Q4 Recap 2020: “Managing in a Mania”
I have a favorite saying I’ve used over the years to begin team meetings: “Every day is a new and exciting adventure.” Following daily developments in this most extraordinary of environments is certainly exciting – these crazy markets, the policymaking, politics and societal drama. I prefer to use words such as “exciting” and “fascinating” to describe things - these days probably more accurately labeled “troubling” or “unnerving.” For me personally, I always work to maintain a positive mindset even when my analysis is pointing negatively. I wish I didn’t find the current fascinating backdrop so deeply troubling.
Let’s begin the analysis with an update of this unbelievable monetary environment. Federal Reserve credit has increased $3.1 TN over the past 45 weeks – or 88% annualized. Fed credit was up $3.6 TN over the past 70 weeks, or 95%. After beginning 2008 at $850 billion, Fed assets are on course to surpass $8 TN around mid-year.
M2 money supply has expanded about $3.7 TN over the past 45 weeks to a record $19.2 TN, a stunning 29% annualized growth rate since March. It’s worth noting, as well, that Institutional Money Fund assets – not included in M2 – were up another $522 billion over the past 45 weeks, or 27% annualized.
The 2020 fiscal year federal deficit spiked to an incredible $3.1 TN, or 15% of GDP. For the first quarter of fiscal 2021, the deficit jumped 61% y-o-y to $573 billion. The government borrowed 45 cents of every dollar spent during the quarter, down somewhat from last year’s 50%. There’s been nothing comparable since World War II.
And let’s briefly delve into key data from the Fed’s quarterly Z.1 report. U.S. Non-Financial Debt (NFD) surged $5.74 TN during the first three quarters of the year, an increase of 188% from comparable 2019 growth. For perspective, non-financial debt expanded on average $1.83 TN annually over the previous decade – and had not previously surpassed $3.0 TN on an annual basis. Outstanding Treasury Securities surged almost $3.89 TN during 2020’s first three quarters, with year-over-year growth of an astounding $4.3 TN, or 23%. After concluding 2007 at about $8.0 TN, Treasury Liabilities ended September at $25.8 TN.
Over the past five quarters, Total Debt Securities – Treasuries, agencies, corporates, munis - jumped $6.88 TN to $52.62 TN – growth more than double any previous comparable increase. At 249% of GDP, Total Debt Securities compares to a ratio of 200% in 2007, 157% to end the nineties; and 126% to end the eighties; and 74% to conclude the seventies.
Total Securities – combining Debt and Equities - ended Q4 at a record $110 TN. At 518% of GDP, this 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 inflating to record highs, Household Net Worth reached an all-time high $124 TN. Household Net Worth ended Q3 at 584% of GDP – greatly surpassing previous cycle peaks. This compares to previous cycle peaks 492% in 2007 and 446% in early 2000.
Never in our nation’s history has there been such egregious monetary inflation. Money and credit have quite literally become unhinged – and at least some consequences have turned conspicuous.
With market liquidity injections the primary mechanism for Federal Reserve stimulus, there’s no mystery surrounding extraordinary asset inflation and bubble dynamics. Following years of progressively expanding excess and bailouts, the U.S. stock market has degenerated into a full-fledged mania.
The Nasdaq100 more than doubled in two years – with a current price-to-earnings ratio of 39. The S&P500 trades with a P/E ratio north of 30 – an all-time high according to Bloomberg. And this is no 1999-style mania propelled by a single sector and narrow group of stocks. The “average stock” Value Line Arithmetic Index has gained 130% from March lows – in the strongest broad-based market rally I can recall. The small cap Russell 2000 almost doubled from March lows – with a Bloomberg P/E designated as “N.A.” – not applicable - meaning the index in aggregate is devoid of positive company earnings. Tesla surged 700% over the past year with its market capitalization reaching $800bn.
The Goldman Sachs Short Index is up 260% from March lows in one of history’s great short squeezes. The GS Short Index is already up 20% y-t-d. Short interest in the SPY S&P500 ETF has dropped below 2% - a level rarely seen over the past decade.
IPO madness: Companies raised $167bn last year, trouncing the previous full-year record of $108bn during bubble blow-off year 1999. Including secondary equity offerings, a record $435bn was raised in the U.S. last year, more than 50% ahead of 2014’s record ($279bn). More than 240 SPACs – special purpose acquisition companies - went public, raising an unprecedented $81bn. $100bn of convertible bonds were sold, double 2019’s volume.
The U.S. in 2020 saw corporate debt issuance jump to $1.7 TN – records for both investment-grade and high-yield sales. Globally, almost $5.4 TN of new corporate debt was issued – 25% ahead of the previous record in 2019. Junk-rated companies raised a record $547bn – a third higher than 2019.
ETF industry assets surpassed $8 TN – with global ETF inflows reaching a record $763bn – a 36% increase from record 2019 flows. Vanguard enjoyed inflows of $186bn, with assets surpassing $7 TN. Average daily option trading volume reached 30 million contracts last year, up more than 50% from 2019 levels. Last Friday’s option volume hit a new record with almost 50 million contracts traded. I’ll quote Reuters: “This year, some 416 million U.S equity options contracts have already traded over 10 sessions. That’s equal to the total options volumes over the first four months of 2004…”
The majority of this record volume arises from the mania in call option buying. It’s worth noting the ratio of call versus put buying recently reached the highest since early year-2000. According to Bloomberg, last Monday saw pet-medicine maker Zomedica’s trading volume at the top of the most-active list, reaching 1bn shares. Zomedica and five other stocks trading below a dollar accounted for a full 20% of daily share volume.
Quoting Bloomberg from last week: “Fact: shortly before 1 p.m. New York time Thursday, there were six penny stocks posting daily gains of at least 9,900%. Off-exchange venues where unlisted equities trade had seen about 38 billion shares change hands, up sevenfold from the average a year ago… More than 1 trillion shares changed hands in December over lightly regulated quotation systems…”
And then there’s the cryptocurrencies and Bitcoin – after starting 2020 at about $7,200 and dropping below $4,000 in March – launching a speculative moonshot that surpassed $40,000 earlier this month.
I’m fond of saying how things can get crazy at the end of cycles. And with our view that central banks are prolonging the final phase of a grand super-cycle, we shouldn’t be too surprised by anything at this point. I thought I’d witnessed just about everything in my over three decades operating in unstable bubble markets, but the current mania has taken things to a whole new level.
Traditionally, it was Federal Reserve doctrine to “lean against the wind” to at least ensure monetary policy was not exacerbating excess. The Fed some years back proclaimed that it would not use rate policy to contain asset inflation and bubbles, choosing instead so-called macro-prudential measures. So how is our central bank reacting these days to such conspicuous excess: well, it’s radio silence as they continue to pump $120bn of new liquidity monthly.
We’ve all grown numb to much of this by now. But think of this – stocks are surging in what is clearly a momentous speculative bubble - and the Fed steadfastly sticks to its plan for injecting another almost $1.5 TN into the markets this year. If that’s not crazy, what is.
So, we can today clearly observe unprecedented monetary inflation – money and credit growth – and we can identify resulting monetary disorder manifesting into asset inflation and highly speculative securities markets. So, let’s get to the theme of the call – “Managing in a Mania.”
This extraordinary backdrop beckons for a focused approach to risk management. Discussion of optimal timing and composition for short exposure has been a regular focal point of management discussions throughout my career. There’s complexity that is not self-evident. It seems intuitive that the higher a stock price the better the short opportunity. The more the market goes up, the more attractive shorting becomes. If it were only that simple.
Some of today’s most experienced and successful short analysts suffered huge losses being short Tesla – likely the largest losses of many careers. Tesla’s stock doubled during 2020’s first half – creating what appeared an even better short. The problem is it doubled again – trading to $400 by August – and then more than doubled a third time to trade as high as $884 earlier this month.
It’s common to short stocks based on overvaluation, and there was a solid argument that Tesla was overvalued even prior its 800% gain. The point is that traditional short-side analysis can prove highly problematic when financial conditions loosen. In a more normal monetary environment, it’s likely Tesla would have run out of cash. Many seasoned balance sheet and cash-flow focused analysts were betting on exactly that outcome. But not only has the company survived, it’s become one of the highest market cap stocks in the marketplace. Its founder has become one of the wealthiest individuals in the world. How could the shorts have been so wrong?
Well, financial conditions loosened dramatically, and short-side analysts didn’t appropriately factor this into their micro analysis. Moreover, there’s a dynamic whereby a rising stock price alters trading dynamics. The more Tesla’s stock price rose the more traders and institutions just had to own it – fear of missing out. And the more money that was made in the stock, the more traders and others were delighted to buy Tesla cars. It expanded into a full-fledged mania. I’m highlighting Tesla today, yet similar dynamics propelled scores of stocks. The entire stock market has become one historic speculative mania.
We certainly don’t want to be caught short individual company stocks in a mania – and, fortunately, we weren’t. One of our competitor bear funds lost almost 33% during the fourth quarter and a second dropped 23%, with 2020 losses exceeding 40%. They have been short stocks during a mania, and their investors have suffered.
We didn’t expect this to evolve into a historic mania. There’s been a once-in-a-century pandemic, the intensity of March’s financial crisis, the steep economic downturn, along with alarming social and political instability. On its surface, this didn’t appear an environment where the shorts needed to fear being steamrolled by a mania.
But this is where our analytical framework and disciplines shine through. We focus first and foremost on financial conditions. When financial conditions are loose, we maintain tight control on risk. From my experience, shorting company stocks is a high-risk proposition when finance is loose or loosening. While I may not have anticipated this turning into a full-fledged mania, I appreciated that the probability for such an outcome was bolstered by the policy and monetary environment.
We recognized that market structure was conducive to speculative excess evolving into euphoria and manic behavior. Trend-following and performance-chasing dynamics have proliferated. Hedging programs were dominant in the markets earlier in the year. The unprecedented Fed and central bank crisis response spurred a huge short squeeze and unwind of hedges that propelled the rally. And uncertainties associated with the November election created another major hedging event – followed post-election by a second substantial unwind of hedges and squeeze that, again, powered markets higher.
The fourth quarter rally was an unmitigated disaster for those short company stocks. Already impaired from the earlier liquidity-induced rally, the post-election short squeeze and speculative melt-up incited a panicked reversal of short positions. The Goldman Sachs Most Short Index surged 38% during Q4, pushing its 2020 gain to 51%. This historic short squeeze created a big problem for various hedge fund strategies, particularly long-short and quant factor strategies. I believe the combination of a powerful short squeeze, the unwind of derivative hedges, and mayhem for a segment of the hedge fund industry, was instrumental in fueling melt-up dynamics – an upside market dislocation.
Meanwhile, euphoria was engulfing the bubbling retail trading universe – the so-called “Robinhood effect” - certainly enveloping the Wall Street darling tech and “stay at home” stocks, but also call options and penny stocks. Making money in the markets has never been easier.
A story from Q4: A lot of perceived low-risk shorts turned high beta. After underperforming for much of the year, the small cap Russell 2000 exploded for a 31.4% three-month gain, while the Midcaps returned 24.4%. The KBW Bank Index returned 35% during the quarter, and the Philadelphia Oil Services Index surged 60%. The “average stock” Value Line Arithmetic Index returned 27%. As noted previously, the Goldman Sachs Short Index jumped 38% during Q4. Importantly, it becomes impossible during a mania to accurately gauge the “beta” of a portfolio of individual company shorts.
I want to make a critical point: This doesn’t occur in normal environments - markets wouldn’t behave in such an erratic manner if underpinnings were sound. We’re witnessing a consequence of acute monetary disorder – disorder that arose from the extreme policy responses to financial and economic fragility.
Why do things turn crazy at the end of cycles? Because years of mounting excess culminate in destabilizing speculation - in the face of late-cycle economic maladjustment and vulnerability. Policymakers respond to heightened risk of bursting bubbles with only more forceful measures – aggressive monetary inflation that eventually pushes speculation into a melt-up mania dynamic.
I’ve had a long fascination with past bubbles and monetary fiascos. Perhaps some of you are similar. Earlier in my career, I exhaustively studied the late-twenties period. Often, I was left confounded. How could markets have kept rising in spite of a clearly deteriorating fundamental environment? How could participants have so blindly disregarded such troubling unfolding developments?
I do not recall the book, but I came across contemporaneous accounts of 1929 and its aftermath. Wall Street traders were interviewed, and a key question was posed: “How could you have ignored all the issues – the debt overload, the surge in broker call loans, the obvious speculation, excesses and mounting fragilities?” Many of the responses shared a similar perspective – an explanation that left an indelible mark on my thinking. These market operators basically said you can only worry about things for so long – that they had fretted about these issues for years - especially in 1927. But eventually the late-cycle environment had forced them into abandoning their concerns and blindly embracing the mania.
I think a lot about this dynamic these days. Future historians will surely look back at this period and ponder how on earth so much was ignored. What were people thinking? They will surely question how faith was maintained in the course of unconventional central banking. Why euphoric markets maintained such confidence that more central bank “money” would resolve deepening maladjustment, and how central bankers could turn a blind eye to reckless debt growth, speculative asset bubbles, and mounting structural impairment.
I want to address what I see as one of this bubble period’s most dangerous fallacies – that central banks control market liquidity - and financial conditions more generally. It’s my view that speculative leverage evolved into the prevailing marginal source of marketplace liquidity. So long as speculative leverage is expanding, markets remain highly liquid. And this is a self-reinforcing bubble dynamic. But we saw again in March that this dynamic does not function in reverse - how rapidly illiquidity and dislocation take hold during sudden bouts of de-risking and deleveraging.
I saw in March powerful confirmation of my thesis that global speculative leverage has expanded momentously since the ‘08 crisis. The Fed responded to 2008 deleveraging with an unparalleled $1 TN of new liquidity. Last March, deleveraging actually accelerated even as the Fed announced QE in excess of $1 TN – forcing a panicked Fed to dramatically expand the scope of emergency liquidity operations.
Because of the fragility associated with unparalleled global leveraged speculation, the Fed and fellow central banks were forced to move quickly and extremely aggressively. They were successful in reversing de-leveraging – but at the cost of promoting even more egregious speculative excess and leveraging. The bottom line: an already historic bubble has inflated tremendously since March.
And while it today appears “whatever it takes” central banking has market liquidity well under control, this is a bubble illusion. The next serious bout of de-risking and deleveraging will again incite illiquidity and dislocation – likely on par with March. And I would argue that each of these massive Fed market bailouts provokes only more precarious speculative leverage, a broadening scope of Bubble excess, and much deeper maladjustment. It’s a bad cycle of ever bigger bubbles and bailouts. Come the next serious post-pandemic “risk off” episode, will the Fed be willing and able to reliquefy the markets – with perhaps another few trillion of Fed “money”?
Markets at this point take for granted that “whatever it takes” ensures the Fed will readily resolve any and all problems. I believe there are serious shortcomings in the markets’ complacent and optimistic view – huge risks are being ignored. For one, the Fed in 2020 inserted itself right into intense partisan political rancor. The Federal Reserve became a major force in credit and wealth allocation – dangerous domain for central bankers and central bank independence. Our central bank was rightfully recognized as a major propagator of wealth inequality – inflating the stock market for the benefit of the wealthy and a fortunate segment of the population. Meanwhile, the Fed was also actively promoting monstrous fiscal stimulus and deficits.
Going forward, the Fed will be viewed by many as supporting the Democrats liberal agenda. The Biden administration is already proposing a $1.9 TN stimulus package, while stating that a second round of spending legislation – addressing infrastructure and tax changes – will be coming around mid-year. There was already notable Republican pushback at Yellen’s Tuesday confirmation hearing.
I see the Republican party emerging from disarray with a return to its roots of fiscal conservatism. Expect the Fed’s $120bn monthly “money printing” operation to come under heightened scrutiny. This will especially be the case if inflationary pressures continue to mount.
We view inflation risk as being the highest in years. The 10-year Treasury “breakeven” inflation rate has jumped to 2.17%, the high since October 2018. Commodity prices continue to rally. Food prices are surging. Services and manufacturing surveys point to heightened pricing pressures. Home prices are inflating at the strongest double-digit rates since the housing bubble period.
The world is awash in liquidity. The dollar has weakened, and our central bank overseeing the world’s reserve currency is trapped in reckless monetary inflation. This backdrop has afforded nations around the world the flexibility to recklessly inflate their money and Credit. Global “money” and Credit are today unhinged like never before. And it’s no longer hypothetical: Global central bank “money” is solidly on a trajectory that ensures intractable global monetary disorder.
A critical juncture for global inflationary dynamics has been reached. There does remain a very real possibility of bursting global bubbles, with sinking securities markets and a contraction of speculative leverage galvanizing deflationary pressures. Yet we see reasonably high odds of a particularly problematic scenario: the global central bank community - forced by synchronized de-risking/deleveraging - to move early and aggressively to again flood the system with liquidity. And for the first time, central banks would be inundating the system with liquidity - despite increasingly entrenched inflationary pressures. General price inflation could, finally, catch fire.
We take exception with bullish faith in the Fed maintaining full flexibility and infinite capacity to rescue the system from whatever crisis that might unfold. We view the Fed today as facing diminishing capacity and potentially significant constraints. Surging bond yields and a disorderly decline in the dollar would force the Fed into taking a more measured approach with QE. Meanwhile, political pressures are brewing.
Our nation faces massive intractable fiscal deficits – and unless the Republicans get their act together, the “blue wave” will grow only more formidable. The MMT crowd – modern monetary theory inflationism – is emboldened and eager to push the envelope.
It is now left for the markets to impose some fiscal discipline upon profligate Washington. The bond market today largely disregards the unending massive supply of Treasuries in the pipeline. The view holds that the Fed won’t allow Treasury yields to rise much before boosting purchases. The problem is that a bout of de-risking/deleveraging will require a huge increase in purchases just to absorb the liquidation of Treasuries and other securities. And in an environment of heightened inflationary pressures, we see a problematic scenario whereby markets would start to panic that the Fed has lost control.
This is not farfetched analysis. Recall that markets were initially panicked by the Fed’s response to the March crisis. It required the most extreme measures in the history of the Federal Reserve system to hold financial collapse at bay. But reckless monetary inflation has only inflated a more colossal bubble, creating the potential for an even more chaotic market backdrop come the next serious deleveraging episode.
The new Biden administration took office yesterday. Manic markets have been fixated on additional stimulus, easily dismissing the wealth redistribution policy mandate the Democrat “clean sweep” entails. Monday’s Bloomberg headline read, “Biden’s Wall Street Watchdogs Signal New Era of Tough Oversight.” The President’s pick to head the SEC, Gary Gensler, is a sharp, experienced and proven tough regulator. “Robinhood” retail trading, derivatives and SPACs are now seen in regulation crosshairs.
Corporate tax rates will be going back up, and a $15 national minimum wage a distinct possibility. There will be more regulations. But with trillions of stimulus in the pipeline, Wall Street isn’t today concerned with corporate profits. But inflated bubble-period earnings are unsustainable and vulnerable.
Quoting Treasury Secretary Yellen: “Right now, with interest rates at historic lows, the smartest thing we can do is act big.” But another $3 TN plus annual deficit is not smart – in the past it would have been recognized as foolhardy if not negligent. It’s playing with fire. We believe Washington has pushed things much too far – the most extreme debt growth and the most extreme Federal Reserve debt monetization. We’re witnessing an unprecedented late-cycle runaway expansion of risky non-productive debt – too much of it held by leveraged speculators. Market backlash is inevitable and overdue. We just don’t see market forces remaining inoperative indefinitely - supply and demand will matter again. The quantity and quality of system credit will prove momentously important.
We see a multitude of potential bubble-piercing catalysts, starting with a spike in Treasury yields and a disorderly drop in the dollar. We believe market optimism regarding post-pandemic recovery is too optimistic. The pandemic will leave deep scars, including problematic credit impairment across households, small business, corporations, and state and local governments. Debt problems have thus far been held in check by massive stimulus, repayment moratoriums and the loosest financial conditions imaginable. But there’s no free lunch: credit problems propagate and fester. The system is only a tightening of financial conditions away from serious credit issues.
We have focused much of our attention on this call to domestic issues. Yet there are myriad potential global catalysts that could spell trouble for our markets. Right now, optimism on China’s debt-induced recovery is strong. Beijing’s efforts to get their bubble under control have been repeatedly postponed – more recently due to the U.S. trade war and then the pandemic. Chinese officials have cautiously begun the process of slowing credit growth and removing some stimulus. We believe this process will reveal financial vulnerabilities in their highly speculative asset markets, in corporate credit and in the soundness of China’s bloated banking system.
Over-liquefied and highly speculative markets have masked deep structural impairment throughout the emerging markets. We expect fragilities will be exposed with any “risk off” tightening of global finance. European bond markets are a historic bubble fueled by ECB and global central bank liquidity.
In short, a global system - so overburdened with debt, speculative leverage and unparalleled imbalances - is an accident in the making. And it could be something completely unexpected that pierces vulnerable bubbles. I certainly don’t see heightened U.S. social and political instability as supportive of healthy securities markets.