Aaaaaaaaand We're Back

| About: SPDR S&P (SPY)


It's risk-on across the board--how forgiving markets can be!

Nevermind the fact that the EU may be on the brink of collapse and Italian banks could go bust.

Are markets capable of sustained risk-off periods in light of free money policies?

We're back in the saddle again. is it possible we will ever fall off? Vol futures tells us no.

If the global financial market had a psychiatrist, it would likely be heavily medicated. Up, down, up, down, up, down, in perpetuity. There's always a convenient and oftentimes glib explanation for the fluctuations, but they are often just that: fluctuations. Upside, downside, it's all the product of herd mentality (more on that later).

The market's inherent instability is important to keep in mind on the way down, more than on the way up. If you were one of the marginal Brexit-induced risk-off'ers a few weeks ago, you're probably kicking yourself.

U.S. Equities are breaking all-time highs (NYSEARCA:SPY) (NYSEARCA:DIA).

The FTSE 100 (NYSEARCA:VGK) has made up all post-Brexit losses and looks to be propelling higher.

EM currencies are making up their losses incurred after the spell of Brexit-induced risk aversion.

It's risk on, folks. Back in the saddle again.

On net, capital has been flowing out of safe-haven fixed income ETF's:

Click to enlarge

Market correlations are holding up surprisingly well. As demand for risk assets rises, capital is able to flow into those riskier holdings because it's on net flowing out of the 'safer' holdings. That's why you see Gold (NYSEARCA:GLD) falling, and high-rated government yields rising (today, at least) most of the time that equities shoot up (though obviously, that's not a perfect correlation, especially when institutional portfolios' cash allocations are being altered).

A while back, I remember Jim Chanos said that there are two imperative realities holding up markets today:

  1. Central banks have your back.
  2. China will stimulate.

This seems especially relevant this week (I'm referring primarily to #1, though I will presumably give some thought to #2 in a future piece).

Italian banks are unstable at best, and more likely have severe liquidity, bordering on solvency issues. While that may seem like a periphery issue, market participants have a proclivity to underestimate the interconnection of segments of the international capital markets. If the uneasiness (or worse...) around Italian banks (NYSEARCA:EWI) continues, that could severely impair credit flows in continental Europe, which has knock-on effects on the rest of the world (yes, even America).

Clearly, there are widespread concerns. It's difficult to get such extreme sell-offs in an entire market segment without well-informed institutions and insiders knowing that there are real and clear difficulties. The bottom line is this: you should probably be worried. Here's a quick FT bar chart:

Zero hedge pointed out how noxious the impacts could be, with a chart that shows how other European banks (who, perhaps with the exception of Deutsche (NYSE:DB) [though I remain unconvinced!] don't have capital adequacy problems of their own) are reacting to the 'Italian threat':

Click to enlarge

History tells us that markets don't like to acknowledge the elephant in the room. Right now, while there may not necessarily be a ten-tonne elephant about to trample risk-on people, I would liken the environment to one with a bunch of baby elephants walking around, slowly growing, gathering size and strength, while participants continue to act like they aren't there, preferring to devote their energies to going long just about every risk asset obtainable.

As I was writing this, the Dow hit a new all-time high. I don't get it. But I don't need to get it, because either way, it looks like we're back to risk-on. But... why? Markets are supposed to reflect reality to some degree. Certainly, there is a hugely significant herd mentality component... but since when did that matter more than base reality? I've never been a member of the camp that blames central bankers for all of the world's ailments, but is sure does look like the market disconnection from reality has to do in large part with ZIRP.

What choice do you have if your government's debt (i.e. if you are a Germany, Japan, Switzerland, etc. resident) is literally guaranteed to make you ~$0 or lose you money? Well, I guess you buy equities... but when the entire world is buying equities based on that same logic, what happens when yields start to rise? Can they rise?

There is a halting feedback loop of equities faltering the slightest bit, world central banks freaking out and promising to never lower rates, then markets rising to ever higher valuations, then the Fed says, 'hey, come on, everyone: please slow down!' Then the market falters again, and we're back to square one, with the ultimate effect being one of ever-rising risk valuations.

Be on the look out for tricky, somewhat nasty dynamics such as this one. But for now, fire away in risk assets, but pray you aren't caught holding the bag should one of the central banks decide to put an end to all of this nonsense.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.