May 20, 2015

Could buying the dips be over

A sage observer once remarked, "Speculation is going on when someone else is making money and you and I aren't."

Speculation ("mothered" by Fed policy) has been ripe, as hot money has raised the price of financial assets even in the face of disappointing progress in the real economy, rising geopolitical risks, numerous negative macroeconomic events (particularly of a EU kind), multiple signposts of malinvestment and to a host of other factors that, in the past, have adversely impacted financial asset prices.

Valuations, particularly as expressed by CAPE or market capitalizations relative to GDP, have moved towards lofty levels.

Indeed, some have openly criticized those that were concerned as Cassandras and worrywarts -- preferring, instead, to take the position that "the data doesn't matter" (as both good and bad news were seen as good news) and to respond to positive market price behavior.

That approach has paid off handsomely as this has been the correct strategy, with averages tripling since the Generational Low.

The crowds of bulls have outsmarted the bearish remnants, as dips have been bought and even corporations have joined the celebration with a record level of share buybacks. Despite clear corporate history of buying high and selling low, financial engineering has been celebrated and has been a mainstay of the bull market over the last three years.

However, at some point -- and we are likely close -- market participants will confront, and retaliate against, the artificiality of stock and bond prices. 

While no one knows (with certainty) where Mr. Market or the global economy is headed, I remain convinced that the following additional 12 key "big picture" factors could weigh on markets and on the real economy over the balance of the year and into 2016:

  -  Multiple and unpredictable outcomes: There have likely never been in history more numerous market and economic outcomes some of which are adverse and most of which are being ignored by market participants.

  -  Stuff happens: Black swans appear to be happening with greater regularity.

  -  Weak growth ahead: Central bankers' aggressive monetary antics have only produced sub-par global economic growth.

  -  Borrowing from the future: Zero interest rate policy (ZIRP) has borrowed past and present sales from the future, underscoring the challenge of future economic growth.

  -  Unknown consequences of policy: No one knows the consequences of an extended period of ZIRP "punch bowls," often resulting in aberrant behavior and hangovers.

  -  Making no sense: Indeed, if there were no consequences to zero interest rate policy, interest rates could have been held at zero forever -- in the past, as well as in the future.

  -  Stop looking up, start looking down: Monetary overkill (in duration and in the level of interest rates) may produce the adverse consequences of malinvestment. It has resulted in the hoarding of cash and reduction in spending by the disadvantaged savings class.

  -  Uneven and less dependable growth: The "exclusive prosperity" of the haves (vs. the have-nots) is politically unstable, leads to more uncertainty (and unexpected outcomes) and will likely have a negative and more volatile impact on our social system, on the global economy and on our markets.

  -  Tom Friedman has the ticket: Our world has never been more flat, more networked and more interconnected. As such, the notion of an "oasis of prosperity" is not likely rooted in fact.

  -  Trouble ahead, trouble behind: Terrorism and religious radicalism (political and economic) will be more of a threat in the future than in the past.

  -  Treacherous technology: In a paperless (and "cloudy") world, investors and citizens are not likely as safe as the markets assume.

  -  Lack of coordination: Geopolitical coordination is at an all-time low and isolationism seems likely to be a mainstay in the time ahead.

No one knows for sure what factors will impact our markets. But one thing is for sure: When it occurs, a near peak in complacency will be the overriding condition and the absence of fear and doubt will be the overriding emotion.

Historically, these have been fresh conditions that have contributed to the emergence of "contagion" (in which a decline in one asset class impacts another asset class). We will likely soon recognize how shallow and illiquid our markets have become as a direct result of policymakers and in the absence of skepticism.

Safe Havens Become Unsafe

The return of price discovery may have already started in the world's fixed-income markets (as the bond vigilantes have come out of hibernation -- taking the 10-year U.S. note yield about 22 basis points higher in the last two trading days) and it is difficult to envision global equity markets unscathed.

When safe havens become unsafe (and volatile), most investors should be buckled down now in the current period of uncertainty... and complacency.

With heightened uncertainty and rising volatility, the most reasonable strategy is to reduce your portfolio's "Value at Risk."

Position: Long SPY Puts TBF, Short SPY (small), TLT