Winter Storm By King In The North

by: Tautvydas Marciulaitis


There is a housing bubble in Sweden you know nothing about.

However. it might make the King in the North (a.k.a. Norwegian Oil Fund) stop buying equities.

Given current market conditions, if NSWF is gone, correction of 20-30 percent in global equity markets might follow.

The current bull market is so overheated that a Swedish housing market bubble, which normally should have almost no effect on the global financial system, may trigger a chain of events leading to a technical correction of large magnitude in the global equity markets.

Both realized and implied volatility is extremely low this year. We now live in a permanent state of exception and a new status quo. Markets can't go down, because everyone just keeps buying the dip. But that cannot go on forever.

Correction Implies Selling

For prices to move down, someone needs to start selling. That is simple supply and demand. At this moment, nevertheless, no one is willing to sell, because it is still profitable to be on this ride. I will not go into details; full coverage of whys and hows may be found here.

However, in a nutshell, as long as the market is dominated by the price insensitive behemoths, like Swiss National Bank and Norwegian Sovereign Wealth Fund, followed by overoptimistic and greedy institutional players, there will be more buyers than sellers.

On top of that, strong macro data, which means goldilocks for equities, as described by Goldman Sachs, also adds to the demand for equities, as it creates incentives for both more orthodox professionals and retail investors to buy.

So will this get contrarian at all? Well, yes.

Times They Are A-Changin'

As most of you will not know, currently there are some big issues in Scandinavia. The keystone of turmoil is the Swedish housing market, which stalled this summer and began to fall in September. And that problem is really huge. Please read the new Riksbank's report on this; it outlines the key things.

Source: | NASDAQ OMX, Valueguard-KTH

Well, you may ask, what a tiny Sweden with its housing market can do to the world's financial system? Answer to this question is not that straightforward; however, it is pretty simple.

Before going into the details, please understand that problems in the Swedish housing market imply problems in all Scandinavian housing markets. If Sweden falls, so will Norway and so will other Scandi countries.

On that note, there are three main issues: (1) All Scandinavian markets are highly interconnected, (2) they are dependent on the European Central Bank, and (3) the Norwegian Sovereign Wealth Fund is in Scandinavia.

Let's begin with the issue number two. Dependence on ECB implies that when ECB starts tightening monetary policy, central banks in Scandinavia will also tighten in order to avoid large capital outflows. In addition, given the overheated housing market, tightening is something they were willing to do for a long time.

However, as monetary policy needs to be calibrated and adjusted to local markets and expectations of their participants, tightening from ECB now means that real economic agents in the Scandi markets are being signaled not to take out new mortgages. Thus dependence implies additional pressure on the crashing market.

While the issue number one leads to the fact that if housing market in Sweden crashes for real, implications will be felt in the whole region. Or like Bloomberg put it:

These are "big exposures," he said by phone on Tuesday. "Nobody really knows what's happening" with that market, he said. "If they end up in trouble, the banks end up in trouble as well."

Thus, in short, if Swedish market fails, all Scandi banking system, therefore real economies, will face problems. Or as from Riksbank's report:

This makes the banks sensitive to larger falls in housing prices, as this could affect confidence in them, making it more difficult and expensive to find funding. The major banks are also closely interconnected and have significant exposures towards each other, in part because they own each other's securities.

Now we arrive at the issue number three - the largest wealth fund in the world. If ECB continues to talk about tightening and thus Scandi housing markets continue to crash, those "big exposures" might lead to big problems and banks ending up in trouble as well, due to which we might come to a point where governments need to intervene.

Which means an increase in either fiscal or monetary spending. Where will governments, say Norway's, get the necessary money from? Exactly, the largest sovereign wealth fund. That implies Norwegian Oil Fund not buying equities anymore. Or, in other words, disappearance of one of the largest buyers in global markets.

Thus, we now know how a tiny Swedish housing market may have an impact on the world's financial system. If it gets really bad, which realistically might happen, governments will intervene, which will make the NSWF stop buying, which will hit the total equity demand all over the globe.

The Setup For A Perfect Winter Storm

Disappearance of one buyer, despite it being very large, might not be that big of a concern in normal market conditions. However, given how much demand Norwegian State Wealth Fund creates and taking into account current market conditions, one could expect a technical correction of 20-30 percent. Not a real recession or a full-scale crisis, but rather a technical correction, whose size will be larger than usual.

If you think that such an impact is too huge, let me remind you of the current market conditions:

1) Extremely low cash and record-high equity positions (read more here):

Source: BusinessInsider

Cash level is a contrarian indicator, with high levels signaling higher potential equity market returns, and vice versa. Given current levels, it is hard to be too bullish, because there is no money left to keep on buying. Additionally, hedge fund net equity exposure rose to the highest level in 11 years. Therefore, they have plenty of equity to sell and not that much of cash to buy.

2) The liquidity issues, due to the rise of ETFs and popularity of index funds, more on which you can read in this perfect piece by Heisenbergreport or an article here on SA by yours truly.

3) The fact that leveraged CTAs and entities using volatility based portfolio allocation strategies will have to sell huge amounts of equities. According to

CTAs beta to SPX has risen to the top of its 3 year range over the past month, so there is some risk that the funds could sell a large number of futures into a declining market if there was shock and subsequent deleveraging. <...> DB estimates they would need to sell $9-12 billion in equities during a 3% selloff.


4) The permanent state of exception and a new status quo. No one believes that markets can crash - just look at VIX trading at 10 for almost a year.

Given all these, any larger drop in demand might wipe out billions if not trillions in minutes. Everyone is long. Everyone is leveraged. No one believes that markets can crash. This is the perfect setup for large correction and problems in Scandinavian housing market may be just enough of a catalyst, as long as they have an impact on NSWF.

This Is Coming - The Only Question Is When

They key takeaway here is that this is coming. Sooner or later the perfect storm will happen. It might be induced by Swedish housing market within next months. Or by any other factors whilst Scandinavians sort themselves out.

But one way or another, any larger drop in demand will lead to spike in volatility, which will imply selling by institutional players who have much equities and no cash, which will create even more volatility so leveraged CTAs and volatility followers will have to start selling, and which will bring out problems buried in lies about ETF liquidity.

During all this, equity markets may crash by 20-30 percent. Thus investors and traders need to be ready:

1) Have positions in equities sold or hedged - this will minimize your risk, thus potential losses.

2) Have enough cash - money is made by buying low and selling high, so liquidate now in order to sell high and have some cash in order to buy low after the correction.

3) Follow the before-mentioned largest players - one of them quitting might indicate that correction is under its way.

Correction is simply inevitable. The only question is when it will start. Stay put and stay strong. Winter is coming.

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.