True Liquidity

These recent events are the sort we expect.  They expose true liquidity and are a major reason we have been compelled to remain hedged.  Does anyone besides us wonder what is going on behind the scenes?  Treasury bonds still aren’t buying the optimistic interpretation of events being spun by Wall Street where one strategist has boldly declared that investors should buy everything because risk is dead.

Investors required a daily dose of market-supporting jawboning all year as fundamentals like earnings and economic growth deteriorated.  The Fed had to reverse course completely. At the same time, Trump conceded ground on trade to placate markets and to try to win next year’s election, but even that was not enough in the end as liquidity still dried up just like last December.  It happens in December as major participants attempt to conceal how much risk they have been taking all year in the carnival atmosphere or to otherwise satisfy regulators and new capital requirements.

With this in mind, it’s getting tougher for these major players to hold risk assets because many of the usual cycle-end markers are making an appearance.  We aren’t alone in thinking this.  The CFO survey is saying the same thing.

Half of CFO’s expect a recession next year.  These are people inside real companies looking past the hype.  That seems to fly in the face of investor consensus given current stock prices.  Also, CEO’s are retiring in droves. That’s never a good sign.  They must see the writing on the wall too.  We may not get a recession next year, but because valuations are so stretched, that may not matter.

This year has been largely about the Fed learning that it will be impossible for it to return to any semblance of its historical role as we have said all along.  It got caught thinking that growth was strong enough to withstand policy normalization, but it was forced to become extremely dovish as the year progressed because the data rolled over.  Plus, after markets had become volatile late last year, it wanted no more drama.  In addition, with Wall street earnings estimates having come down about 8% for this year, it was getting harder to keep investors in the game.

Against this backdrop, the Fed omnipotence narrative may be in need of repair.  Bloomberg recently had a piece about central banks losing their ability to shock and awe markets while the WSJ wrote about retail investors fleeing stocks this year at the fastest pace in decades.

What is gaining acceptance among investors is the realization that what used to be considered extraordinary monetary policy is now simply ordinary.  It is required just to maintain the system as opposed to providing stimulus.   How exciting is it for investors when the Fed is simply helping finance government spending as the federal deficit skyrockets and supplying funding to Wall Street in highly unusual ways to prevent a liquidity crisis like last December’s?

Even with the recent rally, over the last couple years the equity market has lost momentum to an unusual degree that shows that all the central bankers have been able to do so far is to keep air in the public market bubble, not further inflate it.  The average stock is not along for the ride.  Venture capital and private equity investors have also been forced to mark down values on numerous investments as WeWork imploded before it came public while numerous other companies received poor receptions once IPO’d.

We are seeing more investment managers writing those circa Y2K Zen-like client letters about how they have learned to ignore the many issues facing markets.  It goes something like, “How I Learned to Stop Worrying and Relax While Owning Stocks at Bubble Valuations.”  In those, they often say things like we just own good stocks and over time that works.

The problem with that buy-and-hold forever notion is that so many stocks are overvalued to a concerning degree and once real selling starts, time horizons tend to shrink as risk aversion sets in.  The math matters over time.  One would have been better off owning Treasury bonds over the last twenty years since the last bubble of similar magnitude (similar returns, much lower risk), but that is not well understood or appreciated.

The Fed has taken on the job of market supporter to a degree that would have been laughable not so long ago.  Is it a central bank or a broker-dealer?  It’s new involvement in what used to be the private securities lending market should be recognized as a sign of how desperate it has become to maintain order.  In addition, buying $60 billion per month of T-bills and arguing it’s not QE only makes the desperation case stronger. It’s hard to imagine that there won’t be consequences perhaps as soon as emergency funding efforts by the Fed run their course in the next few months.