May 14/15 – Don’t make Stevie send you home

2015-05-14 8am EDT  |  #bonds #Steve Cohen

Can you remember back to the last financial crisis? As the 20078 credit swoon dragged on, do you recall how many traders tried to catch what they felt was an oversold stock market? It was after all, down a long way.

The S&P 500 hit 1,600 in the summer of 2007, and by the end of that year had given up 300 points. After a brief rally in the spring of 2008, the stock market once again started sinking. By summertime it was hitting new lows. Once autumn arrived, the selling really picked up. The S&P 500 began falling 50 points a week. Finally, 17 months after first rolling over, the selling climaxed with the 666 devil’s tick in the S&P 500.

Today it is easy to look at the chart and “know” you shouldn’t buy too early. But think back to that period. Did you start bidding when it was down 20%? How about 30%? Maybe 40%? Any of those levels were terrible points to get long. Yet, at the time the selling seemed so panicky, every decline felt like it had to be the bottom.

I was not immune. I had been bearish in 2007, and after nailing the trade, I covered mid 2008. In the fall, I decided that the selling was over done, and I started nibbling on some long positions. I figured I was buying from the weak hands. Well, I was reminded first hand how stupid it is to catch falling knives.

All of a sudden, my great trade had turned into a loser. The decline caught me totally off guard. I misjudged the possibility of it declining another 30% after already declining 30%. Like a complete mope I suddenly found myself long and wrong.

There is one story from this period I will never forget. Into this cascading free fall, when everyone was trying to pick a bottom, the controversial hedge fund manager Steve Cohen told all of his traders to go home and not come back until the crisis was over. I can’t find the article, but I think he screamed at them something about being a bunch of idiots for trying to catch the bottom tick. Cohen is reported to be a prickly boss at the best of times, so I assume his tirade was a dialogue Scorsese would have liked to steal for his Wolf of Wall Street movie. Stevie and his trusted couple of lieutenants took over all trading. He understood the dynamics of a liquidation better than his younger traders, and he wasn’t going to let them screw it up.

I am well aware of Cohen’s reputation. My buddies have to cover his account so I know first hand about all the “allegedly” dubious trades. You need not tell me how close he plays over to the line. But at the same time, at least he never goes on CNBC and spews his bullshit on us. He never speaks out of both sides of his mouth, or gets into screaming matches with other hedge fund managers on national TV. Cohen is an old school tough guy, settle it after school in the field, hedge fund manager. For that, hats off to him.

But the important lesson was his recognition the trend would overwhelm all other metrics. He understood equities were being liquidated and the selling could last longer than traditional “fundamentals” would dictate.

The top tick

I believe the 0.05% tick in the German bund was the top tick in the global bond bull market. At that point the financial community had suspended all hope Central Banks could ever create inflation. The inevitability of deflation was firmly entrenched in the mindset of investors. We had also passed well into a period of what can only be described as Ponzi fixed income “investing.” When bond fund managers justify purchasing negative yielding 10 year bonds because they are confident they will be able to sell them even higher, it is time to take a breath and sell with both fists.

Remember this Bloomberg article from earlier in the year?

This sort of ponzi rationale is symptomatic of a long term top. This was the Jim Cramer “winners of the new world” 2000 speech at the top of the DotCom bubble moment.

The 1.5 billion of Mexican 100 year bonds issued with a 4% yield might have also been a clue things were getting a little frothy.

Global bond bear market

Back to Steve Cohen telling all his traders to go pound sand during the 20078 credit crisis. Cohen recognized the severity of the global bear market in stocks. He understood in a liquidation prices go way lower than anyone imagines.

I contend we have entered into what will be an equally damaging bear market in bonds. The surprise will be how low bond prices go, not the other way round. Even though the bond market has gotten shellacked for the past month, most market pundits still don’t believe inflation is coming. Even if they begrudgingly admit the bond market is acting poorly, they view the decline as temporary.

Don’t forget that since the start of the 20078 credit crisis, Central Bankers have been expanding their balance sheets at an unprecedented rate.

The common narrative is Central Bankers are pushing liquidity into the system, but there is no demand for credit, so the liquidity simply drives down risk free rate. That might have been correct for the past year or two, but the bond market is now telling you something different.

Just as Stanley Druckenmiller tells you prices in Chinese equities move before their economy picks up, the same truth applies to the bond market. The price of bonds will move lower ahead of an economic pickup.

And then, as this bond bear market becomes fully entrenched, you need to remember the wisdom of Steve Cohen. Don’t make the mistake of trying to catch the bottom tick. Rallies are to be sold, not the other way round.

Over the past half dozen years monetary policy has bordered on lunacy. Central Bankers have been tossing around billions in quantitative easing with a surprising calmness from the markets.

Eventually this monetary expansion is going to kick in. The Central Banks have been pouring massive amounts of fuel onto the fire, and the lack of a spark has convinced market participants it will never start. Well, I see a small part of the bonfire smoking in the centre with this recent decline in the bond market. The problem is that the Central Banks have piled so much wood onto the fire, once it starts, it will quickly become a raging inferno.

The inflationistas will eventually be right

Remember back in 2009 when the inflationistas warned the Fed’s aggressive monetary policy would cause inflation? There were some really smart people warning about the consequences from overly aggressive quantitative easing. In November 2010 some of the brightest minds in finance wrote an open letter to Ben Bernanke in the Wall Street Journal:

We believe the Federal Reserve's large-scale asset purchase plan (so-called "quantitative easing") should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed's objective of promoting employment.

We subscribe to your statement in the Washington Post on November 4 that "the Federal Reserve cannot solve all the economy's problems on its own." In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed's purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.

Cliff Asness, Jim Chanos, Seth Klarman, Jim Grant, Paul Singer and John Taylor were among the individuals that signed the letter. Over the years there have been other wise market veterans such as Julian Robertson and Jeremy Grantham who have also warned about the bond bubble.

These warnings were not wrong, they were simply early.

Everyone hedges for the wrong disaster

The market has been obsessed with worrying about a bubble in high yield bonds and equities because this is where the last financial crisis began. Although those asset classes are pricy, this is simply the result of the bubble in the sovereign debt. This is the true bubble. All other assets are derivatives of the underlying risk free rate. This bubble is especially scary because it has affected all other asset prices, from equities to real estate.

Don’t forget that everyone hedges for the wrong crisis. If they did manage to foresee the crisis, it wouldn’t be a crisis because the price would already reflect their worry.

The fact that no one believes we can get a sustained sell off in sovereign debt should scare you. German 10 year bunds going from 0.05% to 0.71% in a week and a half should be a monster wake up call about the instability of this market.

Can we get a rally? For sure. During the final stages of the DotCom bubble there were some big breaks that were met with spirited buying. But the increase in volatility was a sign the end was near. Ditto for the recent declines in the sovereign debt market.

Don’t try to be a hero and bottom tick the recent decline in bonds. Instead, take the advice of Stevie Cohen and write the pink tickets first. In a bear market this is the only way to have him not yell at you.