MorningWord 1/20/16: One Step Forward, Two Steps Back

by Dan January 20, 2016 9:31 am • Commentary

This morning I was having a conversation with an equity and options trader who presides over a fairly large pool of risk capital, making directional and volatility oriented trades.  He and I have been in agreement for weeks, if not months, that rallies in U.S. stocks are to be sold. The primary reason is that for the first time in years the incremental buyer of U.S. stocks does not have the explicit backing of the U.S. Fed of more accomadative monetary policy. It still may implicit, but with the recent end of ZIRP, it’s no longer explicit. We were both amazed that despite the worst start of the year for U.S. stocks ever (this morning down about 9% in less than three weeks) the sell off has been fairly orderly.  Orderly though, can be deceiving.  My friend made the following point: “10% sell-off in three weeks on a 22 vol (referring to implied volatility, options prices, of the S&P 500), compared to a 10% sell-off in three days in late August on a 35 vol).”  I think the big difference here is that August’s decline caught many off-sides, while the stone cold playas, the “smart money” are better hedged this time around, causing the illusion of an orderly decline.

Speaking of the “smart money”, this morning on CNBC, one of the most successful investors the world has ever known, Ray Dalio of Bridgewater Associates, seems a tad at odds with the Fed’s recent course:

“I think a move to a quantitative easing would bolster psychology,”

“This will be a negative for the economy, this market movement. The Fed should remain flexible. It’s shouldn’t be so wedded to a path,” Dalio said. “We’re going to have a lower level of growth in six months from now … about 1.5 percent.”

“The risks are asymmetric on the downside, because asset prices are comparatively high at the same time there’s not an ability to ease,” he added. “That asymmetric risk exists all around the world. So every country in the world needs an easier monetary policy.”

“It’s going to be much more difficult this next time,” he said, because the U.S. needs movement on fiscal policy from lawmakers in addition to just monetary policy from the central bank.

Watch the full interview here:

If the Fed were to re-initiate easing rather than continue tightening, orderly declines in risk assets would get downright panicky. The Fed had been pushing on a string, I am not sure more of the same, in an about face, in an increasingly stressed global economy will achieve their intended results. I bring you back to what I deem to be one of the most prescient pieces of financial journalism last year. From the WSJ’s John Hilsenrath on August 17th, 2015:


Accomadative monetary policy (for seven years the world over) has not produced desired inflation, aside from that of risk assets. And now the unwind of QE and the end of ZIRP has caused a rip in the dollar creating a deflationary spiral in oil and industrial commodities that is now threatening the third wave of the credit crisis that started here in the U.S. last decade.  Which brings me an article in this morning’s WSJ:


Here is the most important part:

After years of powering the global economy, emerging markets are caught between fading growth and tighter lending conditions, squeezing their private sectors, which had borrowed heavily during an era of low rates.


The fallout from any debt defaults can spread fast: Foreign banks have lent $3.6 trillion to companies in emerging markets, and foreign investors hold, on average, 25% of local debt in developing economies.

Standard & Poor’s Ratings Services said corporate defaults in emerging markets rose in 2015 to their highest levels since 2004. Corporate-debt downgrades in the five largest emerging economies outside of China increased sixfold over the past two years, to 154.

As I mentioned in this space last week (MorningWord 1/13/16: Runs & Ammo):

The lack of policy options for our powers that be, in the face of some sort of emerging market debt deleveraging hangover that drags down our tepid recovery will manifest itself in a sub-optimal equity investment environment much like the post crash period. U.S. domestic (non-dollar exposed) defensive sectors like Utilities, Telcos and even some large cap Pharma are decent places to park cash, take in some yield while providing a mild downside cushion.

If you feel as I do that the prior highs in U.S. stocks are a distant memory and won’t be tested for some time, then the question you have to ask yourself at this point is whether or not:

A) we see a protracted bear market like we did from 2000 to early 2003, or

B) a violent crash like the one we had in 2008/09?

Obviously there is an in-between, and I suspect the path before us is one that we have not yet paved. But I do not think it will be short and sweet, it may be an orderly one step forward two steps back environment for risk assets while emerging markets complete the debt deleveraging trifecta that started in the U.S. in 2008.

There is always the possibility that we get a 10% snap-back like we saw from late September to early November, but if that happens too quickly, it would be the sale of the century at 2000 in the SPX, as it will be born into a grave.

My view has been consistent, stay defensive, take cautious guidance and commentary from corporate management’s and central bankers at face value, and discount the normal chorus of geniuses to buy the dips. Use the current orderly declining market environment to test your investment thesis and drill your financial adviser on your portfolio allocation (be gentle, they have feelings too), and reduce risk on an easing of downward pressure if you are uncomfortable with current exposures.

I am not screaming fire in a crowded movie theater, the views that I have expressed here today are an aggregation of my thought process for the better part of the last year and a half.  There will be counter-trend rallies, like there had been sell-offs during the raging QE/ZIRP induced bull market. But the market environment changed in mid 2015, and most importantly the trend has changed.  In the near term, I expect most counter trend rallies to end like yesterday’s. Despite already poor investro sentiment, the orderly nature of the decline and the relatively low levels of volatility (relative to sell-offs past), suggest that the big money is properly hedged. For now.  But this can change fast. At this point we won’t see a near term bottom for U.S. stocks until we see some sort of V reversal from a panic sell off.