“The Selling Has Just Begun”
by Brian Maher
“The selling has just begun,” panics Morgan Stanley, “and this correction will be the biggest since the one we experienced in February." "The most important trade of the past decade is now reversing," shrieks Charlie McElligott, head of Nomura’s cross-asset strategy. Since last Friday the S&P technology sector lost $350 billion of artificial wealth… swept away to the Land of Wind and Dust, the graveyard of illusions.
Facebook has absorbed the heartiest slating of the bunch. Twitter, with disappointing second-quarter earnings of its own, follows. If you wish to understand the outsized market influence of technology stocks, consider: The S&P’s five largest companies - Apple, Amazon, Alphabet (Google), Microsoft and Facebook - boast a combined market cap exceeding $4 trillion. These five technology stocks thus equal the market cap of the index’s bottom 282 companies, combined.
The S&P is up 5% year to date. But were you aware that 73% of S&P stocks are down at least 5% this year? Or that 49% are down 10% or more? It is true - our agents confirm it. Ten stocks alone account for 100% of the S&P’s yearly gains - and six of these wagon-pullers have been technology stocks.
Rarely before, we conclude, have so many investors... owed so much... to so few stocks. But what if these market supporters crack under the strain and throw off the burden of leadership? Will anyone carry the standard forward? No, suggests Goldman Sachs: “Narrow bull markets eventually lead to large drawdowns.”
Of chief concern to many analysts is the strategy of “passive investing.” Passive, because it rises or falls with the prevailing tide. Technology stocks like Facebook have lifted markets on a flowing tide of momentum. Much of Wall Street has poured into these stocks… sat back on its oars… and let the current take markets to record highs.
But the danger is this: When the tide recedes… it recedes. And the same handful of stocks can wash the market out to sea, quick as a wink. Panic selling begets panic selling, and where it ends is an awful mystery. Jim Rickards explains: "What matters is the array of traders, all leaning over one side of the boat, suddenly running to the other side of the boat before the vessel capsizes. The technical name for this kind of spontaneous crowd behavior is hypersynchronicity, but it’s just as helpful to think of it as a herd of wildebeest that suddenly stampede as one at the first scent of an approaching lion. The last one to run is mostly likely to be eaten alive."
Or as analysts Lance Roberts and Michael Lebowitz of Real Investment Advice style it: "When the “herding” into ETFs begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures. Importantly, as prices decline it will trigger margin calls,* which will induce more indiscriminate selling. As investors are forced to dump positions the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments."
Roberts and Lebowitz remind that investors lost 29% of their capital over a three-week span in 2008 — and 44% over three months. “This is what happens during a margin liquidation event,” they conclude. “It is fast, furious and without remorse.”
We can of course provide no timeline for the described phenomenon. Nor, for the matter of that, can anyone else. But we have argued against a general catastrophe this year. We believe the ultimate reckoning may wait until next year… or the year following. Why? Because we first expect a “melt-up” - that final manic, incandescent phase bull markets enter before the inevitable melt-down. And these conditions do not obtain today.
We admit the possibility of an impending correction as Morgan Stanley predicts - but why, we wonder, can markets only “correct” lower? If a 10% market fall is a correction, is a 10% increase an incorrection?And if the S&P was correct when it plunged 10% in February, must we conclude any subsequent rise has been incorrect? Questions to ponder of a lazy midsummer day. We may soon have our answers.
Regardless, more questions will follow in the days ahead, and some may bring unsatisfying answers. In the words of former fund manager Richard Breslow: “This isn’t shaping up to be an old-fashioned quiet August.” Below, Jim Rickards shows you why investors have been lulled into a false sense of security, and why they may pay dearly as a result. Read on."
"Investors Have Fallen Into a False Sense of Security"
By Jim Rickards
"In January 2018, two significant market events occurred nearly simultaneously. Major U.S. stock market indexes peaked and volatility indexes extended one of their longest streaks of low volatility in history. Investors were happy, complacency ruled the day and all was right with the world. Then markets were turned upside down in a matter of days. Major stock market indexes fell over 11%, a technical correction, from Feb. 2–8, 2018, just five trading days. The CBOE Volatility Index, commonly known as the “VIX,” surged from 14.51 to 49.21 in an even shorter period from Feb. 2–6.
The last time the VIX has been at those levels was late August 2015 in the aftermath of the Chinese shock devaluation of the yuan when U.S. stocks also fell 11% in two weeks. Investors were suddenly frightened and there was nowhere to hide from the storm.
Analysts blamed a monthly employment report released by the Labor Department on Feb. 2 for the debacle. The report showed that wage gains were accelerating. This led investors to increase the odds that the Federal Reserve would raise rates in March and June (they did) to fend off inflation that might arise from the wage gains. The rising interest rates were said to be bad for stocks because of rising corporate interest expense and because fixed-income instruments compete with stocks for investor dollars.
Wall Street loves a good story, and the “rising wages” story seemed to fit the facts and explain that downturn. Yet the story was mostly nonsense. Wages did rise somewhat, but the move was not extreme and should not have been unexpected. The Fed was already on track to raise interest rates several times in 2018 with or without that particular wage increase. Subsequent wage increases have been moderate. The employment report story was popular at the time, but it had very little explanatory power as to why stocks suddenly tanked and volatility surged.
The fact is that stocks and volatility had both reached extreme levels and were already primed for sudden reversals. The specific catalyst almost doesn’t matter. What matters is the array of traders, all leaning over one side of the boat, suddenly running to the other side of the boat before the vessel capsizes. The technical name for this kind of spontaneous crowd behavior is hypersynchronicity, but it’s just as helpful to think of it as a herd of wildebeest that suddenly stampede as one at the first scent of an approaching lion. The last one to run is mostly likely to be eaten alive.
Markets are once again primed for this kind of spontaneous crowd reaction. Except now there are far more catalysts than a random wage report, despite last week’s optimistic GDP report.
We all know what’s happened to Facebook since last Friday. But look at the potential trouble from geopolitical sources alone... The U.S. has ended its nuclear deal with Iran and has implemented extreme sanctions designed to sink the Iranian economy and force regime change through a popular uprising. Iran has threatened to resume its nuclear weapons development program in response. Both Israel and the U.S. have warned that any resumption of Iran’s nuclear weapons program could lead to a military attack.
Venezuela, led by the corrupt dictator Nicolás Maduro, has already collapsed economically and is now approaching the level of a failed state. Inflation exceeds 40,000% and the people have no food. Its inflation rate has now exceeded the hyperinflation of Weimar Germany.
Social unrest, civil war or a revolution are all possible outcomes. If infrastructure and political dysfunction reach the point that oil exports cannot continue, the U.S. may have to intervene militarily on both humanitarian and economic grounds.
North Korea and the U.S. have pursued on-again, off-again negotiations aimed at denuclearizing the Korean Peninsula. While there have been encouraging signs, the most likely outcome continues to be that North Korean leader Kim Jong Un is playing for time and dealing in bad faith. The U.S. may yet have to resort to military force there to negate an existential threat.
This litany of flash points goes on to include Iranian-backed attacks on Saudi Arabia and Israel, a civil war in Syria, confrontation in the South China Sea and Russian intervention in eastern Ukraine. These traditional geopolitical fault lines are in addition to cyber threats, critical infrastructure collapses and natural disasters from Kilauea to the Congo.
Investors have a tendency to dismiss these threats, either because they have persisted for a long time in many instances without catastrophic results, or because of a belief that somehow the crises will resolve themselves or be brought in for a soft landing by policymakers and politicians. These beliefs are good examples of well-known cognitive biases such as anchoring, confirmation bias and selective perception. Analysis tells us that there is little basis for complacency. Yet the VIX is back near all-time lows as shown in Chart 1 below.
Even if the probability of any one event blowing up is low, when you have a long list of volatile events, the probability of at least one blowing up approaches 100%.
With this litany of crises in mind, each ready to erupt into market turmoil, what are my predictive analytic models saying about the prospects for an increase in measures of market volatility in the months ahead?They’re saying that investor complacency is overdone and market volatility is set to return with a vengeance. Even with the Facebook blowup and trouble in the tech space, VIX is just above 13.
Changes in VIX and other measures of market volatility do not occur in a smooth, linear way. The dynamic is much more likely to involve extreme spikes rather than gradual increases. This tendency toward extreme spikes is the result of dynamic short-covering that feeds on itself in a recursive manner - or what is commonly known as a feedback loop.
Shorting volatility indexes has been a very popular income-producing strategy for years. Traders sell put options on volatility indexes, collect the option premium as income, wait out the option expiration and profit at the option buyer’s expense. It’s been like selling flood protection in the desert; seems like easy money. The problem is that every now and then a flash flood does hit the desert.
When we consider recent financial catastrophes affecting U.S. investors only, without regard to other types of disaster, we have had major stock market crashes or global liquidity crises in 1987, 1994, 1998, 2000 and 2008. That’s five major drawdowns in 31 years, or an average of about once every six years. The last such event was 10 years ago. So the world is overdue for another crisis based on market history.
Investors expect that the future will resemble the past, that markets move in continuous ways and that extreme events occur rarely, if at all.
These assumptions are all false. The future often diverges sharply from the recent past. Markets gap up or down, giving investors no opportunity to trade at intermediate prices. Extreme events occur with much greater frequency than standard models expect. When they do strike seemingly from nowhere, like fire in a crowded theater, everybody panics and a wave of selling feeds upon itself. The trouble is, most investors will never make it out of the theater in time."
If they're standing you in front of a firing squad,
wouldn't you at least want to know why?