Thursday, June 20, 2013

Markets Rocked Around The World

While readers of this site have known for months that a broad sell-off in all assets was more than overdue (which we are witnessing today as investors around the world dump everything and rush to cash), it is important to put a bigger picture perspective on what is occurring.

The world is selling off based on the utterance of the word "taper" by Bernanke a few weeks ago which he acknowledged again in his testimony yesterday.

Tapering means that the Fed will purchase less than the current $85 billion of bonds it is currently purchasing every month. As a reminder, the Fed prints money out of thin air to purchase these bonds; a process known as Quantitative Easing (QE).

Before we discuss what will actually happen, it is staggering to think about what the markets would do if the Fed were to actually begin the process of "normalizing" rates. Remember that during this now 5 year running artificial expansion the Fed has been buying assets (bonds) and flooding the market with cash. During an exit strategy, which the Fed tells us is entirely possible, it would have to stop buying bonds completely and then sell bonds into the market to reduce the size of its balance sheet. 

Can you imagine what would happen should that occur?

Today we are talking about just a minor little reduction in what they are buying and there is a global earthquake in the financial markets. Imagine if they were forced to sell! The truth is, something we have long discussed here, the Fed can never sell. They have painted themselves into a corner and their only solution from here is to talk the markets into believing that there is a possible exit strategy that would not destroy the financial system overnight. Hint: There is not.

But back to where we are today. The Fed is trying to set up a scenario where they can announce the reduction of what they are purchasing sometime around their September 2013 meeting. They are trying to prepare the markets for this coming announcement as delicately as possible.

Zero Hedge put together the following graph, which sums up what a "tapering" would look like beautifully. If the Fed were to reduce their bond buying by $20 billion per month (taper), down to just $65 billion, their balance sheet would still be growing exponentially, just at a slightly slower pace.

We have discussed for months now the importance of ignoring the artificial "recovery" in the financial markets and the focus toward raising cash to prepare for the coming sale on high quality assets. Some of my favorite long term assets have now begun to decline significantly and they are closing in on the first taste of a buying range.

Now that everyone is beginning to panic, if the long overdue sell-off is finally here, then you can begin to exchange your cash for top quality assets as they are thrown out with both the baby and the bathwater. The chart above should help keep the big picture in perspective on how this story will ultimately end.

Sunday, June 16, 2013

The Bull Climbs The Stairs & The Bear Jumps Out The Window

From the start of the year to the middle of last month, I spent four and a half long months discussing how over-inflated "yielding" assets had become with a steady focus on U.S. stocks and bonds. Every week I would put up both sentiment and fundamental valuations showing how manic each had become. Then the following week sentiment levels would become more manic and valuations would become even more absurd as both stocks and bonds pushed higher and higher and higher.

How long was I prepared to continue this discussion? Forever, I guess. If an asset is overvalued and it moves higher in price then it becomes less fundamentally attractive. I was ready to continue the endless brigade of charts, fundamental valuation, and rational thinking on through eternity as we watched these bubble credit markets move higher, and higher, and higher. Then in the middle of May something very strange happened.

Stocks and bonds both started to fall simultaneously around the world, including even in.....gasp....the United States of America? Was that possible?

The following is Barclays U.S. Bond Index, which has now wiped out an entire year's worth of gains in just a matter of weeks.

Junk bonds, the recent darling of the high yield mania in the United States, reached a historic high yield May 9 at 5.24%, and have since fallen off a cliff crushing any late entrants (over the last year) to the party. As a reminder, interest rates rising means that bond prices are falling. While it is impossible to know the future, I believe the winning bid for bonds at 5.24% on May 9, may be end up being the highest price paid for junk bonds in a generation. Something that was perfectly normal just 30 days ago will be looked back on in the financial history books with complete awe years from now.

Outflows in the bond mutual funds can be seen in the weekly data where over the last two weeks there has been a full blown rush for the exits after years and years of relentless inflows.

It has been often repeated that as money moves out of bond funds it will quickly find a home into the stock market, a term that has become known as the "Great Rotation." As the bond markets began to unravel last month everyone got their popcorn out to watch the stock market explode higher to new endless daily, hourly, and minute by minute record highs in price. Then?

Stocks unimaginably started to fall with bonds. This may only be a preview of the main event coming, but this major trend of both stocks and bonds falling together will be the black swan event that no one has prepared for.

The following chart shows mutual fund flows in 2013, where investors recently have been exiting stock and bond funds simultaneously.

Where has the money moved? The place that we have been discussing here on this site as the most attractive investment all year long, the formerly most hated place on earth; cash.

Mutual fund flows have soared over the past few weeks as investors have begun to get worried about these so called "risk free" high yielding assets that have somehow found.....risk?

What is most shocking to investors is how quickly assets sell off compared to their long and steady march higher. I refer to this process as The Bull Climbing The Stairs & The Bear Jumping Out The Window. It has tended to occur this way in almost every major market advance in asset classes throughout history. Take a look at the recent 21% plunge in Japanese stocks:

As I just mentioned, a year's worth of bond gains were wiped out in just a few trading days. What took years of advances for the U.S. stock market climb from 2002 through 2008, took only a few months to completely wipe out.

Selling has a way of having a liquidating, waterfall type effect in the market due to both mass psychology and the use of leverage. This is why when markets are most complacent they are the most dangerous. The recent decline in utility stocks, one of the darling sectors of the higher paying dividend stocks, took just a few weeks to wipe out 2.5 years worth of dividend payments.

Can the markets find a footing and charge back higher to new insane valuation and sentiment levels? Absolutely. What would that mean for stocks and bonds? That they would be far more dangerous. I can imagine the same type of mentality during the peak of cyclical tops during the last secular bear market from 1966 to 1982 in stock prices (seen below).

We are currently 13 years into the current bear market. History shows that secular bear markets have lasted for 17.6 years. Will this time be different? It is going to take a once-in-a-generation type of cleansing in these markets to bring them back to attractive valuation levels, which we were close to having in both 2000 and 2008 before the government and Fed stepped in to try and artificially push markets higher.

The third and final sell-off will be by far the most violent because this time around both the governments and central banks will be all-in before the declines even begin.

h/t Sober Look, Zero Hedge, Business Insider

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