Below, we take a deeper look at global debt levels, bond yield triggers and volatility trades combining into a potential “perfect storm.”
This is perhaps the most unloved bull I’ve traded since the eve of my first bubble in the late 90’s. And like us at Signals Matter, you’ve probably seen a few things in your own forays into supply and demand that made you wince or smile over the years.
But as for current markets, I’ve never seen anything, this… well…. this crazy.
Nor am I complaining. Our trades at Signals Matter—both long and short—work in bull or bear markets, and have been grossly outperforming the indexes. In short, we make money even when markets don’t make sense.
But I can’t help but ponder these crazy times.
Four Letter Reality: DEBT
Let’s remind ourselves of the four-letter-word that so defines our era, markets, world and country: D-E-B-T. In a four-part series on the US debt cycle, we gave this topic center stage. But this “debt thing” needs more attention.
It’s madness really. We live—and trade—in the backdrop of $225T in outstanding global debt. Here in the US, our deficit has passed $20T, and in the two months since we postponed (as expected) our debt ceiling deadline, our national debt has grown by an additional $640B.
Of course, the inevitable “temporary suspension” of our debt ceiling will eventually be passed by Congress after some dramatic stand-offs in DC. Thereafter, we, as a nation, and many of us as traders, can continue to invest in an equally temporary “suspension of reality.”
That’s why a reality check is needed once more.
It’s human to kick the can of current problems into tomorrow’s headlights. Since the 2011 debt ceiling, for example, we increased our public debt by $6T, and for this national VISA binge, we’ve bought ourselves the 3rd largest business expansion and the world’s largest stock and bond bubble in history.
Yep: in history. The S&P is hitting record highs and is currently valued as if markets can only go up, and never down. Meanwhile, the yield on the US 10-year recently hit its lowest point in the history of America.
But that’s what yields do when bond prices are so inflated by money printing, sovereign debt expansion and artificially compressed rates replacing natural price discovery or supply and demand. Things get bubbly.
But in case you haven’t noticed, bond prices are beginning to tick down, and bond yields are beginning to tick up…That’s a crack in the ice worth considering—and we at Signals Matter are considering it all the time.
How Did We Get Here?
Central banks in general, and the Fed in particular, have risen from obscurity to becoming the sole tailwind and back-stop of fantasy markets and a nearly universal faith that a few PhD’s and appointed Fed governors can control global markets, employment and inflation like a thermostat that can be dialed up and down.
That’s like saying yachtsmen can control the ocean. Pure hubris.
Yet the markets actually believe this.
Hooray for that. At least for now. It’s fun, after all, to keep our heads in the sand and ignore the reckoning ahead for our national accounting and irrational markets. As US debt rises by nearly $1T a year, no one in DC or Wall Street seems to notice the storm brewing.
After all—and as triumphant Trump tweets keep reminding us (while applauding himself)—markets continue to rise like hockey sticks. Why bother worrying now about a puck to the face? The good times are here to stay, right?
The Bull Case
The market bulls, Wall Street, and their cheerleaders in the MSFM keep repeating the meme of “synchronized global growth” to keep us full speed ahead for more years of continued up-and-to-the-right markets. They primarily rely upon today’s “record-breaking earnings” and point as well to clear signs of continued economic growth, revenue growth, and corporate profit growth.
Furthermore, the market bulls see the next Fed chairman as just another Yellen-in-pants (not untrue) and thus anticipate further “low rate support” and “accommodation” from the Eccles building, the very same kind of “accommodation” we’ve enjoyed since 1981 in general and certainly since 2008 in particular.
In short, the market bulls assume lots of money printing and low rates to come (when and if needed) to refill the kegs.
And then of course there’s the great tax reform ahead, poised to take markets into the next few years with all kinds of fiscal trickle-down effects from the Laffer curve’s promise that tax cuts lead to economic spikes.
Overall confidence, moreover, has never been higher nor the VIX lower, and we all know how confidence—even exuberance can carry a bull through just about any reality check.
Finally, the market bulls always point to China as the continued engine of global growth. If DC can’t save the securities market, perhaps Beijing will.
In short, the market bulls have reasons to be bullish and they have the market highs to confirm it.
So, What’s Wrong with Being a Market Bull?
After all, bulls are what keep markets thriving. We need em.
But here’s the rub—one even bulls can accept: markets, like people, can’t binge forever. Market, business, and economic corrections, like hangovers, are not only inevitable, they’re helpful. They keep us controlled. And boy are we out of control right now…
Because our central banks, CIO’s, big-banks and markets have been drinking too much of their own spiked Kool-aide and want to keep on partying. But as any of us who drank in college know: it’s bad for them—and bad for us. In short, it’s time for a Sunday hangover.
This, of course, assumes, things are really that intoxicated today. Are they?
Signs of a Binge
So, let’s give these markets, bulls and times a little sobriety test, eh?
First, let’s consider the “synchronized global growth” rumor going around the bull pen. In fact, US GDP has been flat-lining, not growing, at around 1.8% per year since 2008. If you don’t believe me, just take a gander at this little graph below, which compares our market binge against actual (GDP) performance:
The GDP graphs aren’t any prettier elsewhere in the world either. From the EC to Tokyo to Beijing, it’s the same sad story: lots of central bank stimulus, market bubbles and debt, yet no correlated GDP rise (and hence money) to compensate/show for it. The only thing rising is Wall Street memes, soundbites, robo trades, valuations and fantasy.
And as for the “earnings revolution” pointed out by all the market apologists, well, they really do owe you an apology. Let’s look bluntly at earnings.
During the last 3 years, earnings have grown at .63% per annum while stock prices have grown at 10% per year. That’s what we call a “wild and crazy disconnect.” And if you think the FANG exception will save us, keep in mind that despite even their outlier (and totally drunken) earnings numbers, they only account for 4% of our GDP.
In short, Facebook et al is not going to make America great again.
The only thing “growing” today is a market bubble. With almost 90% of the S&P having reported their Q3 earnings (LTM and on a GAAP basis), the numbers average out to $107 per share, which means the broad market PE now sits at the nosebleed level of 24.3X.
Now that, by any measure, is a bubble.
As for economic growth, since 2014 the economy has grown by just over 8%, and top line revenues by only 3% while corporate profits and earnings have grown by just 2%. Yet during that same period, asset prices in the markets have grown by 30%.
Again, that’s what we call a “wild and crazy disconnect.”
And the Fed? Is it truly wise to think it’s here to save us next time a correction comes around? With its bloated balance sheet and already anemic rate policy, our Fed has no dry powder left to pay for another fake, V-shaped ride ala 08-09.
In fact, the QT pointing Fed is dialing its magical (and soon to be broken) thermostat down, not up. The Oz behind our FOMC curtain is actually scrambling like mad right now to reduce its balance sheet and raise rates rather than “accommodate” a fattening bull market.
And the only reason they’re doing this “tightening” now is that they know damn well another market plunge (and economic recession) is on the horizon. That is, they need to raise rates and shrink their balance sheets fast in order to have even a semblance of dry powder available when the next—and far worse—“08 moment” comes.
Yields Rising and Markets Falling: A Perfect Storm
This demonetizing campaign will dramatically increase the supply of US Treasuries looking for a buyer—and all at the same time that our post-debt-ceiling Congress will be instructing the US Treasury Department to issue more fiat IOU’s (i.e. 10-Year bonds) to the world.
In short, markets will be flooded with US bonds. And what does that mean? Well, as supply rises, bond prices fall, which means bond yields—and hence interest rates—will rise out of this Fed created monster-bubble with a vengeance.
But as the US is looking for buyers of its debt, China will be looking to unload its own book of US 10-Years just to keep their currency from tanking with the USD—which means even more US bonds floating into the market, and hence even higher bond yields (and interest rates) in their wake. In sum: a kind of perfect storm.
As for China, it’s a Ponzi scheme, not a market savior. But I’ll save that topic for another blog…
The Volatility Trade—More Wind in a Perfect Storm
Finally, as we consider the perfect storm ahead, it’s not just rising yields we need to focus on as an indicator or weather vane. We need to look again and that nifty little volatility market.
In a world and market gone mad in the search of yield and return, it should come as no surprise that the same folks who gave us derivatives and structured credit “weapons of mass destruction” have also found a way to monetize volatility as a trade rather than simply as a humble measure of risk.
Today, the Greenspans, Friedmans and Larry Summers of the world have found a way to legalize the selling (bullish) and buying (bearish) of market volatility as widget rather than an indicator.
In this bull market drunken binge, it should therefore come as no surprise that the global short volatility trade has grown to more than $2T. I’ve described these volatility sellers elsewhere as akin to the 2 little piggy’s who built straw and mud houses rather than brick ones, choosing a short-term party rather than long-term concern for a big, bad market wolf.
Not surprisingly, these little piggies are currently having a ton of fun in a market where the VIX (fear index) has fallen lower than Harvey Weinstein.
But what these little piggy’s –like so many volatility sellers—have forgotten is that whenever a shock comes to the markets (i.e. a bond yield spike), the short volatility trade will fold like a straw house before an angry wolf, and hence, by simple rules of reflexivity, this higher volatility will trade will beget more volatility, adding fuel to an already raging market fire.
That is, the unwinding of the short-volatility trade will in and of itself lead to a mega crash much worse than what was seen in Black Monday of 1987.
You should be.
A Silver Lining
But for every crisis there’s opportunity. And we at Signals Matter are looking at the long volatility trade as perhaps the most undervalued asset class in the globe. And so we are looking at it very carefully.
What about you?
One response to “Market Reality Check, Part II: Debt, Bond Yields, and the Volatility Trade”
November 13 2017