THE GLOBAL MADOFF MOMENT

When enough people believe a lie, then it becomes the truth. For a while...

The reason the Madoff Ponzi scheme went on so long is because investors never questioned it. They enjoyed their outsized returns and therefore didn't ask questions. Prior to 2008, there was never a mass exodus from the fund so there was no prior "discovery" of insolvency. The inbound money from new investors was always sufficient to pay out the few people who exited his fund. In addition, his fund did not trade on an exchange so there was no way to know its true price and therefore no way to know that the Net Asset Value was zero.

A similar dynamic is taking place in today's Ponzified stock market.  No one questioned the outsized returns, so it has remained solvent. Due to the aging population there hasn't been a mass redemption event since 2008. In March 2020, retirement investors held on through the panic phase which only lasted a few weeks. Unlike Madoff's fund however, it won't take a mass redemption to reveal this market's true underlying value. All it will take is an illiquid market and margin calls to discover "true value". The sequence of events leading up to this juncture have essentially created a bidless market, because stocks are now massively overvalued relative to bonds, due to the inflationary mentality. When inflation turns to deflation and recession, then stocks will be MORE overvalued relative to Treasury bonds.

The chart below shows the "Equity Risk Premium" (ERP) which is the yield on stocks minus the yield on Treasury bonds. Here we see that in past bear markets/recessions the ERP rose because stocks fell faster than profits AND interest rates fell as well. However, this time interest rates have been rising and profits are now falling. Which means that stocks have become MORE overvalued during this decline. Which is why David Rosenberg says stocks could easily drop -30% from these levels:

"The stock market bottoms 70% of the way into a recession and 70% of the way into the easing cycle"

Also, on the topic of "fundamentals", this week when asked if she saw a recession on the horizon, Treasury Secretary Janet Yellen replied: 

"Recessions don't happen when the unemployment rate is at a 53 year low".

However, it just so happens that TWO recessions took place when unemployment was at a record low. One was exactly 53 years ago in 1970 and the other was three years ago in 2020. In my last post I showed that in an inflationary economy, the jobs market is lagged by so much that it rolls over well AFTER recession has started. Currently, due to pandemic mass layoffs and early retirements, job openings relative to job seekers are still at an all time high. 

More importantly, REAL wages are deeply NEGATIVE. So you don't need a lot of unemployed people to start a recession, all you need is a lot of broke people. 

Of course the problem with saying that stocks will go down a specific 30% based upon historical baselines, is that it's an impossible prediction to make. Until we get down there, we won't DISCOVER how many Bernie Madoffs have been going into business since 2008. So far, we've seen the spontaneous explosion of hedge fund Archegos in 2021 which was over-leveraged to Chinese Tech stocks. In October 2022 FTX Crypto exchange spontaneously exploded due to the Crypto decline. And just recently Indian conglomerate Adani went into full scale meltdown during a global rally. If Ponzi schemes can implode in a massive rally, imagine what is waiting for these markets on the other side of a global crash. People will be shocked at the level of criminality that has accumulated in these central bank Disneyfied markets. 

 

In summary, from a long term investor's standpoint, there has never been a worse time in modern history to be fully invested in stocks. If someone is in their 20's then sure they will recover. But for anyone over the age of 40, this event will be cataclysmic to their retirement plans.

When my wife asked me recently what should everyone do, short the market? My response was no, most people should never short anything. What they should do is spend less and save more. Because that's what the Chinese and Japanese do now that their Ponzi markets have exploded. 

For most people - especially passive investors - that is the ONLY true retirement now.

Not betting their life savings on Ponzified markets. 

BULLS ARE OFFICIALLY TRAPPED

This will be the first RISK ON recession in world history...

Here we see the Baltic Dry Index and Global Dow. Every other time the BDI was at this level, global risk markets were selling off.

This week, global stocks are back near their all time high.

Which means we are VERY LATE in the Ponzi cycle and all warnings have been totally ignored. 

The standard narrative for the past year is that the Fed kept interest rates too low for too long which caused rampant inflation. This narrative is totally unquestioned and yet a total fabrication. During the 2008 Global Financial crisis, the Fed lowered interest rates from 5% to 0% and kept them at 0% for SIX YEARS. In March 2020, the Fed lowered interest rates by 1.5% to 0% and kept them there for two years. Subsequently, they have raised interest rates to 4.5% which is 3x the pre-pandemic level. If interest rates were causing inflation then why hasn't inflation come back down to the pre-pandemic level? It's because in the meantime, they have only brought their balance sheet down by a minor amount (see chart below).

This massive policy error has caused markets to remain in RISK ON mode throughout the end of the cycle. Which has never happened before in market history. Usually the prospect of rate hikes and a recession have caused markets to de-risk and de-leverage. Not this time. Throughout the past year, investors have been continually buying every dip in order to front-run what they view as the inevitable bailout. However, the irony is that THEY are the reason why the Fed can't stop raising interest rates. They are the reason this will be a depression instead of a recession. Granted, they were conditioned by Fed bailouts. 

In other words, via misallocated capital, investors have created their own illusion of solvency which is now totally divorced from the economy. Friday's blowout jobs number caused the bond market to finally price in a 5% rate by May. Pundits can rationalize the seasonality of that massive jobs print all they want, but the fact remains that the Treasury market is starting to believe the Fed when they say that interest rates are going higher. However, risk markets are STILL in total denial.  

As a measure of misallocated risk capital, here we see the high yield spread is HALF the level it's usually at when the leading indicators are at this level. 

 

Those who believe the U.S. can't go into recession when the jobs market is still strong, don't know their history. During the inflationary recessions of the 1970s, the jobs market always rolled over long AFTER recession had already begun:

1970-1980:

Sky-rocketing credit card debt and interest rates shows that consumers for now still maintain an inflationary mindset. However the belief that this can continue indefinitely is totally fantastical.

Credit card carrying costs: 

The rest of the world is making the same massive mistake of keeping risk markets elevated via their bloated monetary balance sheets while imploding their economy. 

This week, Europe's market round-tripped back to the all time highs of a year ago right before the Ukraine war:

All of which means that bulls are now trapped by their own greed and hubris. 

The dominoes have been falling for two years now since the February 2021 melt-up which imploded IPOs, SPACs, Meme stonks, and Emerging Markets. 

This is a two year head and shoulders top as indicated by "Momentum stocks" which is a basket of the top performing stocks. 

The Adani meltdown is merely a symptom of a much larger problem:

The TOTAL Ponzification of markets. Meaning ALL return is dependent upon the next greater fool willing to provide return to exiting investors. 

Soon ALL risk markets will be in Adani mode at the same time. Which will be a clusterfuck of unprecedented proportion causing dislocation and panic we have not seen in our lifetimes. 

Yet. 

Oil stocks rolled over hard this week. Oil is already down -40% from the March 2022 highs (not shown). Clearly late cycle Energy stocks are rolling over later in the economic cycle than they did in the last major recession:

In summary, we are very late in the Ponzi cycle. And all warnings have been ignored.  

"Shares crash, hopes are dashed. People forget it's bullshit"

PREPARE FOR BROWN SWAN EVENT

A Black Swan event - coined by Nassim Taleb - is a rare and highly unpredictable event that no one sees coming. A Brown Swan event  - coined by me - is a rare and highly predictable event that no one sees coming.

Those who know their history know that the U.S. Navy was on high alert for imminent attack in the days before the Pearl Harbor attack. Which is considered one of the greatest Black Swan events in history. But, the Navy didn't expect the attack in Hawaii they expected it in Indonesia. Similarly, during the lead up to the  2020 pandemic, global markets melted up even as the pandemic grew larger and more lethal in scale. At the beginning it was a RISK ON event.

Complacency reigned supreme: 

Rewind to February 26th, 2020:

Via Emerging Markets, we can see that where Suze Orman said to rejoice at the buying opportunity was that first dip down ~10%. Which was followed by a three day oversold rally and then explosion lower. Whether that sequence repeats again remains to be seen. This market is so far still significantly overbought. 

 

As of this past week, the Nasdaq was enjoying its biggest January up month since 2001. Which happened to be the beginning of the post-Y2K recession. 

This is a headline from TODAY:

"Traders are rushing to profit from the January rally in the stock market, sending call options trading to one of the highest levels ever. More than 33 million calls changed hands on Friday, the fourth-highest level on record"

The Nasdaq VIX shows there is not even the slightest sign of fear in this market. The volatility algos are working overtime to monetize put options and otherwise prevent a RISK OFF event.

 

In order to be a true contrarian investor and survive the entire economic cycle, one must be able to endure times like these when the herd is stampeding off a cliff. I can tell from my Twitter stats, that many bears capitulated in January and joined the stampeding bulls. That's what happens at the end. 

In the lower pane below, we see the the Nasdaq Market Thrust , which equals (Nasdaq advances * advancing volume) - (declines * declining volume). Basically it shows the amount of buying or selling pressure.

This level of speculation has only been seen three times in the past decade. February 2021. March 2022. And now. The last time it was this high (March 2022), the Nasdaq fell straight down to the 200 week moving average. Where the Nasdaq is now.

"Earnings from high-profile technology companies last week ranged from uninspiring to downright disastrous. But that didn’t stop traders from scooping up tech stocks ahead of more potential land mines"

Almost everywhere you look in the stock market, fear is vanishing"

Which gets us to option skew, which measures investor fear:

"The October 1987 crash sensitized the market to the possibility of large downwards jumps in the S&P 500. The distribution of S&P 500 log-returns (“S&P 500 distribution”) is unlikely to be normal if there are large jumps in returns. Jumps fatten the weights of the tails and asymmetric jumps skew the distribution. The standard deviation of returns is then insufficient to characterize risk and the probability of returns two or three standard deviations below the mean is not negligible, as it is under a normal distribution" 

To paraphrase, in English - crashes are far more common than a normal aka. random distribution would have us believe. However, recall that in "Fooled By Randomness" when Nassim Taleb introduces the Black Swan event he calls it a RANDOM event. Hence the name of the book. However, the problem is that as the CBOE admits, crashes are NOT random. They are highly correlated to WELL KNOWN risk factors such as over-valuation, interest rates, positioning, lack of hedging, and SPECULATION. In the Minsky Hypothesis, crashes are inevitable and usually caused by monetary tightening in an inflationary economy such as the one we are in right now:

"Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values"

Be that as it may, hedging is expensive. And under Wall Street's heads I win, tails you lose, no one hedges anymore. Why would they, when they have the "Fed put". Under today's bullish hyper fantasy, the Fed can both implode markets AND then rescue markets at the same time. Like a baseball pitcher catching his own pitch. 

Here we see option skew was very high at the stock market's all time high, but subsequently it has collapsed as hedge funds monetized their hedges. In other words, they don't use hedges for hedging they use them to generate income. Which means when they see fat premiums they sell into it. Similar to how hedge funds were selling subprime CDS contracts in the burgeoning risk of 2008.  

In summary, this event will be highly predictable but highly unpredicted. The herd is currently stampeding into risk and skeptics have been getting run over. All that means is that there will be far more carnage on the other side of this unforeseen collapse. The problem of course is that the RISK OFF "event" is invisible right up until it takes place. Hence, it is subject to plausible deniability of the likes we are witnessing right now.

Few people will see this coming, and far fewer will be positioned for it. Therefore we should expect SERIOUS dislocation.  

FOMC: FEAR OF MISSING CRASH

The market is overbought heading into ANOTHER Fed rate hike, while the Fed takes liquidity down to ZERO. Today's investors are not thinking about what could go wrong, only about what could go right...

This week we learned that Artificial Intelligence is within seven years of overtaking human intelligence. The event is called the "singularity" and it means that artificial intelligence will be in total control. How that's different from now is not for me to say. I had been thinking about this recently so I created a graphic to show how I predict human intelligence "evolving" in the future based upon the current trajectory. 

Which very aptly ties back to central bank rigged markets and the long-awaited aspiration of investors to ignore all risk. Stop worrying and outsource all thinking to the Federal Reserve investment bank.

Recall that no one questioned Bernie Madoff until they couldn’t get their money out. Before his implosion in 2008, the extraordinary gains he provided over many years went totally unquestioned. The same can be said about Modern Monetary Thermonuclear policy aka. MMT for the rich. Until it explodes with extreme dislocation, the policy of manipulating markets will go totally unquestioned. Moreover, it has become the primary reason to ignore all risk and misallocate capital without the slighest concern over valuation or impending recession.

The Fed is set to raise rates again next week and STILL not one pundit has caught on to the fact that interest rates are too tight and Fed balance sheet is too loose. The Fed is imploding the economy, but not the markets. Which is driving a chasmic divergence between fantasy and reality. This week, the Conference Board Leading Index confirmed that the economy is heading for a hard landing. The Fed has never hiked rates with leading indicators at this level. Therefore we have now officially crossed the Rubicon of unprecedented policy disaster aka. "BTFD".

Moral hazard has driven a chasmic gap between stocks and fundamentals. Inflation trades REMAIN late stage bid because money is fleeing Tech into the rest of the market. Which is causing the divergences between reflation stocks and their underlying markets to reach lethal extremes.

Case in point, homebuilders:

This article by investment manager "RIA" posits that investors are all bearish hence the contrarian trade is to be bullish. If one uses the past decade+ of central bank bailouts as a reference baseline that is true. However, on a timeline spanning multiple cycles that assertion is patently false, as we see in the chart below.

What is clear is that a lot of money managers are betting the farm that this IS not the end of the cycle. Because if it is the end of the cycle, this will be the end of THEIR cycle as well.

It's called "Heads I win, tails you lose" and it's Wall Street's favourite game. 

What we are witnessing is lethal misallocation of capital, on the belief that central banks are invincible. This week's NYSE glitch was a warning that there is NO liquidity in this market. Low volume and volatility are masking fragility. Below we see in the lower pane that Nasdaq (and NYSE) volume are at multi-month lows. The lowest since the August 2022 countertrend market high. On the left shoulder we see late Jan/early Feb 2021 which was the Gamestop blow-off top in global risk. After Chinese New Year, which happens to be this week, the wheels came off the bus. Nasdaq down volume hit an all time high and the Archegos hedge fund exploded. 

EMs show that Chinese New Year was a critical turning point for markets for the past three years. 

There has been no real selling since the debt ceiling crisis and it turns out that we are in ANOTHER debt ceiling crisis right now.

"The debt ceiling is a real risk that will come to a point where it will terrify markets, because it is a wild game of chicken

Expectation of a recession has made markets more sensitive to unanticipated risks"

Debt ceiling

Recession

Tech collapse

Housing collapse

NYSE glitches

Liquidity collapse

What else do bulls want?

Fed tightening.

 

THE BIG LONG

Today's investors all believe that as long as they never sell they can never take a loss. Unfortunately, that's not how it works...

What investors "learned" from the central bank assisted v-bottom in 2008 and again in 2020 is that as long as they never panic sell, they will eventually make up their losses. The 2020 losses were particularly short-lived because after March 2020, the Nasdaq entered its blow-off top, over a decade in the making. All of which explains why we are now witnessing mass complacency in the face of economic meltdown. Because that is how central bank moral hazard was ALWAYS going to end. Bulls loading up on stocks going into a depression. 

I would remind bulls at this juncture, that Japan's stock market is STILL lower than 1990 and China's market is lower than it was 2008. And yet, BOTH of those central banks are STILL easing. Which puts to rest the Efficient Bailout Hypothesis.

Note that for Japan, the pandemic pullback preceded the melt-up into wave 'C'. It wasn't a bear market, it was merely a correction in an ending bull market. 

But, but, but...this is the United States NOT China and Japan. In this country, back in 1929 it took 25 years to make a new all time high, in 1955. If you have that kind of time then finish your homework and go to bed on time. 

In the book/movie "The Big Short" there was a period of time in 2008 when the economy and real estate market were clearly imploding but the subprime mortgage market remained well bid. The "CDS" contracts insuring subprime loans actually lost value because the risk premia came out of the market due to investors hungry for yield. This was the point in time when Michael Burry and a few others were the lone unwavering bears in the subprime market.

That's where we are NOW. 

The economy is imploding and the real estate market is seeing collapsing sales - a precursor to lower prices. However, global risk markets are rallying. 

The only traders who have capitulated are the bears, as we witnessed by the epic collapse in the VIX a week ago. Another place we saw bearish capitulation was in high yield spreads which are highly correlated with the stock market. The Fed is not going to rescue markets when markets are signaling that everything is A-OK. 

FYI, in the past decade each time we saw the high yield spread blow out, the stock market was down at least -20%. . 

Not only is the Fed not going to rescue markets, they are going to keep tightening which is what they said this past week. Three separate Fed members (Bullard, Mester, Brainard) said that the Fed rate must now go ABOVE 5% and stay there until inflation comes back down. Recall, that the Fed's target rate has been moving higher for over a year now. It should be called the moving target rate. 

What we are witnessing is a massive bullish circle jerk into the abyss. 

Clearly, the bear capitulation shows that being "right" on the market is not the same as being a good trader. In order to survive volatile markets one must spread their bets across asset classes and learn to take profit in stages instead of all at once. Be that as it may, the great irony of markets is that the greatest risk arrives when the majority of bearish participants have turned bullish. So unfortunately, for this event to be spectacular, bear capitulation was required. 

Which gets us to the next order of business, bull capitulation. We can surmise that it would take a major meltdown to cause panic in this market. So that's what we should expect.  

What I've noticed is that the "January Effect" has been very pronounced in recent years. The January Effect means that stocks that were dumped for tax loss purposes in the prior year get bought back in the new year. However, this effect now gets pulled forward into the fourth quarter.

Below, we see that EM stocks took massive losses in 2021 and 2022 and have now enjoyed a 25% rally. The same size rally they had in 2020 pre-pandemic. However, the biggest rally culminated in Q1 of 2021. We also see that U.S. consumer sentiment followed the same pattern. Each time peaking in Q1. 

What's happening is that rebounding markets are dragging social mood higher. 

In summary, today's investors have "diamond hands". But, it's their intestinal fortitude that will be system tested. 

And it will shit a brick. 

At which point all economic predictions for 2023 will be wrong, by a minus sign.

But don't forget, no one saw it coming. 

October 2022:

DAVOS 2023: LETHAL COMPLACENCY

It's Davos 2023, amid peak market hubris. What could wrong?

The central bank gambit of increasing the wealth of corporate oligarchs at the EXPENSE of everyone else reached new lethal levels of inequality in 2022. According to Oxfam, the ultra wealthy almost doubled the $ wealth increase of the remaining 99%. For those who know their history - few to be sure - this does not end well:

Go back to the aftermath of 2008 when the Occupy Wall Street movement started to protest bailouts for the ultra-wealthy while the middle class imploded. Fast forward one decade to the pandemic and this time around it was Millennials "democratizing markets" with their Reddit-ordered pump and dump schemes and Crypto con jobs. 

The central bank policy of inflating capital wealth while imploding the middle class further escalated in 2022 as they kept their balance sheet unchanged year over year while DOUBLING mortgage rates. Rates now on everything are far higher than they were pre-pandemic. 

And yet, complacency reigns supreme. 

This set-up is starting to look a lot like the one that preceded the pandemic in early 2020. First a melt-up and then a meltdown. 

Then, as now, gamblers were front-running central banks and not worried about the pandemic. FOMO was running wild. 

Now however, the greatest risk that investors face is not a pandemic, it's central banks themselves. In other words, investors are embracing the cognitive dissonance of ignoring central bank-caused tightening by believing in central bank bailout. Nothing quite as obviously asinine has ever been believed in market history. 

Let's take a trip down memory lane circa February 2020.

This headline states that the pandemic melt-up - that unbeknownst at the time preceded meltdown - was due to investor FOMO:

Feb. 5th, 2020:

Sound familiar?

The riskiest stocks surged ahead of the pandemic lockdown, as they are surging now:

In addition, to moral hazard and belief in central bank invincibility, what fueled this parabolic rise into meltdown? For one thing, China was ALREADY easing massively and their markets were leading global risk assets.

As they are right now. Except this time, the risk to markets and the economy is the risk posed by policy makers as they take down all of the supports put up during the pandemic. Recall, it was China that led the way with tightening of lending conditions for real estate a year ago.

In addition to the above risks, what we are witnessing across many sectors is a scenario in which stocks are trading AGAINST the fundamentals. Meaning fundamentals are imploding, but stocks are going higher. This is because investors are "looking across the valley" to the other side of bailout. The most obvious examples are in housing stocks, oil stocks, retail stocks, financial stocks, and of course Tech stocks.

Here we see homebuilders usually peak LAST. Right before the crash. And of course pending homes sales lowest in history:

Oil stocks, which normally trade in lockstep with the leading indicators, are decoupling massively as they did in 2008.

For a time.

Oil services are not just decoupling from the leading indicators, they are now decoupled from oil itself:

Nothing could be more asinine however than Wall Street's prevailing view that earnings will grow in 2023. A prediction that is TOTALLY decoupled from consumer sentiment and Fed policy.

Now recall one thing about March 2020 - it was the largest combined fiscal and monetary stimulus in human history. Dwarfing 2008. And yet, U.S. markets STILL crashed -30%. There were six overnight limit down S&P futures gap opens in two weeks. 

I say remember that fact because this time around the amount of stimulus will be a fraction of what abided in March 2020.