Month: April 2017

Submitted by Wolf Richter of Wolf Street

Based on fundamentals? You gotta be kidding.

Residential property sales in Greater Toronto soared 17.7% year-over-year to 12,077 homes, according to the Toronto Real Estate Board (TREB). New listings jumped 15.2% to 17,052. Prices for all types of homes, based on the MLS Home Price Index Composite “Benchmark,” soared 28.6%. The “average” selling price soared 33.2%!

That average selling price of C$916,567 is up from C$688,011 a year ago. Over the past five years, it has doubled!

The heavenly manna was spread across the spectrum. For condos, the average price in Greater Toronto soared 33.1% to C$518,879; for townhouses it soared 32.9% to C$705,078; for semi-detached houses, 34.4% to C$858,202; and for detached houses, 33.4% to C$1,214,422.

Even the house price bubble in Beijing cannot compete with this sort of miracle; new house prices there increased only 22% year-over-year in February. And Sydney’s fabulous house price bubble just flat out pales compared to the spectacle transpiring in Toronto, with prices up only 19% in March.

Vancouver has its own housing bubble to deal with. But there, the government of British Columbia has tried to tamp down on wild speculation with various measures, including a transfer tax aimed squarely at foreign non-resident investors, with “mixed” success.

Now the great fear in Toronto’s real estate circles is that the government of Ontario might impose similarly cruel and unusual punishment on the participants in this spectacle. Some measures are on the table, with folks wondering how to stop the bubble from inflating further and causing even greater harm to the real economy when it deflates, as all bubbles eventually do.

They’re reluctant. It seems they want to see how BC’s measures are washing out in Vancouver. The central government too is trying to fine-tune some macroprudential measures, but they’ve had absolutely no effect on Toronto’s housing bubble. And the Bank of Canada, which has been fretting about the housing bubble for a while – always couched in its very careful terms – refuses to raise rates. Everyone is talking. No one dares to do anything real about Toronto’s house price bubble.

In Toronto, according the real estate folks, it’s all based on fundamentals. It’s based on supply and demand and very rational calculated thinking, and there is no bubble in sight, lenders are just fine, and if Canadians are locked out of the housing market, so be it, it’s just a shortage of housing, really. So TREB President Larry Cerqua is glad the efforts to tamp down on it all have not come to fruition, in part due to TREB’s vigorous lobbying:

“It has been encouraging to see that policymakers have not implemented any knee-jerk policies regarding the GTA housing market,” he said in a statement.

“Different levels of government are holding consultations with market stakeholders and TREB has participated and will continue to participate in these discussions,” he said. “Policy makers must remember that it is the interplay between the demand for and supply of listings that influences price growth.”

Singing a similar tune, Jason Mercer, TREB’s Director of Market Analysis, explained the basic supply and demand problem:

“Annual rates of price growth continued to accelerate in March as growth in sales outstripped growth in listings,” he said. “A substantial period of months in which listings growth is greater than sales growth will be required to bring the GTA housing market back into balance.”

And he told policy makers to tread carefully: “As policy makers seek to achieve this balance, it is important that an evidence-based approach is followed,” he said. This is a gravy train, and it must be allowed to speed on until the last cent has been extracted.

It doesn’t take a genius to figure out that this will end in tears. What we don’t know yet is when it will end in tears, and whose tears it will end with. But we already know: When it does end in tears, real estate organizations will first be denying it, and then they’ll be clamoring for a bailout of their stakeholders – so it will end in the tears of others.

Even the big Canadian banks are fretting. “Let’s drop the pretense. The Toronto housing market and the many cities surrounding it are in a housing bubble,” Bank of Montreal Chief Economist Doug Porter warned clients. But the bubble’s deflation would push the city into a fiscal and financial sinkhole

via http://ift.tt/2oEJ1I9 Tyler Durden

Authored by Charles Hugh-Smith via OfTwoMinds blog,

While we're being reassured that all these grandiose promises are resting on trends that are as reliably predictable as the tides, the next easily predictable crisis will very likely reveal the trends are speculative bubbles that will predictably burst in a devastating reversion.

Certainty and uncertainty come in a variety of flavors. "Certainty" seems rather definite, but lurking beneath certainty is the more scientifically verifiable notion of probability: the probability of outcomes can be high enough to qualify as certain and low enough to qualify as unlikely.

We can't know with perfect certainty that our neighbor hasn't invented a death-ray and may decide to test it on us due to that simmering feud over his dog Fluffy's antics on our yard.

But we can make an assessment of the probability of this occurring, and conclude the probability is low with a high degree of certainty.

This assessment should change, of course, if we hear strange noises in his shop and notice shrubs in his back yard are now charred in peculiarly symmetric circles–and we learn he previously worked at a national lab on high-energy weapons but was dismissed for pursuing crazy ideas about developing handheld death-ray devices, i.e. phasers. (Star Trek fans, please raise a cheer.)

This brings us to a critical distinction between low-probability events, i.e. known unknowns a.k.a. highly unlikely "long-tail" events, and unknown unknowns, a.k.a. "black swans" made famous by author Nassim Taleb.

What is a known unknown? Death qualifies as a known unknown: we know with a high degree of certainty that the vast majority of living things eventually die (even cancer cells die once their host dies)–but the timing of their individual natural death is inherently uncertain, due to the great number of inputs, variables and causal factors intrinsic to life.

Statistically, there is a high degree of certainty that any dynamic data series will eventually revert to the mean. Spikes in asset prices will typically drop back to the trendline, but the timing of this reversion is intrinsically uncertain due to the unpredictable interactions and feedback loops inherent in complex systems of dynamic inputs and causal factors.

Thus statisticians who are tracking a tulip-bulb (or South Seas Company) like bubble in a speculative asset can forecast the eventual collapse of the bubble, but not the date and time of the reversion.

This collapse (reversion) can be forecast with a very high degree of certainty. (If tulip bulb prices had continued rising with no reversion, tulip bulbs would now cost $1 trillion each).

There are causal mechanisms that explain this eventual collapse: the market eventually runs out of "greater fools" willing to outbid other buyers seeking to buy tulip bulbs, and sellers deciding to cash in their gains overwhelm the few buyers still in the market.

Once the speculative frenzy driven by certainty of staggering profits evaporates into a fear of equally staggering losses, the bubble loses its momentum and prices revert to the long-term trend (often after briefly falling below the mean, requiring a reversion higher).

The bubble in tulips could not be forecast like a reversion to trend. We can forecast that humanity's attraction to speculative frenzies will not disappear, but we can't predict the next manifestation of this human trait.

Then there are the unknown unknowns–the stuff that can't be forecast except as a generalization, i.e. that there are unknown unknowns that will crop up with some regularity– a regularity we can't forecast with any certainty.

All this should nurture a profound sense of humility in all who dare to forecast an inherently unpredictable future. While humans love a good speculative frenzy that promises unearned wealth for everyone who gets into the game, they also love the illusory certainty of comforting forecasts based on past trends.

Thus we are reassured by long-term forecasts that claim a high degree of certainty that our comfortable lifestyle and all the promises issued by governments and pension plans will come to fruition as promised without any untidy or distressing reversions, phase transitions, collapses triggered by highly unlikely events (those pesky known-unknowns) or even peskier unknown-unknowns).

We are now facing an unpredictable collision of these conflicting sources of certainty and uncertainty. On the one hand, we're constantly assured our status quo is durably permanent, and all the lines that assure us all the promises that have been issued will be met without any sacrifices or disruptions have been extended with handy pencils and rulers.

But on the other hand, we're also assured that a certain number of unlikely events will occur despite the low probability we calculate. We're also assured that unknown-unknowns black swans) will crop up and surprise everyone from time to time.

Can both of these assurances be true? Can we be assured that the odds of something completely upsetting our apple cart of predictable comforts, entitlements, pensions, etc. are so low we needn't worry about them, and also be assured that highly unlikely events and unanticipated events (black swans) will arise from time to time, threatening the comfortable certainty of all these systemic promises?

The answer is "yes and no." We can say that based on current trendlines, the future should be predictable with a high degree of certainty, but these trendlines could be completely disrupted by low-probability events and/or black swans.

The question boils down to: are "current trends" the bubble equivalents of the tulip bulb craze? Please glance at this chart of skyrocketing federal debt before answering.

In essence, while we're being reassured that all these grandiose promises are resting on trends that are as reliably predictable as the tides, the next easily predictable crisis will very likely reveal the trends are speculative bubbles that will predictably burst in a devastating reversion. The wise approach forecasting the future with a profound humility, while the soon to be bankrupted foolish are confident in their grasp of what's knowable, unknowable and predictable.

via http://ift.tt/2obu67y Tyler Durden

2014 and early 2015 was a great time for Nehal Chopra, recently named an Institutional Investor Rising Star, the former Tiger Seed’s hedge fund Tiger Ratan Capital Management had received a $25 million investment in 2011 from investing legend Julian Robertson himself (subsequently the amount grew to $100 million) and after a series of impressive annual returns, including three straight blockbuster years, gaining 26.3% in 2012, 46.8% in 2013 and 22.3% in 2014, she was running a whopping $1.4 billion by June 2015.

The financial press would not stop fawning over Chopra.

Here is what Economic Times wrote about her in late 2014:

Nehal Chopra has been sprinting ahead of the pack most of her life. She became a top-ranked youth tennis player growing up in Mumbai, and received an MBA from Wharton while most of her peers were getting their bachelor’s degrees  Before she was 30, she persuaded billionaire Julian Robertson to seed her hedge fund firm Ratan Capital Management. Since 2009, Chopra has averaged 19 per cent annual gains by betting on companies in upheaval, almost triple the industry average. To her supporters, including Robertson, she’s a brilliant stock picker.

 

Chopra pitched Robertson after meeting him at charity events. The billionaire was impressed by her academic pedigree and tennis prowess. After growing up in Mumbai, where she attended Fort Convent and Sydenham College, Chopra graduated in 2002 from Wharton.

In short order, she made countless other financial outlets including both CNBC…

… and Bloomberg TV, where she appeared on Tom Keene’s show alongside Robertson himself.

That appearance, however, was her personal “top tick”, because shortly thereafter, everything started going very wrong for Chopra, who as it later emerged was heavily invested in a handful of “hedge fund hotel” stocks, many of which were about to suffer spectacular losses.

After posting a 15.5% return in the first quarter of 2015, the fund collapsed – largely a function of the implosion of VRX – eventually producing a 19% loss for the year, a swing of more than 34% points in just nine months. As Institutional Investor reported, the fund continued to implode in the first half of 2016 when it suffered a 51.59% drawdown from May 2015 through June 2016.

As we previously reported and as II notes, like many of the Tiger Cubs and Seeds, Ratan runs a concentrated portfolio but Chopra always took it to a much greater extreme, with Ratan typically owning just seven to nine individual stocks.

Think Bill Ackman.  And just like Ackman, Ratan was mauled by its huge bets on drug companies Valeant and to a lesser extent, Allergan, which started to suffer big losses in the middle of 2015. They accounted for 35% of assets at the end of June 2015, just before the two stocks, especially Valeant, went into their tailspins. Valeant fell 75% in the first quarter of 2016 alone. At the end of Q2 2016 of last year, Ratan liquidated four positions, including Valeant and Allergan.

By the third quarter of 2016 Ratan liquidated four positions again, including two major holdings: Starz, the cable television network that was the firm’s third-largest position, and bottler Coca-Cola European Partners.

By the end of the fourth quarter Ratan was much more diversified, holding 20 individual stocks, a lot for the firm. All but six were new positions.

However, it was too little, too late for none other than her original sponsor, and as Institutional Investor reports, Julian Robertson told investors in the Q4 of last year that he was redeeming his money from Chopra’s Tiger Ratan Capital Master Fund.

Ratan confirmed this in a recent regulatory filing.

In 2016, Tiger Partners, LLC and Tiger Accelerator Seed Holdings, L.P. (“collectively, Tiger”) fully redeemed its investment in funds advised by Ratan and terminated its “seed” arrangement with Ratan. Ratan no longer shares revenues or any economics with Tiger.

Tiger Ratan has even dropped the “Tiger” name from its funds.

In its SEC filing, the firm reported having $375 million in regulatory capital, an inflated figure which includes leverage and notional values of derivatives. At the end of 2016, Ratan’s U.S. stock portfolio was valued at $165 million, up modestly from $135 million the previous quarter, and down over $1 billion from the $1.4 billion in AUM as of the summer of 2015.

The firm also disclosed in the filing that it currently has just four employees. It is not clear if it can afford any more employees with such a modest AUM. It was also not clear if this is the first time Julian Robertson has “disowned” a former Tiger Seed and if his departure will prompt the rest of her LPs to follow suit.

via http://ift.tt/2ncssTZ Tyler Durden

The much anticipated March FOMC minutes were released today, and the minutes concluded exactly what I predicted in my last post titled “Is the Fed Trying to stop a “Market” that has gotten ahead of itself”. In it I said that the only reason they were raising rates unexpectedly is because they are trying to slow the bubble from getting any bigger. The minutes confirmed that the February ‘out of nowhere talk’ of a rate hike, which led to a March rate hike, was all due to stocks and many other assets classes being a bubble.  FOMC officials are now openly admitting that their disastrous policies have created the largest asset bubbles in history, which has never been done before. On multiple occasions in years prior, many Fed officials, including former chair Greenspan, have openly said that it was very hard to spot asset bubbles in advance. Now they are openly saying that they are seeing bubbles. Many current Fed officials share that same stupid viewpoint as Greenspan, including Kashkari, Fisher and Powell. Powell, just this past January at a conference in Chicago, said “low rates can lead to excessive leverage and broadly unsustainable asset prices – things that we watch carefully for and do not observe at this point.” So it was surprising to see the following In today’s minutes from the March meeting:

In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.

 

And also this major point:

 In addition, a number of participants remarked that recent and prospective changes in financial conditions posed upside risks to their economic projections, to the extent that financial developments provided greater stimulus to spending than currently anticipated, as well as downside risks to their economic projections if, for example, financial markets were to experience a significant correction. Participants also mentioned potential developments abroad that could have adverse implications for the U.S. economy.

 

Wait what? Didn’t Yellen herself say in June of 2016 that the Fed doesn’t target stock prices. Yes she did. That’s what makes this whole circus truly funny. Their polices of QE and years of ZIRP were to supposedly help create growth, and get the economy back on track. It was the “tinfoil hat conspiracy theorists” who said from the beginning, that the experiment that the fed was embarking on would not help the economy, but rather help the stock market and Wall Street. Even four former fed officials, Richard Fischer, Thomas Hoenig, Charles Plosser, and Jeremy Stein shared the same view as these evil conspiracy theorists. Plosser put quite well in an interview for the documentary “Money For Nothing” by saying: “Stimulating the economy through monetary policy really does almost nothing to contribute to low unemployment rates or high employment in the long term. Printing money doesn’t produce goods and services, it doesn’t hire people.” 

But this is not the first time the Fed has warned that stock valuations are high, but it was the first time that they admitted that they have created, as Trump said, a Huge Bubble. Sometimes it can take a while, years in this case, for the people out of touch with reality who are put into positions to fix the economy that they destroyed, to finally see reality. 

 

via http://ift.tt/2oDjZt6 StalingradandPoorski

Authored by Brendan Brown via MisesInstitute,

We’re now three months into the new administration and more than a year on from the start of a powerful late-cycle monetary stimulus (otherwise described as “the Yellen Put” in which all planned rate rises for 2016 were halted) by the Federal Reserve. But, we haven’t heard a whimper from the Republicans over the Fed’s extremely timid efforts at ending it’s ultra-easy-money policy. They have been focused instead on Ryancare and the border adjustment tax. Meanwhile in the marketplace the Fed-watchers are back to business as usual — deciphering every word and dot plot change from the leading monetary bureaucrats still at their posts. 

Counter-factual historians can wonder how different and better the situation might now be if conservatives and nationalists had begun the Trump era with efforts to rein in the Fed. Instead, what we got was an aborted repeal-and-replace of Obamacare and now a planned “tax reform” that still appears far off on the horizon. Yes, any monetary reform bill would have faced most probably a filibuster in the Senate, but the president has the power to at least point us in the direction of sound money by filling the empty chairs in the Fed and nominating successors-in-waiting to Professors Fischer and Yellen.

What Trump Should Have Done

Several markets deeply infected by asset-price-inflation might indeed have experienced steep drops in speculative temperature. But an accelerated end phase to the present great inflation (most prominent in asset markets) with its roots in the Great Monetary Experiment could have been blamed on the preceding administration. 

That might well have been a superior political strategy to allowing the Obama Fed to enjoy a new lease on life after the exit of its appointing president. Instead, the Fed freely sought to extend the Indian summer in asset markets (consistent with two tiny hikes in the official money rate which signal “success” for its inflation targeting). 

But the Trump administration seems to be fine with this and has been taking credit for continued asset price inflation as reflecting business and consumer optimism about its policies. Trump has been taking advantage of the present growth cycle upturn stimulated by the Yellen Put of 2016 to pump up credibility of his growth target which makes absolutely no allowance for a recession further ahead.

 

The Polyanna-ish Assumptions Behind Trump’s Tax Plan

Moreover, Trump’s assumptions of continued growth play an essential role in the budget arithmetic which will be used to demonstrate that Trump’s proposed tax cuts are fully funded, even given the planned increases in defense spending and no rollback of Obamacare entitlements. 

The core of the reform is a slashing of the headline tax rate on domestically generated corporate profits together with a “modest” levy on profits from low-tax foreign jurisdictions. The conservatives are ready to go along with these as part of a general trimming of marginal tax rates which would be in line with supply-side reform of old dating back to the Reagan era. There is much wishful thinking here.

In fact, a bold corporate tax cut unmatched by spending cuts is a parody of supply-side reform. Individuals can look through the sham and see that taxes will rise in the future, or that inflation tax will be levied by stealth. 

Yes, the corporation tax changes should induce increased demand for labor in the US as part of an induced repatriation of economic activity. But this will go along with a boost to domestic wage rates and ultimately a shrinking of pre-tax profit margins in aggregate across the US economy. In effect, the tax changes amount to a subsidy regime which would shelter profits from erosion as a protective layer is put in place for domestic labor.

Lessons from Europe: Shifting the Tax Burden

When implemented in this way, lopsided cuts in corporate tax rates can become a source of economic inefficiency and inequity. The problem stems in part from incentives created to retain profits rather than distribute them (as would occur if personal tax rates do not fall in step with the headline corporate tax rates), and in part from ultimate tax burden shifting to pay for the cuts. Look, for example, at how the “race to the bottom” on corporate tax cuts has played out in Europe.

The UK boasts of one of the lowest corporate tax rates (headed to 17 percent in 2020); and yet the effective marginal tax rates elsewhere in the economy (taking account of cuts in deductions) have been increasing. A recent study by the Daily Telegraph showed that the top 1 percent of income taxpayers now pay nearly a third of all income tax; by contrast under the notoriously high tax regime on the eve of Margaret Thatcher becoming PM, they paid just 11 percent of the total.

Make Government Smaller — Don’t Just Favor Certain Special Interests

There is much talk of benign global tax competition unleashed by corporate tax cuts. But the competition which matters is that which tames big government and causing a general revulsion against personal (including consumption and capital) tax rates. Historically though, in the Reagan and Thatcher era, the decisive competition was that between the onshore economies and the offshore world of which London was the center.

In that era, national tax revenues could be bolstered by a lowering of high marginal rates as this would reduce the incentive for tax arbitrage between onshore and offshore. This arbitrage has largely been shut down in recent years. In consequence, governments in high tax jurisdictions have tremendous new power to apply high marginal rates across the board

Big cuts in corporate tax rates driven by a nationalist race toward the bottom might turn out to favor mainly the receivers of high rental income (subsumed under corporate profits) whether stemming from crony capitalism, or monopoly power, or too-big-to-fail bailouts. Many critics see the strong rise of corporate profits in this cycle as in part reflecting the weakening of the power of new entrants into the marketplace — thanks to a tax burden and regulatory burden that falls especially hard on start-ups and small businesses. Bold cuts in headline corporate tax rates do nothing to remedy that situation. Indeed it may become worse.

via http://ift.tt/2nLCxmR Tyler Durden

Following weeks of utter comaplcency, there are signs that investors are beginning to hedge for potential U.S. stock swings around France’s presidential ballot.

As Bloomberg writes, futures on the CBOE Volatility Index
expiring in the next month are now trading around the same level as
contracts maturing a month later.

In fact the VIX term structure briefly inverted on Monday…

“The U.S. options market is finally starting to care about the French elections,” said Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors in New York, who recommended positioning with iPath S&P 500 VIX Short-Term Futures ETN options.

via http://ift.tt/2obkXeX Tyler Durden

This isn’t what I signed up for. If it’s Trump’s intention to continue the neocon policies that have left this country indebted to its eyeballs fighting meaningless wars, costing the lives of America’s bravest, count me out.

Bannon’s removal at the NSC on the same day that Trump upped his rhetoric for war with Assad isn’t a coincidence. Bannon has been an anti war advocate and wanted America out of the Middle East. Now here we are, being led down a ruinous road by 35 year old Jared Kushner and Trump’s generals, positioning for conflict in Syria over a chemical weapons attack.

In regard to the chemical attack that has left dozens dead, many of whom were children, no one knows with certainty who was responsible. There is so much fuckery going on there, you’ll drive yourself mad trying to figure it out.

Then there’s this.

Disgraced Dr. @DrShajulIslam received gas masks two days before "chemical attack" in Al Qaeda held #Idlib
The propaganda continues. #Syria http://pic.twitter.com/jPncQgtuXo

— H e b a (@HKX07) April 5, 2017

h

Wow. This anti-Assad "reporter" tweeted about the sarin attack in #Syria 24 hours before it happened. Still think nothing fishy is going on? http://pic.twitter.com/xrGWemylFW

— Sarah Abdallah (@sahouraxo) April 5, 2017

Here is President Trump’s response.

President Trump calls the Syria chemical attack "so horrific" https://t.co/01vVkC2lHN http://pic.twitter.com/QGrG5utki1

— Bloomberg (@business) April 5, 2017

Trump: #Syria chemical attack "crossed many, many lines, beyond a red line." http://pic.twitter.com/sJa14Hfhaw

— Omar Ghabra (@omarghabra) April 5, 2017

Asked his message to Iranian militias in Syria, Trump says "You'll see. They will have a message, you will see what the message will be." http://pic.twitter.com/zrDqwllTtK

— Tommy Christopher (@tommyxtopher) April 5, 2017

Trump told @GlennThrush and me that Syria was an "affront to humanity," as he just did at presser. Also of Russia's role: "disappointing"

— Maggie Haberman (@maggieNYT) April 5, 2017

Thus far, we have a President pursuing conflict escalations in both N. Korea and Syria. Everyone wants to be Churchill. We get to feel the brunt, however.

Content originally published at iBankCoin.com

 

via http://ift.tt/2nc780z The_Real_Fly

Authored by Axel Merk via Merk Investments,

This time is different. Stocks will always go up. And pigs can fly. Given that pigs are highly intelligent, don’t bet against them. That said, investors might want to take at least the first two statements with a grain of salt.

 

In the 1990s, stocks continued to rise relentlessly for years, even after then Fed Chair Greenspan warned of irrational exuberance in late 1996.

Last decade, the rally in home prices continued as ever more people appeared convinced that home prices never fall.

This time around, we are eight years into a bull market. As in those times, investors have all but given up betting against conventional wisdom. Much of that is because it has cost investors dearly to bet against the markets. In fact, it has been so costly to bet against the market that some advisors who have been cautious are no longer in business. And I’m not just talking about short sellers, but also many who have – in our view prudently – diversified beyond a traditional “60/40” stock/bond portfolio. We know of advisors who positioned their portfolios more aggressively not because they thought the markets were going higher, but because they were losing clients for underperforming the S&P 500.

Some things are different.

 The investment industry has evolved to provide ever more index products, with lots of touting how active management is dead. If that were true, we wouldn’t have a plethora of index funds for many slices of the market as selecting anything but a market portfolio is the very definition of active management. Then again, when “everything” goes up, does it really matter what you buy, so long as investors buy something? So what is different?

• A new breed of liquidity providers

In the old days, we had banks and floor traders provide liquidity. Dodd Frank has significantly cut back the type of trading banks may engage in. And floor traders have been replaced by computers. Floor traders on the New York Stock Exchange used to have a duty to make orderly markets with the ability to slow down trading to match buyers and sellers. That philosophy lost out to the philosophy that speed is more important than price, meaning that if an investor wants to trade, let them trade instantaneously, even if the price needs to adjust sharply.

Today’s liquidity providers include ETF market makers and hedge funds. They will provide all the liquidity in the world, so long as everything appears orderly. But let the algorithms flag an abnormality, and their systems may go offline. Without going into the arcane details how market making works, let’s take a common model (there are others) how ETFs trade:

– A so-called lead market maker gets incentivized to offer a tight spread for an ETF (the incentive comes from the exchange giving the market maker a rebate on the price, i.e. giving them a price advantage through actual cash; the rebate comes from the exchange fee investors are paying).

– There’s a plethora of other market makers also providing liquidity, enabling what appear to be mostly efficient markets. These other market makers also get incentives from the exchange, albeit lower ones than the lead market maker. As a result, it creates a structure where all market makers can offload their risk to the lead market maker. This makes it comparatively easy for market makers to make markets in thousands of ETFs, as they don’t need to understand too well the ETF they are providing liquidity for; all they need to know is that they can offload their risk to the lead market maker.

– This system works great until the lead market maker has a glitch and takes its systems offline. When that happens, other market makers see that the party that is supposed to be best informed (the lead market maker) is stepping away. Not surprisingly, everyone else also steps away, causing spreads to widen.

– A flash crash can then happen if investors place large market orders just as liquidity providers are offline.

• Lower volatility?

Markets have been rising on the backdrop of low liquidity. Why has volatility been so low? We see two primary drivers: the rise of machines, as well as central banks:

– To the extent that information is processed correctly, trading firms focused on ‘big data’ scanning the news flow automatically may well speed up how readily new information is absorbed in the market. As such, the rising influence of machines in the market may well contribute to the lower volatility we have seen. That said, we wonder how big that impact is.

– When ECB chief Draghi said, he’ll do “whatever it takes” to save the euro a few years ago, he put into plain English what had been happening for some time since the onset of the financial crisis: taking risk out of markets. A few weeks ago, he said in a press conference there’s no need to be concerned about upcoming events in the Eurozone because we can’t do anything about the outcome anyway; and if something bad were to develop for the markets, the ECB would take the appropriate action. Differently said: heads, I win; tails, you lose.

– More abstractly speaking, central banks have compressed risk premia through quantitative easing and their forward guidance.

Some things stay the same…

 In our analysis, all else equal, lower volatility warrants higher valuations. That’s because in a classic valuation model where asset prices reflect the present value of discounted future cash flows. Lower volatility increases valuations because future cash flows are discounted at a lower rate. This warrants the question whether volatility will stay lower, permanently.

I have my doubts. On the contrary, in my assessment the hallmark of any asset bubble is low volatility. Capital misallocations happen when risk is underpriced. When it is a central bank, be that the Fed, the ECB or another central bank causing the underpricing of risk, it doesn’t suddenly become rational. Sure, one can argue that it is a quixotic task to fight the Fed, but that doesn’t mean an asset bubble won’t be created and won’t burst.

Get ready for the crash…

We believe one of the reasons the Fed has been so reluctant to raise interest rates is because of the “taper tantrums” the market has exhibited. Because we believe the economic recovery was driven by asset price reflation, the Fed has been hesitant to withdraw stimulus too early, to avoid deflationary forces taking over again. The Fed has been trying to engineer what we call a “cliff walk” trying to normalize interest rates without causing a shock to asset prices.

Of late, the Fed has been emboldened: with a few speeches, the market delivered the Fed a rate hike on a silver platter, without equity markets having a fit. Indeed, some Fed officials have been all chirpy of late, talking about three to four interest rate hikes this year. Fed officials are acting as if they were at cocktail parties bragging about their great trade, pardon, rate decision. The reason I’m skeptical is because the folks at the Fed are so data dependent that they tend to fight yesterday’s war. For example, President Trump’s inability to pass healthcare legislation at this stage, and the implication that he might be less effective with other items of his agenda, may not appear on the minds of ivory tower academics more concerned about extrapolating data from non-farm payroll reports. By the way, as of this writing, the market is pricing in just under 2 and half rate hikes for the year, including the March rate hike (based on Fed Funds futures).

Let’s also not forget that Fed Chair Yellen’s term is due to end early next year. In a few months, the talk about her successor will increase. Our chips are with Kevin Warsh; Mr. Warsh was governor at the Fed during the financial crisis. Importantly, he was invited to be part of President Trump’s economic round-table earlier this year. And very relevant, he has argued that the Fed’s policies have helped owners of stocks, but actually hurt investments in the real economy. In multiple Wall Street Journal OpEds, he has criticized the Fed for a lack of strategy. He has argued that the Fed must revert to focusing on the real economy rather than a focus on the financial markets. We interpret this to mean that a Fed under Kevin Warsh may well raise rates even if the market has a fit. That said, he wouldn’t be the first Fed Chair to learn that the markets have a way of convincing the Fed to change course…

Differently said, we believe the Fed may well be thinking that the crisis is behind us, that the time to normalize is now. This may well mean higher volatility and lower asset prices. So should you “get ready for the crash…”? Isn’t this alarmist? We don’t think so. In fact, you may always want to be ready for a crash. You may want to hope for the best, but that’s not a strategy; you should always plan for the worst. As such, stress testing one’s portfolio may always be a prudent idea. That said, we do think that the odds of a more serious decline in asset prices have increased sharply given a combination of what we believe are high valuations; a period of low volatility that may be nearing its end; rising interest rates; all of this in the context of what we believe is an over-exposure to equities in both individual and institutional portfolios.

What about gold?

So here I am cautioning that the Fed may drop its reluctance and become more assertive in raising rates. Isn’t that bad for the price of gold? It all depends on how one thinks this will play out. I happen to believe that a more assertive Fed will take it away from its path on the cliff walk. And once you take a step to the side when walking on a cliff, well, watch out below. That is, I don’t think the Fed can normalize rates even if they wanted to. I happen to think that a more assertive normalization attempt will cause equity prices to plunge. When equity prices plunge, investors may well think the glass is half empty, i.e. interpret any news on the economy or out of Washington to be bad for the markets. Confidence can evaporate rather quickly. The ivory tower club at the Fed will take note of deteriorating financial conditions and, well, not be able to execute the normalization of interest rate policy as underlying economic data increasingly start to disappoint. There are obviously many other scenarios as well, but the above is our baseline scenario for the time being (and subject to change at any moment).

Note that gold has outperformed the S&P in the first quarter despite an interest rate hike. In our analysis, the price of gold has gone up in each bear market since the early 1970s, with the notable exception of the Volcker-induced bear market in the early 1980s where real interest rates were pushed to very high levels. We aren’t suggesting investors should dump their equities and buy gold. We mention gold because it is one of the “easiest” diversifiers; easy because gold dynamics are easier to understand than other ways to seek diversification for one’s portfolio in an era when most asset prices may be elevated. Easiest also doesn’t mean best, as the price of gold doesn’t always go up when equities go down.

via http://ift.tt/2obxmzD Tyler Durden