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Axel Merk Comes Out... As A Bear

Tyler Durden's picture




 

Via Axel Merk of Merk Investments,

Increasingly concerned about the markets, I’ve taken more aggressive action than in 2007, the last time I soured on the equity markets. Let me explain why and what I’m doing to try to profit from what may lie ahead.

I started to get concerned about the markets in 2014, when I heard of a couple of investment advisers that increased their allocation to the stock market because they were losing clients for not keeping up with the averages.

Earlier this year, as the market kept marching upward, I decided that buying put options on equities wouldn’t give me the kind of protection I was looking for. So I liquidated most of my equity holdings. We also shut down our equity strategy for the firm.

Of late, I’ve taken it a step further, starting to build an outright short position on the market. In the long-run, this may be losing proposition, but right now, I am rather concerned about traditional asset allocation.

Fallacy of traditional asset allocation
The media has touted quotes of me saying things like, "Investors may want to allocate at least 20% of their portfolio to alternatives [to have a meaningful impact on their portfolio]."  The context of this quote is that because many (certainly not all!) alternative investments have a lower volatility than equities, they won’t make much of a dent on investors’ portfolios unless they represent a substantial portion of one’s investment. Sure, I said that. And I believe in what I said. Yet, I’m also embarrassed by it. I’m embarrassed because while this is a perfectly fine statement in a normal market, it may be hogwash when a crash is looming. If you have a theoretical traditional "60/40" portfolio (60% stocks, 40% bonds), and we suppose stocks plunge 20% while bonds rise 2%, you have a theoretical return of -11.2%. Now let’s suppose you add a 20% allocation of alternatives to the theoretical mix (48% stocks, 32% bonds, 20% alternatives) and let’s suppose alternatives rise by 5%: you reduce your losses to -7.96%. But what if you don’t really feel great about losing less than others; think the stock market will plunge by more than 20%; and that bonds won’t provide the refuge you are looking for? What about 100% alternatives? Part of the challenge is, of course, that alternatives provide no assurance of providing 5% return or any positive return when the market crashes; in fact, many alternative investments faired poorly in 2008, as low liquidity made it difficult for investors to execute some strategies.

Why?
Scholars and pundits alike say diversification pays off in the long-run, so why should one deviate from a traditional asset allocation. So why even suggest to deviate and look for alternatives? The reason is that modern portfolio theory, the theory traditional asset allocation is based on, relies on the fact that market prices reflect rational expectations. In the opinion of your humble observer, market prices have increasingly been reflecting the perceived next move of policy makers, most notably those of central bankers. And it’s one thing for central bankers to buy assets, in the process pushing prices higher; it’s an entirely different story for central bankers trying to extricate themselves from what they have created, which is what we believe they may be attempting. The common theme of central bank action around the world is that risk premia have been compressed, meaning risky assets don’t trade at much of a discount versus "risk-free" assets, notably:

  • Junk bonds and peripheral government bonds (bonds of Spain, Portugal, Italy, etc.) trade at a low discount versus US or German bonds; and
  • Stocks have been climbing relentlessly on the backdrop of low volatility.

When volatility is low and asset prices rise, buyers are attracted that don’t fully appreciate the underlying risks. Should volatility rise, these investors might flee their investments, saying they didn’t sign up for this. Differently said, central banks have fostered complacency, but fear may well be coming back. At least as importantly, these assets are still risky, but have not suddenly become safe. When investors realize this, they might react violently. This can be seen most easily when darlings on Wall Street miss earnings, but might also happen when central banks change course or any currently unforeseen event changes risk appetite in the market.

Relevant with regards to my concern over a more severe correction is that it is complacency that drove the tech bubble to ever new highs in the nineties; and it was similar complacency that drove housing into the stratosphere ahead of 2008. Bubbles are created when investors have the illusion that there’s no or little risk with the strategy they are pursuing, bidding up asset prices.

Did I mention that I’m concerned about stocks and bonds? That may not make sense to some, as bonds are the historic refuge when stocks tank, but just as stock and bond prices have both been rising, it is possible for both of them to fall simultaneously.

Why now?
Historically, it’s difficult to say when markets top, when bubbles burst. In my analysis, relevant is the rise of volatility, i.e. the return of fear. With hindsight, we will attribute that fear to a specific event, but to me, it’s secondary whether it is concerns about China, Greece, the Fed, Ebola, or what not. Remember that the market has been climbing a wall of worries? Well, similarly, the market can fall on good news or bad news. The question is what will get investors to think the glass is now half empty rather than half full.

As such, it’s difficult to get the timing right. It was in December 1996 that former Fed Chair Greenspan warned about irrational exuberance, yet the markets continued to rally until the spring of 2000.

I don’t claim to have a crystal ball, either. But I do know that if we have a severe correction, I prefer to be early than late: the time to prepare one’s portfolio for what may be ahead is before it happens. That’s why I explained I’m taking increasingly aggressive steps to protect myself, at this stage "starting to build" a short position. I can’t know for certain where my analysis will take me in the future, but should the market continue to climb, I don’t see that as a failure, but as a potential opportunity to increase my short position.

Part of the reason I’m willing to short the market is because, aside from the potential expansion of risk premia as the Fed is trying to engineer an exit, there are other red flags that suggest to me a more pronounced downturn may come sooner rather than later:

  • Glass half empty. In our analysis, the market has increasingly been reacting negatively to news. We see little sign of a market climbing a wall of worries.
  • In our analysis, market breadth has deteriorated. It was last in the late 90s that the Nasdaq reached new highs, but the number of shares reaching new lows on a fifty-two week basis exceeded those reaching new highs. In plain English, few stocks are driving rallies, a sign of a market that’s tired.
  • Stale revenue. Too many firms, in our assessment, don’t have revenue growth.
  • P/E ratios. All else equal, low interest rates warrant higher price-to-earnings (P/E) ratios as future earnings are discounted at a lower rate. As interest rates rise, we expect "multiple compression", i.e. lower P/E ratios.
  • Share buybacks. Earnings per share for many businesses move higher despite stale revenue or higher costs because of share buybacks. As many firms borrow money to buy back shares, buybacks may become much less attractive as rates rise. They’ll have the additional headwind that they’ll then have to pay higher interest on the money they borrowed to buy back their shares.
  • Whisper numbers are back. Some tech stocks get burned for not making "whisper numbers," i.e. elevated expectations that go beyond what analysts have forecast. Investors expect that optimistic expectations are beat, a recipe for disappointment.
  • The strong dollar. The strong dollar is another headwind, as well as a great excuse when companies miss earnings, masking underlying weakness.
  • Global slowdown. In our analysis China is slowing down; many firms that have tried to sell to the ever more affluent Chinese middle class may be facing headwinds.
  • Valuation. We don’t think stocks or bonds are cheap. We list this last, as everyone has his or her own preferred measure of valuation (in bull markets, investors are very creative in how they justify valuations). All I would like to add here is that any pundit that tells you "stocks can go up 10% from here" has no clue what he or she is talking about – in my experience, that’s what pundits say if they have stocks to sell.

The biggest argument, and one I take very seriously, as to why none of the above means the market is going to fall is that the above points are rather obvious. The question is when will the market start to care about any or all of the above.

Note that I believe the Fed will raise rates, but will "remain behind the curve." That is, we believe the Fed will be rather slow in raising rates, keeping nominal rates (i.e. interest rates net of inflation) near zero, if not negative. The Fed is well aware of past "temper tantrums" which contributes to its reluctance to raise rates. As such, it’s well possible that risk premia may not expand rapidly, thus keeping complacency alive and well. However, my base case scenario is that the Fed’s gradual approach will still get risk premia to rise, thereby toppling the markets. More so, Fed Chair Yellen has not experienced a major correction as Fed Chair; as such, she may well be late to succumbing the pleas of the market to back off. But given that much of the recovery may be based on Fed induced asset price inflation, a deflating of asset prices may cause significant headwinds to economic growth. As a result, I expect volatile Fed policy going forward; a Fed insider would more likely call it "fine tuning" of policy rather than volatile – you choose.

How to profit?
So what is one to make of this? Again, we can’t give specific investment advice here, but I can tell you that for myself:

  • I have eliminated most of my equity exposure;
  • I have started to build a short position in stocks;
  • I wouldn’t touch bonds with a broom stick;
  • Aside from cash in U.S. dollar and hard currencies, I focus on alternative investments.

 What alternatives? A commonly cited alternative is gold. The price of gold, over the long run, has had a low correlation to equities and bonds. Having said that, gold has been most out of favor. Well, that’s part of the reason I like gold, as so many other things are in favor. As I indicated before, I don’t expect real interest rates to move up much; it’s high real interest rates that are the key competitor to gold. More so, our analysis suggests the dollar rally over the past year might have been extreme. In fact, I would not be surprised if, in a year from now, the U.S. would be on a flatter tightening path than some other central banks. Differently said, we see the greenback as vulnerable. Long-term, we like gold because we don't think the U.S., Europe or Japan can afford positive real interest rates a decade from now.

Talking about out of favor stocks, I have recently bought some gold miners. Again, just like anything else in here, this isn’t an investment recommendation. Importantly, gold miners come with their own set of risks – they are certainly not safe.

Beyond that, I have dedicated much of what I have available to invest to my home turf, the currency markets. The beauty of the currency market, in our assessment anyway, is that one can design a portfolio that has a low correlation to other asset classes. In a "long/short" currency portfolio that takes a relative position of, say, the Swedish krona versus the Euro, the returns generated are highly unlikely to be correlated to equity returns. That’s exactly what I’m looking for. And as the liquidity in the currency space is high, I don’t have the same fear I would have with many other alternatives. As always, I’m putting my money where my mouth is; amongst others, as a firm, we have built out our infrastructure, so we can offer long/short currency overlay services to institutional investors; we think that if/when markets plunge, they’ll be scrambling to learn more about services such as the ones we have been building.

Of course there are other alternatives. They all have their own pros and cons, they have their own risk profiles. Note that there’s no easy answer should this analysis be right. And there’s certainly no assurance I’ll come out as a winner. But I firmly believe that just as former Fed Chair Bernanke talked about his toolbox, investors should consider having a toolbox.

I’m ready for a bear market. Are you?

 

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Tue, 08/04/2015 - 11:49 | 6389637 JustObserving
JustObserving's picture

I wouldn’t touch bonds with a broom stick

US bonds will crash - not sure when:

Fed says inflation in USA was 0.8% in 2014.  Chapwood Index says it was 9.7%.  So what are the consequences?

Let's use a Zero Coupon Bond Calculator to see the effect of fake inflation on a $1000 bond  for 30 years:

A zero coupon bond is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity

With Fed's 0.8% fake inflation, Zero Coupon Bond Value = $787.38

With Chapwood inflation of 9.7%, Zero Coupon Bond Value = $62.20

So with Fed's inflation assumption, you can borrow $787.38 for 30 years and pay $212.62 as interest

With Chapwood inflation, you borrow $62.20 for 30 years and pay $937.80 as interest

With Chapwood Index, if you borrow $787.38 for 30 years, you pay $11,871 as interest.  Or 55.83 times  that with the Fed's inflation  adjustment.

http://www.chapwoodindex.com/

Tue, 08/04/2015 - 11:51 | 6389655 38BWD22
38BWD22's picture

 

 

Consider overweighting in gold and CA$H.  Physical gold, physical cash.

Tue, 08/04/2015 - 12:23 | 6389842 Winston Churchill
Winston Churchill's picture

Agreed. The market has been acting like a drunk on the top landing with the lights off.

You know it will end up falling down the stairs, just not when exactly.

This time it will probably break its neck.

Tue, 08/04/2015 - 13:00 | 6390067 beaker
beaker's picture

Question: If paper gold is  artificially manipulated and physical gold is in diminishing supply, why isn't this spread blowing out?

Tue, 08/04/2015 - 13:11 | 6390122 indygo55
indygo55's picture

I understand that if you are a buyer of gold bars and you are looking for size like 500K and up you will pay a 20%-30% premium over the paper spot to take delivery. Those transactions don't make it to the media. Pretty quiet about it. The spreads are there. 

Tue, 08/04/2015 - 12:32 | 6389897 KnuckleDragger-X
KnuckleDragger-X's picture

Yeah, bonds scare me because of all the bad bets going down. Chicago will likely destroy the MUNI market it when they default. The HY bonds in both oil and other highly leveraged sectors will start defaulting this Fall and I see a very hard Winter coming.......

Tue, 08/04/2015 - 12:38 | 6389930 LawsofPhysics
LawsofPhysics's picture

Sure, sure, blah, blah...  ...should the sovereign bond market collapse WWIII will be well underway.

Yes, it will happen, just a question of when, could be tomorrow, could be in 100 fucking years...

same as it ever was...

Tue, 08/04/2015 - 16:11 | 6390987 daveO
daveO's picture

But I do know that if we have a severe correction, I prefer to be early than late: the time to prepare one’s portfolio for what may be ahead is before it happens. 

Exactly.

Greenspan made his irrational exuberance speech in 96, 4 years before the market topped. I traded a boat load of stocks(many that disappeared after the top) before the turn. The trigger for the top back then was the antitrust lawsuit against MSFT(biggest stock) in 99-00. The market sold off on the news in 2000. It's always more profitable to be early than late. The market crash always wipes out several years worth of gains.

Judge Thomas Penfield Jackson issued his findings of fact on November 5, 1999, which stated that Microsoft's dominance of the x86-based personal computer operating systems market constituted a monopoly, and that Microsoft had taken actions to crush threats to that monopoly, including AppleJava, Netscape, Lotus NotesRealNetworksLinux, and others.[15]Judgment was split in two parts. On April 3, 2000, he issued his conclusions of law, according to which Microsoft had committed monopolization, attempted monopolization, andtying in violation of Sections 1 and 2 of the Sherman Antitrust Act. Microsoft immediately appealed the decision.[16]

On June 7, 2000, the court ordered a breakup of Microsoft as its "remedy". According to that judgment, Microsoft would have to be broken into two separate units, one to produce the operating system, and one to produce other software components.[16][17]

https://en.wikipedia.org/wiki/United_States_v._Microsoft_Corp. Heavy volume selloffs mean the big boys are leaving the casino. Nowadays, all it'll take is the FED pretending to normalize rates(LMAO).
Tue, 08/04/2015 - 11:51 | 6389640 Elliott Eldrich
Elliott Eldrich's picture

Calling all bears! Calling all bears! Time to short the market! No, really, this time it's true! No, really, the Fed won't come swooping in to buy up the entire board and jam up prices yet again! No, no, Lucy won't yank away the football again, not this time, really, it's different!

Calling all bears... any still alive out there? Anyone? Anyone? I've got some nice, tasty short plays you can buy, on sale! Anyone want any? Anyone? Anyone?

Tue, 08/04/2015 - 12:39 | 6389937 LawsofPhysics
LawsofPhysics's picture

Should I just ripp my own face off and save the "market" the trouble?

LOL!

Tue, 08/04/2015 - 12:43 | 6389955 explodinghead
explodinghead's picture

+100 for the Lucy and Charlie Brown reference.  Thats exactly what its been like for bears.

Tue, 08/04/2015 - 13:00 | 6390058 AGuy
AGuy's picture

"Calling all bears... any still alive out there? Anyone? Anyone? I've got some nice, tasty short plays you can buy, on sale! Anyone want any? Anyone? Anyone?"

Risky investment. If Stocks begin to plunge, what are the odds that Yellen will unleash another huge round of QE. She is after all the Dove of doves. You pretty much need to be a full time daytrader since the market could turn on a dime and force a short squeeze especially with HFT on the loose. You need to be able to dump your shorts at any given time to avoid getting clobbered. Also need to exit all positions before the end of the day, to avoid the after-hours announcement by the Fed or other officials.

 

 

 

Tue, 08/04/2015 - 13:14 | 6390135 Seer
Seer's picture

Well, if you look at it on the surface you'd be inclined to believe that they'd be able to just rack it up again.  Problem is, companies ARE hemorrhaging, margins (as I'd been stating for years- "economies of scale in reverse!") are being compressed.  We're now pushing out all the marginal producers.  This translates to lost jobs (in the case of commodities that tends to be higher-paying jobs).  This then pushes down final product demand.  This is a downward, self-reinforcing cycle.  TPTB can print up a storm, they can try anything they can think of, but they cannot push on a string!

Only the very few, the ones that have oodles of "balance sheet" power are going to be able to improve their positions.  Aye, but it's STILL nothing but paper!

It's nothing but a house of mirrors built on top of a house of cards...

Tue, 08/04/2015 - 11:51 | 6389656 ANestIOS
ANestIOS's picture

Merkel comes out (just for a moment there I've seen it as) 

Tue, 08/04/2015 - 12:16 | 6389791 Arnold
Arnold's picture

I got the same with the speed read.

(Where was the HIllsenwrath dummie on her lap?)

Tue, 08/04/2015 - 11:53 | 6389673 arbwhore
arbwhore's picture

"cash in U.S. dollar and hard currencies"

 

What hard currencies? They are ALL soft... just like Charmin.

Tue, 08/04/2015 - 12:50 | 6390000 hound dog vigilante
hound dog vigilante's picture

Agreed.

However, one could make the argument that the Yuan (and possibly the Ruble) is lurching toward unofficial 'hard currency' status, given the commodity production/accumulation that has occured in China.  I would be curious to hear more from Merk regarding the potential/future of the Yuan (and Ruble).

 

Tue, 08/04/2015 - 12:05 | 6389734 Sudden Debt
Sudden Debt's picture

The more and longer they talk about a crash, the more I start to believe that to many are going short and something could trigger a massive shortsqueeze in a month from now wipping out everybody who prepared for the worst.

Tue, 08/04/2015 - 12:14 | 6389780 Consuelo
Consuelo's picture

Generally speaking, I'm with your sentiments, in that knee-cappings are rarely telegraphed.    Never know though - every now & again a hard bitch-slap might just coincide with the 'crowd'.

 

Tue, 08/04/2015 - 12:18 | 6389804 Perseus son of Zeus
Perseus son of Zeus's picture

Keep in mind the political debt that is still due.

Obama, king of negro, was promised by the FED an Abe Lincoln veneer if he joined the races as a consumer force for USSA. Go USSA Freedoms!

Tue, 08/04/2015 - 13:15 | 6390146 Seer
Seer's picture

You're a fucking idiot.

Tue, 08/04/2015 - 16:38 | 6391109 Perseus son of Zeus
Perseus son of Zeus's picture

Some of you small minded, slow-to-evolve, people get angry when the truth is presented to you. The problem is not so much the shock of learning the truth that drives the anger, rather your anger is derived from your minds reaction to change.

You're super lazy and you don't want to consider the truth because it is going to require everything that you know to be reevaluated and OMG that's way too much work. Plus you learned all that good stuff at an Ivy League School.

So your first reaction is to bark out "hey you fucking idiot, you better stop saying that".

Seer a ZH paradox.

Tue, 08/04/2015 - 17:06 | 6391234 Perseus son of Zeus
Perseus son of Zeus's picture

Trust me bro, you don't want to fight club with me cause I will knock you the fuck out!

Tue, 08/04/2015 - 13:43 | 6390216 Crocodile
Crocodile's picture

That has been the pattern since mid February of this year; 2014 was very quiet in comparison.  They are setting one up as we type right now.  I believe, if you are in equities (options), setting up shorts on the SPY is not a bad idea 3-6 months out.  The problem with all of this is the inherit risk of the toxic currency exposure with no real alternative than metals as far as I can see...other than that...go long on toilet paper and tampons.

Tue, 08/04/2015 - 16:28 | 6391042 daveO
daveO's picture

"it’s an entirely different story for central bankers trying to extricate themselves from what they have created, which is what we believe they may be attempting."

'May be attempting' is all!

A quarter point FED rate increase would fit the bill for a short covering rally. Not a meaningful increase and has already been discounted. A smaller increase would be even better.

They will never 'extricate themselves'. Too much debt!!! If they seriously try, by raising rates like Helicopter Ben did 10 years ago, they will crash the casino. He signed the dollar's death warrant with his response of QE counterfeiting. 

Tue, 08/04/2015 - 12:26 | 6389857 dcohen
dcohen's picture

I had a talk with Axel Merk online a ~year ago.

Axel Merk said: Yellen is very smart

I am not kidding

Tue, 08/04/2015 - 13:18 | 6390160 Seer
Seer's picture

If she and the other of her ilk are so stupid then why are we here and why are they in control?

The SYSTEM is stupid.  They're quite capable of working the SYSTEM.  Trouble is is that we're all measuring as though the SYSTEM is based on a solid premise; it is not: perpetual growth on a finite planet is NOT smart; despite all the morons running around here claiming that this simple law of physics can be resolved if we just get rid of the "nigger' etc...

Tue, 08/04/2015 - 12:26 | 6389864 headhunt
headhunt's picture

This guy just said in a bunch of words; 'I are confused'

Tue, 08/04/2015 - 12:52 | 6390014 hound dog vigilante
hound dog vigilante's picture

All the more reason to minimize prevailing market bias exposure.

 

Tue, 08/04/2015 - 13:19 | 6390166 Crocodile
Crocodile's picture

There are many cracks beginning to be revealed in the open; the FED's and their demons cannot keep the facade up very much longer from the mainstream.  Therefore, they raise interest rates to implode the system or more likely, find a foreign scapegoat OR create a domestic scapegoat via some "natural looking" disaster.  By way of reminder from Janet Napolitano.  http://www.rt.com/usa/janet-napolitano-farewell-speech-084/  (make note of the date - these things often manifest themselves 2-3 years out)

------------------

An example from the perpetrators of 9/11, Al-CIAda, was given almost exactly 2 years prior to the event and remember we know that the NSA funds and trains and is IS, ISIL, ISIS or Al-CIAda.

QUOTE: However, a federal report issued exactly two years before the Sept. 11 attacks contrasts with that statement.

The report, entitled the "Sociology and Psychology of Terrorism: Who Becomes a Terrorist and Why?," warned the executive branch that bin Laden's terrorists might hijack an airliner and dive bomb it into the Pentagon or other government building. http://www.cbsnews.com/news/what-bush-knew-before-sept-11/

Tue, 08/04/2015 - 13:35 | 6390251 large_wooden_badger
large_wooden_badger's picture

At a bar one lunch hour in maybe 1997, 98 or 99, really not sure what year it was, but there was an older fireman on the other side of the bar loudly asserting that the Twin Towers were going to be the next "Pearl Harbor". Noboby paid him much mind. I wonder what he knew.

True Story.

Tue, 08/04/2015 - 16:43 | 6391131 daveO
daveO's picture

Iranian deal=nuke attack in about 2 years. BHO and Cheney have repeatedly warned of dirty bombs in Manhattan(to hide the empty gold vaults at the FED, imo) and elsewhere. The bomb must be exploded after the next puppet goes in, a puppet from the warfare party, of course. That way, the masses will go along with the draft needed to invade Iran. DC did the math on invading Iran, before they invaded Iraq, and knew they'd need a draft to do it. 

Tue, 08/04/2015 - 16:52 | 6391169 daveO
daveO's picture

Iranian deal=nuke attack in about 2 years. BHO and Cheney have repeatedly warned of dirty bombs in Manhattan(to hide the empty gold vaults at the FED, imo). The bomb must be exploded after the next puppet goes in, a puppet from the warfare party, of course. That way, the masses will go along with the draft needed to invade Iran. DC did the math on invading Iran, before they invaded Iraq, and knew they'd need a draft, politically undoable at the time. Iran is being setup like a bowling pin.

@ large, He was just looking at history. I had older, depression era relatives who swore Pearl Harbor was a setup by FDR, to get the US out of the depression. Some of them joined the navy ahead of pearl harbor simply because FDR got reelected in '40. Then, there's the Gulf of Tonken, and the USS Maine.

 

Tue, 08/04/2015 - 13:48 | 6390321 jimfcarroll
jimfcarroll's picture

Hum. More bears mean time to go long.

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