This Is How The U.S. Market Might Crash

by: Raphael Rottgen

- We could see a non-linear break in the market.

- This would be caused by a number of potential vicious circles of selling.

- Some of these potential vicious circles are the result of recent changes in market participant structure and activity.

I have developed the conviction that we will have a non-linear break in the market in the near future, say the next 3-12 months. "Non-linear" in the sense that it will not be along the lines of losing a few percent or so every week to enter a bear market over the period of a few months, but an exponentially accelerating sell-off, similar to 1987, for example, whereby we could lose 20%+ in one trading day. This is less based on arguments along the lines that certain valuation metrics for the (U.S.) market are high (an argument that could have been made years ago) and more on arguments that a number of mechanistic pieces are now in place that could cause this type of sell-off.
So, what would we need to see such a scenario?
1. We need a trigger
We need something that tips us into selling territory far enough. Far enough to overcome the vested interest of market participants to keep the party going (this, by the way, was one of the typical pre-crash characteristics that John Kenneth Galbraith identified in his book The Great Crash, 1929. Far enough to overcome the price thresholds above which armies of automated algorithms (and also human traders) simply buy on the dip. Like in a chemical reaction, there is an activation energy threshold to overcome to get it going, and, again like in a chemical reaction, you need a catalyst.
What could be that catalyst?
First, we could have a cataclysmic event. For sure, it would have to be something very traumatic - 9/11 was on obvious example (the Dow was down approx. 14% for the week after the market reopened). If it happens, it may well be something that we did not expect at all - if we had expected it, we would have been prepared for it psychologically, practically (hedging), etc. I recently got reminded of this when the Qatar crisis started to unfold, and I contemplated the remote possibility of a war involving Saudi Arabia (I am not saying this is likely).

Second, and I think more likely (we should of course hope this will be the trigger rather than the first option), we could see a stark sell-off in some remote-seeming corner of the world of financial assets. A remote corner, but one that is sufficiently connected to the overall network of financial assets that it has the potential to spread its "sell virus" via contagion. This, of course, was the example of the crisis of 2008, which started with seemingly localized blow-ups like that of two internal Bear Stearns MBS hedge funds in June 2007. As Galbraith put it, in an eerily prescient article in January 1987: "For the loss will come. The market at this stage is inherently unstable. At some point, something - no one can ever know when or quite what - will trigger a decision by some to get out."
Or, do we need such a hard, human-rationalize-able trigger after all? Remember the flash crash of May-10 (Dow down 9% at its worst)? Remember the weird price action in tech stocks that Friday a few weeks ago? I tend to think that kind of "catalyst" would not be enough, though, as it would not push us down far enough and/or fulfill the other two conditions for the crash to which we shall now turn our attention.
2. We need perpetuation of the selling
Ideally in a self-reinforcing "vicious circle" way, where selling triggers further selling. This, too, may happen in various ways.
First, with humans as investment decision-makers in the middle. As Edwin Levèfre already said in Reminiscences of a Stock Operator, "the greatest publicity agent in the wide world is the ticker tape" and "never argue with it [the tape]." People who see prices dropping like a stone may just sell themselves, too, and ask questions later - especially if they have reasonable justifications for doing so (see next point "We need absence of significant supportive buying" below). This is also true as selling right now can be easily rationalized: we are almost eight years into a bull market (one of the longest ever in the U.S.), market valuations are high (again, in the U.S.) on most traditional metrics, QE seems to be ending, growth in many sectors is unexciting, etc. Note that against many of these points, one could elaborate counterarguments - e.g., who cares how long the bull market has gone on for? Or, regarding market valuations: high multiples are justifiable, given the ultra-low interest rates.

I, for one, will place my bet that, once a sell-off starts, few investors will stop to argue that the equity risk premium is actually correct; more likely, the majority will simply remember that the CAPE of U.S. stocks is near 30 and that we might just go back to something in the teens (the long-run mean and median) and that this will not happen via earnings catching up with prices. Lastly, with human decision-makers in the middle, most of which also tend to be employed rather than self-employed, Keynes's famous quote applies: "it is better for reputation to fail conventionally than to succeed unconventionally." Selling will be the conventional thing to do (just like continuing to buy is the conventional thing to do for now).
Second, via good old-fashioned contagion and forced selling. Once the crash starts, even if it is in some remote corner of the asset network, it will often force investors who commingle some of the affected assets with "good" assets to sell the latter ones, too, and soon, the selling may reverberate through the entire financial asset network. The exact extent and speed of contagion will depend on where the contagion starts and on the network topography, which is virtually impossible to know, but I would bet that the markets are more interlinked now than they were during the last crisis.
The more leverage, obviously, the worse, as assets pledged as collateral (including and in particular margined stocks) lose value, which then generates margin calls and, if those calls are unmet, forced sales of the collateral, leading to another vicious circle.
Third, in some perverse hard-wired, machine-driven way - which is really the same forced selling as above, but on steroids, as there are no humans in the middle and things may unfold extremely quickly. Remember the role of portfolio insurance in the 1987 crash? (Now, I am dating myself). In brief, in case of price falls, portfolios were programmed to sell a portion of the portfolio value short, via futures. That sounded like a great idea at the time until it entered a vicious circle, whereby a fall in cash equities caused the future to fall (via the portfolio insurance programmed actions) which in turn caused cash equities to fall further which in turn caused the future to fall further, which - you get the point. Here, we note that a "financial innovation" was another typical pre-crash characteristic that John Kenneth Galbraith identified in this book. The 1929 and 2008 innovations were investment trusts and MBS/CDO/etc. What could be current financial innovation that may become a culprit?
How about a class of instrument that grew at 20%+ CAGR over the last 12 years (and keeps going) and of which there are now more types (almost 6,000) than U.S. stocks of at least some reasonable size (using the Wilshire 5000 as a proxy)? I am talking about ETFs, of course (and ETPs).

Unless I am missing something, I can see how ETFs and their underlying assets could develop the same unhealthy, vicious interplay (i.e., another vicious circle) as happened between futures and underlying shares in the 1987 crash. Selling pressure may start in either place, ETF or underlying assets, but then the other instrument(s) will get dragged down via hedging activity which in turn will drag down the initial instrument(s), and so on - yet another vicious circle. Arguably, this same effect may have just happened on the way up, albeit in a slower and more controlled way as is likely on the way down.
An ETF, of course, is also often an excellent way to promote contagion, as they nearly always rather indiscriminately mix "good" with "bad" assets, interlinking them in a rigid, mechanical way, allowing the good to be dragged down with the bad (or the bad to rise jointly with the good). Although I cannot prove it, I sensed this happening recently, when in May 2017 the Brazilian market was shocked by the release of wiretaps implicating the Brazilian president in potentially criminal activities. The prominent Brazil-tracking ETF EWZ was down more than 15%, and pretty much all of its component stocks were also down roughly this percentage, albeit they represent a wide variety of companies that even cursory fundamental analysis would show to be of rather diverse quality and valuation.
The growth of ETFs has been a major, major change in market structure and may well be the cause for many a hedge fund manager's frustrated proclamations about how the market is not rational anymore. Of course, it really probably just means the market is not rational anymore on the previous time frames, now that many ETFs reinforce the prevailing trend and hence extend the trend's lifetime. But, considering how many hedge fund investors have tended to become more short-term oriented, you can see how this dichotomy between increasing periods of market irrationality (read: drawdowns/losses) and decreasing investor patience can drive hedge fund managers into returning outside money.

Galbraith mentions the emergence of investment trusts as a sign of the pre-1929 froth. I read about the first ETF of ETFs earlier this year.
Another potential source of forced selling may come to us thanks to the same folks that have brought volatility to its knees over the last few years. While again I cannot prove it with hard data, I have by now heard ample anecdotes of large institutions reaching for yield (understandable in our ZIRP world) by shorting vol. This includes, for example, me having had to listen to a senior investment management professional of an insurance company gloating about how he makes lots of yield by basically coming to the office every day writing puts. Let's see - reaching for yield via massively shorting an asset class already trading at historical lows - might we have seen this before? AIG Financial Products Group London writing CDS pre-2008? I listened to that person and thought I was looking at the guy that Steve Eisman had dinner with in Las Vegas in the movie The Big Short.
In any event, that game works fine until the day it does not work anymore. If a market drop is big enough, those institutions that are short puts will want to, and need to, cover their positions - i.e., they will either buy back the puts, which will then cause the counterparty to hedge itself by selling the underlying in the market, or more likely (as in a severe fall there may not be any people around writing puts), the institutions will just sell the underlying assets themselves. In any event, this activity will depress prices and probably set off yet another vicious circle.
3. We need absence of significant supportive buying
If things go down rapidly, where could the bid come from?
Some of them may reinforce the downward trend, by following simplistic trend-following rules. Eventually (but likely not quickly enough), many machines will probably be taken offline - which is arguably correct anyway, even, or, perhaps especially, if the machines are sophisticated machine learning-based ones - as these rely on patterns observed in past data and are plainly unreliable when faced with data points that have never been seen before or only seen very few times.

"Regular human" investors?
Given the speed with which things will unfold, they will probably fall back on time-proven heuristics rather than any sort of deep analysis. I would bet that "don't catch the falling knife" will be a widely remembered and applied heuristic. Note also that investors will be able to rationalize not buying in the same manner they rationalized selling, as elaborated above.
Risk-loving prop desks who can enter a trade early and ride out a draw-down?
Well, thanks to the Volcker rule (not debating its merit here), there are fewer of those around these days.
Central Banks?
Their balance sheets are already full of stocks - just look at the JCB's ownership of the Japanese equity market (it was a top 10 holder in 90% of Japanese shares already as of mid-2016; by the way, they also buy loads of ETFs) or even the staid, quaint Swiss National Bank, who held over $63bn of U.S. shares as of year-end 2016. However, now the trend seems to be to shrink balance sheets.
Private equity?
Yes, they are full of cash but cannot, and do not need to, act quickly enough - but they will come out having a heyday (payday?).
Failed attempt at an upbeat note
The only fact that in theory could counterbalance my pessimist view so far is that there is actually an increasing number of voices that warn about the potential of a sharp downturn in markets - e.g., Jim Rogers or Mark Yusko. If these are just the visible exponents of a much larger, silent group that shares this belief, then maybe in the end, the market is already reflecting actions reflecting that belief, and it is not vulnerable as it actually is not overbought and overvalued? Maybe without these cautious beliefs and the resulting positioning, the CAPE would be in the 30s?
I do not buy it. The difficulty is that for many investors, even if they do share the belief that the market will come down, it is in practice very difficult to act on that belief, especially if they are employed (same Keynes argument as above) and/or managing other people's money - other people who typically do not look kindly on relative underperformance (even in hedge funds!) or things like holding cash reserves (which they have to pay fees on). That is why "as long as the music is playing, you've got to get up and dance," as Citigroup's Chuck Prince famously said in 2007. And, then you are magically supposed to know exactly when to stop dancing and quit the party before drunk people trash the furniture and start a fight.

It is like a multi-player game of chicken, made worse by the high payoffs/incentives to stay in the game. As somebody more eloquent than myself, John Hussmann, has said: "The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak." Many a smart person has looked like an idiot before the peak, at least temporarily - e.g., Warren Buffett during the internet bubble and Crispin Odey more recently.
Most people do not have Warren's or Crispin's financial or psychological stamina, though.
I could go on, but I'll stop here. We have not even talked about the links to the real economy yet (the whole reflexivity thing), but that might have to be another article.
So, do you agree? If so, how are you preparing/positioning yourself?

sábado, julio 22, 2017




I’m sure you’ve heard that malls are getting killed. Pretty soon there will be no malls. Except for those with a Planet Fitness!

Source: WZZM

There has been lots of ink (and electrons) spilled over the death of retail.

Everyone knows it is only a matter of time before Amazon puts every department store, every mall, every brick-and-mortar retailer out of business. Amazon gets an infinity market cap and everyone else gets zero. Sound familiar?

That’s the accepted wisdom.

Is Amazon a great business? Yes.

Is a department store a bad business? Probably.

Does Amazon get 100% market share, with department stores getting zero? Probably not.
Amazon has over 80 million Prime subscribers in the US. It’s not quite saturated, but it’s getting close.

I admit to being a Prime member, a late adopter.

It is pretty cool. Stuff shows up on my doorstep in two days, for free. The huge poker chip set I just ordered probably weighs about 40 pounds—free shipping! And I get all the Prime movies and TV shows.

Sometimes, when I reflect on what a good deal Amazon Prime is, I think that I’m picking Amazon off. But they’re probably picking me off! 80 million customers times $100 is a lot of money.

Here is my thesis: Amazon will grow and grow, but there will always be a role for physical retailers.

A reduced role, for sure, but there will always be a role.

From a capital markets standpoint, now might be the time to put on the trade.

The Bottom

This is when I started thinking that we've reached a bottom in physical retailers: Last week, ProShares—a $27 billion ETF manager—registered to list some double short leveraged ETFs on brick and mortar retailers!

According to Bloomberg, “The ProShares UltraShort Bricks and Mortar Retail fund and ProShares UltraPro Short Bricks and Mortar Retail fund will seek to use derivatives to generate daily returns of two or three times the inverse of an index comprising the most at-risk US retailers…”


In my experience, specialty ETFs like this are usually listed at the worst possible times. Plus, you know my thoughts on leveraged ETFs.

When 2x short leveraged ETFs are being listed on physical retailers… it is probably time to buy physical retailers.

This infographic from AEI is a couple of months old. Since then, Amazon’s market cap has increased to $481 billion. Meanwhile, Macy’s market cap has fallen to a little under $6.5 billion.

Amazon is worth around 75 times more than Macy’s? That doesn’t seem right.

I hope by this point in the article I have you thinking.

I am no Macy’s fan. It is a pretty terrible business, they sell middlebrow stuff in middlebrow locations. Although their online business is actually not bad.

I used to buy ties at Macy’s, back in 2001. People laughed at those ties. I no longer buy ties at Macy’s.

But look—at a $6.5 billion market cap, Macy’s is reaching distressed levels. That means we have to put our distressed investor hat on, pick this business apart, and see if there is value—in all parts of the capital structure. Maybe we don’t like the stock, but maybe we like the bonds, for example.
And, Staples was bought by private equity recently for about 0.4 times revenue. Apply that standard to Macy’s and you get to a $10 billion valuation. They’re still kicking.

Plus, there’s an argument that this whole Internet retailing thing is just a giant bubble, according to the chart below.

Source: @bySamRo

How Do You Play It?

This is a smart trade, but it is also a dangerous trade unless you are smart.

There are two ways to do this:

1) Be a distressed investor: Look at the worst-case scenario, look at all parts of the capital structure, and find value.

2) Be a quant: Buy a basket of physical retailers, sell a basket of Internet retailers, and wait for them to converge.

The worst way to play it is just to naively buy Macy’s (or another retailer) and hope for the best.

Furthermore, I think it’s time to go dumpster-diving in Mall REITs, which is what we’re going to do in the next issue of Street Freak.

One final remark. As you look around for ideas, invest in the things that would get you laughed off the set of CNBC. I assure you, if I went on Fast Money and pitched Macy’s as a long idea, I would get laughed off the set.

Those are the best trades.

How to Squeeze China

Force ruling elites to choose between North Korea and American colleges for their kids.

By William McGurn

If the first Duke of Wellington were alive today, he might advise that the battle for North Korea will be won or lost on Harvard Yard.

Add Stanford, Yale, Dartmouth, Chicago and other top-tier private American universities so popular with China’s “red nobility” i.e., the children and grandchildren of Communist Chinese elites. For if the Trump administration hopes to enlist an unwilling Beijing to check North Korea’s nuclear ambitions, visas for the children of China’s ruling class to attend these universities offer an excellent pressure point.

Beijing has been Pyongyang’s closest ally ever since the Cold War split the peninsula after World War II. According to the Council on Foreign Relations, China provides North Korea with “most of its food and energy.” Though China has warned Kim Jong Un about his nuclear testing (which Mr. Kim has ignored), plainly it fears a free and united Korean peninsula more than a nuclear-armed North.

Revoking visas for Chinese students, of course, would not alone resolve the North Korea problem even if it did force Beijing to act. But Beijing could make life for North Korea difficult if it chose to.
Thus far most talk about U.S. options regarding North Korea has focused on economic sanctions or military action against the Pyongyang regime. The dilemma is that every meaningful option comes with big risks, including the devastation of Seoul, retaliation against U.S. troops and more suffering for innocent North Koreans. The advantage of starting with student visas is twofold: The unintended harm done would be more limited than any military strike, and visas are likely a more effective lever than sanctions.

Today 328,547 Chinese students attend American universities, according to the Institute for International Education. The Chinese represent the largest group of foreign students in America.

How many of these students are children of Chinese leaders is unclear. American universities are disinclined to provide this information. In addition, the children of Chinese government officials sometimes attend U.S. universities under assumed names.

The Chinese taste for prestigious American universities goes right to the top. Although President Xi Jinping rails against the corruption of Western values, his daughter went to Harvard, which Mr. Xi managed to swing on an official annual salary of roughly $20,000. A few years back, the Washington Post noted that of the nine members of the standing committee of China’s Politburo, at least five had children or grandchildren studying in the U.S. There are many, many more.

Officially, of course, China is an egalitarian society. In reality, hereditary favors, which now include access to top U.S. universities, are a fixed perk of Communist Chinese culture.

Put it this way: If China’s ruling elite were forced to choose between supporting North Korea and their children’s access to American universities, is it all that hard to see where they would come down? This might be especially true if we continued to allow ordinary Chinese citizens with no family connections to the party or government to come study here.

Would China retaliate? Probably. Would our universities scream? Without doubt. Would there be unfairness? Absolutely.

But if the U.S. does not act quickly, a despot who executes people with antiaircraft guns will soon have the capability to strike Seattle or Chicago with a nuclear-tipped intercontinental ballistic missile.

A White House unwilling to consider Chinese student visas as leverage to prevent this would signal Pyongyang and Beijing alike that America is not serious.

U.S. visas are the one thing we know people want. Before Ray Mabus served as Barack Obama’s secretary of the Navy, he was Bill Clinton’s ambassador to Saudi Arabia. There he championed the cause of two American women who had been kidnapped as children and taken to Saudi Arabia by their father, after he’d been divorced in the U.S. by his American wife.

To make the pressure real, Ambassador Mabus cut off all American visas for the father and his Saudi relatives. That got their attention. Unfortunately the deal for the girls’ freedom collapsed after Mr. Mabus left Riyadh and his successor lifted the hold on the visas.

China is even more vulnerable to such pressure. Perry Link, a China scholar at the University of California, notes that the family connections that lie just below the surface in Chinese Communist culture are more powerful than outsiders realize. He likens it to the Mafia.

Imposing sanctions on the offspring of China’s rulers “might raise howls in the U.S. but would be perfectly normal and rational—unexceptional—inside the culture of the people we would be sanctioning,” says Mr. Link. “They would ‘get it,’ and the pinch would be felt.

“Whether or not it would be enough to budge them from their 30-year-old position on North Korea is a different question. But I support making the try.”

Preparing for THE Bottom - Gold to Silver Ratio

By: Przemyslaw Radomski

In the first part of the Preparing for THE Bottom series, we emphasized the need to be sure to stay alert and focused in the precious metals market, even though it may not appear all that interesting. We argued that preparing for the big moves in gold that are likely to be seen later this year should prove extremely worth one’s while. In the second part of the series, we discussed when, approximately, one can expect the key bottom in gold to form (reminder: this winter appears a likely target).

In today’s issue, we would like to feature one of the signs that are likely to confirm that the final bottom is indeed in. The thing that a relatively small number of investors follow (mostly those who have been interested in the sector for some time) are the intra-market ratios. One of the most important ones is the gold to silver ratio and to be honest, it’s no wonder that this ratio is so important – after all, gold and silver are the parts of the precious metals sector that practically everyone recognizes.

Due to both metals’ popularity and the fact that different types of investors tend to focus on them (gold is more popular among institutions and, generally, big investors, while silver is particularly desired by smaller, individual investors), their relative performance can tell us quite a lot about the situation in the sector. This includes helping to detect and confirming the major turning points in gold and silver.

Let’s take a closer look at the ratio (charts courtesy of and

The first thing that comes to mind while looking at the above chart is that the tops in the ratio usually correspond to bottoms in the precious metals market - silver tends to underperform gold to a big extent in the final part of the decline. The mid-2003 spike in the ratio doesn’t directly confirm this rule (there was a local bottom at that time, though), but the 2008 spike, 2011 bottom and the 2016 spike certainly do. So, while it is not inevitable, it seems likely that the major bottom in the precious metals will be accompanied by a big upward spike in the gold to silver ratio i.e. silver’s extreme underperformance.

Having said the above, let’s move to the current trend. Despite the decline in 2016, the main direction in which the ratio is heading is still up. We marked the borders of the rising trend channel with blue lines and the ratio is still closer to the lower line than the upper one – meaning that the upside potential remains intact.

If the ratio is to continue to move higher (it’s likely, because an uptrend is intact as long as there is no confirmed breakdown below it), then we can expect the upper border of the trend channel to be reached (or breached – more on that in just a moment) before the top is in. If this is to be seen in 6 months or so (as we indicated in our previous article in this series), then we can expect the ratio to move to about 94.

This target is additionally supported by Fibonacci extensions based on the 2016 bottom, 2016 top and the 2015 top. The Fibonacci extensions work similarly to the Fibonacci retracements – they differ, because the latter provide targets between the levels that were already reached, while the former are usually used to provide targets outside of the previous trading range. In this case, we get another confirmation of 94 as an upside target.

One might ask that if the above is the case, then why didn’t we draw the target area around the 94 level, but between 94 and 100. There are two good reasons for it.

The first reason is visible on the above chart. Namely, history tends to repeat itself to a considerable extent, and during the previous steady uptrend (the 2008 lack-of-liquidity-driven spike was far from being steady) at the beginning of this century, the gold to silver ratio moved temporarily above the upper border of the trend channel (marked with dashed lines) and formed a top above it.

Consequently, the upper border of the current rising trend channel may not stop the rally in the following months. Instead, a breakout above it might indicate that the key top in the ratio and the key bottom in the precious metals market are just around the corner.

The second reason for a higher target is visible on the chart below that includes even more data than the previous one.

The tops that you saw on the previous chart appear to be the key long-term tops, but in reality, the key long-term tops are at / closer to the 100 level, while the ones from this century are not as important. Surely, they all are important long-term tops, however, we need to keep in mind that the strongest resistance will not be provided by the 2003 or 2008 tops, but by the 100 level.

Moreover, please note that round numbers tend to be important support and resistance levels as they tend to attract more attention (for instance, gold breaking below $1,000 will definitely get more attention than a breakdown below $1,032) – it would be difficult to find a rounder number for the ratio to reach than the 100 level.

Additionally, if the final bottom in the precious metals market was not reached in late 2015 / early 2016, because too many investors were still bullish at that time, then perhaps the extreme that the gold to silver ratio reached at that time was not extreme enough. The next resistance above the 2015 / 2016 tops is provided by the very long-term tops at or a little below 100.

So, should one ignore everything else and wait with the purchases until the gold to silver ratio spikes to 100? Of course not. That’s just one of the tools that one can use in order to determine the optimal entry prices. On a side note, please note that we wrote “optimal” instead of “final” lows. The reason is that it is not 100% certain that a bottom is in at a specified price (it can only be certain when one looks at the past prices after a longer while), so while it may be tempting to wait for the perfect target to be reached, it might be more prudent to place the buy order above the target price to greatly increase the chance of filling it at all – however, these details go beyond the topic of this essay.

When the ratio approaches its target area, all other signals will become more important – for instance gold reaching important support levels without the same action in silver or mining stocks - but with the gold to silver ratio at exactly 100 or only a bit below it and a couple other confirmations, it might be wise to invest at least partially in the entire trio (gold, silver and miners), as the confirmations would make gold’s reaching its target much more important for the entire sector than it would be without the confirmations. In other words, the gold to silver ratio serves as yet another tool in the investors’ arsenal that can help to determine whether or not the final bottom is in or at hand. It’s not a crystal ball, but one of the things one needs to keep in mind when investing capital in this promising sector. 

Summing up, the gold to silver ratio can provide us with an important confirmation that the final bottom in the precious metals is indeed in and while it seems that the bottom is still ahead of us, it doesn’t mean that it’s a good idea to delay preparing yourself to take advantage of this epic buying opportunity.