“The Cause of the Next ‘Black Monday’”
by Brian Maher
"Be afraid. Be very afraid. So reads billionaire Paul Tudor Jones’ message to Janet Yellen. Jones says that eight years of essentially zero interest rates have pushed stock valuations to their highest level since 2000 - right before the dot-com bust. Nothing new there, you say? But Jones also identified the ticking time bomb that could generate another October 1987-like explosion. You’ve probably never heard of it - even though your portfolio might be loaded to the gunwales with financial dynamite. But what could it be?
Answer anon. But first a check on the ammunition factory… Dow down 31 today... S&P down seven… Nasdaq down six. Oil’s down about 50 cents. The one patch of green? Gold. Up about two bucks. All in all: meh. But that ticking time bomb…
“Black Monday" - Oct. 19, 1987 - saw the largest one-day market crash in history. The Dow plunged 508 points that day. A 22% dive. A similar event today would spell a 4,523-point one-day collapse. What turned a bad day on Wall Street into Black Monday?
With all possible irony, something called portfolio insurance. That’s a computer-based strategy that sells stock futures if markets begin to fall. It lets investors minimize their losses when the market turns south. In theory. Portfolio insurance didn’t cause the initial sell-off in October ’87. But once the initial selling started the computers went apes**t and the initial selling snowballed and snowballed and snowballed until the Dow lost 22% of its value in a single day.
As The New York Times styles it, Black Monday was caused by “computers programmed by fallible people and trusted by people who did not understand the computer programs’ limitations.” The Times concludes with this gem: "As computers came in, human judgment went out."
A cautionary tale, as computers make more investment “decisions” than ever. Paul Tudor Jones made a fortune in October 1987 - he tripled his money - by calling the crash in advance. Even though they instituted reforms to prevent another Black Monday-type event (Plunge Protection Team?), Jones says today’s version of portfolio insurance can lead to another event just like it…
What is it? Something called “risk parity.” “Risk parity,” warns Jones, “will be the hammer on the downside.” Risk parity attempts to distribute risk across several asset classes by allocating more money to lower-volatility investments and less to higher-volatility securities. Instead of the usual 60% stock, 40% bond portfolio, risk parity funds theoretically reduce risk by limiting the more volatile stock weighting and increasing the less volatile bond weighting. Portfolio insurance, in other words.
But according to Jones, risk parity funds have been buying a ton of stocks lately. Why? Because of extremely low levels of volatility in the stock market. It’s all seashells and balloons on the way up. But when the fall comes... And cometh the fall, the computers behind these risk parity funds will drop those stocks like nobody’s business. And that could start the snowball rolling. Or to return to our original metaphor... spark the fuse on the bomb. Just like 1987.
Bloomberg paraphrasing Jones: "Because risk parity funds have been scooping up equities of late as volatility hit historic lows, some market participants, Jones included, believe they’ll be forced to dump them quickly in a stock tumble, exacerbating any decline. Like Jones, Seabreeze Partners Management President Doug Kass thinks today’s low level of volatility masks the danger.
Kass thinks risk parity could soon write the October 1987 sequel - “Portfolio Insurance Act II”: "We all must recognize that when the market moves in a northerly direction the potential structural issues and emerging-market inefficiencies are camouflaged by the rising tide of higher stocks. But when, inevitably, the tide retreats and stocks fall, we may re-run the movie of October 1987 in Portfolio Insurance Act II."
Risk parity funds total about a half-trillion dollars. That is, they’re large enough to work sorry damage before the fires are out on the next crash. Remember, if Act II is a faithful sequel to Act I… it could mean a 4,523 blood-and-thunder drop on the Dow. Even if a weaker script leads to, say, a 2,000- or even a 1,000-point intraday plunge, that’s no “dip.”
“You know neither the day nor the hour,” instructs Matthew 25:13. And neither Jones nor Kass pretends to know the day or the hour of “Portfolio Insurance Act II.” Nor do they know the severity of the script. But we simply can’t escape the irony of it all. It’s too rich for words, really… and let this one soak overnight... “Portfolio insurance,” as it was in October ’87, could be the very fire it was designed to insure against...
Below, David Stockman shows you why the “greatest folly of all” - the Trump reflation trade - is kaput. Read on."
"Donald Trump's Big Fat Ugly Bubble Is Ready to Pop"
By David Stockman
"There have been numerous eruptions of irrational exuberance since Alan Greenspan launched the modern era of monetary central planning in response to the 22% crash of the stock market in October 1987. But for my money, the Trump-O-Mania since the wee hours of election night is the greatest folly of all.
That’s because Donald Trump is destined to be history’s Great Disruptor - not the 11th hour savior of the mutant financial system and giant bubbles that have been generated by our Wall Street/Washington rulers over the past three decades. The latter is a product of massive financial asset inflation fueled by the Fed’s cheap debt, falsified financial prices and the tidal wave of Wall Street speculation they have induced. But the Fed (and its convoy of central bank imitators around the world) is finally out of dry powder. If it resumes quantitative easing (QE) preemptively to thwart the now incipient recession, it will generate a panicked sell-off - stoking fears in the casino that it “knows” something the gamblers don’t.
Likewise, if it even hints at reversing course toward sub-zero interest rates, it will bring the aroused populations of Flyover America, which elected Donald Trump, descending upon the Imperial City with torches and pitchforks. The savers and retirees of America have already been so severely savaged by 99 months of zero or next to zero interest rates (ZIRP) that they are not about to take it any more or have their savings flat-out confiscated by the elitist fools who inhabit Eccles Building.
In short, after having impaled itself on the zero bound and hideously bloating its balance sheet - from $900 billion to $4.4 trillion since the Lehman event in September 2008 - the Fed has no capacity whatsoever to forestall the oncoming recession or reflate the economy and financial markets once it begins. Janet Yellen’s 25 basis point slight bump last month is really a big nothing.
The market should currently be in panicked retreat because, despite his recent favorable comments about Janet Yellen, it is unlikely that the Donald will appoint to the Fed even more aggressive money-pumpers than the paralyzed posse currently in command. But in one of the most ludicrous stick saves ever confected in the bowels of Wall Street, the day traders and robo-machines have been induced to slam the “buy” button on a theory so preposterous that even CNBC’s chief circus barker, Jim Cramer, could not have invented it.
That is, the notion that Donald Trump was the second coming of Ronald Reagan and that a huge deficit-fueled “stimulus” was just around the corner is just plain nuts. There will be no such thing.
Trump-O-Mania was the greatest eruption of irrational exuberance yet because it occurred in the wake of an election outcome that is a repudiation of the very regime of Bubble Finance from which it took flight. Donald Trump’s shocking election victory was in fact due to the fact that the nation’s economic prospects and future growth potential has dimmed dramatically since 1987.
Since the Greenspan era of Bubble Finance began in October, the value of corporate equities owned by households has soared from $1.8 trillion to nearly $15 trillion. That means that equity values have increased 65% faster than the 4.5% annual gain in GDP during the same 29-year period. ("Households?!" You mean the 1% "households", because it sure as hell wasn't mine or yours, Good Citizen... - CP)
[The Takeaway: There’s a word for that sort of imbalance: unsustainable. Does anyone with a pair of brain cells to rub together think it can last much longer? But the greatest headwind Trump faces is his wildly inconsistent and irresponsible fiscal program. It will not result in a smooth hand-off the “stimulus” baton from the Fed to fiscal policy and the vaunted “Trump Stimulus” as Wall Street so blithely expects. And that’s becoming more obvious by the day.
Instead, it will actually produce a political conflagration and Fiscal Bloodbath like the Imperial City has never before witnessed. The failed health care reform effort was just the start. Consequently, the extreme stock market euphoria that somehow still exists will give way to its opposite as the casino gamblers come to recognize that the jig is up. With a possible government shutdown next week, the message from the beltway will become increasingly cacophonous and disconcerting.
Namely, it will become obvious there is no known combination of Congressional votes - Republican, Democratic or mixed - that the Trump White House will be able to marshal on behalf of deep corporate and personal tax cuts, a major defense spending increase, a huge infrastructure program, more money for veterans, border control, the Mexican Wall, domestic law enforcement and homeland security - while given a free pass to the giant retirement entitlement programs, social security and medicare at $1.6 trillion per year.
That’s because the current public debt of $20 trillion will grow by $1 trillion per year to upwards of $25 trillion during the Great Disrupter’s first term, and that’s before one dime of the ballyhooed Trump Stimulus is added to the equation. To add $500 billion per year or more of additional red ink to the equation is beyond the pale. That’s true even for the spenders who inhabit the Imperial City - especially after they realize the bond vigilantes who keep careful watch of federal spending were not extinguished back in 1994, but only went into a long hibernation that is now over as the era of central bank money printing has reached its end game.
So unless Donald Trump can accomplish the seeming impossible, his entire and largely misbegotten fiscal stimulus program will be stillborn. It will simply disappear amidst endless budget battles and debt ceiling showdowns/government shutdowns which will make the budgetary fireworks of August 2011 look like a Sunday School picnic in comparison. End Takeaway]
And that gets us back to the whole idea that the Reagan Boom of 1983-1984 can be replicated from a cold start at the very end of a long-in-the-tooth business cycle. The fact is, the original event was not a supply side miracle in the slightest. It was a “borrow and spend” eruption that depended upon a massive expansion of the Federal deficit from 2% of GDP under the outgoing Carter budget to an unprecedented 5-6% of GDP during the Gipper’s first term.
Even then, the celebrated Morning in America boom during 1983-1984 was not remotely what it is cracked-up to be by Trump’s aging posse of supply siders like Stephen Moore and Larry Kudlow. During the six quarters of 1983 through Q2 1984, fully 27% of the real GDP growth was accounted for by a huge but one-time restocking of business inventories - after they had been flushed out of the system by Volcker’s 20% interest rate medicine during the 1980-1982 battle against inflation.
That is not remotely relevant today because inventories stand at cyclical highs, and are virtually certain to be liquidated - not restocked - in the period ahead. Even the housing surge happened during this interval because mortgage rates were plummeting after the crushing double-digit rates generated by the Volcker anti-inflation campaign. Self-evidently, after 8 years of ZIRP, mortgage rates will now be rising, not falling, as far as the eye can see.
Finally, when the Reagan boom began, the stock market’s price/earnings (PE) ratio had been hammered down into single digits by the prior decade of soaring inflation. So it had nowhere to go except up - the very opposite of today’s 25X multiple, which flirts with PE ratios normally associated with those preceding violent market crashes.
In short, the greatest Sucker’s Rally in history is now nearly over. And the Wall Street casino is about to feel the full brunt of the Great Disrupter - and one of an altogether different kind than that invented by the Wall Street brokers on election night. As a contra-Cramer might say, there will never be a better time to sell, sell, sell!”
This will be anything but peaceful...