Timing the top.

Kobe Bryant

Kobe Bryant

The challenge of a life time. Now I know how Kobe Bryant feels, when his teammates hand him the ball with just a few seconds left on the shot clock. With no time left to create a better choice, he just has to get lucky on a miracle shot.  Financially speaking, after years of market manipulation -if not outright deception- by central banks, it’s really now, or never. Last chance to make big money with this new, last super bubble of the lot.

Oh yes, there will be a market after this top, but it will be an illiquid one, with limited chances of making big money. Cleaning up this credit bubble is going to take a long, long time. This next top is, as Warren Buffet would put it, the fat pitch we should have been waiting for. I know most batters have been swinging at pitches lately, and they made money with this market in the interim. Good for them; but I disagree with the risk-reward targeted. Risk didn´t materialize, but it was there all the time. Unlike in baseball, there is no penalty for being patient in investing. As I grow old, my patience improves daily. Nothing else does.

This top is going to be “the mother of all tops”. And it will come, as sure as night follows day. It is keeping me awake some very long nights. As Herb Stein stated,“If something cannot go on forever, it will stop.” ¿When? In order to get the three points from the Kobe Bryant last nanosecond shot (make money shorting the next market top), we need luck, and even then, a lot of aspects around the trade have to be perfect.  Two elements have to be right: precise timing, and determining if the first top will be in bonds, or stocks.

Of course, all aspects to consider, interact between themselves, in order to make things as complex as possible. The market is a bitch. First and foremost, precise timing is crucial. A correct predefinition of the macro aggregates to watch, simplifies the problem enormously (if correct!). Then there is noise to account for, and behavioral market player considerations. The POMO desks of the Central Banks manipulating everything they can, as much as they can, for as long as possible, are also to be considered. And it’s a dog fight. It will be their last stand in the current credit expansion.

I am certain that the timing will be related to global money supply and credit growth, or credit risk spread considerations, and much less so, to central bank interest rate hikes. That means we can focus on monetary aggregates, and forget about qualitative, traditional, interest rate tightening by the central banks. It is reasonably safe to assume that short term interest rate levels will only be brought up voluntarily, well after the monetary expansion is finished. There will be a time lag in all currencies, between the end of QE, and abandoning ZIRP or NIRP.  If we wait for interest rates to move, by then it will be too late to implement a short strategy. I know it is not the market view. With all respect for Andrew Garthwaite and his team, this is what they wrote on a first of August report:

“Markets have not peaked more than 5 months prior to the first rate rise, which would imply possible market turbulence around year-end. We would also note that markets peaked a month after the end of QE1 and QE2 which, with QE set to end in October, would also suggest a more troubling time for markets toward the end of Q4.”

It’s not that I disagree with that possible outcome. I simply think it will be too late to opt out by then. Why “stick with it” (remain fully invested) for a modest “year end target of 2020 for the SP500”, with substantial downside risk?

The general view is that it is important to determine if “Yellen et al” will hike interest rates in Q1 of 2015, or it will be in the second or third quarter. I think it is irrelevant. Money growth will have shown us the way long before that happens. And I don’t want to fool around trying to time the last few weeks of life for the bull. Too risky for my age. I prefer to fully enjoy the María Callas complete remastered edition by Warner Classics, coming out on september 22 (69 CD’s). I need to be relaxed in order to do so.

So money supply growth is the pivotal factor. Regardless of where it takes place, if it is a convertible, systemic currency. There can be money growth in any of the wide monetary aggregates in USD, JPY, EUR or CNY. Even sterling could help (I very much doubt it right now). Global liquidity is what sustains super-high Schiller CAPE’s in equity markets. ZIRP helps, but money supply is the driver.

US equities sport an eye-catching schiller PE of 26.46. And profits are heavily biased by massive government deficits via de Kalecki profits equation!

US equities sport an eye-catching schiller PE of 26.46. And profits are heavily biased by massive government deficits via de Kalecki profits equation!

It’s not easy to add up all the global liquidity curves, but that is exactly what we have to do. Details are messy. To begin with the fact that Chinese monetary aggregates are as reliable as a social media news tip. And they are largely relevant. We have to live with that. Statistics incorporate their own noise and lags, and, when you include China, their own lies as well.

The second variable that counts, is determining if it will be an equity top that rolls over to credit markets, or the other way around. Equities will only fall with money supply, because they are perceived as the only game in town. Steepness of the curve (duration risk), and credit risk spreads are an entirely different animal. They don’t have to be coincident with a substantial reduction of monetary growth.

Interest rate curve would steepen mostly related to inflation expectations. Increased risk aversion also affects duration pricing, but markedly less so. Inflation is still a long term worry, and I can’t see inflation surging in the foreseeable future. If it does appear, it will be in China or the US. That leaves curve steepening as the less likely factor. Actually, curves have been flattening over the last couple of months, after the 2013 scare. I don’t think inflationary expectations will be the leading indicator for the next market top.

Credit spread widening is linked to behavioral factors. The credit cycle is of course the relevant issue long term. But it is market perception of risk that leads the way initially. Risk perception is an issue that could be brought up by the market any time. In fact it already has.

If this scenario continues to play out, base money pricing would remain constant, but available financial costs would soar for the weakest credit quality. The problem would be contained initially, affecting only the weakest credit, and then, ultimately, escalate out of control. Remember subprime mortgages? They were the credit quality tip of the iceberg. Junk bonds could be the canary in the coal mine at this time. Sovereigns would come later. Corporate bond pricing would suffer last. You know the quote:  history doesn’t repeat itself, but it does rhyme.

¿What happens next: interest credit spreads shoot up; or money supply and credit growth stalls (it is reduced to a normal nominal GDP growth figure) before that?

If central bank money expansion/credit expansion is brought to an end, and money velocity doesn’t pick up the tab, it will be a global equity top. Safe bonds and monetary instruments would be well bid in this scenario. Risk spreads would go up consequentially, but probably would not be the leading market to use for timing purposes. It will not take much of a tightening in liquidity conditions to tip the markets lower. US equity is pricing in the best of the best escenarios.

Stock prices are already above the level implied by the total base money at the end of Q3 (in october). www.zerohedge.com

Stock prices are already above the level implied by the total base money at the end of Q3 (in october).

And it is also overbought to a large degree. Just take a close look at the following chart.

Chart courtesy of Doug Short at advisorperspectives.com

Chart courtesy of Doug Short at advisorperspectives.com

If central bank coordinated money expansion continues unabated, with simple geographic adjustments, the low credit rating (junk) bond top, or a major, sovereign, credit risk event, will likely precede the equity top. And, most likely,  we have to wait longer. Or not that long. You want to be wary when you see a chart like this. Again, history doesn’t repeat itself, but it does rhyme.

Effective yield of the Merrill US high yield master II index – currently at 5.5%. Similar levels of return-free risk were on offer in 2005-2007. www.acting-man.com

Effective yield of the Merrill US high yield master II index – currently at 5.5%. Similar levels of return-free risk were on offer in 2005-2007.

If all this reasoning is accurate, we have to monitor three factors closely:

1. Economic growth. Nominal GDP growth, globally, and individually on a per country basis, is what supports the fallacy of public debt sustainability. Particularly in the context of substantial public net debt generation taking place in some of the most heavily indebted countries: Japan, France, Italy, Spain, Portugal… If the general public comes to the conclusion debt is unsustainable, it is “the end”. It is vital that everybody continues to believe the emperor is not naked.

Global debt has to be felt as sustainable, and because debt is always measured in relative terms (as a percentage of GDP), nominal growth of the denominator is essential. Not exactly what’s happening in Europe today. Market complacency is high. Be well aware that, in the meantime, Central Banks will try to buy growth at all costs.

China’s eventual hard-landing, and the euro area, are the main areas to watch. China’s growth has lost sensitivity to credit expansion. They need enormous credit growth to support economic stability. Reforms are difficult to implement, and will take time. Their macroeconomic situation is highly unstable.

If Europe doesn’t grow, we have a serious problem brewing as well. To a lesser extent, we should keep an eye on the economic stability of Japan.

2. Individual, systemic-country stability, is also a must. Not only the global economy has to continue to evolve steadily, but individual relevant country stability is a requirement as well. Argentina was well discounted by the markets. It´s default is not big enough. No shock and awe there.  Other cases are not priced in the cards. If, by any chance, a systemic country comes to a point where it cannot make ends meet, and cannot service its debt load, it is also “the end”.

Europe is the leading candidate for a run on an individual country’s bond markets. Japan could easily get itself into trouble if they lose control of the ten year interest rates (now below 50 bps). Money printing in Japan is a double edged sword, they have to be careful.

3. Money supply growth. We know by now, that the US is done with Q Eternity. We’ve seen this coming for months (I personally think it was the price payed to Congress for their support to the dovish Yellen nomination). Japan continues to print, but they are closer to the end than the beginning. The wild cards are China, were we really do not know what’s going on, and the ECB.

As I said, China is more a global economic stability consideration, than a money growth concern. Nevertheless Chinese credit growth counts in the global picture, because the amounts involved are enormous. A yuan depreciation would be highly destabilizing. We have to remain vigilant on Chinese credit figures, as false as they may be.

Europe is where the main money growth action is to be found. ¿Will super Mario provide some action to back his words? Probably, that is, unless European growth suddenly picks up again. ¿Will it be enough? Probably not. I can’t see the ECB on a full scale QEternity, and I think anything short of that will not make the grade.

After all the macro thinking, and last but not least, we have to use all our trading capabilities in order to hit a home run. Sizing the shorts correctly, scaling the entry level, using stop loss GTC orders, and assuming we will have to spend some money in a couple of losing trades, before we get the big one set up and running. Soros is looking at it differently. He has implemented a long put strategy in size. Timing is tough and he knows it. Time decay is his price to pay. But his window of opportunity is larger.

And while it would be expensive to be early, you just can’t be late for this show. If you are, much like in an Opera performance, they won’t let you in until the third act. John Hussman explains why succinctly:

“…it’s helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, … is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. 

Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all.

We have to be both patient, and emotionally resilient. As George Orwell once said, it is the anvil that breaks the hammer. It is not going to be easy. This is the mother of all trades. The alternative is: “stand aside and look”. But you only live once: be as nimble as you want to be, but you have to give it a go.