BIll Blain: "The Unintended Consequences Are Finally Coming Back To Bite Us"

Submitted by Bill Blain of Mint Partners

Fundamentals ok, Technicals corrected, so why we should still be nervous on what comes next for markets...

“If the apocalypse comes, tweet me..”

That was an interesting week that was.... but what a hangover we face! What happened to the global bull stock market? Just as the party was looking likely to carry on forever, the music stopped... Reading through market the scribblers this morning, the consensus seems to be it was just a correction, and we should be buying the dips. I’m always a big supporter of buying dips.... I’m not so keen on buying into a more secular decline.

Thing is, it feels there is nothing particular we can put the finger on as responsible for last week’s stock market ructions. Bond yields rose a bit, inflation has gathered a bit of momentum, and economic fundamentals remain generally positive and are expected to improve in line with rising growth estimates. There is little threat of an oil-shock. Folk have pointed out that with so much money likely to be invested in share-buybacks and special dividends by US companies repatriating cash, the stock fundamentals look positive.

Central banks remain hawkish re normalisation and higher interest rates - but modestly so. A world with moderate on-trend inflation, still low interest rates, and solid growth prospects should be positive. A screaming buy signal.  

Others say last week’s pain was technically driven – on the back of a massive sudden and shocking unwind of “short-vol” trades. Others say if was due to AI driven algorithmic traders, while the FT carries a story about insurance companies dumping massive amounts of stocks, triggered by rising volatility, linked to “managed volatility” variable annuities.

These two views, i) that fundamentals haven’t fundamentally changed, and ii) that it was technical driving the sudden sell off, suggest we should be doing what we always do at times like this – wonder when to buy the dips! And that’s what the bulk of market commentary is about this morning – when to BUY THE DIP.

Look at that table I sent round last week. Most crashes reverse quite quickly - the really bad long ones require a very significant element of economic destruction or fundamental reassessment. Aside from catching a few foolish levered Vol players, there hasn’t been a fundamental product or sector destruction this time.

There are clues in trading patterns – Lower highs and lower lows. Or the CNN Fear and Greed index spinning round 180 degrees over a few days into Extreme Fear Zone. My stock pickers say the last bear phase in Feb 2016 was a far more negative market phase than what we’ve just seen. Anyone that bot then has seen massive gains! Steve Previs comments this morning: “sure the market has dropped 10%, but its not that big a deal. If the SPX breaks and closes below 2500, then something different may be taking place.” However, he expects the market will remain highly volatile for at least the next few weeks.

But.. But and But again. I’m not convinced…

What drives the kind of fear we saw last week? There are the risks we can plan for and hedge against, and there are the Cygnus Atratus events we can’t. But, the biggest threats of all might just be things so blindingly obvious they are hidden in plain sight for no one to notice. A few years ago it was the silly notion that bundling up risk into mortgage pools or CLOs made the risks go away. My first ever market crash was when buyers of perpetual bank bonds suddenly realised they were buying equity not credit. This time it might be the passive/docile cash tied up in ETFs.. or something else completely.

10-years ago central banks started playing with “extraordinary momentary policy” in their efforts to stabilise markets. Economists warned that printing so much money - which is what it was - would result in catastrophic inflation as money was transferred from the financial markets to the real economy – the convoluted theory behind QE.

Of course, that is not what happened. Inflation never occurred. In fact Deflation became the threat. What if it is lurking elsewhere? The money central banks spent on bond purchases caused investors to arbitrage the buy programmes. It created massive distortion across financial assets and if you are looking for inflation - there it is. In stock markets and bond markets. QE is why bonds are so tight and stocks so high. And its over.

While it made little rational sense to invest in European peripheral sovereign credits because of their credit outlook, it made enormous sense to buy them on the basis the ECB was buying them (or giving banks free money from LTROs to buy them)! Smart investors rode prices higher. What was their to worry about? Same is true across bonds and into equity.

The unintended consequences are now coming back to bite us. Yield tourists find themselves sitting on financial assets they barely understand, except to worry they look.... overpriced. Now that QE is over - or soon to be over – they are wondering where we go next, and that’s fuelling the current fear and uncertainty!

I reckon I’ve warned about the unintended consequences of QE and financial asset inflation over 500 times in last 10-yrs. Maybe I’m finally right? There is a great article by Bloomberg Gadfly Marcus Ashworth this morning on ECB corporate purchases – read it and tremble.

Anyway… it’s a fantastic morning here in London. My train ride in from Hamble was perfect (for second week in a row), and Scotland beat France y’day. Life is perfect, except for fact I’ve got the dentist this afternoon after breaking a tooth. It’s going to hurt.

Just like market.