is our 84th report on the consequences of the stock market mania
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The articles below are
reprinted from previous issues of Crosscurrents
and are chosen for their timeliness
Negative Liquidity Will Drive
The Year Ahead 2016
REPRINTED FROM THE DECEMBER
28th ISSUE OF CROSSCURRENTS
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
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
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
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
198 Trillion Reasons To Fear
REPRINTED FROM THE NOVEMBER
29th ISSUE OF CROSSCURRENTS
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
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
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
THIS IS AN EXCERPT
- REPRINTED FROM THE JANUARY 31st ISSUE OF CROSSCURRENTS
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
separate opinions we witnessed in our recent
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
We are headed into a recession
and indeed, are likely already there.
"Last Minute News..."
REPRINTED FROM THE MAY 31st
ISSUE OF CROSSCURRENTS - ONLY 8 TRADING SESSIONS AFTER THE MAY 19th PEAK.
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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