Melt Up or Melt Down?
Please consider some snips from Fat Tails.
Everyone on Wall Street is freaking out over the 2/10-year yield curve inversion, with recession being the most feared outcome. I am fully aware of the fact that the expression of “consensus view” is often biased and very influenced by a subjective assessment of the outlook. But it seems clear that the risk perception of the investment world has migrated to the darker side.
With more investors believing that a recession could be just around the corner, there could be only two extreme cases — things turn out to be either a lot better than feared or much worse than what is currently discounted. Which is it?
I had a conversation recently with a very shrewd and smart investor whom I have known for nearly 30 years. Let’s call him Joe. Joe is seriously concerned that things could turn out to be much worse than most anticipate. His bearish case starts with Trump being highly unpredictable, and no one seems to know his game plan for his trade war with China. This is very bad for the economy in general and harmful for business investment in particular.
Besides, Joe is worried that the trade war could easily degenerate into a full-scale Sino-U.S. confrontation that leads to military skirmishes in the South China Sea, an invasion of Taiwan by the PLA and China cracking down on Hong Kong demonstrations, all of which could lead to economic sanctions, trade embargos or financial blockage. These aredepression shocks that can inflict huge financial losses.
Besides, even if Trump is defeated by any of the leading Democrat candidates today, Joe thinks that the U.S. stock market would get destroyed, along with the dollar. In his view, all Democrat presidential hopefuls are racing to the left and their policy agendas are best described as extremist. As a result, Joe has completely shunned risk assets, but he does not like bonds either. To him, European bonds are rip-offs and long-dated U.S. Treasurys are too expensive, offering no investment value.
“Where do you put your money?” I asked. “Gold. Period.” replied Joe.
The Other Tail
I understand Joe’s concerns and don’t think he is irrational. China-U.S. relations are obviously front and center of the stock market fluctuations, and policy in both Beijing and Washington has been hijacked by hawks. Nevertheless, I think Joe is too pessimistic and that we should not ignore the other side of the tail risk: that things could turn out much better than what is feared.
Both Trump and Xi are not only rational, but highly calculating. With U.S. elections fast approaching, Trump’s pain threshold has been lowered. He will do whatever it takes to get re-elected, and this means that he will have to tread very carefully not to push the stock market over the edge.
Xi is dealing with a slowing economy and, of course, he hopes to stabilize trade relations with the U.S. China’s decision to not go for tit-for-tat retaliation on Trump’s latest set of tariffs is a smart move, allowing Trump to “save face” and could pave the way for some sort of a deal. In other words, Trump’s outburst over China’s retaliation two weeks ago might have been the peak of the trade tensions leading to the U.S. presidential elections.
Besides, neither Xi nor Trump want to have a “hot war”, as both know the impact of any shooting war between the two countries would be devastating for the world. Besides, it is extremely unlikely that Beijing will send troops into Hong Kong to squash the protests.
Why Any Fat Tail?
I think that was an excellent discussion but why does there have to be any fat tail?
Yes, consumers are still holding up and yes there is a heck of a lot of recession talk, me included. But that does not imply an extreme move.
I side with those who do not expect a crash. By crash I mean a 25% decline in a calendar year or short stretch in adjoining years.
But I also side with those who find investing at these lofty heights a bad idea.
Most Frustrating Move
The most frustrating and damaging move would be a very long, very slow decline coupled with fake breakdowns and fake breakouts. Why not -15%, +5%, -10%, +3%, -15%, +8%, -18% etc etc and at the end of it all stocks are down 50%or more over 7-10 years.
The bulls and bears would get chewed up.
I do not think a “crash” is likely simply because credit conditions are not the same as in 2008 and 2009.
On the other hand, valuations are stretched as much as 2007, 2000, and 1929.
Admittedly, this is the scenario I felt likely for several years and it has not played out that way, yet. Perhaps it never does.
My point now is think about something besides an either this or that setup.
I still favor a brutal neither but I do side with “Joe” on gold.
Mike “Mish” Shedlock
Old beliefs die hard, especially in the aged and inflexible. The whole system has been nonsense since the beginning.
The Chinese are not irrational. Nobody knows that they prefer a democrat to Trump. Hell, they may even make some kind of deal with Trump to help him, if there is a quid pro quo.
The Chinese have already concluded that they will be in a struggle with the US deep state for a long time, regardless of politics.
Trump is rational? Do rational people really still believe this?
The cultists, sure…. he could set one on fire and it would expend its last fiery breaths declaiming how this was part of Trump/God’s master plan, and how it was stigginit to those snowflake libs who turn pail at the scent of burning meat.
Anybody rational that has been paying attention know’s he’s a stumbling demented child-king, who’s only thought is the prosecutions waiting for him when he’s kicked out of office. He will destroy the world to save himself if he can. Luckily the folks around him give him a hamburder and let him rant when he tips over, and only let him out when he’s calmed down.
He’s rational. In the sense that he won’t drink crank case oil and keel over just out of spite. At least I believe he is….
He’s just not very bright. Hence beholden, like all politicians who aren’t particularly bright, to listen to those who has his ear. Who are, inevitably, those who have benefited the most from the undifferentiated theft rackets which is all an economy can possibly come to harbor, after any meaningful period with a fiat money supply.
The last spasms of a dying idiot, will always be unlikely to appear all that rational to outside observers. When the idiot is as big as darned near the entire Western “leadership” and “ownership” class; public as well as nominally “private;” the apparent irrationality just ends up seeming a bit over the top.
Mish: “Admittedly, this is the scenario I felt likely for several years and it has not played out that way, yet. Perhaps it never does.”
It is difficult to make a timely read on a manipulated market.
“Meanwhile, as Credit Suisse notes, one of the major features of the US equity market since the low in 2009 is that the US corporate sector has bought over 20% of market cap, while institutions have sold 7% of market cap.”
BofA CIO Michael Hartnett: “the sole buyer of US stocks remain corporate buybacks, not institutions”
With some 250 trillion in global debt, we are in the midst of the greatest financial fraud in the history of the world. Interest rates are the lowest in 5,000 years, which is how long civilization has existed. Negative rates are an ultimate fraud.
The real question is how not to play that game.
And how governments will, more and more, force you to play that game.
“Negative rates are an ultimate fraud.”
Seems like no one wants to live under the communists.
Kinda like New York State and Chicago.
“skirmishes in the South China Sea, an invasion of Taiwan by the PLA and China cracking down on Hong Kong demonstrations,…”
Noone wants to live “under” anyone else.
“Most Frustrating Move”
…
Anything possible, but put me down for CRASH when the time comes.
Why?
Crash allows Shock Doctrine. Again. Massive taxpayer bailout. ARRA.2. TARP.2. Sometime after the fact Hank Paulson admitted TARP was written months earlier. Just waiting for the right moment to spring on Congress.
Wall Street would prefer a CRASH over long drawn out affair. One or two bad years (with bailout, of course) then back to Big Bonuses as everyone piles back into market.
CFOs desperately want a kitchen sink quarter … or year. A period when everyone comes clean together. No one will be singled out for extra punishment.
For now bias is to the upside, right up to Lehman Moment (where someone big can’t pay [Deutsche Bank?] or China devalues bigly? Something Big will happen).
‘Joe’ is clueless re Treasury market
John Hussman (and many other bond bulls) are fighting the last war, linearly extrapolating how things worked when the federal government was solvent vs when it is not.
Congress has made too many promises that they simply are not able to keep. That a previous generation of legislators kept their promises does not mean this group will keep theirs.
Ultimately, what separates the credit of the US Congress versus the credit of Zimbabwe — is the size and quality of the US tax base. The US government has been at war with its own tax base for decades, and is now as big as its tax base. That is a huge difference versus how things were when Hussman (and others) started in the investment business.
California’s muni bond market is a good case study. Perfect weather, a strongly left leaning political climate, high taxes…
California also has muni yields well above other states, as it defaulted only a couple years ago. Bicker the legal technicalities if you want, but they didn’t pay their debts on time which is a default. SF and LA are over-run by homeless people, feces, rats, and garbage. LA even has outbreaks of the plague (a medieval disease!) and this week LA had reports of leprosy breaking out among the homeless population.
California is a nightmare, which is why so many people are leaving. The rich hollywood / dot-com types are holing up in gated communities or they are leaving.
Treasuries became known as “certificates of confiscation” in the 1970s as their coupons failed to cover cost of living increases.
‘Joe’ knows something that bond bulls like Hussman haven’t grasped yet.
I’ll add Country Bob to that list.
Fwiw, monetary policy of central banks (QE + ZIRP/NIRP) is disinflationary … deflationary when asset bust arrives (starting now or very soon).
Lots of armchair experts claiming disinflation, citing economic models and academic theories. Most of these experts travel from gated community to limo to office to luxury hotel, expensing everything and the bills go straight to accountants. They haven’t paid a bill themselves in years. Everyone in Congress, every Wall Street talking head, every bank CEO — how many of them have even bought groceries for themselves in the last decade?
Real world costs are going up. For those living in the real world, that is what matters.
Treasury yields going down is evidence of central bank manipulating prices, nothing more than that.
“Real world costs are going up. For those living in the real world, that is what matters”
…
No argument. Count me in the CPI under reports crowd.
But not because of Federal Reserve. Give thanks to fedgov for allowing monopolies / cartels to thrive, subsidizing mortgage / student loans, running large deficits, excessive regulation, etc.
“Treasury yields going down is evidence of central bank manipulating prices, nothing more than that.”
…
Nope.
Too much debt. As debt grows it consumes greater share of disposable income (and tax revenue). Lowering current consumption. Forcing prices (and interest rates) lower. Self reinforcing loop.
Until debt paid down / written down / written off, loop will continue.
Too much debt should make bond prices lower, and yields HIGHER… but the Fed is manipulating bond prices.
Fed manipulation is not deflationary. Its just Fed manipulation
It is obviously disinflationary from the peak. That’s pretty much tautological.
From where it was before the creation of Central Banks and the start of their distortionary meddling……..That’s a long, long way down…..
From where we are today, which I assume is what most practical people, including you, are concerned with; it depends on how long they (the CBs) can keep levitating and propping up the corpse before it falls over.
My personal view:
1) property has got saturated and detached from proper valuation based on rents
2) interest rates ( inverted bond prices) went so low that reached negaives, or it got saturated too
1) capital preservation will go into Gold until it is saturated… probably a couple of years…
2) anything else will have to go into stocks, probably income stocks would be a priority
A couple of things: the proceeds of QE went directly to financial institutions thus securities being direct beneficiaries. This is hardly going to drive the cost of bread – not immediately anyway.
Low rates are driven lower by CB intervention in two ways: demand for bonds drives yields lower but the printed money with which the bonds are purchased form what has become known, among the economics fraternity, as the ‘savings glut’ ie the weight of these ‘savings’ drives rates lower too. Econ 101.
There is no saturation point for gold if there is no limit to its price. Demand will dertermine all. Therefore there are no surpluses of cash that ‘need’ to go anywhere else. Beware also that most of the money in the world is not permanent. In a credit bust, the money supply is inclined to shrink and cash is likely to be horded rather than invested in any risk assets (note that an outright decline in money supply these days will almost certainly be met with more CB intervention).
Apparently you haven’t checked the costs of health care, college tuition, or home prices in the last 10 years 🙂
The true cost of living (which is not the same as CPI or PCE) has been going up faster than GDP, faster than CPI, and faster than many paychecks.
I would suggest that stocks have more or less gone sideways — merely holding value over a decade or two versus the true cost of living. Stock prices are going up in nominal terms because the ruler used to measure those prices (the USDollar) is getting shorter.
Gold prices have been all over the place (500 to 1650ish?) over the last 15 years. Recent ~$1420 is about 7% annualized, which means, before taxes, gold slightly outpaced the true cost of living (5 or 6% annualized).
Consumers I know buy health care, send their kids to school, and live in houses. I don’t know anyone who eats a CPI, or lives in a CPI or uses CPI to treat a cold — its a number without any meaning
“A brutal neither” – a well-turned phrase. And, from a trader’s perspective, the most brutal scenario.
The 10 year US bond yield bounced sharply this week after a couple months to the downside. All the headlines of negative interest rates was contrarian.
Nothing goes up or down in a straight line. Are you calling an end to the 40yr underlying trend?
Mish “Fat Tails, But Which Way? Up or Down?” …. Neither. Sideways, and for a very long time.
The entire G7 is “going Japanese”. Decades of ineffective QE and negative short term interest rates. It means endless barrage of fiscal stimulus that accomplishes very little initially, and less and less over time. It means every year the Bank of Japan / Fed / ECB lowers interest rates to negative, and it has no material effect. No one even bothers to report when the Japanese announce another round of fiscal stimulus or central bank buying, because who cares?
It means the political class can’t even save a nuclear power plant from widely expected tsunami after effects. It means all the G7 governments become increasingly irrelevant. It means all the G7 governments get bogged down in gridlock and quagmire.
I am sure the US congress will do studies and pass legislation to make themselves look busy. I am sure the Fed will have FOMC announcements to make themselves look busy. I am sure none of if will actually matter. The debt matters, and it will essentially neuter the G7.
I am not worried. I agree with Mish that a stock market crash is highly unlikely, sideways is my default scenario. Mom and pop businesses (outside of retail) will also do OK. Banks and pension funds will buy Treasuries because they are legally required to, same reason the Japanese post office buys JGBs.
Many Japanese people are quite happy, in spite of their government’s impotence. I have been studying how they adjusted, because I suspect that will be very relevant throughout the G7.
I’ll definitely take the other side of the Japan call:
They are a nation of savers and until recently have always run a current account surplus. The Anglosphere countries are the opposite – trade deficits, huge household debts. We are not the same.
We cannot all be Japan simultaneously:
A boat sinks mid sea, 5 survivors bob around in the water awaiting rescue. They tie up in order to stick together as a group. 1 person starts to sink, the other 4 are strong enough to keep the other 1 afloat. A second starts to tire but the other 3 keep the other 2 going. Eventually fatigue overtakes the stronger 3.
The anglos are literally drowning in debt and their economies, gutted by financialisation, are consuming precious capital. We are not Japan and couldn’t possibly stay afloat as long as they have. The Japanese, despite their credit bust still have an economy of substance, which, with the assistance of the developed world has kept afloat. Once the rest falter Japan will finally succumb.
I argued that the G7 (not just the USA) is similar to Japan in monetary and fiscal policy. I argued that the G7 governments are employing Japan like tactics in a failed attempt to maintain the status quo.
I did not argue that the results would be exactly the same. You are right that the “G6” (G7 minus Japan) is not starting with the savings pool. I would add that western cultures do not have the same reverence to the elderly that Japan does — no one in the west hesitates to call the PM / President a half wit (and a lot worse things).
I would argue that the US stock market has gone sideways for 20 years in real terms already. Instead of blindly accepting CPI as “correct”, take an independent look at the true cost of living — health care costs, costs of raising a child especially education / college, look at housing costs. The true cost of living increase has been more like 5-6% (many consumers barely got raises to match CPI and made up the difference with debt).
So discount the S&P500 by 5.5% annually instead of CPI average…. adjusted for the true cost of living, the US stock market has essentially gone sideways since the 1990s. Blips higher than that, blips lower than that, but essentially sideways.
Japan’s stock market got a lot more overvalued than the US (which mostly had dot-coms get over valued, but the broader market didn’t). The Nikkei crashed and has gone sideways since in nominal terms, but adjusted for their cost of living it has gone down.
I predict more of the same for both stock markets.
That doesn’t mean we in the west can’t learn a thing or two about how common Japanese adjusted to their government’s impotence. But you are right that it won’t be exactly the same
“Japan’s stock market got a lot more overvalued than the US (which mostly had dot-coms get over valued, but the broader market didn’t).”
+a lot!!
The overvaluation was largely confined to a somewhat narrow set of stocks, and Tokyo land.
As well as mostly impacting institutions (insurance cos) directly. The average Japanese and Japanese business was less (directly at least) exposed.
And, it was for a very short term. Not long enough to compete destroy the entire culture and economy, the way central banking has in the west. Even at the worst of it, most Japanese, while somewhat gleeful at how much “greater” their county now was compared to the “old powers,” deep down realized the whole thing was just a sideshow for Ms Watanabe and a few corrupt Tokyo cronies; not really something all that consequential for a real economy consisting of constantly improving stuff and making it better than anyone else.
The US is completely different. “Noone” here has done lick squat of value since the start of the Vietnam War. It has all been burning built up capital stock. While attempting to cover it up, with braindead CNBC mumbo jumbo befitting the childlike (at best), meager brains of the near 100% Fed-welfare enabled new “elite.” Talk about resting on ones laurels. Makes Rome’s final stages seem positively rational and economically efficient.
Anyone looking for a “role model” for the US for the coming generations, are much better off looking at Argentina post 2001, than Japan post early 90s. With the Dems as the Kirchners, and Trump as some sort of dug up, half rotten zombiefied Peron.
have a look at the historical Nikkei chart; it reached 46K at one point, it is now at 21k and even that level has to be ‘supported’ by the BoJ…..
“In his view, all Democrat presidential hopefuls are racing to the left and their policy agendas are best described as extremist.” Huh? How old are you, Mish? 2 years old? Democrats are not liberal they are ultra right wing. So called socialist Bernie is what Dems & Republicans were 50 yrs ago and they were not socialist and neither is Bernie or Corybn. Dick Nixon was the most liberal President since FDR. Saying Dems are liberal is like saying Hitler loved Jews.