On The Nature of the Pullback

Why have stocks and high yield debt recently declined? The standard excuses trotted out by the financial press make very little sense. For instance, it is held that stocks have fallen due to rising geopolitical upheaval in Ukraine, Iraq and elsewhere (actually, the “elsewhere” situations, such as the falling apart of Libya are rarely mentioned, because they are overshadowed by the other two).

But this makes no sense when we consider that the market was perfectly happy to completely ignore both developments for months. Why should they matter now, if they haven't previously? There is only a kernel of truth in these assertions insofar as “bad news” from these conflicts can serve as short term triggers for market weakness on a daily or even hourly basis. However, there is a difference between a trigger and a “reason”.

As Zerohedge has pointed out, outflows from high yield debt ETFs are causing some indigestion, because the ETFs themselves are highly liquid, while the underlying debt is anything but. We have also briefly discussed this problem of bond market illiquidity in our recent comprehensive update on the junk debt bubble (see: “A Dangerous Boom in Unsound Corporate Debt” for details), however, we haven't brought it into context with ETFs.

Zerohedge is quite correct in pointing this relationship out – it is an added wrinkle complicating the situation. Why are corporate bonds illiquid? Because the biggest banks have withdrawn from proprietary trading and market making in these instruments due to various post-crisis regulations that have been imposed (such as the Dodd-Frank monstrosity).

 

It is important to understand in this context that these vast addition of regulations in what is already one of the most over-regulated sectors of the economy brings a raft of unintended negative consequences with it. The entire shebang fails to strike at the root, instead it is yet another attempt to make fractional reserve banking somehow “viable”.  The most important privilege banks enjoy, which is the basis of our entire debt money system, is to be preserved at all cost.

This system siphons wealth in insidious ways from actual wealth creators to the State and its favored  industries, among which the banking industry inhabits the top spot. Almost no regulations would be required in a true free market banking system that  scrupulously respects property rights. You may wonder why the big banks haven't made more of an effort to roll these regulations back. The reason is simple: one of the main effects of imposing ever more bureaucratic oversight and decrees is to completely stamp out competition from smaller rivals and upstarts, who cannot afford paying the costs of compliance. Thus the business becomes ever more concentrated in the hands of fewer and fewer large banks.

This sounds almost like the Marxian analysis of capitalism, but note here that it has nothing to do with free market capitalism. In an unhampered free market, this could not possibly happen – it is a hallmark of the so-called state-capitalistic system, which at its root is based on socialist premises (in short, there is only a very fine line between socialism and fascism in terms of economic policy – for all practical purposes, both systems lead to very similar outcomes).

 

DJIA and HYG (2)  The DJIA and HYG – both have just tested their 200 day moving averages. Regardless of whether the current “dip” is only a temporary pullback or the beginning of a larger decline, one must expect these markets to reflexively bounce from this support area – click to enlarge.

 

Let us get back to the “nature of the pullback”. In a bull market, tests of the 200 day moving average and large outflows from funds investing in a previously favored asset class are actually contrarian bullish signals. In other words, these outflows are not telling us “a bear market has begun”. One must look at this the other way around: if a bear market has begun, then these outflows are a bearish datum. If no bear market has begun yet, they actually represent a bullish datum.

Hence, such data are conveying little actionable information. In fact, regardless of whether or not a bear market has begun, a spike in outflows will almost always at least coincide with a short term low.

 

What to Look For

The same that applies to data like fund flows also applies to sentiment data. Consider for instance the updated chart of the NAAIM  survey of fund manager exposure below:

 

NAAIMThe NAAIM survey of fund managers – the range of responses is from “-200% net short” to “+200% net long”. The peak reading was an aggregate net long exposure of 104% (recorded last year), with not a single manager short (actually, this latter condition was recorded several times) – click to enlarge.

 

The most important information on this chart is the divergence (indicated by the red line) between the SPX and NAAIM net exposure at the peak. This is a medium to long term bearish warning signal. It doesn't always work, but it raises the probability that the current downturn is more than just a routine pullback considerably. Similar divergences have been recorded in nearly every sentiment and positioning datum. Many other technical divergences have been seen as well since the end of 2013  –  we have regularly documented them in these pages.

Consider now the recent pullback in exposure. In a bull market, such a pullback is bullish – it indicates caution that will later turn out to have been unwarranted. However, this level of exposure is actually not “low” – it is quite high, and only appears low in the context of recent history. Moreover, if a bear market has begun, then one must begin to interpret the data differently. Exposure peaks will be lower, as will exposure troughs. Growing short term caution will no longer be bullish, but will actually become a bearish confirming indicator.

What one must actually watch in order to be able to tell whether the pullback is meaningful in a medium to long term sense is the nature of the rebound. If the rebound very quickly reestablished extreme bullish sentiment, when it occurs in herky-jerky fashion with many overlapping waves, and when it ultimately fails at a lower high, with the subsequent decline producing a lower low, then we will have confirmation that the market's character has changed from cyclical bull to cyclical bear. The danger that this could happen is great, given the many divergences we have observed over the past several months. Only the still fairly brisk growth in money supply growth argues in favor of the bull market having more life left – but even that growth rate is decelerating.  Once the bull market does end, the extremely distorted capital structure of the economy will likely lead to the mother of all busts.

 

capital vs. concumer goods productionThe capital (business equipment) vs. consumer goods production ratio has reached a new all time high. Once the current boom fades, this guarantees that there will be a severe bust, as these investments in the higher order stages of the capital structure are not supported by voluntary savings, but by the diversion of factors due to monetary pumping – click to enlarge.

 

The Real Reason for the Decline

Lastly, the question what the real reason for the decline actually is remains to be answered. This is actually an easy one: the only thing the markets care about is that ZIRP and monetary pumping continue for as long as possible. Whenever the market declines, it does so for one reason only, namely growing worries that an attempt may be made to “normalize” monetary policy earlier and faster than hitherto expected.

Given the bizarre economic theories the Fed bases its decisions on (such as the absurd idea that growing economic output “causes inflation”), the danger that this might happen is actually very real. One must not forget that Janet Yellen really does believe that central bank meddling with the economy can somehow improve it. She will therefore regard the increase in bubble activities that depend on her loose monetary policy as a sign that the economy is “achieving escape velocity”. Of course, contrary to the mainstream view, the economy is neither an “engine” that can be “jump-started”, nor is it a spaceship.

Once potential rate hikes come into view – i.e., once the market begins to believe they may actually happen –  the financial markets may well discount the coming liquidation of unsound investments and unsound debt in advance. Given how extremely extended and over-leveraged the markets in stocks and corporate debt  are, and for how long volatility has been suppressed,  it would not surprise us at all if the initial downturn were to include a crash. In fact, this has almost become our default expectation by now.

Steve Saville recently showed a chart that demonstrates how far “behind the curve” current Fed policy actually is. It compares ECRI's “future inflation gauge” (which refers to CPI inflation) with the fed Funds rate. This chart suggests that market expectations could eventually shift from complacency about interest rates to looking for very fast and large rate hikes. It also tells us indirectly that the amount of malinvested capital in the economy and the extent to which reported profits are illusory and actually reflect capital consumption must be quite large indeed:

 

ecriECRI's future inflation gauge vs. the Fed Funds rate – another chart that shows us that we are experiencing a huge bubble. It also illustrates the danger that the market could suddenly find itself bereft of help from loose monetary policy for a while – click to enlarge.

 

Conclusion:

Regardless of the fact that the markets are almost certain to bounce in the near term, the dangers to the bubble are growing by the day. Once a rebound rally fails, things are likely to get very dicey very fast.

 

Charts by: StockCharts, St. Louis Fed, speculative-investor.com
 
 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

4 Responses to “Financial Markets at Critical Juncture – Could a Crash Eventually Happen?”

  • No6:

    When this fed induced market collapses, I will bet a few bucks Putin will get the blame.

  • Kreditanstalt:

    We all know that the governments and their central banks can never afford to lose control of interest rates.

    Firstly, were the manipulation of rates to fail all sorts of misallocations would be exposed, leveraged entities would be in major trouble, government debts would become unmanageable, home”owners” would find their mortgage costs soaring, &c., &c. It’s the absolute LAST outcome any government would wish to see…and maintaining control of the cost of money (so it is not determined by the market!) via counterfeiting is Job #1.

    Secondly, the fiat money system is at heart a Ponzi scheme: it needs not only continuing expansion of money and credit, but it needs that at an ever-increasing pace. Without that, credit would contract – and we saw how the leveraged world nearly had a heart attack when that (barely) happened in 2008.

    For these reasons some form of QE will have to remain in place. Some form of printing will continue. As “peak credit” – limits to growth – appear to have been reached (oil prices? resource scarcity? demographics? financialization?), the governments will grow increasingly desperate to re-start the engine as they always managed to do in the past. But “escape velocity” will not come.

    My question is: don’t the market participants KNOW all this? Why are they panicking? I find it hard to believe that they are so naive and short-sighted as to believe that some kind of genuine “recovery” is/was underway and is now under threat in light of potential “rising interest rates”…

    There must be more to this. Collateral problems? Insufficient yield? The lack of REAL growth beginning to tell? What could it be?

  • rodney:

    OFF-TOPIC

    If GDX can close above 27, gold miners are going to experience a “rip your face off rally” (to borrow a hedge fund manager’s phrase).

  • rodney:

    This is all very good and I fully agree. But there’s a missing element in the analysis. We agree that this is a stock market bubble, so it should be said that it is in the nature of bubbles for price to get to levels you couldn’t imagine a priori.

    It is also in the nature of bubbles to explode higher precisely when fundamentals are already deteriorating (as you point out in this article). It’s just human nature, and I mean the investing crowd, to feel good about investing and plunge into equities at the worst point.

    All of this argues for a buying climax of crazy proportions before the final crash.

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Gold Sector: Positioning and Sentiment
      A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
  • India: The next Pakistan?
      India’s Rapid Degradation This is Part XI of a series of articles (the most recent of which is linked here) in which I have provided regular updates on what started as the demonetization of 86% of India's currency. The story of demonetization and the ensuing developments were merely a vehicle for me to explore Indian institutions, culture and society.   The Modimobile is making the rounds amid a flower shower. [PT] Photo credit: PTI Photo   Tribal cultures face...
  • The Long Run Economics of Debt Based Stimulus
      Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century.  Gross domestic product (GDP) has moderated onward while government debt has spiked upward.  Orthodox economists continue to be flummoxed by what has transpired.   What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity.  Although the fat lady has so far only...
  • Welcome to Totalitarian America, President Trump!
      Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed.   Image adapted from the cover of “Deep State #5” - depicting an assassin from the future   President Trump joins the very crowded list of opponents of the American...
  • Boosting Stock Market Returns With A Simple Trick
      Systematic Trading Based on Statistics Trading methods based on statistics represent an unusual approach for many investors. Evaluation of a security's fundamental merits is not of concern, even though it can of course be done additionally. Rather, the only important criterion consists of typical price patterns determined by statistical examination of past trends.   Fundamental considerations such as the valuation of stocks are not really relevant to the statistics-based trading...
  • Searching for Truth
      Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth?   Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
  • March to Default
      Style Over Substance “May you live in interesting times,” says the ancient Chinese curse.  No doubt about it, we live in interesting times.  Hardly a day goes by that we’re not aghast and astounded by a series of grotesque caricatures of the world as at devolves towards vulgarity. Just this week, for instance, U.S. Representative Maxine Waters tweeted, “Get ready for impeachment.”   Well, Maxine Waters is obviously right – impeaching the president is an urgent...
  • Why the 21st Century Sucks - Turtles All the Way Down
      A Truly Sucky Century BALTIMORE – What an awful century! Worst we’ve ever seen. Household incomes are down. Employment is down, with 7 million people in the U.S. of working age without jobs. Productivity growth is down. GDP growth is down – to only about 0.5% per capita last year. Even life expectancies are down. Drug overdoses are up. Suicides are up. One out of every eight children lives in a family getting food stamps. One of out every eight adults takes psychoactive drugs...
  • Gold and the Fed's Looming Rate Hike in March
      Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
  • The Unstable Empire – A Campfire Tale
      Campfire Tale   Caesar: The Ides of March are come. Soothsayer: Ay, Caesar, but not gone. — Julius Caesar, Shakespeare   GRANADA, NICARAGUA – Today, we stop the horses and circle the wagons. For 19 years, we have been rolling along, exploring, discovering. We began with the assumption that we didn’t “know” anything - so we kept our eyes open. Now we know even less.   Famous people who knew nothing and were not shy to admit it: Sergeant Schultz...
  • Off the Beaten Path in Mesoamerica
      Greeted by Rooster There’s an endearing quality to a steadfast rooster call at the crack of dawn when overheard from a warm country farmhouse.  There’s a reassuring charm that comes with the committed gallinaceous greeting of daybreak that’s particularly suited to a rural ambiance.  The allure of a morning cock-a-doodle-doo somehow falls flat in all other settings.   Good morning everyone! Before meteorological forecasts were available on TV and smart phones, people...
  • Why Silver Went Down – Precious Metals Supply and Demand
      Rumor-Mongering vs. Data The question on the lips of everyone who plans to exchange his metal for dollars—widely thought to be money—is why did silver go down? The price of silver in dollar terms dropped from about 18 bucks to about 17, or about 5 percent.   Reportedly silver was already assassinated in the late 19th century... so last week they must have assassinated its corpse. [PT] Illustration taken from 'Coin's Financial School'   The facile answer is...

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com