Weekly Economic Update 12-01-2017

A Market Built on Nitroglycerin

In 1847, nitroglycerin, a heavy and colorless, oily liquid, was invented. Nitroglycerin was primarily used as an explosive, but for more than one-hundred years it has also been used to treat heart conditions. It is so unstable that the original German factory where it was produced exploded several times, killing many of the workers. To say nitroglycerin is dangerous is an understatement. Nobody in their right mind would store such a substance, but since 2008, Wall Street has sold tons of nitroglycerin-infused investments to the public and nobody seems too concerned about it.

If anyone asked you to store a barrel or two of nitroglycerin in your home, you’d be crazy to say yes, even if they offered to pay you to store it. Yet institutional money managers, public pensions, traders and the retail investor have all invited nitroglycerin into their portfolios because Wall Street has made the ownership of nitroglycerin profitable. Like anything Wall Street sells, it’s only profitable until the moment it isn’t. Trusting Wall Street is a lesson investors should have learned after the housing meltdown of 2008, but most haven’t.

If you ask the average person why the stock market has gone up since President Trump was elected, you’ll hear things such as, “the Trump bump” or “earnings expansion” or “profits” or any number of things. But they are all wrong. As I have written about since the election, the rise in stock prices has nothing to do with any of those things. If they did, earnings growth would be higher than it was in 2014 (but it’s not) and profits would be up (but they have fallen for the past two quarters). What is it that’s driving this market if it’s not profits, fundamentals or valuations? It’s short volatility. Short volatility is something very few people understand, including most money managers.

Following the Great Financial Crisis of 2008-09 the Federal Reserve (or Fed) lowered the Federal Funds Rate (the bank overnight lending rate) to zero in hopes to simulate borrowing. Since borrowing increases the money supply, which had fallen since the GFC, this was an important part of the Fed’s plan to reflate the economy. Unfortunately, pensions, insurance companies, and retirees can’t get by on zero interest rates, so Wall Street introduced the public to an investment idea that was only used previously by highly trained professional money managers – short volatility.

To understand what short volatility is, it’s important to first understand what volatility is. Volatility, which is measured by the VIX index (symbol: VIX), shows the 30-day expected volatility of the stock market. Volatility attempts to predict the future price movement of the stock market. When volatility is high, stock prices are expected to have a high degree of fluctuation and when volatility is low, stock prices are expected to have a low degree of fluctuation. While it is inferred that periods of high volatility come with stock market crashes, that isn’t always the case. There have been periods of elevated volatility where stock prices have risen.

During periods of low volatility, like the current period which this is the second lowest of volatility on record, stock prices are expected to rise, but very slowly. Over the past year stock prices have slowly risen as volatility has fallen.

The average investor should interpret a period of low volatility as an opportunity to invest in risk assets (i.e. stocks) with minimal risk. And since the election, that is exactly what we’ve seen in the markets as investors sold defensive assets, such as bonds and gold, for risk assets. Before I get into the more technical details, there’s something else I need to explain first.

When someone buys a stock on the open market they purchase those shares from a willing seller. When there are more buyers than sellers, stock prices rise and when there are more sellers than buyers, stock prices fall. The key to this relationship is that there is a seller for every buyer and vice-versa. With the invention of Exchange Traded Funds (ETFs), Wall Street has come up with a way to sell shares of an index even when there aren’t any actual shares backing the transaction. The way this is done is rather ingenious.

Let’s say someone wants to buy a share of an S&P 500 index ETF (there are several that track the S&P 500). The securities dealer sells the buyer one share of the index, then enters an opposing short position on that ETF. To balance their short position, the dealer then takes out a long-futures contract on the S&P 500. The net result of the transaction is the S&P 500 goes up. What this means is that an unlimited number of shares can be created against an index even when there aren’t enough physical shares to back the transaction.

Following the Great Financial Crisis, the Fed lowered interest rates and began purchasing Treasury bonds and mortgaged-backed securities on the open market. By putting cash back into the hands of investors who normally buy bonds, it forced them to invest that cash into equities and corporate bonds, which helped boost the stock market. Corporations also jumped on the bandwagon and began buying their stock back by borrowing money to fund their share-repurchase programs. (On a side note, these corporate-share-buyback schemes are nothing more than stealing from investors, but nobody seems to mind at the moment because it causes stock prices to rise.) Between the Fed and corporate-share-buyback programs, the stock market rose, and volatility fell. Now that you understand that setup, let’s explore the huge pile of nitroglycerin that Wall Street has been peddling to investors.

Pension funds, insurance companies, retirees and investors rely on the fixed income market, or bond market, to earn a consistent yield on their investments. With the Fed reducing short term yields to zero and buying up over $4 trillion in bonds, it left these investors and institutions with few options. This offers some explanation of why the corporate bond market has taken off since the Great Financial Crisis, because yield-starved investors are willing to exchange their money for any opportunity to earn a regular dividend yield. But Wall Street came up with a better idea for those investors – shorting volatility.

There are two ways to short volatility, either directly or indirectly. An indirect short of volatility is simply buying stocks. The more money that flows into stocks, the lower volatility falls. The direct way to short volatility is through the futures market, the options market or through a short volatility Exchange Traded Fund (ETF). After the GFC, Wall Street created several short volatility ETFs which, after the Presidential election, became very popular. Investors who are shorting volatility are betting that stock prices are going to go up and as long as stock prices rise, volatility will fall. Today there is approximately $2 trillion of investors’ money that is directly shorting volatility, which has made this the second lowest point of volatility in the history of the stock market.

As you can see the reason the market has risen to such high levels is a function of everyone buying stocks due to the Fed and the massive short-volatility trade. This is why the stock market appears to be immune to any type of bad news—investors are suppressing the natural tendencies of the stock market! As long as stock investors refuse to sell and more people short volatility, the stock market can stay at these elevated levels for a long period of time. But should an event trigger a spike in volatility or a drop in stocks, it will trigger a chain reaction that will set off all this nitroglycerin that’s been innocently hiding in everyone’s portfolio.

The reason short volatility can blow up the stock market is simply due to how it was sold. Just like with stocks, there needs to be a buyer for every seller of volatility. But there was an overwhelmingly large number of people who wanted to short volatility that Wall Street simply ran out of people who wanted to buy volatility. So, Wall Street came up with a way to sell an infinite number of short-volatility shares, just like they came up with a way to sell an infinite number of ETF shares. When someone buys a share of short volatility, the dealer buys one share of volatility to balance the trade and then they buy a long futures contract on the S&P 500. The net result is that volatility falls and the stock market rises. This might seem innocent, but the un-wind is where it gets interesting.

Some experts believe that a mere 3% drop in the S&P 500 will begin a feedback loop where stocks will fall and volatility will rise, but a 8-12% drop in the stock market could cause the short volatility shares to fall below zero. Yes, short volatility is it’s one of the few investments you can buy where you can end up owing money if it goes to zero. What is more interesting is that a big enough drop in the stock market could cause the short-volatility shares to go to zero in one day. In other words, the securities’ dealers would then be forced to sell all of the long S&P 500 futures contracts that are backing the short volatility positions at one time. If that happened, it would cause the stock market to violently plunge which would then trigger even more volatility. The net effect is that it could cause the stock market to plunge overnight, but only by 20%.

It’s at the 20% mark where the circuit breakers trip and the exchanges shut down for the day. Even a short cooling-off period won’t change what will happen the following day, as dealers continue to dump long S&P 500 futures contracts before the next couple layers of nitroglycerin start to blow. And this is where you run into the problem of having too many sellers and not enough buyers. Those sitting on the contracts that have no buyers will be forced to ride them out while stock prices plunge day after day. The Fed, to which everyone is hoping will buy up all these stocks, will be too busy dealing with the banks who will once again find themselves on the brink of failure.

This is when the phrase “cash is king” will become relevant, because there will be no way to stop the selling once it begins. Much of the problem will be due to the snowball effect of selling that will start will the short volatility unwind, which will be followed by selling from the approximately $2 trillion in risk parity investments and then the selling triggered from the $250+ billion in margin accounts. The public won’t stand a chance against this tidal wave of selling. Those looking for ways to protect themselves will find there are few options.

One could hedge by buying volatility, but there is the potential that if the short-volatility side is completely wiped out that those holding long-volatility positions might not be able to cash in on their gains. But buying volatility isn’t without its risks, as it has lost -60% per year since inception. One might seek to short the market, but there have been periods where short selling is suspended, and I have a hunch it will be suspended again. Even if it’s not, timing a trade on the short side isn’t easy, because it, too, has been a losing trade over the past eight years. The only hedge that has stood the test of time is U.S. Treasuries, but investors have largely shunned Treasuries due to the expectation that the economy is about to boom. Ultimately cash will once again be king.

The reason why I say this is the most dangerous market in history isn’t because stock prices have detached themselves from historical valuations or because the central bankers have created the world’s biggest asset bubble. It’s because lurking right underneath this market is several layers of nitroglycerin that are set to ignite in a cascading fashion during the next market correction. Those thinking they can get out fast enough will be in for a shock. When the market bottoms, wherever that may be, there will be a tremendous opportunity to buy quality stocks at distressed pricing, which is why Warren Buffet is holding so much of his investors’ money in cash. Those hoping that this time will be different should be aware that it’s never different.

Video Topic of the Week – More on the Money Supply

The money supply continues to fall as it reaches critical levels. The evidence is in the foreign equity markets and it appears that it’s starting to show up in the U.S. markets.

Chart of the Week – Margin Debt

If you think the short volatility structure is dangerous, then wait until you see how much margin debt or leverage is holding up this market. Not to worry, the Fed doesn’t think this is a problem.

Portfolio Shield™ Update

The algorithm continues to be in a risk on mode, which so far has been accurate to the movements of the market. I do remain concerned that if there is a sudden turn in the market that the algorithm won’t be able to adjust quick enough due to the monthly rebalance. This could be fixed by changing the frequency of the rebalance, but for now, the strategy continues to function within expected parameters.

Work progresses on the momentum strategy. In the charts this week I’ll show you what a momentum chart looks like against a price chart, which will allow you to see how momentum can anticipate the direction of price. All that is left is for me to figure out the optimal way for buys and sells to track momentum. That has proved more complex then I envisioned, but once I can crack the code, it should reveal a strategy that can adjust from being long to short depending on momentum. If I am able to figure that out, this could be the most exciting strategy to ever be developed, which is why I continue to press on!

Weekly Broad Market / Economy Commentary

The retail apocalypse continues as three times the number of stores are closing this year then closed in 2016. Last year 2,056 stores closed and this year 6,700 stores closed. There have been stores opened this year, but they fall well short of those that closed. Some experts are suggesting that more than 9,000 stores may close next year, which suggests that this economic recovery isn’t nearly as strong as the stock market might indicate.

The Shanghai Composite is trading at its three-month low with the Japanese stock market struggling to gain footing. I think this is a good example of the falling money supply, because as the money supply falls, it affects the assets of those who hold dollars. And since the U.S. dollar is the world’s reserve currency, we should start seeing the effects of a declining money supply.

My assumption is that our Asian trading partners hold more dollars than anyone else. It does make sense that the Shanghai Composite is falling because China is tightening conditions, but the Japanese Nikkei 225 probably shouldn’t be struggling, since Bank of Japan is keeping financial conditions very loose. Then on Wednesday, the tech heave Nasdaq dropped nearly 2%, which was unexpected. This is possibly due to the falling money supply.

Also on Wednesday, South Korea’s industrial production crashed -5.9% on a year-over-year basis making it the biggest drop in industrial production since February 2013. Why? There was a huge -17.5% fall in auto production, which could be due to the slowing US demand for autos, but one cannot dismiss the falling money supply. The rising US money supply affected asset prices throughout the world, so a falling money supply should shrink global asset prices.

In the meantime, Europe continues to provide liquidity into the U.S. stock market, which continues to remind me of what happened in 1929. The US hiked rates and tightened financial conditions going into the Great Depression out of hopes that lower European interest rates would attract investors. It did the opposite. Money continued to flow into the US stock market until it crashed.

Over the past two weeks, the US stock market has experienced several strong one-day moves in price, which oddly enough has to do with someone(s) targeting short sellers. While that information shouldn’t be available, we live in an era that if you have the money, someone will sell you the information, including on where all the short sellers are at. And with military-like precision, someone(s) targeted these short sellers and flushed them out. When that happens, it leads to a quick jump in stock prices. Now that the stock market is at all-time price highs, investors are nearly 100% allocated to stocks and the short sellers have been flushed out, it makes me wonder what is the next move? Or was the plan to get everyone into stocks, then sell?

All I can tell you is that you can’t fight liquidity. And with the money supply contracting, at some point, that will negatively affect domestic asset prices, including stock prices.