Although I have not been perfect, on the whole I have resisted the desire to fade this equity rally or load up on tons of VIX betting on a replay of 2008. It has been difficult as there are plenty of really smart (and some not so smart) hedge fund managers taking the exact opposite bet. George Soros, Stanley Druckenmiller, Howard Marks and Raoul Pal have all expressed serious concerns about the potential for a stock market crash. Even that blow hard Carl Icahn has disclosed a 150% net short position. Joining their crowd would certainly be easy. After all, their argument seems to make so much sense. Stock market valuation is stupid. The global economy is mired in a slowdown. Monetary policy seems to be losing its effectiveness. Central Banks are becoming increasingly desperate and fiscal policy solutions are a non-starter. It has all the ingredients for a big nasty stock market decline.
Yet even though all these supposedly smart legendary investors are uber bearish, here we are with the S&P 500 hitting new highs for the year.
I must admit that I have not been able to articulate a logical reason to own stocks. The trader in me simply believed too many investors were set up for a decline and the short side was much too crowded. The Market Gods never let a large group (regardless of their credentials) forecast a crash.
These bearish hedge fund managers are confident in their negative forecast. But they don’t realize the old rules are breaking. The global economy and markets are not behaving like they used to.
I have been unable to pin down all the factors driving this new market, but this weekend I got much closer when I stumbled upon a post by Two&Twenty titled “Boombers stuck in a circular unfunded liability they will never break out of…”
When I read his piece, a big light bulb went off. Two&Twenty explained much better than anyone I have ever read why there is an incessant bid in the stock market. I will probably end up quoting the whole post because it is so good, but let’s have a look at his argument:
-Assume you are nearing retirement and trying to calculate how much you need to save for your golden years.
-Assume also that due to advances in medical technology, you really have no idea what your lifespan will be. It could be 5, 10, or 50 years.
-Assume you need $50,000 year for living expenses and that there is no inflation (just to make things simple).
How much will you need? This equation tells you what you will need:
Present Value = Cash Flow / Rate of Interest (lets make Rate of Interest = r)
So, you will need $50,000/r.
OK, what the hell is r? (I’m simplifying here, bear with me…)
-In 1980, r was around 20%…for both stocks and bonds.
-In 2000, r was around 5%…for both stocks and bonds.
-in 2015, r is 2%….for both stocks and bonds.
So, if you did this exercise in 1980, you needed $250k ($50,000/.2)
-If you did this exercise in 2000, you needed $1.0MM ($50,000/.05)
-If you did this exercise in 2015, you needed $2.5MM ($50,000/.02)
See, what’s happening?
The way the math works, the lower the yield goes, the more money we need. Halve returns again and the liability goes up to $5m… The more time goes by, the more you need. The more you need, the higher the price of the assets you are buying and hence the lower the expected return. And hence the more you need. If you are unfunded, your “hole” just gets bigger and bigger…You are in a trap you may never get out of. No wonder you don’t feel great about your situation.
Now, imagine if you were going through this same exercise along with millions of other people in your exact same situation in developed markets around the world….All chasing basically the same financial assets. They are all in a massive prisoner’s dilemna with each other. The more they bid, the more they need.
This is what is happening right now. All the DMs are aging. This is a global phenomenon. Insurance companies, pension funds and others trying to store assets for the next 30 years are screaming for returns. And we are thus seeing correlation amongst DM financial assets skyrocket.
Two&Twenty lays out the math that accompanies an aging population that has not saved enough, combined with declining yields and increasing life expectancy. But the conclusion that arise from this situation is the part that triggers the “aha” moment:
It explains so many things:
-This is why CAPE has been inflated for 30 years running.
-This is why there is a never-ending bid to E-minis. The “plunge protection team” are boomers looking to fund their retirement, not some government bogeyman.
-This explains why all financial assets are in a “bubble”; they are just substitutes for each other in the quest to get funded.
-This is why low bond yields in Europe infected US bond yields. Dutch pension funds in a hole just want yield & they could care less about F/X risk…
-This is why Hussman just gets wronger and wronger.
-This also explains volatility in the back end of the yield curve. Pensions dominate this space; when yields go down, their unfunded liability shoots up and they chase yields lower. When yields back up their unfunded liability goes down massively and we get liquidity holes in the back end like we just saw in Euro 30yr rates. They are effectively very short gamma in the back end. (Which means also that all boomers are short gamma on their liability…)
The boomers are in a hole and chasing a carrot that just gets farther and farther away….Don’t bet any time soon that financial assets are going lower. The boomers aren’t going away.
This is why it is quite painful being a Gen Xer. The boomers have literally drained all value out of financial assets in their desperation to fund their unfunded liability.
This is a demographic shift we have NEVER seen. That is why CAPE has NEVER been this high for this long.
Shiller doesn’t understand the valuation and thinks it may crash. It won’t crash until all the boomers are funded….Sure, there may be temporary selloffs, particularly in risk assets. But any sell-off is a boon to these guys. They are effectively short them.
Shiller needs to walk into a Financial Advisor’s office and spend a day and he will immediately understand what is happening. It’s not lack of confidence in the future. On the contrary, it’s confidence in a LONG future for boomers.
Shiller gets so close in that interview to hitting on this….without going there. He keeps saying people need to save more because returns will be lower. He doesn’t make the connection to the circular loop of what this does to asset prices; i.e., more funds chase limited assets, driving the expect returns on those assets still lower. I found myself screaming when I read the interview. As an options trader, I understand this negative gamma intuitively.
In many ways, the boomer’s have given us a free put on financial assets: they basically have to buy them at lower prices. When we see panic sell-offs, we should literally all start front-running the boomers.
What will solve this? Increasing the retirement age. This will have a massive effect on the perceived unfunded liability. Social security in theory could help, but there aren’t enough young workers to pay for the boomer’s retirement.
We as a global society need to wake up to the fact that a life expectancy of 100 is not consistent with a retirement age of 65-70 (or for government/military, 45, but don’t get me started on that…).
The other thing that this opens up which I won’t go into is this: is the Central Bank rate repression effectively increasing the angst among the boomers with regard to their unfunded liability?
Many have this view and I am sympathetic. After all, if CDs yielded 5-10% like they did 10-20 years ago, a potential retiree would feel less pressure to save for retirement. If you are 70 and rolling CDs at zero, you are hating life. [Imagine how you would feel if you were a Swiss 70 year old who is very close to PAYING interest on his/her bank deposits? ]
So, yes, Mr. Shiller, people don’t feel confident about the future. But it is because the financial asset prices are telling them they can’t fund it…
And it will end badly, but not because asset prices crash. If anything, this is what Boomers are rooting for so they can buy them cheaper! From everything I’ve read and understand there are trillions really upset they missed the bargains of 2008/2009 and desperately hoping it happens again.
Two&Twenty’s view is definitely non-consensus. And although most hedge fund managers would probably laugh in his face, I am extremely sympathetic to his analysis.
All of these bearish hedgies think they are being contrarian by shorting stocks, buying VIX and shorting credit. I contend the truly contrarian trade is to embrace Two&Twenty’s thinking. Given he is so lonely in his call, I tend to think he is the one who has gotten it right…
Yellen is a labour economist?
Janet Yellen is supposedly a labour economist. You would think that would make her especially aware of the intricacies of the labour market. Yet when you listen to her relatively hawkish comments yesterday that dismissed the recent employment report as only one data point, you have to wonder if she has been spending too much time in Colorado.
Yellen’s favourite general employment index, the Labour Market Conditions Index, has been declining for the past year and has recently accelerated to the downside.
What is the LCMI (Labour Market Conditions Index)?
The Federal Reserve Labor Market Conditions Index is calculated as a weighted average based on 19 monthly labor market indicators to gauge improvements in the labor market. The 19 labor market variables used are: the unemployment rate, the labor participation rate, part-time for economic reasons, private payroll employment, government payroll employment, temporary help employment, average weekly hours, average weekly hours of persons at work, the average hourly earnings, the composite help-wanted index, the hiring rate, the transition rate from unemployment to employment, the insured unemployment rate, job losers unemployed less than 5 weeks, the quit rate, job leavers unemployed less than 5 weeks, the Conference Board Survey on job availability, The NFIB Survey on hiring plans and difficulty to fill a job. The Federal Reserve does not report the actual but the seasonally adjusted average monthly change.
It is a good general barometer of the health of the labour market. But it is screaming that this recent economic slowdown is not nearly as benign as Fed officials believe:
I continue to be amazed at Yellen’s inability to see the damage her hawkish rhetoric is having…
Thanks for reading,