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 Because the biggest banks have withdrawn from proprietary trading and market making in these instruments due to various post-crisis regulations that have been imposed (such as the Dodd-Frank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).
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:
The 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.
The 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:
ECRI'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.
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.
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