The crux of the matter

“Every time the economy stops slowing or contracting, people seem to become irrationally hopeful that means something truly radical and positive even though all experience since 2007 has demonstrated that there actually is no rational basis for that hope. The road to Japanification is surely paved with so much disbelief. It’s completely understandable in a sense since it has been almost eight years of all the “experts” constantly claiming that things were definitely going to get better.”

Jeffrey P. Snider

So much for the Hopium apex of H1 2017. Hope has never been a viable investment strategy, and if you base ten investment decisions on hope, on average you are going to turn out as a loser. But if you do it just once, maybe you can pull it off. Not because hope helped your chances of success (it sure didn’t), but because what you were hoping for just happened.

So right now, this is a binary risk. Like tossing a coin for heads or tails. After ten years extending and pretending (in fact a couple more if you take into account some pre-GFC central bank practices), we are about to find out which side of the intellectual divide of our economics profession got it right. Can we reignite a credit cycle without cleaning up the previous excess, or is it correct to state that Japanification is our course, and no sustainable recovery can take place in this context?

Everything I read or hear points to a state of mind where investors have decided that the time has come for an economic take off after the crisis. This must be it, everybody thinks. Yeah, lots of risks looming, but experience has taught them that BTFD is the thing to do. Central Banks will prevail. And it has unsurprisingly become a self-fulfilling, self-reinforcing, prophecy. Investors keep on buying the tiniest dip in spite of nuclear war threats, or even a couple of FOMC members coming out “en masse” to suggest that the time has come for the Fed to shrink its balance sheet. Nothing can stop this train.

Monetary Policy started this last tranche of the bubble (the “everything bubble”) when credit growth flopped in 2007. Ironically, this last 2017 bull market blow off comes at a time when monetary policy is being accepted as nearly exhausted everywhere. Isolated and pretentious as they are, even CB politburo members have begun to realize the long-term dangers of shoring up monetary and credit aggregates. Not only The Fed openly suggests it is going to reduce its balance sheet, but the Dutch parliament gives Draghi a warm welcome with a beautiful tulip -to remind him of one of the best bubbles of all times. Very subtle. I’ve got more examples, but I feel these two suffice. Confidence in monetary policy has declined markedly, at least in academia.

Nevertheless, we Austrian economists are all discredited by now. Some very respected names are in deep trouble for failing to join the mob in their indiscriminate buying. Case in point, this is personally a year to forget. At some point, CBs were going to hit me too. One after the other, we are all failing to keep up with ETFs and long only’s. Why should investors trust us? The best thing you can underline about our thesis is that it sounds good, even makes sense, but is not surviving confrontation with reality. Sooner or later, we are all ending up behind the curve.

Long only active managers are doing a lot better, but not well enough. QE has been a killer of alpha generation (chart via Zerohedge). The clear winner is the ETF. To paraphrase Buffet, I think they are, if not weapons of, at least vehicles for, mass destruction. Less powerful than the 500 trillion in derivatives now trading in the global markets, but certainly more far reaching. At least derivatives are traded by professionals. People buying ETFs don’t have a clue of the risks they are undertaking. They are destroying the markets, and they will bankrupt themselves.

“A single percentage point increase in ETF ownership has demonstrable effects on an individual stock, the researchers found. Over the ensuing year, correlation to the share’s industry group and the broader market ticks up 9 percent, while the relationship between its price and future earnings falls 14 percent. Meanwhile, bid-ask spreads rise 1.6 percent and absolute returns grow 2 percent.”

Doron Israeli, Charles Lee and Suhas Sridharan, researchers at Stanford University, Emory University and the Interdisciplinary Center of Herzliya in Israel.

On a positive note, I find something to like about this state of affairs. My strong perception is that this long credit cycle, stretched and supported by monetary base growth almost everywhere, is about to end. If we do take off into a new cycle, following the reflation narrative, we Austrian economists must accept defeat and assume we were wrong. The world must look for help in a different direction. If we don’t take off, the recession that ensues will wipe out more than half of the false wealth effect embedded in current market pricing. Maybe a lot more than a half! A full repricing of asset values will be well on its way by the time hopium is gone for good. One way or another we are near the end. Thank God.

If it sounds philosophical and detached from market reality, it is meant to be. After lots of hours reading, working on the macro, visualizing charts, and checking inconsistencies in the system, you realize this is a major turn point in history. Ray Dalio, pressed for a sentence in which to combine what he thinks is going on, says that the short term looks good, but the long term does not.

To put it another way, it is not a matter of short versus long term but stability breeding instability. The surface looks as stable as ever, but underneath we have a volcanic substrate. Regardless of apparently calm waters (US VIX below 11, European VIX below 14), the global economy is not in equilibrium -and asset pricing is a fantasy. Examples are everywhere. European high-yield returns less than 3%! That is not investing: it is gambling.

I always end up talking about valuations. They never seem to matter anymore. Europe, the last fad, is no longer cheap relative to the US, and the US is outrageously expensive. Japan is the only relatively cheap market left, and not without some serious risks. I like the valuation criteria in the following charts because you can’t manipulate those ratios playing games with leverage to increase ROE, or using non-GAAP operating earnings in your P&L statement.

Markets are priced for more than perfection, not just today but fifty years ahead. If we fail to reflate this last time, it is going to be bad. Why? Because we have been “selling” this reflationary outcome to investors, for nearly a decade now. After more than a few false dawns, the general public, fed up with the situation, has taken one of two routes. The “have-nots” have embraced populism. The “haves” have signed up for Keynesianism and Central Banking. Both sides are in fact engaging in a planetary exercise of wishful groupthink. For some, it is populism that will save the day. For others, it is Central Bank priests that will help them preserve their status in society. Both are wrong.

Entitlement driven stability and protectionism, are not the solution. And a credit and money growth driven perpetuation of the model is not going to work. We will soon find out. In the meantime, we naysayers are going to have a hard time.

“The real tragedy of our life is not that someone else is getting richer or healthier than us, but that he is getting there faster than us. (…) 

This habit of unintelligently buying things because someone else is making fast money on them comes to the fore when the markets have been rising for some time. (…)

But if you can’t ignore and avoid the temptation that comes from watching other people get rich due to a sharp rise in stock prices, it’s best to know sooner than later that that’s often a path to destruction.”

Vishal Khandelwal (hat tip: Lance Roberts)

It is not just my point of view. Professionals are increasingly skeptical about the sustainability of market valuations. This last tranche of the bull market is being driven by individual investors. An ominous event. They are always the last to join the party.

In my last post, I elaborated on the three central risks for this cycle: a strong dollar, inflation, or a recession. The first of them has been well taken care of by CBs -helped by the time lag between the US economic cycle and the rest. The US is cooling well before Europe and Japan. A sudden, harsh turnaround is unlikely. I hedged 85% of my EURUSD risks a couple of weeks ago.

Inflation seems to be taking care of itself. Aggregate demand is too weak to support cost increases in pricing. Nevertheless, cost pressures subsist, and somebody has to pay for that. If inflation does not go up (it looks as if it won’t), then it will be margins or disposable income that suffer. Both ways, not good for the economy. But not a game changer.

A global recession is looking more and more likely. Credit impulse is the life of this global economy, and China has some frightening figures showing up in that area. The importance of Chinese credit growth cannot be overstated. China is crucial for the cycle and, on its own, as a tail risk.

It is too early to say. Central banks might have the upper hand once again. The PBOC will do anything if needed to stabilize the country before the Communist Party meeting this fall. They are powerful. But the credit cycle is in its last stages in the US and China, and Draghi is running out of options to prolong QE much more. We live interesting times.