New Year Is Coming: The Biggest Disconnect Ever
Above all, I wish everyone a happy new year 2021. After ten months of pandemic, curfews, and lockdowns, I am sure that we all want our lives back soon. Hopefully, vaccines may drive a form of “return to normal”.
2020 may have been the craziest year ever on capital markets. While most economies have suffered the biggest drops in history, impacting the personal situation of millions to billions of individuals on Earth, and creating miles-long queues at food banks in America, US stock indices are ending at record high. Beyond equities, most assets have soared to unbelievable levels, from corporate bonds to cryptocurrencies.
We are facing the biggest global disconnect ever, with speculative bubble everywhere, including the property market.
Greed, Intersubjectivity, and Market Narratives
As already explained in previous posts, irrational exuberance is an endogenous phenomenon, meaning that an external trigger is not necessarily required to end the mania. From that perspective, I thought that econophysics findings could help us to anticipate the end of the bubble. For instance, the log-periodicity power law singularity (LPPLS) model.
Of course, the simulations I ran could have been enhanced with the help of up-to-date papers, as indicated by some researchers. Nevertheless, the GitHub version produced interesting results as it correctly anticipated the rupture of September 3 on the Nasdaq, and other meaningful ruptures on individual stocks (e.g. Palantir). It was possible to trade them and to generate decent returns.
However, many of those ruptures were just temporary corrections and did not lead to a deep bear market as one could have previously thought. There are many reasons behind that.
First, assuming capital markets to be self-organized critical systems, I argue that asset prices correction are not the real proxy for avalanche intensity. Indeed, instantaneous volatility spikes seem play that role as they are distributed following a power law. I wrote a short note on that – focusing on VIX index moves – that will soon be published.
Second, bubbles are caused by narratives, which can be defined as intersubjective frameworks connecting participants to each other. As long as a dominant narrative is valid, the bubble keeps growing. As the system becomes unstable, the risk is that the narrative suddenly vanishes, leading to a severe period of uncertainty. I wrote a longer paper about that intersubjective hypothesis and the concept of narratives, which is currently under review.
“I See No Bubble Here” – Jerome Powell
The current dominant narrative is clearly the so-called “Fed put” (i.e. the idea that whatever happens, financial losses will be pared thanks to central banks). What has changed in 2020 is the fact that the Federal Reserve has officially endorsed the narrative, leading to out-of-control speculation in the system.
Now that the Fed is deliberately lying to the general public about the consequences of their actions and about the absurd valuations of assets, why not taking advantage of that situation to “ride the bubble”? This is what many people have recently suggested, including professionals and even skeptical fund managers.
That is a tempting idea, but my question is simple: as nothing concrete seems to matter anymore, how will you identify the exit door before the others? Because if you do not sell before the rest of the crowd, then you might be exposed to severe losses.
I have always been clear about the future of this mania. It will end in tears and most participants will lose, even if a limited number of experienced traders, founders, and executives may benefit from this bubble.
Money for Nothing and Chicks for Free?
When I say that, people tell me that “there is no limit to quantitative easing”. Fair enough. That is correct. You can grow a balance sheet forever if you can create money out of nothing.
But everything comes at a cost. Therefore, more QE means that you get more negative externalities. There is no free lunch in economics, even for the United States of America.
I have already discussed the negative impacts of unconventional monetary policy, such as asset hyperinflation and moral hazard (see There Ain’t No Such Thing as a Free Lunch – Part 1 and Part 2). Those are domestic externalities. Even though asset hyperinflation is more and more painful for working and middle classes, that does not seem to stop the Fed or the ECB.
In fact, the most problematic consequence of QE could be the dollar depreciation. There is no limit to infinite dovishness if foreign agents continue to accept your currency. But as soon as trust disappears, QE stops to be solution and becomes the problem.
The Fed is not crushing the dollar. But their policy has incited people to massively bet against it. Thus, the question is, can the dollar stop depreciating if the Fed keeps being more dovish each time they speak? The answer might be “no”. Maybe the pressure will come from political leaders, as Larry Summers said last month that “it would be unwise to appear actively devaluationist or indifferent to the dollar.”
Should we regard the dollar depreciation as an opportunity for US economy? Indeed, one could argue that a weaker dollar could boost exports. However, it seems that many countries are looking to rebuild domestic supply chains and reduce dependency on external producers. Even the biggest exporter is changing, as the Xi Jinping administration is betting on self-sustainability with the “Made in China for China” plan. Besides, after decades of retreat of American manufacturing, it would take years to significantly reverse the trend (even after four years of Trump’s protectionist policy).
Beyond the question of exports, the problem with the dollar’s depreciation is the fact that it continues, then the US may soon have a problem of imported inflation. Given the state of the economy, such a situation could be very painful for American individuals and firms.
As the Fed is feeding a speculative narrative, the dollar is unlikely to strengthen unless they become more hawkish. But if that happens, then the whole system collapses. In other words, Western authorities are trapped: either they crush their currencies, or they crash the markets. Of course, Europe and Japan are doing the same thing, but times are changing as some countries (e.g. China) are more and more willing to challenge the existing order.
I do not know what level would be critical for Jerome Powell. Peter Schiff recently suggested that if the DXY index went below 70, then it could be a game changer for the US economy.
What we know for sure, if that if the Fed is forced to reverse the trend, then the mother of all crashes will occur. Once again, there is no free lunch.
Don’t Stay Passive
In this environment, my biggest conviction remains that passive strategies are the riskiest bets today. Especially when it comes to overcrowded trades like US equity large caps.
While individual names like Tesla or Zoom are obvious sources of risk, “risk-free” Tech ETFs could trigger the real black swan event that may threaten the whole system (see To Be Passive Is to Let Others Decide for You). The subprime crisis occurred mainly because of overrated AAA tranches of RMBS and CDOs, rather than lower rated securities like BB tranches.
While passive investing has led to unjustified distortions on equity markets and hyper concentration on a few names (e.g. Apple, Amazon, Microsoft, Facebook, Alphabet), the problem is that if the Fed’s put narrative suddenly vanishes, then most participants will be selling the same names at the same time and large ETFs may face a liquidity crunch.
Since central banks have “killed” most bears, and even incited participants to sell downside volatility “as the Fed has our backs whatever happens”, what happens if US large caps ETFs receive massive outflow orders the same day? Who will be buying in front of them? What happens if the portfolio managers cannot match the outflows? What if the Fed cannot help them anymore?
I do not know whether such an event will occur in 2021, but I believe that Western countries are trapped into economic and monetary measures that will lead to a disaster.
And please, beware of those who claim that there is no alternative. For years, Europe and America could have taken advantage of artificial low rates to support small agents while restructuring their economies. Stimulating zombie firms or indebted households does not lead to sustainable growth, and the solvency problem has been growing since the 1990’s (see Black Holes and Revelations: Kondratiev Waves, Infinite QE and Economic Spaghettification).
For the past nine months, we have heard that “the market is not the economy”. Thus, record indices do not mean that the economic system has become stronger. Quite the contrary. As Warren Buffet said, “price is what you pay, value is what you get”.
Will 2021 be the year of reckoning?