It’s Just Math

Posted on Sunday, February 11th, 2018

So much to say and so little space. Let’s jump right in.

What Happened?

Investors are convinced that Interest rates have begun to move higher and may have broken their 30 year + downtrend. The US 10 year has gone from 2% to 2.85% in just 5 months. The 10 year is in every risk calculation. The risk free rate is a base from which just about every valuation springs from. Has the 30 year bond bull market ended? It seems more and more are in that camp.

It can’t be just Bonds. Can it?

No. The severity of the move was exacerbated by the short volatility trade (see our warnings Very Superstitious, Less In and Fall is In the Air) and market structure which we warned about My Name is Mario, Paradox and Caution Flags.

Short Volatility Trade

In the next sharp market move volatility will be the driver as investors scramble to cover their shorts wiping out many involved in that trade. Blog Post 10/21/2017 “Very Superstitious

Bonds, the Vol Trade and Risk Parity

We continue to fret about risk parity and volatility selling. When stocks go down we will look at bond prices. At some point they will both go down in tandem and selling will beget selling. If there is a meltdown, we believe that is where we will see it start. Blog PostLess In” 11/18/2017

Market Structure – Or Why the Market Fell So Fast

The market is flawed in its design as its automated structure puts the momentum players, the market makers and algorithms in control. While it is pleasurable to see it go up every day it will be much quicker and painful when the market goes down in a one way fashion. For every action there is an equal and opposite reaction. Blog Post “My Name is Mario” 10/28/2017

You may have pundits who say that it cannot be bond yields. They will say, “Four years ago the 10 year was at 3%. 3% 10-year yields didn’t stop the bull market then”.  Yes, but 3 years ago the S&P 500 was at 2000. It is now closer to 3000 with a high of 2872 put in a month ago. The S&P 500 at 2000 with a 3% ten year yield is a lot more palatable than when the S&P 500 is at 3000. Stocks are more expensive and have a lower dividend yield in 2018. Remember, stocks are valued in light of the risk free rate – the 10 year yield.

We are now in the late part of the short-term debt/business cycle when demand is increasing faster than the capacity to produce, so interest rates rise to put the breaks on and that hurts investment asset prices before it hurts the economy. -Ray Dalio Bridgewater Associates LinkedIn 2/8/18

The three legged stool of a higher stock market since the GFC has been stronger economic growth, low inflation and central bank stimulus. Those components of a stronger stock market may become a headwind in 2018. Currently, the Atlanta Fed is predicting 4% GDP in Q1 of 2018. That tells us that if growth gets much stronger central banks will have to take away stimulus at a more rapid pace. Inflation is rising with higher wages and central banks are already scheduled to take away stimulus in 2018. Don’t fall for the stronger economy = stronger stock market argument. A stronger economy and higher inflation will only lead to the Fed tightening faster. Trump’s policies may force the Fed to take away stimulus.

The combination of experimental central bank monetary policy and the Trump administration’s stated goals, if not enacted in concert, raise the risks that something is going to break. Those stated policy goals, while giving the Federal Reserve cover to raise rates, also make the Federal Reserve’s exit from their easy money polices of the last 8 years particularly tricky. To be frank their exit was never going to be easy. Blog Post Witches’ Brew 4/8/2017

Governments want inflation – just not too much inflation. Great investing minds such as Jeff Gundlach and Paul Tudor Jones are telling us that inflation is coming and commodities should play out well this late in the cycle. Central banks still have negative rates in parts of the world and in the US we have a President trying to stimulate the economy and having success. Right policies, wrong timing. Central banks are now behind the curve and markets may not like faster tightening. Another issue is the Fed Put. The Fed Put has given investors enormous confidence to buy ever rising stocks. Where will the Fed step in if markets get in trouble? We think that as inflation rises the Fed Put moves lower. The Fed cannot repeat the mistakes of the Weimar Republic and let inflation rage out of control. They will need to stop inflation and the acceptance of more volatility and a lower stock market may be the price.

The fundamentals have changed. Good news has become bad news. Any positive developments on the economy may be translated to a need for more tightening from the Fed. As Main Street benefits in higher wages Wall Street may suffer. Inflation will create the regime change from global economic recovery to global stimulus withdrawal. Governments want some inflation. Some inflation is good. From a government’s perspective deflation is always bad. That is why the Fed will support the market in a deflationary environment but not support it as quickly when it comes to too much inflation. Their support of the market is much, much slower to arrive in an inflationary environment especially when it sees a White House that is already stimulating the economy fiscally.

We have grown weary of hearing one pundit after another tell us that “The fundamentals have not changed; that the economy is strong and that stocks will go higher once this correction has run its course.” It is precisely because the fundamentals have not changed that stocks are weak, for the history of equities is to discount the future and the equity markets are looking beyond today’s economic fundamentals… which are, again, very strong… and are looking to the future when those fundamentals will eventually change for the worse. That is the job of the capital markets: to discount the future by looking into the future and not looking at the present. Dennis Gartman – The Gartman Letter

Bull market tops are a process and are usually not an event. We believe that we are at the beginning of that process. Fixed income is becoming more attractive as rates rise and central bankers will now attempt to step away from their support of assets. We do not think that they will have any luck but we think that the next 12-18 months in markets will be difficult with a strong increase in volatility.

This is what we had to say last month.

We believe it is prudent to be a bit more conservatively positioned this late in the cycle and expect lower returns in order to be prepared to profit from others panic and flawed market structure. Paradox 1/8/18

We were prepared for this selloff and continue to position our clients for success in this environment. We have been underweight equities and have shortened bond duration as far we can stand. We continue to expect volatility and market shocks while being prepared for the return of inflation and to profit from both.

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I  think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

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Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.