IT'S TOO EASY TO WRITE BEARISH PIECES

2017-04-24 5pm EDT  |  #stocks #French election #SKEW

This morning global equities are spiking higher on news that Macron and Le Penn will proceed to the second round of the French election. U.S. stocks are up more than 1%, while European equities are flirting with up 4%.

What’s interesting is that this result was predicted perfectly by the polls. So why the big moves?

Since the Trump and BREXIT debacles, the market is on tenterhooks with worry about another surprise disruptive populist win. Last night’s French result is seen as benign because the market has determined Le Pen will lose handily to Macron in the second round. The markets have therefore breathed a sigh of relief, and rallied hard. I believe the market is now overestimating Macron’s lock on the election (in the next couple of weeks Macron’s lead will narrow and it will end up being closer than the market expects), but that’s not what I want to focus on.

Instead of talking about the French election and all the short term squiggles, I would rather step back and ask why do we keep having these “risk on” surprises?

There is no doubt in my mind that stocks are expensive. I have seen all the studies. I know history says valuations matter, and that buying equities at these levels has low expected future returns.

I can tell you with certainty that if I wrote a piece about the absurd price of equities and the coming crash, I would be inundated with agreeable comments. Writing an ber bearish piece is not brave or earth shattering. In fact, it is completely consensus and safe.

Look at the esteemed company I would be joining. From a recent Bloomberg article:

Billionaire investor Paul Tudor Jones has a message for Janet Yellen and investors: Be very afraid.

The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure – the value of the stock market relative to the size of the economy – should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.

Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.

Last week, Guggenheim Partner’s Scott Minerd said he expected a “significant correction” this summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, sees a stock plunge of between 20 and 40 percent, according to people familiar with his thinking.

Even Larry Fink, whose BlackRock Inc. oversees $5.4 trillion mostly betting on rising markets, acknowledged this week that stocks could fall between 5 and 10 percent if corporate earnings disappoint.

Managers expecting the worst each have a pet harbinger of doom. Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter last week that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive.”

Share sales by insiders outstripped purchases by $38 billion in the first quarter, the most since 2013, according to The Washington Service, a provider of data and analysis on insider trading.

Klarman also noted that margin debt – the money clients borrow from their brokers to purchase shares – hit a record $528 billion in February, a signal to some that enthusiasm for stocks may be overheating. Baupost was a small net seller in the first quarter, according to the letter.

Another multi-billion-dollar hedge fund manager, who asked not to be named, said that rising interest rates in the U.S. mean fewer companies will be able to borrow money to pay dividends and buy back shares. About 30 percent of the jump in the S&P 500 between the third quarter of 2009 and the end of last year was fueled by buybacks, according to data compiled by Bloomberg Intelligence. The manager says he has been shorting the market, expecting as much as a 10 percent correction in U.S. equities this year.

Other worried investors, like Guggenheim’s Minerd, cite as potential triggers President Donald Trump’s struggle to enact policies, including a tax overhaul, as well as geopolitical risks.

Yang’s prediction of a dive rests on things like a severe slowdown in China or a greater-than-expected rise in inflation that could lead to bigger rate hikes, people said. Yang didn’t return calls and emails seeking a comment.

Even billionaire Leon Cooperman – long a stock bull – wrote to investors in his Omega Advisors that he thinks U.S. shares might stand still until August or September, in part because of flagging confidence in the so-called Trump reflation trade.

This article reads like a who’s who of the hedge fund elite. Taking the other side of their trade is like telling Wayne Gretzky he doesn’t really understand the intricacies of the left wing lock and proceeding to school him about the finer points of hockey.

Don’t mistake me for some sort of neophyte who believes the financial system is safe and stable. You cannot simply take the playbook for the last half a century and apply it to today’s environment. The sheer amount of debt out there, and the mad science experiments being run by the world’s Central Banks make today’s investing landscape completely different than anything we have ever experienced.

When we went through the 2008 credit crisis, something big changed. We are all still learning how the financial system has been altered, but make no mistake, it is different today than it was prior to the credit crisis.

Although I am not suggesting we all rush out to buy S&P 500 futures tomorrow, I wanted to illuminate the fact that everybody is already leaning short. Do you think all these hedge fund managers shared these bearish views while sitting on long positions that they need to sell? Not a chance. These guys are all under-invested, and in some cases, outright short. Do you think that when pension funds look at the chart of the expected future returns versus valuation levels, they don’t, at the margin, lighten up on equities? Again, there is no way a quantitatively based endowment manager is currently overweight equities. And how about retail? With visions of 2008 still seared in their brains, do you think individual investors are loading up the boat with stocks? Nope, no way.

This is truly the most hated bull market in the history of investing.

I don’t have any answers about how this will all end. If someone thinks they do, they are probably wrong. This is uncharted territory.

All I know is that the stock market keeps pushing higher, much to the bewilderment of almost everyone. Yes, there might be some old school managers who mistakenly believe this cycle is the same as all the previous ones, but they are few and far between. Not only that, but they are most likely wrong. The economy is not nearly as strong as they continually predict. Earnings are not growing as fast as they forecast. Yet stocks keep pushing higher.

I believe the chart above regarding the Central Bank balance sheet growth has more to do with the incessant financial asset bid than any other input, but there’s no way I can really prove that.

Everyone is looking at stocks and seeing over-valuations and bubbles. Yet stocks are not being bought by some out of control crowd suffering from mad delusions. No, the madness is confined to a half dozen Central Banks with the ability to buy financial assets without the worry of coming up with the capital to pay for them.

Private sector participants are reluctantly participating in the buying, but they are constantly watching for the first sign of trouble, ready to abandon ship.

They are all hedging, worried the 2008 credit crisis will repeat. ZeroHedge had a great article about the mysterious trader who buys 50,000 VIX calls that are trading for around 50 cents everyday, stinging him with $89 million in losses so far this year.

I don’t have any fundamental way to justify this potential outcome, but I worry that the real surprise will not be a repeat of 2008, but instead a crazy, out of control melt-up.

Market dislocations seldom occur due to the accident everyone is predicting. By their very nature, surprises are… surprises.

And I ask you, what would be the bigger surprise? A stock market that sells off hard, confirming all those hedge fund managers’ opinions? Or a monster melt-up that becomes parabolic as all those under-invested investors chase stocks in a mad “just get me in” scramble?

Well, the market definitely has an opinion about what it is most worried about. The CBOE SKEW index measures the price of buying out-of-the-money puts versus ones closer to the index. In effect, it represents the extra premium investors are paying to hedge for a large dislocation to the downside.

You would have thought the SKEW would have hit its highest level during the 2008 credit crisis. Yet surprisingly, we have just recently hit a new high. And not only that, the level of “SKEW’ness” has been consistently rising over the past few years.

I am by no means dismissing the possibility of a large downside correction. Equities are stupid expensive. They are being held aloft by Central Bank asset purchases. If Central Bankers retreat, there will be an air vacuum underneath the market that makes those out-of-the-money puts seem cheap.

Yet if that does happen, I contend it will be quickly met with renewed Central Bank stimulation that once again puts a mindless bid underneath the market.

I am not arguing about the possibility that all these negative naysayers end up being correct, but I wanted to highlight the chances of them being wrong are greatly underestimated.

Everyone is bearish. There is no great value added by warning about the potential that this ends badly. We all know this will end in an ugly mess. Our wealth is more illusionary than real, held aloft by ever increasing debts.

Yet the market is missing the possibility that all this debt ends up being paid back in greatly depreciated dollars. And if that is the case, the actual nominal prices of financial assets might end up significantly higher than today’s prices.

I will repeat my favourite line stolen from Bill Fleckenstein - Central Banks will continue printing until the bond market takes away the keys. We are nowhere near that point, and it might not occur until private investors finally give up worrying about the downside.

When the market mood is such that writing a bearish piece gets as many boos as this piece will get me, that will be the time to think about betting against the stock market. Until then, I am going to look at buying some of those way out-of-the-money calls as lottery tickets in case I am right.

Thanks for reading,
Kevin Muir
the MacroTourist