most Overvalued in History

1. Price to Sales


2. Price to Book


3. Enterprise Value to Sales


4. Enterprise Value to EBITDA


5. Price to Earnings


6. Enterprise Value to Free Cash Flow

Here are a few snips from the report.

Bear Market Catalysts

There are many catalysts that are likely to send stocks into bear market in the near term. A likely bursting of the China credit bubble is first and foremost among them. Our data and analysis show that China today is the biggest credit bubble of any country in history. We believe its bursting will be globally contagious for equities, real estate, and credit markets. The US and China bubbles are part of a larger, global debt-to-GDP bubble, which is also historic in scale, and the product of excessive, lingering central bank easy monetary policies in the wake of the now long-passed 2008 Global Financial Crisis. 

 

These policies failed to resolve the debt-to-GDP imbalances that preceded the last crisis. Now, easy money policies have created even bigger debt-to-GDP imbalances and asset bubbles that will precipitate the next one.We are in the very late stages of a global economic and business expansion cycle with investor sentiment reflecting record optimism typical at market peaks, a sign of capitulation at the end of a bull market. Crescat is positioned to profit from the coming broad, global cyclical market and economic downturn that we foresee. We strongly believe that our global equity net short positioning in our hedge funds will be validated soon.

Cyclical PE Smoothing

It is critical to use cyclical smoothing to accurately gauge market valuations in their current and historical context when using P/E.Yale economics professor, Robert Shiller, received a Nobel Prize in 2013 for proving this fact so we hope you will believe it. 

 

The problem with just looking at trailing 12-month P/E ratios to determine valuation is that it produces sometimes-false readings due to large cyclical swings in earnings at peaks and valleys of the business cycle. For example, in the middle of the recession in 2001, P/Es looked artificially high due to a broad earnings plunge. P/Es can also look artificially low at the peak of a short-term business cycle, which can produce what is known as a “value trap”, such as in 2007 during the US housing bubble and such as we believe is the case today in China, Australia, and Canada.

 

Shiller showed a method for cyclically-adjusting P/Es using a 10-year moving average of real earnings in the denominator of the P/E. Shiller’s Cyclically-Adjusted P/E, called CAPE multiples have been better predictors of future full-business-cycle stock market returns than raw 12-month trailing P/Es. Shiller showed that markets with historically high CAPEs lead to low long-term returns for long-only index investors. Shiller CAPEs are fantastic, but they can be improved by including an adjustment for corporate profit margins which makes them even better predictors of future stock price performance and therefore even better measures of cyclically-adjusted P/E for valuation purposes. 

 

.Shiller’s CAPEs simply need an adjustment for profit margins because margins are a key element of earnings cyclicality. We can understand this by looking at median S&P 500 profit margins in the chart below. For example, even though profit margins were cyclically and historically high during the tech bubble, they are even higher today. In the same spirit of Shiller’s attempt to cyclically adjust earnings to determine a useful P/E, CAPEs need to be adjusted for cyclical swings in profit margins.

When we multiply Shiller CAPEs by a cyclical adjustment factor for profit margins (10-year trailing profit margins divided by long term profit margin), we get a margin-adjusted CAPE that is not only theoretically valid but empirically valid as it proves to be an even better predictor of future returns than Shiller’s CAPE!

 

Credit goes to John P. Hussman, Ph.D. for the idea and method to adjust Shiller CAPEs for swings in profit margins.As we can see in the Hussman chart below, margin-adjusted CAPE, shows that today’s P/E ratio for comparative historical purposes is 43, the highest ever! The 1999 peak P/E was 41 and the 1929 P/E was 40. Once again, we can see that today we have the highest valuation multiples ever for US stocks, higher than 1929 and higher than 1999 and 2000!

Margin-Adjusted CAPE

It"s easy to discard such talk, just as it was in 2000 and 2006. People readily dispute CAPE, concocting all sorts or reasons why it"s different this time. The most common reason is interest rates are low. We also hear "stocks are cheap to bonds" which is like saying moon rocks are cheap compared to oranges. I do not know when this all matters. And no one else knows either. What I am sure if is that it will matter.

How?

I don"t know when, nor am I sure "how" it happens. It could play out as a crash or stocks can decline over a period of 6-10 years with nothing worse than a 15% decline in any given year, accompanied with several sucker rallies leading people to believe the bottom is in.

History Lesson

Some might ask: If you don"t know when or how, of what use is such analysis.The answer is that history shows this is a very poor time to invest in stocks. That does not mean, they cannot go higher(and they have).

History also suggests that people who invest in bubbles, start believing in them. People believe in bubbles because they have to, in order to rationalize their investments. Others know full well it"s a bubble but they think they can get out in time. Historically, few do because they are conditioned to "buy-the-dip" philosophy, and keep doing so even after it no longer works.

Yesterday, I noted Oppenheimer Predicts PE Expansion, Most Bullish S&P Forecast Yet.So if you are looking for a reason to stay heavily invested in this market, you have one. But don"t fool yourself, this is the most expensive market in history.

 

Francesco Filia: The World"s Twin Asset Bubbles Could Collapse Under Their Own Weight

In this week"s MacroVoices podcast, Erik Townsend interviews Francesco Filia, a fund manager at Fasanara Capital. After exchanging pleasantries, Townsend begins the interview by asking Filia, an analysts who"s widely regarded for his research about how post-crisis monetary policy has impacted distorted markets, about the different metrics he uses to determine whether a certain asset is in a bubble.

Filia begins by ticking off a laundry list of metrics that all point to the same conclusion: That today’s market is more overvalued than at any point in recent history – including the run-up to the financial crisis.

Thank you, Erik. I think the equity bubble is quite uncontroversial, is quite unambiguous. There are a lot of different valuation metrics for those that care to look into them. They’ve been valid for over a hundred years of modern financial markets. And this time is no different in that respect.

 

There are the usual metrics that the valuation guys are looking at, like financial assets to disposable income that shows that this market is way more expensive than at any point in history including the big dot com bubble and the Lehman moment in 2007-2008.

 

But there are other metrics like the Buffett Indicator (market cap on GDP), the median debt on total assets, the corporate debt to GDP, the price on sales, the price to book, enterprise value on sales, enterprise value on EBITDA – there are a number of different metrics. They all convene that this is a market bubble that has not been seen before in history.

Filia said he created his own valuation metric that is loosely based on the famous Shiller PE (or CAPE) ratio. Economist Robert Shiller, who teaches at Yale School of Management. Filia"s ratio helps filter out distortions caused by the drop off in corporate earnings caused by the crisis.

But we at Fasanara, we developed our own indicator just to try to add something to what was available already. And we started with one of the most famous of all the indicators in this respect, which is the Shiller adjusted PE ratio, or the CAPE ratio. This is the most famous of them. Professor Shiller got a Nobel Prize in 2013 for it. And for his studies on market inefficiencies and for the ability to infer future expected returns from valuation metrics such as the Shiller PE.

 

 

And, based on the Shiller PE, what it does is simply to compare current prices to not spot earnings of foreign earnings, but a more reliable measure of the average of the last ten years and adjusted for inflation. So the average of the last ten years of real earnings. And on the basis of this index, we find out that the market is as expensive and just a little bit less expensive than it was in 1929 during the Great Depression, the peak of the market before the biggest collapse in equity prices ever seen, and the year 2000. So just slightly cheaper than the year 2000.

Filia"s ratio is loosely based on the work of John Hussman of the Hussman funds, who was the first to utilize peak earnings instead of average earnings in his PE ratio calculations.

What we do is an evolution of the Hussman PE ratio (which is taken from the Shiller ratio) which is to compare – kind of putting all in the basket. So we put the peak earnings as opposed to average earnings, and for peak earnings we really mean the peak. We take the two top quarters over the last 40 quarters. So we cannot really be seen as being any more generous to the current markets, we take the two peak quarters of the last 40 quarters. And then what we do is we compare these peak earnings to potential growth, or trend growth.

 

Because the point here is that what you pay in terms of stocks, should compare, not just to the past or the earnings of proposition, but also to the overall economy generally. Because if the overall economy has a lower potential growth you should be expecting to be able to pay less in terms of multiples than otherwise. The overall economy has a big correlation to earnings and to profit margins, so you should expect the potential growth rate of the economy to be quite relevant when it comes to PE multiples.

Of course, what makes modern markets so uniquely precarious is the fact that investors are struggling with twin bubbles in bonds and equities. However, the former is often overlooked because the public doesn’t have as nuanced an understanding of the bond market. Yet historically speaking, bonds are even more closely correlated with metrics like inflation, as the chart below shows.

However, NIRP and ZIRP has created distortions in bond valuations that have left them extremely overvalued compared with history, meaning that the inevitable regression to the mean will likely take the form of a vicious selloff.

And our point is, look at bonds and look at how they compare to history and how they compare to metrics such as inflation and the GDP – to which historically they are very well correlated – and you find out what this chart on this page, which is showing that we are in totally uncharted territory at present.

 

What is this chart? This chart compares the real rate on German bunds – which are some of the most expensive government bonds on earth and in history – and takes, basically, the real rate on German bunds and compares them to the growth currently experienced by Germany. So the idea – and you see that also in the next slide – the idea is that the real rates in Germany are heavily negative at present.

 

Because what you had was, at the turn of the year, at the end of 2016, inflation started to resurface. So you had deflation and you had a pickup in inflation, which is exactly what you see on the next slide.

 

You see that inflation picked up, whereas nominal rates on German bunds continued their descent. And they continued deeper into negative territory because, obviously, of the ECB policy, of the policies of the central bank. At that point you had a gap opening up between nominal rates and inflation, which means that the real yields were becoming very, very negative. And you see here a table with the negative yields being minus 2.5 on average.

 

And the other thing that interest rates are correlated to is growth. We know that very well, that long-term interest rates, they tend to converge on nominal growth expectations for the economy. So here, in this one indicator which we call the real rate of growth ratio, we put it all together so we compare the nominal rate to inflation to growth. And we end up seeing this.

 

That these bonds have never been so expensive, because they are in deep negative territory – despite a GDP which has resurfaced. It’s not any more zero negative; it is close to 2% as far as Germany is concerned.

Having discussed the bubbles in equity and bond markets, Townsend proceeds to the next logical question. Now that we know we’re in a bubble, how can we tell if the bubble is going to burst? To his credit, Filia admitted he has no idea what the catalyst might be. Furthermore, there doesn’t necessarily need to be a catalyst for these bubbles to burst – but once their valuations have reached a kind of tipping point, they could implode on their own.

There can be a catalyst. Or there can be no catalyst. If you talk about catalysts, I could argue that can be inflation, for example. At the moment, we have seen that inflation resurfaced. We have seen some tightness in the job market. It has not translated yet into wages growth and therefore inflation. But we could just be about to see that. And, in that case, rates would rise and they would provoke as a catalyst the kind of downfall that we expect. Or the catalyst could be political. A lot of quantitative easing is being created and it is benefiting only the top 1% of the population. And it is resulting in this so-called income inequality concept.

 

 

And, so much, the central banks are pushing the wealth effect as they try to make people easier for them to spend more in the economy. But in reality what they are really triggering is income inequality. The consequence of income inequality is populism. Populism can provoke a regime change. Regime change can then affect quantitative easing if the result was not to help the real economy and the middle classes but only the top 1%.

 

So the catalyst could be political.

 

But I can also argue the catalyst could be China. China has a huge problem over indebtedness. It is said to be between 300% and 600% of GDP. GDP is $11 trillion. So it is a monumental credit bubble that could give troubles at any point. And if it gives troubles you can expect the whole world to listen carefully like it did in August of 2015 and January of 2016, and even more than that.

 

I think that it can be also no catalyst. And why is it no catalyst? Because at moments in which the market is overvalued you can never know for sure how much further the bubble can go. But at some point, it reaches a tipping point, a critical mass, where the probability is higher and higher for it to fall down.

At a certain point, swollen valuations reach a level where they no longer make sense, bids evaporate, and prices plunge. But it’s exceedingly difficult to pinpoint just when that point might be.

Get Out Now: SocGen Predicts Market Crash, Bear Market For The S&P

While the charade of sellside analysts releasing optimistic, and in the case of Barclays and Goldman "rationally exuberant"previews of the year ahead...

... is a familiar, long-running tradition on Wall Street, rarely has the intellectual dishonesty and cognitive dissonance been quite so glaring: take Goldman, which while admitting that valuations have never been higher, and the upside case never more reliant on just one piece of legislation which has a significant chance of not passing (GOP tax reform for those unaware), Goldman still has to temerity to predict not only no bear market in the next three years, but goes so far as to suggest an "irrationally exuberant" target of 5,300 in three years.

And as of this morning, the penguins are on full parade, with virtually not a single big bank predicting the market will drop in the coming year. Here are the latest S&P price targets, EPS forecasts and implied PE multiples, for the year ahead:

• Bank of Montreal, Brian Belski, 2,950, EPS $145.00, P/E 20.3x


• UBS, Keith Parker, 2,900, EPS $141.00, P/E  20.6x


• Canaccord, Tony Dwyer, 2,800, EPS $140.00, P/E 20.0x


• Credit Suisse, Jonathan Golub, 2,875, EPS $139.00, P/E 20.7x


• Deutsche Bank, Binky Chadha, 2,850, EPS $140.00, P/E 20.4x


• Goldman Sachs, David Kostin, 2,850, EPS $150.00, P/E 19x


• Citigroup, Tobias Levkovich, 2,675, EPS $141.00, P/E 19.0x


• HSBC, Ben Laidler, 2,650, EPS $142.00, P/E 18.7x

Good luck with all those 20x P/Es in a world in which rates are rising and central bank balance sheets will start contracting in one year.

Luckily, there is the occasional honest bank, like Macquarie (whose Viktor Shvets has become one of our favorite commentators for his objective, no nonsence analysis) and - as of this morning - SocGen, whose strategist Roland Kaloyan has written a note which warns that with bond yields rising (see the crash in China overnight, where the Shanghai Composite tumbled the most in 17 months on the realization that rising rates is bad for stocks), there is effectively no upside left in stocks, which coupled with the prospect of a US economy recession in 2020 will "crimp returns in 2019" Furthermore, in light of the record vol shorts, SocGen jumps on the VIX-squeeze crash bandwaon, warning vol positioning could "strongly deteriorate the risk reward profile of equity markets."

In not so many words: with little stock upside left, with the threat of rising interest rates slamming P/E multiples, with the economy in deep in late cycle, with equities trading at record valuations, with everyone short vol and just begging for a vol short squeeze, SocGen"s advice is simple: get out now.

Here is SocGen:

We are less enthusiastic about equities heading into 2018 – We do not see much upside on our major equity targets for the next 12 months. We expect stretched valuations and rising bond  yields to limit equity index performances in 2018 and the prospect of a US economic slowdown in 2020 to further cramp returns in 2019. We also raise some concerns about the quantity of shorts on volatility, which could potentially strongly deteriorate the risk reward profile of equity markets.

Specifically, with regards to the S&P, SocGen reports that US equities are now at - or rather about 100 points above - their fair value:

The S&P 500 has reached our target for the end of this cycle (2,500pts) and is now entering expensive territory. Indeed, on all the metrics, US equities are trading at levels only seen during the late-90s bubble. Since Trump’s election, the US equity market has risen 24%, but only half of this came from earnings growth. The other half has been driven by P/E expansion. According to our calculations, the US equity market is already pricing in potential tax reform. The rise in bond yields and Fed repricing should be headwinds against further US equity rerating.

If that wasn"t enough, SocGen also notes that its valuation model suggests "that upside on the S&P 500 is limited: the US equity market is already pricing in a rebound in growth and inflation. The rise in bond yields and Fed repricing should be a headwind against further US equity rerating."

In practical terms, this means that SocGen is predicting that the S&P, which is already 100 points above the bank"s year end target of 2,500, will tumble to 2,000, or more than 20%, before rebounding modestly to 2,200 just as the US economy succumbs to a recession, at which point all bets are off. And not just the S&P, but virtually all major European bourses are due for a bear market in the coming 12 months.

Here are some of the key arguments behind SocGen"s bearish outlook, first a familiar discussion of the risk posted by the biggest vol short ever observed.

Equity volatility, both realised and implied, has been edging ever lower for quite some time now. Being invested in a simple systematic short VIX future volatility has been strongly rewarding: +290% over the last two years. However, when the tide turns (i.e. VIX spikes), the drawdown can be significant. The quantity of short positioning on VIX open in the market (see right chart) would potentially amplify any spike of the VIX.

The risk of a VIX surge ties into the question of how the market"s risk/return profile will be shaped in the coming year based on what the prevalent VIX level is:

The risk /reward ratio as measured by the Sharpe ratio has been very attractive for US equities: good expected return supported by reasonable valuation and EPS growth, a very low Fed fund rate and an ultra-low volatility regime. At the current 12-month forward P/E, we factor in our Fed Fund scenario (2.25% by end-2018) and a different volatility regime. A change of VIX regime from 10% to 15% would push the US equity Sharpe ratio back to its historical average.

Then there is the already record stretched valuations, something even Goldman admitted earlier this week, with "US equities trading above their long-term average and at a level only seen during the dotcom bubble."

US equities have not been in attractive territory valuation-wise for a while. Indeed, on all the main valuation metrics, US equities are trading above their long-term average and at a level only seen during the dotcom bubble. However, expected earnings growth for the next 12 months (12%) is below the 20y annual earnings growth average (14%).

The last risk is that bond yields are going higher, forcing a contraction to PE multiples, as investors shift away from equities into bonds, as the dividend yield on US stocks at 2.0%, is now lower than the 10Y yield  of 2.3%.

Under our scenario, US Treasures will reach 2.70% at the end of 2018. This should be a headwind for equity markets. Indeed, our US equity risk premium is at 2.9%, one standard deviation below the long-term average . Any increase in bond yields would push the equity market further into expensive territory relative to bonds The dividend yield offered by US equities (2.0%) is already lower than the current US longterm bond yield (2.3%).

Finally, SocGen points out something that few other analysts  have admitted: half the S&P rally since the Trump election has been on the back of multiple expansion, with just 48% the result of earnings growth. Furthermore, as SocGen calculates, assuming tax reform passes, a decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months. In other words, contrary to conventional wisdom, more than 100% of Trump"s tax reform is already priced in.

Since Trump’s election, the S&P 500 has risen 24%. Only half of this performance has been driven by earnings growth; the other half is from P/E expansion. Assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. The S&P 500 index tax rate is currently 26.6%. Assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months.

Separately, turning to Europe, Socgen acknowledges the euro zone"s economic recovery is in full swing but - in yet another bearish thesis - argues that the current valuations don"t leave "much meat on the bone" and that the expected rise in the Euro could also weigh on exporters in particular, and European stocks in general. Additionally, with the European Central Bank set to progressively unwind its stimulus package, investors are increasingly wary of the amount of debt some companies have accumulated thanks to historically low interest rates.

Cable group Altice, whose shares have collapsed more than 50% in the last 30 days due to concerns on its €50 billion euros pile of debt, and whose debt plunge has been seen by some as the catalyst for the recent junk bond swoon, is an example of what is likely to come, Societe Generale said.

And while the French bank saw pockets of growth in Germany, France and in sectors such as financials, but warned that political risks are still present, notably in Spain with the Catalonia crisis and Italy which faces general elections in 2018. Oh, and the UK too: "We also recommend staying away from the UK as Brexit negotiations are accelerating and several scenarios are possible: only a soft Brexit would be supportive for the FTSE 100.

And yet, after all that, not even Socgen is willing to bite the bullet, and warn that ahead of what clearly is "a bear market is coming" call, investors should dump risk: so ingrained is the desire to run with the penguin herd, that even the most contrarian calls are doused in such a big layer of caveats, Arnold could easily driver his hummer on top of.

To wit: "But then again, should we be outright bears? After all, we do see some value pockets in the market and some specific themes (M&A, consumer in the eurozone)."

Which almost explains the report"s cover page...

Positive Feedback Loops, Financial Instability, & The Blind Spot Of Policymakers

Authored by Francesco Filia of Fasanara Capital,

“Learn how to see. Realize that everything connects to everything else.” – Leonardo da Vinci

A Dangerous Market Structure is More Worrying than Expensive Asset Valuations and Record Debt Levels

Macro-prudential regulations follow financial crises, rarely do they precede one. Even when evidence is abundant of systemic risks building up, as is today, regulators and policymakers have a marked tendency to turn an institutional blind eye, hoping for imbalances to fizzle out on their own – at least beyond the duration of their mandates. It does not work differently in economics than it does for politics, where short-termism drives the agenda, oftentimes at the expenses of either the next government, the broader population or the next generation.

It does not work differently in the business world either, where corporate actions are selected based on the immediate gratification of shareholders, which means pleasing them at the next round of earnings, often at the expenses of long-term planning and at times exposing the company itself to disruption threats from up-and-comers.

Long-term vision does not pay; it barely shows up in the incentive schemes laid out for most professions. Economics is no exception. Orthodoxy and stillness preserve the status quo, and the advantages hard earned by the few who rose from the ranks of the establishment beforehand.

Yet, when it comes to Central Banking, and more in general policymaking, financial stability should top the priority list. It honorably shows up in the utility function, together with price stability and employment, but is not pursued nearly as actively as them. Central planning and interventionism is no anathema when it comes to target the decimals of unemployment or consumer prices, yet is residual when it comes to master systemic risks, relegated to the camp of ex-post macro-prudential regulation. This is all the more surprising as we know all too well how badly a deep unsettlement of financial markets can reverberate across the real economy, possibly leading into recessions, unemployment, un-anchoring of inflation expectations and durable disruption to consumer patterns. There is no shortage of reminders for that in the history books, looking at the fallout of dee dives in markets in 1929, 2000 and 2007, amongst others.

Intriguingly, the other way round is accepted and even theorized. Manipulating bond and stock prices, directly or indirectly, is mainstream policy theory today. From Ben Bernanke’s ‘portfolio balance channel theory’, to the relentless pursuit of the ‘wealth effect’ via financial repression under Janet Yellen and Haruhiko Kuroda, to Mario Draghi tackling the fragmentation of credit markets across the EU via direct asset purchases, the practice has become commonplace. To some, like us, the ‘wealth effect’ may be proving to be more of an ‘inequality effect’ than much, leading to populism and constantly threatening regime change, but that is beyond the scope of this note today.

What we want to focus on instead is the direct impact that monetary interventionism like Quantitative Easing (‘QE’) and Negative or Zero Interest Rate Policies (‘NIRP’ or ’ZIRP’) have on the structure of the market itself, how they help create a one-sided investment community, oftentimes long-only, fully invested when not levered up, relying on record-highs for bonds and stocks to perpetuate themselves endlessly - despite a striking disconnect from fundamentals, life-dependent on the lowest levels of volatility ever seen in history. The market structure morphed under the eyes of policymakers over the last few years, to become a pressure cooker at risk of blowing-up, with a small but steadily growing probability as times goes by and the bubble inflates. The positive feedback loops between monetary flooding and the private investment community are culpable for transforming an ever present market risk into a systemic risk, and for masking as peaceful what is instead an unstable equilibrium and market fragility.

Positive Feedback Loops create divergence from general equilibrium, and Systemic Risks

Positive feedback loops, in finance like in biology, chemistry, cybernetics, breed system instability, as they orchestrate a further divergence from equilibrium. An unstable equilibrium is defined as one where a small disturbance is sufficient to trigger a large adjustment.

QE and NIRP have two predominant effects on markets: (i) relentless up-trend in stocks and bonds (the ‘Trend Factor’), dominated by the buy-the-dip mentality, which encapsulates the ‘moral hazard’ of investors knowing Central Banks are prompt to come to their rescue (otherwise known as ‘Bernanke/Yellen/Kuroda/Draghi put’), and (ii) the relentless down-trend in volatility (the ‘Volatility Factor’).

Two Factors Explain All: Trend and Volatility

The most fashionable investment strategies these days are directly impacted by either one or both of these drivers. Such strategies make the bulk of the overall market, after leverage or turnover is taken into account: we will refer to them in the following as ‘passive’ or ‘quasi-passive’. The trend impacts the long-only community, crowning it as a sure winner, making the case for low- cost passive investing. The low volatility permeates everything else, making the case for full- investment and leverage.

The vast majority of investors these days are not independent from the QE environment they operate within: ETFs and index funds, Risk Parity funds and Target Volatility vehicles, Low Volatility / Short Volatility vehicles, trend-chasing algos, Machine Learning-inspired funds, behavioral Alternative Risk Premia funds. They are the poster children of the QE world. We estimate combined assets under management of in excess of $8trn across the spectrum. They form a broad category of ‘passive’ or ‘quasi-passive’ investors, as are being mechanically driven by two main factors: trend and volatility.

Source: Fasanara Presentations | Market Fragility - How to Position for Twin Bubbles Bust, 16^th October 2017. The slide is described in details in this video recording.

Extraordinary monetary policies have feedback loops with the asset management industry as a whole, reinforcing the effects on markets of such policies in a vicious – or virtuous - cycle. QE and NIRP help a large number of investment strategies to flourish, validating their success and  supporting their asset gathering in the process, and are in return helped in boosting bond and stock markets by their flows joining the already monumental public flows.

Private flows so reach singularity with public flows, and the whole market economy morphs into a one big common bet on ever-rising prices, in shallow volatility. Here is the story of how $15trn of money printing by major Central Banks in the last ten years, of which $3.7trn in 2017 alone, is joined by total assets of $8trn managed into buying the same safe and risk assets across, with leverage, indiscriminately.

How Market Risk became Systemic Risk

Let"s give a cursory look at the main players involved (a recent presentation we did is recorded here). As markets trend higher, no matter what happens (ever against the shocked disbeliefs of Brexit, Trump, an Italian failed referendum and nuclear threats in North Korea), investors understand the outperformance that comes from pricing risks out of their portfolios entirely and going long-only and fully-invested. Whoever under-weighs positions in an attempt to be prudent ends up underperforming its benchmarks and is then penalized with redemptions. Passive investors who are long-only and fully invested are the winners, as they are designed to be bold and insensitive to risks. As Central Banks policies reduce the level of interest rates to zero or whereabouts, fees become ever more relevant, making the case for passive investing most compelling. The rise of ETF and passive index funds is then inevitable.

According to JP Morgan, in the last 10 years, $2trn left active managers in equities and $2trn entered passive managers (pag.39 here). We may be excused for thinking they are the same $ 2trn of underlying investors progressively pricing risk provisions out of books, de facto, while chasing outperformance and lower fees.

To be sure, ETFs are a great financial innovation, helping reducing costs in an expensive industry and giving entry to markets previously un-accessible to most investors. Yet, what matters here is their impact on systemic risks, via positive feedback loops. In circular reference, beyond Central Banks flows, markets are helped rise by such classes of valuations-insensitive passive investors, which are then rewarded with further inflows, with which they can then buy more. The more expensive valuations get, the more they disconnect from fundamentals, the more divergence from equilibrium occurs, the larger fat-tail risks become.

In ever-rising markets, ‘buy-and-hold’ strategies may only possibly be outsmarted by ‘buy-the-dip’ strategies. Whatever the outcome of risk events, be ready to buy the dip quickly and blindly. As more investors design themselves up to do so, the dips are shallower over time, leading to an S&P500 that never lost 3% in 2017, an historical milestone. Machine learning is another beautiful market innovation, but what is there to learn from the time series of the last several years, if not that buy- the-dip works, irrespective of what caused the dip. Big Data is yet another great concept, shaping the future of us all. Yet, most data ever generated in humankind dates back three years only, in and by itself a striking limitation. The quality of the deduction cannot exceed the quality of the time series upon which the data science was applied. If the time series is untrustworthy, as is heavily influenced by monumental public flows ($300bn per months), what trust can we put on any model output originating from it? What pattern recognition can we really be hopeful of getting, in the first place? May some of it just be a commercial disguise for going long, selling volatility and leveraging up in various shapes or forms? What is hype and what is real? A short and compromised data series makes it hard, if not possible, to really know. Once public flows abate and price discovery is let free again, then and only then will we be in a position to know the difference.

Low volatility does what trending markets alone cannot. A state of low volatility presents the appearance of stuporous, innocuous, narcotized markets, thus enticing new swathes of unfitting investors in, mostly retail-type ‘weak hands’. Weak hands are investors who are brought to like investments by certain characteristics which are uncommon to the specific investment itself, such as featuring a low volatility. It is in this form that we see bond-like investors looking at the stock market for yield pick-up purposes, magnetized by levels of realized volatility similar to what fixed income used to provide with during the Great Moderation. It is in this form that Tech companies out of the US have started filling the coffers of not just Growth ETF, where they should rightfully reside, but also Momentum ETF, and even, incredibly, Low-Volatility ETF.

Low volatility is also a dominant input for Risk Parity funds and Target Volatility vehicles. The lower the volatility, the higher the leverage allowed in such players, mechanically. All of which are long-only players, joining public flows, again helping the market rise to record levels in the process,  in circular reference. Rewarded by new inflows, the buying spree gathers momentum, in a virtuous circle. Valuations are no real input in the process, volatility is what matters the most. Volatility is not risk, except for them it is.

It goes further than that. It is not only the level of volatility that count, but its direction too. As volatility implodes, relentlessly, into historical lows never seen before in history, a plethora of investment strategies is launched to capitalize on just that, directly: Short Volatility vehicles. They are the best performing strategy of the last decade, by and large. The problem here is that, due to construction, as volatility got to single-digit territory, relatively small spikes are now enough to trigger wipe-out events on several of these instruments. Our analysis shows that if equity volatility doubles up from current levels (while still being half of what it was as recently as in August 2015), certain Short Vol ETFs may stand to lose up to 75% or more. Moreover, short positions on long-vol ETFs can lose up to 250% of capital. For some, ‘termination events’ are built into contracts  for sudden losses of this magnitude, meaning that the notes would be prematurely withdrawn. It is one thing to expect a spike in volatility to cause losses, it is quite another to know that a minor move is all it takes to trigger a default event.

On such spikes in volatility, Morgan Stanley Quant Derivatives Strategy desk warns further that market makers may be forced to rebalance their exposure non-linearly on a spike in volatility. A drop in the S&P 500 of 5% in one day may trigger approximately $ 400mn of Vega notional of rebalancing (pag.48 here). We estimate that half a trillion dollars of additional selling on S&P stocks may occur following a correction of between 5% and 10%. That is a lot of selling, pre-set in markets, waiting to strike. Unless you expect the market to not have another 5% sell-off, ever again.

For more details, we describe the role of these different players in a recent video presentation and in our June Investment Outlook and May Investment Outlook.

It"s All One Big Position

What do ETFs, Risk Parity and Target Vol vehicles, Low Vol / Short Vol vehicles, trend-chasing algos, Machine Learning, behavioral Alternative Risk Premia, factor investing have in common? Except, of course, being the ‘winners take all’ of QE-driven markets. They all share one or more of the following risk factors: long-only, fully invested when not leveraged-up, short volatility, short correlation, short gamma. Thanks to QE and NIRP, the whole market is becoming one single big position.

The ‘Trend Factor’ and the ‘Volatility Factor’ are over-whelming, making it inevitable for a high- beta, long-bias, short-vol proxy to disseminate across. Almost inescapably so, given the time series the asset management industry has to deal with, and derive its signals from.

Several classes of investors may move to sell in lock-steps if and when markets turn. The boost to asset prices and the zero-volatility environment created the conditions for systemic risks in the form of an over-compensation to the downside. Record-low volatility breeds market fragility, it precedes system instability.

Flows Matter, Both Ways!

We will know soon if the fragility of markets is that bad. The undoing of loose monetary policies (NIRP, ZIRP) will create a liquidity withdrawal of over $1 trillion in 2018 alone (pag.61-62 here). The reaction of the passive and quasi-passive communities will determine the speed of the adjustment in the pricing for both safe and risk assets, and how quickly risk provisions will re- enter portfolios. Such liquidity withdrawal will represent the first real crash-test for markets in 10 years.

As public spending on Wall Street abates, the risk is evident of seeing the whole market turning with it. The shocks of Trump and Brexit did not manage to derail markets for long, as public flows were overwhelming. Flows is what mattered, above all elusive, over-fitting economic narratives justifying price action at the margin. Flows may matter again now as they fade.

Systemic Risk is Not Just About Banks: Look at Funds

The role of trending markets is known when it comes to systemic risks: a not sufficient but necessary condition. Most trends do not necessarily lead to systemic risks, but hardly systemic risks ever build up without a prolonged period of uptrend beforehand. Prolonged uptrends in any asset class hold the potential to instill the perception that such asset class will grow forever, irrespective of the fundamentals, and may thus lead to excessive risk taking, excess leverage, the formation of a bubble and, ultimately, systemic risks. The mind goes to the asset class of real estate, its undeterred uptrend into 2006/2007, its perception of perpetuity (”we have never had a decline in house prices on a nationwide basis’’ Ben Bernanke), the credit bubble built on banks hazardous activities on subprime mortgages as a result, and the systemic risks which emanated, with damages spanning well beyond the borders of real estate.

The role of volatility is also well-researched, especially low volatility. Hayman Minsky, in his “Financial Instability Hypothesis’’ in 1977, analyses the behavioral changes induced by a reduction of volatility, postulating that economic agents observing a low risk are induced to increase risk taking, which may in turn lead to a crisis: “stability is destabilizing”. In a recent study, Jon Danielsson, Director of the Systemic Risk Centre at the LSE, finds unambiguous support for the ‘low volatility channel’, insofar as prolonged periods of low volatility have a strong predictive power over the incidence of a banking crisis, owing to excess lending and excess leverage. The economic impact is the highest if the economy stays in the low volatility environment for five years: a 1% decrease in volatility below its trend translates in a 1.01% increase in the probability of a crisis. He also finds that, counter-intuitively, high volatility has little predictive power: very interesting, when the whole finance world at large is based on retrospective VAR metrics, and equivocates high volatility for high risk.

Both a persistent trend and prolonged low-volatility can lead banks to take excessive risks. But what about their impact on the asset management industry?

Thinking at the hard economic impact of the Great Depression (1929-1932) and the Great Recession (2007-2009), and the eminent role played by banks in both, it comes as little surprise that the banking sector captures all the attention. However, what remains to be looked into, and perhaps more worrying in today’s environment, is the role of prolonged periods of uptrend and low-vol on the asset management industry.

In 2014, the Financial Stability Board (FSB), an international body that makes recommendations to G20 nations on financial risks, published a consultation paper asking whether fund managers might need to be designated as “global systemically important financial institution” or G-SIFI, a step that would involve greater regulation and oversight. It did not result in much, as the industry lobbied in protest, emphasizing the difference between the levered balance sheet of a bank and the business of funds.

The reason for asking the question is evident: (i) sheer size, as the AM industry ballooned in the last few years, to now represent over [15trnXX] for just the top 5 US players!, (ii) funds have partially substituted banks in certain market-making activities, as banks dialed back their participation in response to tighter regulation and (iii) , funds can indeed do damage: think of LTCM in 1998, the fatal bailout of two Real Estate funds by Bear Stearns in 2007, the money market funds ‘breaking the buck’ in 2008 amongst others.

But it is not just sheer size that matters for asset managers. What may worry more is the positive feedback loops discussed above and the resulting concentration of bets in one single global pot, life-dependent on infinite momentum/trend and ever-falling volatility. Positive feedback loops are the link for the sheer size of the AM industry to become systemically relevant. Today more than ever, they morph market risks in systemic risks.

Volatility will not forever be low, the trend will not forever go: how bad a damage when it stops? As macro prudential policy is not the art of “whether or not it will happen” but of “what happens if”, it is hard not to see this as a blind spot for policymakers nowadays.

The addiction that could not be let go

In conclusion, we believe that markets are being brought into an unstable equilibrium, at risk of snapping violently. The stability of markets resembles the one of a pendulum held in vertical position: a small disturbance is able to create large swings. The swing can be so violent as to send tremors across the real economy, thus jeopardizing the hard earned progress on recovery in growth rates and unemployment of recent years. If positive feedback loops are ignored and bubbles are left unchecked, that may one day most unambiguously qualify as a policy mistake: the addiction to monetary steroids and price control that could not be let go, on time. A bust that was entirely predictable, if only macropru conditions had been a real target, and short termism had not prevailed.

*  *  *

Full Fasanara Letter below...

 

What If The "Exuberance" Is "Irrational"? Then Hold On To Your Hats...

As discussed earlier, Goldman"s entire S&P500 price forecast for 2018 and the next three years is based on two things: tax reform passing, but more broadly, something that David Kostin dubbed "Rational Exuberance", to wit:

“Rational exuberance” best describes our forecast for the trajectory of the S&P 500 during the next several years. Earnings drive stocks over time and should support the index rising to 2850 at year-end 2018, 3000 at the end of 2019, and 3100 by the close of 2020, representing a price gain during the next three years of 20%. Our price targets imply a modest expansion in forward P/E multiple to 18.2x at year-end 2018, a flat multiple in 2019, and a contraction to 18.1x in 2020.

As Kostin describes it, "rational exuberance" is defined by "above-trend US and global economic growth, low inflation, low albeit slowly rising interest rates, and underlying corporate profits boosted by pending corporate tax reform likely to be adopted by early next year."

So far so good, but as Kostin also explained, absent tax reform passing, the S&P will not only not hit 3,100 in 3 years, it may well be lower: "Assuming tax reform passes, we forecast S&P 500 adjusted EPS will jump by 14% to $150 in 2018. Equity investors will be rewarded as the index advances by 11% to 2850 at year-end 2018 and delivers a total return of 13% including the 2% dividend yield." Meanwhile, "If tax reform fails, S&P 500 will fall near-term by 5% to 2450."

It was not clear what would happen to Goldman"s 2020 S&P price target of 3,100 if tax reform does not pass.

What was clear is what would - according to Goldman - happen if the rational exuberance is, in fact, irrational. Here the bank notes that it is impossible to know ex post what flavor the current exuberance has: "Unfortunately, it is only in retrospect that one can definitively establish that assets have reached unsustainable levels. Greenspan was prescient, but three years early. Following Greenspan’s speech warning of the potential for excessive valuations, the S&P 500 subsequently more than doubled (+116%) during the next three years before the Tech bubble finally peaked in March 2000 at a forward P/E multiple of 24x."

So what would happen if the exuberance that awaits the S&P is, in fact, irrational? To that question, Goldman has a ready answer: "We would deem it “irrational exuberance” if the S&P 500 during the next three years followed the exponential trajectory of stocks in the late 1990s."

In such a case, Goldman predicts that the S&P 500 would trade at 5300 by year-end 2020 (a 105% rise from today). If slightly "less irrational" bubble over the next three years would mean stocks instead trade at a similar forward P/E to the Tech Bubble (24x), and would imply a year-end 2020 index level of 4050 (57% above today). During the three years post Greenspan’s speech, S&P 500 EPS rose by 26% ($40 to $50). Translated to today, Goldman calculates such a growth rate would imply 2020 EPS of $166 compared with our estimate of $163.

And for the visual traders, the light blue line in the chart below - i.e., the "irrational" one - would recreate the late 1990s exuberance in the context of today"s market.