The bear continues to growl and investors, retail and institutional, wonder when the furry critter will go into hybernations.
We have not wondered, as we have been steadfastly bearish for much of this year. It is no fun being a bear, as we are not natural pessimists. But we find it hard to be optimistic when governments think they can spend their way out of any problem at hand. The central banks are supposed to be analytic, rational thinkers, but they have gone off the rails. Not to be outdone, central banks have joined forces with governments and decided there is no problem that money printing could not solve.
But government spending and money printing make matters worse. The government takes money from citizens and spends it on stuff they do not want. If they wanted it, they would have spent their money on it in the first place. So, in the end, the money gets wasted. Central banks enable governments to spend with reckless abandon on things nobody wants. They pay for the spending by purchasing government bonds. We pay the price through inflation.
The table above is but one of many indicators that everything the government has done since the financial crisis did not work. They artificially puffed up the price of assets, and the bubble is bursting. Year to date, the stock price of every sector in the economy is down big. The only exception is the energy sector which is primarily comprised of oil and gas companies. Not a pretty picture.
If we look a the price performance for the last month, it is just as bad. Everything is down, although energy is close to “punched.” We have been right to hold a bearish view. But what should one expect going forward? We think more of the same. Inflation is still running hot. While the mainstream government and wall street economists predict a reduction in the inflation rate, history does not support this point of view.
Stanley Druckenmiller, one of the best investors of all time, notes a very uncomfortable truth. When inflation is elevated like it is now, it does not come under control until short-term interest rates exceed the inflation rate. Yikes! This experience means rates have much higher to go. If that is the case, the prices of bonds will fall, taking stock and real estate prices with them. Higher rates are our working thesis. We differ from the mainstream economists in that we think rates go higher than expected, and they stay there longer. This is why we have been and continue to be bearish stocks.
But we do have a caveat to this thesis. Investors are highly levered as it made sense to borrow and buy stocks, bonds, and real estate. This is what hedge funds do. Banks borrow and buy bonds. We have yet to see any dislocations hit the front page of the Wall Street Journal discussing one or more financial institutions giving up the ghost. We think the key operative word is “yet.”
If financial distress or bankruptcy of financial institutions manifests, we suspect the Fed will halt additional rate hikes and buy some assets hoping people do not notice. The Bank of England just pivoted as several pension funds suffered huge losses with their bond investments. A 10-year bond with a 0.5% coupon trading at 0.5% has a price of $100. That same bond with rates at 6% has a price of $59. This rate rise occurred in the past year or so. Government bonds are supposed to preserve wealth. To our way of thinking, this scenario was guaranteed to play out. The only question we had was when.
The losses in the US bond market are not quite so bad. 10-year Treasuries have gone from 0.5% to 4%, so they have lost 60% of their value in the last year. Pensions and insurance companies tend to buy 30-year governments. While the pensions are underfunded, the insurance companies are well-capitalized, so they can weather the ups and downs.
The US economy is far stronger than Europe’s. So there have not been any large bankruptcies that might jeopardize the banking system. That said, the price of real estate peaked last month and is just starting to r0ll over. So it is not a problem now, but it could become one six months from now. About 20% of the S&P500 cannot meet interest payments with cash flow. They raise a lot of equity in the bull market and sit on a lot of cash. They have a fair bit of runway for now. But, like real estate, it could become an issue six months from now.
The chart above shows the VIX, aka the Volatility Index. It is a measure of uncertainty in returns of the S&p500 looking out 30 days. It is derived from 3o day, at-the-money options on the S&P500. When it is low, investors have few worries. When it is high, they are willing to pay up for options to protect their portfolios or speculate on a price drop.
The VIX is currently at 32. This reading is somewhat elevated and means investors expect a 2% [32/sqrt(252)] move daily. 2% is a rather sizable move when you think about it. However, market bottoms tend to come when it spikes to 60 or higher. Volatility spikes when stock prices go into freefall. The Fed typically panics and buys government bonds to inject liquidity into the financial system. Stock prices usually find a bottom within a few months of asset purchases, bringing an end to the bear market. Since the VIX is nowhere near this point, we think stock prices have a destiny with lower prices.
The chart below the VIX is the VVIX. It is a measure of how fast VIX is changing. It is the “volatility of volatility.” It typically spikes when stocks are in freefall as investors scramble to buy puts and sell stocks putting even more pressure on stock prices. Notice that VVIX is in the middle of its historical range. This also tells us that investors still do not seem too concerned about lower prices.
Our interpretation of the VIX & VVIX figures suggests there could be a bounce that could last for a week to a month before the next leg down gets underway. On the other hand, the downward slope of the support trendline suggests the S&P500 could fall as much as 400 points or 11% before we get a tradable bounce. Since Fed board members and beach presidents have been saying more rates lie ahead (75 bps in November and 75 bps more in December), we think the past of least resistance is down.
We have not seen the financial press report on a fund margin call and liquidation. This event is what we are looking for next. It does not have to happen to a US-based company to matter. A non-US entity, like a European bank, may fall prey to the bear market. The Fed has opened up $6.3 billion swap lines with the Swiss Nation Bank. It seems they have a shortage of US Dollars. The entire banking system in Europe is undercapitalized as they could not make money during ZIRP (Zero Interest Rate Policy).
If and when the first domino falls, that will be the time we will look for a pivot. If that unfortunate event does not manifest, rate increases will continue unchecked. We now live in a binomial world, which is a difficult place to trade.
