'No One Could Have Seen It Coming'

by: Acting Man

Leon Black is selling, but speculators aren't seeing things his way.

That the memories of investors are rather short was already clear in 2007. Evidently, nothing has changed. Dispensing a bit of biblical wisdom last week, Apollo's Leon Black remarked:

"It's almost biblical. There is a time to reap and there's a time to sow," Leon Black, chairman and chief executive of Apollo Global Management declared to the Milken Institute's global conference in Los Angeles, alluding to that same Scriptural passage. "We are harvesting," he added pointedly.

That is, the private-equity giant is a net seller because things simply can't get much better. "We think it's a fabulous environment to be selling," he says, noting Apollo has sold about $13 billion in assets in the past 15 months. "We're selling everything that's not nailed down. And if we're not selling, we're refinancing."

That's because there has never been such a good time to borrow - which is raising warning flags for Black. "The financing market is as good as we have ever seen it. It's back to 2007 levels. There is no institutional memory," he observed, referring to the peak of the last credit bubble. That was when then-Citigroup CEO Chuck Prince famously said that as long as the music was playing, bankers had to keep dancing - which they did, with disastrous consequences when the band stopped."

(emphasis added)

Admittedly, there are two major differences between 2007 and today. In 2007, money supply growth in both the U.S. and the euro area had been in the low single digits for two years already. Both the Fed and the ECB had been raising interest rates in baby steps for three years and in the course of 2007, numerous warning shots were fired - beginning with the bankruptcies of subprime lenders in February, and then moving on to the difficulties experienced by a Bear Stearns hedge fund invested in CDOs (collateralized debt obligations) in the summer, followed by growing convulsions in interbank markets and the first injections of emergency liquidity by the ECB in the fall. The mood was still oddly upbeat in many quarters (people like Ben Bernanke and Hank Paulson supplied us with immortal quotes like 'the sub-prime crisis is well contained' and 'the U.S. banking system has never been healthier than today'). However, it wasn't too difficult to see that big trouble was on its way.

This time around, money supply growth remains fairly brisk, rate hikes are far from everybody's mind (the ECB even ponders 'negative rates' on its deposit facility) and the nature of the echo bubble is more diffuse - there is no particular sector of the economy that is standing out as the center of the bubble and very few clear warnings are in sight.

In fact, the environment is now held to be so ideal - especially for the U.S. stock market - that it can probably only get worse. Leaving aside for a moment that about half of the developed world is in recession and the rest isn't exactly brimming with growth, for stocks, the environment has proved quite positive. On the one hand things aren't bad enough to derail corporate earnings too much (not yet, anyway), on the other hand they aren't so great as to give the central bank ideas about stopping its monetary pumping. The debt crisis in Europe looks like it has gone into prolonged hibernation. As a bonus, commodity prices haven't been going anywhere lately due to growing worries about China. This is probably a good summary of the bullish argument (we'll leave out some of the more far out ideas like 'stocks are cheap'. The assessment of valuation cannot be simplistically reduced to the current trailing or 'forward' p/e and their relation to the historical mean).

Perceptions, Sentiment and Positioning

It would probably be best to state that it is the current perception that this represents an ideal environment for stocks. So far the hugely one-sided bets by speculators have been rewarded quite handsomely. And contrary to Leon Black, who is selling precisely because things are seemingly going so well, speculators are setting new records in bullish positioning. Last week's commitments of traders report on stock index futures has set a stunning new record - hand in hand with a new all time high in NYSE margin debt.

Funny enough, we keep hearing from a number of sources that 'sentiment is still bearish'. Really? Do bearish traders bet record amounts of money on a continuation of the rally? For instance, Laszlo Birinyi just increased his SPX target to 1900 points, and opined that "this year's bull market most resembles the patterns etched in 1982 and 1990, suggesting another 20% of upside. In addition to the historical parallels, we still view sentiment as subdued and nowhere approaching extremes."

Never mind that the current market has precisely nothing in common with 1982 or 1990 (the fact that rates are at zero and the Fed is printing $85 billion every month seems to be a decisive difference). The year 1982 followed on the heels of a major liquidation of malinvested capital in the U.S. economy. Interest rates were very high at the time, and the Fed decided to finally begin lowering them in August of 1982. Sound fundamentals and extremely low market valuations met with a beginning downtrend of very high administered interest rates. This is so unlike today's situation that it is really difficult to see on what basis anyone would feel compelled to assert that the two time periods are in any way similar.

In addition to that, we are really wondering what exactly Birinyi (and several others) would regard as 'sentiment extremes'. If margin debt sitting at a record high is not an expression of extreme bullish sentiment, then what is it? If a near record low in mutual fund cash relative to assets is not an expression of extreme bullish sentiment among fund managers, then what does it signify? Record high inflows into stock mutual funds are telling us what? That investors are bearish? A record high in the Barron's big money poll's bullish consensus on equities, with a full 96% of the money managers surveyed declaring themselves 'bullish on stocks for the next five years' is not an 'extreme'?

Take a look at the net commercial hedger position in all stock index futures combined (which is the obverse of the net speculative position):


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The net commercial hedger position in all stock index futures combined (inversely plotted) is now at a record dollar value of $55 billion net short. In other words, speculators hold a record net long position valued at $55 billion. Nothing can possibly go wrong.

A few things have to be said about that. Speculators buying index futures are obviously trend followers, and since the trend remains their friend, they will be right until they aren't anymore. By definition, a market top can only happen once, and the market's price action - apart from a number of momentum divergences (price/RSI, price/MACD) - isn't yet doing anything that says that that the trend may have ended. These momentum divergences are illustrated below:

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The SPX vs. RSI and MACD - so far a string of divergences has not stopped the advance - but the divergences continue to persist.

Moreover, what usually happens is that indicators of positioning and sentiment also diverge from prices in the vicinity of major tops (one might e.g. see a lower price peak accompanied by an even bigger speculative net long position, or vice versa, a higher price peak accompanied by a lower high in the total net long position). Therefore timing a reversal remains a tricky proposition. Joining the herd is however just as tricky and definitely entails major risk.

Also, we have seen in the past several years that sentiment and positioning extremes have become far more frequent and far larger than anything that has been seen before in stock market history - to apparently no ill effect. So far, that is. As an example, consider the chart of the Hulbert Nasdaq sentiment indicator, which has already bested its record high from March 2000 twice in a row this year - and yet, prices have continued to advance (as an aside, this sentiment index does currently diverge from prices):

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By almost reaching the 100 level, the Hulbert index of Nasdaq advisor sentiment has produced two new all time record highs in net bullishness this year already.

We could provide a great many more charts of this sort. By our count, at least 20 different sentiment and positioning indicators have either produced new record highs in the bullish consensus or have risen to within a hair's breadth of their previous record highs over the past 12 months (they haven't all reached peaks at the same time). Whatever else one might say about this market, it is simply impossible to assert that there is 'skepticism' or that "sentiment is subdued and nowhere approaching extremes". That is just complete nonsense. What can be argued about is only "when will it matter", and "what will happen when it finally does".

The Major Weakness in the Consensus Case

There is a major error on which the consensus is based. It is no doubt true that the central bank can blow bubbles of increasing magnitude, which are invariably followed by ever more severe busts. The error is in the belief that central bank intervention can actually restore economic growth. It can do no such thing. It can, for a time, goose 'economic activity' as measured by various aggregation type statistics. This is not the equivalent to genuine wealth accumulation or a genuinely progressing economy.

While creating 'activity', the policy concurrently distorts the entire price structure, and thereby falsifies economic calculation. The profits reported by corporations are largely an inflationary illusion. In reality, they tend to mask a great deal of capital consumption. We know this must be the case even if we don't delve into the details (as we have frequently done in these pages). It is an inevitable outcome of an inflationary policy and the suppression of interest rates below the natural rate dictated by time preferences. Sooner or later a crisis must result, even if we can at this point not yet forecast the precise timing or precise shape of the crisis.

Monetary pumping cannot create wealth - it can only redistribute resources, as a rule away from true wealth-generating activities into what one could term 'bubble activities' - investment lines that will ultimately turn out to represent capital misallocations, the very existence of which crucially depends on a continuation and constant acceleration of the inflationary policy.

However, this should not be taken to mean that there is no limit if the central bank simply continues to inflate ever faster 'forever'. The limit is given by the fact that the real savings that are required to fund this diversion of resources into bubble activities are not large enough to support all or even most of them forever. In addition, this pool of savings is continually damaged further by the overconsumption phenomenon that invariably accompanies the boom period. Many people wrongly assume that the central problem of the boom is 'too much' investment (the term 'overinvestment' is usually employed to describe this process). However, this is a logical impossibility, due to the limitations imposed by the pool of real savings. Rather, it is malinvestment, i.e., investment in the wrong lines, that is the problem. Reality can be 'papered over' for a long time, especially in a rich, developed economy. But it cannot be held at bay indefinitely.

Conclusion:

It is obvious that the effects of the inflationary policy on prices is currently expressing itself mainly in stocks and other 'risk assets', such as high yield bonds. At the same time, the economy is structurally weakening underneath the distorted picture painted by aggregate economic statistics and reported corporate profits, all of which are goosed artificially by a massive inflation of the money supply. Ultimately these profits will turn out to have been illusions. Moreover, we have evidence that speculators in the stock market are for the most part sitting on the same side of the boat and have done so for a good while already.

Although it is unknowable when the turning point will arrive, this is a situation that becomes ever more dangerous the longer it continues. Once perceptions change, a great many people will try to to leave the party all at once through what will then appear to be a very small exit.

Thereafter we will be told that "no one could have seen it coming".

Charts by: Sentimentrader, StockCharts