Global Macro "Reality" - The Hopium Vs Doomium Model Explained

Authored by Peter Tchir via Academy Securities,

When Reality and Sentiment Diverge

The Hopium versus Doomium Model

We are initiating the Hopium vs. Doomium model today.  I first came across the word Hopium in the aftermath of the financial crisis.  It was typically used by ‘doomers’ who believed markets were far ahead of themselves and were betting on hope rather than reality.

This model attempts to pit what I view as reality versus what view as sentiment.  The scoring system is partly objective (technical indicating overbought or oversold, fund flows, positioning reports, etc.) and partly subjective (largely me trolling the media and social media trying to uncover true sentiment shifts).

What this is meant to do, is to identify opportunities where sentiment and reality diverge.  If sentiment and reality are roughly lined up, then there is no obvious trade to me, but when one is very different than the other, we can identify underweight or overweight opportunities (or even long vs short ideas depending on your mandate).

Macro Hopium/Doomium

VIX

Let’s start with volatility, or more specifically, the VIX index.  It briefly spiked above 13 on Wednesday as global bond selling, concerns about the next Fed Chairperson and even some pre-earnings anxiety swept through the market.  It finished the week at 9.8 which was lower than where it closed the prior Friday.  VXN, a measure of the Nasdaq volatility, also dropped significantly as the Nasdaq composite surged more than 2%.

I do believe that the biggest risk facing the market is a spike in correlation and volatility – but I don’t see that risk as very high right now.  I have VIX showing up as barely in the green – meaning it might be a buy, but it isn’t that compelling.

Reasons VIX can stay low

• Seasonality.  With fewer trading days as we start the U.S. holiday season can often push VIX lower.  There have been instances, like the fiscal cliff and around elections, that hasn’t been the case, but anyone looking to buy VIX must take seasonality into account.


• Expectations for Tax Reform in 2017 are low.  Anything short of killing all possibility of tax reform is likely to be largely ignored by the market.  The market does expect Tax Reform, but not until early next year.  So long as it looks like it is grinding towards that conclusion, there is little need for markets to react – keeping VIX low.  Any setback that can be framed as ‘negotiations’ will be muted.  I am not sure what will constitute derailment, but I suspect we will know it if we see it.

Surprisingly Nervous Volatility Sellers

• No Rush to Sell VIX.  When VIX dropped into the close on Wednesday I expect to see large inflows into the short VIX ETFs and ETNs.  When VIX spiked in August, we saw extremely large inflows into those stocks.  We didn’t see anything like this, which is an indicator that the sellers of volatility are more cautious here, which as a contrarian, means there is less likelihood of a VIX spike.

SVXY Shares Outstanding Aug vs Oct

We did see a significant reduction in shares outstanding in UVXY – an ETF that is double long the VIX short term futures index.  It looks like either profit taking, or more accurately, investors happy to get out with less of a loss than they had, but nothing so dramatic to indicate volatility bulls (market bears) have given up yet.

From a technical standpoint, the VIX futures curve is relatively flat.  The 3rd VIX futures contract (January) closed at 13.35 versus the 1st VIX futures contract (November) which closed at 11.45.   That spread of 1.9 is almost exactly the average for the year between the 3rd and 1st VIX futures contract (UX3 vs UX1 are the tickers on Bloomberg).

Geopolitical Tail Risk

• VIX has responded most violently to increased geopolitical risk.  More than any other asset class, VIX has responded when geopolitical risk has increased.  Academy Securities hosted a client conference call on October 18th (replays are available) where Major General (retired) Spider Marks analyzed the White House Chief of Staff’s assertion that the North Korea threat is ‘manageable’ and largely agreed with that assessment.  We will update you as our views on current geopolitical risk evolve, but in the meantime, for those concerned about it, the best hedges are either VIX call options of long dated European Sovereign Debt – which leads us to our next asset classes.

Bunds and Treasuries

As of the initial writing of this report, I do not know who President Trump will name as next Fed Chairperson, but like everyone else, I await that decision as it should provide some clarity.  I view that while there will be an initial price reaction to any decision, the market will quickly rule out the possibility of a major change in policy.  The reality is that the head of the Fed is virtually forced to be dovish.  If they are dovish and the economy does well – they are lauded.  If they are dovish and the economy does poorly – they can just get even more dovish.  The only thing that really hurts them, is being hawkish and the economy slowing.  Why risk that?  Draghi didn’t risk that this week!

I continue to view Treasuries as a good candidate to be underweight as my ongoing target for the 10-year treasury is 2.60% with a chance of briefly spiking above that.  The fundamentals for treasury investors are poor – improving economic data, D.C. trudging its way towards a near term deficit increasing tax plan, etc.  There seems to be more denial in the bond market than the equity market on the potential for sustained economic growth. 

I struggle with the positioning of the bond market as many surveys indicate extreme bearish positioning, yet I find relatively few bears and a disproportionate number of bulls – who are bulls because everyone else is bearish – despite my inability to find that overwhelming bearish community.

Draghi does it again – crafting every action to be as dovish as possible.

German 10 Year Bund Yields

Bunds bounced right at the 0.49% yield level again.  That is the 4th time this year that bunds have failed to rally though that level.

While it is hard to like European yields here, they are universally hated.  That puts them into the ‘yellow’ or neutral area – at least until some more of the short positions are closed post Draghi.

It is difficult to disentangle emotions from true market impact regarding what is occurring in Spain and Catalonia.  The headlines and images are awful, but it is difficult to form a direct and near-term path that impact all European markets, let alone global markets.  It needs to be watched and while the market’s muted reaction may ‘feel’ wrong, it seems correct from a trading viewpoint.

Bunds (and other high credit quality EU Sovereign Debt) can provide excellent protection from North Korean Geopolitical risk.  Any risk-off trading emanating from Korea should help sovereign debt yields, but should also strengthen the Euro versus the Yen and versus the Dollar – adding an extra kicker to those bonds.

Dollar Weakness

DXY, a dollar index has rebounded sharply since threatening to break through multi-year lows in early September.  While there is nothing that changes my view that this administration wants a weaker dollar and is capable of jawboning it down, the clear diversion between a Fed that seems intent on hiking and an ECB that figured out how to renew its dovish bias, could support the dollar.  

DXY Bounce on Support & Retakes Moving Averages

DXY broke the 100-day moving average last week as it closed at 94.9.  That puts the 200-day moving average of 96.9 as a possible target.  The model is biased towards weaker dollar, but with very limited conviction.

Domestic Stocks

After last week’s surge, both U.S. Large Cap and U.S. Small Cap stocks looked stretched.  Sentiment is clearly high for both groups by virtually any measure, but the fundamentals seem to warrant the valuations here.  If something occurs to really disrupt the Tax Reform than look for significant pullbacks as that would dramatically shift the fundamental outlook.

Credit

Boring.  Not sure that I can put a better description than boring on the overall credit market.  Individual companies and sectors are exhibiting some idiosyncratic risk, but overall, risks and rewards seem balanced.  Credit spreads are tight, but with the global economy marching along and volatility suppressed – there is little need for credit spreads to widen.  In fact, while equities are hitting all-time highs, credit spreads are still above their pre-crisis lows.

Tax Reform can create some winners and losers – especially once Washington decides what to do, if anything, about the deductibility of interest expenses.  

I will run a full Fixed Income Hopium/Doomium Report on Tuesday where we will delve deeper into the fixed income markets while drilling down into high yield, investment grade, bonds versus loans, structured credit, etc.

Oil

For much of the year, I had a range on oil of $40 to $55, but I think we could support higher oil prices here.  Sentiment does seem bullish, but may be behind the bullish case.  I have a bias towards domestic energy companies – equities and high yield bonds – as there is still an undercurrent in Washington that wants to focus on energy selfsufficiency.  Tax Reform and Decreased Regulations should help these companies, especially if it releases any pent-up demand for M&A activity (high yield bonds tend to do better than IG bonds during periods of M&A and the high yield energy bonds could do very well if we get that combination of higher prices and reduced regulation.

Gold and Bitcoin

I always have trouble with sentiment for gold and that is even more true with Bitcoin (or cryptocurrencies in general).  How do you create a sentiment when one portion of the world sits on ‘fraud’ and another portion of the world sits on ‘greatest thing ever.’  For gold, I find I have to sort through the barbaric relic crowd and the evangelists to derive a reasonable market view of sentiment – and Bitcoin forces me to do that exercise on steroids.

I think gold is losing its luster as a hedge.  Yes, it is something many talk about and own.  In fact, there are people that I know well and respect that advocate for a 5% to 10% holding of gold – ideally in physical form.  That may make sense, but lately gold does seem to be responding less dramatically than cryptocurrencies.  Whether it is lack of portability or that it just isn’t the new kid on the block – it really doesn’t seem to perform like you would expect – it lagged both VIX and Bitcoin when the situation in Korea became more concerning back in August.

I think at some level Bitcoin is syphoning demand from Gold.  Some portion of money that used to at the margin, buy gold on geopolitical concern, now buys cryptocurrencies (the vast majority just buys long dated sovereign debt as their geopolitical risk hedge because not only has it worked lately, you get paid to hold it – part of my ongoing theme of the popularity of Risk Parity Lite).

Bitcoin is slowing attracting new users as the price attracts attention, as it demonstrated its ability to navigate China’s crackdown and it is becoming easier to own (Coinbase, I have been told by several knowledgeable people, has made it much easier to transact).  If any ETF is eventually launched, that should create yet another wave of demand as it is easier to purchase.  The purists will scream that owning it in ETF form misses the point, but the gold purists scream about physical too, and it hasn’t stopped GLD from being highly successful.

Longer term, I have no idea where Bitcoin and cryptocurrencies will head – I do believe there will be more attempts from government authorities to crack down on it, but near term, I think it is gaining traction and is something that comes up in virtually every conversation I have that last more than a few minutes.
As a caveat, I want to highlight that I do live by my 3 Rules of Bitcoin and I don’t find it paradoxical that rule number 2 is that there are no rules – it just makes analyzing it more difficult.

Bottom Line

Relatively few obvious trades out there, at least as generated by this model.  I really want to see outliers and as much as I stare at this, it is currently difficult to identify outliers.

Short treasuries and short USD might be an interesting pair.

Long oil versus short gold would need some additional work, but is another possibility. 

Own some VIX calls – it hasn’t worked, and I would wait to see sentiment get a bit more extreme on the ‘volatility is dead’ side of things before entering.

As mentioned earlier, I will do full update on the fixed income and credit side of things for Tuesday and will add some additional Macro Asset classes in the coming weeks as I rebuild my models.

Short

 

Institutions Are Selling To Retail Investors At An Unprecedented Pace

According to the latest EPFR fund flow data compiled by BofA"s Michael Hartnett, the great "institutional to equity" stockholding rotation is accelerating, with another $8.8bn allocated to equities, more than all of it from retail investors, and another $5.8bn going into bonds, offset by a $0.4bn outflows from gold.

Ironically, the one place where active investors are still putting back at least a token fight against the robots is in bonds, where $3.6bn went into active bond funds this week vs "only" $2.2bn into passive bond ETFs. And, as Hartnett writes, active AUM is fighting back, if only in bondland, where there have been $1.04tn in active bond inflows past 10 yrs vs. $0.93tn into passives...

.... a very different trend from what has taken place in stocks in the past decade (Chart 2) where institutions are delighted to dump to "low-cost" passive alternatives.

Of course, this particular "great rotation" is no surprise: earlier this week we were surprised to report that on its conference call, Morgan Stanley reported that the cash levels in its clients (retail) accounts, is the lowest it has ever been:

... we"ve been talking about our deposit deployment strategy for quite sometime, and we"ve been investing excess liquidity into our loan product over the last several years. In the beginning of the year, we told you that, that trend would come to an end. We did see that this year. It happened a bit sooner than we anticipated as we saw more cash go into the markets, particularly the equity markets, as those markets rose around the world. And we"ve seen cash in our clients" accounts at its lowest level.

Meanwhile we also showed that institutions continue to sell at a torrid pace, and as BofA reported, in the last week when the S&P hit new all time highs, its clients were net sellers of US equities for the fourth consecutive week. Large net sales of single stocks offset small net buys of ETFs, leading to overall net sales of $1.7bn. Net sales were led by institutional clients, who have sold US equities for the last eight weeks; hedge funds were also (small) net sellers for the sixth straight week.

The best way to visualize the institutional selling? This chart from BofA:

 

Who bought? Why retail"s favorite investment product of course, ETFs: "Private clients were net buyers, which has been the case in four of the last five weeks, but with buying almost entirely via ETFs. Clients sold stocks across all three size segments last week."

* * *

Going back to the latest fund flows report, BofA reports that for all the talk about an imminent surge in interest rates, yields are still winning: $6.3bn inflows to IG+HY+EM bonds this week; investors continue to discount low-rate environment. This happens as the 5s30s yield curve (88bps) is the flattest since GFC, a fact Mike Hartnett finds "remarkable given the Philly Fed Employment outlook hit a 50-year high today." Just as surprisng: bond funds have now seen 31 straight weeks of inflows, as investors continue to overwhelmingly pick yield over capital appreciation.

Across the globe, Japan is losing (for a change), with a record $4.4bn outflows from Japan equities (86% ETF redemptions, possibly via BoJ); which is odd considering the Nikkei hasn"t had a down day in the past 14 days: the longest stretch of gains on record! It likely won"t last however, with BofA predicting that after Sunday"s election "we expect Japan TOPIX to revert to tracking US bond yields (Chart 4)."

In the US, where the S&P just hit all time highs, there was a solid week of $7.5bn US in equity inflows.

Some more bad news for professional investors:  while there have been inflows in 17 of past 19 weeks, all of this continues to go into passive funds, with $11.1bn flowing into ETFs offset by another $2.2bn outflow from mutual funds.

As a result, Hartnett concludes that robots continue to win, especially since this week"s launch of the 1st ETF in which stocks will be selected by robots (AIEQ) comes as tech funds see biggest inflows in 38 weeks; AIEQ outperforming SPX thus far.

As for the retail equity euphoria, nowehere is it more obvious than in BofA"s high net worth client tracking where YTD flows show a decisive cyclical shift by private clients, who are buying bank loans, financials, EAFE ETFs, while shunning quality, utilities, large caps & dividends (Chart 6). And as the next chart shows, equity allocations among BofA private clients are just shy of all time highs, and well above where they were during the last market peak.

BofA"s takeaways:

• Alpha in bonds; inflows to active funds continue to outstrip passive


• AIpha in stocks: first ETF where stocks selected by robots launches amidst biggest Tech inflows in 38 weeks
   


• Tick-tock: risk-on equity & bond flows push B&B indicator up to 7.6

To which we can only add: the rush by institutions to dump their equity holdings to retail investors - courtesy of "low-cost" ETFs - has never been greater. The only question now is when does the Fed pull the trapdoor, as it always does just when the market peaks...

Bank of America: "The Best Reason To Be Bearish Is...There Is No Reason To Be Bearish"

Back in mid-July, Bank of America chief investment strategist Michael Hartnett wrote "The Most Dangerous Moment For Markets Will Come In 3 Or 4 Months" in which he warned that "further upside in risk assets will create problems later in the year" and concluded that "ultimately, we believe the extremely strong performance by equities and bonds in H1 is very unlikely to be repeated in H2" because "monetary policy will have to tighten to raise volatility, reduce Wall St inflation, and reduce inequality. There are two ways to cure inequality: you can make the poor richer, or you can make the rich poorer. The Fed will reduce its balance sheet in the hope of making Wall St poorer."

Or maybe not, because almost three months later, the same Hartnett today writes that the "best reason to be bearish is...there is no reason to be bearish." and admits that the "Icarus "long risk" trade extended into autumn (Humpty-Dumpty "great fall" postponed a tad longer) by low inflation, big liquidity ($2.0tn central bank buying), high EPS, and promise of US tax reform", noting that the "monster rally in credit and equity markets began 18 months ago when best reason to be bullish was there was no reason to be bullish."

And with the VIX approaching all time lows as the S&P hits another daily high, the BofA strategist reiterates that his "Icarus Rally" price targets for Q4 remains 2630 in the S&P, 6666 on the Nasdaq, and the 10-year Treasury hitting 2.85%, as the rising dollar pushed the EURUSD down to 1.15. So what will prompt Q4 peak in the market? According to the BofA strategist, the catalyst will be a "Q4 "top" driven by tax reform, i.e. "peak Policy, a rise in MOVE index, and a peak RMB.

As Hartnett details further, here are the three catalysts that could end the current period of record complacency.

• Tax reform = "peak policy" = buy rumor, sell fact…but too early to sell fact; tax reform = quicker Fed balance sheet reduction and less share buybacks if capex accelerates (since 2009 lows S&P equity market cap up $15.3tn, Fed"s balance sheet up $4.5tn, share buybacks up $3.5tn)


• Big jump in the MOVE index of US Treasury market volatility (i.e. "bond shock") catalyst for cross-asset vol, but requires inflation to rise


• China financial conditions have tightened & EM "carry-trade" unwind another source of cross-asset vol (Chart 3)…Chinese policy panic kickstarted this 18-month rally, and consensus now much more complacent on China

The question then is how long after said top drags the market lower before the Fed casually hint that QE4 may be just around the corner to keep the wealth effect alive in perpetuity.

Here are some other observations from Hartnett on the latest weekly fund flows:

• Risk-off week of flows: $8.8bn into bonds, $2.2bn outflows from equities, $0.3bn into gold


• Q3 rotation from US to rest of world: week of $7.5bn US equity outflows biggest in 14 weeks; $23bn US equity outflows in Q3 vs $41bn inflows to rest of world, continuing clear flow divergence YTD (Chart 1)


• 


• Q3 "yield-on" continues in fixed income: inflows to HY bonds (biggest in 10 weeks) & EM debt vs Treasury outflows reflects ongoing lust for yield; $68bn IG bond inflows in Q3 dominated all fixed income flows and IG continues to be the big "yield winner"


• Stocks star in 2017: YTD annualized returns…stocks 24%, bonds 7%, commodities -2%, US dollar -11%


• Our Q4 targets: S&P 2630, Nasdaq 6666, 10-year Treasury 2.85%, EUR 1.15


• Our Q4 AA: long stocks, commodities, volatility, US$, short bonds; more bearish AA expected in 2018


• Our Q4 trades: long US$ vs EM FX, long oil, long barbell of uber-growth (IBOTZ, DJECOM) & uber-value (BKX) = Icarus trade; further unwind of extended "long disruptor, short disrupted" trade likely (i.e. death of old Retail, Media, Autos, Advertising by Tech Disruptors - Chart 2); rotational outperformance of oil>credit, EAFE>EM, value/growth


• And monster rally in credit and equity markets began 18 months ago when best reason to be bullish was there was no reason to be bullish


• Returns since Feb"16 lows: EM equities 63%, Nasdaq 45%, S&P 42%, HY bonds 30% reflect core bull market leadership of scarce Growth, scarce Yield


• Global stock market cap up a massive $18.5tn over period, an amount equivalent to the entire US GDP


• 318 trading days since SPX -5%, the 4th-longest streak since 1928


• So risk assets can rally further but we expect Q4 "top" in equities and credit driven by: a. pricing-in of US tax reform (= peak Policy), b. rise in MOVE index (= peak Positioning), c. rally in oil + trough in Chinese RMB + upgrades to global GDP (= peak Profits)


• Tax reform = "peak policy" = buy rumor, sell fact…but too early to sell fact; tax reform = quicker Fed balance sheet reduction and less share buybacks if capex accelerates (since 2009 lows S&P equity market cap up $15.3tn, Fed"s balance sheet up $4.5tn, share buybacks up $3.5tn)


• Big jump in the MOVE index of US Treasury market volatility (i.e. "bond shock") catalyst for cross-asset vol, but requires inflation to rise


• China financial conditions have tightened & EM "carry-trade" unwind another source of cross-asset vol (Chart 3)…Chinese policy panic kickstarted this 18-month rally, and consensus now much more complacent on China

Meanwhile, as Hartnett concludes, the pain for active managers continues, because in a week in which ETFs saw another inflow of $1.2 billion, mutual funds suffered their latest $3.3 billion outflows.

Matt King: Global QE And "ETFs Everywhere" Have Created An Unstable, One-Way Market

While the financial industry remains divided over what precisely is the cause of the malaise that affects modern markets, characterized by plunging volumes and trading activity, record low volatility and dispersion, a relentless ascent disconnected from fundamentals, and generally a sense of foreboding doom, manifested by an all time high OMT skew - or record high price for crash insurance - as discussed previously...

... it can agree on one thing: it has something to do with the interplay of QE, the artificial force that has disconnected market prices from values for the past 8 years, and ETFs, which as some prominent investors have said are "devouring capitalism." They also agree that the combination of QE and ETFs have made the market almost entirely "one-sided", and thus prone to collapse when conditions finally reverse.

Indeed, as Citi"s Matt King - our favorite sellside cross-asset strategist - writes in his latest report, a growing number of institutional managers, from Oaktree to Elliott to  Bridgewater, have recently been expressing concerns not only about elevated valuations and the potential for a correction, but in many cases also about the potential for herding and the risk that markets have grown one-sided."

King points out a trend observed among the financial literature over the past 2-3 years (starting with Howard Marks" March 2015 note in which he asked, rhetorically "What Would Happen If ETF Holders Sold All At Once? Howard Marks Explains"), "everyone’s number-one suspect in potentially creating such a tendency seems to be ETFs. In Paul Singer’s memorable words, passive investment through the likes of ETFs “is unsustainable and brittle” and “is in danger of devouring capitalism”.

But are ETFs really to blame, King wonders, or simply a symptom of some other underlying tendency? His answer is the latter, and begins with an explanation we have shown many times on this website: the relentless shift away from active to passive management:

It’s easy to see why active managers are complaining. Over the past ten years, the cumulative inflow to US HY mutual funds is precisely zero, while HY ETFs have netted $40bn. In US IG, where inflows have been stronger, more than a quarter of the money over the past decade has gone to ETFs; in EM FI in recent years, the proportion is more like one-third. For European credit, ETF outstandings may look far smaller, and yet these belie the true size of the threat since (unlike the US) most trading occurs OTC and hence goes unrecorded. All of these are nothing compared to the massive rotational shift being seen in equities, in which around $500bn has flowed away from active managers and into ETFs over the past 12 months alone, and where ETFs now account for over one-quarter of markets’ traded volume.

It"s not just investors who are worried about ETF flows: regulators are too, having become "alarmed at the dramatic growth in ETFs, focusing in particular on the potential for a sudden reversal, notwithstanding ETF managers’ robust defence that ETFs’ potential to trade at a discount to NAV gives them an additional escape valve relative to traditional open-ended mutual funds."

But, as King shows in the following chart, there is a puzzle here, or rather a pair of them. "Rather than being the fickle retail fad of the popular imagination, ETF flows have actually proved much more stable than mutual fund flows (Figure 1). Either the potential for a future reversal is far greater than anything seen in the historical data, or the problem is not unique to ETFs."

Furthermore, it is odd for fund managers - professional investors trained to capture market short and long-term  market inefficiencies - to be complaining about something which in principle should be creating additional opportunities for them.Here King makes an absolutely spot on point about inefficient markets, which however we have to note, is only relevant inasmuch as central banks don"t do everything in their power to perpetuate the inefficiencies, now in their 9th year:

Indiscriminate buying and selling by ETFs should add to the potential for active managers to spot mispriced securities. The greater the proportion of trading done by passive entities, the greater should be the opportunities.

So are fund managers simply suffering from a case of sour grapes, King asks, "or is there some other factor preventing these opportunities from occurring in the way theory says they should be?"

His answer for why the current market regime has made active investors a species facing extinction, is due to two things: record low volatility and record low dispersion:

The obvious culprit is the lack of volatility. Our Cross-Asset Volatility Indices show that realized volatility now stands at multi-decade lows in every major asset class bar FX (Figure 2). But even worse for active managers is the lack of dispersion. A manager can still make money when markets themselves are involatile provided there is sufficient variation in the performance of individual securities. Dispersion, or the cross-sectional standard deviation, effectively captures how much a manager with perfect  foresight could have made by overweighting the best performing securities or sectors and

underweighting the worst performers. Dispersion in both credit and equities is now at the lowest levels on record.

As Citi points out, this lack of potential for outperformance might seem surprising on the back of obvious single-name sell-offs like Teva or Provident Financial. However as he explains, "these names have been too small to offer much outperformance potential: even managers who had zero-weighted them prior to the sell-offs would only have increased total returns by 1.4bp with Teva in € and 1.3bp with Provident in £ respectively. To outperform, managers need there to be multiple names moving in opposite directions – to have, if you like, a genuine two-way market. The only market which has come close to this description in recent years is the only one where volatility is not making new record lows: FX. Is this a coincidence, or a feature?"

King then reverts back to this key point: the confluence of QE and ETFs have led to one-way markets, in which the main feature is investor clustering, and herding: "for us, the real damage in markets in recent years is an increase in herding. ETFs are contributing to this tendency but they are not its primary driver."

The result is an increasingly illiquid market: "What we think has been happening in recent years is that investors are displaying an increased tendency to position themselves the same way round. In the process we are therefore losing the heterogeneity which is the source of a liquid market. This tendency is likely to have been strongest in the markets where the price action has largely been one-way. With the notable exception of markets with currency pegs, FX has some built-in protection against this because its securities automatically have two sides. Thanks to the fragmented nature of trading and the large role carry plays in driving returns, credit is particularly vulnerable."

Of course, it"s not just the shift to passive investing that is forcing active investors to group together for their very survivla: other factors are also exacerbating this trend.

"The combination of global credit growth and QE has created such a sustained bull market in many asset classes that investors are inevitably concluding that their best trade is simply to close their eyes and go long the market in the cheapest way possible. ETFs in principle offer a panoply of potentially uncorrelated factors, but in practice trading volumes have been overwhelmingly concentrated on the major indices. The rise of algorithmic trading and regulators’ increased tendency to insist on marking to market likewise build in a short-termism which is likely to be self-reinforcing. Whatever factor or trade has been doing well is likely to receive inflows; whatever has been doing poorly will be shifted away from."

Which brings us to the conclusion: whether QE is the driving force behind ETF-mediate herding, or some different factor is responsible, the trouble with one-way markets is that they are not really one-way, and as Citi"s King warns "wooner or later the herd turns around. This creates a risk that current record lows in volatility are misleading."

Here King points out something we brought to readers" attention last week when we showed the record high cost of market crash insurance: "To some extent this is reflected in high levels of OTM skew, but conceivably not enough given the potential for asymmetry."

The problem, according to Citi - and certainly central bankers who however will never admit this in public - is that when the herd has been moving in one direction for long enough, it becomes hard to envisage what might turn it around. For credit  investors, the “buy on dips” mentality has become deeply entrenched – even if the justification for doing so is never valuations, and always “the strength of technicals".

Typically these are attributed to some sort of irresistible but poorly understood external force, such as mutual fund inflows (in IG, but interestingly not HY at present) or “the strength of the Asian bid”. Rather like the blurb from a London estate agent which recently landed in my letter box, investors are urged to buy precisely because prices have gone up so much: the idea that the demand which led to those price rises might one day reverse is unthinkable.

Still, despite the "fake markets" of the past 8 years, in which every dip has so far been bought - profitably - Citi says that investors should be thinking about such reversals, preferably before they actually occur.

Will mutual fund inflows always remain strong even as deposit rates rise? Will Japanese investors’ bid for US credit remain as intense even as reduced BoJ purchases mean private investors have to absorb more net supply in JGBs, or are there signs that is fading already. In particular, what is the potential for abrupt discontinuities on this front?

The answer, according to King, very high, but "to say that this or that threshold is automatically a danger" is not the point: Citi"s punchline is that increases in herding, or equivalently a reduction in the diversity of the investor ecosystem, create large asymmetries which are in themselves a threat to financial stability – whether or not they are accompanied by financial leverage, something which not even Fed presidents can grasp.

And yet, while King can warn until he is blue in the face, the reality for an entire generation of "investors" in artifical markets is that no matter what happened, risk assets would keep going up, as did mutual funds and ETFs. That may change soon: King looks at fund flows among equity and debt (IG and HY) fund flows, and calculates that the standard deviations and maximum moves, are much larger for outflows than for inflows – modestly so in some cases, shockingly so for equities.

Even if ETF flows have not shown this tendency to date, there is every reason to think that both ETF and mutual fund flows will exhibit these characteristics in future. One-way markets trend for extended periods with very little volatility, but are then vulnerable to abrupt turnarounds.

All of the above leads King to an ironic conclusion, one which we have discussed previously and which we will comment on more shortly, namely that in this fake market, the one thing that can potentially save the active management community, is a reversal, or as King puts it, "paradoxically, the very thing required to save active managers is a reversal of the conditions which gave rise to their tremendous growth in the first place."

Namely, a crash. Unfortunately, with central banks more concerned than ever that markets can simply no longer function on their own without daily central bank support, a crash, or even a correction, may not happen... or rather when it does, trading would simply shut down as this "one-way market" can no longer even discount such a simple alternative outcome as "selling."

"Mystery" Central Bank Buyer Revealed: SNB Now Owns A Record $84 Billion In US Stocks

In the second quarter of the year, one in which unlike in Q1 fund flows showed a persistent and perplexing outflow from US stocks and into European and Emerging Markets, a trading desk rumor emerged that even as institutional traders dumped stocks and retail investors piled into ETFs, a "mystery" central bank was quietly bidding up risk assets by aggressively buying stocks. And no, it was not the BOJ: the Japanese Central Bank"s interventions in the stock market are familiar to all by now, and for the most part the BOJ keeps its interventions local, mostly propping up Japanese stocks, whether the Nikkei 225 or the Topix.

The answer was revealed this morning when the hedge fund known as the "Swiss National Bank" posted its latest 13-F holdings. What it showed is that, as rumored, the Swiss National Bank had gone on another aggressive buying spree in the second quarter, and following its record purchases in the first quarter, the central bank boosted its total equity holdings to an all time high $84.3 billion, up 5% or $4.1 billion from the $80.4 billion at the end of the first quarter.

As reported last week, the Swiss central bank has accumulated foreign exchange worth 714.3 billion francs (over $740 billion) due to its ongoing interventions to depress the Swiss franc, and has "invested" those funds created out of thin air in stocks and bonds. At the end of the second quarter, it held 20% in equities, of which the bulk was in US stocks.

While we are far beyond the point of debating central bank intervention in equity markets (we do want to remind readers that until several years ago, it was considered "fake news" to even mention it, and those who accused central bankers of manipulating stock markets were said to be paranoid tinfoil basement dwellers), we want to point out that unlike the BOJ, which at least keeps its capital markets distortion local, the SNB, which likewise creates money out of thin air (then sells it for dollars in an attempt to keep the Swiss franc depressed) is actively causing substantial price distortions in the US.

While we doubt this will be investigated with stocks are at all time highs, we look forward to the Congressional hearings after the crash when the scapegoating and fingerpointing begins, and everyone is "stunned" to learn that central banks were responsible for blowing the biggest asset bubble the world has ever seen by directly buying stocks.

What else did the SNB reveal in its 13F? Two main things.

First, its top 20 holdings are as shown in the following chart. The central bank was clearly not shy in adding to its top positions, especially the top position, which increased as a result of both appreciation and new purchases.

And while we have yet to learn if Warren Buffett was actively frontrunning the SNB once again during the quarter, similarly to his activity in Q1 when he more than doubled his AAPL stake making him a top 5 holder of the tech giant, a look at the SNB"s holdings of AAPL stock which again increased from 18.9 to 19.2 million shares, making it a larger holder of AAPL stock than Schwab and Franklin Resources (with 18.3 and 17.8 million shares respectively), and just behind AllianceBernstein, shows why the Nasdaq has until recently been hitting new all time highs on a daily basis.

The chart above may also explain why Goldman, despite warning of rising worries about record low volatility remains bullish on the Nasdaq 100: after all, when a central bank can and does create money out of thin air, then splurges on the handful of tech companies that have the biggest impact on the broader market, pushing both the Nasdaq and all indices higher, what is the point of even talking about "risk"?

Source: SNB 13-F

BofA Institutional Clients Sell Tech Stocks For 3rd Straight Week

As tech stocks continue to hit new all time highs, the general assumption is that they are being, well, bought by the broader population even if non-growth stocks remain largely shunned. Well, at least according to Bank of America that is not happening. And it"s not just tech stocks.

In the latest client flow report from BofA" Jill Hall, we learn that last week, during which the S&P 500 climbed 0.2%, BofAML clients were net sellers of single stocks for the third consecutive week, although the number was almost offset by net buying of ETFs. Institutional clients were the biggest sellers and have now sold stocks the last two weeks, while private clients were also sellers following two weeks of buying. Hedge funds were net buyers for the second consecutive week. Clients bought mid caps for the third week in a row, and sold both large and small caps. Buybacks by corporate clients slowed ahead of quarter-end, and continue to track below typical June levels.

As for Tech, it appears thatit goes up the more traders sellit:

• While hedge funds were buyers of Tech stocks for the second week, institutional and private clients continued to sell Tech stocks for the third and fifth consecutive week, respectively. Quarter-end rebalancing may pose risk to Tech, where mutual funds carry their biggest overweight positioning in our post-2008 data history.


• Energy and Staples stocks saw net selling by institutional clients, hedge funds and private clients alike last week. No sector saw net buying by all three groups.


• Pension fund clients were net buyers of US equities for the fourth week, chiefly due to ETFs. Single stock buying was mostly in defensive sectors, while the group’s biggest net sales were in Tech and Energy stocks. See Pension fund flows for deta

Some other details:

Clients’ biggest net sales last week were in both defensive sectors (Staples, Health Care) and cyclical sectors (Discretionary, Energy and Tech). Only stocks in the bond proxy sectors of Telecom, Utilities and Real Estate – along with the Industrials sector—saw net buying, as interest rates continued to tick downward. Staples—where fundamentals remain challenged—continues to see the longest net buying trend at 11 consecutive weeks, but flow sentiment remains most persistently negative within Health Care, where four-week average flows have been negative since March’16. Telecom has seen four straight weeks of net buying and is the only sector which has seen cumulative net buying year-to-date.

Institutional clients were the biggest net sellers, while private clients were also net sellers vs. hedge funds who were buyers. Corporate buybacks continued to slow and remain  below typical June levels. Large and small caps saw net sales while clients bought mid caps.

Finally, here is the rolling four-week average trends by sector

• Net buying: ETFs since early Oct 2016; Industrials since mid-April 2017; Telecom since mid June 2017.


• Net selling: Health Care since mid-March 2016; Consumer Discretionary since mid- Jan 2017; Tech since early March 2017; Staples since early April 2017; Materials since early May 2017; Telecom since late May 2017; Real Estate (not shown; data since Sept. 2016) since mid June 2017; Financials since mid-June 2017.


• Notable changes in trends: Energy is now back to seeing net selling after a brief period of buying; Utilities is now seeing net buying after sales since early May ‘17.

Fund flows of this size could mark a top, says Joe Friday

A year ago flows into ETFs were extremely low, actually the lowest in years, as many stock market indices were testing rising support off the 2009 lows. The crowd wasn’t adding money to ETFs as lows were taking place. In hindsight, this was a mistake by the majority. Below I look at ETF flows over the past few years with an inset chart of the S&P 500.

Nearly three months into this year, fund flows have surpassed money invested in the past few years by a large margin. Could that be a good sign for stocks? Could be!

The trend in the S&P 500, from a intermediate and long-term perspective remains solidly up. As fund flows are going vertical; the S&P 500 is testing the top of a 1-year rising channel and the 161% Fibonacci extension level, based upon last years (2016) “weekly closing highs and lows.” While testing the top of the channel and 161% level, the past couple of weeks the S&P has chopped sideways.  This week the S&P is making an attempt to break below rising support that has been in place since the election.

Joe Friday Just The Facts:  With fund flows at such a high level, the S&P 500 finds itself at a key price point, where the bulls do NOT want to see weakness start creeping into the market.

The crowd missed the boat last year at the lows, will it be different this time, as fund flows are sky high? Investors long the S&P 500 want it to break above the top of the rising channel and Fib 161% extension level, which comes into play at the 2,400 level.

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World Out of Whack: Your Attention Please

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all its glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, we are capitalists.

In this week"s edition of the WOW: Beware The Attention Seekers!

I"m getting sick and tired of stupidity. No, really. There really are some proper morons out there. Just the other day I read in the Telegraph that living near a busy road raises your chance of getting dementia by 12%.

Being the sceptic grump that I am and taking very little at face value I was curious about this. After all, 12% seemed significant.

15 seconds later (I"m a bit slow) and my stubby fingers had met with my phone to reveal the medical journals stats on dementia. Lo and behold, there"s an 11% chance of getting dementia no matter where the hell you live. Further investigation revealed that the study in question actually showed that the risk of dementia caused by living near a busy road raised the odds TO 12%, not BY 12%. That little fact wouldn"t grab as many readers attention, though, now would it.

Key here is the abject failure to distinguish between relative and absolute risk.

Absolute risk is 11% and relative risk, if your pad overlooks a noisy highway with Mac trucks belching fumes out 24/7, increases this by a "whopping" 1.32%.

Think of it like this: Out of 100 people who are lulled to sleep at night by the comforting drone of 18 wheelers this "startling new research" reveals that 12 folks will be affected by dementia rather than 11. Now, I understand that there are those among us who desperately want that last 1.32% of longevity (you can find them scoffing the tofu at the buffet) but personally, I"m not so sure those extra days spent confusing my nurse, who"s changing my soiled diaper with my wife while being fed sludge through a straw are worth worrying about.

This sort of nonsense happens all the time.

It grabs our attention because our amygdala (that squishy almond shaped part of our brain that deals with fear) goes berserk trying to protect us from pain sending out "watch out, buddy" messages and getting us all lathered up with anxiety. There was a fascinating experiment done on this which I wrote about some time ago.

In any event, the headlines for this "startling" piece of trivia on dementia sound frightfully scary but are actually complete bollocks. The problem, of course, is that, unless you"re actually knowledgable in a particular area - in this instance medical research (which I"m not) - you"re likely to accept at face value what you see.

The same thing happens to folks evaluating financial markets. All too often there"s a vested interest or bias to selling a particular narrative. When your bread gets buttered running, say, a fixed income fund, it shouldn"t come as a surprise when you"re found searching for metrics supportive of more suckers investors plonking their hard earned dollars into your fixed income fund.

Other times, it"s a matter of simply looking at the trees failing to see that "whoah, we"re actually in a forest" and not using second order thinking.

Recently, I came across headlines screaming that the US stock market was due to crash. Whoah! The primitive part of my brain can"t help itself and kicks into action telling me to quickly find out more. How might I be at risk of being eaten by the lion it wants to know.

Reading through the article I noted that lo and behold, the author had some "little known" indicator that said it was so. Urghh! Listen there are NO, none, zero "secret" indicators OK? Nada! There are just indicators, and if you don"t know one that doesn"t make it "secret". It just means you don"t know it.

For shits and giggles I read the report and, to summarise, the "indicator" was this:

Household equity ownership was now at the same levels we"d experienced in the 1960s and in 2007. Notably, two previous market peaks. Investors holding equities in both of those periods got their shirts handed to them. Ergo, investors are again going to get their shirts handed to them. Run!

Not so fast hombre...

Let"s deal with the data first.

Sure, equity ownership in both 2007 and the 60s was around the 30% mark, which is where we"re at today. And sure, both periods experienced painful stock market crashes, but looking deeper, we find that equity ownership has reached these levels before, most notably in both 1998 and 2013.

Take a look at the S&P500 from 1990 through 2009 below:

As you can see the market ran another 60% from 2008 when equity ownership had reached these levels. Anyone short got hosed. Anyone long made 60%.

Then in 2013 anyone short took a beating as the market ran another 40%.

I"ll also point out that the 87 crash took place when equity participation was at just 18% and, in fact, we"ve had stock market crashes when equity participation was well below current levels.

So now we"ve got two instances where the market tanked at these equity participation levels. We"ve also got two instances where it did the opposite.

Heck, I could come out screaming that, "Hey! Look, equity participation levels indicate that we"re about to rocket higher, somewhere between 40% and 60% from these levels. Look here is the data (selective, of course). Get in now, by George."

Sheesh! I may as well flip a coin or go to Vegas and put it all on black because my odds are identical. Neither ideas impress me as a good ones. Both evaluations are just noise.

So using this as a "secret indicator" is a bunch of hogwash designed to get your amygdala all hot and flustered.

The problem is Joe Sixpack reads this, the mushy bit in his cranium does what it"s supposed to do (go haywire), and next thing you know, Joe"s shorting the market through some leveraged reverse ETF where not only is the risk that he"s wrong at least 50/50 but the cost to entry in this particular trade means that even if he"s right he doesn"t stand to make much money. And if he"s wrong he stands to lose a whole lot because those leveraged ETFs are terrible, terrible tools and Joe hasn"t done his homework to figure out how they work.

That is all as impressive as Miley Cyrus swinging naked on a wrecking ball - not so much.

Back to Basics

The way to think about this is taking it back to basics.

Let"s say you"ve got $1m portfolio. If you invest $300k into equities, then you"re at an equity participation level of 30%.

Fine, but what if you only invested $100k a decade ago and that $100k now (due to appreciation) sits at a 30% equity participation rate? Well, you"ve actually got another $900k in "spare cash" sitting on the sidelines. The 30% equity participation is a red herring.

Bull markets rarely end like that.

No, they end with Darren and Julie mortgaging the house, selling Bobby the family Labrador, and asking the oldies for a loan to invest. Once they"re fully invested with nothing left in the cookie jar you"ve got market exhaustion because there are literally no more suckers to come in.

Incidentally, at the tops of markets what we find is that mutual fund flows continue even as the market has turned. If we go back to look at the data, what we notice is that net inflows for dumb mutual funds money typically continue even after the market has turned. Darren and Julie via mutual funds keep buying into the peak...just as the 20% (Pareto"s law) begins to exit. The trade at this point is truly asymmetric as the boat is extremely one-sided. This is typically how bull markets end.

The other thing that isn"t even considered is where existing capital is invested.

Let"s go back to our theoretical $1m portfolio and say, for example, we"ve invested 50% into fixed income. So now we"ve got $500k invested. Let"s further say that we"re spooked by the fact we"re eking out a piddly 1% yield and concerned that lending our money to bankrupt entities might not work out too well in the long run. A simple rotation of just 10% from our fixed income basket into equities translates into a 17% capital infusion into our equity bucket. Looking at just one investment bucket is akin to looking at just one tree in the forest.

Clearly we need to look at more than just equity participation on it"s own before jumping to a conclusion.

Now, don"t get me wrong - I"m not supporting buying US equities here. Valuations are far from low, and history provides sufficient evidence that buying high in order to sell higher can lead investors from going from BMW to Suzuki pretty swiftly.

What I am suggesting is that you want to sit on the sidelines until you see favourable risk reward setups. The most favourable of all are where convexity exists and I don"t see any in US equity markets either long or short here.

What Do You Think?

Cast your vote here and also see what others think

- Chris

"The way to build long-term returns is through preservation of capital and home runs" — Stanley Druckenmiller

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Speculative Blow-Offs In Stock Markets – Part 1

Via Pater Tenebrarum of Acting-Man.com,

Defying Expectations

Why is the stock market seemingly so utterly oblivious to the potential dangers and in some respects quite obvious fundamental problems the global economy faces? Why in particular does this happen at a time when valuations are already extremely stretched? Questions along these lines are raised increasingly often by our correspondents lately. One could be smug about it and say “it’s all technical”, but there is more to it than that. It may not be rocket science, but there are a few issues that are probably not getting the attention they deserve.

The stock market has blown widespread expectations out of the water by embarking on a seemingly unstoppable rally since Donald Trump was elected POTUS.

As you can see below, we have marked “Brexit day” on the chart as well, which was another noteworthy juncture. Not only was the success of the “Leave” campaign just as big a surprise as Trump’s election victory, but it was yet another occasion on which the market ended up fooling most observers by dramatically reversing course after a mere two days of relatively mild panic selling.

DJIA, daily. Since the US presidential election, the stock market has rallied relentlessly, after breaking through a long-standing resistance level with ease. The move since then is increasingly looks like a blow-off rally, and we think that is precisely what it is – click to enlarge.

Not to belabor the obvious too much, but it is actually a hallmark of bull markets that they ignore any and all bad news. In fact, bad news quite often end up extending the lives of bull markets, not least because they help with sustaining a certain degree of skepticism among market participants. To be sure, at times that is not the only reason. In the “Brexit” case we have little doubt that the reaction of central banks to the outcome of the referendum played a big role in the market reversal.

We have discussed the market’s post-election performance before, but here is a reminder of how deeply ingrained the views about the likely effects of a Trump victory on the stock market were. As the probabilities shifted toward Trump winning on election night, DJIA futures intermittently fell by more than 900 points in Asian trade. Many Trump opponents felt compelled to remark on this without awaiting further developments.

Paul Krugman for instance made an especially ambitious forecast that was shredded within a few hours:

“It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? […] I guess people want an answer: If the question is when markets will recover, a first-pass answer is never.”

Admittedly we like poking fun at Paul Krugman. That is however not the point here, the opportunity to pick on Krugman is merely an agreeable side effect. The point is that his comment is an excellent illustration of the expectations prevailing at the time. Our own forecast was by no means better – we did map out possible near term paths for the market depending on the election outcome, but none of these assigned a very high probability to a blow-off rally, even if the possibility was at the back of our mind some time ago already.

We have previously stated that we believe the overnight reassessment of the market’s prospects after the election was inter alia motivated by the Republican party’s “clean sweep”, i.e., the fact that in addition to its candidate becoming president, it managed to win majorities in the House and Senate as well. That made it more likely that Trump would be able to enact his economic policies and wouldn’t have to face a hostile Congress. That was likely the immediate trigger, but not the main driver of what has happened since then.

The Fundamental Driver of the Blow-Off Rally in Stocks

Stock prices have been driven to valuations that seemingly make little sense from a fundamental perspective. We believe the main culprit was way above-average money supply growth over the past eight years. What we are seeing now are partly its lagged effects; its pace actually remains quite brisk, but it has begun to slow down noticeably and that seems set to continue. The recent market action displays a number of characteristics typically associated with a final rally phase.

What we say about the stock market below is premised on certain basic assumptions – the most important ones are the following:

1. the market’s long term returns will continue to adhere to historical precedents, which is to say, in the long term valuations will fluctuate with some regularity over a fairly wide range. The boundaries of this range are certainly not fixed, but market history does provide a few useful indications. What these historical precedents imply is best described by John Hussman – see the following chart:

The expected nominal 12-year return of the S&P 500 index based on gross value added, via John Hussman (the concept is explained here). The current outlook is the worst since the peak of the tech mania. The indicator has been back-tested to 1950, i.e., essentially the bulk of the post WW2 era and has worked quite well so far.

2. the central banks of major currency areas, particularly the Fed, will at least attempt to prevent the emergence of hyperinflation. In other words, if price inflation ever reaches worrisome proportions such as in the late 1970s, we expect its suppression will be prioritized over all other considerations, as happened when Paul Volcker was appointed chairman.

The first assumption depends directly on the second, which we admit may turn out to be incorrect at some point in the future. A number of scenarios is imaginable in which it would have to be reassessed, but these seem unlikely to be relevant in the near to medium term. That may change in a severe enough “economic emergency” situation. We mention this for the simple reason that everything we state below is simply not applicable to nominal stock prices in a hyperinflation environment.

The IBC General Index in Caracas. This index was at 6 points in early 2002 – it is at 37,600 points today. After a recent correction, it has rallied from 27,500 points to 37,600 points in a mere two months. This illustrates that inflation is a far more important driver of stock prices than other inputs. In hyperinflation any considerations about earnings and valuations become utterly meaningless – stocks will rally even if the companies listed on the exchange operate in an economy in total free-fall. The chart of the IBC General is simply a reflection of the collapsing value of Venezuela’s currency – click to enlarge.

The same things that are happening at the moment could be observed in the late stages of the 2003-2007 mini echo bubble and the bubble of the 1990s that preceded it: just as the time arrived when money supply growth and the trend  in interest rates showed signs of beginning to deteriorate, a blow-off move got underway (incidentally this also happened in the late 1920s).

Two major phenomena always seem to coincide in these final blow-offs: for oon thing, the lagged effects of the preceding money supply expansion continue to play out. There is for instance a feedback loop between rising asset prices and the amount of money one can borrow using these assets as margin collateral. In short, there is inter alia a self-feeding spiral that is helping to push prices up further. Rising demand for credit to purchase securities is also contributing to upward pressure on market interest rates though, which the Fed is not actively countering at the moment.

Year-on-year growth of TMS-2 (broad true US money supply) and total bank credit. This chart illustrates several things: when the Fed became serious about increasing the pace of monetary pumping in late 2008, money supply growth took off like a scalded cat. Even though it is well below previous peak levels, the growth rate never went much below 7.5% y/y and cumulative growth from the end of January 2008 to the end of January 2017 was 141%, i.e., there is now almost 2 ½ times more money in the US economy than at the beginning of 2008 (you may have noticed that we have somehow failed to become 2 ½ times richer). However, the Fed is no longer expanding its balance sheet  – QE has been reduced to replacing maturing debt held by the Fed –  and the effect of money market regulations was a one-off event. Hence, money supply growth depends entirely on commercial bank credit expansion at present – and  bank credit growth has begun to slow sharply – click to enlarge.

In order for the amount of money sloshing about in the financial sphere to become too small to support further price increases, money supply growth needs to fall below an unknowable threshold, that is a moving target to boot (even if we knew where it is at present, it would shift as time passes). When and whether this happens is determined by real economic activity, the willingness of banks to extend additional loans to the private sector and monetary policy. Note that the borrowing of companies for the purpose of buying back their own stock puts upward pressure on market interest rates as well, ceteris paribus. Over time it should also make banks more reluctant to lend, as they will become worried about the growing risks (even if CEOs ignore them).

New money tends to spread across the economy in a wave-like movement. In the era of QE, it clearly enters financial markets first, but over time, some of it still “leaks out” from there. Low demand for funding in the real economy in an economy that is merely muddling along, perversely supports asset prices, as a smaller amount of money will be allocated to other uses than buying securities and the above mentioned “leakage” will be minimized.  As long as enough money remains in the financial sphere to push stock prices higher in theory, they can also be pushed higher in practice.

Market Psychology

The second major characteristic of blow-offs are their underlying psychological drivers. By the time money supply growth actually begins to falter, bull markets are usually quite extended and stocks have been at elevated valuations for quite some time already. Many market participants who took profits and raised cash at an earlier juncture, or didn’t fully take part in the most recent rally phase because they could not bring themselves to buy at these valuations, are in a quandary at this stage.

The market just keeps going up in spite of what their rational assessment told them to expect and they are increasingly under pressure as a result. Some investors employing call-writing or hedging strategies either blow up or are abandoning hedges because they are no longer deemed worth the cost (just as they actually become very inexpensive).

Professional investors are particularly affected by this, as the short term underperformance that necessarily results from hedging and/or holding large cash positions begins to cost them customers. Here are two recent examples illustrating that we have arrived at such a juncture:

Zerohedge recently reported that an open-ended hedged futures strategy fund (HFXAX) was forced out of a large number of S&P 500 call spreads involving a staggering amount of notional value:

“RBC’s Charlie McElligott, who dug deeper into the details behind this move, notes the melt-up in the S&P is the result of “a purported / murky melt-down over the past week in a large trade by a multi-billion Dollar (open-ended) futures fund which sells vol on S&P.  Without going into specifics, there is market speculation that the entity is effectively short upwards of ~$17B of SPX (deltas to buy) through selling February expiry upside 1×5 (or 1×4) call spreads.”

The fund’s call-writing strategy has not fared well, to put it mildly:

HFXAX (red line) vs. SPX (black line), performance comparison. Note: there are two sister strategies, HFXIX and HFXCX. The former performed slightly better, while the latter generated an even bigger loss, plunging by 31.5% between late October and late February. Each of the three funds holds slightly more than $4 bn. in assets; that translates into a great deal more notional exposure in futures and options – click to enlarge.

Our friends at INK in Canada recently pointed out to us that Canadian insurer Fairfax Financial recently took a US $2.66 billion loss on closing out its short position – here is a blurb from its annual report explaining the decision:

“Included in realized losses in 2016 was a loss of $2,663.9 million realized in the fourth quarter when the company, recognizing fundamental changes in the U.S. which obviated the need for defensive equity hedges, discontinued its economic equity hedging strategy, closing all of its short positions in the Russell 2000, S&P 500 and S&P/TSX 60 equity indexes effected through total return swaps.”

Quite a few investors have thrown caution to the wind long ago, but the blow-off stage is putting enormous pressure on those who were hitherto cautious or skeptical. Short sellers are only a small group and a highly sophisticated one at that, but at least some of them are likely forced to cover their positions as well.

Retail investors were scared to get back into the market while memories of the last crash were still fresh, but they are finally losing their inhibitions too – the waters are evidently deemed safe again. This is evidenced by a dramatic reversal in fund flows and ETF inflows (e.g. $8.2 billion flowed into SPY alone on a single day last week) and the stunning collapse in Rydex money market fund assets.

The top panel shows the collapse in Rydex money market assets – note that this is well aligned with the no less astonishing decline in the ratio between total stock market capitalization and all retail money market funds combined. Rydex assets an fund flows represent only a very small slice of total market activity, but are nevertheless generally a very good indicator of the mood of retail investors and small traders and we believe of investor psychology in general – click to enlarge.

The Story

The late stage of a stock market bubble is always accompanied by a “story”. For example, in 1999/2000 it was that “demand for technology will grow at X% (insert impressively high number) forever and ever”. Large productivity growth rates were similarly extrapolated and used to rationalize absurd valuations (incidentally the sharp slowdown in productivity growth in recent years is not mentioned very often).

Once the final blow-off stage was underway, this underlying premise was decorated with amusing little side stories, such as e.g. rumors of a “DRAM shortage” (we remember laughing out loud when this was excitedly discussed on TV) and similar unlikely notions; not to mention that traditional valuation parameters were replaced by somewhat silly ideas like “eyeball counts”. The situation is probably no less crazy today, it is merely somewhat less obvious. The most egregious insanity is on display in stocks of unlisted so-called unicorns (and derivatives on them) which trade in private markets.

Up until recently, the main “story” serving to rationalize valuations was unrelenting central bank support (not a completely unreasonable idea). A new story is underlying the current blow-off phase though – namely that Donald Trump, who was once held to cause nothing but “uncertainty”, is going to produce so much economic growth that valuations can be safely ignored. Within a few weeks, he has been repackaged into a kind of supernatural warp drive entity which American voters have lashed to the stock market in their infinite wisdom.

The stories and psychological underpinnings of the late 1990s/ early 2000 blow-off briefly summarized above are representative of every stock market blow-off in history – even if the rationalizations are always slightly different.

For instance, in 1988-1989, we often heard that although Japanese stocks were trading at an insane average multiple of 80, they could not possibly decline due to Japan’s incestuous Keiretsu cross-shareholdings system and the “wall of money” besieging the stock market. As we recall, only very few observers occasionally mentioned that sharply rising interest rates and weakening money supply growth might endanger this happy situation.

The Nikkei from 1987 to 1990. it was the only index that immediately streaked to new all time highs after the 1987 crash (it was also the index least affected by the crash).  Once the blow-off phase was underway,  Japanese stocks were widely deemed invulnerable. The rationalizations offered at the time are quite interesting in retrospect, especially as some of them were later used to explain the market’s decline! The relentless surge in stock prices in 1988-1989 was no longer supported by money supply growth and interest rate trends.

Up Next:

In Part 2 we will discuss blow-off pattern recognition:  how one can tell whether a blow-off stage is underway; the self-similarity of blow-off patterns throughout history; what to expect when the blow-off stage concludes.

"What Has Kept The Rally Going": Some Thoughts From Deutsche Bank

The relentless, steady, monotonous levitation to all time highs keeps chugging along: while last week saw the S&P experience its first 1% intraday move in nearly two months, there has yet to be a comparable move on the downside. As Deutsche Bank notes, pull backs of 3-5% in the S&P 500 are typical every 2 to 3 months historically. The last such pull back occurred just prior to the US presidential election. The 4 month uninterrupted rally since is now well above average and if it continues for another 2 weeks will put it in the top 10% of rallies by duration. At 14%, the size of the rally is also somewhat larger than the historical average between such pullbacks (+10%).

Incidentally, sell-offs of 5% or more occurred on average every 5 to 6 months. With the last one occurring after the Brexit vote, the 8 months since is also well above the historical average. If the rally continues past mid-April it will be in the top 10% by duration. In size, the 19% rally since then is also well above the 14% historical average

So while it is clear that the recent move is an outlier, the next question is what factors have kept the rally going. Here, Deutsche Bank offers several possible answers:

Strong equity inflows following large outflows and massive under-allocation. After stalling at the beginning of the year, US equity fund flows have resumed over the last 5 weeks. US equities have got $80bn of inflows since the election but from a slightly longer term perspective, under-allocation remains massive. Over the last two years cumulative outflows from US equities still stand at a large -$230bn compared to inflows of +$250bn to other developed market equities and +$310bn into bond funds. The direction and pace of equity inflows remains tightly tied to macro data surprises.

US equity fund positioning moved from under- to over-weight though has been pared since. From slightly underweight positioning at the start of the year, positioning rose steadily through January, then leveled off and over the last two weeks has been trimmed even as data surprises which tend to drive positioning have moved up, suggesting funds may already be anticipating a modest slowdown in data surprises

Buybacks remain solid but seasonal slowdown during the earnings blackout period is approaching. After a slowing in Q2 and Q3 last year, buybacks ramped up again in Q4 and the 2016 annual total ($460bn net) was in line with our forecast (Buybacks: Myths, Realities and the Outlook, Jan 2016). We see net buybacks rising in line with earnings growth and forecast $500bn in 2017. Our demand-supply model for equities points to buybacks continuing to provide steady support and by themselves imply 10% upside for the S&P 500 in 2017. However, the buyback blackout periods starting in two weeks should see the pace slow temporarily again.

DB then points out that from a fundamental perspective, the rally has kept going as data surprises skipped typical negative phase. With equity inflows and positioning both tending to follow data surprises, the fundamental reason for the long duration of the equity rally has been the unusually long period without sustained negative surprises. Data surprises generally alternate between positive and negative phases. This time around, however, they skipped a negative phase. After falling to neutral by the end of last year, DB"s index of US data surprises, the MAPI, hovered around neutral for the first 6 weeks of the year, then rose sharply again and moved back up to near a 4 year high. The MAPI has consequently been neutral or positive for the last 3.5 months.

Finally, while rates futures positioning remains very short an upside risk is that bond outflows
resume on strong data and rising rates. Leveraged fund shorts in
bond futures remain very large albeit off extremes while real money bond
funds are already neutral their benchmark. Bond funds have received
steady inflows this year but the historical relationship with rising
data surprises and rates suggests outflows to come.

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That said, as Deutsche Bank pointed out recently, the global "economic surprise" rally is finally poised to roll over after hitting near record highs...

... primarily as a result of a loss in Chinese momentum and the slowdown, or in some cases outright drop, in commodity prices:

Deutsche also added the following warning:

We believe global macro momentum is likely to roll over from current elevated levels:

• Global macro surprises have only been higher 5% of the time since 2003 (when the data series starts), typically roll over from these elevated levels and have shown first signs of softening over the past week;


• Global PMIs are already consistent with global GDP growth 50bps above our economists’ 2017 growth forecasts of 3%, despite the fact that the latter incorporate aggressive assumptions for fiscal stimulus in the US;


• Chinese PMIs are already close to a six-year high, having rebounded by 7 points over the past 15 months. They point to quarterly annualized GDP growth of 8%+ (above the government’s target of 6.5%) and the credit impulse (a key driver of SoE fixed asset investment) is set to turn negative. This suggests the risk to Chinese growth momentum is now to the downside;


• Our model of global PMIs suggests global growth momentum has rebounded because of the easing in financial conditions due to tighter HY spreads and a reduced drag from USD strength as well as lower global uncertainty. However, it also implies that the rebound in growth momentum should start to fade, as the lagged benefit from falling commodity prices is wearing off.

So whether it is any of the above factors, or simply the influx of retail investors as JPM showed last weekend, coupled with an aggressive selloff by institutions and hedge funds, or an even simpler explanation - a relentless short squeeze - it is clear that while everyone has a theory to "explain" what is going on, nobody really knows, even though everyone can admit the duration of this latest market surge is anything but normal.

As such perhaps the best indicator of what to expect in terms of future returns may be the good, old Shiller CAPE. At 30x, the market has been at these valuations only 2% of the time in history, with future returns without fail being negative in the medium to long-run.

Of course, it is the short-run that everyone obsesses about these days, and as such, those betting on further upside may be wiser to just put their money in "Millennial momentum favorites" like Snapchat. At least there nobody pretends to even bother with such anachronistic concepts like "valuation."