Institutional Investors Are Waking Up From The Matrix

In my opinion nothing has changed fundamentally from the September lows.  In my second to last post, I talked about last Tuesday as potentially being the top of this rally.  So far we have compelling evidence that this is the case.  I have added some exposure this week and I will likely add some more if we don’t gap down tomorrow.  The high yield complex is rolling again and most of this week had a distinctly risk off tone with stocks cratering left and right except for the few chosen FANGS.  We are entering the part of the bear market where most will realize it is a bear market.  I had thought this phase would have occurred sooner but I did not expect the bear market rally that we saw.

The indices are being held up by air and I expect this sell off to gather steam barring any central bank intervention.  Underneath the hood is a disaster as evidenced by the out performance of mega caps versus small caps and mid caps.  The global economy is slowing very quickly as can be seen by the commodity recession that is showing up in earnings of the industrial, energy, mining, enterprise tech and semiconductor companies.  The malaise is spreading to the US consumer as corporate layoffs from the previously mentioned sectors and Obamacare’s 25% premium increase next year are both coming into the collective consciousness of the masses.  The reports by Macy’s, Nordstroms, Walmart, Wholefoods and others suggest the consumer is tampering spending way down.  What is interesting is that the high end retailers are having issues as well.  Bottom line is that inventories are high and sales and earnings are down which suggests a very poor x-mass and serious discounting and no reordering over the next couple of months.  Essentially we are about to have an old fashioned inventory liquidation recession.  Wholesale inventories versus sales have not been this high since the Great Recession.

In addition to the rapidly weakening economy we have a Fed that is hell bent on raising rates.  They are either stupid, bluffing or there is some other geopolitical consideration going on here that I may talk about at a later date.  Clearly they have amped up the rhetoric and the bond market for the time being is believing them.  This is clearly not helpful to the liquidity situation and the deflation that is raging across the globe.

We also have the lifting of the veil and by that I mean the capital markets are slowly shutting down frauds and questionable business models that rely on the capital markets to grow.  In very short order we have had both Valeant and Theranos, Hedge Fund and VC darlings, completely implode.  These revelations are withdrawing capital from the markets at an alarming rate and the Tech Unicorns and other financial engineering stocks are likely to implode in very short order.  Fidelity has written down their Snapchat holding by 25% and the Square IPO is coming in 30% below their last private round.  There is a perfect way to play this implosion through a certain bubble stock.  I will be writing on this soon.

Finally I believe many institutions are waking up out of their QE induced slumber and don’t like what they see.  The Matrix is being revealed.  QE does not work and deflation is the result.  This is showing up in revenues and earnings.  Trust me the buy-side will not ignore lower earnings and revenues for long.  Half of my friends on the buy side knew this was bullshit from the get go and have one foot out the door.  The other half truly believed there was a recovery and refused to listen to my warnings.  Interestingly enough many of these true believer folks are calling me and are no longer hostile to my bear thesis.  The risk is that the non believers who played the game and the believers who are awakening to the Matrix of QE both head for the exits at the same time.  Liquidity is non existent and if this selloff gathers steam we could see a repeat of August.  I am fairly certain that the August lows will be retested. In my mind the question is how quickly it happens?

James Bullard just gave a speech that seems to be flying under the radar tonight.  In the speech he basically is saying the Fed needs to mount a communication campaign to convince the market that a slowing jobs growth market is ok and natural thus allowing them to stay on course to raise rates in December.  A couple of things come to mind: 1) They know the number and the jobs growth number tomorrow is likely sub par and 2) They are going to raise rates anyway criticism be damned.  Bullard is a slight Hawk but he also noted that the Fed used its statement last week to reel in market expectations which had pushed the rate hike into next year.  Those statements had the blessings of Janet and I think Bullard is not off of the reservation on this one.  I think the Fed is communicating to the market that “we” are going ahead despite the data between now and December. Below is part of the interview:

The Federal Reserve has been struggling to convince investors it is about to raise interest rates and now faces the risk that a likely slowdown in job growth will be interpreted as a downturn in the broader economy that will cause the Fed to hold off yet again, St. Louis Fed President James Bullard said on Thursday.

In an interview with Reuters, Bullard said U.S. central bankers may need to mount a new communications campaign to convince markets and the public of a counter-intuitive idea: that slowing monthly job growth is natural at this point in the recovery, and will allow the Fed to stay on track for a likely December rate hike.

Job growth averaging more than 200,000 per month during the recovery is unsustainable, Bullard said, estimating that growth of between 100,000 and 125,000 per month would be enough to account for an increasing population and a trend rate of economic growth.

“This is not Lake Wobegon. You cannot be above average all the time,” Bullard said. “I don’t think markets have absorbed this. Everyone has in their head 200,000…The natural expectation is for the pace of job growth to slow in the months and quarters ahead. We are expecting that to happen. It would be normal, and that would not indicate poor macroeconomic performance.”

The market participants are not ready for this kind of thinking.  I did a twitter poll and asked if folks thought they would raise rates no matter what happens before December. The poll results were 80% in favor of ‘no’ they will not raise rates in December and they will add more Vodka to the punch bowl instead.  I think the Fed is moving forward with rate hikes and I don’t think they care what happens to asset prices in the short term.  I don’t think many are prepared for that outcome.  I believe they want to test the waters and see what happens.  Janet did put NIRP on the table just in case and gave herself an out.

If you are a GenXer like me you must remember the show Different Strokes.  Well the market may be about to have an Arnold moment “Whatcha Talkin Bout Bullard!”

The rally from the August lows has been nothing short of amazing.  I did not expect it to go this far.  I am still of the belief that this is a bear market rally .  Nothing has changed except my P&L.  Everyone needs to step back and take their hands off the wheel for a moment and ask yourself this question: What kind of rally would cause maximum pain and wealth destruction if I am right and we are in the beginning stages of a bear market?  Yesterday some of the most stalwart bears approached me and said they were about to cover.  I suspect many did.  I heard the same anecdotes from others.  We basically came within a stones throw of the AT closing highs.  The logical assumption is that we might as well go to new highs.  So we have the folks hopping on board to punch this through and the bears covering for fear of the new ATH thus proving them wrong.  So if we were to top yesterday it was a fitting day and would cause the most amount of pain.  The market just took the bears money.  Now its coming for the Bulls.   If I am right then the next leg down will scare even me.  I am close to yelling “Sell 30 April at 142”.

The 12 month LIBOR rate (Chart 1) is not buying this rally as well as the TED Spread (Chart 2).  The TED Spread rose 4 BP this week  This rate is the Interbank lending rate. Apparently the banks don’t trust each other.  Its a measurement of financial stress in the system.  If this rally was real it should not be accelerating higher.  I suspect CDS and HY will begin to follow soon and then finally equities.  

The rally has been powerful and gone on longer than I suspected.  The CB’s have been up to their old coordinated tricks.  However there is one big difference  between last years rally and this years rally.  Earnings have been coming down as well as Revenue projections since October 2014.  The Trailing Twelve Month Earnings (not the Forward Earnings) have been rolling over and we now sit at the same earnings level as Mid 2013 when the S&P was 1680.  We all know that QE’s effectiveness is diminishing and the sugar high most likely won’t last long.  Especially with earnings and revenues apparently decelerating rather quickly.

Notice in 2011 when the market went down 20% earnings never fell.  That correction was due to Systemic European issues and not the end of business cycle and tightening conditions from the Fed like we have today.  The current multiple is 22 versus the 17 registered in Mid 2013.  In the 1998 analogue, that everyone is so keen on, earnings came down as well but very slowly over 18 months about 8% as compared to today where earnings are down over 11% in about 12 months.  In 1998 earnings bottomed rather quickly and accelerated into the 2000 top.  So if you are bullish 1 of 2 things needs to happen: 1) Multiples will continue to expand as earnings and revenues continue to go lower or 2) Earnings will recover quickly and the economy will lift off like it did in 1999-2000.

The big difference between then and now is we were heading into the year 2000 computer fix problem and the birth of the world wide web.  Both caused massive business investment and hiring that lead to a virtuous feedback loop of increased earnings and the blow off top to the greatest bull market ever.  Oh!…did I fail to mention, the Fed was extremely loose with money then because of the fear that the world would end due to the dreaded y2k computer bug fix.  So lets compare 1998-2000 to now: 1) We have no investment on the horizon, 2) the Fed is taking money out of the system and 3) firms are laying folks off again.  In fact Challenger Gray, an outplacement services firm, said job cuts in September accelerated and reached a level not seen since the 3rd quarter of 2009.  Additionally, the global back drop is grim and I suspect credit, which has bounced with equities, will roll over again and widen.  So this is nothing like 1998…nothing at all.  Its not like 2011 either but instead it’s 2015 which is the top of a business cycle and at the end of the monetary accommodation.  So if you are a bull I guess your banking on multiple expansion into an earnings and revenue recession.  I guess there is a first for everything.

I still expect a top soon.  In fact we may have seen it this week.  I have not added short exposure lately  and I plan to await confirmation and shoot this market in the back.  Could I be wrong?…Sure, but I don’t see anything other than a counter trend rally so far.  Of interest to note that we closed this Friday below last weeks high (Chart below).  After all that drama with the Fed and the BOJ this is all the market could do this week?  Also this rally has been with fewer and fewer issues.  Bull market rallies don’t act this way and I would also point out the dramatic underperformance of the small caps.  If I am right about this being a bear market the next big move down should carry us below the August lows.  If it doesn’t then something else is at play.

Nothing has changed.  Draghi is going to print some more euros.  So what? What have we learned about ECB QE people? It doesn’t makes US stocks go up!  It make the Euro go down and European stocks go up.  Did the S&P go up the last time they did ECB QE? No they barely limped sideways and then crashed into August.  ECB QE actually makes the dollar go up which then causes more deflation and financial stress around the world.  Today’s equity move was an ending move with a final short squeeze and late to the party FOMO chasing.  All the divergences mentioned yesterday are still in force and have only gotten more extreme.  The small caps where not even in the game.  This was a risk off day despite price going higher.  The Boyz were busy selling to retail today.

Look at the charts below.  The volatility has not disappeared.  It is hiding.  The VVIX is turning up and the VVIX/VIX ratio is even more extreme.  What this tells me is that the rally is stretched. It is not real and we will reverse hard within the next 72 hours.  My guess is we top out (baring another CB intervention) tomorrow.  The sell off and subsequent correction will tell us whether we are heading much lower or if we are going to new ATHs (very doubtful).  I am fairly certain that in the very near term one can make some money fading this market with some well timed puts tomorrow.

In the video above is the scene where Winthrop waits for the short squeeze to mature before he sells at the top.  I did not add to my positions today as I was waiting for a moment like the scene above after I heard Draghi utter his nonsense.  I am going to find my moment to yell “Sell 30 April at 142” tomorrow baring some crazy set up that suggests a melt-up.

The bulls have had a grand time for a few weeks.  Fun time is over and reality is about to set in for the short-term memory impaired.  Again What has changed in a few short weeks?  Are earnings getting better? No!…they are imploding.  Did the Fed announce a New QE? No!…Will they…No!…not until stocks have gone sufficiently lower.  You see bulls, the Global economy is falling apart and the Fed can’t do QE until US stocks implode.  Can you imagine the Fed doing QE 4% from ATHs?  Congress would hoist them up by their own petard in this election year.  If that is your bet then great go for it.  Otherwise you are betting on the market to have multiple expansion while earnings are going lower.  That seems like a fairly ridiculous thesis.  So that leaves rational contrarians looking for the second chance top.  There is a very good chance it arrived while you were sleeping last night as we exploded up in an orgy of last minute short covering in Globex Futures and hit a perfect level of resistance and then reversed hard.  I saw that and went to bed with a smile on my face.

So what do the bears have going for them?  Well the fundamentals are awful and nothing has changed.  Credit is still very stressed and we are no longer oversold but we are in fact we are extremely overbought.  We have the VVIX  (the vol of the vol) which bottomed on October 8th signaling that the downside is not done.  The VVIX has been making higher highs and higher lows since June of last year when Oil and Credit Spread tightness peaked (2nd Chart).  Looks like we just made a higher low and have turned back up strongly (1st chart).  The VVIX is important because it is telling a story about a system that is coming apart at the seams.  The Central Banks are literally holding this market together with spit, gum and glue.  They are playing wack-a-mole putting out fires behind the scenes only to have the pressures pop up somewhere else.  The second long term VVIX chart below is telling you that not all is well behind the curtain.  I warned about the rapid repricing of stocks on 8/15 when the VIX was low but the VVIX was rising (3rd Chart).  The set up is very similar to today as it was that weekend before the crash.  Are we going to crash?  No idea but the opportunity to crash is there for the market to take it.

Additionally, the SPX is diverging from oil’s current swoon which when it is under $50 dollars causes financial derivative mayhem in the system.  We also have a non-confirmation of highs this week from the Dow Jones Transportation Index which topped out on 10/8 they same day the VVIX bottomed.  And finally it seems the SPX has become completely unhinged from 5 Year Inflation Break Evens (below).  So basically most every other asset class is screaming deflation yet stocks are whistling past the graveyard.  I believe we will take out the August lows and go much lower.  I think this was nothing more than a counter trend rally in the context of a bear market and I think the repricing of this market will happen quickly.  This may be a truly horrifying Halloween for equity investors.  Could I be wrong? Yes…but sadly I don’t believe I will.  Don’t end up like the Duke Brothers from the movie Trading Places.

This week is shaping up like the OPEX week of August when we crashed into the abyss.  The big question is: can the dealers hold the Pin?  In August they lost control and they chased it down with all their gamma hedging.  On Monday it looks like this market topped and appears to be rolling.  As I have said we are in a bear market and this rally is counter trend.  The question before us is: Do we accelerate to the downside from here or rally up one more time? It all depends on this OPEX week in my mind.  Normally in a healthy bull market the street can temporarily manipulate the market to screw the maximum number of option holders as possible by magically pinning it to the level where the most damage is done.  Will the street be able to control the action or will the selling overwhelm them and we crack hard again to the downside?  Earnings so far are awful so they won’t help as numbers appear to be coming down quickly.  Additionally, the carry trade seems to be in jeopardy as USDJPY looks like it is rolling hard out of a triangle wedge pattern.  If the carry trade is disturbed the dealers may be overwhelmed with selling tomorrow and Friday.  This will be a nail bitter for the longs.  Regardless of whether it begins this week I expect the market to be lower over the next several weeks as fundamentals continue to deteriorate and we break the lows of August.  As far as I can tell the bull thesis is that we will get multiple expansion on declining earnings.  I have never seen that happen before this close to ATHs but I guess there is a first for everything.

This correction that began in May will not end until we find the cockroaches.  What do I mean by that?  I mean every credit induced correction does not end and bottom on no news like we had the last week of September.  Markets bottom on bad news.  So where is our bad news?  In the 1998 analogue we bottomed much lower percentage wise and after Long Term Capital went bankrupt and was saved by the Fed and a consortium of I-Banks.  In the first part of the Financial crisis in 2008 we did not bottom until Bear Stearns went bankrupt.  In 2011 we did not bottom until coordinated CB action was induced to save Greece.  Have we had any coordinated CB action yet?  No!

Behind the curtain is an absolute mess.  I believe that the CBs are participating in behind the scenes support of large financial institutions.  How do I know that?  I watch asset prices and commodity prices which suggest massive derivative losses have occurred.  Also the BIS and IMF are basically telling you that a crisis is coming if you read their press releases and cryptic statements.  Additionally, the Fed has been engaging in exponentially rising reverse repurchase agreements.  I sold Repo when I was a bond salesman back in the day so when it comes to Repo I know what I am talking about.  The Fed has been releasing collateral in part I believe to settle margin calls on derivative bets gone bad.  Treasuries are the preferred security for margin collateral posts.  Look at the below chart that has been circulating around and talked about on other blogs:

Some of the increase is explained by past Fed press releases stating that reverse repos would be used to help unwind accommodation. So yes these occur at quarter end for legitimate and non-nefarious reasons.   However, I find the spikes in December and September which are 2x the other quarter end spikes to be very interesting.  The common denominator for both was Oil which was heading to new lows and was below $50 a barrel at the end of Q4 2014 and and Q3 2015.  Also we had Equity market swoons occur then with the VVIX (vol of the vol) spiking.  So essentially someone is exposed to sub $50 oil in a massive way that requires insane amounts of collateral to be posted.  The cockroach is likely one or many institutions that wrote derivative contracts back in the day when Oil was $100 a barrel.  Who is it?  Glencore? DB? GS? JPM?  I don’t know nor do I care.  This ends when one of these or multiple players gives up the ghost and dies.  I am guessing its not GS as they are calling for $20 oil and likely trying to feed off the corpse of the victim.  The bottom line is the counter party risk is immense here and it threatens the system.  This equity market sell off bottoms when we see a bankruptcy.

So where does that leave us today?  Oil sold off hard all day and the VIX and VVIX appear to be bottoming.  On Friday the SPX Put/Call ratio collapsed to lows not seen since December of 2014 and the NYMO was over 100.  I expect pain and new lows soon.  This recent rally, as spectacular as it was, is a bear market rally and until we see a cockroach emerge all rallies will be counter trend.

When I was running my growth fund back in 2005 I knew early on that housing was going to blow up the credit and equity markets.  I was reading this article in in the WSJ and I had an epiphany.  My epiphany back then was that the dollar based debt system is designed to blow up with regularity and that whatever is driving the economy at the time using credit will eventually be the unraveling of the economy.  Above you can see the article because I cut it out at the time and taped it to my PC to remind me of what was to come.  I have kept this article in my wallet as a reminder of how this game works.  Now did I go out and position my portfolio for a disaster?  No, but many did and lost their jobs and lots of money because being too early is the same as being wrong.  What I did do is I waited until price started to tell me that I should begin to get nervous.  In February of 2007 the sub prime market blew up and I knew it was time to watch the technicals very closely.  So I began to shift the portfolio away from the consumer, housing and financials.  When the market broke in the fall of 2007 I got extremely defensive and raised cash.  For the next 18 months I put my feet up on my desk and watched as people ran around like chickens with their heads cut off buying every dip saying it was all priced in.  I knew then that it takes time for credit and margin to unwind.

Lets fast forward to today 10 years later.  The warning signs started to show up last spring when the momentum stocks took it on the chin and then credit spreads started to widen in the summer, then commodities took a nose dive followed by energy stocks getting decimated in the fall.  This August the U.S. indices finally cracked.  Basically this has been a bubble of literally everything.  The Fed has inflated ALL FINANCIAL ASSETS.  The economy used to wag financial assets now financial assets wag the economy.  The next bit of news we shall hear is dreadful earnings misses and a complete air pocket of orders filtering through the system.  CEO’s get paid on EPS and stock price appreciation so as stock prices fall they cut capex to increase earnings and a virtuous cycle is born the wrong way.  This credit based system is designed to blow up.  Unfortunately we have reached the end game and now $9 trillion of our poison lies on the balance sheets of the emerging market corporates and governements.  At the end of this crisis, which is picking up into high gear, we will see a cry for a new currency system.

This is not the 1987, 1929, 2000, 1998, 2011 or 2008 analogue.  This is the 2015 analogue and it is going to be worse than all of them.  I have warned people for the better part of a year.  My obligation and my conscience are clear now.  I will not feel bad for making a ton of money for what is about to unfold.  This will be fast, brutal and unforgiving.

Below is he last paragraph of the 2005 article.  Ask yourself what are the similarities to today?  Clearly energy has been a big contributor to the economy since the recovery began.  Nearly 1/3 of all capex in the US came from energy.  That is now gone.  Also US exports were strong until the rise in the dollar.  That is now gone.  Housing in the US is about to implode along with the stock market which will cause more jobs to be lost.  You see the Fed bubble is literally in everything and the prices you see before you are fake. They are Fugazis.  The key to understanding the economy since 2009 is one of money printing.  It has been a fake recovery, an illusion so to speak.  In the absence of money printing what will pick up the slack?  Answer: Nothing…this crappy economic recovery implodes.

Friday was an interesting day for both Bulls and Bears.  We opened way lower only to see a huge outside reversal bar closing at the highs.  So what changed?  The bulls felt good because they think we have successfully retested the August lows and we will rip into the end of the year so many of you bought on Friday like drunken sailors.  The bears on the other hand freaked out and covered because 90% of the bears have zero conviction and are “whimps” for lack of a better word.  But what really changed on a fundamental basis?  Did we see a massive improvement in credit spreads? Did we see the kind of capitulation selling on massive volume one usually sees at bottoms? Has the global economy started to improve? No…none of these things have happened.  In fact credit is worse now than it was at the August lows but equities are a mere 8% from the top.  Below are three snapshots of credit and financial conditions as of Friday.  Take a good hard look at these charts.  I have told you time and time again that credit drives equity valuations.  When credit heads South equity heads South with a lag.  Well we are diverging again and if you look at the Goldman Sachs Financial Conditions Index we are well above the stress levels we saw in 2011.

So logic would only dictate that unless credit improves dramatically equites will definitely go below the August lows and head toward 1700 on the S&P for a likely near term target.  Additionally I hear a lot about the 1998 and 2011 analogues.  Important distinction is that in both those instances we were in a primary up trend as no Dow Theory Trend change had occurred.  The case today is we do have a bearish primary trend change and that is how I know we are in a bear market.  Also in 2011 we went down 20% from top to bottom so by that measure we should go to 1700 on the S&P at a minimum if you believe this analogue.

The market is an energy system and it needs energy to move.  Bulls and bears provide that energy for tops as well as bottoms.  I want to thank all of you who bought on Friday and all the bears who covered their shorts.  The bulls have provided panic fuel as we roll over and they puke out what they just bought and the bears have removed potential buyers from the market and leave a vacuum below.  Also don’t forget the energy provided by Margin calls that continue to happen and will accelerate as we go lower.  Bear markets are designed to kill both bears and bulls.  So you see this is the set up I wanted before the final plunge to a tradable low.  Since we are in a bear market I can see 1500 also being a potential low but I won’t know that until I see the structure once we roll.  So when do we roll?  It could happen as early as Monday or by Friday at the latest.  The ideal situation would be for the market to rip up to 1977 by Monday afternoon and then begin to reverse.  I remain focused and try not to let fear get the best of me when we get these rip your face off rallies.  I always shave some off as we go lower and have fuel for the rise.  I do this with confidence because I know we are in a bear market and we have not seen a capitulation bottom to this first stage of the bear market.  Remember 95% of the world does not know we are in a bear market yet but they soon will as the price action that is about to happen wakes up the sleeping masses.