It's been six years and the joke's getting old

2015-01-28 9am EDT  |  #bonds #Crispin #Odey #stocks

Back in 2011 when the stock market had taken a pause and looked like it was about to roll over, I remember being bullish. It seemed like everyone was convinced that the bull market had run its course and we were due to resume the great bear market. The S&P 500 had declined from 1350 down to under 1100 and it looked ugly. I remember saying to my trading buddies that “right now I am long and hurting, but it won’t be long before we are hitting new highs and I will be short and screaming at the stupidity of the buyers for chasing it.” Well I did nail the long trade, but like a chump, I have been fighting it all too often since then as we have pushed to new high after new high…

This bull market is now over six years old, and although sentiment never got 1999 frothy, there is no doubt that a sense of complacency has crept into the collective psyche of investors. Smart bearish guys have been laughed out of the room as the relentless bid from the Central Banks and their agents have steam rolled financial markets to new highs. If you even suggest that stocks might due for a decline you get labelled a crackpot perma-bear that “just doesn’t get it.” Meanwhile, the strategists that suggest loading up on stocks after a 200% increase are the prudent ones whose opinion is met with agreeing nods from the investing masses.

My main worry is that there is precious little worry out there. There seems to be an utter lack of concern about the really momentous changes that are happening in the financial markets. Almost the entire yield curve of Switzerland has moved to negative yields. Think about the absurdity of that for a second. Switzerland can make money by issuing bonds! Or think about the amount of buying that the Bank of Japan is doing. They are basically monetizing their debt with equity purchases. The CME even has a Central Bank rebate program for S&P 500 futures. F’ me. These are not normal times. Yet everyone is merrily going along ignoring all the warning signs.

Something big is going to break. I don’t know if it is going to be an equity market crash, or a bond market that goes bananas, but I do know that the system is becoming increasingly unstable.

Yet into this madness, strategists are behaving like everything is normal. Investors are justifying the preposterousness of this environment with amazingly self delusional ideas. Just have a look at the title of this article from Bloomberg: Owners of Negative Yield Sovereign Debt Say They’re No Fools. Really? Buying a 10 year Swiss bond at a negative yield is a wise investment? Or how about a 30 year Japanese bond at 1.30% yield? Giving money for that long for so little yield to the most heavily indebted developed country in the world that is committed to expanding their balance sheet until they achieve 2% inflation is nuts. This is the biggest version of the greater fool theory in the history of finance!

During this next correction, there is going to absolutely no where to hide. Bonds are beyond priced for perfection. Stocks are filled with risk as they have been levitated into the stratosphere by Central Bank buying.

The classic 6040 portfolio (60 percent equities with 40 percent bonds) has had an amazing run over the past few decades. I couldn’t find a chart of a 6040, but I did find this chart of a 5050 portfolio’s drawdowns. In the US, there has not been a draw down of more than 20% since the 1980s.

Here is my prediction: in the next decade this portfolio will experience a decline that rivals the 1920s decline. Remember this is in real terms. The decline might be the result of a return of inflation. Or it might be the result of a market crash. I don’t know, but financial assets have been goosed to levels where they are destined to disappoint. You might find a way to hide in the least expensive bond market over the short run. But over the long run, these sorts of yields with this stock market valuation is going to result in a big drawdown. I suspect that this classic 6040 portfolio gets cut in half in real terms.

Although many of the financial talking heads will quickly dismiss this as another perma bear that just doesn’t get it, I noticed that yet another smart guy has quietly gone full bear. From ZeroHedge:

“I think equity markets will get devastated,” warns famed $12bn AUM hedge fund manager Crispin Odey in his latest letter to investors. Having been one of the biggest bulls of this particular central bank artificial-bull cycle, his dramatic bearish tilt (as we discussed what he thinks are the biggest risks underpriced by the market previously), is notable. Finally, Odey fears major economies are entering a recession that will be “remembered in a hundred years,” adding that the “bearish opportunity” to short stocks looks as great as it was in 2007-2009.

I am not sure that he is right about the economy collapsing, but when wise old sages like Crispin get worried, I don’t find ways to justify disagreeing with them. Especially when everyone else is relying on the greater fool to offload their risky assets to.

Investors are being lulled into thinking that financial assets are safe. The constant bid from Central Banks with all their financial repression has created a sense of safety. Yet prices are becoming increasingly volatile. The party might not be over yet, but it is getting late and people are swinging from the chandeliers. This is the time where you should be eyeing the exit and thinking hard about how to avoid the coming tragic ending.