Shrinkage
Posted on Monday, November 26th, 2018
The S&P 500 lost 3.5% on the week. (So much for the bulls having the ball.) During shortened holiday weeks the bulls tend to have the upper hand. We pay attention to seasonality issues a bunch but the signals are strongest when the seasonality patterns do not hold. A nasty 3.5% drop when the bulls should be able to walk it over the goal line is a signal that there is something rotten in Denmark. We see the possibility of contagion on the horizon. What we have seen in 2018 is a rolling bear market. According to Deutsche Bank 90% of major world assets are down in value in 2018. Not exactly a banner year. The bear has rolled from one asset class to another with the S&P 500 being the last to fall.
We are starting to see pressure in the debt market which tells us that the fear is real and investors are de-risking – and fast. We have a close eye on the debt markets as US corporations have borrowed hand over fist to buy back stock and now those low interest rates are gone. 2019 is faced with a fading fiscal stimulus (from Trump tax cuts), slowing demand from abroad (trade wars), a declining Fed balance sheet and higher interest rates in the US along with the possibility of slowing corporate buy backs. We think, by far, the most dangerous threat to asset prices is the declining Fed balance sheet. All else is basically noise. Fed officials may try to walk back hawkish comments and markets may rally on those comments but as long as the flow is to decrease the balance sheet asset prices will struggle.
Stan Druckenmiller is a legend in the investing world. He is a multi billionaire and in over thirty years of managing money he never had a down year. He averaged 30% a year! Quite simply one of the best who ever played the game. He are two snippets from an interview he recently did with Real Vision.
Everything for me has never been about earnings, has never been about politics, it’s always about liquidity.
They’re all (Japanese Central Bank, ECB, Fed) going in the same direction which is why I made the (short to market) bet in June and July…It is going to be the shrinkage of liquidity that triggers this thing. And frankly it has already triggered this in emerging markets. And that is kind of where it always starts. What I haven’t seen yet, and where I think we should see it before we see it in the equity markets, and God knows, talk about a crazy priced market it’s the credit market… and it’s amazing… probably since the 1880s-1890s, this is the most disruptive economic market in history, there are hardly any bankruptcies. So that Warren Buffett line about swimming naked when the tide goes out? There are probably so many zombies (companies) swimming out there and there is going to be some level of liquidity that triggers it… who knows, it might start with Tesla. – Stanley Druckenmiller Real Vision interview 11/2018
We think it starts with GE. It’s all about liquidity. GE does not have the liquidity to get past its rough spots as they have gotten shut out of commercial paper markets. They are now drawing down their credit lines. Pacific Electric and Gas is drawing down its reserve lines with banks to pay for the wildfires in California. Illiquidity begets illiquidity. We have been awash in liquidity for ten years. Businesses have survived that should not have. Zombie companies. The walking dead. The central bankers are taking liquidity away. We will see stress in high yield and corporate debt market first. We will find some who are not prepared and corporate buybacks will be a swift victim.
We see the Fed capitulating. The market just cannot handle the tightening and the drawdown of liquidity. The Fed will make a show of it to look like they are not bowing to Trump but they know the market is under stress. At the end of the day the Fed does not mind if the market goes down it just minds if the market goes down too fast. The Fed is going to blink. The question is at what level in the market? What happens next? Will we see inflation rise? Will stocks bounce? How high? Our guess is that the Fed will blink sooner rather than later but that may not stop the market from falling.
Be hyper vigilant. These markets can change on a dime. We expect Fed officials to be out and about this week trying to talk back the hawkish tone set from Powell on October 3rd. Traders handbook says we should start to see a Santa Claus Rally. Will Trump deliver one next Monday after the G20 summit? We would guess that he will try.
For a year now we have warned that the 2666 level on the S&P 500 would be a fulcrum and that it would take 18-24 months to surmount this area on the charts. It has been 12 months and counting. The market closed Friday at 2632 after rising as high as 2940 last month.
Signposts like this along the way are good spots for investors to take a respite and reflect on how far we have come and whether the trend should continue. 2018 may be a Year of Reflection.
We also noted that Bitcoin would be a canary in the coal mine for markets.
Keep an eye on Bitcoin. The crypto currency market seems to be shaping up as a temperature gauge for risk. Bitcoin just made a lower high and there seems to be pressure in the space. As goes bitcoin so goes the market? It is trading at about $8300 as we write. It is very important that the support at $6700 remain steady otherwise bitcoin could see a $2000 fall quite quickly. –Blog May 2018 (Bitcoin closed last week at $4200)
Well, here we are. Bitcoin broke support and fell $2000- very quickly. Speculators are getting out. Liquidity is drying up. We have seen it across all asset classes. It’s just time for stocks. In our April Letter we warned that you should not have more than 50% in stocks.
We remind you of these to show you the pattern. Markets were very speculative and had gotten ahead of themselves. 2018 was a Year of Reflection – A time to pause and see if prices reflected reality. The market is very oversold short term but long term markets were VERY over bought and valuations had gotten unreasonable. Just look at bitcoin. 18-24 months seems about right to see if investors can digest this level in the market. We suspect they cannot if the Fed continues to drain liquidity. It’s always about liquidity.
We are due for a bounce but last week was not a real confidence builder. The 2525-2575 level on the S&P, if tested this week, needs to hold for the bulls. If the bulls fail the test a trapdoor could open. The end of the year gets tricky as investment managers will try to make things look good and come out with a positive year. There are also esoteric concerns about liquidity and bank reserves at the end of the year which could exacerbate things. The risk is asymmetric to the downside with a selloff being of less likelihood but of greater magnitude.
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
To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .
A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill
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.