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Musings Report 2023-12 3-18-23 I Get Nervous When Everyone Suddenly Agrees With Me
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I Get Nervous When Everyone Suddenly Agrees With Me
In the two previous Musings Reports, I presented the bearish case for the stock market. The incipient banking crisis acted as a catalyst, and suddenly everyone else is bearish, too. As a contrarian, I get nervous when everyone suddenly agrees with me, for when the consensus is near-universal that X is going to happen, that means something not-X is going to happen.
The bearish case is straightforward: the Federal Reserve over-stimulated the economy after the Covid lockdown, sparking inflation. To tamp down inflation, the Fed has raised interest rates at the fastest pace ever. This increase in borrowing costs is filtering into the economy, triggering higher mortgage and auto loan rates, weakening demand. The inevitable result is recession, which reduces corporate profits, which causes the stock market to tumble.
While there was a flurry of "no recession" calls early in 2023, others have called this "the most anticipated recession in history," as the consensus sees recession as unavoidable. Many surefire signals such as inverted Treasury yields are sending the same message: recession is coming.
Now the higher interest rates have filtered into the banking sector, triggering a crisis as banks' holdings of long-term bonds have lost value, reducing their capital. At the same time, high short-term Treasury yields encouraged depositors to withdraw their cash from banks and buy high-yield short-term Treasuries, further reducing banks' deposits capital.
Fears of a 2008-type banking contagion are running high, a contagion that many fear could go global (Credit Suisse, etc.).
The list of bearish factors is dauntingly long. The list includes:
-- excessive debt levels
-- the decline in the value of commercial real estate as office space is no longer needed as remote work becomes commonplace.
-- inflation is now embedded
-- unemployment lags financial distress, so job losses are predictable
-- bond market volatility is very high, and this bleeds into stocks
-- the lag time between rising rates and the consequences of rising rates, and so on.
The net result is scanning my twitter feed (I follow 980 pundits, analysts and commentators) I find near-zero stock market Bulls. Nobody sees any reason for the market to rally except a very few technical-analysts who use idiosyncratic indicators, for example, Tom McClellan's VIX/VIX-futures ratio which is indicating a bottom in stocks.
Here's a very basic 10-year monthly chart of the S&P 500 (SPX). Monthly charts are useful because they smooth out day-to-day and even week-to-week price movements. Note that the RSI (relative strength) indicator has been at levels indicating a bottom for nearly a year. Also note the MACD (moving average convergence / divergence) is approaching a bottom and the divergence bars are showing positive divergence (rising even as price remains in a range). If March and April close higher, this chart could become long-term bullish--completely contrary to expectations of a recessionary crash.
Those predicting a stock market crash based on all the bearish fundamentals reckon the entire market "should" crash. What they may be overlooking is how many sectors of the market have already crashed. In other words, maybe we've already had the crash. Here is the once red-hot ARK Innovation ETF which declined from $120 to $30 before entering a trading range of $30 to $40. Interestingly, RSI is showing positive divergence (a bullish indicator).
As for those who say the crash has only hit risk-on tech/crypto assets, look at Disney (DIS): a crash from $180 to $85.
Other than technical indicators, what's the Bull case? Why should the stock market soar as recession looms (or has already started) and a bank crisis spreads?
One factor is sentiment, which is now so negative (though not negative enough for purists) that it becomes a signal for a reversal, i.e. a rip-your-face-off stock market rally. I recall the market declines of 2000-2002 and 2008-09 very clearly, and sentiment didn't reach these levels of universal bearishness until the crash had already occurred. (I also recall the market in the 1970s stagflation, the 1987 crash, and the market weakness circa 1991-92.)
Another is the reservoir of speculative "animal spirits." At multi-year lows, everyone has given up on the market, and the percentage of assets invested in stocks drops from nearly 40% to 13%. The speculative frenzy is still red-hot in my view; despite all the bad news and dire prognostications of a crash, most players are looking for the next big-win trade. This trend-chasing mentality drives self-reinforcing stock rallies as those who bet on a crash (shorts) are forced to cover and skeptics are forced to chase yet another "most hated" rally.
Another is transparency. The 2008 banking contagion was fundamentally an issue of systemic fraud in mortgage origination, risk rating and MBS (mortgage backed securities) packaging, all of which were riddled with massive fraud. The closest current analogy is the FTX fiasco, in which entities that were presented as rock-solid and low risk turned out to be Ponzi schemes or outright fraud.
All these issues--recession, Treasury yield inversion, rising rates, tightening financial conditions, commercial real estate, housing, employment, debt, deficit spending and bond yield duration mismatches--have been out in the open for anyone who cared to look.
I make no claim to expertise, but it seems self-evident that the current "bond duration/risk management" banking crisis is nothing like the 2008 global financial meltdown because the current issues were all visible for the past 15 months. Here is Joseph Wang, @FedGuy12: "All these guys looking for a banking crisis are fighting the last war. Regulation and policy response are just in a totally different place today."
Silicon Valley Bank failed because it made little effort to manage the risks embedded in its bond portfolio. This is incompetence, not fraud. (Insiders selling shares at the last minute may well be malfeasance.)
Many commentators are now saying the mega-banks will get bigger at the expense of smaller regional banks. This may be so, and it may be unwelcome but if the goal is to keep the entire economy exactly as it was in 2019 forever, that goal is not realistic. The greatest strength of any organism or system is its ability and willingness to adapt to changing conditions.
The market is famously a forward-looking discounting mechanism. What's known and easily anticipated is absorbed and discounted. In the current setting, a recession has been discussed and anticipated for many months. The banking crisis was a surprise, but the source was no surprise to those "in the know." Everyone could see long-duration bonds were losing value as rates rose and short-term bonds were the place to be as yields inverted. Anyone could predict that "capital goes where it's treated best" and so some of the cash earning near-zero in banks would migrate to short-term Treasury notes, bills and bonds paying almost 5%.
So in this sense, nothing was unknown or obscured by intentional fraud. Take commercial real estate (CRE) as an example. The Covid-induced move to remote work catalyzed a movement that was already gaining ground due to technological advances. It was obvious to anyone who cared to look that the demand for office space would not return to pre-Covid levels for a long time, or maybe never. Those owning the office buildings and the mortgages on the buildings would experience a decline in the valuation of the assets, as demand had changed for secular / technological reasons.
It was also obvious to those with access to the data that 80% of these CRE loans were originated and held by regional banks, and so the pain would be concentrated there.
The post-2008 regulatory structure imposed on banks and credit unions predictably drove marginal lending and shady practices into the unregulated "shadow banking" sectors, where the risks were inherently opaque. All this was obvious. And so the demise of FTX--a classic example of unregulated financial enterprise--was surprising only to the unwary.
Another difference is who's losing their capital and who's getting bailed out. Shareholders and bondholders in failed banks are not getting bailed out. Depositors are getting bailed out, largely by federal agencies taking long-duration bonds at par value rather than forcing banks to liquidate them for a loss. Held to duration, the bond will maintain its par value.
Turning to the Federal Reserve, we're in an interesting juncture where no matter what the Fed does, it's instantly declared a "monumental policy error." If it continues to raise rates, that's a monumental policy error. But if the Fed pauses its rate hikes, that's also a monumental policy error.
I don't see the value of declaring every Fed action a monumental policy error regardless of what the action might be. Common sense suggests pausing the fastest rate hikes in history here would be prudent, to let the lag effects of this major change ripple through the economy. Once the economy has caught up, so to speak, then the Fed can adapt to whatever conditions hold at that time.
There seems to be an unspoken belief that no one should ever get hurt in the economy. Everything "should" always get better for everyone, without any messy loss or pain. This isn't realistic. The economy has been plagued by over-easy financial conditions for 25 years, and so a vast array of marginal and superfluous activity was funded that would never have been funded in more prudent financial conditions. Too many marginal structures were built and too many marginal enterprises and ventures were funded.
So we ended up with too many malls, too much retail space, too many office towers and too many empty houses and flats being kept off the long-term rental market to feast on the riches of the AirBnB short-term rental market, a market that is just now starting its implosion as cities ban or restrict these rentals.
Everyone who staked capital or a livelihood in these marginal assets / enterprises will get hurt. Everyone who bought a bond that yields 1% as rates rise to 4% got hurt. Everyone counting on nearly free capital to flow forever will get hurt.
All of which is to say the panicky fear of Financial Armageddon that pervades the zeitgeist seems overblown because it's based on a template (2008) that isn't applicable to the present.
This brings us to the fear of a well-deserved stock market crash as all these bad things can no longer be denied: recession, bank meltdown, job losses, monumental policy errors by the Fed, CRE snd housing imploding, and so on.
Given the weight of all these bad things, the market "should" crash to reflect the coming decline in profits and recessionary malaise.
But markets are perverse. What they "should" do isn't what always what they end up doing. In my 50 years of adulthood, I've witnessed a number of stock market crashes, and none occurred when everyone was skittish and fearful of a crash. Crashes occurred when everyone was (delusionally) complacent.
What markets tend to do when everyone is suddenly hyper-aware of all the risks that were largely out in the open but brushed aside is rally. A rally would confound everyone, for why would markets rally when all the news is so obviously bad? They rally because all the news is finally out and so people start looking beyond the bad news, which can now be discounted.
Legendary stock trader Jesse Livermore famously said that markets leave the station with the fewest possible participants on board. When markets are melting up, optimistic and complacent, Bears give up (think February 2020) and so there are few Bears on board to profit from the crash (March 2020). When markets are skittish and volatile, people hesitate to build bullish positions, so the rally leaves everyone scrambling to chase the bus that already left the station.
As noted above, the greatest strength of any individual, household, enterprise, nation or economy is its ability to adapt on the fly and absorb the costs of experimentation, dissent and trial-and-error advances: some assets decline or become worthless, jobs are lost, enterprises are liquidated, budgets are cut, and so on.
The bullish case is threefold:
1. Sentiment is so bearish that a crash seems likely. This is not how crashes unfold, it's how rallies unfold.
2. All the bad news is out in the open and being endlessly hashed over.
3. People are adapting and the costs of adaptation are being paid. Mass layoffs in Mega-Tech, banks bought or bankrupted, office towers converted to residential, assets repriced, and so on.
We make projections on current conditions without making allowances for the rapid adaptation that's already in motion. I think the evolutionary model of Punctuated Equilibrium offers a useful template for economies as well as for organisms.
When evolutionary pressure rises to the level of crisis, organisms and economies start churning out variations and mutations in vast numbers, enabling fast adaptation. Once the most successful variations have been absorbed and copied, then the species / economy returns to a low-rate-of-mutation equilibrium.
The bullish case is: the market is looking past all the bad things and seeing rapid adaptations that are changing the economy for the better, despite the pain.
Nobody knows the future. We're all on our own. Maybe the market will crash next week when the Fed does whatever it does, i.e. for the first time in recent history, the herd is fearful of a crash and the crash happens just as everyone feared.
Or maybe the Fed says something along the lines of "we've done enough for now and future policy decisions will be based on our assessment of conditions at that time." This will be interpreted as a "pause in pushing rates higher" and a precursor to the end of rate hikes, and the market might soar on anticipation of better times ahead.
Or maybe the market chops up and down for another few weeks or months, unable to decide between crash and rally.
The banking scare changed my mind because it crystalized a useful hyper-awareness of risk and a useful focus on what changes are needed to enable fast adaptation to changing conditions. I have no prediction nor do I put much faith in anyone else's predictions. In periods of panic and flux, keeping an open mind might have more value than juggling forecasts and predictions.
In conclusion, I get nervous when everyone suddenly agrees with me because that generally means the market will do the opposite of what I expected back when my view was contrarian. Now that my view is consensus, something else will happen.
On the individual / household level, I constantly promote self-reliance because this is the foundation of fostering adaptability in our own lives. Forecasting markets is an interesting speculative game, but we shouldn't put our own adaptability on the line for things we don't control.
Highlights of the Blog
Funny Things Happen on the Way to "Restoring Financial Stability" 3/16/23
Banks, Banks, Banks: The Elephant Nobody Even Sees 3/14/23
Chart of the Month: Any Questions? 3/11/23
Best Thing That Happened To Me This Week
Strange cloud portends something (Crash? Rally? Alien visitation?) and harvested an 8-hand stalk of apple bananas.
From Left Field
NOTE TO NEW READERS: This list is not comprised of articles I agree with or that I judge to be correct or of the highest quality. It is representative of the content I find interesting as reflections of the current zeitgeist. The list is intended to be perused with an open, critical, occasionally amused mind.
Many links are behind paywalls. Most paywalled sites allow a few free articles per month if you register. It's the New Normal.
Europe leaps towards energy autonomy as sanctions undercut Russia (aljazeera.com) Moscow has waged an energy war against the European Union over the past year, but the bloc appears to be holding firm.
As Millions of Solar Panels Age Out, Recyclers Hope to Cash In -- only a tiny percentage of panels are recycled...
A century of COVID-19: what history tells us about the long-term effects of a pandemic
The resilience secret: 13 ways to stay strong and active – from the man who runs a marathon a day -- yes, 26 miles every morning....
How Does Excessive Debt Hurt an Economy? --Michael Pettis in fine form....
Is the Entire Economy Gentrifying? Companies are trying to maintain fat profits as the economy changes, making 'premiumization' their new favorite buzzword.
'Very precarious': Europe faces growing water crisis as winter drought worsens
BlackRock’s tyrannical ESG agenda (via Cheryl A.)
'This is my chance!' Everything Everywhere’s James Hong on bullying, 'yellowface' and his big break – at 94
So You Want to Turn an Office Building Into a Home? Cities are eager to do this amid rising remote work. But it’s harder than you might think. -- very good infographic explanation for non-builders. People think empty malls and office towers can be be converted into something useful but the costs can be prohibitive...
"You don't do well by trying to be right; it is impossible for humans. You do well by figuring out when you're wrong faster than others do." Nassim Taleb
Thanks for reading--
charles |
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