IceCap Asset Management's Monthly outlook on global investment markets: October 2017, submitted by Keith Decker of IceCap Asset Management
“Should I Stay or Should I Go?”
Darlin’ you got to let me know
During the 1970s, The Clash pushed rock and roll to the edge. Their hard charging, explosive, and anger-filled style, inspired spiked hair, rocked generations and forced people to question conventional thinking.
Along the way, they rocked the casbah. They called London. They got lost in a super market and then they went straight to hell.
For many – The Clash was the only band that mattered.
For investors, they are more – much more.
Today, as investors around the world become increasingly anxious, one of the greatest Clash songs of all time is making a comeback. In board rooms, on trade desks, in living rooms and around kitchen tables – investors everywhere are nervously singing “Should I Stay or Should I go.” Stock market investors are nervous. Housing market investors are nervous. Gold and oil investors are nervous. US Dollar and Euro investors are nervous too.
After all, avoiding near-certain losses should be the most important goal for every investor.
Yet, the confusion today is that practically every talking and writing head has declared everything to be at extreme risk levels. In reality, everything cannot decline at once – money and capital just doesn’t move that way.
Yet, as chaos continues to engulf our world, traditional investment metrics seemingly make less and less sense.
And once you understand this all important fact – then and only then, will you be able to ignore the hyperbole, tune out the 24-7 talking heads, and dismiss the irrelevant quarterly commentaries from the big bank mutual funds.
For investors, these are exciting times. Markets are on the cusp of some of the most dramatic movements we’ve (n)ever seen.
In this latest IceCap Global Outlook, we examine where and why you should be nervous, what to do, and along the way – sing and enjoy the show.
The Stock Market
What can we say – there’s an awful lot of people out there saying an awful lot of awful things about the stock market. The central theme or reason for these negative views is entirely based upon stock market valuation. This view is of course wrong. And to understand why, first you must understand the background supporting these awful claims. For starters, many who proclaim stock investors are living on the edge, have actually been living on the edge themselves.
Many of these bearish investors have shockingly been out of the stock market since the 2008 crash, with others selling out just a few years later. Investors must know that despite the marketing machines, the Hollywood movies, and the internets – many investment managers are simple humans; full of emotion, full of pride, and perhaps worst of all – more stubborn than a goat.
Yes, many managers today are not insensitive, objective androids possessing the gift, the ability, the process and the flexibility to change their investment mind.
Instead – investment managers can be slotted into 3 groups:
Group 1 – this manager works for a mega-big investment firm, that is typically a part of an even bigger firm – a bank. These firms are devoid of dynamic thinking. All peripheral visions have been checked at the door. Client money comes in through the same door and then it is always invested the same way, with no consideration of any significant and obvious events on the horizon.
These managers have no market view, and if for some strange reason they possessed a market view, the compliance and enterprise risk management departments would sniff it out and exterminate it faster than a speeding macchiato. These firms did not see the tech bubble breaking until it was too late. These same firms did not see the housing bubble breaking until it was too late.
And, today these same firms continue to whistle, Disney-themed tunes as the world passes them bye.
Group 2 – these managers were burnt badly by the last crisis and therefore continue to fight the last war. In many ways - these managers are to be commended. They understand risk. They understand how the loss of capital can be devastating for their clients.
These managers have really nice intentions. Yet their deepest concerns about another stock market crash has kept them out of stocks during one of the largest rallies in stock market history.
These managers are so geared towards another market crash that they epitomize confirmation bias. Every single waking hour, day and week – which have turned into months and now years are spent agonizing over how markets are not correctly priced.
The confirmation bias first begins with showing how stocks are more expensive today than they were immediately before the 2008 crash and immediately before the 2000 crash.
And since stocks are more expensive today than compared to immediately before the 2000 and 2008 bubbles, then stocks must therefore be on the verge of crashing yet again.
But they haven’t. Another commonly trolled chart shows the VIX or market fear index:
And since this data point shows current markets are also at the exact same level as they were prior to the 2000 and 2008 bubbles, then stocks therefore must also be on the verge of cracking again.
But they haven’t.
Next, the stock bears whip out charts showing the deterioration in Consumer Credit, the effect of Stock Buy Backs on Earnings per Share, record high profit margins, lower trending GDP, Donald Trump, Brexit, Marine Le Penn, North Korea, Russia, and the beat goes on.
Yet, stocks continue to defy gravity.
Then there’s the money printing, zero interest rates, negative interest rates, financial oppression, and the socialized bad debt.
And yet, stock markets just won’t go down. In fact, not only will stocks not go down, but they continue to go up.
Yes – it’s confusing. But it’s only confusing for those using linear thinking, one-dimensional perspectives, and the refusal to consider that maybe there’s something else a foot. Here at IceCap, we completely agree with this negative assessment of all the above factors.
Yes, on a stand alone and consolidated basis, a stock market specific focus concludes nothing good is about to happen. Yet – this is the very point that is completely missed by managers in Group 2. They absolutely refuse to even consider for a moment that their analysis of risk is correct BUT maybe the risk will not be reflected in the stock market.
Throughout all of these negative reports and analysis, one major point is missing – the consideration that all of the risk in the world today certainly does exist, yet this risk lies within a market completely different than the stock market.
And since, none of these managers in Group 2 believe a major risk can ever occur outside of the stock market – then it is completely missed and dismissed.
Whereas the managers in Group 2 are singularly focused on the stock market, other managers have assessed the exact same global macro dynamics but came to a different conclusion as to where the risk really lies.
Which naturally brings us to investment managers in Group 3.
Group 3 – in many ways, these managers are similar to those in Group 2. They also have terrific intentions, possess a laser-like attention to avoiding capital losses, and a strongly held belief that markets can be pushed and pulled into extreme positions.
Yet, the difference between the two groups lies in the ability to remain asset class agnostic. Whereas the managers in Group 2 are solely focused on the stock market as being the center of all evil.
Managers in Group 3 believe that at different times, any market can be either good or evil. What we mean by this, is that these managers in Group 3 never fall in or out of love with any investment market. Just as there are times to embrace and avoid stocks, the same is true for bonds, gold, currencies and different commodities. When market conditions change, so too will the investment view of these managers. But the key point to understanding this seemingly obvious expectation – and is completely missed by those managers in Group 2; all markets are interconnected.
In other words, stock markets cannot move in isolation without impacting other markets. And of the utmost importance – other markets cannot move in isolation without impacting the stock market.
And, perhaps the single, biggest revelation of all and commonly missed by many – the financial world does not revolve around the stock market.
Yes, the global stock market is big. But it is dwarfed by bond markets, interest rate markets and currency markets. Walk onto the trading floor of any major bank and you’ll see that over 75% of the floor is dedicated to bond, interest rate & currency trading.
The remaining sliver is for the stock market.
Believing the stock market is the king of the hill, is akin to believing the tail wags the dog. Understanding this all important point, will help you see the why the conclusion of the managers in Group 2 has been wrong. Whether they realise it or not, all of their analysis has assumed that everything is fine in the bond, interest rate and currency world.
The reason for this is quite obvious. For many, the stumbling block today is the fact that during the past 35 years – every market crisis has eventually manifested itself in the stock market. And since few in the industry today have worked beyond the last 35 years, then they inherently believe that every crisis is eventually reflected in the stock market.
Here at IceCap, we clearly see that today’s global financial world contains risk unlike anything we’ve seen before in our lifetime. After all, 35 years of accumulated effects of central bank policies, bailouts, fiscal deficits, and excessive borrowings have culminated in today’s rather awkward financial position. Yet, the culmination of these awkward moments, lies in the fact that central banks and their craft have finally hit rock bottom. And in the confusing world of bonds, interest rates, debt and currencies – hitting rock bottom is really the opposite of what you’d expect.
It is bad.
The reason it is bad, is because when interest rates are falling – the bond market zooms higher and higher.
Reality is also true. When interest rates begin to zoom higher – the bond market drops like a stone. And because this stone is multiple times bigger than the stock market, the ripples turn into waves that will gush investors out of the bond market seeking safety. And contrary to every manager in Group 2 – this safety zone will be the USD, gold and yes, the stock market.
So, to answer the classic question from The Clash about the stock market – absolutely stay. The ride will be a bit rough, but it will be nothing compared to what is about to happen in the bond market.
The Bond Market: It’s coming.
And when it hits, it is going to be a doozy. The global bond market is on the verge of doing something never before seen in our lifetime. Of course, the trick to seeing and understanding this certain risk is simply acknowledging the length of your current investment experience. Just because something hasn’t occurred over the last 35 years, doesn’t mean it can never happen.
The near-complete lack of acceptance of a bond bubble is partly due in course to the fact that over the past 35 years, the investing world has only ever seen crises in the stock market. To understand why investors see it this way, see Chart 1 below.
The chart shows the history of long-term interest rates in the United States from 1962 to 2017. Note how from 1962 to 1982, long-term interest rates increased from 3% all the way up to 16%. During this 20 year period of rising long-term rates, financial markets were a disaster. No one made money. Stock investors lost money. And bond investors lost a lot of money.
If I go, there will be trouble
Life was so bad – especially for bond investors, that by the time 1982 rolled around you couldn’t give a bond away. If you were an investor or working in the investment industry at the time – you were painfully aware of the bond market and you were schooled to never, ever buy a bond again.
Of course, 1982 was actually the best time ever to buy a bond. With long-term rates dropping like a stone over the next 35 years, bond investors and bond managers became known as the smartest people in the room. But, that was then and this is now. There are 2 points to remember forever here:
1) What goes down, must come up
2) There’s no one around today to remind us of what life was like for bond investors when long-term rates marched relentlessly higher
Interest rates are secular. And with interest rates today already hitting the theoretical 0% level – they have started to rise. And when long-term rates begin to rise, (unlike short-term rates) it happens in a snapping, violent manner. Neither of which is good for bond investors.
Of course, there’s another important point to consider, the rise in long-rates from 1962 to 1982 occurred when there wasn’t a debt crisis in the developed world.
And since 99% of the industry has only worked since 1982 to today, then 99% of the industry has never experienced, lived or even dreamt of a crisis in the bond market.
This of course is the primary reason why all the negative stories about the stock market are alive and well played out in the media – they simply don’t know any better.
And this is wrong. Very wrong. After all, the bond bubble dwarfs the tech bubble and the housing bubble. Think about it.
And if I stay it will be double
To grasp why the bond market is on the verge of crisis, and why trillions of Dollars, Euros, Yen and Pounds are about to panic and run away, we ask you to understand how free-markets really work.
For starters, all free markets have two sides competing and participating.
There are natural buyers and there are natural sellers. The point at which they meet in the middle is the selling/purchase price and the entire process is called price discovery.
Price discovery is a wonderful thing. It always results in the determination of a true price for a product or service. However, a big problem arises when there is an imbalance between the buyers and sellers, and when one of the sides isn’t a natural buyer or seller.
This is what has happened in the bond market. And this is why bond prices (or yields) have become so distorted; the true price of a bond hasn’t existed now for almost 9 years. When the 2008-09 housing crisis crippled the world, central banks decided they would help the world recover by providing stimulus.
The stimulus to be provided was in the form of Quantitative Easing, or money printing.
What happened next has long been forgotten by the majority of the market, and is the prime reason why so few today understand and appreciate the magnitude of the stress that has been created in the bond market.
When the central banks printed money, they actually used this printed money to buy government bonds.
And with central banks suddenly becoming “buyers” of government bonds, the number of “buyers” in the bond market had instantly increased.
And with the number of buyers increasing, the price of bonds increased – which caused long-term interest rates to come down. [note that in the bond world, when prices go up, interest rates go down, and vice-versa].
In effect, the global adoption of Quantitative Easing/Money Printing meant the entire price discovery process would become suspended.
And with a suspended price discovery process, the real or true price for bonds, has not been seen for 9 years. The big point here, and it’s especially big in Europe – the elimination of the price discovery process has resulted in all countries paying lower rates of interest when they borrow.
So come on and let me know
Which, to the average person may seem good. After all, paying lower rates of interest has to be a good thing.
But it isn’t.
Instead, the manipulation of the global yield curve has created an interest rate environment that has become so stretched, shredded and tattered – that even the slightest hint of an end to this financial nirvana is enough to send investors off the deep end.
Case in point - over the last year, we’ve seen the most significant market reaction in the history of the bond world, not once but twice. Yet, the talking heads, the big banks and their mutual fund commentaries, and the stock market focused world have completely missed it.
Almost a year ago in November immediately after the American Election, over a span of 54 hours – the bond market blew up.
To put things into perspective, Chart 2 shows what happened during those fateful days. Ignoring the why’s, the how’s and the who’s – the fact remains that this tiny, miniscule increase in long-term interest rates caused the bond market to vomit over itself.
Yes, a +0.7% increase in the US 10-Year Treasury market yield created chaos, havoc and over $1.7 Trillion in losses around the world.
We’ve spoken before how we had meetings the day after with the world’s largest bond manager and they described the previous few days as registering an 8 out of 10 on the holy smokes scale. Let that sink in.
This +0.7% increase in long-term rates caused this bond behemoth to go down for an 8-count. Folks – this is not reassuring.
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Much more in the full presentation below:
http://www.scribd.com/embeds/362309486/content