richard fisher 1
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The Only Guy On The FOMC With Any Experience Actually Managing Risk Is Sounding The Alarm

Below is a compilation I put together using excerpts from Richard Fisher’s speeches this year (emphasis mine):

There is no greater gift to a financial market operator—or anyone, for that matter—than free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call “beer goggles.” This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy. Here are some of the developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat:

  • Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth.
  • Dividend payouts financed by cheap debt that bolster share prices.
  • The “bull/bear spread” for equities now being higher than in October 2007.
  • Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s.
  • The price-to-earnings (PE) ratio of stocks is among the highest decile of reported values since 1881. Bob Shiller’s inflation-adjusted PE ratio reached 26 this week as the Standard & Poor’s 500 hit yet another record high. For context, the measure hit 30 before Black Tuesday in 1929 and reached an all-time high of 44 before the dot-com implosion at the end of 1999….
  • Margin debt that is pushing into all-time records.
  • In the bond market, investment-grade yield spreads over “risk free” government bonds becoming abnormally tight.
  • “Covenant lite” lending becoming robust – surpassing even the 2007 highs – and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when “junk” companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk. I may be too close to this given my background. I have been involved with the credit markets since 1975. I have never seen such ebullient credit markets. From 1989 through 1997, I was managing partner of a fund that bought distressed debt, used our positions to bring about changes in the companies we invested in, and made a handsome profit from the dividends, interest payments and stock price appreciation that flowed from the restructured companies. Today, I would have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy. The big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.

The former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability. We must watch these developments carefully lest we become responsible for raising the ghost of irrational exuberance.

Why isn’t anyone listening?

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All Eyes On The Bond Market

The most critical asset class in the world right now might just be the US bond market, as represented by the 10-year treasury note yield. So far this year bonds have performed very well as this rate has declined – foiling the best laid plans of all the bond bears (and there have been loads of them). But the bulls can’t quite plan their victory parade just yet because right now this critical interest rate is sitting at a critical technical level, a crossroads, actually.

The downtrend for this rate is well-established. It might be the longest tenured trend, in fact, of any major asset class out there right now. Here’s a look a the monthly chart:

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Clearly it’s not even close to breaking above that upper downtrend line that dates back to the mid-1980’s. So anyone making the case for higher interest rates is swimming upstream.

But take a look at the weekly chart and it’s a little bit different story:

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After briefly breaching the 2.25% level during the height of the financial crisis and then testing it again in the fall of 2010 this rate finally broke down to new lows during the summer of 2011. It wallowed below that key level for a couple of years before regaining it during mid-2013 – along with breaking the downtrend line on that time frame – in a year that amounted to a walloping for long bond holders.

Much has been made of the weakness in rates/strength in bonds since then but, in actual fact, the action over the past few months has only amounted to a 50% retracement of the surge in rates from last year. And that area between 2.25% and 2.4% serves once again as key technical support. A closer look at a daily time frame shows what might be described as a bull flag (for the price action year-to-date) that has taken the rate right to the 50% retracement of the 2013 rise:

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In any case the action this year has been corrective rather than implusive, as Elliott Wave aficionados would say, suggesting yet higher rates are in order. However, the trend is still pointing lower on all of these time frames so there’s something both bulls and bears can point to right now.

All in all, this 2.3%ish level serves as a technical line in the sand. Until it breaks meaningfully one way or the other bulls and bears are at a stalemate. Once it does break out, though, it could have major implications for both the stock market (in terms of relative valuations) and the economy (in terms of leading indicators).

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Have Analysts Morphed Into ManBearPigs?
Posts

Here’s Why You Can’t Be Too Bullish Or Too Bearish Right Now

If you couldn’t already tell I’ve been thinking about cognitive biases and logical fallacies a lot lately. And while I’ve been fairly bearish for quite some time now I haven’t been, “sell everything and hide your cash in the mattress bearish.” Those who are that bearish are suffering from clear biases or fallacies I’ll get to in a minute. By the same token, those who are rip-snorting bullish right now are also suffering from a similar condition.

By being overly bullish right now, you’re simply in denial over a plethora of evidence that suggests the risk/reward equation is heavily skewed toward the risk side without much potential for reward at all. But what I really think bulls are relying on most heavily right now is a little something called “recency bias” or, as the Fed likes to put it (emphasis mine):

If asset prices start to rise, the success of some investors attracts public attention that fuels the spread of enthusiasm for the market. New (often less sophisticated) investors enter the market and bid up prices. This “irrational exuberance” heightens expectations of further price increases, as investors extrapolate recent price action far into the future. – “Asset Price Bubbles” FRBSF

That’s all “recency bias” is: investors ‘extrapolating recent price action far into the future.’ In other words, Mr. Market has been flipping a coin that just keeps coming up heads (big gains) so investors begin to believe that it’s just going to be heads forever. Tails (corrections or bear markets) are a thing of the past.

Obviously, this is just faulty logic. But when BTFD becomes so ingrained into the broader market psyche it just becomes painfully clear that investors are relying on nothing but the trend. Which is fine, of course, until the trend comes to an end. Just don’t pretend there are any other reasons to be bullish aside from the trend because there just aren’t.

On the flipside, uber-bears are suffering from a similar ailment called “gambler’s fallacy.” They believe that because Mr. Market has flipped heads so many times in a row (how long have we gone without a 10% correction?) that the likelihood of him flipping tails is now much greater which is also bogus logic but something people do all the time. The likelihood of flipping heads or tails is still 50% no matter what sort of streak has come before this flip of the coin.

Despite the fact that the odds haven’t changed at all, bulls believe there’s a near 100% chance the next flip is gonna be heads once again (because it’s just persisted so long) and bears believe there’s a near 100% chance it will be tails (because the ridiculous streak of heads just can’t persist). Both are wrong. So what’s an investor to do?

To me the fundamentals, sentiment and the macro backdrop are clearly bearish right now. But I grant that these are not timing mechanisms. These are just the shade of the lens we should be looking through right now. In 2009, you wanted rose-colored glasses because all three of these indicators were flipped. Today, you want the opposite, whatever that is (brown-colored glasses?).

Still, you probably don’t want to express that view in your investments to any great degree simply because Mr. Market is still, in fact, flipping heads… for now. So don’t get me wrong; I’m bearish. Clearly. But I’d recommend waiting until Mr. Market flips a tails or two to before jumping feet first into your bear costume.

Next week I’ll post the third in my “market timing” series which will make this much more clear.

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Posts

5 Quotes From Financial Wizards To Help You Understand The Current Asset Bubble

Fed policy “makes no sense from a risk/reward perspective” and it will “end badly.” -Stan Druckenmiller

Druckenmiller went on to say, “every ounce of intuition in my body is that the potential costs have crossed the potential benefits in Fed policies.” I think what he is referring to here is that the tools available to the Fed are not precision tools. They are blunt instruments that are not very effective in their mission and their use comes with all sorts of side effects and consequences. I wrote a bit about this yesterday. We’re seeing the majority of the effects ZIRP and QE appear in stock and bond prices rather than in employment and wages. But so what?

“We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.” -Raghuram Rajan

When you push up asset prices in an effort to stimulate the economy you also subject the economy and financial markets to the risk of asset bubbles – which, when they eventually pop (as they all do sooner or later), can undo all the work the policies or tools did in the first place. Anyone remember the financial crisis? We were well on our way to the Great Depression, part deux, as the Fed would have us believe. But have we reached “bubble” levels yet?

“Yellen’s comments suggest, and I agree, that we are in an asset bubble.” -Carl Icahn

Carl sure thinks so and evidently believes the Fed is doing it consciously. But how can we determine if we’re in a bubble?

Corporate bonds and junk bonds “have never been more over-valued in history.” -Jeff Gundlach

Oh, that’s how. Junk bonds valuations are sky high (not to mention other asset classes like stocks, farmland or office towers)…

“It is worrisome that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.” -Richard Fisher

…and the riskiest sort of bonds are being issued at a record pace. Didn’t we learn our lesson after the financial crisis? That this sort of thing is not a fix at all but just exacerbates the problem? Will we ever learn?

Maybe somebody ought to teach the Fed Albert Einstein’s definition of insanity: ‘doing the same thing over and over again and expecting different results.’

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Posts

It’s A Put On

This morning over coffee my wife said to me, “I don’t think Kate Upton is very pretty at all. Are they even looking at her face?” And I thought (though I can’t wholeheartedly agree with her), it’s just like the music business: modern technology lets you take anyone and make them look and sound like a superstar. Hire a world-class photographer and take him to the most beautiful place on earth, let him shoot anyone – really anyone – and then give the shots to a photoshop expert and you’ll have your SI swimsuit cover.

Or have a world-class producer pick his favorite song from one of the top songwriters in the world, put him in a top-of-the-line studio where he can also hire the best musicians on the planet and you can literally take anyone – yes, anyone – put them on the mike and using ProTools or AutoTune you will have a hit record. Guaranteed. (If you don’t believe me listen to this.)

But where is the “real” in that? I miss “real” (with apologies to Bob Lefsetz for stealing his modus operandi.) There are an amazing number of talented and beautiful people out there that don’t get even a smidgeon of the notoriety that Kate Upton and Brittany Spears get. I heard a guy last night playing here in Bend down at the shopping plaza. He sounded awesome. Who cares?

Nobody – because we’ve been trained to eat up the “fake” and ignore the “real.” “Fake” is way more profitable for corporate America because it’s so easy. “Real” takes too much time and effort. 10,000 hours? Who’s got that kind of time?

In the Sixties, “real” was everywhere. Jimi Hendrix, Cream, The Stones, Bob Dylan, The Beatles. For Christ’s sake, The BEATLES! They were the ones who really capitalized (forgive the pun) on “real.” And now everyone wants the shortcut to being/finding/capitalizing on the next Beatles. The irony is that they’ll never find it so long as they do it the “fake” way.

And this is all happening in our financial world, too. We long for the days of real growth in the economy, jobs and wages but rather than do what it takes to make it “real” (like allowing institutions to fail and debt cycles to cycle) we insist on “faking” it. We (The Fed) do absolutely everything in our power, lower interest rates to zero, print trillions of new dollars, etc. in an effort to see “real” growth in the economy only to find that we only get “fake” signs of growth like soaring stock and bond markets while the things that really matter in the big picture, jobs and wages, continue to stagnate.

It’s ALL an “Eminence Front” but nobody’s talking about it because we’re much closer to the top of the cycle than we are to the bottom. Maybe at the completion of this cycle Brittany Spears will cover The Who’s classic. Wouldn’t that be an awesome contrary indicator?

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Stoogelogo
Investing, Markets, Weekly Reports

On The Stock/Bond Conundrum

Professional investors typically look at the stock market as playing Curly to the bond market’s Moe. (I don’t know who Larry is… Currencies? Commodities?) Behavioral finance teaches us that neither of them are very rational over the short run and can, at times, get pretty zany. But the bond market is typically a bit wiser than the stock market and at times it likes to slap the stock market around when it gets wise. Maybe it’s because the bond market has things like “vigilantes” (or used to) that keep it a bit more honest. Who really knows?

Right now traders can’t stop talking about the divergence between the two. Bonds are saying the economy looks punk (as the yield curve continues to flatten) and stocks are saying everything looks hunky dory (as they surge to new highs). So who’s right? Is Moe about to do the eye poke on Curly or will Curly get the block in along with the last laugh.

I’ll just say that I don’t know; I’m not an economist and I wouldn’t trust those guys to know either. But I do have at least a clue.

First quarter GDP would suggest that the bond market has it right but, as we all know, markets are forward-looking, discounting mechanisms. So the continued weakness in yields would suggest that bonds see the Q1 contraction as more then just a blip while stocks are saying, “it’s not so bad.

And we’ve recently heard from a couple of market watchers I do trust who have come down on the side of the bond market. Stephanie Pomboy gave a terrific interview to Barron’s over the weekend:

The No. 1 thing is that investors generally have underestimated the impact that QE [quantitative easing] has had on the economy and the degree to which it has supported growth. As a consequence, they have underestimated the cost the tapering [of monthly Treasury bond purchases by the Fed] would have, and that is starting to come into focus. People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing…. I expect to see Treasury yields trading in a range from 2% to 3%, basically how it’s been for the past several years. You want to sell at 2% and buy at 3%. I wouldn’t be surprised to see rates fall below 2%, as investor perceptions about the economy meet with reality and they realize that the Fed still has a lot of work to do.

Is it just a coincidence that the Fed began to taper in January and the economy began to contract at the very same time? Maybe. But it’s worth making a note of especially due to the fact that each time QE has ended in the past it’s led to problems that have forced the Fed into a new round of QE. Different this time?

Jeff Gundlach, another whose work I greatly admire, seems to agree with Stephanie. A couple of weeks ago he predicted we would see “one of the biggest short covering scrambles of all time” in the bond market that would send the 10-year yield below 2% and perhaps even below the 1.5% level tagged back in 2012. The recent economic slowing would have to at least continue if not accelerate for something like this to occur.

To be sure, this is THE contrarian call right now. A recent poll of 72 economists found none of them see a contraction in our future. To me, this is the sort of consensus that Bob Dylan sang about:

“Half of the people can be part right all of the time
Some of the people can be all right part of the time
But all of the people can’t be all right all of the time” [emphasis mine]
I think Abraham Lincoln said that
“I’ll let you be in my dreams if I can be in yours”
I said that.

And I wouldn’t be surprised to see Curly get slapped upside the head yet again.

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Investing, Markets

The Calm Before The Storm

It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you’re not supposed to short a dull market but…

When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now. Bianco research recently noted that over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007. This marked the beginning of a volatility pick up that ultimately peaked manifold higher during the height of the financial crisis.

Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this it does suggest that investors are usually in for some sort of ‘surprise’ that sends volatility higher. And there’s a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.

It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security or confidence that stocks just don’t go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the “great moderation” line of bullshit. This causes them to become overconfident and over-commit to stocks. When a pullback greater than just a few percent finally happens these investors are surprised by the ‘extreme volatility’ (which is really just normal volatility that has been dormant) and they reduce the undue exposure they put on when they believed volatility was dead. Add this to the normal selling that occurs during and you get a greater than average sell off. Multiply all of these effects (to account for record low vol) from the beginning and that’s how you get a crash like we saw subsequent to the record low vol mid-2007.

Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations and that’s not about to happen again. But history does look like it could be rhyming in some ways right now.

Any major dude will tell you” about not just the record low vol but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double digit decline once this happened. And @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.

I know: Correlation ≠ causation. Still, it makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.

And we’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs.

As for the latter, @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “RUT [Russell 2000] recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead.” That level lies >5% below its current number but there’s a good chance stocks could fall at least twice that much. Again @ukarlewitz:

At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.

No. This doesn’t mean stocks are about to fall 20%+. But with record low vol over this span how many investors are prepared for such a scenario?

There are also divergences galore. Toddo, calls our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since… you guessed it. Yep, 2007.

Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well. So what to junk bond investors see that equity investors don’t?

Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.

Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.

Maybe it’s the bursting of the bubble in profit margins.

Maybe it’s the bursting of the housing bubble in China.

Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction. Who knows?

In any case, I’d argue that the record low vol shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible. But people love to believe things even when they know they’re not true. And you know what? According to the Fed, this is the very definition of a bubble.

It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today. And it’s increasingly likely this is just the calm before the storm.

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