The Instability of Investment Prompted by Financial Speculation

“The last five major global cyclical events were the early 1990s recession — largely occasioned by the U.S. Savings & Loan crisis, the collapse of Japan Inc. after the stock market crash of 1990, the Asian crisis of the mid-1990s, the fabulous technology boom/bust cycle at the turn of the millennium and the unprecedented rise and then collapse for U.S. residential real estate in 2007-2008.

All five episodes delivered recessions, either global or regional. In no case was there as significant prior acceleration of wages and general prices. In each case, an investment boom and an associated asset market ran to improbably heights and then collapsed. From 1945 to 1985 there was no recession caused by the instability of investment prompted by financial speculation — and since 1985 there has been no recession that has not been caused by these factors.”

– Robert Barbera’s explanation of Hyman Minsky’s ideas, The Cost of Capitalism (Featured in “It’s a Tidal Wave of Liquidity. And Waves Crash” by John Authers)

In a Bloomberg piece titled, “It’s a Tidal Wave of Liquidity. And Waves Crash,” John Authers writes about renowned economist Hyman Minsky, who “argued that the economic cycle is driven more by surges in the banking system and in the supply of credit than by the relationship which is traditionally thought more important, between companies and workers in the labor market.”

So much for the monthly employment report and pretty much every other economic data point that flashes across our screens. Focus on liquidity, investment booms, and market runs to improbable heights.

In the U.S., it’s the bubble in the credit markets that will, like bubbles past, pop. In Europe, it’s negative rates and what that has done to the banking and pension systems.

Focus on Liquidity

Move away from employment statistics and keep your eye on this next chart. It’s a great way to look at liquidity in the system. With 37% of the companies in the Russell 2000 Index failing to pull a profit, the availability of credit is crucial for their survival. The lights go out when they can no longer borrow more capital. As Warren Buffett said, “Only when the tide goes out do you discover who’s been swimming naked.”

When the lending dries up, defaults soon follow. Once a month, I update the Ned Davis Research Credit Conditions Index on my Trade Signals blog. Let’s call it our swimming naked indicator. It looks at mortgage rates, mortgage delinquency rates, delinquency rates on consumer loans, debt-to-net worth of the household sector, senior loan officer survey on lending standards for consumer credit cards, consumer and residential mortgage loans… all combined into one indicator to give us a sense for the available liquidity in the system. Yes, I hear you… What about the Fed, its balance sheet, the direction of interest rate policy? That information gets transmitted into lending conditions, too.

NDR plots the data monthly to measure if “Credit Conditions” are “Favorable” or “Unfavorable.” The red line in the following chart is the combined score, and a rise above or a drop below the 50 level (green dotted line) is the signal. Note how recessions (indicated by the vertical grey bars) followed shortly after a drop below 50 (three yellow circles). The most recent month-end reading is a relatively high 67.5 on December 31, 2019. The good news is that lending conditions remain favorable—there is no current sign of recession.

Here is a look at the above, plus its components:

We’ll be keeping a close eye on “Credit Conditions” as the year moves forward. And since I believe today’s largest bubble is in the fixed income market, especially high-yield and bank loan funds, let’s also keep a close eye on the trend in the high-yield junk bond market, as there are a lot of naked swimmers there. A simple 50-day moving average line can serve as an early warning indicator. When price moves above its 50-day smoothed moving average price trend line, the trend is favorable. When price declines below its 50-day moving average price trend line, the trend is unfavorable. Nothing bad happens when the trend is favorable. Combine an unfavorable trend with unfavorable lending conditions, though, and prices will plummet. Since the bubble is in the corporate credit markets, these two indicators together may be our most important gauges. Today, the price is above its 50-day trend line. Ride the wave, as the trend is favorable (arrows represent a few select buy and sell signals since 2008).

Manufacturing, consumer spending, employment, and wage information are important, but the credit cycle and speculation matter most to your financial well-being.

And, according to our friend Minsky, there’s a moment in time where everything goes awry, aptly named “The Minsky Moment.” It marks the beginning of a market collapse, spurred by the kind of reckless speculation on the part of investors that is emblematic of a bullish period—one that just isn’t sustainable. What happens next? Prices deflate rapidly and the market collapses.

We should heed the words of the great Sir John Templeton: “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”

Pessimism? No. Skepticism? No. Optimism? Yes.

A close and trusted friend is a managing director at a major Wall Street firm. He sits at the center of the market’s engine. He called me yesterday to get my thoughts and said, “This market is insane. It sure feels like a market blow-off top.” I agreed.

Euphoria? Yes.

He asked me if I had any data on past blow-off tops. And I do… I shared the next chart with you a few weeks ago. Let’s look at it again.

NDR measured prior blow-off tops and found that since 1901, the Dow has posted a median gain of 13.4% over a median time frame of 61 days in blow-off tops. NDR shows 18 prior occurrences and said that the Dow was up 10.5% over the course of just 74 trading days from mid-August to late November. They added, “That kind of rally is similar to the ones that ended previous bull markets.” (Here’s a link to the previous post: On My Radar: A Euphoric Blow-Off Top?)

Since that OMR post, the Dow is now up 13.2% in 107 trading days.

Look at that chart again. It captures 18 prior data points similar to what has just occurred. Number 19 is the current run from mid-August to late November (now mid-January 2020).

We could go higher.

I was in Vail this week at a Market Structures event. Market makers, options traders, vol traders, hedge fund and investment managers. One large takeaway: the cost to put on portfolio protection is very inexpensive. No one sees risk right now. Think put options on ETFs, such as IWM (Russell 2000 Small Cap Index), HYG, or JNK (two popular high-yield junk bond ETFs). There are other ideas out there, too—and keep in mind, this is not a recommendation from me to you to buy or sell any security (I know nothing about your personal financial situation. But do talk to your advisor or call me if you’d like to learn more.)

Bottom line: Put options are inexpensively priced. Volatility is at a near-record low. That should make our risk goosebumps rise. For me, when the HY market turns down, I’m raising cash. And I’m thinking about shorting HY bonds via put options when the credit conditions index drops below 50…maybe sooner. The above remain my two most important indicators.

Grab a coffee and find your favorite chair. David Rosenberg allowed me to share his 2020 Outlook piece with you. And you’ll also find the link to the most recent Trade Signals post. The trend signals remains favorable, but boy am I really getting concerned. As Yoda might say, “When you look forward careful you must be.” By Steve Blumenthal - https://www.cmgwealth.com/