Mr Bear Is Salivating Over His Next Market Meal
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If you believe what CNBC is saying, then everything is just fine. Except for the current correction in the stock market, everything that should be going up is going up…and everything that should be going down is going down. So what’s not to like about the economy or the bargain priced stock market? Well not everything smells of roses. Disturbing data points are easy enough to find if you care to look for them. For instance the great state of Illinois is so poorly managed it’s now paying its big lottery winners with IOUs as the lottery’s funds have been embezzled by state politicians. Unfortunately for Illinois, they can’t just print the necessary funds like the Federal Reserve would.
These lottery winners will get their money eventually, but what a sloppy way to manage a major government program! But then, as noted by ZeroHedge, Illinois was still able to find enough money to pay a hotshot economist $30,000 a month to manage the state’s finances.
It’s not just politicians from Illinois with their hands in the taxpayer’s cookie jar. California and many other cities and states are fiscal basket cases as well because they have taken on too much debt to finance highways to nowhere and other wasteful spending. The problem is that everyone in government wants to save the world from this, that or the other thing. Unfortunately for the voters these idiots don’t know how to live within their means or even balance a check book. When the economy turns down, and tax revenue along with it, there will be big problems at city halls and state capitals across the United States.
The muni-bond market is giving us clear warning of pending municipal defaults as tax-free muni-bond yields have risen above taxable corporate bonds yields now for 252 consecutive weeks (chart below). This is extraordinary; wealthy individuals are foregoing tax-free income, choosing instead a lower taxable yield in the corporate bond market. Why would they do this? Obviously because they fear state and local government defaults.
Ultimately Treasury bonds will prove to be no safer than muni bonds and for the same reasons. Most “market experts” would disagree on that point. But remember what happened in August 2011 when Standard & Poors’ bond raters downgraded the credit of the US Treasury from AAA to AA+. Obama retaliated using the “Justice Department” to harass investigate Standard & Poors.
It should be noted that since August 2011, “professional opinion” of the credit quality of the US Treasury has improved considerably. However when we consider the tens of trillions in unfunded federal liabilities over the next few decades, it certainly should not be improving. What’s shocking is the total lack of coverage by the financial media. Currently they’ve chosen to concentrate on, and in so doing validate the worthless numbers coming out of Washington on GDP, CPI or employment rather than performing their obligation to the public to keep Washington’s politicians and bureaucrats honest.
Today’s situation in the Treasury and muni-bond markets are just two of many facets of the dilemma decades of money printing and interest rate suppression have left our economy in. When yields and interest rates eventually return to free market levels, all financial assets will undergo drastic revaluation. In effect, actual free market valuations have become toxic to the current system of contrived valuations in stocks, bonds and real estate.
This is true not only for the wealth acquired by retiring baby-boomers now entering their retirement years. The global banking system itself is on the losing end of hundreds of trillions in nominal dollar OTC derivatives. The Bank for International Settlements reports that as of March 2015 there were 312 trillion dollars in outstanding interest rate derivatives alone, and many trillions more in credit default swaps. American and European banks are liable as counter-parties on these contracts.
During the 2007-09 credit crisis the financial media never made much of the fact that the crisis was largely one of counter-party failure of derivatives bundled with US single family home mortgages. Wall Street could not cover their gambling losses in the derivatives markets, so the US Treasury and Federal Reserve bailed them out with QE and “regulatory” assistance that allowed the banks to mark their reserves to fantasy, and with many billions of dollars of secret government grants. But nothing was fixed; rather the problem has simply been postponed and allowed to compound for the past seven years.
Look how quickly Barron’s Intermediate-Grade Bond yields (Red Plot below) rose during the credit crisis. Then look how quickly they declined after Doctor Bernanke began “injecting liquidity” into the bond market. So called “market experts” applauded what the best and brightest in government and finance accomplished in 2008 & 2009. But our “best and brightest” are actually a gang of clueless morons stumbling from one crisis to another, totally ignorant of what they’ve done: guaranteed profits in inherently risky dealings which should have been allowed to fail.
The day is coming when we’ll see double digit yields in both Barron’s Best Grade Bonds and in US Treasury bonds and they won’t be coming back down as they did in 2009. That will bring 312 TRILLION DOLLARS in interest rate derivatives “into the money”, overwhelming any effort by the “policy makers” to once again “save the banking system.” What options will the Federal Reserve or ECB have when double-digit yields decimate their balance sheets and the balance sheets of their member banks?
So, one must understand that rising interest rates are lethal to the Federal Reserve itself. Just how lethal can be seen in the chart below. From 1954 to 1981 inflation flowed from the Fed into rising consumer prices. This made the Federal Reserve and the Federal government look very bad.
“By and large we’re as affable as the next man (who around here happens to be a duly licensed curmudgeon), but over several decades of spiraling inflation, we have taken an increasingly dim view of those who manage the nation’s finances.”
- Robert M Bleiberg: Barron’s Managing Editor, 11 June 1979
To slow the increase in consumer prices the Fed was forced to invert the yield curve by frequently increasing the Fed Fund Rate above the yield of the Treasury’s long bond. By October of 1981 the yield curve was inverted by nearly 9%!
But after October 1981, monetary inflation began flowing into financial assets, which economists claimed to be “economic growth” as stock and bond prices ballooned with inflation. The four post 1981 market bubbles are clearly evident in the chart above, as are the successively more feeble yield inversions that popped them. The fragility of the current market bubble (#4) is also evident. Today Yellen could increase the Fed Funds rate by up to 2.34% without inverting the yield curve. However the IMF and World Bank have already warned her – TWICE - not to increase Fed Funds by even 0.25% for fear of causing a global market crash.
Stock market valuations have seen some downward pressure in the past two weeks, and we’ve heard a lot of talk about a 20% decline being the threshold of a bear market. Maybe so, but this idea of a 20% bear market threshold only came about after the 2000-2002 high-tech bear market. Also the current understanding of what a bear market is fails to address why bear markets happen in the first place. Bear markets are about market hygiene. Bear markets deflate the price of assets, dubious or otherwise which have been artificially inflated far above reason.
Purging unviable assets (such as non-performing sub-prime mortgage loans) from the market is also a vital function performed by Mr Bear. But Doctor Bernanke prevented that during the credit crisis by “monetizing” worthless mortgages held by the big Wall Street banks, along with soon to be worthless Treasury debt, which he then “injected” back into the banking system. The Federal Reserve’s balance sheet below tells the story of how the all-mighty buck has been destroyed.
The quote below by Barron’s former Managing Editor; Robert Bleiberg pretty much sums up my opinion of the market today.
“Inflation of course, is a debasement of the standard of value. In the process, inevitably all other standards are debased. For example, consider what happened to Wall Street during the Sixties. Sober enough at the outset, those years degenerated toward the end into an era of disreputable nonsense, in which time-honored yard sticks threatened to topple, while the deadly serious business of managing money turned incredibly into a “game.” Full disclosure notwithstanding, manipulation, deception and worse ran riot.”
- Robert M Bleiberg: Barron’s Managing Editor, 12 April 1976
That was written forty years ago. Whatever inflationary problems the market had in 1976 have been greatly compounded since.
We are now in the early stages of a massive bear market that will rectify the current “era of disreputable nonsense” that has run riot since Alan Greenspan became Chairman at the Federal Reserve in 1987. Before Mr Bear is finished we will see:
- The mighty fall on Wall Street,
- Government transformed (hopefully for the better)
- Current high opinion of “experts” in media, finance and government much reduced.
How far the Dow Jones must fall, and interest rates must increase to accomplish this I don’t know. Still, this must all happen before this bear market finds its ultimate bottom. And it will take more time than most people are willing to give it – not that Mr Bear cares about our schedule.
But the “policy makers” won’t go quietly to their fate. As with every other market decline since January 2000, we again see trading volume (Blue Plot below) increasing dramatically as the Dow Jones (Red Plot) declines. Prior to the high-tech bear market of 2000-2002, market volume had historically always declined along with the Dow Jones. But not anymore as the “policy makers” now “support” the market by purchasing deflating-financial assets with freshly printed money.
Here’s Mr Bear’s report card for the past two weeks. For the second week in a row we’ve been seeing days of extreme breadth and volatility -- and that’s not good for the bulls in the global central banking cartel. As I’ve noted previously, extreme days do occasionally occur during bull markets, but they are isolated events separated by years. Seeing so many extreme days in just two weeks is a sure sign that Mr Bear is hard at work behind the scenes, deflating grossly overvalued financial asset valuations.
Big-bear markets are a process occurring over a period of time. So in the months and years ahead, you should expect some good weeks and maybe months when markets appear to be recovering – strong advances with no extreme days. The next chart shows the Dow Jones (Blue Plot) along with its 200 count (Red Plot: the number of extreme days of volatility within a running 200-day sample) from 1927 to 1934.
Take a moment to study it, and notice that the Dow Jones didn’t travel in a straight line on its journey from its September 1929 top to its absolute bottom of July 1932. At times the stock market enjoyed months of steady gains, typically with few or no days of extreme volatility.
We should be aware of an element of market psychology present in massive bear markets. The initial market crash of October / November 1929 shocked investors as the Dow Jones Plunged 48% just two months after reaching its latest all-time high, as its 200 count increased from 16 to 33. But then, following the 1929 crash, the market experienced a dead-cat bounce which lasted until mid-April 1930 as the 200 count trended sideways.
For the next eighteen months market participants were in denial as the Dow Jones resumed its greatest decline in history as the 200 count oscillated between 30 & 55. By autumn 1931 denial morphed into deep despair. The 200 count exploded as all hope of recovery was abandoned. Just like today’s bear market in gold and silver, during the Great Depression crash investors could never see an end in sight. By July 1932, the Dow Jones had plunged 89% from its September 1929 high as the Dow Jones’200 count peaked. That done, Mr Bear then packed up his bags and departed Wall Street; a year later the Dow Jones was up 164%. So, the worst bear market in history was terminated with the best year in the history of the stock market but no one cared.
A similar story is told by the Dow Jones and its step sum in the chart below. The step sum is a single item advance-decline line using the daily closing price action of the Dow Jones. It’s an indicator of market sentiment. Amazingly, from September 1929 to December 1930 the Dow Jones declined 59% as its step sum increased by a net of nineteen days. The market bulls believed the worst was over – but they were wrong. But after February 1931 the step sum collapsed as the Bear market entered its final stage, taking market sentiment down with it. Six months later Dow Jones 2% days exploded (200 count above) as the market approached its bottom, a market collapse of 89%.
Is our bear market really going to be as bad as the Great Depression? I couldn’t say with any certainty if it will or won’t be. However Doctor Bernanke made a career studying monetary policy of the 1920s, how it resulted in the depressing 1930s. It’s fair saying that while he was Chairman of the Federal Reserve, he wasn’t going to repeat those bone-headed blunders! No, he was determined to blaze his own trail into monetary glory with Zero Interest Rate Policy (ZIRP) and “Operation Twist” (in which he began purchasing long-term bonds to “stimulate economic growth” by flattening the yield curve.)
The chart below slices up the evolutionary time-line of “monetary policy” since World War Two into three phases. And the third phase is labeled exactly right; the FOMC is fighting for their professional lives as the welfare of billions hangs in the balance. Ultimately they’ll lose the battle because in big-bear markets Mr Bear always wins. As soon as bond yields and short-term interest rates begin to increase all hell will break loose in financial markets.
We live in strange times. Judy Shelton spoke some common sense at the recent Jackson-Hole Monetary conference. Not surprisingly her comments didn’t get much coverage in the media.
“We dare to talk about the gold standard and its relative merits, knowing that the merest whisper of a gold standard is enough to elicit the guffaws of the central bankers down the road. Because they say ‘that’s just crazy.’ And I think, really? Crazier than negative interest rates? Crazier than paying banks to keep loanable funds in sterile depository accounts at the Fed? Crazier than having the Fed buy up trillions in government debt, remit the interest payments back to treasury, and then count that as revenue to the federal budget?
Is it crazier than having hordes of financial market analysts parsing every word uttered by a monetary official, obsessing over the minutes of the latest Fed meeting trying to glean clues about what might happen next? It’s almost as if we’ve forgotten how to engage in free enterprise, because we’re waiting for marching orders from a central planning agency. I think we’re the rational ones. They like to brand us as ideologues, but in truth we’re the realists. And that sobering fact is becoming clearer every day as reality continues to whipsaw global markets.”
- Judy Shelton wrapped up her remarks at Jackson Hole (2015) NY Sun Editorial 31 Aug 2015 http://www.nysun.com/editorials/crazy/89270/
Well said, Judy! But what did Mr Bear get done this week? Well looking at the Dow Jones Total Market Group (DJTMG) net 52Wk Highs – Lows we see a new low for the current move with 23 net declines at week’s end.
But more worrisome for the bulls is that the number of DJTMG groups within 20% of their last all-time high (the Top 20%) has slipped to only 41 this week.
To better understand what is plotted above have a look at the table below; the Bear’s Eye View (BEV) frequency distribution used in the plot above (the light brown columns). The actual plot in the chart above uses the second column from the left in the table.
Mr Bear is overcoming the “policy makers” objections of deflating market valuations. With the Top 20% migrating down toward what I call the Bottom 50% (chart below), the big furry fella is putting a full court press on the market bulls at the FOMC. What’s the Bottom 50%? That’s the number of DJTMG indexes that have declined 50% or more from their last all-time highs, which at the end of the week contains twelve groups.
It’s still early in the bear market. So, it’s not unexpected that the DJTMG’s Top 20% would already begin declining before the Bottom 50% sees more groups swelling its ranks. But given more time, Mr Bear will undoubtedly deflate group after group into the Bottom 50%.
Mark J. Lundeen
04 September 2015
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