The “Smart Money” is Going in For the Kill

What makes the “Smart Money” so smart is not their ability to be on the right side of the market when it matters, but how they do it without anyone taking notice until it is too late. While retail investors are hyper-focused on stocks, which are roughly at the same price level they were eighteen months ago despite $1.5 trillion in corporate share buybacks, the U.S. Treasury bond market has been quietly rallying. Few, if any, financial news outlets have alerted investors to start buying bonds, rather they keep telling investors to buy stocks. What investors are about to witness is a major reversal of fortunes.

To keep investors distracted, the financial media has been focusing on the outcome of this week’s Federal Open Market Committee meeting where investors are hoping the Fed will cut rates and the upcoming G-20 summit in Osaka Japan where a meeting between President’s Trump and Xi could signal the end of the trade war. The financial media has been pumping stocks by stating that if both, or either happen, stock prices are headed significantly higher.

The reason the financial markets are calling for a rate cut is not due to the economy undershooting the Fed’s inflation target, even though the Fed has marginally reached its 2% inflation target once during the past ten years, it is due to the lack of liquidity in the financial markets. When liquidity, or excess money sloshing around the financial system, is low, stock prices fall. To attract money into the financial markets, the financial media is telling investors that an interest rate cut is bullish for stocks, even though it is not.

In October 2007, just months before the Great Financial Crisis swept investors legs out from under them, the Fed cut the Federal Funds rate by a quarter percent. Stocks had a strong negative reaction to this move, but most investors have long since forgotten that a reduction in the Federal Funds rate is not a sign of confidence, but a signal from the Fed that monetary policy is too tight.

Anyone who truly understands monetary policy knows the Fed overtightened the moment they raised the Federal Funds rate by a quarter percent up from zero percent. What investors do not understand, and likely will never understand, is the monetary lags. A monetary lag is the amount of time it takes an economy to feel the full effects of a change in monetary policy. The greater the debt of a nation, the longer the monetary lags. The best estimates for the lags of the U.S. economy are eighteen months or longer.

The “Smart Money” understands the monetary lags and has a relatively good idea about how long they are. Even if the Federal Reserve were to drop the Federal Funds rate to zero at this week’s FOMC meeting, it will not affect the economy for at least eighteen months. Yet, the financial media is telling investors to buy stocks should the Fed cut interest rates, when the economy has yet to feel the brunt of the Fed’s tightening cycle. This is the same reason investors were steamrolled in 2008 after buying into stocks following the Fed’s October 2007 rate cut.

Presuming the eighteen-month lag is correct, and it may be slightly longer, the economy is starting to feel the effects from the Fed beginning to unwind their balance sheet back in late 2017. Since the Fed’s balance sheet was used to inflate asset prices, a reduction in the balance sheet should deflate asset prices. The “Smart Money” completely understands the effects monetary policy has on asset prices, including stock prices, which is why the financial media is encouraging investors to buy stocks, so the “Smart Money” can sell stocks.

As far as the trade war goes and the upcoming G-20 meeting, a resolution to the trade war would be economically positive, but it would not have an immediate effect on the economy. Even today, the tariffs are just starting to impact consumer prices, so most consumers have yet to feel the full effect of the tariffs. Just like with the Fed, there are lags associated with tariffs.

Even if the trade war is resolved by the end of the month, which is highly unlikely, it will take months or perhaps even a year or more before the damaging effects of the tariffs have passed through the U.S. economy. Just like with the monetary lags, the financial media and investors both large and small, are underestimating the lags. Even though the Fed is stopping their balance sheet unwinding program at the end of September and has stopped raising the Federal Funds rate, the tariffs will likely weigh on the economy for the next couple years.

Since the financial media, most financial advisors, many hedge-fund managers, pension-fund managers, and retail investors have no clue how the monetary lags work, let alone how long they are. Understanding the monetary lags creates a tremendous opportunity for the “Smart Money” to generate a sizeable return. After all, the “Smart Money” preys upon the ignorance of most investors who right now believe corporate share buybacks will continue to propel stock prices higher.

Even corporate share buybacks eventually come to an end. The only value corporate share buybacks have offered over the past year-and-a-half is keeping the stock prices elevated while other economic indicators, interest rates, and commodity prices have fallen. Every upcoming quarterly earnings season is another chance that corporate earnings and profits will disappoint. With reports of inventories backing up in warehouses and at shipping ports, this next quarter’s earnings season may finally catch investors off guard.

Even if corporate earnings season does not disappoint, the corporate share buyback blackout will start to kick in at the end of the month. Early predictions from investment banks are showing a thirty-five percent reduction on buyback flows. With investors begging the Fed for a rate cut to bring liquidity back to the markets, the “Smart Money” is about to feast on a stock market full of overly bullish investors who have been convinced to forgo any form of protection against falling stock prices.

The “Smart Money” has been buying volatility, which is a leveraged investment on falling stock prices. Volatility rises when the yield curve, or the spread between short- and long-term interest rates fall. When long-term interest rates are falling faster than short-term interest rates, volatility tends to rise.

One of the most popular trades over the past ten years has been to short volatility, regardless of what the yield curve is doing. Since most investors, professional or otherwise, are short volatility, volatility has not kept up with the yield curve. When volatility does catch up to the yield curve, stock prices will crash.

The “Smart Money” plans to use its profits from buying volatility to buy stocks. Rather than short stocks, the “Smart Money” has bought volatility so they can buy even more stocks than they might normally buy had they been short stocks. It is worth noting that buying or selling volatility should only be done by professional investors who have an extremely high pain tolerance.

The spark to drive stock prices lower is going to come from the U.S. Treasury bond market. By design of our monetary system, stock prices and interest rates rise and fall together. Right now, there is one of the largest, if not the largest, divergence between stock prices and U.S. Treasury bond yields. Only one of the two can be right.

Stock investors are hoping that bond investors quickly come to their senses and sell their bonds to buy stocks. However, the largest commercial banks and foreign central banks are buying large quantities of long-term U.S. Treasury bonds. When banks, who are part of the “Smart Money,” buy bonds, it is a sign that the economy is slowing. Banks prefer to lend money, which is more profitable than buying bonds, but to maintain their solvency during a recession, banks need high-quality assets such as U.S. Treasury bonds.

The gap between stock prices and Treasury yields needs to close, with either stock prices falling or Treasury yields rising. The reason the “Smart Money” has been buying bonds for the past few years is that when the recession hits, investors are going to sell their stocks to buy bonds.

Since the “Smart Money” owns most of the available supply of bonds, they will happily mark the value of the bonds up as investors will be desperate to get out of stocks and into the safety offered by U.S. Treasury bonds. As Treasury yields collapse to zero percent during the next recession, the “Smart Money” will sell their bonds and use the proceeds, along with their volatility profits, to buy stocks.

When Treasury yields break through previously established levels where buyers have shorted or sold Treasury bonds, yields tend to fall on average about one-and-a-half percent. While a one-and-a-half percent move down in yields may not sound like much, for longer-term U.S. Treasury bonds, this can lead to a double-digit price return.

The “Smart Money” is also short crude oil and oil stocks, as the executives of the major oil companies are included with the “Smart Money.” The reason they are short crude oil, is those executives know well that crude oil prices fall during recessions as demand falls. The “Smart Money” uses its profits from shorting crude oil to buy crude oil when it is cheap.

With crude oil inventories near their multi-year highs, weak global demand for oil will send crude prices lower. When demand falls, the news will hit about a huge glut of crude oil in the markets, which will lead to production cuts and layoffs. This news will send investors fleeing as crude oil prices tank. The negative news on crude oil will persist until the “Smart Money” has bought up all the inventory, just before prices begin to rise.

With the second-quarter corporate share buyback blackout set to begin next week and second-quarter earnings soon to follow, the “Smart Money” seems well positioned to take advantage of any negative news that may cause stock prices to fall. Even if the “Smart Money” must wait a little longer, U.S. Treasury bond yields peak, on average, seven months prior to the stock prices peaking. Ten-year Treasury yields peaked in early November 2018, which is just over seven-and-a-half months ago.

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