In what has felt like a broken record, markets across the board performed well in the quarter. Emerging markets were strong, European markets were strong, credit markets were strong, property markets were strong and sentiment was strong. US markets, after bouncing around early in the quarter, really took off in September and posted a string of records that continued into the new quarter.
As the Economist summarized [here], "Today ... America and much of the rest of the world are amid a bull market in almost everything: stocks, bonds and property are all strikingly expensive compared to long-term averages, and getting more so." Should investors interpret this performance as indicative of improving economic conditions or are they being, as Tom Petty sang, raised on promises?
One thing we do know is that all of this appreciation has occurred in the context of an increasing array of obvious risks. Grants Interest Rate Observer picked up on one particularly illustrative example in its September 22 edition. Grants reported on the Toys 'R' Us senior unsecured 7 bonds of Oct. 15, 2018 noting, "It was no secret that the financial position of Toys 'R' Us was deteriorating, that $400 million of debt, including the above-cited 7 s, was maturing in a year's time and that the rating agencies were looking askance on that paper ..."
Despite such clear warnings, the market seemed to neither see anything nor hear anything as the bonds "spent the summer vacation lounging in the vicinity of 95 cents on the dollar." It wasn't until "Early September rumors of a debt restructuring" that the bonds prices started falling precipitously and catching up to reality. On Monday, the 18th, the company filed for bankruptcy; "On Tuesday, the bonds traded at 26." Can such insensitivity to deteriorating conditions be, Grants rightfully queried, "emblematic of healthy, functioning capital markets?"
Zerohedge noted similar market dynamics [here]. Aleksandar Kocic from Deutsche Bank observed that "volatility continues to be unfazed by what lies ahead ..." The report continued, "not only is the market not discounting the future as Matt King postulated several months ago, but it is no longer able to even respond to the present ..." In other words, "As the markets are getting inoculated against event risk, volatility continues to be under pressure," an assessment corroborated by, "the lowest average September VIX on record ..."
Michael Lewitt presented his take on market activity in the October 1 edition of The Credit Strategist. Lewitt described, "The pathology of the stock market was on full display on September 11th when the Dow rose more than 250 points and the S&P 500 jumped more than 25 points as Florida was rocked by Hurricane Irma. And the virus just spread during the rest of the month. The worse things got, the higher stock prices rose." Finally, as recent Nobel winner, Richard Thaler, remarked [here], "We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”
The increasing obtuseness of markets in the presence of real risks has left thoughtful, analytical and evidence-based investors trying to make sense of things. Lewitt captured the sentiment well by venting, "If you run into me on the street and it looks like my head is smashed in on one side, it's because I've been banging it against the wall watching stocks keep rising despite one piece of bad news after another." The breadth of evidence that markets for risk assets are no longer incorporating risk sends one message loud and clear: Something is wrong.
Lewitt proffers an explanation that he calls "Soul sickness". "Some attribute current market behavior to complacency. I think something deeper - and far more disturbing - is going on. Complacency is far too tame a term for what we are witnessing. The world suffers from a sickness of the soul - an inability to rationally and objectively process information, to acknowledge facts, to recognize when people are being damaged, to understand the consequences of corrupt policies and immoral behavior."
Strong words for sure, but he isn't the only one; Ben Hunt provides an eerily similar explanation that he calls "Sheep logic" [here]. As Hunt describes, "Sheep are enormously other-aware, but never other-obliged." In essence, "They’re high-functioning sociopaths ... which is exactly the type of human most purely designed to succeed in the modern age."
"Sheep" succeed in the current environment because in the Common Knowledge Game, "It’s not what the crowd believes [that works]. It’s what the crowd believes that the crowd believes." As such, the "other-awareness" of sheep serves them extremely well. Hunt concludes, "The power of a crowd seeing a crowd is one of the most awesome forces in human society. It topples governments. It launches Crusades. It builds cathedrals. And it darn sure moves markets."
Insofar as we buy into Hunt's suggestion that most investors believe that most investors believe the market will keep going up, it begs yet another question: How did we ever get to such a state of sickness? The answer, according to John Mauldin [here], is that we are experiencing "arguably the biggest bubble in human history" which he describes as the "bubble in government promises".
Mauldin captures the essence of bad government promises in an example from Hurricane Harvey. He quotes a Los Angeles Times article: "The storm was unprecedented, but the city has been deceiving itself for decades about its vulnerability to flooding."
The article continued, "The city’s flood system is supposed to protect the public from a 100-year storm, but Bea [a civil engineering professor who has studied hurricane risks] calls that 'a 100-year lie' because it is based on a rainfall total of 13 inches in 24 hours. 'That has happened more than eight times in the last 27 years,' Bea said. 'It is wrong on two counts. It isn’t accurate about the past risk and it doesn’t reflect what will happen in the next 100 years'."
Deception, inaccurate depictions of past risk, and insincere representations of the future are characteristics that are endemic to government promises and especially so with the much, much bigger issue of pensions and social insurance programs. As Mauldin notes, "Your state’s public-sector retirees will not get what they were promised, and they won’t take the outcome kindly." This is no trivial or abstract issue; the outcomes will most likely be "deadly to creditors and retirees."
While underfunded pensions are a big problem, they are but one manifestation of the bigger issue. Mauldin notes: "This is the core problem. Our political system gives some people incentives to make unrealistic promises while also absolving them of liability for doing so. It also places the costs of those must-break promises on innocent parties, i.e. the retirees who did their jobs and rightly expect the compensation they were told they would receive." In other words, the core problem is a political system that is broken in a way that spills into capital markets.
Hunt elucidates, "Forget about markets, our entire political system relies on stocks going up. If stocks don’t go up, our public pension funds and social insurance programs are busted, driving our current levels of wealth inequality from ridiculously unbalanced to Louis XVI unbalanced."
Lewitt picks up on the inherent tension: "The only question is how long states, cities and counties as well as the federal government can keep lying to people." He continues, "We are being led to a very ugly place by the people leading our country ..."
The key point is that to an important extent, market prices have become a function of public policy. Hunt describes the change: "It’s the transformation of capital markets into a political utility, which is just about the greatest gift that status quo political interests can imagine." Nor is this a passing fad. Hunt continues, "Active central bank Narrative construction in the service of their policy goals is a permanent change in our market dynamics."
Further, in the process of trying to mollify investors with soothing narratives, central banks don't eliminate risk; they just change the timing and location. As Chris Cole from Artemis Capital Management notes [here], "Volatility is not dead, but it has been artificially suppressed." He elaborates, "Today, the most effective model for determining the future volatility is, sadly, the Fed’s balance sheet. When the Fed expands its balance sheet, volatility drops."
Worse, in the process of metamorphosizing risk, central banks actually magnify it as well. Claudio Borio, from the Bank for International Settlements (BIS), recognized this in the Economist: "By keeping interest rates low in a vain attempt to fine-tune it [inflation], central banks are instead amplifying a cycle of boom and bust." Cole adds that "central bank intervention that artificially incentivize[s] investors to become volatility short sellers" produces a "tremendous powder keg of risk in the markets."
All of this has truly profound implications for investors. The transformation of markets from clearing places of business and economic information to political utilities represents a fundamental change in how markets work and therefore significantly reshapes the way investors should manage financial assets.
One of the most obvious consequences is that this transformation substantially diminishes the information content of market prices. As a result, there is very little use in trying to infer things about economic activity from prices or in using historical indicators such as business cycles or economic conditions to predict future market conditions. Any information should be evaluated through the filters of central bank narratives and political necessity.
An important investment consequence is that now may be an excellent time to take a contrarian position by reducing exposure to stocks and/or increasing exposure to volatility. As Lewitt notes, "In addition, investors who are long stocks and credit are implicitly short volatility without realizing it because they are betting that the market will continue to trade calmly." He follows, "With virtually everyone short volatility, taking the opposite view is inexpensive and prudent," and concludes, "Patient investors willing to go long volatility are going to make a lot of money."
Perhaps the most important consequence of the transformation of markets is the transformation of risk. Historically, long term returns were characterized by solid economic growth and periodically nudged one way or another by business cycles. This produced returns that varied but were generally positive over long periods of time and as such, provided a very manageable environment to plan around. Long term investors and those saving for retirement could have a reasonably strong sense of control over their future.
The new risk profile is considerably different and less manageable. In the short to intermediate term, volatility is suppressed which makes exposure to financial assets very alluring. Indeed, suppressed volatility is so attractive that it lures many individual and professional investors alike. In doing so, however, it also sows the seeds of destruction. Too many investors ignoring risks creates a "tremendous powder keg of risk in the markets" that is ultimately punctuated by significant disruptions.
In such a wildly uneven risk environment, investors will need to adapt to a different playbook. Here it makes sense to take a page from the disaster recovery and business continuity plans that many of us are familiar with in our everyday lives. These plans simply highlight the usefulness of having a backup for things that are important to us. How many of us have not lost a file, cracked the screen on our phone, had a hard drive go bad, or spilled coffee on the keyboard? By the same token, investors would do well to avoid over-reliance on financial assets by having appropriate backups for when financial assets “don’t work”.
Of course all of this also has an enormous impact on investment services. Many money managers simply cannot afford the patience to make the better investment decision of going long volatility. Stuck in a game of rising risk and diminishing returns, some may be able to extricate themselves before too much harm is caused, but most will not. In addition, many advisers have been caught in the middle for a while now. They have faced an unenviable task of balancing the desire to protect clients with defensive positioning on one hand, while trying to explain the continuing gains in the market on the other. The best defense for maintaining strong fiduciary positions will be a deep knowledge of the landscape and the ability to communicate investment propositions clearly and authentically.
In sum, the shockingly low level of risk in markets right now represents more than just a warning that markets are overdone; it represents a transformation that dramatically alters the proposition of investing in financial assets. As stock and bond prices have become more reflective of political necessities than economic realities, they too have essentially become bad promises. Fortunately, investors who can accept this can adapt and find, as Petty also sang, "a little more to life somewhere else". Those who can't, or won't, will have fun riding the wave of volatility selling for a while but will risk their long term welfare in doing so.