Refuting The (Consensus) Bull Case

Excerpted from Elliott Management's Paul Singer letter to investors,

The consensus (bull) case:

The power of psychology is overwhelming, and investor sentiment indicates that the Fed can be trusted, that asset prices are being driven higher by QE and ZIRP, and that we should not worry too much about the unintended consequences, because the Fed will be able to follow a path to normalization and a soft landing. America, in any event, is the safe haven and always will be.

 

Moreover, goes the case, we may be at the sweet spot of the economic cycle. It has taken a long time to get here, but finally we are getting sustainable growth, and we can expect more of the same.

 

Interest rates are completely under control – in fact, long-term rates are in a secular decline, which is not nearly at its bottom.

 

Inflation is virtually impossible, and we really ought to be worrying about deflation instead. We need to focus on getting inflation higher, and growth will follow.

 

The currency is also under control. In fact, what could the dollar fall against? The competition is in much worse shape.

 

Banks are in far better financial condition than in 2008 and will gradually bleed off any remaining toxic assets that they own.

 

If anything starts to go wrong, the government will step in to fix it.

 

Pushing investors out on the risk curve in search of yield is a good idea and a clever way to encourage them to do what they should be doing on their own (i.e., taking risks to help the economy grow). We should not worry, because things will be okay.

 

We can even trust the representative branches of government, because elected officials will not have to do much that is unpalatable or challenging – the central bankers have it all covered.  

 

Above all, trust the Fed.

The opposite case is basically a refutation of every element above and compels us to look to history for clues about the next market, financial and economic environment.

Six years of stability after the financial crisis, with policies that we believe to be unsound and solutions that have not really solved anything, are concerning to those who want better policies and are afraid of when the next shoe will drop... However, sometimes unsound trends go far past where you think they should go, in both time and price.

 

Consequently, we at Elliott are always hedged.

 

So does it matter whether we are right or wrong about the risks? Yes, because when stocks started falling apart in 2000 and 2008, we knew it could be for real. People who had no comprehension of what a crash could do, or the possible boundaries of price movement, had their careers and/or capital destroyed by one or both of those episodes.

An understanding of history, context, the incentives of policymakers and the fundamentals of the economy is very useful, even essential, for survival, in order to develop a sense of humility and an appreciation for how broad the range of outcomes can be. To start with, we believe that any period of real deflation (however unlikely to occur in the first place) cannot continue for long, because of the alertness of policymakers to such an event and their oft-repeated determination to throw monetary policies at any hint of declining prices. Conversely, regardless of whether serious inflation is possible or on the horizon, a bond market collapse is always possible in a system that is not sound.

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We cannot possibly make the following statement any more clearly or strongly:

Policymakers and pundits, with rare and courageous exceptions, are marching (and looking) in precisely the wrong direction.