"You've been living in a dream world, Neo. This is the world as it exists today. Welcome to the Desert … of the Real."
- Morpheus, "The Matrix"
There is a scene in The Matrix (1999) where Neo gets his mind blown. Morpheus shows Neo he has been living in an artificially constructed dream world. This realization sends Neo into shock, nearly killing him, before he comes to grips with it.
In similar fashion, for the past few years investors have been living in their own blissful alternate reality whose architects were not sentient machines, but central bankers. Endless rounds of QE (quantitative easing), ZIRP (zero interest rate policy), and various stimulus policies have allowed risk assets to levitate far above a barren and blasted economic landscape.
The "Real" world, in which Western economies continue to stagnate (or flirt with outright recession) … where unemployment remains sticky, record high corporate profit margins (built on cost-cutting) are vulnerable, and deflation is a still-persistent threat even as emerging markets break down … is a Matrix-like dystopia for long only investors.
Last week, the dream world finally short-circuited … as the "Desert of the Real" loomed into view …
A Sentiment Tipping Point
In his June 19th policy statement, Ben Bernanke did not mean to crush anyone's hopes. The Federal Reserve was no doubt surprised - shocked even - at the ferocity of the market's response.
The mini-meltdown was in part driven by external factors: In hinting at tapering, Bernanke failed to account for a China SHIBOR shock and concentrated ETF selling, two elements we will address shortly.
In our opinion, though, the real driver behind last week's carnage (with, China etc., as an amplifier) was a tipping point change in sentiment. Investors responded as if awoken from a pleasant dream, only to contemplate a nightmare world waiting for them (relative to the bliss now left behind).
This excerpt from "The Philosopher," a multi-billion-dollar hedge fund manager quoted in Invisible Hands, captures the dynamic superbly:
Although beliefs tend to be driven by fundamentals, people and markets are very slow to fully incorporate macro information, and when they do the results can be overly dramatic. The uncertain nature of the economic future and our flawed attempts to understand it are a permanent source of market mispricing. The economy is not easily predictable, but the reactions of policy makers and the persistent errors in human expectations are. The natural extension of Keynes' beauty contest is that animal spirits are not irrational and because they are not irrational they can be anticipated. To illustrate this idea let's imagine there are two states of the world, and although each is quite reasonable, one is more likely than the other. Unfortunately, the human brain is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Such shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.
Hence confusion on the part of market observers. The Fed's stance did not change all that much … and tapering will not come for a while if it gets here at all … so why did markets panic?
Because the mind's eye vision changed … from endless bids and central bank support (the old world) to the Desert of the Real …
But it wasn't just BB showing glimmers of a dystopian future. It was China too. Here is a quick analysis roundup - we remain short iShares China 25 Index Fund (FXI):
- China Signals More Inaction on Credit (WSJ)
- China's Bonfire of Liquidities Claims First Victim (BreakingViews)
- PBOC Breaks Silence on China Cash Crunch (Financial Times)
- China's Economy is Freezing Up … (Washington Post)
- China's banks: The SHIBOR Shock (Economist)
- Shadow Banking Behind China's Cash Crunch (NYT)
It is widely agreed upon that China's SHIBOR spike and liquidity crisis were artificially induced - a result of deliberate policy implementation by the PBOC (People's Bank of China).
But this provides scant comfort, because we don't know what problems remain beneath the surface. If shadow banking excesses were bad enough to warrant a PBOC response this harsh, how bad is the real problem?
In September of last year we argued that China could be the Biggest Malinvestment Case of All Time. All of that analysis still stands. In terms of timing windows as related to macro crisis, six to twelve months is a mere blip. You never know for certain when the biggest dominoes of all will fall. Now Barron's is on the same case, as illustrated by the most recent cover story (which can be read here).
If China is now on the backside of the artificial growth mountain - after years and years of gross malinvestment, leveraged excess, and a raging real estate bubble to boot … with civil unrest potential and severe pollution problems as icing on the cake … the potential fallout could be tremendous.
Did China Whack Treasuries?
One curious aspect of the post-Fed carnage was the brutal sell-off in Treasuries. On Friday June 21st in particular, fixed income assets got slaughtered.
This price action did not square with some smart players' expectations. Bond king Jeff Gundlach, in particular, was on record pre-Fed as expecting Treasuries to rally, not plummet, on persistent economic weakness in the coming weeks and months.
What's the China connection?
China is sitting on a mountain of Treasuries. And if China needs cash, they might well sell Treasury bonds. Correspondingly, fixed income was crushed last week. Friday was the most brutal day of the week for fixed income even as equities stabilized (somewhat) on that day.
Normally (for the current times), when stocks drop Treasuries rise on flight-to-quality rotation. So the carnage in bonds was doubly unsettling. This could be China influence. It could also be the impact of concentrated ETF selling.
ETFs Fuel Concentrated Bond Selling
ETFs are billed as an investor revolution. They are a more efficient way to gain asset class exposure at low cost. But efficiency has a danger component. Think of the giant corporation with super-streamlined supply chains. To the degree a company relies on just a handful of suppliers, its efficiency is increased. But so too is disruption risk. Just one supply disruption can bring down the whole chain, as we saw after Fukushima.
And thus with ETFs. Concentrated asset-gathering efficiency can lead to concentrated selling.
As ETFs make it easier for investors to put on or take off asset class exposure, they also make it easier for the market to exhibit snowball effects, in which anxiety begets anxiety and selling begets selling. This feedback loop dynamic is enough to make a bad situation worse.
What happens if China continues to sell? What if bond yields continue to rise?
That's bad news for all kinds of yield-related asset plays. As bond yields rise, comparable yields look less attractive … and overbought names get sold. Then add in fears of capital gains loss, HFT pile-on, and ETF selling for a "fire in a crowded theater" effect.
Poor Ben Bernanke. What was he thinking in setting off markets like this? Our guess is that Ben wanted to "manage the client," but utterly failed to account for China / ETF / sentiment tipping point fallout.
Buy the Dip? No Thanks…
Some equity bulls are heroically seeking a silver lining here, trying to see if they can "buy the dip" just one more time.
We think that's a bad idea …
Emerging markets have been a sea of bear market red for a little while now. The major US indices, however, had held up in the face of volatile onslaught.
But not anymore … as the S&P 500 chart above shows, the majors are definitively "broken" from a technical perspective. Of equal importance, broad sentiment appears broken now as well. (How ironic that small investors had just finished ramping up their bullishness, re: getting back into the market …)
The markets are now exceptionally vulnerable to a poor earnings season, which we could easily see. The comforting psychology of the 'Bernanke Put' has been effectively revoked, even if the Fed backtracks and attempts to convince investors that extraordinary accommodation is still there.
Here is a snapshot of our general thoughts and positioning:
Now is an excellent time to start preparing the short roster. The existence of the Bernanke put, and the seemingly endless QE bid in general, made shorting more or less a non-starter for an extended period of time. Conditions have now shifted: Many names in equity land look overextended, overbought, and vulnerable to sustainable decline. It is time to dust off the short-side playbook.
Overbought "conservative" yield plays look particularly vulnerable. In the endless-QE environment, investors went "chasing for yield" to the point of bidding up blue chip dividend plays to excessive valuation levels. That whole trade unwinds, in potential violent fashion, if long-term yields are now in a position to rise. Seek short side opportunity in all areas of the market where excessive optimism and "yield reaching" were a hallmark. We are short Consumer Staples Select Sector (XLP) in heavy size from higher levels.
Strong bullish stance on the U.S. dollar. As written previously, the US economy now looks likeArnold Schwarzenegger in a roomful of 90 pound meth addicts. Emerging markets - see iShares MSCI Emerging Markets (EEM) - are deep in the grip of inflation and civil unrest toil, with more China shock coming and strong potential for things to get worse. At the same time, a rise in US bond yields decreases the relative attractiveness of all EM assets. A further withdrawal of investor funds out of EM assets - and out of China - will strengthen the USD further. We are sizably short the yen, with starter positions in the euro and Canadian dollar. See CurrencyShares Japanese Yen Trust (FXY), CurrencyShares Canadian Dollar Trust (FXC) and CurrencyShares Euro Trust (FXE) as proxies.
Expect more deflationary fallout for commodities - particularly oil. Our good friend Peter Brandt recently made the technical case for crude oil returning to $65. This case is bolstered on the fundamental side by extremely high stockpiles, a slowing global economy, and deflationary pressures on commodities in general as the USD strengthens and the world slows down. Correspondingly, we are interested in the short side for various energy names - see Energy Select Sector SPDR Fund (XLE) - with high leverage to the price of oil. Oil sands producers, for example, could be crushed if crude oil registers a sustained decline.
Forget about gold, silver, and gold stocks. Precious metals - see SPDR Gold Shares (GLD), iShares Silver Trust (SLV) - look dead as a doornail and, barring some out-of-the-blue Armageddon flare-up, will continue to be so. Gold stocks in particular - see Market Vectors Gold Miners (GDX) - now look to be classic value traps, with investors who thought they were buying cheap finding themselves ambushed by the deteriorating profit profiles of miners as the price of gold falls below sustainable production thresholds. The entire inflation-based justification for owning gold has turned out to be not just wrong, but dead wrong - at this juncture inflation exists in struggling EM economies, not the West, where deflation is the continued (and legitimate) fear.