Month: February 2018

Submitted by GnS Economics

The ghost of 1987

Uncertainty is creeping back in the asset markets. In the US, the stock market volatility is staging a comeback. The yields of the long-term bonds are rising and the yield curve has flattened. On Friday, the stock markets were under heavy selling with the Dow Jones Industrial average suffering one of the worst one-day point declines in its history. Looking back, we find disturbing similarities with the period just before the biggest single-day stock market crash in history: the Black Monday in 1987.

The timeline of the crash

Before crashing in 19 October 1987, the stock markets were beating records. The bull market started in August 1982 and raged through the ‘Roaring Eighties’. The upward momentum was driven by fast economic growth, by the extensive growth of corporate profits, by the influx of new institutional investors which increased the demand for stocks and by tax breaks for mergers and buyouts. Although the interest rates were somewhat high (the federal fund rate was 7.5 %), they had much decreased since summer 1981 (around 19 %). Compared with the 1970s, inflation was actually low. It was the Goldilocks period of that time. Complacency took hold.

In early summer 1987 something changed. The interest rates started to rise. Doubts about the virility of the economic expansion started to linger during the fall. The growing trade deficit of the US and the declining value of the dollar raised concerns about inflation and the need for higher interest rates. Uncertainty was increasing.

On the 14th of October, the stock markets started to fall. It was first fueled by the rumors of the elimination of tax benefits associated with the financing mergers and the announcement that trade deficit was well above the expectations in August. The dollar declined further. On Thursday, the decline in the stock market continued. The institutional investors were getting anxious and started to transfer funds from stocks to bonds.

On Friday, the decline in the stock markets started to gain speed. During the previous two days, the price movements had eliminated many of the at-the-money options, which lead to difficulties for investors to hedge their positions. They looked for shelter by selling future contracts. The heavy selling of the futures contracts created a price discrepancy between the value of the stock index in the futures market and the New York Stock Exchange (NYSE). At the close, S&P 500 was down nine percent for the week, which was one of the largest declines during the past decades.

On Monday, the 19th of October, a substantial selling pressure build up for the NYSE at the open. This delayed the opening of trading for the first hour, which made the NYSE index stale. By contrast, the market for futures opened on time to heavy selling. A large gap between the values of the stock indexes in the cash versus the futures markets evolved. When the stocks opened, prices fell promptly. The index arbitragers observed that they had sold stocks below their expectations and tried to cover their positions by buying in the futures market. This induced a temporary rebound of the prices increasing the confusion among the traders. The portfolio insurer models prompted them to resume sales. They sold both in the cash and futures markets. The cascade of sales overwhelmed the short rally and the markets crashed. At the close, S&P 500 had lost (around) 20 % of its value.

Response

Before the opening of the markets at the 20th, the Federal Reserve issued a statement that it will “serve as a source of liquidity to support the economic and financial systems”. Around seven percent of stocks were closed for trading. The margin payments were cleared before opening.  The corporations started to announce stock buyback programs already on Monday, but the critical mass to make an effect on the stock markets was formed only on Tuesday. A small rally evolved at the end of Tuesday trading and carried on for Wednesday.

History can rhyme

The stock markets have been pushing higher for several years and interest rates have been very low for an extensive period of time but are now trending upwards. The dollar has fallen, the US trade balance is negative, economic growth has been sound but doubts about it are starting to linger and the inflation expectations are rising. Corporate profits have also recovered strongly from a previous slump. All these developments preceded the 1987 crash.

 

Corporate profits before tax in the US, Q1 1983 – Q4 1987 versus Q4 2012 – 2017 Q3. Source: GnS Economics, Fed  St. Louis

In addition, this rally has also seen an increase in the program trading, but in much bigger numbers than before the crash in 1987. One big difference is the valuation level, which was more moderate in the 1980s. And, although it cannot be used as an indicative sign, last week’s stock market performance bears some eerie similarities with the week that preceded the Black Monday.

The Fed and the algos: a toxic combination

What becomes to the options of the Fed to respond to a similar crash, the things are rather different now. In 1987, the Fed quickly dropped its fund rate to 7 percent from 7.5 and injected reserves to markets. Now, a 50 -basis point cut in the federal fund rate would take the rate back to the range 0.5 – 0.75, which would likely have a very limited effect of the short-term rates. The Fed has also been pumping massive amounts of liquidity in the markets through its QE program. While re-starting the program would surely provide some temporary relief, there is no certainty that it would be enough to stem the panic; moreover so, because the program trading has a much bigger role now than in 1987.

In the 1980s, the main innovation in the program trading was the portfolio insurance, where the computer models were used to optimize the stock-to-cash ratios at various market prices. Most of the portfolio insurers used the futures market, which was likely to increase the downward pressure of the stock prices during the fall. Currently, the automatic trading is much more widespread. It is estimated that around a half of all trading in the US stock markets is executed by algorithms. Also, it is estimated that ETFs, the risk parity funds and the volatility target funds hold some $8 trillion of the so called passive private assets. They have contributed to the uninterrupted upward trend in the equity markets, but their behavior in a large market correction is untested. When a deep enough correction is reached, the algos are likely to start to sell and short the market and the ETFs and other funds will start to lose value en masse. This will turn their passive assets very active to the sell side. When this point is reached, selling in the markets is likely to morph into a rapid crash halted only by the circuit breakers.

To make things more alarming, the global economic situation resembles more the time before the Great Depression than before the crash of 1987. This makes it possible that, if a stock market crash occurs, it will start a path towards a global depression. Thus, after nearly a decade of central bank induced market manipulation, we may finally be closing to the point where the Abyss starts to gaze back at us.

The timeline of the 1987 crash and details before it, were obtained from “A brief history of the 1987 stock market crash with a discussion of the Federal Reserve response” by Mark Carlson. 

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Senate Judiciary Committee Chairman Chuck Grassley’s push to force the DOJ to open a criminal investigation into ex-British spy and “Trump dossier” author Christopher Steele is being met with resistance from the bureau, the latest sign that it doesn’t want information about its relationship with Steele to be shared with the public.

Bloomberg reported Monday that Senate Judiciary Chairman Chuck Grassley criticized the FBI for blocking the release of key portions of a memo he wrote calling for a criminal investigation of Christopher Steele, the former British spy who compiled a dossier of unverified allegations on Donald Trump.

Grassley also released the memo in its redacted form to the press.

“Seeking transparency and cooperation should not be this challenging,” Grassley said in a statement after posting a heavily redacted version of the criminal referral that he and GOP Senator Lindsey Graham of South Carolina sent to the Justice Department last month. “The government should not be blotting out information that it admits isn’t secret.”

Grassley has been pursuing questions about the FBI’s reliance on Steele separately from House Intelligence Chairman Devin Nunes, the author of the four-page “FISA memo” that was released last week and inspired President Trump to declare that he has been “vindicated” by its findings.

Conservative lawmakers have demanded that President Trump fire Deputy AG Rod Rosenstein, the official responsible for supervising the Mueller probe – and some have even called for Mueller’s firing. But others, including outgoing Congressman and House Oversight Committee Chairman Trey Gowdy, have said the revelations packaged in the memo wouldn’t justify ending the Russia probe.

Grassley’s push is emblematic of the intense rivalry that has sprung up between the various Congressional committees pursuing their own independent investigations of Trump and Hillary Clinton’s relationships with Russian entities or officials.

Democrats have dismissed the memo as inaccurate and misleading and are pushing for release of their own document challenging the Republican account. The Intel Committee is set to meet Monday at 5 pm to decide on whether to release the memo. Washington time to vote on the possible release of the Democratic response.

As the rivalry between the White House and Republicans on one side, and the FBI and DOJ, on the other, accelerates, Grassley and Graham asked the DOJ to investigate whether Steele made false statements to federal investigators.

In the newly released memo, the pair wrote that they had sent the criminal referral because there’s evidence that Steele, whose opposition research was funded largely by Trump rival Hillary Clinton and the Democrats, either lied to the FBI or to a British court, or that classified documents reviewed by the committee are false.

As Bloomberg also notes, Grassley asked the FBI to approve a declassified version of his Steele referral by Tuesday.

Meanwhile, Politico reports that  Grassley and Graham on Monday also asked the Department of Justice and FBI to declassify more information related to their Steele referral, including an application to conduct surveillance of former Trump campaign adviser Carter Page.

That surveillance application, Republicans have said, improperly involved research conducted by Steele that was paid for by the Clinton campaign. Republicans on Friday released a declassified memo they wrote on the subject.

Suspiciously, the redacted letter includes a blacked-out section led by the sentence “there is substantial evidence suggesting that Mr. Steele materially misled the FBI about a key aspect of his dossier efforts, one which bears on his credibility.”

Furthermore, a section on a second memo by Steele says he received information from the State Department, which in turn got it from a foreign source who was in touch with “a friend of the Clintons.”

“It is troubling enough that the Clinton Campaign funded Mr. Steele’s work, but that these Clinton associates were contemporaneously feeding Mr. Steele allegations raises additional concerns about his credibility,” Grassley and Graham wrote in their criminal referral.

Full memo below

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Paging Jay Powell…

 

The Dow is now down over 400 points today and VIX is back above 21 for the first time since the election in Nov 2016.

 

It’s accelerating…

 

This drop has erased 2018’s gain for Small Caps and Dow Transports…

 

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In an embarrassing security lapse that could damage the public’s faith in the Department of Homeland Security early into the tenure of Secretary Kirstjen Nielsen, a top scientist at the Department of Homeland Security accidentally left a folder containing a critique of Minneapolis’s response to a simulated Anthrax attack at the Super Bowl LII, offering a rare glimpse at how America’s top national-security officials safeguard large public events from terror attacks.

The folder, which was marked “for official use only” and “important for national security”, was discovered on a commercial flight by – get this – a CNN journalist who apparently just happened to sit in the same seat as the official who left the documents behind. The folder included the scientists’ name, but CNN was unable to verify whether the name attached to the itinerary was the same as the person who left it. The travel itinerary and boarding pass accompanying the documents was in the name of Michael V. Walter. Walter, a microbiologist, has been the program manager of BioWatch since 2009, according to his LinkedIn profile.

“I am responsible for developing and operating a budget that has ranged up to 90 million dollars and directed a staff or more than 50 members,” his profile says.

The Department of Homeland Security documents critiquing the response to a simulated anthrax attack on Super Bowl Sunday were marked “For Official Use Only” and “important for national security.”

CNN said it discovered the documents before last night’s game, but opted to hold the story at the request of the government, which said releasing the critique could jeopardize national security. Some of the details from the response were apparently so sensitive that CNN decided to withhold them entirely.

The exercises being critiqued in the documents – which the holder was instructed to handle with care and shred immediately after they’d served their purpose – were conducted in July and November of last year.

 

The exercises were meant to determine areas of friction in a coordinated disaster response between the city’s law enforcement, public health facilities and first responders.

The reports were based on exercises designed to evaluate the ability of public health, law enforcement and emergency management officials to engage in a coordinated response were a biological attack to be carried out in Minneapolis on Super Bowl Sunday.

The exercises identified several areas for improvement, including the problem that “some local law enforcement and emergency management agencies possess only a cursory knowledge of the BioWatch program and its mission.”

DHS assured the public the exercises were a resounding success.

“This exercise was a resounding success and was not conducted in response to any specific, credible threat of a bioterrorism attack,” said Tyler Q. Houlton, an agency spokeswoman.

Juliette Kayyem, a former DHS official who now serves as a CNN contributor, said it was not surprising that the documents highlighted deficiencies.

She said such exercises are designed to expose gaps in planning and preparedness so that authorities “are better equipped if something bad were to happen.”

To be sure, leaving the documents in a plane – where any unscrupulous individual could’ve discovered them – was “a really stupid thing.”

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“Hope is not an investment strategy…”

Equity futures back to the overnight lows…

And VIX back above 19…

 

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Echoing his recent comments on how investors’ exposure to low interest rates is extreme and warned that a rise in yields could spark the biggest crisis for fixed-income investors in almost 40 years.

“A 1 percent rise in bond yields will produce the largest bear market in bonds that we have seen since 1980 to 1981,” Bridgewater Associates founder Dalio said in a Bloomberg TV interview in Davos on Wednesday. We’re in a bear market, he said.

Visually:

However, as we explained last December, this is a low-ball estimate which “understates the potential losses” as it “does not include high-yield bonds, fixed-rate mortgages, and fixed-income derivatives”, which would suggest that the real number is likely more than double the estimated when taking into account all duration products.

As a reminder, Goldman calculated the entire duration universe at $40 trillion as of the summer of 2016, resulting in $2.4 trillion in losses for a 1% move. By now the number is far, far greater.

Bridgewater Founder Ray Dalio warns today, Via LinkedIn.com, what we are seeing is typical late-cycle behavior, though more exaggerated because the durations of investment assets (i.e., their sensitivities to interest rate changes) are greater.

Here’s what happened, Dalio explains:

Over the past week or so, we had reports of strong growth and rising wages (good things!), which sent bonds and stocks down (bad for most investors) due to justifiable fears that the Fed will tighten faster than is priced in the credit markets.  

The surge in growth and wages came because of both the fiscal stimulation and the rekindling of animal spirits, thrusting the economy into late-cycle capacity constraints, which is leading to the expectations of faster Fed tightening.  

In other words, fiscal stimulation is hitting the gas, which is driving the economy forward into the capacity constraints, which is triggering interest rate increases that are hitting the brakes, first in the markets and later in the economy.  

This confluence of circumstances will make it difficult for the Fed to get monetary policy exactly right.  

This is classic late-cycle behavior (when it’s difficult to get monetary policy exactly right, which leads to recessions), though it is more exaggerated because the durations of assets are uniquely long, which means that when interest rates are low, prices of assets are more sensitive to changes in interest rates than when interest rates are high.

To be clear, we are not claiming to be smart about this.  In fact, the opposite is true, as this is happening sooner than we expected.  Still, these big declines are just minor corrections in the scope of things (see charts of stocks and bonds below), there is a lot of cash on the side to buy on the break, and what comes next will be most important.

As shown, the recent price declines are not even noticeable within context of the bigger and longer term picture.

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So it seems Dalio continues to suggest those holding cash are idiots, keep calm and carry on.

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