The Big Short

The Big Short

Last week saw the opening in the UK of the movie of the same name. It is a must see for market historians as well as diviners of the future. It will remind us of the abject greed, arrogance and unremitting belief in a system that was in fact falling apart; in other words denial was the theme, unobserved by the many. The few were laughed out of court until the dénouement. Is history, in its own peculiar way, repeating itself?

The movie ends with the observation that there are now more open CDS contracts than there ever were leading up to the “great” financial crisis. There is also significantly more corporate debt; allegedly much of it investment grade. As in 2007, when the risker end of the asset backed bond market deteriorated, the crisis permeated up the rating scale with some alacrity. High yield bond yields are rising fast, helped admittedly by the carnage in the oil sector, but corporate America has been borrowing to finance share buy backs, at unseemingly rich valuations, which all of a sudden are starting to get cheaper.

Here’s a recent example as told by Zero Hedge When your organic growth is over, your revenue just missed consensus expectations once again, your stock is trading near 4 years lows and you are stuck in the imploding energy sector, what do you do? Why you announce a $10 billion stock buyback, but since you will have to fund it with more debt (whose cost in recent weeks has soared) you have to get rid of “overhead.” How do you do that? Simple: you announce you are firing 10,000 workers. Terrible news of course, but wait: here is the spin. Schlumberger’s brand new “yield starved” bondholders will give the company $10 billion to create 10,000 new fast food jobs. And that is what, as the US economy careens into recession, passes for growth. Anyone who says otherwise is peddling fiction.

Equally concerning were the remarks made by Schlumberger CEO Paal Kibsgaard. For many of our customers, available cash and annual budgets were exhausted well before the halfway point for the fourth quarter… as pricing levels for frackers has dropped into unsustainable territory.

Our last post commenting on the opening week of 2016 in global markets posed the question, “Is there cause for concern?” The answer is a resounding yes. The preponderance of top-heavy chart patterns has resulted in clear breaks to the downside for many markets; a pattern we have seen repeated in the past.

Screenshot 2016-01-24 17.22.35After some traumatic falls, not just in equity markets, there is bound to be some reaction to the upside. Markets do not travel in a straight line. They also like to complete their journey with as few passengers on board as possible. So rallies in bear markets tend to shake out those with a predisposition towards the “Big Short” and this move started at the back end of last week. How the rally pans out will give us a clue to the next move and we will watch with more than usual interest.

Albert Edwards at Societe Generale has observed that markets correcting from valuation anomalies make the journey in multiple stages. Those of a nervous disposition should look away now…

Since valuations peaked at the most obscene level ever in 2000, we have only seen two recessions and at the nadir of the last one, in March 2009, the Shiller PE bottomed at 13.3x, way above the typical sub-7x bottom. In valuation terms the bear market was not completed in 2009 and indeed after only two recessions there was no reason to expect it to have been completed (past such recessions have on average had 4 downward corrections post the event). If I am right and we have just seen a cyclical bull market within a secular bear market, then the next recession will spell real trouble for investors ill-prepared for equity valuations to fall to new lows. To bottom on a Shiller PE of 7x would see the S&P falling to around 550. I will repeat that: If I am right, the S&P would fall to 550, a 75% decline from the recent 2100 peak. That obviously will be a catastrophe for the economy via the wealth effect and all the Feds QE hard work will turn dust. That is why I believe the Fed will fight the next bear market with every weapon available including deeply negative Fed Funds rates in addition to more QE. Indeed, negative policy rates will become ubiquitous.

Most believe a 75% equity bear market to be impossible. But those same people said something similar prior to the 2008 Global Financial Crisis. They, including the Fed, failed to predict the vulnerability of the US economy that would fall into deep recession, well before Lehman went bust in September 2008.

This chart shows what a move to 550 would look like. Ouch! All the way back to July 1995 and not far from the level when Greenspan got concerned about irrational exuberance! 650-800 is also a likely target and fits in with Albert’s thesis that corrections get progressively more dramatic (we have only had two so far out of an average of 4)
Screenshot 2016-01-24 17.22.56

His valuation thesis uses the CAPE / Schiller Cyclically Adjusted PE. Many of the bulls attempt to undermine the validity of the Shiller PE and Albert has this to say on that particular subject.

Critics opine that using the 10y moving average of reported earnings as the divisor includes the huge collapse in reported earnings in 2009 due to write-offs, and that it does not reflect the recent strong underlying trend of earnings. Now I think this is an invalid criticism as the whole point of using a 10y moving average is to smooth the cycle and get a cyclically-adjusted measure of earnings in which case you should include the write-offs suffered during a recession! But if I do use a shorter 5y moving average there is good news; to complete the valuation bear market, the S&P would only have to fall by two-thirds to around 650 (a fraction below the March 2009 low of 666), instead of falling by three-quarters to 550.

As he admits himself, a lot of people think he is talking utter garbage and that he may be utterly wrong, but this is not the time to be a hero and go “all in” for the recovery as if this were 2009. “This is a market where you don’t make a lot of money. You try to protect your capital and then play another day.”  Hat tip to Jeff Gundlach for this common sense opinion.

Screenshot 2016-01-24 17.23.25

The top pattern is similar to many equity markets, with a large rounding shape, now entering its third year, showing the tug of war between the bulls and the bears. The trend line from the 2011 bottom to the low in August 2015, as well as significant support at 16,000, has been tested, but thus far has held. The current rally that is underway could easily take us to 17,000. With comments from the Fed a la Draghi last week – “We would be foolish not to revisit our plans for monetary policy and may even need to introduce unconventional remedies” – Yikes! – a new high for this index is not out of the question. However if it fails under the falling long term moving average and breaks 16,000 decisively, then watch out below; that dot in the distance will be a very small image of Albert Edwards coming up to meet you. Let’s hear it for the Dow!

Clive Hale – January 24th 2016

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1 Comment

  • Clive Hale

    January 27, 2016 at 12:41

    Just checking that the comments app works!