Weird begets weird
I said in an earlier piece on this topic:
I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.
So what’s weird now?
- Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
- Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
- Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
- Students and middle-to-lower classes borrowing too much (autos, credit cards)
- Interest rates and goods and services price inflation stay low in the face of this.
- Low volatility (until now)
- Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks (smaller percentage on a big base)
- Low credit spreads
No one should be surprised by the current market action. It wasn’t an “if,” but a “when.” I’m not saying that this is going to spiral out of control, but everyone should understand that The Little Market that Could was a weird situation. Markets are not supposed to go up so steadily, which means something weird was fueling the move.
Lack of volatility gives way to a surfeit of volatility eventually. It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy. It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.
Now, we’re not back in 2007-9. This is different, and likely to be more mild. The banks are in decent shape. The dominoes are NOT set up for a major disaster. Risky asset prices are too high, yes. There is significant speculation in areas Where Money Goes to Die. So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade. Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.
Could this be “the pause that refreshes?” Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly. The lure of free money brings out the worst in many.
You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash. That’s the grand asset-liability mismatch. Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble. Have you considered these concepts:
- Preservation of capital
- Dry powder
- Not finding opportunities
- Momentum gives way to negative arbitrages.
- Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”
Going back to where money goes to die, from the less mentioned portion on the short volatility trade:
Again, this is one where people are very used to selling every spike in volatility. It has been a winning strategy so far. Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.
Again, when the big volatility spike hits, remember, I warned you. Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. Do you have enough wherewithal to survive a longer bull phase?
To all, I wish you well in investing. Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail. And, all asset classes eventually go through failure.
So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap. Do you have the flexibility to buy in at better levels? Should you even touch it if it is like a knockout option?
There are no free lunches. Get used to that idea. If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.
Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation. Where is debt building up? Are there unusual derivative positions building up? What sort of parties are chasing prices? Who is resisting the trend?
And, when markets are falling hard, remember that they go down double-speed. If it’s a lot faster than that, the market is more likely to bounce. (That might be the case now.) Slower, and it might keep going. Fast moves tend to mean-revert, slow moves tend to persist. Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.
And once they have sold, the panic will end, and growth will begin again when everyone is scared.
That’s the perversity of markets. They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).
Don’t let this situation be “too bad” for you. If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down. Preserving capital is not imprudent, even if the market bounces.
In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions. Then when markets get weird, you can smile and bear it. The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”