Massive Leverage = Massive Risk

DATED MARCH 10, 2016
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The articles below are reprinted from previous issues of Crosscurrents
and are chosen for their timeliness and relevance.

Negative Liquidity Will Drive The Year Ahead 2016

We have shown today’s featured chart in six of our twelve issues this year and in fact, we labelled this picture our Chart of the Year many months ago.  Clearly, the circumstances of grossly negative liquidity and major stock market peaks in both 2000 and 2007 were not just mere coincidence.  Stock price movements are quite obviously based on demand and supply.  An excess of demand over supply and prices must rise.  An excess of supply over demand and prices must fall.  We must admit that the metamorphosis of the U.S. stock market to an arena dominated by high frequency trading (HFT) and algorithms of every kind and description has altered the equations somewhat but prices are still driven predominantly by liquidity.

The first major peak in stock prices on our chart in March 2000 was accompanied by an all time record low in the mutual fund cash-to-assets ratio and an all-time record high in margin debt.  A lower cash-to-assets ratio equates to lessened demand.  An all time record high in margin debt equates to an increased supply.  The circumstances easily conspired, first to drive prices in a manic fashion to unrealistic and unsustainable extremes, and then to historically oversold levels.  How bad was it?  Consider that prices collapsed by 50% for the first time in 26 years.  The second major peak in stock prices arrived in October 2007 and was preceded by a negative liquidity extreme just four months earlier.  The negative liquidity extreme in 2000 was $121 billion.  In 2007, it was $192 billion.  This extreme was also accompanied by a 50% collapse in prices.  While the most recent extreme of  negative $272 billion in June 2015 has yet to be accompanied by anything more than a modest decline in prices, we believe a significant loss will occur; perhaps not a 50% collapse, but certainly a bear market, traditionally defined as a minimum 20% downside.

However, the 2009-2015 bull cycle has already survived a ten-month timeout and price correction between the May 2011 high and the March 2012 recovery high.  The downside measured as much as 21.8% from print high to print low, a bear market in our book.  But most observers differ.  Given the 2012 low did not take out the 2010 low, the common wisdom has been the timeout was simply a correction and the correction was simply a timeout, thus we are still in the midst of a six-and-a-half year old bull market.  However, we would point out that we suffered a negative liquidity extreme that coincided roughly with the price highs of May 2011.  Just two months later, liquidity bottomed at minus $155 billion (see arrow), sufficient for stocks to slide 20% in only eight weeks!  Does it really matter if we construe a new bull market or a six-and-a-half year old bull?  We think not.  Far more important is the realization that negative liquidity always equates to extreme danger for stocks. 

The annual percentage change in total margin debt outstanding has turned out to be a very effective timing tool.  Dips into negative territory have preceded price corrections and surges into positive territory have been accompanied by rally phases.  As of September, the differential fell to minus 1.16%, signaling net supply.  While the indicator gained nominally in October and November, the trend of this indicator has been down since December 2013, thus we expect a further decline into negative territory.  The October/November bounce was likely just temporary, similar to the small bounce into April 2015.  Now check out the brief dip into negative territory in 2012 (larger circled area).  That blip was accompanied by a hefty 20% decline in the major indexes, thus there is no way we can ignore the one month negative reading registered in September. Clearly, we are seeing a strong correlation and the trend is negative. 

In the last issue, we promised longer term perspectives and one such view is below.  Cumulative Advancing/Declining volume simply takes the net volume for each day on the NYSE and adds it to the previous day’s total.  As you might suspect, the trend is always rising in a bull market.  However, there has been a distinct change in trend since the May price highs and although prices have come back to near their highs several times, the decline in cumulative A/D volume was only minimally recovered before once again recently giving way to the downside. 

[Data through March 7, 2016]

Taking out the 2015 low would clearly establish a bear trend.  Worse yet, consider where the indicator is now and where it was on December 17, 2013, more than two years ago.  It’s at the exact same level as today.  Two years later, transactional volume totaling $135 trillion have resulted in no gain at all.  Both 2014 and 2015 have been record setting years for dollar trading volume (DTV).  There is almost no way to convey the size of this mania.  We can only try; the metamorphosis is so complete that DTV for each of the last two years is more than double that of the incredible stock market bubble of 2000.

Clearly, we are witnessing the third instance of a veritable mania in the short span of 15 years.  However, if $135 trillion in DTV gets us nowhere over two years, the only assumption that makes any sense is stock prices are not headed significantly higher for a long time to come.  We have shown a number of ways we forecast the long term, including a 5% regression line chart which enabled our forecast of Dow 6400 and SPX 680 five-and-a-half years before the actual fact.  We have shown several times this year how the same regression line now points to roughly Dow 13,800 as a worst case; other charting methodologies suggest the bear forecast would be fulfilled with a move to Dow 14,719.  Below, annualized returns over all 20 year periods average roughly 5%, although obviously there have been times of much better and much worse returns. 

However, returns have been above 5% since May 1989, a period of 26-1/2 years!  A move to the 5% level at this point would actually be a non-event as it can be accomplished with just a sideways jaunt over the next ten months. 

Given the propensity of markets to overshoot,
we believe we are more likely to see the 20-year average fall somewhat lower. 

Our forecasted range of Dow 13,800 to 14,719
would equate to 2.9% to 3.9% for the 20-year average.

Sounds just right.

[Ed. Note: we have since changed our bear market targets. See the latest issue of Crosscurrents for more info.]

198 Trillion Reasons To Fear Another Fiasco 

Although your Editor has been a market observer for 51 years, the first 23 years were relatively tame.  There was a great bull market, then a horrific bear market and then another great bull market.  Nothing truly out of the ordinary and unsurprisingly “normal.”  Things began to get a lot more interesting when the stock market suffered a bona fide crash in 1987, the worst implosion since 1929 and bad enough to create concerns of a total financial collapse.  Six months later, we wrote an in-depth analysis of the crash, concluding that risk parameters had changed dramatically and permanently.  One of the key drivers for this metamorphosis was the establishment of stock index futures trading in 1982, providing the first ever opportunity to trade a derivative based on stock prices, instead of trading the underlying asset—stocks.  While there was an options market for certain stocks at the time, options were infrequently traded and quotes were almost by appointment.  However, as time passed, trading in the S&P stock index futures enabled a more relevant options market and finally provided the impetus for more futures.  When Dow Jones refused to allow futures based on their Industrial index, the XMI major market index was created and began trading on April 29, 1983.  This new index represented 20 “blue chip” industrial issues, and thus approximated the venerable Dow Industrials.

The bull market for stocks provided for growth in stock derivatives and this success spawned the realization that just about anything could be replicated with a derivative.  Within a decade, there were derivatives of just about every stripe.  By 1991, the notional values of all derivatives totaled $7.4 trillion, 1.8 times the $4 trillion value of the stock market.  Growth wasn’t just rapid, it was astonishing.  By 1998, notional values reached almost $33 trillion, 2.56 times the $12.86 trillion value of the stock market.  As in 1987, there was a brief timeout as the entire financial system was threatened by the collapse of Long Term Capital Management.  This time, the Federal Reserve had to step in and broker a deal to stop the bleeding, practically issuing ultimatums to certain Wall Street firms to stop the bleeding.  Savvier minds than ours felt we might be only hours from a total financial collapse.  That’s how bad it was. 

Brief time outs aside, nothing would stop the growth in derivatives.  By 2007, the year the housing bubble peaked and another stock mania saw the Dow first hit the 14,000 mark, notional values of derivatives reached $165.6 trillion, close to nine times total stock market capitalization of $18.8 trillion.  Of course, this marked yet another timeout, this time not so brief. 

By the bottom of the economic recession in March 2009, Citigroup (C) had become a penny stock, falling 98.3% from its December 2006 high.  Much the same circumstance played out for other major banks, such as Bank of America (BAC) and HSBC, and stocks were cut neatly in half.  However, despite this third incredible collapse, there seemed no way to deter the long term rationale of the large banks that the larger their derivative portfolios, the better off we all would be.  Of course, the conduct of the large banks in creating additional trillions in notional values of derivatives was clearly aided by a pliant Federal Reserve and U.S. Congress.  By 2013, total notional values were $236 trillion.  If you’ve never seen this number, we show it below. 


That was the saturation point, the peak in notional values and perhaps the point at which the major players finally realized that yet another debacle was inevitable.  Clearly, risk exposures were ignored in 1987, 1998 and 2008, resulting in gigantic dislocations in our markets.  Worse yet, as our featured chart on page one clearly illustrates, the rapid growth in derivatives has been accompanied by a far lower long term rate of economic growth.  While banks may have presumed economic growth would be enhanced by derivatives,  the opposite has shown to be true. 

Finally, there seems to be some recognition that risk exposures remain gigantic.  In the second quarter of 2015, total notional derivatives fell $5.2 trillion, or 2.6%, to $197.9 trillion, the lowest level since the third quarter of 2008, but nearly 20% higher than at the end of 2007.  Derivative contracts remain concentrated in interest rate products, which comprise nearly 78% of total derivative notional values. 

So-called “Level 3” assets are assets where fair value cannot be determined by using observable inputs, such as market prices.  Another way of assessing market risk is presumed to be the volume of and changes in level 3 trading assets.  Since the peak of the financial crisis at the end of 2008, major dealers have sharply reduced the volume of level 3 trading assets.  Nevertheless, Level 3 assets held by banks total $50.4 billion and estimates of their fair value can only be assumed.  Given that the total of Level 3 assets has contracted by more than 75% from their peak in 2008, this speaks volumes about how reluctant banks formerly were to face the truth. 

Meanwhile, in contrast to insured commercial banks, bank holding companies still have derivative portfolios encompassing $255.2 trillion, of which only four banks account for 91.6% of the total.  At left below, looking at insured commercial banks, we see that 7 banks alone account for 97.6% of all notional values in derivatives.  Our complaint is always as it has been—exposures are far too concentrated in too few companies, which subjects the financial system to inordinate and intolerable risks that cannot be calculated.  At bottom right, any reasonable person would wonder why the total assets of these commercial banks need be dwarfed to the extent shown by notional values of their derivative portfolios.

At center, referencing credit exposures as a percentage of risk based capital shows pretty much the same picture as we have shown for many years.  Despite the apparent recent increase in recognition that derivative portfolios may carry unwelcome risks, several of the largest banks have actually raised their risk profile.  Goldman Sachs (GS) is number three in total notional values and JPMorgan Chase is number one.  In fact, credit exposure as a percentage of risk based capital also rose for Citibank, number two on notional values, but the percentage increase from our last assessment was only nominal. 

A near collapse in 1987.

Eleven years later in 1998, a near collapse.

Ten years later in 2008, a dramatic bubble burst leading to another near collapse.  While the math is only coincidental, we believe the threat of a yet another derivative fiasco is real.  Yes, the situation may not be quite as bad as before.  We used to have 236 trillion reasons why, now we only have 198 trillion reasons. We’d love to believe that banks have learned their lesson but honestly folks, who paid for all their incompetence? 

The rest of us did. 

We believe the odds for another disaster are way too high. 

Retail Insiders Say We're Already In Recession

Every few months, we take the pulse of insiders in one sector or another.  We consider their activity to be a bellwether, perhaps even a bell ringer, as it was at the very bottom in 2009, when insider buying activity was as robust as we have ever seen.  It was the principal reason we turned bullish at that time.  Of course, we should have remained bullish far longer than we did but when the insiders began selling in droves once again, we saw no reason to remain positive.  Retail is a huge chunk of the economy and if insiders want out, we want out.  Given recent activity, we want out, totally and completely.

Our most recent look at insider buys and sells of the top companies in the Market Vectors Retail (RTH) ETF is a sign of a rapidly deteriorating environment.  Back in June 2014, we saw 38 sales for each buy.  Last August, it was 49 sales for each buy and at present, it is 70 sales for each buy.  And if Kroger (KR) Officer Michael Ellis had not purchased 500 shares on August 24, 2015, the ratio would have been infinite.  In fact, this is the first occasion in over three years where we have seen only one insider buy of the top retail stocks in the previous six months.  Looking at the bar for Amazon (AMZN) offers one of those rare moments when you marvel that shares can be so reviled by insiders yet loved institutionally.  Despite 26 insider sales totaling 1.15 million shares and zero buys, the top ten institutional holders of AMZN own roughly 30% of the outstanding shares.

Talk about irrational exuberance!  And that’s precisely what David Stockman refers to on his Contracorner (see http://bit.ly/1OHf5CJ) article, detailing the many ways in which AMZN is explosively overvalued.  But, as they say, that’s not all.  We’d be remiss if we did not also reference the article at Mauldlin Economics (see http://bit.ly/1V5q0Va).  Seems retail just gets “muddier” and “muddier.” 

Given retail sales account for roughly 35% of our gross domestic product (GDP), activity in the sector gives us our best perspective for where the economy is heading and unfortunately, the economy now appears to be pointing down.  After seeing sales flat in August and September and a paltry 0.1% increase in October, sales for the holiday season took on a far more important role than usual but as you can see in Doug Short’s report at http://bit.ly/1ny5imA, the holiday was a bust. 

More bad news for retail.  The number of licensed drivers under the age of 70 is on the decline.  The younger the group, the greater the decline.  For instance, 91.8% of those 20-24 years old were licensed drivers in 1983. By 2008, the number dropped to 82%. Licensed drivers in this age group fell to 79.7% in 2011 and 76.7% in 2014.  This means lower auto sales ahead.  Worse yet, Bank of America recently reported core retail sales data (excluding auto) from credit cards was down for the first time since the financial crisis. 

Last month, there was only one sell recommendation of 260
separate opinions we witnessed in our recent analysis. 

Nevertheless, our top retail stocks were down an average of 9.2% in the last six months. 
This is a stunning, absolutely stunning display of analyst incompetence. 

The only truths are spoken by insiders. 

We are headed into a recession and indeed, are likely already there.

"Last Minute News..."

We believe we are at one of the most dangerous crossroads in stock market history.
We never expected our indicators to be as outlandishly negative as they are today. 
We were hoping for a far more rational environment, not a third mania in 15 years. 

Unfortunately, our greatest confidence lies in the knowledge
that this mania will end like the two before.


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I hope you have enjoyed your visit.  Please return again and feel free to invite your friends to visit as well.

Alan M. Newman, March 10, 2016

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All information on this website is prepared from data obtained from sources believed reliable, but not guaranteed by us, and is not considered to be all inclusive.  Any stocks, sectors or indexes mentioned on this page are not to be construed as buy, sell, hold or short recommendations.  This report is for informational and entertainment purposes only.  Persons affiliated with Crosscurrents Publications, LLC may be long or short the securities or related options or other derivative securities mentioned in this report.  Our perspectives are subject to change without notice.  We assume no responsibility or liability for the information contained in this report.  No investment or trading advice whatsoever is implied by our commentary, coverage or charts.