She was probably my age, maybe a couple of inches taller, and a whole lot more athletic looking. With her deep tan and curly blond hair, she was almost exactly what I thought a stereotypical California girl would look like except her eyes ruined the image. They were startling gray, like storm clouds; pretty, but intimidating, too, as if she were analyzing the best way to take me down in a fight.
—  Percy Jackson, The Lightning Thief
What’s Next For Central Planners And Their Kale Smoothie Economy?

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A Logical Question

Casual market followers, along with many seasoned Wall Street veterans, may have recently had an internal voice ask:

What the heck is going on in the financial markets?

The short answer is everything we have come to know over the past 20 years about the latter stages of economic, interest rate, and market cycles, changed in early 2016. The shift is clearly evident in the odd behavior seen across numerous asset classes, which the tweet below captures:

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The tweet above basically says stocks and bonds simultaneously experienced record-inducing demand. Is it uncommon for stocks and bonds to rise together? No, in fact it is quite common. The extremely rare part of the equation is that maximum confidence (new record high in growth-oriented stocks) occurred, for the most part, simultaneously with maximum fear (new record low in bond yields). Common sense tells us that maximum economic confidence and maximum economic fear should not occur in the markets on the same day, but that is exactly what happened on July 8.

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How Did The Market’s Narrative Change In 2016?

After all the 2016 New Year’s confetti was cleaned up, the Federal Reserve was talking in a very unfriendly tone from an asset price perspective, as evidenced from the January 6 headline below (full Reuters story):

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The Fed’s intention to raise rates as the economic data improved fits the script we have all come to understand over the past 20 years. Often bull markets and periods of economic growth come to an end after the Fed hikes rates a few times in an effort to keep inflation in check (or to restock their policy toolkit).

January 2016: Market And Fed Were Following Traditional Script

All things being equal, the financial markets frown upon Fed rate hikes. The S&P 500 responded to the hawkish and “old-script” Fed with the worst ten-day start in U.S. stock market history. During the January plunge in risk assets, the financial markets were reading from the deflation/weak economy/bear market script, as depicted by the chart of silver relative to defensive Treasury bonds below.

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Today, the same silver:bond ratio looks quite a bit different, reflecting the market’s reaction to the Fed’s new and recently communicated late economic cycle script.

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Debt, Helicopter Money, And The Fed:

This week’s video expands on the concepts covered in this post. How did we get to a point where central banks are seriously talking about helicopter money? What does it mean for the markets and investing?

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

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Debt And Valuations Make Raising Rates Difficult

Why has the Fed adopted a new late economic cycle script? Given extremely high levels of global debtand elevated valuations, central bankers are terrified of inducing anything remotely approximating a Japan-like deflationary spiral. The Fed is concerned if they follow the traditional late-cycle script, asset prices could experience a significant and sharp reset, which could ignite a wave of bond defaults and/or a recession. From the Los Angeles Times:

Eight years ago, unsustainably high debt was the root cause of the worst recession since the Great Depression. Yet, world debt overall now is far above 2008 levels…The overstretched include plenty of governments. Total government debt outstanding worldwide was worrisome in 2008. It has since doubled to $59 trillion, according to Economist Intelligence. But that is just one slice of the global debt pie. Add in household, corporate and bank debt and the grand total was a mind-boggling $199 trillion in mid-2014, up 40% since 2007, according to a study last year by McKinsey Global Institute.

Inflated Asset Prices Reacted To Threat Of Rate Hikes

The Fed was given a taste of what a global reset might look like after they raised rates in late 2015. The S&P 500, as of January 20, 2016, is shown below.

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What Markets Were Anticipating In Early 2016

For illustrative purposes, the S&P 500 is shown below from 1997 to 2004. The old script says central banks raise rates near the end of a bullish cycle (1999); the economy eventually slows, and risk markets eventually fall (2000). Sometime during the bearish/recessionary period that follows, the Fed starts to ease policy again (2001) and eventually a new bullish cycle begins with an improving economy and a new bull run in risk assets (2003).

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How Did Central Banks Flip The Playing Field?

After the Fed’s early 2016 deflationary spiral scare, central banks slowly started delivering a message that they have gone down a policy road (zero/negative rates) that is very difficult to reverse using the traditional late economic cycle playbook.

The dated headlines below, along with links to each article, illustrate the shift that took place between early January 2016 and the present day. The first headline aligns with the traditional late economic cycle script. The last headline aligns with the new “too much debt and valuations say asset prices are vulnerable” late economic cycle script.

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Links to full text of articles referenced above: story one Bloomberg, story two MarketWatch, story three Bloomberg, story four MarketWatch.

The Fed Saw The Writing On The Asset Price Spiral Wall

Experienced investors would quickly label the January 2016 S&P 500 below as a “possible head-and-shoulders topping pattern”. Bull markets often end when earnings slow, valuations become extended, and stocks move sideways for a long-period of time. All three were in play early in 2016, which makes it easier to understand why the Fed shifted abruptly from “four hikes in 2016″ to “helicopter money should be in our toolkit”.

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A Major Bottom Near A New All Time High?

The Fed’s flip flop on rates helped spark the current rally in stocks, which put the mini deflationary spiral fire out. Recently, pre-and-post Brexit and ultra-dovish comments helped markets come to grips with the fact that the central banks plan to extend their zero/negative rate policy experiment further, rather than reign it in as the Fed indicated in January. A July 12 article referenced an extremely rare breadth event that occurred as central banks communicated their asset-price-escalation game plans. The rare event was described via  SentimenTrader’s tweet below:

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In the chart/tweet above, notice the last time the rare breadth event occurred; in early 2009 after an incredible amount of bear market related stimulus had been announced (green arrow). The 2009 bottom in stocks fit into the traditional market and interest rate cycle script (stimulus came during the bear market/recession and helped create a new bull market/expansion).

Trying To Create A Major Bottom From A Major Top

As pointed out by @DowdEdward (see tweet below), notice how the first breadth event occurred near a major market low (green arrow); a low that was assisted greatly by central banks and government bailouts/stimulus. The second occurrence in 2016 (blue arrow) also followed talk of possible bank bailouts in Europe and even  more stimulus from central banks. The big difference is the first rare occurrence happened near a major market low (green arrow) and the second rare occurrence took place in the context of what appeared to be a traditional end of a bull market topping pattern in stocks (blue arrow).

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Central Banks Scratching And Clawing In An Attempt To Avoid Deflationary Spiral

The concept of creating a “bottom near a top” is exactly what global central banks are trying to engineer. They keep hoping the next batch of rate cuts, money printing, asset purchases, etc. will create sustainable economic growth, allowing earnings to catch up to artificially propped up asset prices. Central planners hope the next “wealth effect” program will allow them to grow their way out of the zero/negative rate mess they have created over the past nine years. If their grand policy experiments fail, central bankers will lose a considerable amount of power.

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Helicopters Dropping Money?

In the United States, the Federal Reserve has gone from “four rate hikes in 2016” to “we should have helicopter drops” in our policy toolkit. With Janet Yellen and FOMC member Loretta Mester both having talked about helicopter money within the last thirty days, more and more market participants are coming to the conclusion that it is highly unlikely the Fed has entered a traditional late-cycle campaign to raise interest rates, but instead the next two or three policy moves could push the Fed’s already hyper-dovish stance into maximum hyper-dove mode. From  Australian Broadcasting Corporation:

Dr Loretta Mester, president of the Federal Reserve Bank of Cleveland and a member of the rate-setting Federal Open Market Committee (FOMC), signaled direct payments to households and businesses to stoke spending [a helicopter drop] was an option central banks might look at in addition to interest rate cuts and quantitative easing. “We’re always assessing tools that we could use,” Dr Mester said in response to a question from the ABC about the potential use of helicopter money.

Japan Is Already In Near-Helicopter Mode

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The Bank of Japan has a policy statement due to be released on July 29. The financial markets will be looking for additional stimulus. From a July 14 Bloomberg story:

Etsuro Honda, who has emerged as a matchmaker for Abe in corralling foreign economic experts to offer policy guidance, said that during an hour-long discussion with Bernanke in April the former Federal Reserve chief warned there was a risk Japan at any time could return to deflation. He noted that helicopter money — in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them — could work as the strongest tool to overcome deflation, according to Honda. Bernanke noted it was an option, he said.

“There’s a strong allergy to so-called helicopter money in Japan, though the definition of the word differs from person to person,” Honda said in an interview on Wednesday. “While looking at the BOJ’s bond purchases and fiscal policy as a package, which I see as a kind of helicopter money, it would be beneficial if the prime minister understands that there is a global leading scholar clearly advocating helicopter money,” said Honda, who was speaking by telephone from Switzerland, where he is serving as Japan’s ambassador.

The markets may not get a textbook helicopter plan from the Bank of Japan on July 29, but the degree of accommodation may be in the same money-printing ballpark. From Bloomberg:

Ben S. Bernanke earned the nickname “Helicopter Ben” for once suggesting a central bank could overcome deflation by cranking up the money presses to finance tax cuts. He’s always made clear such efforts would be a last resort, the equivalent of dropping money from the sky. So when the former Federal Reserve chairman arrived in Tokyo for talks with Japan’s top policy makers this week, bond traders, stock investors and economists had reason to wonder. Was Shinzo Abe’s economic team (Bank of Japan) ready to break the glass, pull the emergency lever and entertain such a radical shift in policy as direct fiscal financing by the central bank. While officials Wednesday played down the most extreme scenario, two of Abe’s top advisers did call for a double-barreled blitz of coordinated fiscal stimulus and money printing.

Why Is There Too Much Debt?

There are numerous reasons, but extremely low interest rates and debt bailouts are a good place to start. Recessions, like other processes in nature, help identify weak players in the public and private sector. During recessions, the rate of bond defaults increases, which is a natural way to purge bad debt from the global economy. The problem is central planners have pumped up asset prices to such lofty and artificial levels, central bankers fear that letting economic natural selection into the debt purging process could set off a hard to stop deflationary spiral in asset prices. Below are just a few examples from the central planning bailout collection:

  1. $17.4 Billion Bailout U.S. Auto Industry.
  2. Insurance Company Bailout.
  3. U.S. Bank Bailout.
  4. European Bank Bailout.
  5. Third Bailout For Greece.

More Bailouts Coming In Europe?

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When policy makers continually prevent major debt defaults via bailouts and keep interest rates near zero, the global debt mountain just keeps getting bigger and bigger. The problems are still with us in 2016. Europe is currently debating how to prevent zombie banks from defaulting; some are calling for a $166 billion dollar bailout. From The Wall Street Journal:

Nowhere is the risk concentrated more heavily than in the Italian banking sector. In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans. Years of lax lending standards left Italian banks ill-prepared when an economic slump sent bankruptcies soaring a few years ago.

Helicopters And Paper Currencies

How confident would you feel about the cash in your wallet if global central banks started making direct payments to households and businesses or simply printing money to retire government debts? The answer may help us understand why investor demand for hard currencies (gold, silver) has increased substantially as more and more serious chatter emerges about fueling up the money-drop helicopters. From CFA Institute:

Why has the post-crisis recovery been so disappointing? … Are we stuck in a world of diminished prospects and subdued demand? These were the key questions Lord Adair Turner, chairman of the Institute for New Economic Thinking and author of Between Debt and the Devil… “Debt has become unsustainable across the world,” Turner explained… “The trouble is,” Turner explained, “once we have these cycles of credit, asset prices, more credit, if we then get a swing from the exuberant upswing to the depressive downswing, if we get that when leverage is already high, we seem to enter an environment where the leverage never actually goes away. All it does is move around the economy.”

Debt is never paid down, in other words. It’s only shifted: from corporate debt to public sector debt, from advanced economies to emerging markets, and so on. Citing both Milton Friedman and Ben Bernanke, Turner proposed “helicopter money,” or what he prefers to call “overt monetary finance of increased fiscal expenditure.”

“You can use central bank money to finance tax cuts or expenditure increases in a fashion that does not require the government to borrow money,” he explained. “Or you can monetize existing government bonds. Central banks can buy existing government bonds and simply write them off, which frees up the government to run larger fiscal deficits in future.”

How Long Will The Prop-Up Approach Work?

Only markets can answer that question. However, history tells us that central banks tend to experience waning effectiveness when economic data begins to hint strongly at a recession (especially a U.S. recession) and/or when inflation starts to become a problem. Given recent economic data in the United States is not warning of an imminent recession, and inflation trends around the globe do not fall into an elevated category, the prop-up asset prices strategies have continued to be respected by the markets (see vertical ascent in stock prices off the Brexit lows).

Buying Bonds Is Not Supposed To Be A Risk-Free Proposition

It may be hard to believe, but there was a time when a poorly run company or country couldn’t make ends meet, they were allowed to default on their debt. When investors buy stocks and invest in bonds, it is not supposed to be a risk-free proposition. Bond defaults are part of the risk-reward equation, or at least they used to be. And yet, we hear more and more policy makers complain about too much debt in the system; maybe they should take a look in their never-ending bailout mirrors.

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The data and image above from the Los Angeles Times (full article here).

Negative Rates Are Sending Common Sense Messages

Interest rates are set in the marketplace based on the supply and demand for money (credit). When rates are near zero or negative, it is the market’s way of saying the demand for new credit is incredibly low relative to the availability of credit. If demand for new credit was high, then lenders would have the power to charge higher interest; they do not have that power today. Zero/negative interest rates are a strong and incredibly clear signal to central banks and policy makers that the “wealth effect” approach has been pushed well beyond its useful life.

We Have Arrived At The End Of Reason

The wealth effect approach has been pushed beyond the bounds of economic common sense, and yet, instead of saying enough is enough, we may be on the verge of becoming very familiar with the term helicopter money. The tweet below from @ReformedBroker sums up just how far off track global central planners have taken the financial markets and global economy.

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A Period Of Asset Price Desperation

Central banks are already buying stock-based ETFs and corporate bonds, as outlined on May 11. When serious talk of dropping money from helicopters and fear of “growth causing a recession” enters the equation, it becomes crystal clear that central banks are on the doorstep of asset price desperation.

What to expect from the stock market this week

A weekly excerpt from the Macro Review analysis sent to subscribers on 10 markets and two timeframes.

Last week’s review of the macro market indicators noted that heading into July Options Expiration week the equity indexes were strong and looking for new highs. Elsewhere looked for Gold ($GLD) to continue higher but perhaps see a short term pullback first, similar to the picture for Crude Oil ($USO). The US Dollar Index ($UUP) looked to continue higher toward the top of the broad consolidation while US Treasuries ($TLT) were set to continue higher but with some caution as they were getting extended short term.

The Shanghai Composite ($ASHR) and Emerging Markets ($EEM) both looked better to the upside in their consolidation ranges. Volatility ($VXX) looked to remain subdued and possibly moving lower keeping the bias higher for the equity index ETF’s $SPY, $IWM and $QQQ. Their charts agreed, with the SPY looking for new all-time highs quickly, the IWM chasing and the QQQ looking to break a range by making a new 2016 high.

The week played out with Gold pulling back lower to its 20 day SMA while Crude Oil started lower but found support and bounced. The US Dollar could not break its flag and continued sideways while Treasuries found trouble and pulled back to their 20 day SMA. The Shanghai Composite jumped higher early in the week and then consolidated while Emerging Markets continued to the upside.

Volatility made a new eleven month low showing an all clear sign. The Equity Index ETF’s all moved higher on the week, with the SPY and QQQ the strongest trends but the IWM’s strong early move outpacing them, before consolidating most of the week. What does this mean for the coming week? Lets look at some charts.

SPY Daily, $SPY

The SPY started the week moving above the June high. As it did so, the RSI on the daily chart moved over 60 into a bullish zone, to complement the rising and bullish MACD. It continued higher Tuesday making a new all-time high close. Wednesday pushed higher but eventually closed slightly lower and Thursday made another all-time high. Friday pushed to new intraday highs over 217 but then fell back in a bearish engulfing candle. If confirmed lower Monday this would signal a reversal. For now the short term trend remains higher though.

On the weekly chart there was a third higher candle, this one with an upper shadow. The Bollinger Bands® are opening to the upside but the price has moved outside of them. Perhaps a small pullback or sideways consolidation is in order. The RSI on this timeframe is now into the bullish zone and making a new higher high as the MACD is rising. 

There is resistance at 217 and a Measured Move to 218.90 off of the July 6th bottom. And a Price Objective on an Inverse Head and Shoulders Pattern to 222.70 with the Head at the June low. Support lower may come at 215 and 214.30 followed by 214 and 213.50 then 211.50 and 210. Uptrend Continues with a Possible Short Term Pause Or Pullback.

SPY Weekly, $SPY

Heading into the next week the equity markets have been strong and may need a short term pause or pullback before resuming higher. Elsewhere Gold may be ready to bounce in its downtrend while Crude Oil also looks like it may be ready to reverse higher. The US Dollar Index is continuing to consolidate with an upward bias while US Treasuries are biased lower in the short run in their uptrend. The Shanghai Composite looks to continue its slow reversal higher as Emerging Markets rise to test the long term resistance zone just above.

Volatility looks to remain below normal levels keeping the bias higher for the equity index ETF’s SPY, IWM and QQQ. Their charts also are biased to the upside in the intermediate timeframe while they consolidate in the shorter timeframe. The SPY looks most vulnerable to a short term pullback followed by the QQQ. Use this information as you prepare for the coming week and trad'em well.

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Journey of Cash

A fascinating debate about equity valuations and the validity of lofty bond prices rages on. Some macro thinkers such as @MarkYusko, while not exactly calling top of the stock market, recommend building a substantial cash position. Their strategy is to wait in order to take advantage of an eventual, inevitable bursting of the equity bubble.

I do not intend to contribute an opinion to whether equities are currently a bubble or not; in fact, I have no opinion to contribute. But assuming some reasonable concern over valuations, cash appears aligned with my own recommendations in Chapter 5 of my book. In that chapter I propose sitting out the bubbles rather than trying to aggressively time them. This strategy avoids the risk of blowing up either on the short or on the long side.

However, it is important to understand that line of reasoning is predicated on the assumption that “cash” is actually SAFE.

For an individual cash has two separate, though interwoven aspects: cash is a means to pay for one’s lifestyle and it is a financial asset.

Those financially less secure will require the safety of cash to meet their immediate needs such as rent or food. If they are fortunate to have some savings they may be concerned that cash may fail to keep up with inflationary pressure, but if they live paycheck to paycheck they must count on the wage inflation.

For the purposes of this post, however, I am using the term ‘cash’ from the perspective of a money manager whose central objective is absolute performance. For such a manager, cash is purely a financial asset.

Managers tend to think of cash as “safe”. They lean on the thinking that when benchmarked to cash, cash will never deliver a negative return which is important both psychologically and in terms of calculating incentive fees. But such benchmarking is somewhat arbitrary: for example if you are benchmarked to gold your safest asset is gold and when you are benchmarked to S&P 500 your safest asset is…And so on.

The very concept of a “risky” asset comes from benchmarking.

While the concept of over/underperformance vs. a benchmark is relative to the choice of benchmark, the absolute performance is unambiguous. And by absolute I mean absolute - weighted by the performance of your base currency. That is a Euro-based asset manager who delivered a 10% return in 2014 still underperformed USD cash on that year. Notice that as incentive fees are calculated in base currency, most money manager wouldn’t currency-weigh their performance.

But if you are a truly global money manager you can think of cash as unsafe in three different ways:

  1. You have base currency risk
  2. You have benchmark risk, i.e. if you are supposed to track a stock index and you stay in cash - well you know what bad things may happen…
  3. You may underperform competitors in terms of returns in base currency

In summary, as a global manager, I view cash as an asset as risky as all others. My goal is absolute performance. While long-only managers can only make a decision to hold or not to hold cash, I have the option to be short or long cash like any other asset.

Indeed, using leverage to go long another financial asset is equivalent to going short cash, while going short an asset is equivalent to going leveraged long cash.

Having established our view of cash as a highly speculative investment, let’s look at how it is has performed.

USD cash was a good place to be invested early in 2008. The dollar index bottomed out in March 2008 and surged over the next year to make a cyclical top in March 2009 - the same month the stock market made its bottom. Over that year, dollar cash beat all stock markets, most commodities, most other currencies, most risky bonds. It only underperformed Treasuries - as one might have expected.

A bubble had formed. Yes the greatest bubble of this millennium (so far) was not Internet-2000, Sunprime-2006 or Bitcoin-2014.

It was Cash-2009.

Panicked, trading chickens who had piled into this cash bubble were brutally punished as recovering asset prices left them behind. How do I know that? Well, somebody had to be my counterparty.

Much of my success in subsequent years was due to recognizing this bubble and following my advice to sit it out. No, I didn’t go short cash. I just rotated my money out of it into the “safe haven” of stocks.

After an initial rebound, I got an additional tailwind as the Fed started to pound on cash by the wave of supply provided by multiple QEs.

Between 2010 and 2014 I gradually realized that the other CB’s will have to follow suit and destroy the value of their own cash. Now it was time to short foreign cash. The One Trade was born.

My version of it was not to be just long Treasuries, but to build leverage funding them in low (and now negative) yielding DM currencies.

The continuing success of that trade has been nothing short of magical.

But, now the question is whether the trade has gone too far and the cash has actually become too cheap?  The question more ambiguous as to whether I mean dollar or RoW cash. Much of the recent underperformance of USD-based mangers can be explained by the fact that they are benchmarked to strongly performing asset: USD.

Thus far my answer was to be slightly less net short cash, i.e. book some profits but still run the core position. Why am I being so stubborn, despite the lofty asset valuations?

When I think of cash as an asset (or even as a commodity?) there is practically no limit to how cheap you can get it by producing more and more of it. And that is what the BoJs and the ECBs of the world have been doing without any sign of stopping so far.

So is their no risk to being long bonds vs. cash? Theoretically there is. Going back to the duality of cash we have discussed earlier, cash can cheapen in two different ways:

  • Against real goods and services
  • Against financial assets

So far we are only seeing the latter in DM. The former is called inflation and when it arrives some financial assets may do even worse than cash. Paradoxically, in the event of an inflation scare, cash is historically the place to be as the DM CBs tend to protect it by raising rates and keeping its total return positive. Negative real interest rates are typically a product of a deflationary environment.

My central thesis is that secular automatization and globalization still channel excess cash into the asset rather than goods prices. But cyclical inflationary forces are not to be disregarded out of hand.

The case for cash is not proven, but it needs to be heard.