“Do not put yourself into the position of zero rates, I tell you it will be a lot more painful than you can possibly imagine.“- Japanese Central Banker, Kazuo Ueda in response to Weekend at Bennie’s suggestion that the BoJ needed “to do more”
The implied volatility of the index puts I have been using compressed down to levels last seen at the peak of the 2007 housing bubble market. Sentiment Trader commented that the S&P500 has gone for 30 consecutive days without closing below its 10 day moving average and this has never happened in 88 years. To me this indicates the market is very dysfunctional, as all healthy markets correct, and ebb and flow. The prevailing overused cliche is that we are ok in the short term, thanks to Weekend at Bennies, screwed in the long term.
Back in 2007, I used the term picking up nickels in front of steamrollers to describe this condition. I meant that the sellers (not me) were picking up nickels in front of steamrollers. I referred to the buying of very cheap puts as “going back to the trough one more time.” I am suggesting that the Gumnut itself is the causa proxima of this condition. This creates bizarre distortions in the marketplace, and sets a booby trap for a far more intense negative reaction than the one which evolved in 2007-08.
The recent action in the tax-free muni market demonstrates this. Short-term interest rates were so low that investors stay with an investment class that no longer made any sense, in effect defaulting to a severely overvalued situation feeling that they had no other options. They bought into the overused ok in the short-run cliche. They believed the line about several years of near-zero interest rates ahead.
By looking at the chart, you can see this sucking in the last money in July and August. In hindsight six months later, short-term interest rates are still locked down, but every muni investor who bought through October 2010 ended up receiving an 8-12% loss for other reasons. Some big muni markets, such as New Jersey, have fared even worse. One major problem munis now face centers around the stimulus cliff as the Recovery Act ends mid year. Also, the politics have completely changed as public pensions are a politically charged issue [Illinois Maelstorm].
Of course, the stock markets, commodity and volatility indexes are a much higher beta market, at least historically. You can add a factor of 2x-3x when you look at this MUB chart. Therefore, I have doubts that the air comes out slowly like the tax-free munis initially did in September and October. When the MUB really turned down in November it was because a Gumnut prop (scheduled end of Build America bonds — the Fed’s QE2 played no role) at the margin was removed, combined with too much supply coming to market. Those conditions definitely exist today in the stock markets. In fact, the crack in the tax-free muni market is just one more delayed, fused catalyst to really tank the stock and other bond markets.
So I look at the post Labor Day muni price action model as a best case for the stock market. Given that all these markets are totally addicted to Gumnut involvement and exhibit an endless bailout mentality, they have the potential to break decisively once something at the margin is pulled away. If something significant in the whack- o- mole economy gets jerked, or isn’t offered up in the next crisis du jour, the lit fuse will detonate the booby trap.
Lee Adler and I have debated on our podcast about this causa proxima, and his theory is largely that it would have to be the Fed backing down on QE2 or not going to QE3 because of all the collateral damage to the real economy. Perhaps. Still I feel this is just too convenient for the crowd in these trades, and there are any number of factors beyond the Fed: emerging market/China tightening, food riots and revolutions, Federal spending policy shifts toward marginal austerity, the need for an additional bailout from the state level that can’t or won’t be accommodated, or another bailout (or re-bailout) in Europe that can’t be accommodated. Various Gumnut costs are coming in so many directions now and in perfect whack-o-mole fashion. It could also be a connect-the-dots situation when companies start reporting profit margin squeezes from input inflation.
Looking at market volatility, we can see that in late 2006-2007 the market topped out and VIX went down to the low teens and stayed there for about five months. Then suddenly it spiked higher. I think the difference between then and now was that 2007 was a price discovery market where participants gradually came to the realization that their fictitious investments had no basis beyond bubble economics.
Volatility Index: VIX
Chart: Yahoo Finance
That is also the case in spades today, but there is one huge added factor. In 2007, the governments of almost all the developed countries were not on the cusp of a fiscal crisis. They still had rounds to discharge when fictitious prices collapsed. On this day in 2007, the last time this no-fear condition existed, the US Treasury debt was $8.668 trillion. Today four years later this debt is $5.342 trillion higher at $14.01 trillion. Other than a debt trap, it is not at all clear what the US and other countries got from that either.
To the bulls I ask: If things are so much better, why are all the Gumnut props and activities still needed? I challenge you to remove even a few before the markets force you to. Of course they won’t. So, to me, this has all the hallmarks of a hit-the-wall, pre-bankruptcy, debt run up and should be played accordingly. Further, the notion that somehow China has the ability to fund all these sick Gumnut dogs (and their own bubble infected banking system) is ludicrous [If China Bubble Burst Symposium]
Today, we have fictitious prices combined with an artificial and even sicker economy for the great majority of the gente, combined with few if any ammunition rounds from Gumnuts left for sustaining them. Nothing could be more lethal for markets than that. Therefore the fuse going off will be more profound and I think sudden.
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