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David Hay


Evergreen - GaveKal - November 30, 2018,


This is the weekly GaveKal report from Friday, Nov. 30, 2018 and one of a series of such reports focused on the 'Bubble 3.0'. The others in this series are listed below. The GaveKal reports are available by subscription from Evergreen and are provided in PDF as well as email format. In my summary I will insert my own comments about the text.



The series began in February 2017 and is focused on the author's contention that the investments markets are currently experiencing a massive 'bubble' that is, unsustainable high levels of asset prices. Mr. Hay intends these reports to comprise major parts of a consolidated examination of the phenomena in a forthcoming book form. He notes that the current week (in November) was dominated by the comments of the FED Chairman, Jerome Powell which caused the S&P to rise by 2.3% in one day. The market participants inferred from the Chairman that the FED might soon end its series of interest rate increases, but that is by no means assured. Mr. Hay does consider that the previous decline in the market 'values' was a result of the previous FED policy over the long term of increasing market asset prices - inflation. His analysis is that such a rally is best sold into temporarily as the longer term remains a continued sell-off.

And sure enough the decline accelerated in December.


The pain before the gain

Our author excites us readers with the comment that from his lengthy experience bull markets are "much more fun that bear markets". Whod'a guessed? The youngsters here have never seen a real bear market.
(Being 85, I can assure David that I have seen many of these 'non - fun episodes.)

He turns to GMO for statistics about the general market trend from 'undervalued' in 2009 to fair value in 2012 to overvalue in 2014 to extraordinary hypervalue now.
Then he inserts a chart that depicts the GMO expectation for market performance over the coming years. In two words - Not good - Even with a presumed 50/50 allocation to stocks and bonds the forecast is for negative returns.
His thought about this situation is that the prudent investor ought currently to have a pile of cash on hand. But that those who have continued to chase the markets up likely do not have that reserve. But at that point he waxes optimistic, considering that in the remaining month the market still might achieve an historical record of '10 consecutive up years.'

Sorry about that - December dispelled that unprecedented opportunity.

A few well chosen thoughts follow: "Bull markets ... make investors 'afraid to sell'. And, 'Late stage bull markets become like an elaborate con job.' after a few more punches - "most of the foregoing has fallen on deaf ears".


Flash crash flashback

Now for the meat of the report. He assesses the nature of today's market structure. Computers anyone? The 'algorithms have taken over. 'Passive' investing is the current fad. Statistics again - NYSE trading volume is estimated to be 80 - 90 % the result of algo's. Another insight, "My only insight is that it simply shows that perhaps the only force driving the stock market these days that is more powerful than the 'algos' and computers is the FED." Bingo - enter the FED.
Our author is too polite to mention that all this is the result of the financial industry trying to reduce THEIR costs and attempt to retrieve profits despite enforced regulations. He produces several graphs which depict an interesting 'coincidence' between computer driven exchange volume and the dates of FED pronouncements. (Really? can't be!)

But the situation is worse. Active real research on fundamentals is expensive, of course, but that was the basis for the vaunted 'efficient market theory'. Now we have ETF's created by the industry to entice 'investors' into passive index investing.
But now Mr. Hay brings up the bacon - the FED and the result of its QE in providing a 'pretend' unending increase in asset prices into which the buy-side computer programs are delighted (if computers can have emotions) well anyway their authors - to buy and buy. And all that buying has been financed by the FED purchasing the Treasury debt generated by Fed government paying (exchanging )credit for assets. It is called 'deficit financing'. And many corporations have been happy to emulate the FED. Don't forget that if a single individual were to pay $10 more for a share of stock today than its price yesterday each and every one of those other millions of shares are automatically increased also by $10. But wait, what happens when someone's computer detects some anomaly and SELLS a share for $10 less.

Mr. Hay again. He notes that for several months already (Nov, remember) there has been a 'tide shift', "A key flow reversal is that interest rates have staged a comeback in many countries." The result, he notes, is that computers are no longer 'churning' out buy orders but their programers have considered it is time to sell. He calls this a 'radical departure'. Investors have been 'duped' into 'believing that the stock market is no longer a volatile beast, capable of destroying vast amounts of wealth in breathtaking short order." Including, I confess, your reporter here who lost over 12% between 1 Sept and 31 Dec. At a return of 3% annually it will take over 4 years just to regain the same.
But our intrepid author tries to remain optimistic by hoping in Nov. for a Santa Claus Rally' come December.


What about that upside stuff?

Mr. Hay tells it clearly. "If my belief that Bubble 3.0 is rapidly deflating is correct, this is actually great news for prudent investors - like those who systematically reduced risk late in a bull market".

Well, I did get a few hundred thousand into cash in time but no where near enough. He mentions Jim Grant who has been urging this action for a long time. By coincidence, I happened to see Grant being interviewed on CSPAN on Sunday - excellent - check the interview out in the CSPAN archive.
From this he turns to the bond market and references several previous GaveKal reports and adds graphs depicting the shifting credit spreads between BBB and High-Yield instruments.

He has news "The great news for risk-averse and income needy investors is that these days you can lock in 3% per annum for several years with the safest of bond vehicles." Yes, if you were smart and moved your stash into cash in time to buy bonds now. But he again cites GMO to the effect that the stock market is not going to generate even 3% per year over the next 7 years. So he tells us that a 12 month Treasury now could be a great performer over that 7 years, due not only to the interest but also from the CG by annual roll overs. Furthermore, he adds, credit spreads are already widening - with more graphics to depict that. He believes that the up-move in spreads is going to increase. And such increases are bad news for stocks and on long term corporate bonds.

He repeats, "To be clear, in our view the credit spread eruption is in its early stages so it's best to stay short-term and ultra-high quality for now."


The potential sequential plan

Here comes the climax of this report. "our best guess on what the sequence of events is likely to be as the Fed continues to raise rates AND - very critically but mostly ignored - rapidly contracts it massive balance sheet. As this tightening cycle nears a crescendo, it's probable it will set off a powerful chain reaction that may rival what we saw 10 years ago".
He repeats that the FED reduction of its balance sheet is little appreciated in the media, but that is something I have been harping on for a long time.
He does note Randall Forsyth's column in the Nov 26 Barron's which I also have cited. The point is that the QE program of buying Treasury debt (credit) resulted as expected in the great increase in asset prices (which was the purpose) then the QT program of selling Treasury debt will result in a great decrease in asset prices. Mr. Hay devotes much more space to describing this phenomena.

His bottom line expectation. "as conditions become increasingly precarious (and recessionary), stocks will crater and the Fed will panic. It will begin cutting rates first and then soon, perhaps simultaneously, halt its QT process. at that point long treasury yields will plunge."

So timing is everything for us. And the 2020 election figures in to that.
And Mr. Hay is well aware of this and lays out a complex schedule of what kind of bonds to buy and when, which requires a full page of description folks here should study.

My question about this is not that it will happen but about the timing. The FED is in a dilemma. The anti-Trump establishment economist staff wants to hit Trump with the described here results of continuing the 600 billion a year contraction of the balance sheet (generating much more than 600 billion in contraction of the money supply) But the Democrat (and even Republican establishment) expects the Treasury to expand its credit based purchasing (asset confiscation) program with deficit spending generating over 1 trillion a year increase in the debt - that same balance sheet. Question then is - can the FED hold off on reversing QT for a new QE as long as Mr. Hay believes?


All of this is my inadequate effort to alert you to the seriousness of the current financial situation by trying to summarize one of the best analyses of that situation that I have found and urge you to study the full report and the others in the series. It is an example of a whole being much greater than the sum of its parts.


The other GaveKal weekly reports in this series: They are all available at the Evergreen on line archive


Biggest Bubble ever - Feb. 9, 2018


Bubble 3.0 How Central Banks Created the Next Financial Crisis - April 27, 2018


Bubble 3.0 How Did we Get Here Part I - June 1, 2018


Bubble 3.0 How did we get Here Part II - June 8, 2018


Bubble 3.0 A Fast and Furious Challenge - July 6, 2018


Bubble 3.0 Up from the Ashes - August 24, 2018


Bubble 3.0 The Biggest Bubble Inside the Biggest Bubble Ever - Sept 21, 1018


Bubble 3.0 What Could Go Right _Oct 12, 2018


Bubble 3.0 The Upside of Downside - Nov, 30, 2018


Special Edition EVA, The Stealth Bear Market - Dec 14, 2018

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What Price Prosperity? Part I, January 11, 2019

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What Price Prosperity? Part II, January 18, 2019


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