David M Glassman, President

3055 Harbor Drive, Suite 1101

Fort Lauderdale, Florida 33316

Email: Stockmarketdoc@comcast.net

March 21, 2018

          HAS TOO HOLD  DOW 24,217 -S&P 2647-NASD 7,084

Why This Correction Is Different

Those dreaded words you never want to hear as an investor, “this time is different.”

Stock and Bond Correlation

It does apply to the latest stock market correction, however.

The sell-off that began on January 29th spanned ten trading days and took the S&P500 down 10.2 percent (11.8 percent from intraday high to low), and was the first correction this century that corresponded with a rise in the 10-year Treasury yield.   That is a positive correlation between stocks and bonds to the downside during an official correction.

Moreover, the table below shows there has been only one other correction or bear market in almost 30 years that has seen the 10-year Treasury yield rise.  The correction in 1999 and 41 bps move higher in bond yields was the result of the Fed and market yields rebounding from the sharp drop and overshoot in interest rates during the Russian debt default and LTCM crisis in 1998.

Excluding 1999, a special case, in our opinion, the recent correction was the first that has experienced a simultaneous rise in bond yields since 1990.  Before February for almost 30 years,  bonds have rallied during every stock market correction as a “flight-to-quality” trade.

High Debt Stocks And Rising Rates

What is also remarkable about the rise in rates during the volatility spike is that it coincided with record shorts in bond and note futures.   If past is prologue,  any trader would think the fast money would run to cover their short positions as stock market volatility experienced its largest one-day spike in history.   Rates hardly budged and have traded in 15 bps range since the first day of the sell-off.

The bulls will argue the rise in rates is a positive signal.  That they reflect an economy which is picking up momentum and positive for future earnings.   We do not disagree,  but our bullishness is tempered by the large increase in the stock of debt over the past 20 years.   We believe this is the essence of what is bothering the risk markets.

After all it was not long ago that former Fed Chair, Paul Volcker,  stated that interest rates are not rising because they cannot rise.

Our current debt may be manageable at a time of unprecedentedly low interest rates. But if we let our debt grow, and interest rates normalize, the interest burden alone would choke our budget and squeeze out other essential spending.  – Paul Volcker and Pete Peterson,  Oct 2016

The following table and chart illustrate the change in debt by sector, normalized by GDP,  over the past several years.  The total debt-to-GDP ratio, as measured by the Federal Reserve Flow of Funds data  (Table D.3) currently stands at or near a record high,  2.53 times GDP, up almost 40 percent relative to GDP since the beginning of the century.

The ratio would be much higher if not for the standstill in mortgage debt by households since 2007, as household mortgage debt outstanding  on an absolute basis is below 2007 levels.   Note the massive build in mortgage debt relative to GDP from 2000-07, which was the main culprit of the credit and financial crisis.

Crowding Out

The chart illustrates that a debt-to-GDP ratio of 2.5 seems to be some sort of a ceiling.   It could be markets will not allow it to go much higher.   Therefore as the U.S. government further increases its total debt outstanding,  crowding out may ensue restricting further increases in other types of debt.   That appears to be case with mortgage debt.

Trump Administration Not Heeding The Warning

Furthermore,  we just put the following table together, and to our surprise total U.S. public sector (central government) debt stock has increased over $1.5 trillion since the Trump administration took office even as the economy is experiencing some of its highest growth in a decade.

This is only $500 billion lower than the first 400 days of the Obama administration’s increase in the public debt, which took place during a deep recession borderline depression.

If debt expansion cannot be arrested during periods of increased growth, when will it? This, even before considering phase 2 of the tax cuts and the infrastructure deal.

Again, this is the major underlying worry that is nagging global markets as interest rates creep higher, in our opinion.

Technical Position Of Treasury Market

The current overall technical position of the stock of Treasury securities remains favorable, as the Fed and foreign central banks still control more than half of outstanding marketable notes and bond.    The flow is deteriorating rapidly, however.

The U.S. government financing needs are increasing rapidly, which will result in greater supply in the form of new issuance.   On the demand side,  the Fed is a now a net seller and its supply will also have to absorbed by the price sensitive market.

In addition,  foreign central banks have also been net sellers over the past few months though it appears they did show up at the auctions last week.  This in the context the Fed and foreign central banks have indirectly been the largest financiers of  the U.S. budget deficit over the past ten years.

Structural Headwinds

The equity market should continue to struggle to make new highs during this period of monetary contraction.  The funding of the U.S. budget deficits is now more dependent on market forces and is more price sensitive as opposed to the rate insensitive policy dependence, the dynamics which drove the funding the government over the past ten years.

Granted,  the BoJ and ECB are still injecting liquidity into the global markets,  the hawks will soon be coming from Germany to the ECB, however, and the markets should begin to discount this later in the year.

Who knows what the BoJ will do, but if any country on earth can’t afford higher interest rates, it is Japan.  There is no way out and room for rising rates in the land of the rising sun.   Unless, of course,  they move into full monetization or a BoJ debt jubilee.

Orwellian Monetary Policy –  “Tightening Is Easing”

Thank goodness the U.S. is in a period of Orwellian Monetary Policy,  where monetary tightening is,  in reality,  an easing as the Fed injects liquidity into the system in the form of paying higher interest rates on excess reserves.   Otherwise, liquidity conditions would be growing much tighter.

Interest On Excess Reserves (IOER)
Because of the extremely large amount of excess reserves in the banking system – the liability side of balance sheet expansion —  the Fed no longer uses traditional monetary policy.  The long-standing monetary policy tool prior to the crisis was draining and adding bank reserves through open market operations to control liquidity, the Fed Funds interest rate, and bank credit.

Now, the Fed uses a new tool — interest on excess reserves (IOER) — to tighten monetary policy and raise interest rates.  That is rather than draining it adds liquidity to the financial system in the form of interest payments to the banking system.  – Global Macro Monitor,  May 2017

When Excess Debt Becomes Your Governor

The large stock of global debt in a rising interest rate environment is going to act as governor on both the equity markets and global economic growth.   That was the signal and how we are reading February’s simultaneous rise in bond yields and massive volatility shock.

The U.S. government’s huge and growing budget deficits have become gargantuan enough to threaten the great American growth machine. And Trump’s policies to date—a combination of deep tax cuts and sharp spending increases—are shortening the fuse on that fiscal time bomb, by dramatically widening the already unsustainable gap between revenues and outlays. On our current course, we’re headed for a morass of punitive taxes, puny growth, and stagnant incomes for workers—a future that’s the precise opposite of what Trump champions…

[The Doom Loop]

…as the debt load grows, efforts by the Federal Reserve to stimulate the economy with lower rates would be more likely to feed runaway inflation. “Then, investors will dump Treasuries,” says John Cochrane, an economist at the Hoover Institution. “That will drive rates far higher, and make the budget picture even worse.”  – Fortune, March 15

Time to temper thy short and medium-term bullishness, and be patient for lower prices.

An Unexpected Warning From Goldman Sachs: "Markets Themselves" Will Cause The Next Crash

It all started nearly 9 years ago to the day, when in April 2009 we wrote, "The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans", in which we explained how as a result of the growing influence of HFT, quants and central banks, the market itself was breaking.

We also highlighted what the culmination of the market's "breakage" could look like:

liquidity disruptions could and will lead to unexpected market aberrations, such as exorbitant bid/ask margins, inability to unwind large block positions, and last but not least, explosive volatility: in essence a recreation of the market conditions approximating the days of August 2007, and the days post the Lehman collapse...

We even laid out some likely catalysts for a possible market crash: "continued deleveraging in quant funds, significant pre-market volatility swings as quants rebalance their end of day positions, increasing program trading on decreasing relative overall trading volumes."

One month ago, we saw all of the above elements briefly come together when on February 5 the market finally did break as its topology was torn apart by various, disparate elements, resulting in virtually all of the above materializing, if only for a short time.

To be sure, as time passed, others joined our warning that the market is becoming increasingly broken, with some of the most notable warnings coming from the likes of Bank of America's Benjamin Bowler...

... who explicitly noted the market's increasing fragility on numerous occasions...

... and how the Fed rushed to bail it out on every single occasion...

... as well as Fasanara Capital

... Matt King…

... Hans Lorenzen

... Charlie McElligott, Marko Kolanovic

... Aleksandar Kocic, who first defined the market's current "metastable" state...

... and Artemis Capital,  which too has been warning about the market's growing instability for years.

* * *

To be sure, there have been many others who partially or wholly joined the "dark side" over the past decade - some at great career risk - admitting that the interplay of central bank manipulation and HFTs rigging has left us with broken markets and unfortunately we couldn't list them all, however we do want to note that as of today, one more prominent strategist has joined the fray, none other than Goldman's head of global credit strategy, Charlie Himmelberg, who in the aftermath of last month's VIXplosion, asks today if "liquidity" itself has become the new market leverage - that critical leading indicator which historically has flashed red ahead of an imminent crash, and which the Fed still uses -erroneously - to guide its macroprudential decisions.

This is how Himmelberg introduces his - far less tinfoil hatted - readers, i.e., those institutional clients who still believe that the market is working as it was designed, as a liquid, efficient, discounting mechanism, to the premise that everything they know is false:

Where is there complacency in this expansion? And where might complacency be hiding unappreciated risks that will be exposed when the expansion ends or the bull market turns? We see clues in Monday, Feb. 5, when the VIX had its largest one-day move in its history, jumping from 17.31 to 37.32, a move of 20 VIX points. Like previous “flash crashes” in other markets over the post-crisis period, there was nothing in the fundamental data to explain a jump of this magnitude. Instead, we think the VIX spike was primarily a reflection of technical trading dynamics.

And while there may not have been a fundamental catalyst to the February vol eruption, the Goldman strategist picks up on what both we, and BofA's Benjamin Bowler have repeatedly warned about, namely the market's rising "financial fragility." To wit:

We suspect the Feb. sell-off is symptomatic of a broader risk, namely, the rising “financial fragility” during the post-crisis period. By “fragility” we mean price volatility that arises not from changes in the fundamental outlook for markets, but rather from markets themselves.

Here Goldman's analyst notes that while various conventional indicators of market liquidity like bid-ask spreads suggest that liquidity conditions have been reasonably good during the post-crisis era, he warns that Goldman is starting to see "several reasons to worry that “markets themselves” are becoming a bigger source of market risk than fundamentals."

And here is where Goldman in 2018 sounds like an echo of Zero Hedge in 2009, because among the factors listed by the world's most influential bank to validate that the market is broken, is everything we have railed against for nearly a decade. As such, none of the below should come as a surprise:

In particular, new regulations and new technologies have caused a dramatic evolution of the post-crisis ecosystem for providing trading liquidity. In this new market structure, machines have replaced humans, and speed has replaced capital. While such changes have greatly reduced the need for equity capital, and are thus efficiency-enhancing, the same was also true about leverage and structured products during the run-up to the

financial crisis. While the new ecosystem for providing market liquidity has arguably freed up equity capital for more efficient uses, it has also depleted the pools of capital that will be available for liquidity when the cycle turns.

Also, remember when back in early and mid 2009 all we warned about was High Frequency Trading, and how it destabilized markets (with the help of Goldman Sachs)? Well, it took Goldman about nine year to reach the same conclusion:

One conspicuous consequence of post-crisis evolution is that trading volumes in many markets are now dominated by high-frequency traders (HFTs). While bid-ask spreads and other indicators of trading liquidity appear to indicate liquidity has improved in markets where HFT has grown, the quality of this liquidity has not yet been stress-tested by recession. The recent experience of the “VIX spike” suggests there is good reason to worry about how well liquidity will be provided during episodes of market distress, and this is only the latest example of a “flash crash”. Regulators and researchers increasingly warn that HFT strategies can contribute to breakdowns in market quality during periods of distress.

Right, and tinfoil hat wearing blogs have been warning about it long before it became cool.

Ok fine, but despite all the warnings, every time the market tumbled, flash crash or otherwise, it managed to rebound, so why should that change? Two answers: the first one came from Bank of America, which in December showed that "In Every Market Shock Since 2013 Central Banks Have Stepped In To Protect Markets." The other is from Goldman which writes that so far, the "strong fundamental backdrop", i.e., massive global releveraging, offset the market weakness. That, however, is coming to an end.

So far breakdowns in the new liquidity ecosystem have been short-lived and relatively benign, in part, we suspect, because the fundamental backdrop has been strong. But under alternative scenarios where fundamentals have deteriorated, we worry that a future such a collapse in market liquidity could amplify sell-offs. This could contribute to price declines and possibly prolonged periods of financial instability in ways that are reminiscent of the price declines caused by financial deleveraging.

If Goldman's "epiphany" is right, and it is, it has profound consequences for virtually every aspect of macroprudential regulation, first and foremost that it is no longer leverage that matters, especially since most of its has been directly onboarded by central banks, but rather liquidity is the only critical variable.

While the analogy is imperfect and our uncertainty is high, we see reasons to think that “liquidity is the new  leverage”. Like financial leverage during the previous cycle, the rapid evolution of the post-crisis market structure has been a period of exciting technological innovations, but also one of low volatility and untested complexity.

Goldman's conclusion: those seeking an exogenous catalyst to the next market crash will be disappointed, as the next crash will come from within the broken market itself:

Along with the uncomfortably high number of flash crashes in most major markets, we think “markets themselves” belong on the short list of late-cycle risks to which markets are potentially complacent.

While Goldman ends on a relatively optimistic note, suggesting that an "endogenous" crash is not imminent...

Over the foreseeable horizon, of course, these risks from “markets themselves” are just risks, and we think investors will be forced to cautiously own the risk opportunities on offer.

... we suggest that this is certainly not a given, and for those asking what happens when the market officially crosses beyond the "liquidity" event horizon, we will leave with what we said back in April 2009, as nothing has changed since then:

"what happens in a world where the very core of the capital markets system is gradually deleveraging to a point where maintaining a liquid and orderly market becomes impossible: large swings on low volume, massive bid-offer spreads, huge trading costs, inability to clear and numerous failed trades....

the consequences will likely be unprecedented, with dramatic dislocations leading the market both higher and lower on record volatility. Furthermore, high convexity names such as double and triple negative ETFs, which are massively disbalanced with regard to underlying values after recent trading patterns."

February 5 was just the preview of the main event.

'Death Cross' Strikes European Stocks As Dead-Cat-Bounce Dies

The hope-strewn rebound in European stocks, following February's fracas, is dying once again and may be about to get another technical leg lower as both the Euro Stoxx 600 and DAX suffer a 'Death Cross'...

The last time the 50-day moving average crossed below the 200-day moving average - the so-called 'Death Cross' trigger - was in Sept 2015 (which preceded a 17% tumble in European stocks tumble)...


Germany's DAX is just as ugly as trade war concerns add to worries...

The bear  is no longer hiding!   Stock Doc

This Websight is only for Educational and Teaching. No recommendations to Buy or to Sell Securities or Assets in any form.