Crispin Odey: One Thing Will Determine If The Selling Is Over

For a few days last week, Crispin Odey, arguably the world's most bearish hedge fund manager, felt vindicated when the very structure of the market appeared to be disintegrating before our very eyes, when a relentless liquidation panic by vol-selling machines seemed unstoppable and humans could only watch in horror and pray that someone would step in and BTFD. Then abruptly as it started, the selling stopped and the relentless low-volume, central-bank mandated grinding levitation that has become the hallmark of this "bull market" returned and last week's correction is fast on its way to being relegated to the "crash" compost heap of the traders' collective subconscious.

Or maybe not.

In his latest letter to clients - who were pleasantly surprised to see a modest pick up in Odey's January performance - Crispin Odey wrote that there is one potential catalyst that will decide over the next few weeks that will determine whether the market slide is indeed over, or if what follows is continued risk asset pain, another market correction, and ultimately a recession: namely, whether investors, comforted by record high credit card balances and the promise of surging stocks, will retrench and start saving again after last week's stock market scare:

Whether the fall was the herald of more bad news to come out of financial assets, the next few weeks will tell. High asset prices have driven down precautionary savings. Will a fall in those assets be sufficient to cause savings to rise sharply – a classic reason for a recession – that is the question?

The logic is simple: as we showed recently, America's personal savings rate recently dropped to near all time lows. While this has had a stimulatory effect on the economy - and boosted stocks - there is only so much "deferred spending" that US households can extract from record credit cards balances, while hoping that the S&P will keep rising indefinitely. If and when this process shifts into reverse, is also when the recent economic gains start receding, eventually pushing the economy into contraction, while hurting corporate profits in the process. And since all this is taking place as the Fed continues to hike rates, the concurrent drop in both Earnings and P/E multiples would be sufficient to send stocks substantially lower from here.

Savings aside, Odey also writes that the key question going forward is whether inflation is truly back. To answer that, one needs to consider three things: central banks and math PhD's...

QE introduced mathematicians to our market place. With risk doubled down, they had a ball with financial instruments. Their ability to marshal data was game changing but their demand for data was also their weakness. The further back in time they went, the poorer the data they could recover and the sheer amount made it impossible to mine far back.

... and of course, QE:

Monetising has taken many forms in the past, but it rarely lasts more than 2 years before it passes from financial assets into the real economy. For my money the closest fit is with 1971-1974. Like then nobody had witnessed inflation greater than 2%.

Governments reacted to the end of the Bretton Woods exchange rate system (a gold standard) by both monetising and spending on a giant scale. The massive monetary injection was felt firstly in 1972 by the rise of the nifty fifty stocks – those companies whose prospects could never dim – to begin with but by the end of ’73 and into ’74 by a global boom which in the end lifted all commodities and by ’75 had led to wage inflation in the western world of over 8%.

However, unlike the 1970s, assets today are priced far, far higher. In fact, "financial assets – both bonds and equities – react only badly to ever rising inflation and moreover equities, thanks to QE, are as expensively priced as they were in 1928/9 and 1999/2000."

As for the threat of inflation, recall that as we showed one week ago, after two decades of declines the velocity of money appears to have finally bottomed.

There is also one more parallel to the 1970s: back then, besides the global economic crisis, the world faced a "crisis for capitalism." Well, according to a growing chorus of skeptics, thanks to the countless passive investing vehicles used today, among them countless levered and inverse ETFs many of which destabilize the market and threaten an illiquid collapse which combines the worst aspects of the August 2015 and February 2018 crashes, the market once again no longer rewards the proper allocation of capital - i.e., the core purpose of "capitalism" - and as such we face a new, and even more serious "crisis of capitalism" today.

This is not a place from which you would like to begin this journey. For the optimists, globalisation and productivity needs to come to their aid. Remember that the 70’s were not just a time of economic crisis. It witnessed a crisis for capitalism as well. Wealth cannot be defended, but capitalism is about competition overcoming rent-seeking and should be defended.

Unfortunately, as last week's events showed, nobody will care until it is too late, and the accusations, fingerpointing, name-calling and scapegoating will be all the rage... after the crash. Until then, well, stocks are going up so best to keep pretending everything is fine, and all the problems which led to a global, coordinated freak out last week, have magically been fixed.

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Odey's full January 2018 Fund Manager Report below.

Frankly what happened when the Dow Jones fell by 1400 points in a little under an hour, had nothing to do with humans. A reputation for being safe and secure was enough for mathematicians to build castles in the sky for ‘investors’ to live in. On Monday those castles fell from the sky.

What caused the move? Undoubtedly the rise in bond yields over the last three weeks was responsible, and behind that a conviction that after two years of rampant monetising by the authorities in general, economic activity was picking up quickly and with little give left in global capacity, would result in rising prices and even wages.

Whether the fall was the herald of more bad news to come out of financial assets, the next few weeks will tell. High asset prices have driven down precautionary savings. Will a fall in those assets be sufficient to cause savings to rise sharply – a classic reason for a recession – that is the question? Another, and I think, important angle is whether the printing of so much money over ten years would allow global inflation to become a problem.

24 years after China first burst onto the global trading scene thanks to a devaluation of the Renminbi and the signing of GATT which brought 6 billion people into a trading system of 1.6bn people, there are signs now that the deflation caused by their participation, has well and truly fed through the system.

Recently my investing has taken me into the arcane world of antimony refining. Antinomy is a very small market but like all commodities it is dominated by China who manufacture 50% of it. In 1995 they arrived in this market and quickly drove out western refineries with the low margins they were willing to work for. Twenty three years later the world is running scarce of easily obtained antimony and this is a market in which domination by a country more interested in trading than commercialisation has had a price. From here supply can only be brought on by higher prices and a commercial thinking which develops markets outside of where they currently are. It feels like a microcosm of many commodities’ positioning today. If the world is again full of scarcity, printing money will first lead to inflation and more importantly stagflation.

QE introduced mathematicians to our market place. With risk doubled down, they had a ball with financial instruments. Their ability to marshal data was game changing but their demand for data was also their weakness. The further back in time they went, the poorer the data they could recover and the sheer amount made it impossible to mine far back.

And thankfully so because it allowed historians to study similar times to this and draw out trends that rhyme with today. Monetising has taken many forms in the past, but it rarely lasts more than 2 years before it passes from financial assets into the real economy. For my money the closest fit is with 1971-1974. Like then nobody had witnessed inflation greater than 2%.

Governments reacted to the end of the Bretton Woods exchange rate system (a gold standard) by both monetising and spending on a giant scale. The massive monetary injection was felt firstly in 1972 by the rise of the nifty fifty stocks – those companies whose prospects could never dim – to begin with but by the end of ’73 and into ’74 by a global boom which in the end lifted all commodities and by ’75 had led to wage inflation in the western world of over 8%.

The secret as to why this happened was that the authorities were very slow to tighten monetary policy and were more intent on maintaining full employment than a sound currency. If this all sounds familiar, please remember that the stagflation of the 1970’s came only after 2 years of monetising, not ten years.

Financial assets – both bonds and equities – react only badly to ever rising inflation and moreover equities, thanks to QE, are as expensively priced as they were in 1928/9 and 1999/2000. This is not a place from which you would like to begin this journey. For the optimists, globalisation and productivity needs to come to their aid. Remember that the 70’s were not just a time of economic crisis. It witnessed a crisis for capitalism as well. Wealth cannot be defended, but capitalism is about competition overcoming rent-seeking and should be defended.

Finally, for those curious, here is Odey's latest summary P&L: