Hey Investor… Tread Lightly!
The dramatic change in current market conditions from their behavior in the last few years reminds me of one of the most intense episodes in the legendary “Breaking Bad” television series. The protagonist – Walter White – is an awkward former high school chemistry teacher who is diagnosed with terminal cancer and becomes a ‘meth’ (methamphetamine) dealer in order to pay his hospital bills.
Towards the end of the series, his alpha-male brother-in-law Hank – a DEA agent – finally realizes that Walter is “Heisenberg” – the ruthless drug overlord and criminal mastermind that has eluded them for years. Hank is shocked that his mild-mannered and seemingly hapless brother-in-law could have pulled the wool over his eyes for so long. He confronts Walt in his garage and says:
“I don’t know who you are, I don’t even know who I am talking to,” to which Walt famously responds: “If you don’t know who I am then maybe your best course would be to tread lightly.”
In many respects the same can be said about China and the global economy. We have gone from a world of Quantitative Easing (QE) to suddenly facing the risk of Quantitative Tightening (QT). Suddenly the zero interest rate world of “free money” doesn’t seem like a free lunch anymore. The Fed – once omnipotent and ready to fire all of the weapons at their disposal to save the latest crisis – appears to be running out of ammunition just as the gun fight is getting ugly.
At one time market doomsayers were confidently preaching their fears of rampant inflation from Fed intervention. But all of the facts are now starting to point towards deflation as being the real risk. You can’t lend the banks money at rates substantially below the level of a fair risk-free interest rate and expect them to loan it out to risky businesses at comparable levels. Instead, it makes more sense for banks to lend money to real estate transactions where they have some collateral, and also invest the spare proceeds into higher yielding investments.
And that is exactly what they have done.
This is not the China that we all know – with perpetual 10% growth rates, an insatiable demand for commodities, and an all-powerful centrally-controlled economy. Instead, this Red Dragon impostor appears to be a massive Ponzi scheme – an economy built on unsustainable levels of debt, and a 1929 style stock market that was built on 5-to-1 margin speculation. China now appears to be heading down the path of yet another failed Communist regime that showed little respect for free market principles and is now suffering unexpected financial consequences. Recent steps to devalue the Yuan does not just appear to be a typical central bank response toward taking the froth out of an overvalued currency. Instead, it appears to be an act of desperation to revive their rapidly sinking export economy. The US and China appear to be now engaging in dangerous currency wars that threaten to rock both markets.
How the stock market has behaved over the last few years also appears to have deceived its true character. This is no longer your father’s or grandfather’s stock market – dependable to make you 8%-12% per year without a fuss. No longer does the market march upwards relentlessly and shake off a constant stream of bad news. Instead, all bad news leads to selling and any seemingly good news barely leads to any buying – indicating that the psychology of the market has completely changed. This is not the quiet, and mild-mannered stock market with a Volatility Index (VIX) hovering between 10 and 20. It is not the market that rarely sees a 1% down day. It is not the market that doesn’t have more than a 5% drawdown before sharply recovering and crushing the short-sellers.
No, this market is a very different beast.
Traditional quantitative indicators like the 200 day moving average, the 252-day return minus t-bills, and the 10-month moving average have been fairly reliable throughout history at signalling new market regimes and reducing exposure to risk.
Currently all of these are flashing sell signals.
Does this mean we are heading for imminent collapse? Not necessarily. No one knows what the future holds. When Walter White was discovered to be the infamous “Heisenberg” by Hank, it was by no means the end of his criminal career. Instead, it marked the beginning of a dramatic cat and mouse chase that lasted for several episodes.
The market may simply be entering its own dramatic final chapter before the real bear market gets under way. Alternatively, it is entirely possible that the market is just experiencing a normal correction – a typical thunderstorm in Miami as Ken Fisher describes recent market action – and may return to full health at some point in the fall. But we think that the market is beginning to show its uglier side – its true nature. In either case, the damage done near the end of August and beginning of September is not likely going to be erased any time soon. We expect high levels of volatility to continue in the interim with sharp rallies and dramatic declines.
In the meanwhile investors should tread lightly and reduce their exposure to the market until evidence demonstrates otherwise.
Notes and Disclosures
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