Saturday, September 22, 2012

Mass Complacency @Max Risk

This (Brief) Suspension of Reality Sponsored By Global Central Banks, iPhoney5, ESPN, South Park and The Kardashians.

The Policy of "Extend and Pretend" Employed Since 2008 Is Merely a Faustian Bargain - The Bill Is Past Due, But We Seem To Have Conveniently Forgotten Our Side of the Bargain

How Much Will It Cost:   How Much Do We Have...

The VIX Options Volatility (Fear) Gauge:  
Fear has left the building (far right) - back down to the same level it was at the market's all time high in October 2007.  The major spike up is the 2008 Lehman crisis.



Never Cry Brown Swan Event
As anyone can see from the title of this blog, my core prediction is that a market collapse is inevitable and imminent.  Some would say that it's a cop out to say this could occur at "any time" without being more specific.  However, in fairness to me, predicting the collapse of the global economy down to the last minute is essentially an impossible task.  Some would say that it's a fool's errand to make such an attempt at all, but my primary assertion is that the risks at this juncture far outweigh the rewards and it's better to be prepared in advance.  Bear in mind however, that this risk:reward posture is the exact opposite of what global central banks want people to believe.  They need people to believe that rewards far outweigh risks so that they can stimulate the "animal spirits", levitate the markets, and thereby invoke the "trickle down" wealth effect wherein the minority of wealthy people who still own assets buy their baubles and otherwise shower bread crumbs on the masses.

Business As Usual
Coming out of the 2008 debacle, or what I call the "test", I fairly quickly became bearish again on the economy and markets, because it was clear that all policy-makers had done after 2008, was a massive damage control operation which merely papered over (literally) the underlying problems.  As we all know, amazingly there have been no major structural changes to the markets in the intervening period and they haven't even put in place the Volcker Rule to prevent banks from speculating with depositor money.  Also, as we know, certain banks took the opportunity to become even larger - and therefore "Too Bigger To Fail".    The definition of insanity is to keep doing the same (stupid) things over and over again, expecting a different result.

Time is Not On The Side of Comfort Seekers Hiding From Reality
Therefore, I have viewed the passage of time to be a major liability for the global markets because 1) it was allowing the underlying imbalances (speculation, carry trades, debt accumulation etc.) to resume their upward trend again - which they have and 2) because it would lead to an overwhelming widespread complacency in the markets, media and public that somehow all of the underlying issues have been resolved.  As I commented recently, there is nothing like a rising stock market to make everyone feel fat and happy, obviously disproportionately so those who actually gain from the rise in wealth.  Just the fact that the European debt crisis has magically disappeared from headlines in recent weeks - despite the fact that there has been no underlying structural changes made to the over-leveraged nature of the debt impaired economies - is Exhibit A of complacency at this juncture.  

Exhibit B is the VIX chart above which shows that stock market (options VIX) volatility is back down to a level last seen at the all time stock market high in 2007.  And it has revisited this level several times in the past few weeks.  Could it go lower?  Certainly, but the all time low in the past fifteen years was ~10 whereas the high was ~80.  So according to the VIX we have about 4 more points of anxiety easing potential, versus 65+ points of "oh shit, not again !" potential.

Massive Dopium - What Could Go Wrong?
I will spare you my usual diatribe, but I have littered this blog with posts indicating that the amount of fiscal and monetary stimulus being applied is unprecedented in U.S. and World history.  So the analogy I would give of the world economy is that of a morbidly ill patient whose sole rehabilitation program involves ever-larger doses of morphine to mask the underlying deteriorating condition.  How else can we look at it?  Should we assume that adding more 'easy money' to the world economy will incentivize less borrowing and otherwise resolve the underlying debt problem?

Dude, Where's My Market?
Another key reason for concern at this juncture is the fact that the markets due to the overwhelming takeover by High Frequency Trading (HFT) computers, are in a very fragile state.  The prices that exist today in an extremely low volume environment dominated by HFT bots trading back and forth with each other on millisecond boundaries, are not necessarily the prices that will exist when motivated real sellers come to the market with large blocks of stock to sell.  As we found out during the 2010 Flash Crash, the "market" as it were, disappeared rather abruptly.  

BTFD - So Says Don Hays
For those looking for a good counterpoint argument to my bearish thesis, this is your lucky week.  Yesterday, Don Hays, one of the most respected market advisors, gave some (very rare) free advice.  He sees the market having 10% (max) near-term downside with 30% upside thereafter i.e. a new all time high in the markets within 12 months.  Most people on Wall Street subscribe to Don Hays' advisory so you can assume that what he said yesterday has already been fully digested by Wall Street.  Also, a 10% downside, 30% upside scenario is IDEAL from the hedge fund perspective.  First, it gives some initial downside which they can use to monetize their hedges and thereby gain a relative edge on the underlying market.  At that point, being freed of the hedges, they take the 30% rocket ride higher into year end BIG BONUS time.  Perfect.

The End of the World Only Comes Once - And You Can't Make Any Money Off Of It
Before I rebut his thesis, keep the most important factoid in mind, which is that when it comes to the markets, the media takes its cue from Wall Street who in turn pay these advisory services like Don Hays for their market advice.  Wall Street's time horizon is the current bonus season (i.e. 3 months) and as ZeroHedge just indicated, due to this year's unusual Central Bank induced head fakes and sector rotations, The Street is now fighting for its own survival.  Therefore, they are only tuned into those strategies that can make the most amount of money in the least amount of time and tuned out to the larger macro risk hanging over the world economy like a Damocles Sword.  So unlike 2007 when everyone on Wall Street had a plan on how to profit from the demise of subprime, today despite macro risks which are 10x higher, no one has a macro-based profit plan and hence are oblivious to the risk.

Don Hays' main bull thesis is based on monetary stimulus, market sentiment and valuation.  

1) Monetary Stimulus - my rebuttal on this one is above i.e. prescribing more of the same "go juice" that got us into this mess, is at best a short-term strategy that will inevitably end catastrophically.  What better proof that Central Banks have these people conditioned like Pavlov's Dog to reflexively salivate whenever stimulus is added. 

2) Valuation - as in earnings relative to stock prices.  These valuations are predicated on earnings estimates which can change at a moment's notice.  Market strategists base their market predictions on earnings predictions; however, when the market tanks, they just revise down their earnings projections in light of new "economic conditions" i.e. it's a circular reference.  Meanwhile, profit margins are at their highest point in U.S. history so to assume stocks are "cheap" is to assume that profits are not mean reverting, which (un)fortunately, they are.

3) Sentiment - I just showed in the chart above that market sentiment is extremely complacent and he somewhat agrees.  However, he thinks that one little spike in anxiety will be enough to engender another run higher in the markets.  His fatal error is using the past 50 years of data as his baseline which includes the largest artificially inflated economic expansion in human history, without any comparison.  Suffice to say, that when the real buying opportunity arrives, few people will have the capital and fewer still will have the desire to own stocks.