Q3 2020: “Managing Short Exposure in Extreme Uncertainty.”
This continues to be just an incredibly fascinating – if not comforting – environment. I’ll repeat a comment from last quarter: From both analytical and investment management perspectives, it’s difficult to imagine a more challenging backdrop. I’m fond of saying that things get crazy at the end of cycles. Well, this has become nuts – the markets, finance more generally, policymaking and politics. Alarmingly, society has taken a troubling turn as well. Let’s all hope and pray for a smooth and peaceful election a week from Tuesday.
It seems fitting to get the analysis started with an update on the monetary environment. Federal Reserve credit has increased $2.9 TN over the past 32 weeks – and $3.32 TN – or 88% - over the past 57 weeks. It makes the Fed’s $1.0 TN 2008 crisis response appear rather anemic.
M2 money supply has expanded about $3.2 TN over the past 32 weeks to a record $18.7 TN, a 33% annualized growth rate since March. Over the past year, M2 rose $3.56 TN, or 24%. It’s worth noting, as well, that Institutional Money Fund assets – not included in M2 – were up $627 billion over the past year, or 28%.
The federal deficit for the fiscal year ended in September surged to an unprecedented $3.1 TN, or 15% of GDP. The government borrowed 48 cents of every dollar spent this past year. There’s been nothing comparable since World War II.
And let’s briefly delve into some data from the Fed’s quarterly Z.1 report. Total Non-Financial Debt increased $3.52 TN during Q2, more than doubling Q1’s record expansion. This pushed first-half Non-Financial Debt growth to an incredible $5 TN. For perspective, Non-Financial Debt expanded $2.44 TN in 2019 and averaged $1.83 TN annually over the past decade. Think of it this way, debt growth for the 2nd quarter was almost double the annual average over the past 10 years. At $59.3 TN, Non-Financial Debt surged to a record 304% of GDP. For comparison, NonFinDebt-to-GDP ended 2007 at 227% and 1999 at 184%.
Outstanding Treasury Securities jumped $2.85 TN during Q2 to a record $22.37 TN. Treasuries were up $3.35 TN for the first half – and $4.56 TN, or 26%, over the past year. After ending 2007 at about $6.0 TN, outstanding Treasury Securities have increased $16.3 TN, or 270%. Treasuries ended Q2 at 115% of GDP. This compares to 69% at the end of 2010 and 44% to conclude the nineties.
Over the past year, Total Debt Securities – Treasuries, agencies, corporates, munis - jumped $6 TN - more than doubling 2007’s record $2.7 TN increase. As a percentage of GDP, Total Debt Securities surged to 265%. For comparison, Debt Securities ended 2007 at 200% of GDP; the nineties at 157%; the eighties at 126%; and the seventies at 74%.
Total Securities – that’s combining Debt and Equities - ended Q2 at a record $104 TN. This was a record 532% of GDP, that compares to cycle peaks 379% in 2007 and 359% during Q1 2000. Total Securities ended the eighties at 194% and the seventies at 117%.
And with the value of securities surging to record highs, Household Net Worth reached an all-time high $119 TN. Household Net Worth ended Q2 at a record 610% of GDP. This compares to previous cycle peaks 492% in 2007 and 446% in early 2000.
This data underscore the interconnection between the Fed’s ballooning balance sheet, massive fiscal deficits & Treasury issuance, record securities prices, and inflated household perceived wealth. Considering the scope of fiscal and monetary stimulus and the surge in household perceived wealth, recovery thus far has been unimpressive.
The bottom line is - financial conditions have been extraordinarily loose – with virtually every key monetary indicator now in uncharted territory.
At $1.4 TN, corporate debt issuance has already set a new annual record with a full quarter to go – and that’s record issuance for both investment-grade and junk bonds.
Meanwhile, Standard and Poor’s recently updated their forecast for U.S. corporate defaults. S&P now expects U.S. defaults to double to 12.5% over the next nine months. On a global basis, S&P has so far this year downgraded $400 billion of debt to junk status. An unprecedented 37% of S&P-rated companies are on downgrade watch.
The divergence between record stock prices and deep recession in the real economy garners some attention. Little focus is given to the extraordinary divergence between the booming corporate bond market and the deteriorating credit landscape.
I’m reminded of the backdrop after the subprime mortgage blowup in the Spring of 2007 – that proved the beginning of the end for the mortgage finance bubble. Despite ongoing deterioration in mortgage credit, the vast majority of MBS and ABS continued to trade at elevated prices completely detached from serious unfolding credit problems. Mortgage securities markets were supported by Fed rate cuts and the general perception that the Fed and Treasury would not allow a housing bust. During the mortgage finance bubble period, my analysis highlighted a powerful “moneyness of credit” dynamic. And the delusion that Washington could ensure mortgage credit remained safe and liquid culminated most precariously in the 18 months leading up to the ’08 crisis.
There’s no mystery behind today’s record prices and issuance of corporate debt. Not only has the Fed injected over $3 TN of liquidity into the markets, in March it began directly backstopping corporate credit with purchases of bonds and even ETFs that hold junk debt.
Exuberant investors responded to the Fed bailout, ploughing $488bn into ETFs during the first nine months of the year, 40% ahead of comparable 2019. Back in 2007, I was convinced a major crisis was unavoidable. Trillions of mortgage credit were being significantly mispriced and the entire risk intermediation process had turned dysfunctional – markets were dangerously distorted, and adjustment was inevitable. Market adjustment would entail a downward revaluation, a major problem for a marketplace dominated by leveraged speculation and complex risk intermediation.
Allow me to repeat a most pertinent market reality: Financial leverage works miraculously so long as securities prices are inflating. But this miracle doesn’t work in reverse: prices decline, de-risking/deleveraging takes hold, and bubbles burst. And as we saw unfold in late-2008 – and temporarily in March - de-risking/deleveraging foments illiquidity, market dislocation and a dramatic tightening of financial conditions. The harsh reality is that a financial system and economy that come to rely on rapidly expanding speculative credit - face mounting risk of a sudden and destabilizing contraction of credit.
I have previously stated my thesis that the global bubble has been pierced – a view challenged by bubbling global securities markets. Let me to attempt to clarify. I believe the clock is now ticking – credit losses are mounting, and painful market adjustment is unavoidable. The past six month’s credit tsunami – and attendant surging securities values – have thus far masked the scope of credit and economic impairment. Moreover, the most recent Fed-induced speculative mania – having gathered strong momentum in U.S. markets – raises the risk of a highly destabilizing market correction. We witnessed a near global market meltdown in March. Policies since that crisis have promoted only more egregious speculation and leverage.
And while pundits celebrate near record stock prices, improving consumer confidence and economic recovery - for me, the more critical question is - how does this all end? I do believe we’re in the “end-game”. We're witnessing record Treasury debt growth and record corporate issuance - at yields completely divorced from underlying credit risk. It truly has become the "moneyness of risk assets" – late-cycle blind faith in the safety and liquidity of financial assets generally. It’s a foregone conclusion the Fed will do whatever it takes to shore up the markets and real economy.
I’m just convinced – to me it’s become obvious over the past year - that whatever they’re doing is only making the situation worse – only exacerbating excesses along with underlying fragilities.
We titled today’s call “Managing Short Exposure in Extreme Uncertainty.” It’s difficult to envision a backdrop fraught with a greater degree of uncertainty. Let’s start with COVID. We’re entering the winter months with daily infections already nearing 65,000. Does a spike in cases lead to restrictions and a population more resolved to hunker down at home? What will this mean for economic recovery – especially the tepid recoveries in restaurant, travel and leisure businesses. How about the tens of thousands of small businesses struggling to survive? When does a vaccine become widely available? Will it be trusted? What percentage of the population will be willing to be vaccinated? How efficacious do vaccinations prove to be – how long until the next shot is required? My view holds we’re only at the early stage of recognizing the momentous economic, social, political and geopolitical ramifications from the pandemic.
What is the course of policymaking: Will there be a new administration in January ushering in a momentous shift in ideology and policy focus. How large are prospective fiscal stimulus programs? What does the tax code look like in 12 months? Would a Biden administration use the stock market as a barometer of its success, or will the market going forward be more a symbol of systemic inequality.
One aspect of the environment is rather certain: Monetary policy will remain ultra-loose – zero rates and at least $100 billion monthly securities purchases - seem baked in the cake. Yet uncertainties lurk. How might the Fed respond to fledgling market instability? Would the Federal Reserve be willing to expand Fed credit another $3 TN in the event of market dislocation? How quickly will they react? And I do appreciate the Pavlovian response: “Doug, they will, of course, do whatever it takes.”
But how might a momentous political shift in Washington impact the Federal Reserve? The Fed has bestowed Washington a blank checkbook. Going forward, how might Republicans view enormous handouts to the troubled blue states that are being monetized by the Fed? It was inevitable – and pushed forward by the pandemic: The Federal Reserve interjected itself into the deepening divide of social and political acrimony - and conflict. From 2008 to the present, the Federal Reserve has faced no serious pushback to its QE experiment. This may be about to change. I can see the Republican Party emerging from a traumatic election with a much more suspicious eye toward Federal Reserve “money printing” and deficit monetization. How the Fed would respond to such a predicament may become yet another major uncertainty.
And when it comes to extreme uncertainty, look no further than the markets. I have a favorite Bubble maxim that is more pertinent than ever: “Bubbles go to unimaginable extremes – and then double.”
It’s virtually impossible to time the bursting of a Bubble – especially in this age of zero rates, open-ended central bank liquidity-creation along with myriad other support measures. Yet bubbles do inevitably deflate. So, the spectrum of reasonably high-probability scenarios varies between ongoing phenomenal speculative market “melt-up” to a historic crash. Market uncertainty cannot be more extreme than that.
So, how do we manage short exposure in such a backdrop? How do we balance our mandate of providing a hedge against extreme market downside risk - versus our risk management focus? Admittedly, it’s quite a challenge.
As I’ve commented in the past, our strategy can be simplified down to “working to be a reliable hedge without getting killed”. This means adhering to risk disciplines – to start with, taking a cautious approach with short exposure. Most importantly, we’ve avoided the nightmare of being short individual company stocks. In high-risk environments for shorting, we’ll also avoid high-beta sectors – we’ll try to stay clear of what others are shorting. This framework has helped mitigate risk from what continues to be a historic short squeeze environment – the worst I’ve witnessed in over three decades.
Unwinding their individual company short positions and replacing this exposure with a short in the S&P500 - would not be an option. Managers will instead be under intense pressure to improve stock selection. And a crucial element comes into play on the short side: poor performance begets poor performance. As losses mount, risk management tends to surrender to intensifying pressure to recover losses and improve performance. It’s a bad cycle - that we are keen to avoid.
Problematic trading dynamics unfold. You tend to see a circumstance where mounting losses eventually dictate risk mitigation - focused on the unwind of the largest losing positions. Often, these shorts are replaced with short positions in perceived lower risk stocks that have lagged the general market. But then you confront this dynamic in speculative markets where dramatic rotations see the lagging stocks and sectors suddenly outperform – inflicting painful losses from short positions that were viewed as low-risk and out of the fray. Things can just really turn sour – and this over time takes an emotional toll.
In the 11 trading sessions between September 24th and October 9th – the broader market significantly outperformed the S&P500 – in a classic speculative bubble rotation dynamic. Over this period, the S&P gained 7.2% - while small caps were up 12.9%, the Mid-Caps 11.5% and the average stock - as represented by the Value Line Arithmetic Index - rose 10.2%. The Banks jumped 13.5%.
These types of price spikes are problematic for managing exposure on the short-side – especially after having suffered through a period of painful losses. Rather quickly, surging stock prices coupled with losses can see a significant jump in overall short exposure. In a hypothetical example of an account 100% short – a quick 10% jump in stock prices leads to short exposure rising 10% to 110 – while losses see account value drop 10% to 90 – with short exposure rising to 110 over 90 – or 122%.
Most short managers don’t want to see their short exposure rise exponentially when the market is going against them – especially after already suffering major losses. So, they will move to reduce exposure by buying back shares to unwind – or cover - some of their shorts. This means purchasing stocks into market strength – often on price spikes – which can really hurt performance. Running high-beta – or higher volatility - short exposure can quickly turn problematic – with price spikes and resulting deep losses forcing significant short covering at unfavorable prices.
I’m nothing if not disciplined. Candidly, few in the industry would be willing to adhere so strictly to such a risk management focus. Over time, the pressure to modify strategies becomes too much to bear. I’ve lived it in the past. I’ll adjust the strategy when the market backdrop for shorting becomes less hostile.
Let’s now take a deeper dive into the current market environment. While I was working in fixed-income at the time, I vividly recall 1987’s speculative bubble that ended that October with “Black Monday.” I lived through the abrupt market reversal and intense short squeeze in 1991. Speculation coming out of the Russia/LTCM market bailout was spectacular, with Nasdaq almost doubling in 1999. The market’s rally to new highs in 2007 - after the subprime crash - was extraordinary. And 2009’s abrupt rally set the stage for bouts of wild speculative excess over the next decade. - But I’ve witnessed nothing comparable to the mania that was unleashed after the Fed and global central bank market bailout this past March.
From my vantage point of 30 plus years of analysis, we’re witnessing the worst-case scenario. The Fed has lost control – in that they no longer retain the capacity to stabilize the system. Their year ago stimulus stoked speculative excess – and then their March emergency measures incited only more precarious speculation. I believe speculative leverage – that was already unprecedented - has increased meaningfully over recent months – especially in corporate credit. A record $170 billion has flooded into corporate bond funds. There are all these SPACs and loss-making IPOs.
We’ve witnessed a major surge in online trading – with gains in the technology stocks reminiscent of the 1999 and early-2000 speculative blow-off. And, importantly, there has been a proliferation of options and derivative trading that I believe has been a major factor in market melt-up dynamics.
Let there be no doubt: the derivatives trading frenzy – and that’s both retail and institutional – has become a huge and pressing systemic issue. I believe derivative-related selling was instrumental in March’s market dislocation – and near melt-down. And clearly options and derivatives have been instrumental in what I view as a speculative blow-off, especially for the big Nasdaq stocks.
Both on the upside and downside, the popularity of derivatives trading poses a clear and present danger to system stability. Let’s look back to January and February. The VIX index traded as low as 14.5 on February 20th – a remarkably depressed level considering escalating pandemic risks. I strongly argue the low cost of market “insurance” was a direct consequence of the Fed’s September adoption of a so-called “insurance” approach with stimulus measures. Why not sell put options and other market derivative insurance with the Fed committed to moving early and aggressively to counter nascent market instability?
So rather than pare back portfolio risk profiles as pandemic risk began to escalate, many instead bought cheap derivative insurance. There had become little doubt: It was best to remain fully invested. Manage risk, not by adjusting portfolio composition, but with options and other derivatives.
As markets disregarded COVID risk through much of February, large amounts of derivative market “insurance” accumulated in the marketplace. Finally, the pandemic could no longer be ignored; risk markets reversed sharply lower, and those that had sold derivative insurance were forced to aggressively sell stocks, futures and ETFs to hedge rapidly expanding exposures. This selling was integral to what quickly escalated into a cascade of self-reinforcing liquidations.
And then over recent months, we’ve witnessed unprecedented options trading – by the Robinhood and retail crowd, as well as by sophisticated hedge funds and institutions. There’s been a craze for buying out-of-the money call options, as well as the adoption of trading strategies that use derivatives to duplicate more traditional long stock portfolios. In both cases, these derivative strategies lead to self-reinforcing buying and melt-up dynamics – as a rising market forces those that had sold call options and similar derivatives to aggressively buy the underlying stocks and ETFs to hedge escalating risks.
I have posited that the November 3rd election is the single largest event for risk hedging in market history. Moreover, this most hedged event comes in the most speculative of market backdrops – which tracked history’s greatest expansion of central bank liquidity.
The marketplace has had months to purchase put options and other derivative “insurance” ahead of the election. Too much of the marketplace has acquired products or adopted trading strategies that are expected to offload risk in the event of a meaningful market drop. If we do see negative developments and a resulting market downturn, massive sell-programs would kick in - as sellers of market insurance move to hedge their risk. Moreover, an extraordinarily speculative market is susceptible to any shift in risk tolerance. In short, the potential for a self-reinforcing cascade of selling and market dislocation is today even greater than March.
If markets gap lower on disturbing election developments, there’s clear potential for derivatives-related selling and market dislocation. This would follow March’s melt-down and the subsequent derivatives-related melt-up. Importantly, the greater the Fed’s market interventions - the potentially more destabilizing this derivatives monster becomes.
I believe we’re already witnessing heightened market distortions from this massive derivatives overhang. Stocks have rallied over recent weeks, at least partially fueled by the unwinding of hedges. As Joe Biden extended his lead in the polls, concerns have waned for the contested election scenario with a long, drawn-out court battle and possible eruption of social unrest.
Meanwhile, the market has rallied in the face of a widening Biden lead and rising odds of a Democratic “clean sweep” – or, more specifically, the Democrats taking control of the Senate. This has spawned the narrative that a Democratically-controlled Washington is actually good for the stock market. And while Wall Street today relishes the thought of ongoing massive fiscal stimulus, I’m skeptical of the bullish “clean sweep” narrative.
A Democratic-controlled Washington would likely ensure upwards of a $3 TN stimulus program – just to get started. Such massive new supply would risk a Treasury market backlash – and we’ve already seen some backup in long-term yields. And I do appreciate the bullish view that the Fed would simply step in to buy all the Treasuries necessary to ensure yields remain pegged at minimal rates.
I just don’t believe this would be a slam dunk for our central bank. For one, confidence in the dollar has begun to wane. Significantly expanding QE risks unleashing dollar and market instability. Analyzing the potential course of policymaking, - massive fiscal and current account deficits, and the potential for general U.S. instability - a crisis of confidence in the dollar cannot be ruled out. Importantly, the Fed’s QE resolve has yet to be tested by either dollar or Treasury market instability. A combination of both would surely have the Fed moving more gingerly on QE than markets currently anticipate.
And as I mentioned earlier, I expect strong pushback from Republicans when it appears the Fed is monetizing the Democrat’s state & local government bailouts and liberal agenda. While Republicans in such a scenario would have limited legislative recourse, the Fed does not want to be in the middle of such an acerbic partisan clash. The Federal Reserve will be taking significant institutional risk, with the conservative media and a major segment of the populace adopting a critical view of the Fed’s non-traditional policy course.
Let’s wrap up this segment with a section I’ll call “troubling spikes” – what I see as a series of parabolic spikes supporting the super-cycle “end game” thesis. I mentioned earlier the spike in U.S. Non-Financial Debt – that expanded $3.5 TN during the second quarter. Adding Q2 U.S. Debt growth to second quarter growth in Chinese Aggregate Financing brings combined U.S./China credit expansion for the quarter to as astounding $5 TN – an amount that until recently would have been an annual record. There’s nothing in history that compares.
And not only is the quantity of credit growth unparalleled, this credit is predominately non-productive. Late-cycle spikes in non-productive credit have traditionally been the kiss of death for system stability. I talk about a hypothetical chart of systemic risk showing a big parabolic rise – a spike that unfolds during the “terminal phase” rapid expansion of credit of deteriorating quality. This has been a defining characteristic of credit bubbles and subsequent crises over recent decades, including Japan, Mexico, SE Asia, Russia, Brazil, Argentina, U.S. mortgage credit, and European periphery debt. What we are witnessing now – a synchronized spike in “terminal phase” excess globally – is unique in history.
It’s worth noting the spike in Chinese credit – Aggregate Financing – continued in September with another $500bn jump. This pushed nine-month growth to a staggering $4.4 TN. As an analyst, I look at China expanding credit $500bn monthly over a nine-month period – and I’m in awe. In a year where their economy was essentially stagnant, aggregate financing expanded 13.5% - the strongest growth rate in years.
These are incredible numbers – a historic credit boom – and so few take notice. The view remains that Beijing has everything under control. But a $500bn monthly credit boom – and largely non-productive credit at that – is evidence of finance running out of control. It’s a highly unstable situation that appears “under control” only so long as credit continues to expand rapidly. But unless Chinese policymakers have completely “thrown in the towel” on monetary stability – they will once again be forced to restrain financial excess. History provides a clear warning: After a parabolic spike in non-productive credit, the reining in process never goes smoothly.
This parabolic rise in non-productive credit is not a characteristic limited to China and the U.S. It’s global – Europe, Asia, and the Emerging Markets more generally. And this credit fiasco is only possible because of corresponding parabolic spikes in central bank credit – an additional $3 TN from the Fed, $2 TN from the ECB, $1.3 TN from the Bank of Japan and likely a trillion or two from others.
And what are the prevailing consequences of this massive global liquidity injection? More powerful and synchronized asset bubble inflation, destabilizing manic market behavior and, I believe, an only greater accumulation of speculative leverage – with resulting acute systemic fragility.
Here in the U.S., markets are more convinced than ever that the Fed will do whatever it takes to continue bolstering markets. After last September’s “insurance” monetary stimulus and March’s incredible crisis response, markets do not doubt the power of the Fed’s toolkit.
But there are notable holes in this point of view. For one, there’s an overarching global bubble with much residing beyond the Fed’s control. There is major fragility in China, in Europe and throughout the emerging markets. Secondly, each Fed orchestrated market bailout only ensures greater speculative excess and leverage – only creating a more problematic bubble dynamic. Distorted markets have turned hopelessly dysfunctional, incapable of self-adjustment or disciplining even the most egregious excess. Third, as I mentioned earlier, the Fed is now fully immersed in a far-reaching political and social battle – with Fed monetization policies to now garner more attention and criticism. These days, the Federal Reserve and market nexus is viewed as a prevailing source of societal inequity and resulting strife. Fourth, the Fed’s rapid $3.0 TN policy frenzy was in response to a unique crisis backdrop characterized by a rapidly escalating pandemic, economic lockdown and market dislocation. The next crisis will unfold in disparate circumstances, which could see the Fed taking a more measured approach with stimulus.
I worry about all these parabolics – the confluence of spikes in Credit, in central bank balance sheets, in market prices, and in social and geopolitical insecurity. The spike in credit only exacerbates myriad inflationary effects that have festered for years – including asset inflation, market distortions and deep economic maladjustment. All will turn more unwieldy with any waning of the credit boom.
The spike in central bank credit incited unsustainable speculative excess and a full-fledged market mania. Elevated market prices and leverage worsen fragility and now ensure only greater dislocation come the next bout of “risk off” de-risking and deleveraging. The spike in market prices further expanded the gulf between inflated markets and deflating economic prospects. This chasm – arguably the widest since 1929 – creates vulnerability to market reassessment and adjustment. Over recent months, the spike in central bank liquidity and government deficits fed directly into a market spike – that has supported economic recovery. Faltering markets would see a hit to perceived wealth and confidence – while a tightening of financial conditions would choke a structurally frail economic structure.
I am very confident in the bubble analysis. And while timing is always quite challenging, I believe we’re late in the game. In my analytical framework – these unsustainable spikes are the beginning of the end – the clock is ticking.
And COVID cases are spiking again – just as we’re headed into the winter months. Daily cases have spiked to a record 120,000 in Europe, and governments are in the process of reimposing restrictions that will crimp recovery. While I don’t expect a return to full-fledged national lockdown conditions here in the U.S., a COVID spike comes with negative consequences.
There’s a general misconception in policy circles and the markets. The bullish view holds that the system was robust prior to the pandemic. With some temporary support from aggressive monetary and fiscal stimulus, the economy can get right back on its sound trajectory. My analytical framework communicates something altogether different: The system was unsound - a maladjusted bubble economy - badly distorted from years of ultra-loose monetary policy and huge fiscal deficits. Asset prices were already inflated, with powerful speculative bubble dynamics in force throughout the financial markets. In the real economy, loose finance nurtured scores of uneconomic businesses and enterprises. The corporate sector was already over-leveraged.
Importantly, this bubble economy structure has become an absolute credit glutton. And this credit addiction ensures massive fiscal deficits CAN NOT be a temporary phenomenon. Our system is in the throes of a runaway inflation of non-productive credit – a predicament shared around the globe.
At this point, I don’t believe there is any turning back. The stock market mania these days feeds off the notion of zero rates, QE, and a fiscal spending bonanza. Yet there are monumental risks in the current policy course.
Let’s return to the virtues and vulnerability of “money” and moneyness. Policymakers have failed to learn crucial lessons from history. We’re now in a period of unparalleled over-issuance – over-issuance of central bank credit, of Treasuries – of money - of agency debt, of corporate credit – along with over-issuance of suspect equities securities and derivatives of all stripes. We are today risking no less than a crisis of confidence in finance and policymaking.
There was a point during the Fed’s initial crisis response back in March when aggressive Fed measures were actually failing to contain the market panic. It was very alarming - I had never witnessed this in my decades of following the markets. While quickly forgotten in the marketplace, I fear that episode was a harbinger of what we will face with the next crisis.