Two Markets Principles: “The law of unintended consequences is the only real law of history.” - Niall Ferguson. And when markets move from being investment fundamentals driven to sentiment, directional changes may be volatile and dramatic.
I believe that governments are increasing the risks of more unintended consequences as they change policies to address political rather than strategic needs.
After an extended period of stock markets rising with comfortable complacency that most numbers and attitudes will be pro-growth, we have entered a new phase.
I have recently written about forthcoming declines that may be either of the normal cyclical nature or the far less frequent abnormal declines. I don’t know which type will be the next decline that we will be facing. In each case declines are followed by recoveries.
The key difference in terms of the recoveries is the level of damage the declines cause due to the psyche of both individual and institutional investors. The greater the damage the longer it takes for the full recovery to do its restoration of capital.
Currently there are a number of signals being produced. Some of them will have little or no longer term impact. However, some will be signposts to the future. As a contrarian I am going to be focusing on possible negative signals.
This is appropriate for two reasons. First in the current period of rising enthusiasm and excitement there are fewer voices of caution. Second, I believe that I owe to our managed accounts to look for possible problems on the horizon that are not already in today’s prices.
In no particular order the following are input signals to my thinking:
1. Before we awoke last Monday morning, Samsung Electronics stock price in South Korea fell 5.1%. Over the next few days the leading FAANG stocks were also weak. At times Ex-US markets can trigger US markets.
2. Of the eight major ten year sovereign debt yields, only Canada’s higher yield was greater than the 10 year US Treasury bonds. This means that investors found that six countries’ debt was a better investment than the US.
3. In the recovering repurchase agreements market it is difficult to buy both US Treasuries and German Bunds in quantity. I believe that this indicates that these markets are not being largely driven by investment needs, but the need to find acceptable collateral. Today only Bank of New York/Mellon is clearing repos.
4. Some believe in the run up to year-end banks and some other financial institutions are dressing up their balance sheets by reducing their loans and trading inventory. This may impact available liquidity.
5. “Liquidity is that which moves the market,” said Stan Druckenmiller, who is said to be one of the soundest investors for many years.
6. The law firm Williams & Jensen is tracking the SEC’s interest in Fixed Income Market Structure changes as are the Federal Reserve Bank of New York and the Treasury Department. The current and evolving structure is very different from what was in place during prior financial crises even though the new Federal Reserve Board Chair-designate believes that there is no longer any bank that is too big to fail.
7. The stock and bond markets are interrelated in many ways. Fixed income investors and dealers are crucial to the supply of short-term credit to finance dealers, authorized participants, Money Market funds, derivatives and trading. They also play a role in the high yield bond and loan market that is experiencing a wave of “covenant lite” issuance. Further, fixed income investors are providing debt being used to both buy back corporate shares and also to invest in their businesses.
8. Marathon Global Investment Review out of London regularly discusses the impact of the capital cycle on corporate results and stock prices. When borrowers can borrow cheaply in an undisciplined way, they get too much money that expands capacity which eventually forces lower prices to create demand or buy market share which is destructive to the issuer’s stock prices. Recent examples include the oil industry and reinsurance companies. Possible current longer term risks could be two stock market darlings: Tesla and Amazon. A significant problem with either will not be likely treated as an isolated event.
9. At the March 2000 peak of the MSCI Europe, the ten largest stocks in the Index fell in the next 12 months twice as much as the index declined and in the following 12 months fell four times what the index did. Some 17 1/2 years from the peak, only one of the ten, Royal Dutch, has regained its full value. This highlights the difference between a “normal “ cyclical decline and an absolute one.
10. Central Banks are utilizing stocks as a substitute for bonds in their attempts to stabilize their economies. The Bank of Japan owns 2/3 of the equity ETFs in Japan. The Swiss National Bank owns $10,000 dollars of US stocks for every inhabitant in Switzerland. Perhaps the ECB (if it continues to manipulate the market) could buy shares as it already owns 3/4 of all the eligible bonds.
11. While Power Shares in its NASDAQ 100 ETF has gained 41% in the top five stocks (See point 1), perhaps connected, JP Morgan has pointed out that some ETFs have short positions greater than the shares outstanding due to re-lending.
12. Jason Zweig reports that the fifth most popular stock among the brokerage customers of Fidelity Investments was Bitcoin Investment Trust that holds bitcoins. The stock traded at a 70% premium over the value of the underlying holdings. There were 40% more buyers than sellers. (Is this a South Sea Bubble?)
A former president of the New York Society for Security Analysts, he was president of Lipper Analytical Services Inc. the home of the global array of Lipper indexes, averages and performance analyses for mutual funds. His blog can be found here.