Why this time is different

We are living within an incredible monetary policy experiment. One the likes of which has never been embarked upon in human history. Therefore the results are difficult to forecast. However, I do believe we are in the initial stages of a bear market and that the next central bank monetary policies and their impacts will be different than those of the last several crises.

We have seen the last three bull markets catalyzed largely by loosening liquidity conditions during the bear markets that preceded them by central banks — in more and more of a globally coordinated fashion. This has led me to believe that the expansion of liquidity is the primary driver for consistent risk asset upward price revisions (aka bull markets). More than economic developments, earnings or political discourse.

As a result it is crucial to realize that the ‘punch bowl’ of quantitative easing, the veritable liquidity spigot that juiced markets higher over the last 9.5 years, is not only running dry, but going in reverse (taking liquidity from markets).

The impact of this reversal cannot overstated. It will be the primary catalyst that drives this bear market in equities lower. Only a reversal of tightening liquidity conditions will drive risk assets higher again in my view.

Below I will discuss, in summary, my view of how future crises may be remedied by central bank monetary policy, and how the law of diminishing returns may not deliver a buoyant bull market as we saw from early 2009 to mid 2018.


  • The evolving variable for each crises’ remedy is lower and lower interest rates; then QE and finally direct future/stock buying. See Bank of Japan playbook for the ‘end game’.
  • As a result it is reasonable to expect the next crisis will result in not just QE, but likely direct future/stock buying in US markets.
  • Further, there are fewer listed shares now and the listed shares have been shrinking their floats as a result of share buybacks, exacerbating both upward and downward moves.
  • Adding to that, HFT algorithms do not tend to bid during downward moves, causing the smaller floats to experience outsize downward volatility on any liquidation. Next major crash could be significantly exaggerated as a result.


  • $1 of US GDP growth now costs $4 of debt, and is only growing as we push on the string of debt to borrow forward demand to today.
  • US now has $200 trillion of unfunded liabilities over the next 10 year period.
  • Debt monetization isn’t just important, it will become a necessity. Otherwise rates normalize and the party ends in a very bad way (insolvency and/or extreme austerity measures).

Broader takeaway:

  • Muted returns for US equities over next 5-10 years (unless next crash corrects more than 80% of gains during this cycle).
  • Growing risk of protracted rolling global equity bear market as compression in economic activity, earnings — and the all important liquidity spigot (QE becomes QT) slows and reverses.
  • Future monetary policy easing will have a diminished impact on equity prices due to enormous expansion of multiples during this business cycle. If one discounts QE and share buybacks stocks are about 70-80% overvalued.
  • Next bubble will likely have to be in sovereign debt, aka US treasury yields approaching zero. Out of necessity to keep the gov’t open. Other assets may benefit as well. Especially if US dollar is debased to support forward liabilities.
  • Social factors will prevent future large scale bail-outs of Wall Street such as those that we saw in 2008. Unrest has grown as wealth disparity between working and wealthy grows to record levels.
  • I don’t expect US equities to perform as well in that environment, but do suspect strong headwinds against US dollar; emerging market / commodity outperformance. Largely due to the prospect that the US dollar is significantly overvalued based on economic fundamentals when netting out gov’t debt expansion (doing so shows we’ve largely been in a recession since 2008).
  • Emerging markets also have much more realistic valuations, better yields, lower nominal debt levels and the share buyback activity has been muted so EPS distortions are minimal.

As we can see, over the last several decades the primary trend in US interest rates has been lower. Countertrend rallies revert to the larger primary trend of lower lows in interest rates. Should this trend break down and rates normalize, we would see significant delinquencies emerge across corporate, financial and household variable rate debt markets. The US government would struggle to pay the interest on its longer dated treasuries.

While past is not prologue, it is reasonable to assume that the path of least resistance for interest rates is lower. Perhaps as low as 0% or even negative as we’ve seen in massively mispriced debt markets in the EU and Japan.

The larger underlying theme being that monetary policy authorities see massive distortions in asset pricing and capital misallocation as a lower risk than a sovereign debt insolvency. Therefore it is also reasonable to assume that they will do whatever is necessary to accommodate that trajectory over the longer term. That is to say, each subsequent business cycle will see lower nominal interest rates until we reach the mathematical limits of ZIRP/NIRP policies.

Eventually, with zero to subzero interest rates, sovereign debt becomes less attractive to hold (outside of regulatory mandates for financial companies). But before such an occasion arises, there is plenty of room for interest rates to keep going down — following a well established trend.

Why are stocks selling off?

First let’s dive in to the mechanics of what’s changed. We were accustomed to a market where there was practically no volatility. Complacency was high and on a technical basis the Dow and S&P were more overbought than at any period since perhaps 1929. In essence euphoria and perhaps even blind optimism were becoming extreme. That condition quickly and violently reversed as more than five trillion dollars of market capitalization have been wiped out by selling since January 26th, 2018.

Volatility has returned

We’re now seeing volatility pick up and equities give back much of their gains over the past several months rapidly. Downward moves are generally faster paced and more intense than moves upward. Easy come, easier go.

That relatively uneventful journey up in most of 2017 is part of the problem with markets right now. During the rise in prices equities didn’t consolidate or correct which led to almost no technical support for buyers.

This is important because when there is volatility, market participants often utilize charts and technical patterns to determine areas of support. But in moves that are parabolic there generally aren’t such areas of technical support on the chart to rely on. So buyers (both human and bots) are more shy to put a bid out.

Fear is a powerful emotion

When volatility picks up and losses accumulate, speculators that used leverage (debt) to buy equities are often hit the hardest, forced to liquidate their positions. When this sort of activity crescendos with other investors panicking we typically see a capitulation selling event. I’m not certain we’ve seen that event as of yet, though. The market will have to demonstrate whether or not it has buyers here.

An example of how powerful fear can be is how inverse volatility index (VIX) ETFs have imploded in the wake of volatility returning to markets, meaning buyers who bet against intense trading price ranges were essentially wiped out. This trade worked well for years — until one day it didn’t.

These dislocations are not enough to create a full on selling panic on their own. Instead they are representative of instruments that were too heavily bought in to on the long side unraveling as the markets normalize to higher levels of volatility.

Bots are not buyers during sell-offs

High frequency trading bots have overtaken humans as the largest component of buying and selling volume for US equities. That seems efficient in theory, but the problem we see is when the selling intensifies the bots stop bidding. That allows declines to intensify as those wishing to exit will be fighting against a larger spread and less buy-side liquidity.

Indeed, during the last week we’ve seen situations where smaller lots were moving markets up and down by handles, rather than ticks. That’s the sort of activity one expects in an illiquid and immature market. Yet we are seeing it on a continuing basis here in the US with its extremely deep and previously liquid stock markets.

Technically speaking

Zooming out to a 30,000ft perspective, we haven’t seen any truly significant selling. Even though many points have been lost on major indices, this selling event is relatively normal. The pace of it is a bit intense, but for a maturing bull market one should expect increasing volatility along with leadership consolidation.

S&P 500 technical analysis

The S&P 500 appears to be hitting a lower area of support. Watching to see whether cautious buyers come in for a move more substantive than a “dead cat bounce” is crucial in determining whether or not the downward move is ending or if there is more to go. If we move meaningfully down from here across the US equity indices I believe we are going to see much more significant selling pressure and volatility.

It’s almost entirely about rates

The selling intensity and loss of confidence in bidding up equities seems to be tied to increasing rates on the longer end of the yield curve. Related to that development is that inflation expectations are beginning to change and concerns are rising. That is to say, bond buyers may be questioning whether a 10 year bond at 2.851% is a fair interest rate or if perhaps a higher rate is justified based on what the rate of inflation may be over the next 10 year period. If buyers commit to an interest rate that is lower than inflation they walk away with a loss when the coupon matures.

While the yield curve has had a flattening spread for several years — it is beginning to steepen again. Higher interest rates are also inducing higher borrowing costs for mortgages, margin debt as well as other variable rate debts and could compress consumer spending as well as market buy-side participation. Borrowing costs are one of the most important factors in market psychology as well as interest earned on presumably safe government bonds.

That means if the 10 year bond continues higher, say at 3% or more, then many equity participants may re-balance their portfolio away from equities and more towards US Treasury bonds. Assuming other shorter dated bonds were not as well bought, that change would steepen the yield curve which would also potentially assist lenders in capturing a larger interest rate delta between the short term borrowing they engage in vs. the long term lending at higher rates.

On the other side of that, if yields peak and meaningfully decline then there is a fair chance that a bid returns to the equity markets and they move meaningfully higher. Whether or not stocks are able to make a higher high in prices is the most important technical consideration for maintaining a healthy bull market uptrend.

Economic development trajectory

If economic data begins to slow meaningfully, which it may with higher rates, that is another area where weakness may be demonstrated as a result of reduced economic participant confidence. Such slowdowns often happen as rates increase and borrowing costs rise at the end of a business cycle. The most leveraged companies, states, cities and private debt holders are hit the hardest.

Closing thoughts

As I told a friend, the “crisis” now is that there is a lack of a crisis to keep crisis-level accommodations flowing. In essence the central bank liquidity spigots are slowing and commercial lending is taking a breather. The Fed has also recently made it clear that the “Powell Put” is at much lower price levels.

These developments impact both equity markets and real-world economic activity.  I’ll be watching the economic data releases, interest rate complex, especially 10 year yields and junk bonds, to see where equities may go from here.

Are emerging markets a good bet right now?

US equities have a smoothed P/E of approximately 24 whereas emerging markets average P/E is 16. Combine that with the potential of the US dollar uptrend (which started in summer of 2014) unwinding (adding emerging market native currency appreciation potential) and higher yields in emerging markets (an average of about 6.5% based on my math).

It seems like there is an opportunity here, if even only for normalization of valuations. I would suspect that liquidity would continue to be drawn, perhaps at an even faster pace, to EM equities and bonds (as it has been since early 2016) as the US dollar rally unwinds.

Full disclosure: I have been investing in EM equities and bonds since January, 2016 when I felt an enormous opportunity was on the horizon.

A stronger dollar means a weaker everything else

As the dollar surges past 97, toward 100, the rest of the market seems to be catching on that this is a risk off signal. Just about every asset class is selling off today as a result. There’s no single catalyst for the stronger dollar. More a myriad of micro-catalysts:

  • The assumption that the EU, UK, Japan and others will continue QE and ZIRP/NIRP as the US Fed raises rates.
  • The notion that the US Fed will raise rates at a faster pace (than they have in the last 3 years of jawboning about it).
  • The structural economic problems in other economies (making ours seem like the least bad of the bunch).
  • Weakness in demand for assets in Japan and Europe.
  • Brexit and the follow-on economic impact on UK.

With all of that in mind, I believe that the current leg of the US dollar rally is becoming problematic for the goals of the US Federal Reserve. Indeed, a strengthening dollar on top of rising US Treasury yields is in a way a de facto tightening. Liquidity tightens and lending/margin speculation decreases.

Should the rally strengthen I believe it will create a significant downside catalyst for a multitude of other asset classes. And there is some small chance that it could spiral in to a deflationary headwind should the situation grow out of the control. My opinion is that the dollar strength could be utilized as an entry point in to beaten up asset classes, especially commodities and emerging markets.

Let’s watch carefully and see where the market takes us from here.

Liquidity is not solvency

Apparently this is not a very well understood concept among the financial elite. Or perhaps they understand it all too well and are milking every incentive and easing measure for all of the salary, stock options and bonuses they can provide.

Not much has truly changed

Other than transferring an enormous amount of risk from the financial system in to the hands of central banks and governments, the underlying fragility of the financial system remains. Further, because the lenders of last resort are now burdened and their arsenal of financial ammunition near empty, there are not many options for the next economic hiccup.

With both US equities and bonds expensive by most measures, the logical alternative for most value conscious investors is to search for value in other asset classes: emerging markets, commodities, foreign exchange and real estate in distressed markets. But these options don’t come without risks of their own as their fates are tied to that of the US dollar (read more below).

With a great rally comes a greater upset

The last 7.5 years have been very generous to equity and bond investors. Perhaps too generous if current valuations are of any indication. What many are not prepared for based on current sentiment readings is a sustained downturn. Yet at the same time expectations of interest rate hikes by the Federal Reserve continue to rise (as they have in fits and bursts since jaw boning about such tightening began in 2013).

When rates rise, lending conditions tighten. And as that happens margin levels shrink, leverage is reduced as the cost of holding positions rises. This means that most of the time a series of rate hikes, as is being priced in to Fed Funds Futures, is the beginning of the end for modern bull markets in equities.

Yet stocks don’t seem to have received the memo. And they usually are last. 10 year Treasury Bonds, however, have seen yields rise from a paltry 1.3% to nearly 1.75% over the last few months. This may be more than just smoke signals as there are many foreign sovereign investors lightening up on Treasury Bond positions over the course of 2016, including China.

King Dollar’s mighty move

The US dollar has been rallying as of late on interest rate expectations as well. This has knocked down many commodities, outside of the energy sector, and caused renewed pressure on foreign currencies. Dollar strength should be watched carefully. If the dollar continues to rally (the dollar index is now testing 97) then we may see a renewal of equity selling as rate hike fears begin to permeate the US stock market.

Fears of the Fed are foolish

They say don’t fight the Fed. But what if the Fed is all talk? Over the last three years, there’s been a lot of talk of higher rates, even normalization. But what we have after all that talk is one lonely rate hike that is almost a year old now. The market seems to key in on every word every Fed official says, almost as if their words were seen as valuable insights.

But if each speaker’s rate forecast, economic forecasting track record and previous speeches are carefully examined the inconsistencies and inaccuracies accumulate. My opinion is that many of these officials, while they probably mean well, don’t have the requisite tools to forecast something as complex and intricate as the US economy. Why? Because no one does. Such tools do not exist.

But one thing is certain…

With a track record as dismal as Fed officials seem to have, their forecasts and banter about tightening should be taken with nothing more than a grain of salt. They don’t have a magic ball  and they can’t see in to the future much more than any other market participant, economist or statistician.

These are the same minds that brought us such failed monetary experiments as quantitative easing, which had the effect of redistributing middle class wealth to the already very wealthy, and bank bailouts which enabled more systemically reckless gambling.

As if flooding the system with credit would resolve the underlying structural solvency problems that our financial system and our government suffer from (hint: it made these issues worse by failing to address them in any meaningful way).

In conclusion, and I’m talking to you Mr. Market, let’s try not to take the hot air too seriously. After all, the people making it don’t seem to recognize the difference between liquidity and solvency.

Seesaw market creates opportunities in volatility

There is a lot of emotion charging the market, creating exaggerated moves both up and down.  One day everything is fixed, the next everything is broken.  Manic depression wouldn’t even begin to describe the back and fourth being witnessed.

But with chaos comes opportunity.  And the opportunity here is finding beaten up, misunderstood and frankly cheap assets.  Right now the areas that seem to be most attractive are commodities, commodities companies, energy and energy companies.

The global markets are pricing in worldwide depressed demand.  Oil producers are pumping at frantic rates, more concerned about the flow of cash than the margin on each sale.  This has created a glut of energy supply — and with little demand oil prices have crashed below $30.00 to about $28.00 a barrel for West Texas Intermediate Crude (WTIC).

Consider the following opportunity: The US dollar has had a rally which induced a de facto tightening even before the US Federal Reserve raised interest rates.  As such, one can reasonably expect that the actual pace of interest rate tightening, with the backdrop of a softening US economy, will likely be subdued.

Markets have priced in a more aggressive interest rate hiking cycle, which is putting pressure on everything that’s priced in dollars.  Even stocks.

I think that we’re getting ahead of ourselves here.  The Federal Reserve is unlikely to let this situation turn in to a full blown 2008 panic again, unless there is a desire to bring back all the calls to audit the Fed and the political upheaval that protests and social unrest would bring.  Instead, especially given that it’s a critical election year, I believe the Fed will tap the breaks and ease off the gas, leaving interest rates at 0.25% and possibly cutting them to negative levels if the global slowdown increases in momentum.