The Titanic Stock Market
When the “unsinkable Titanic” set sail on her maiden voyage on April 10th, 1912, nobody expected it to sink five days later, just three hours after striking an iceberg. Today we have a seemingly unsinkable stock market that set sail, so to speak, back in March 2009 and nobody realizes just how fast it can sink during the next recession.
Before I share with you the mechanisms that will sink this market faster than any Bear market in history, it’s important to understand how the recent Bull market was built.
The stock market, by design, if for the wealthy to take money from the masses. The rich always buy at market bottoms, then they sell their stocks to the masses at the top, right before stock prices collapse. Market cycles run about every eight to ten years and the wealthy are extremely good at timing stock purchases and sales.
Ninety percent of all stocks are owned by a mere ten percent of the population. Of that ten percent, most of it is own by the richest one percent. When the one-percenters start buying stocks at the bottom, they immediately begin plotting their exit strategy some eight-to-ten years out.
The rich rely on the fear-of-missing-out syndrome to get people sucked into the stock market at the peak. It works every time because after a market has gone up 300-400%, as it typically does each cycle, most of the masses are eager to dump their hard-earned money into stocks thinking it will go higher.
Since the richest control such a large amount of stocks, they needed to create investment vehicles that would automatically force people into stocks, because they didn’t want to rely solely on market hype.
Wall Street investment banks, which are run by some of the wealthiest people in the country, created investment vehicles and computerized trading algorithms to force investors into stocks. They began deploying some of those investment vehicles prior to the Great Financial Crisis, but it wasn’t until the crisis was over that the masses would start investing in them.
One of the first positions eliminated were the proprietary trading desks. Prop desks, as they are referred to by industry insiders, were groups of traders inside each investment bank who traded with the investment banks’ money. These groups had access to high levels of information and could use “house” money to make a market in a security. As market makers, they could take advantage of opportunities when markets became illiquid and the traders could earn a cut of their profits.
Prop desks have been replaced by High-Frequency Traders (HFTs), which are computers who front-run purchases and sales of securities. By front-running trades, the HFTs provide liquidity to the market, but they aren’t required to do so. When HFTs stop providing liquidity, a stock, or indices, will experience a sudden and rapid drop in price. HFTs front-run purchases and sales of stocks, which is why half of all daily trading volume on the exchanges is attributed to HFTs.
Wall Street also created fully autonomous computer trading programs that use machine learning to trade in the market. The owners of these machines are very tight-lipped, but what we do know they account for twenty percent of all daily trading volume. What we do know about AI trading programs is they are programmed to buy stocks, short volatility, and short bonds, which, in my opinion, is the correct way to trade when the Fed is easing.
The last major innovation by Wall Street was risk-parity. Risk-parity uses the VIX volatility index to determine what percentage of stocks and bonds a portfolio should own. When volatility is low, the stock weighting can be 100% and when volatility is high, the bond weighting can be 100%.
Risk-parity programs can adjust on a daily, weekly or monthly basis depending on how they were designed. Today there is approximately $3 trillion of investor money in various forms of risk-parity products.
As you can see, these products and computer programs were designed with one objective in mind – get as much money into stocks as possible. And it worked. Today the average investor has about ninety percent of their investable assets in stocks and a mere ten percent in bonds. With the stock market near all-time highs and volatility near all-time lows, more money is tied up in stocks than ever before.
These investment products and computer programs are giving the wealthy a way to sell their stocks to the public without the public even realizing it. The public, who believes they can prop up the stock market indefinitely, has placed their faith in the design of these products, which have never been tested during a Bear market, nor in the Federal Reserve.
At the market bottom in 2009, when the average American couldn’t access the credit markets even if they wanted to, the wealthiest borrowed money at super low interest-rates to buy stocks. Today, the total amount of money borrowed to buy stocks is two-and-a-half times the record set at the peak of the dot-com bubble.
We know this Bull market was built on a record amount of debt, investment products designed to push money into stocks, and computer algorithms coded with a bias towards buying stocks. Before I reveal how the big unwind will go, which will cause this market to sink like the Titanic, I need to share with you how market participants are currently positioned.
Stock ownership is at record high levels, volatility is near all-time lows, and short-Treasury positions are at a record low as of this week. When the Fed is easing, this was the best way to profit from the Fed’s Quantitative Easing programs. Quantitative Tightening, which the Fed is doing right now, should have the opposite effect. Stocks should fall, and volatility and Treasury bonds should rise.
The unwinding may be triggered by the Fed’s tightening or an external shock, but when it goes, it will sink the market.
Treasury bonds should rise in price despite the largest short-position in history. As Treasury bond prices rise, speculators will be forced to exit their short positions or buy Treasury bonds to mitigate losses from their short positions. To buy Treasuries, speculators will likely need to sell their stocks, since cash allocations are extremely low. As they sell stocks, volatility will rise, which is also near its record short-position set back in November of last year.
As volatility rises, speculators will need to buy volatility or exit their short volatility positions. This will cause stocks to fall and Treasury bond prices to rise. Speculators will be forced to sell stocks to buy bonds and to buy volatility, which will start a feedback loop.
As volatility rises, the risk-parity portfolios will start selling stocks to buy bonds, which will push volatility higher and stock prices lower. It will also drive Treasury bond prices higher, which will force speculators to buy more Treasuries, to hedge the losses from their short positions.
As stocks fall, those who bought on margin will be forced to bring more cash into their brokerage accounts or sell some of their positions to meet the margin requirements. The average investor has ninety percent of their money in stocks and ten percent in bonds, so investors will be forced to sell their stocks to meet the margin requirements.
As investors are forced to sell due to margin calls, volatility will rise and risk-parity portfolios will accelerate their move out of stocks and into bonds. This will further drive Treasury bond prices up and stock prices down, which will trigger a massive unstoppable feedback loop.
High-Frequency Traders may continue to provide liquidity to the market, but in the past when heavy selling has hit the market, they disappear. Without anyone providing liquidity, stock prices quickly fall, which will accelerate the speed of the feedback loop.
To make matters worse, the autonomous artificial intelligence programs will begin dumping their positions as the market falls. Since these programs trade in milliseconds, they can unload a sizeable amount in the blink of an eye. As they dump their stock holdings, this will further exasperate the feedback loop.
The last factor is the Boomers who have all their wealth tied up in stocks and can’t afford to lose half or more of their money for the third time in twenty years. With electronic access to their brokerage and qualified plan accounts, they will quickly reach for the sell button. By this point, the feedback loop will be completely out of control.
How fast will the market sink once it starts taking on water, so to speak? The unsinkable Titanic went down in three hours. This market could easily sink a in a week or two, or maybe in a few days.
Can the Fed stop this? They’ve never been able to stop a market decline in the past, so I doubt they will be able to stop this one. Besides, computers are faster than the Fed.
The exchanges do have safety nets to halt trading, but they’ve never been tested and even the programmers who wrote them aren’t certain the safety nets will work. Plus, many of these trades will happen after market close, where no safety nets exist.
Now you know why I’ve been so concerned and outspoken about the risks of this market. This is also the reason I have taken a defensive allocation for my clients’ accounts. When this market collapses, it will create the greatest buying opportunity for stocks in the history of the stock market. When this Titanic stock market sinks, I will be there with you to buy at the bottom.
Q&A with Steve – Your Questions Answered
- Thoughts from the Weekend
Turkey looks to be the epicenter of the next Emerging Markets crisis, but few understand why it’s such a big deal. Turkey is the 17th largest economy in the world and is geographically well located for international trade. The problem with Turkey is it is running deficits and has a large number of external debts.
Turkey, like many other Emerging Markets countries, chooses to borrow money in dollars. Turkey has an estimated $180 billion in dollar-denominated debts, which may not sound like much, but as they are running deficits, it is a big deal.
For the Turks to borrow in dollars would be like you or me taking a loan out in Euros. The reason Turkey did this is that interest rates were being artificially suppressed by the Fed. Borrowing money in a foreign currency isn’t risk-free.
When the USD falls in value, the servicing costs of a dollar-denominated loan falls. When the USD rises, as it has been recently, the servicing costs of a dollar-denominated loan rises. Turkey’s costs to repay their dollar-denominated loans are rising at a time when the Federal Reserve is pulling dollars out of the global economy. There are fewer dollars chasing large dollar-denominated loans. Turkey wasn’t the only country to do this.
There’s a dollar shortage in the global economy which is making it difficult for Turkey and other countries with dollar-denominated debt, to the sum of several trillion dollars, to pay those loans back.
China’s largest oil refiner, as I mentioned last week, is going to cease purchasing US oil next month. China, who is sitting on a large number of USD reserves, has allowed its currency to devalue rather than spending its USD reserves to prop up the Yuan.
What I find interesting, is China is letting its currency devalue to offset some of the effects of the tariffs. But rather than burn its dollar reserves, it is seeking to trade with Iran and other countries in other currencies. By not trading in USD’s, the dollar shortage only gets worse.
Countries receive dollars by trading with the United States, and as the global economy cools down, tariffs slow global trade and the Fed destroys USDs, there are fewer dollars being created to pay these debts. The eventual fear is that Turkey and other countries with dollar-denominated debts will default.
The more I think about China’s largest refiner purchasing Iranian oil next month, the more I believe it is being done to preserve China’s dollar reserves and not to strike back at the Trump Administration. Regardless of their true intentions, as the Fed continues to tighten monetary policy and reduce the number of dollars in the global economy, there is likely to be severe repercussions for the banks and investors who lent all this dollar-denominated debt.
- What happened to the stock market on Monday?
News from Turkey has calmed down as the country is on a week-long holiday as the banks switch over to a new oil-backed cryptocurrency. We’ll find out soon enough if it works.
While the US equity market pushed higher on lower volatility, trading volume has collapsed again. Volume on the SPY, the largest S&P 500 ETF, came in below 40 million shares, which makes today one of the lowest days in terms of trading volume in the past twelve months.
The S&P 500 keeps running out of buyers at 2,86x, so we’ll see if the computer algorithms can find a way to push the market higher. I didn’t see the risk-parity portfolio adjust back to stocks after moving a small amount into bonds, but if they do tonight, that could be the boost the market needs to make a run at its all-time highs.
Most eyes were on the Treasury market today as experts weighed in over the weekend about how an epic short-squeeze is coming. Ten-year Treasury yields were down on the day and broke below the neckline of its head and shoulders reversal pattern. The long bond is not far behind. As Treasuries rise on a technical breakout, traders and others should start buying, which will put the squeeze on the short-sellers.
Physical gold tried to find buyers from a weak technical level, but there doesn’t appear to be much conviction. The large gold miners also tried to rally but didn’t find too many buyers either. Unless buyers show up soon, sellers will continue to push prices down until buyers show up. After spending some time reviewing the charts this weekend, I think buyers will show up when gold falls between $1,230-45/oz. We’ll see…
Foreign investors have been buying agricultural commodities while US investors continue to short them. If supply was outpacing demand, then the short-sellers would be justified in their short position. With record demand and global drought conditions, agricultural commodity prices won’t stay this low forever.
- What happened to the stock market on Tuesday?
The S&P 500 rang the bell and briefly set a new all-time high. The next question is: is this the end of the Bull market or will the markets vault higher from here? When Bull markets set a “double-top,” it frequently signals the end of a Bull market. We shall soon see.
Treasury yields started the day lower, but buyers stepped in, which indicates a short-squeeze is not far off. Lower Treasury yields are ahead.
Physical gold is in the search for buyers as it ran into headwinds at $1,200/oz. I still expect one leg lower for gold as buyers are rather quiet. The gold miners also tried to rally but couldn’t get far. I also expect another leg down before buyers arrive.
- What happened to the stock market on Wednesday?
Trading volumes were light as buyers remained quiet after the S&P 500 touched its all-time high. Trading volume on the largest S&P 500 ETF (symbol: SPY) came in around 42 million shares, which is low. Treasury yields closed lower on the day, which continues to put pressure on short-sellers.
Physical gold hit a high of $1,208/oz before closing at $1,202/oz. There is a supply zone between $1,197-1,206/oz where I expect the price to be rejected. Sellers have backed off to test buying pressure and so far, buying hasn’t been very strong. Trading volumes have risen the last five days along with the price of gold, but trading volumes have been light.
The large gold miners, symbol GDX, have also been falling with gold. They too rebounded over the past five days, but also on weak volume. This tells us that buyers aren’t rushing in at this price level. Plus, there is overhead resistance between $19-19.25, which GDX will have to push through or face another move down to a lower supply zone.
Given the lack of enthusiasm from buyers, I expect to see GDX fall to $16.50-17 where I will reassess our entry unless buyers show up in the meantime.
- What happened to the stock market on Thursday?
A little over a week ago the stock market celebrated an upcoming trade meeting between China and the United States. While the meetings haven’t concluded, the U.S. and China will implement an additional 25% tariff on $16 billion worth of goods at midnight eastern time. The US stock market continues to ignore any downside risks from tariffs.
New and existing home sales continue to fall on a month-over-month basis as buyers are getting priced out of the housing market due to higher interest rates and home prices. Sales of low-priced homes are falling fast, suggesting that first-time homebuyers are tapped out.
The Markit manufacturing survey came out today showing further deceleration in the manufacturing sector. New orders and employment slowed last month as manufacturers find it increasingly difficult to pass rising prices on to consumers. Survey data is considered “soft” data, but lately, the soft data has been overly optimistic compared to the hard data.
Both the stock market and bond market were flat for the day. As expected, sellers resumed selling gold which pushed the price of physical gold down to $1,191/oz. Gold prices should fall to retest its recent lows and if buyers don’t show up there, prices should fall to $1,130-40/oz. The large gold miners reversed as expected with a price target in the $16.50-17 range.
When the price of a security is falling, it will fall until buyers arrive. As gold and the miners are falling, the sellers will push prices down, then pause to check buying interest. At some point, the price will be low enough where buyers step in. This is what we are looking for. With gold prices falling back towards its 2015 lows, buyers will be eager to jump in hoping gold will reverse direction. Seasonality puts the bottom for gold somewhere around July and August, so the timing is looking favorable once buyers step in.
The trade talks with China went nowhere, so speculators were once again shorting agricultural commodities. I’m not sure why because last week China paid their own self-imposed 25% tariff to import a tanker of US soybeans. Nobody said speculators were right, they just have enough money to move markets where they want to.
- What happened to the stock market on Friday?
The China-US trade talks ended with no resolution. The Trump Administration pushed for China to back off on its subsidies while China offered to purchase more US commodities in hopes to get Trump to back off. With no further talks scheduled, President Trump is expected to announce a substantial increase in tariffs as early as next month.
Fed Chairman Jerome Powell spoke at the Fed’s annual Jackson Hole meeting this morning. I think many investors were hoping to hear Powell turn dovish, but he reaffirmed the Fed’s view that our economy is strong and further gradual rate hikes are needed. Expect the Fed to raise the Federal Funds rate next month.
Based on my assumptions which factor the Fed’s balance sheet unwind, the economy should start choking in October due to the Fed’s monetary tightening. Despite the Fed’s claim that the economy is doing well, Durable Goods orders fell -1.7% MoM against analyst expectations of a -1.0% drop. Durable Goods orders have been down the past three out of four months, which is hardly a sign of a booming economy.
The equity market ignored Chairman Powell’s remarks and the lack of any resolution from the latest trade talks with China. In early trading, all major indices are up with the S&P 500 attempting to break its all-time highs. Meanwhile, interest rates are falling, and Treasury bonds are rising. The bond market is signaling the Fed is about to overtighten until the economy recesses.
The S&P 500 reached for the sky today and set a new all-time high, as stock prices are clearly divergent from the recent economic data. Treasury yields were down today and are exerting pressure on the short-sellers who will either have to try to force yields back up or become buyers.
Physical gold rebounded as the Chinese Yuan was up – the two seem to be correlated right now. The move in physical gold isn’t significant enough to indicate a bottom is in. The gold miners also tried to rally, but sellers came in during late afternoon trading to push back against the Bulls.
Agricultural commodities continue to be bought by foreign investors as American investors continue to short them. With China paying its own tariffs to buy agricultural commodities from the US, shorting this sector is only helping the Chinese out. Momentum is starting to bottom, which would be nice as price generally follows momentum.