Tagged: recession

Interesting Year

“It’s going to be an interesting year.”

We wrote that phrase in the Jan 2, 2019 edition of the Market Structure Map. (By the way, we’re in Rhode Island this week visiting customers, and in Newport you’ll see the sea in everything.)

I don’t mean to suggest we’re amongst those arrogant buffoons quoting themselves. I do think we drew the right line from Dec 2018 to the future. We noted, and it’s worth reading, that the Federal Reserve had shut down the Maiden Lane financial entity used to buy assets from AIG. An epochal event.

We said it could mark a top for the inflationary arc in risk assets spawned by the flood of cheap central-bank money.  We’ve had no gains in stocks from Sep 20, 2018 to present.

In December last year, pundits blamed the market maelstrom on impending recession. It was false then and it’s false now. Sure, all economies contract – fall into recession.  It wasn’t a uniformly engrossing event before central banks, though.

The human propensity to borrow and spend on growth, which at some point slows, leading to the collapse of borrowers and lenders alike, is normal and not something we should be trying to eradicate by juicing credit markets.

The bigger the credit wave, the farther the economic surfboard skims, and everyone marvels at the duration of the expansion cycle. And then the wave dies on the shoals. We’re now riding it, wind in our hair, with a vast curl beginning to form overhead.

But that’s not what sparked the market’s volatile descent.

One client (thank you!) shared notes from a JP Morgan conference call on recent volatility. JPM says economic underpinnings are reasonably sound and no cause for market troubles. Hedging strategies leading to the consumption of fixed income securities and sale of equities generated market duress (and skyrocketing bond prices), says JPM.

What prompted hedging strategies to change?  The cries of “recession!” didn’t commence until the market had already plummeted.

The same thing happened last December. After the market tanked, people were searching for reasons – failing to consider the structure of markets today and once again errantly supposing rational thought was at fault – and decided that so large a drop could only mean economic contraction had arrived.

It had not.

Think about how incorrect premises cost public companies money. There’s lost equity value. Higher equity cost of capital on volatility. Time and money spent messaging to the market about recession defenses.

CNBC had data yesterday on the spiking occurrence of Google searches around “the R word,” as they say.  No doubt a chunk of readers were searching earnings-call transcripts and press releases for it.

Behavioral data show no evidence of rational thought behind the market’s decline. Passive Investment plunged 20% the week ended Aug 2.  Stocks cratered.

Further, our data show the same thing JPM discussed. At Aug 19, order flow related to directional bets is down 11% versus the 200-day average. Occurring with expiring August options and newly trading September instruments Aug 15-21, it’s telling. Bets and hedges have gone awry. Low volatility schemes have failed. Insurance costs are up.

Low volatility investing is the most popular “smart beta” technique used to beat general market performance with rules-based investments. The dominance of smart beta is largely responsible for the outperformance of Utilities stocks tied to smart beta Exchange Traded Funds (ETFs.). Those strategies failed in August.

Volatility bets like the VIX expire today, Aug 21.

We can often peg the amount a stock will fall on bad earnings news to the percentage of market-cap tied to derivatives. Why? If future prices become indeterminate, the value of the instruments predicated on them declines near zero.

Currently, 16.4% of market cap traces back to derivatives and leverage, such as borrowing, down from pre-August levels over 18%. Volatility clouds predictability. The cost of leverage and protection increases, while use diminishes.

What if the market fell because Passive money was overweight equities and overdue for rebalancing, and stopped buying stocks in late July, which caused a gut-lurching swoon, which in turn rendered hedges worthless?

Talk of recession is a consequence of the market’s decline. Not causality.  Think about your own stock, IR professionals. Do you understand what drives it?  Investors, if you weight your portfolio for a recession that doesn’t exist, you’ll be wrong.

Our premise Jan 2 was that the end of Maiden Lane was the end of a monetary era, and it had the potential to create an interesting year. So far, seems right.  We also know what kind of money is waxing or waning. You should too. It’s not just interesting. It’s essential to correct actions.

Receding

The X-Files are back on TV so the pursuit of paranormal activity can resume. Thank goodness, because the market appears to be paranormal (X-Files theme in background).

Volatility signals behavioral-change, the meaning of which lies in patterns. Sounds like something Fox Mulder would utter but we embrace that notion here at ModernIR. It’s not revolutionary, but it is universal, from ocean tides to personalities, weather forecasts to stock-market trading.  Volatility, patterns.

Stocks are volatile. Where’s the pattern?

Let’s find it. A headline yesterday splashed across news strings said CEOs have “unleashed recession fears” on earnings calls. Fact Set’s excellent Earnings Insight might buttress that assertion with data showing S&P 500 earnings down 5.8% so far, revenues off 3.5%. It marks three straight quarters of declines for earnings, the worst since 2009, and four in a row for revenues, last seen in late 2008.

What happened then was a recession. That’s a pattern, you say.

Hard to argue your reasoning. We’re also told it’s oil pulling markets down. China’s slowing growth is pulling us down.  Slowing growth globally is the problem, reflected in Japan’s shift to negative interest rates. First-read fourth-quarter US Gross Domestic Product (GDP) last week was a wheezing 0.6%.  Slowing is slowing us, is the message.

But what’s the pattern?  One would expect a trigger for a recession so where is it?  In 2008, banks had inflated access to real estate investments by securitizing mortgage debt on the belief that demand was, I guess, infinite. When infinity proved finite, leverage shriveled like an extraterrestrial in earth atmosphere. Homes didn’t vanish. Money did. Result: a recession in home-values.

It spread.  In 2007, the gap between stock-values and underlying earnings was the widest until now, with the S&P 500 at 1560 trading more than 10% higher than forward earnings justified. Oil hit $150.

But by March 2009 oil was $35 and the S&P 500 below 700. To reverse this catastrophic deflation in asset prices, central banks embarked on the Infinite Money Theorem, an effort to expand the supply of money in the world enough to halt the snapping mortgage rubber band.  Imagine the biggest-ever long-short pairs trade.

It worked after a fashion. By the end of 2009, a plunging dollar had shot oil back to $76.  The S&P 500 was over 1100 and rapidly rising earnings justified it. Trusting only broad measures, investors in pandemic uniformity stampeded from stock-picking to index-investing and Exchange-Traded Funds (ETFs).

The Infinite Money Theorem reached orbital zenith in Aug 2014 when the Federal Reserve stopped expanding its balance sheet.  The dollar shot up.  Oil began to fall. By Jan 2015 companies were using the words “constant currency” to explain why currency-conversions were crushing revenues and profits.  In Aug 2015 after the Chinese central bank moved to devalue the yuan, US stocks caterwauled.

On Nov 19, 2015, the Fed’s balance sheet showed contraction year-over-year. Stocks have never returned to November levels. On Dec 16, 2015, the Fed lifted interest rates.  Stocks have since swooned.

Pattern? Proof of the paranormal?  No, math. When a trader shorts your stock – borrows and sells it – the event raises cash but creates a liability. Borrow, sell shares, and reap cash gain (with a debt – shares to return).  When central banks pump cash into the global economy, they are shorting the future to raise current capital.

How?  Money can’t materialize from space like something out of the X-Files. The cash the Fed uses to buy, say, $2 trillion of mortgages is from the future – backed by tax receipts expected long from now. That’s a short.

We’re getting to the root.  Say the global economy fell into a funk in 2008 from decades of overspending and never left it. Let me explain it this way.  One divided by one is one.  But one divided by 0.9 is 1.11.  The way the world counts GDP , that’s 11% growth.  But that growth is really just a smaller denominator – a weaker currency.

Now the dollar is revaluing to one and maybe more (it did the same in 2001 and in 2008). Why? Since the financial crisis trillions of dollars have benchmarked markets through indexes and ETFs.  In 2015, $570 billion flowed to Blackrock and Vanguard alone.  All that money bought rising markets until the excess money was used up by assets with now sharply higher prices.

The denominator is reverting and the economic growth we thought we had is receding back toward its initial shape, such as $35 oil (with stretch marks related to supply/demand issues). That’s what’s causing volatility. This is the pattern.  It’s colossally messy because the dollar is the world’s reserve currency and thus affects all other currencies (unevenly).

Volatility signals behavioral-change, the meaning of which is in patterns. This is it. A boomerang (read Michael Lewis’s book by that title for another perspective).  The dollar was made small to cause prices to grow large and create the illusion of growth in hopes it would become reality.  At the top of the orbit nothing had really changed and now that seven-year shadow on the planet is receding.

We’ll be fine. We humans always are.  But this is no short-term event. It’s a huge short.