Weekly Economic Update 05-12-2017

In Fed We Trust
A year ago, the mere mention of a rate hike would send the equity markets into turmoil. Today the Fed sends out their members on a weekly basis to talk about hiking rates and winding down the balance sheet, and the market doesn’t even flinch. I find it interesting that investors no longer worried about this, so I had to ask myself why this could be.

The post-election narrative has been one of asset inflation (visible through high stock prices) and the belief that our new President will implement pro-business policies. This belief quickly filtered into the survey data that now shows extreme optimism from consumers and businesses. It does make sense – these people who were once bearish on the economy have turned bullish. And to support that view they find themselves supporting the Fed’s view of rising rates. If the economy is going to grow then it can handle higher rates. Or can it?

Investor memory is short. Surprisingly short. In the past 13 rate hike cycles, ten of them have led to recessions and three of them have led to soft landings. Not one of them led to economic prosperity. Those are bad odds!!

When the Fed tells the public they are probably going to raise rates and there’s no reaction from the stock market, what investors are telling the Fed is they have a clear signal to proceed. While higher rates may sound good now, history tells us that this story won’t have a happy ending. I have a hunch that the public’s misplaced faith in the Fed’s abilities to manage the economy will come back to haunt them in the not too distant future.

Fun Facts
For 55 continuous months household debt has grown faster than household wages.
Despite all the hype of corporate profits this past quarter, corporate profits peaked in Q1 2012.

Global debt to GDP ratio is at 320% with the average debt service at 2%. It will take a growth rate of 6.4% just to cover the interest on the debt.

Chinese Yields Invert
In what is a major recession signal, or at least when it happens in the US it is Chinese interest rates have inverted. Yields on five-year Chinese government bonds are now higher than their 10-year counterpart. Normally investors receive a premium in yield for taking more risk. This shows there are significant structural imbalances there. If the Chinese economy starts to recess that means commodity prices are likely to head down because they are a large consumer of commodities.

Consumer Price Index Dips
The Consumer Price Index (CPI) dipped this past month which came as a surprise to most analysts. We already know that the CPI follows the year-over-year change in oil prices, so this is not a surprise to us. When the CPI goes down that means inflation is waning and if the trend continues we are back in a deflationary cycle. When the economy deflates, interest rates fall and US Treasuries and physical metals outperform.

If oil prices continue to fall then that is bad news for the high yield bonds which follow oil prices. Oil companies represent about a third of all high yield bonds issued while retailers, which are projected to close more stores this year than at the bottom of the 2009 recession, also represent a third of all high yield bonds issued. US equities are highly correlated to high yields bonds, meaning if high yield bonds start to drop than stocks won’t be far behind.

Shorting Volatility May Cause a Violent Feedback Loop
You may have heard me say that this is one of the most dangerous stock markets in history. I’m not saying that because stock prices are high or because valuations are rich or because I believe a recession is coming, but those would be all valid reasons. I’ve said this because of the sheer number of investors who are shorting volatility.
Last week in the video portion I touched on how traders and investors were shorting volatility when most of them have no idea how it works or what the actual risks are. Volatility is the grease that makes the stock market work. When volatility is low, an investor can assume the bid / ask spread (or the difference in price a buyer and seller pay to exchange shares) is low because there is sufficient liquidity on both sides of the trade. In periods of high volatility, the spread can be high as there are usually more sellers than buyers. A flood of sellers can lead to a rapid decline in stock prices as the market seeks to find a price where buyers are willing to step in.

Stock prices can be held at artificially high levels, even when there is a lack of volume (or trading activity) if volatility is suppressed. Since the election, the popular trade has been to short volatility. Keep in mind that using short or long volatility positions is a tool of large portfolio managers and institutional managers to hedge risk, or it used to be. Today it’s what all the “cool kids” are doing.

Most investors don’t know how to use options to do this, so back in 2010 an ETF was created to allow investors the opportunity to easily short volatility and in 2016 it started to gain popularity. But as I am about to share with you, it is a very risky trade unless you know what you are doing. Today we have a case where stock prices are very high and volatility is very low. When volatility starts to rise, that’s when things could get ugly fast.

This risk is that all those who are short volatility will face massive losses should volatility spike or if the stock market should start to sell off. It’s like balancing a teeter-totter. Except, in this case, the higher stocks go or the lower volatility goes, the harder it becomes to maintain a balance between the two. The only solution is to push stock prices higher and volatility lower, and hope the trend never changes.
If there’s an event that causes volatility to spike it would immediate force all of those who are “short” volatility sell their short positions or to buy volatility to hedge against their losses. As they become buyers of volatility, volatility will rise even faster. As volatility rises stock prices usually start to fall. If these same investors are long stocks, which they likely are, those positions will start falling as well.

On a side note, many investors are leveraged, meaning they borrowed money to buy stocks. To protect their gains and avoid a margin call they will be forced to sell. As they and other investors rush to sell it will cause volatility to spike even more.
And now you have a self-feeding feedback loop where volatility is spiking which leads to an illiquid stock market (meaning prices start rapidly falling). As prices fall investors are willing to sell, even at a lower price, which then pushes volatility even higher. This will cycle until stock prices fall to a point where buyers are willing to step in.

You may be thinking this is an unlikely scenario. It’s happened several times before. As I have mentioned in prior updates, on one fabled day in 1987 the stock market opened down 20% from the night before. Liquidity dried up and there were no buyers, so prices plunged. As prices dropped investors panicked and sold, causing further illiquidity in the markets. That day turned out to be a great buying opportunity for those with cash on hand.

What I am seeing today is a similar build up that will have a violent unwinding when that time comes. Remember, suppressed volatility leads to hyper-volatility. When that day comes, I assure you that you’ll know volatility is back.

Client Update:
I am excited to announce we have added Michael Oliver of Momentum Structural Analysis to our research advisory team. You may have heard me mention momentum trends in the past and there’s only one person that looks at momentum trends based on a security’s change in price relative to an average. While this may not sound special, it’s extremely unique from a trend analysis perspective. Most “momentum” analysts look at price change, but price change moves after momentum has already changed.

Michael’s research identifies when momentum has shifted, which often occurs closer to the peaks and valleys then traditional analysis that waits until prices have moved well off their tops or bottoms before signaling that momentum has shifted.
The other big reason I’ve had an interest in his work is that he is one of the foremost experts on physical metals (gold) and commodity producers (miners). He publishes his research nearly six days a week and seeks in any given year to advise his clients (us) of major trend changes – either bullish or bearish. Once momentum shifts based on his research, prices usually follow in a big way depending on his bullish or bearish call. I have gone back and reviewed some of his past research where he made calls on momentum shifts and his research is impressively accurate.

As you know I have a strong interest in physical metals and commodity producers due to the fact we are in the very late stages of this economic cycle, which usually leads to a recession. Given these ridiculous levels of global debt, there is little doubt in my mind that there will be a financial catastrophe somewhere in this world. When that happens I believe it will shock the global equity markets and investors will run to hard assets to protect themselves. I intent is to catch the bottom of this wave or as close to it as possible. If my view is correct, and Michael’s research is accurate, then there is substantial upside potential in these positions.