When I was growing up, I loved the Adventures of Tintin books. I had all the books, and as I read them with my son today, I find that I still remember all the words. For those who are not familiar with the series, it is cartoon book about a strangely young looking reporter who, accompanied by his faithful dog Snowy and his assortment of eclectic friends, travel the world solving mysteries and participating in fantastic adventures.
There are a couple things you could usually count on. Tintin’s friend Captain Hadock would consume copious amounts of Loch Lomond scotch whiskey and that Snowy’s tail would get hurt in some way. You would think that Snowy would learn, but he never does. Time after time, he either gets it caught in an elevator door on the rocket ship destined for the moon, or burns it escaping from a plane crash in the Sahara desert.
In fact it happens so often that the Tintin Wiki has a whole page devoted to Snowy’s tail traumas.
Even though Tintin and Snowy know about tail risk, they don’t seem to be able to stop it from happening. Much like the market today.
We all know about the tail risk. We can all see the massive imbalances in the system. Almost no one thinks that the long term prospects for either the economy or the market are that robust.
Yet, even though the risks are skewed heavily against long term gains, we keep piling into risky assets. We are mesmerized from the allure of recent short term gains. The pain of not participating is way worse than the risks of buying at the top. As the great investor Jeremy Grantham said:
Watching neighbours get rich at the end of a bubble while you sit it out patiently is pure torture.
Most don’t have the stomach to sit it out. Even wise old sages like Jeremy have a tough time.
And that is why these bubbles are formed. Even though we know it is wrong, we can’t help but buy along with our peers. The pain of being alone is way worse than the pain of buying at a stupid price.
It is crazy, but we convince ourselves that this time is different all the time. Somehow this time it will end better. This time, the excesses won’t cause a market crash.
But of course, it never is different. Buying at stretched valuations always produces subpar returns.
As markets move farther away from fundamental value, and start rising due to momentum chasing rather than improving fundamentals, the risks increase exponentially. The tail risk goes through the roof.
Just like you know that it is just a matter of time before Snowy gets his tail hurt again, we know that it is only a matter of time until we get a big market dislocation.
I am scared about a serious sell off that catches many investors off guard. I understand that I seem like a chicken little, but the level of complacency is as high as I have seen it in quite some time. There is a shockingly naive expectation that markets have to continue to go higher.
We are in a positive feedback loop that is causing a dangerous move away from fundamental value. After the 2008/9 credit crisis it took a long time to persuade investors to move back out the risk curve into equities. But in the last couple of years there has been a big shift out towards the riskiest portion of the curve. We are now in an environment where stocks are rising because they have been rising, which only causes more money to chase them even higher. Remember financial markets are one of the few markets where demand can increase as prices rise. Soros’ theory of reflextivity is hard at work in today’s market.
But this feedback loop will eventually collapse on itself. The larger the rise, the bigger the dislocation when it does.
The equity index option market has figured this out. The SKEW index, which measures the difference between implied volatilities of at-the-money and out-of-the money puts is pushing up against all time highs! That means investors are paying more to hedge the possibility of a large downward move versus the cost of volatility around current prices than any other time.
The option market knows that it is only a matter of time until Snowy’s tail experiences another trauma and the stock market encounters a serious reversal of fortunes.
Don’t get complacent. Yes, we can go higher, but the risks only increase from here. Smart investors are already hedging that risk in the option market.
Yardeni’s “fundamental indicator”
I am a big fan of Ed Yardeni’s work. I follow one of his indicators that he calls the “Fundamental Indicator” quite closely.
Since the credit crisis, the indicator has done a decent job of modelling the equity market.
After the crash there was a general hesitation to plough back into equities and that caused the Yardeni indicator to run ahead of the stock market. But eventually Bernanke & Co. coaxed investors back into equities. During the past couple of years the stock market has actually been running ahead of the Yardeni “fundamental indicator.”
For the past couple of months the Yardeni indicator has been slipping, but the stock market seemed impervious.
The selling in the stock market during the past week seems to be correcting that divergence, but there is room for stocks to fall further.
Most importantly, we have to remember what drives this indicator so we can understand where it might go from here.
The indicator is created through a mix of the ABC weekly Consumer Confidence number, the weekly initial jobless claims and industrial commodity prices. Both the Consumer Confidence and the initial jobless claims are performing well, so the recent decline in the indicator can almost be solely attributed to the decline in industrial commodities.
Industrial commodities are going down due to a mix of a global economic slowdown and the US dollar strength. Whether this continues I am not sure.
I don’t have any profound insights into any of this, but I just wanted to update you on Yardeni’s stock market model and what is affecting its level.
CEF is one of the oldest closed end funds that specializes in holding precious metals. I have written about Central Fund’s wide discount to NAV in the past.
In the past week the discount to NAV has once again widened, hitting 9% a couple of days ago.
This was a new low for the past decade and it has brought out a lot of bottom pickers. Although I love CEF as a great way to gain exposure to gold and silver at a discount, be careful if you think that this spread has to narrow. This was indeed a new low for this decade, but in the 1990s when gold was something only your grandfather owned, CEF’s discount to NAV went to almost 20%.
Don’t misunderstand me – I love CEF. Just be aware that as hated as gold is today, it can always get more hated…