The Search For Improbable Scenarios

Includes: DIA, IEF, QQQ, SPY, TLT
by: Acting Man

A New Variation of the "Cleanest Dirty Shirt" Theory

Bill Gross has for some time forwarded the theory that the U.S. was doing better relative to other regions in the post-2008 crisis era because it was the owner of the "cleanest dirty shirt". This was specifically in reference to U.S. treasury bonds, which time and again have proven to attract "safe haven flows" when trouble erupted elsewhere.

Following the sizable decline in stocks late last week, others are now trying to expand this theory to the U.S. stock market in the wake of the rout in emerging market currencies:

"The ongoing concerns about emerging markets could end up boosting U.S. stocks as investors look for greener pastures, BMO's Brian Belski told CNBC on Monday.

Belski, chief investment strategist at BMO Capital Markets, said the jitters that caused ripples across global stock markets last week stem from a redeployment of cash between emerging markets and the next investment opportunity. As currencies in emerging markets such as Argentina, Turkey and South Africa continue to falter, the U.S. stock market could be the next best option for investors, he said.

"That's why people are freaking out," Belski said on "Squawk Box." "When you think about asset cycles, the last cycle was driven by credit. The current investment cycle has been driven by cash. … Which companies in the world have the strongest balance sheets in cash? It's America."

Michael Purves, chief global strategist at Weeden & Co., agreed that the ongoing worries over emerging market currencies could bode well for U.S. Equities. Multinational companies that do large amounts of business in developing countries, however, could have trouble if those nations continue to appear unstable, he said."

(emphasis added)

Allow us to point out here that somehow, the U.S. dollar hasn't been told about this. Emerging market currencies can be said to have been in a kind of "rolling crisis" since the Indian rupee more or less crashed in the summer of 2013 (note that it has been in a downtrend since late 2011, which morphed into a rout last year). Over the same time period, the U.S. dollar index actually went down. Admittedly, not by much (it got a lot of help from the weakening yen), but it sure hasn't been reflective of the idea that the U.S. has been the prime destination of international capital flows.

Further below we will briefly discuss a historical occasion when the above suggestion actually "worked" in a way, but at the time the dollar was in a rising trend. This time it has proved spectacularly incapable of profiting from currency turmoil elsewhere. Among the major currencies, the euro has turned out to be the strongest over this time stretch (it was officially declared dead by Newsweek on May 17, 2011, and again on July 2012, which was a rather big hint that the funerary rites had to be postponed). Not only that, European stock markets, long underperforming, have outperformed the SPX as well in the second half of 2013.

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Newsweek cover, May 17, 2011 - this could be called 'Newsweek trying to save the euro by noticing the currency's downtrend exactly three weeks before it reversed again'

Newsweek trying to save the euro again in June 2012 - so far it has worked surprisingly well (with support from at least two 'Economist' cover stories along the way)

Turbulence in emerging market currencies as well as a weak yen have failed to buoy the dollar index

It Once Worked …

To be fair, there have been occasions when the idea of emerging market troubles lifting U.S. stocks actually kind of "worked" in a sense (provided one believes enormous stock market bubbles are indicative of things "working" as they should). For instance, the 1997-1998 Asian/Russian crisis produced a mini crash in the U.S. stock market in 1997 and a somewhat more serious crash in 1998. Following the second event, the market went on to a bubble-like advance that saw the Nasdaq index go parabolic (it went from a low of less than 1,400 points in October 1998 to a high above 5,000 points in March of 2000, easily one of the biggest stock market bubbles ever witnessed in such a short time span).

The Nasdaq Composite from the summer of 1998 to Q1 2000 - one of the biggest stock market manias of all time started with an emerging markets crisis.

Apart from the fact that the U.S. dollar index was actually rising at the time, two other things are worth pointing about this previous occasion. First of all, before the U.S. stock market was able to "benefit" from turmoil elsewhere, it crashed. The 1998 crash was actually quite a scary event (most observers certainly agreed that systemic risk was rearing its head at the time) and definitely wiped out the excess bullish sentiment that was in evidence earlier that year. The decline also happened to reduce outstanding margin debt considerably.

Secondly, the eventual rally was triggered by repeated interest rate cuts by the Federal Reserve, including an inter-meeting "surprise cut" in October 1998 on options expiration day, for maximum effect (sellers of calls were forced to delta-hedge as the market exploded into their face in the final hour of trading, producing a huge one-day rise that proved to be the "kick-off" to the rally that followed).

When considering the current situation, we must first of all note that the market has not (yet) crashed and that sentiment remains quite complacent - as the above article excerpt actually confirms. Margin debt definitely has not had a chance to reach sensible levels, quite on the contrary, it has reached a new record high. Not only that, but the negative net worth of investors finally slightly exceeds the record that was set at the peak of the tech stock mania in 2000 (or putting it differently: investors using margin are now more dependent on a continuation of the rally than ever before in history. The market rarely obliges in such situations and if it does, it usually won't be for long).

Every aspect of margin debt has reached new record levels - this demonstrates the current extremes of bullish sentiment quite starkly.

Monetary Policy Inertia

Finally, one wonders what interest rate the Fed is supposed to cut this time around. With the federal funds rate already at zero, effectively only a reversal of the "QE tapering" course could be in the offing at some point (in fact, we believe this will eventually happen), but one must not forget that Fed policy is subject to a great deal of inertia. It is always reactive - i.e., the Fed is generally trying to close the barn door long after the horse has escaped, whether it is by means of tightening or easing monetary policy.

The Fed is moreover the one place in the world where one can find what is quite likely the biggest congregation of "always wrong" forecasters. Meteorologists (though not, we should add, climatologists) are founts of remarkable forecasting accuracy by comparison. Hence, its policies are actually never forward-looking, and even if they were, the entire effort would still be no better than throwing dice. Occasionally, its inept bungling from crisis to crisis is masked by sheer luck, but in essence this bureaucracy represents a monument to the long-known fact that central economic planning simply does not work.

Having just begun the "QE taper", the above-mentioned inertia almost guarantees that the policy will be continued for a while yet and that it will indeed require a lot more turbulence in the market for it to be altered again. That is, however, a crucial point for those who express the view that crises elsewhere will prove "supportive for U.S. stocks." They will only if and when monetary pumping re-accelerates, and even then there can be no guarantee, as much will depend on the state of the economy's pool of real funding, the demand for money, and other not yet foreseeable and inherently unmeasurable contingent circumstances.

Lastly, it is always possible that emerging markets will calm down again and that the market remains unperturbed for a while longer. As noted yesterday, an initial sharp decline is often merely a "warning shot". This scenario would postpone a denouement, but would make it even more likely that it will be painful, as money supply growth would have more time to continue to slow down.

We should also mention again that the idea expressed by one of the analysts quoted above that "U.S. corporations have so much cash" is slightly misleading. First of all, cash holdings are very unevenly distributed - the vast bulk of this cash is held by just a handful of corporations. Secondly, corporate debt has grown even faster than cash hoards, which means that the aggregate corporate net cash position has actually worsened.


While in the spirit of "all news is bullish" that has been so pervasive throughout 2013, it is highly doubtful that the idea that a crisis in emerging markets is also bullish will turn out to hold water. That is actually tortured logic. If the crisis continues or worsens, it may be bullish for U.S. treasury bonds and other "safe haven" assets, but certainly not for stocks.

Addendum: More Trend Line Breaks

We pointed out that the Nasdaq and Russell indexes had not yet broken their short-term uptrend lines as of Friday - this changed on Monday, as both indexes played "catch up". We still don't regard these declines as particularly large or meaningful from a technical perspective, but they certainly could be the harbinger of worse to come down the road.

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