Monday, August 24, 2015

Relax, have a glass of wine

Years ago, our infant daughter had an accident whose details I don't remember anymore. My wife called an non-emergency line and was connected to a triage nurse, whose job was to try and diagnose the problem over the phone and escalate the matter if it was deemed serious. After listening to my wife describe the problem, the answer was, "Your daughter is fine and she doesn't need anything, but you seem very agitated. You should sit down, relax and have a glass of wine."

Today everybody is suddenly a technical analyst, I am going to be contrary and put on my fundamental investor's hat and tell investors, "Sit down, relax and have a glass of wine."

When a financial panic hits the markets, I have a simple checklist:
  1. Is this going to push the economy into a recession?
  2. If not, then is there some factor that will accelerate the selling, such as excessive debt that needs to be unwound, which is the typical causes of market crashes, or technical factors, such as the concentration of delta-hedging portfolio insurance programs in 1987?

Recession or Renaissance?
Consider the proximate cause of the risk-off environment today, namely worries about a China slowdown. So the question becomes, will a China slowdown push the US, or the world, into a recession?

The fact that China is slowing should be no surprise as the data has been coming in over at least the last year that growth has been slowing. These changes are so well telegraphed that the BoAML Fund Manager Survey shows that equity institutional managers have already de-risked their portfolios from the China effect by underweighting emerging market equities and resource sectors (see my last post Is this the Ashley Madison market panic?).

I wrote before about what a Chinese slowdown might mean for the US economy (see Is China sparking an American Renaissance?):
  • Lower commodity prices, which translates into lower input costs;
  • More onshoring as Chinese labor becomes less competitive, though US wages pressures will be restrained because of the globalized nature of the labor markets; which means...
  • Better operating margins from lower material costs and restrained labor costs
This represents unabashedly good news for the suppliers of US capital. So what are you worried about?

From a global perspective, the ones who are going to get hurt are the suppliers into China, namely the resource based economies (Australia, Canada, South Africa, Brazil, etc.) and China`s major Asian trading partners. Unlike past crises, however, there is little excess leverage to unwind and, in fact, the world has been deleveraging and eschewing debt in favor of cash.

Addressing a possible EM crisis
There is, however, a key risk of about USD 9 trillion in loans sloshing around in the offshore market. Of that amount, the BIS estimates USD 1.1 trillion is attributable to China and Chinese SOE and SME companies (see The tail-risk that the FOMC missed (and that you should pay attention to)). In that blog post, I had pointed to an FT article the highlighted the risks of an EM meltdown:
A decade ago, the market for EM hard currency corporate bonds hardly existed. Today, it is bigger than the US high-yield corporate bond market, an asset class familiar to investors for decades, and more than four times the size of Europe’s high-yield bond market.

What has driven such extraordinary growth? In just a few years before the global financial crisis of 2008-09, emerging markets won over the world’s investors. In 2001, Goldman Sachs identified the Bric economies — Brazil, Russia, India and China — as the new engines of global growth. Chinese demand drove a commodity boom that helped billions of people rise out of poverty and into the consuming classes.

After the crisis, the developed world’s expansionary monetary policies kept the party going, pushing cheap credit to EM consumers and sending ever more foreign money into EM assets. Emerging companies, many able to tap overseas markets for the first time, embarked on a borrowing spree. Yield-hungry foreign investors were happy to help.

David Spegel, global head of EM sovereign and corporate bond strategy at BNP Paribas, has been following hard currency EM corporate bonds since 1994. His figures show that the value of such bonds in the market has grown from $107bn then to more than $2tn today.

But with Brazil’s economy imploding, China slowing and dark shadows over markets from Venezuela to Russia and Ukraine, some analysts worry that the party has gone on too long.

Stuart Oakley, global head of EM foreign exchange trading at Nomura in London, points to how easily things could go wrong. “It is entirely possible that we could see a default by a big, emerging market commodity exporting corporate,” he says.

“In that scenario you would get people redeeming money from big EM asset managers, bids for the bonds from banks would dry up, there would be sharp price drops on those and all associated assets and a sell-off across this or another asset class.”
Remember, these are USD debts that are not in the US banking system and therefore beyond the direct control of the Federal Reserve. What would happen do should events start to turn south in the EM economies?

First of all, the key risk here is not some company going under because they got offside on their debt, but companies and countries getting in over their heads in foreign currency debt (in this case USD) and then getting hit by enormous FX devaluation. In Asia, monetary authorities learned from the Asian Crisis and had built up large FX reserves. The strongest case is China, where USD 1.1 trillion of offshore debt is supported by USD 3.8 trillion in reserves.

When push comes to shove, the Federal Reserve would swing into action by either activating or offering swap lines to other central banks (for a primer on how swap lines work, see this). Extending USD swap lines to foreign central banks would be a strong signal that the Fed is prepared to flood the global financial system with liquidity in order to stabilize markets. Here is what the ECB has said about swap lines and those principles of limiting contagion risk are well understood by central bankers:
Since the onset of the financial crisis in 2007, bilateral central bank swap lines allowing the provision of foreign currency to local counterparties have become an important tool of central bank international cooperation to prevent systemic risk and limit contagion across major currencies. The design and calibration of the operations used by the ECB to provide foreign currency liquidity to domestic banks helped to achieve the key objectives of the swap lines and calmed markets and funding concerns during the crisis.
Sit down, relax and have a glass of wine.

What can accelerate the downside?
So far, I have addressed the first question of whether the financial panic could push the US or global economy into recession. The answer is no, largely because recessionary risks are not present, a China slowdown presents growth opportunities for the US and there is minimal contagion risk.

The second question I want to address is whether there are any factors that could accelerate the downside risk. In the past, we have seen financial events that could have sparked financial panics, but didn't. Examples include the failure of Barings, which failed to bring down the global financial system (unlike Bear Stearns and Lehman Brothers), and the Dubai World default of 2009.

Why Lehman and not Barings or Dubai? The answer is excessive financial leverage. When events go south, financial leverage kills. Today, the world has been reducing debt and balance sheets are in much better shape. Much of the debt has moved from private and corporate balance sheets to the government, which is usually in better shape because their central banks can print money. If you don't believe that, then just remember how many fortunes have been lost in the Japanese widowmaker trade of shorting JGBs.

True, China is just starting the deleveraging process and the current crisis could be a test for Beijing. Just remember that the PBoC is nowhere near the point where it is out of ammunition. Ambrose Evans-Pritchard, who has been a permabear for many years, recently described China's woes and concluded:
None of this is to say that China's economy is healthy. Credit still rising by seven percentage points of GDP each year, pushing the debt ratio ever further into the danger zone. It will be 270pc by next year. This will end badly.

But China is not in immediate crisis. The Reserve Requirement Ratio (RRR) for banks is still 18.5pc. The PBOC can slash this to 6pc - as did in the late 1990s - flooding the system with $3 trillion of liquidity. It can even go to zero in extremis.

The time to worry is when China has exhausted this last buffer. This August scare of 2015 is a false alarm.
Relax, have a glass of wine.

One technical note
My inner investor tells me that financial panics are great opportunities to step up and buy discounted assets. The world only ends once and it isn't going to end today.

In a world where everyone has turned technical, I have turned contrarian and become fundamental, largely because technical support levels are next to useless because the markets are in panic mode. I don't need to cite more statistics about how oversold the market is or how stretched bearish psychology is.

If you really want a technical perspective on the depth of the panic, Richard Chappell, writing as Springheel Jack, went all the way back to 1930 and studied past instances where the SPX had significantly dropped below its 3 standard deviation band on a weekly basis (as it did on Friday). Here are the instances that he discovered and he found that virtually all cases, the market staged an oversold rally and recovered most, if not all of its losses. The only exceptions occurred in 1940 when German troops rolled into Paris:

  1. 10th October 2008 (Lehman Brothers) – Recovered 75% of break candle in (inside candle) week 2 – after this rally resumed overall downtrend.
  2. 21st September 2001 (Tech Crash) – Recovered 60% of break candle in (inside candle) week 2, full retrace week 3 – after this rally resumed overall downtrend.
  3. 1st April 2004 (Bonds Crash) – Marginal new low next day (Monday) to make 1994 low. Closed up 0.5% in week 2, full retrace of break candle in week 9. That Monday low has never been broken since.
  4. 23rd October 1987 (Equity Crash) – Gapped up hard Monday, retracing all of break candle body. Higher low Wednesday. 955 of break candle retrace week 3, all in week 13. Break candle low never broken since.
  5. 11th May 1962 (1961/2 Bear Market) – Flat open Monday, fell another 2.5% to make intraweek low, closed day up 1%. Closed week 2 up 2%, 60% of break candle retraced in week 3 – after this rally resumed overall downtrend.
  6. 24th May 1940 (WW2 Fall of France) – Gapped up hard Monday, never tested lows in week 2, retrace 50% of break candle intraweek, closed at 25% retrace. Marginal new low week 3 and close at 40% low. Marginal new low in week 4 that lasted 17 months and closed at more than full retrace of break candle.
  7. 17th May 1940 (WW2 Fall of France) – Gapped down hard into following week and closed week down 8.7% and still well below the 3SD weekly lower band.
The moral of this story: Unless the markets are discounting a major military defeat involving the permanent loss of capital, you should relax and have a glass of wine.


Anonymous said...


You obviously have a lot of market insight.
Many people are making eerie predictions. Lots of market crashes are predicted. Lots of resemblances to the market crashes of 2000 and 2007 are portrayed.
And you provide an antithesis. By telling why their predictions are unsubstantiated in this market.
Clearly the market is no black box. But I also understand that in order to exclude the possibility of the market being a black box, one must be able to exclude all the possibilities by which the market could be a black box. And that can be a hard call to make. Many people are clearly guessing.
So I'd like to pose this question to a knowledgeable person as yourself:
Can there really no way by which you could see this market become really bearish at this point in time?
I understand that there can always arise unlikely circumstances which cannot be predicted. But can you exclude the possibility of a market crash at this point in time which would have been predictable?
I understand that answering this question is way above my head. But I would have regretted it if I would not have asked you to ponder about this question.

Cam Hui, CFA said...

There are three main reasons why a stock market enters a bear market (not a correction):

1) Recession
2) Overly aggressive Fed tightening
3) A war where the political structure country is destroyed (e.g. Russian revolution, WW II)

Do you see any of those events on the horizon?

Anonymous said...

No. Thank you.

thus- said...

Thank you for the post. I appreciate your perspective.

One of your assertions raised questions for me, however. You acknowledge that excessive debt can be a factor in accelerating a selloff, but state that "Unlike past crises, however, there is little excess leverage to unwind and, in fact, the world has been deleveraging and eschewing debt in favor of cash." I've been hearing the exact opposite, that debt (both margin debt and corporate debt) are at record highs:

Can you clarify on what data you base your conclusion that leverage is not a concern?

Cam Hui, CFA said...

I was referring to the level of overall debt in the system. The Lehman Crisis downturn was exacerbated by too much mortgage debt, Asia Crisis too much external USD debt that when Asian currencies devalued, borrowers got in way over their heads.

Today we don't have the same kinds of problems. Even Chinese debt is RMB denominated and therefore local debt. That problem will get resolved in a different way because the banks are not allowed to go bankrupt.

WimpyInvestor said...

Retest SPY $183 or No Retest, That is the Question?

I think by now, all of the "extreme oversold" charts and indicators (I have gathered 20+ of them since July) have been "priced into" SPY. Assuming the markets are somewhat efficient, then perhaps hedge funds, high frequency traders, pension managers, mutual fund managers, etc, have all seen these charts (including your Trifecta OS model).

Some suggest V shape bottom, but most suggest re-test of SPY $183 low (and maybe go a bit lower), then 10%, 15%, 20%, or ever higher rebound depending on the "extreme oversold" indicator.

What do you think?

V or W?


Unknown said...

Fantastic post. Learned a lot from this.

P.Binder said...

Well a month has gone past and we are again in crises mode - or not ? High Yield bonds and everything that has to do with take overs or leveraged buyouts or related businesses are under attack and even such great companies such as BX and PYPL are taken to the cleaners - clearly we had a bull market since 2009 one of the longest in our history - and all things come to an end some time - I do agree with this blog - and like it very much