Author: Mark Dow

US – From anemic to sluggish to solid

US cycle will be protracted and moderate. Disaster myopia from the Great Recession lingers and its shadow over real-economy risk taking will be slow to fade. Structural issues too will keep growth throttled back.

The chance of recession—even in the face of external shocks—will be low until the real economy is investing, taking more risk.

It’s hard to be strategically bearish US stocks until the output gap is at a minimum closed. Bear markets typically come when cycles turn.

The spectacular oil drop causes dislocations up front, but has a long-tailed payoff if it stays below 75.

Rate scares might trigger corrections and echo taper tantrums, but won’t derail the growth trajectory.

Long-end rates will go higher when the Fed starts to let its book run off, probably late next year. The economy will be in a position to handle it when it happens.

If the yield curve inverts along the way, it may scare some, but it would be technical and transitory, not a sign of impending slowdown/recession.

Fear of stronger dollar is overblown, given closed nature of US economy. But it will weigh on sentiment and to some degree earnings.

Housing will continue to disappoint, as the epicenter of a bubble is always last to work off the excesses. Also, lots of institutional investors saddled with inventory are looking for an exit strategy.

There may be pockets of financial exhuberance but I am not worried about broad-based excesses bringing down the economy for the foreseeable future. Too many people still too fearful of the systemic risk scenario to get the “All Aboard” sentiment necessary for that degree of risk taking.

And too many people ascribe too much of the markets performance over the past few years to the Fed. This keeps many worried and has been a huge positive.

However, there will eventually be financial excesses that do damage. That’s the nature of markets in a financially globalized world. But the real economy underneath has to be vulnerable to that kind of feedback loop, and the froth in the real economy and SIFIs is not yet on the horizon.

Europe – That which is not sustainable will not be sustained

Europe can’t grow. And the hurdle to overcome demography, technological substitution and globalization is high. In the meantime, internal devaluation uber alles.

ECB QE won’t be able to turn the growth dial. QE has lost much of its shock value, sentiment is in a more neutral place relative to when US QE was rolled out, yields in EU are already low, EU banks are still clogged (and EU finance is bank-centric). I don’t even think EU sovereign QE will boost markets much. We have already seen the man behind the curtain.

I do not think structural reforms—desirable though they most certainly are—can be enough even in the abstract to return peripheral countries to the level of productivity necessary to resolve the lack of competitiveness. In practice, of course, far less in the way of structural reforms will be attempted, much less achieved.

A weaker euro won’t help much either; the imbalances are inside the EU. Externally, it is a closed economy, one that mostly exports products whose demand is fairly price inelastic (if you’re buying on price and not quality, you’d already be buying from somewhere else).

This implies that the euro will continue to depreciate, and if it is to make a meaningful contribution to EU GDP, it will have to depreciate a lot, perhaps even below the levels we saw back in 2002. It bears recalling that the trade-weighted euro has depreciated far less than EURUSD.

In the absence of growth, the centrifugal political forces that were set in motion by the crisis will only gain momentum. I expect this to be a drawn out process, but it is what will ultimately lead to a reconfiguration of membership in the single currency.

The timing in my mind is very uncertain. And this is a problem for me. Every time I see a bout of instability in Europe I will ask myself is this THE moment. This will make it hard to hold onto investment positions, because when the man bobbing in the ocean finally goes down for good, you will want to be light on risk.

Emerging Markets – Muddling through, no crisis

The fantastic 10-year run in EM started to unwind in 2012. I expect this has further to go while EM digests the rapid domestic credit expansion that drove its growth phase.

I do not expect a return to the EM crises of yesteryear, even though there may be a country or two that gets itself into policy trouble managing the transition. Unless social unrest breaks out in China (very low probability), I think the far superior initial conditions with which EM countries entered this down cycle will keep systemic EM crisis off the table.

To attract capital back into the EM asset class on a sustainable basis you will need a story with some combination of three things:

• Weakening dollar,
• Low/falling US rates, and
• A compelling growth differential story to convince investors to take that extra risk associated with EM allocations.

We are not there on any of these points—even though there may be a temptation to take a stab at EM in the beginning of the New Year, as the cumulative underperformance there has been enough to attract some mean reverters.

Commodities – Stay away

Very much like EM, commodities had a supercycle run that ended in 2012. With the prospect of rising rates in the US and a strengthening dollar, it’s hard to see when its fortunes might change.

The bottom line is that portfolio demand for commodity allocations will continue to retreat. Investors chase performance in reverse as well. Pension funds will cut back or get out, and commodity funds and specialty products will continue to unwind. Commodity investors just started in 2014 getting used to the notion that the wind is no longer at their backs.

Soft commodities have faster supply responses, so, they may well do fine. But hard commodities and especially precious metals should continue to go lower in dollar terms.

Oil is a bit of a special case, if for no other reason than it has already fallen far and fast. It could well bounce. But the weaker portfolio demand for commodities and the technological substitution that will likely threaten oil long term make a sustained bounce a serious uphill endeavor.

Of course there will be many things that surprise us over the course of the year ahead. And we will have to adjust to them as they develop, but these are the grandes lignes as they appear to me on the eve of the New Year.

Mark

Bologna, Italy

December 23rd 2014

I need to say something about precious metals. I’ve been a vocal bear on them since 2011. Those who’ve subjected themselves to my blog—or worse, my Twitter account—know that. The reasons were gently laid out in a 2012 post. Less gently in subsequent ones.

The bottom line is that a pre-crisis boom in commodities lifted gold and silver—even with Fed funds at 5%. Post-crisis monetary policy then turbo-charged it, as people feared rapid inflation, renewed systemic crisis, a dollar crash, and bond vigilantes. Macro tourists lined up to pile in. Big name guys wearing money halos. ETFs and electronic futures trading for the masses poured the gasoline.

In short, they built a bubble. A bubble replete with charlatans hawking it on every medium. Just look at the chart of silver over the past 10 years.

The irony of the precious metals bubble is that it was the guys yelling ‘bubble’, bubbles of every stripe–bond, stock, credit—who sought refuge in the only asset class that was truly in a bubble. In other words, the fear of bubbles created its own bubble, trapping the bubblers. Karma really is running over dogma.

Why did the bubble pop? People progressively suspected there was a recovery, inflation wasn’t materializing, and a dollar wasn’t really going anywhere. Then, when prices started to fall, the real sellers came out. QE3 couldn’t even stop it. This was the first leg of the bubble unwind, roughly late 2012-June 2013.

Since then we’ve been consolidating, with successive bounces of lower amplitude, each time finding footing between 1200-1250. This is what technicians call a descending triangle. Odds massively favor descending triangles resolving themselves to the downside.

Last week my senses started tingling that the second leg of the bubble unwind that I’ve long awaited was on. These calls are always difficult. But I’ve been emboldened by two things. One, the price action after those tingles tended to confirm my suspicions. Second, I read the post today about RIA flows by Josh Brown over at the Reformed Broker. He said the reports showed the largest inflows last week were into gold.

Into gold? How is that bearish? First, as Josh tweeted “Flows follow price action, they don’t lead it”. Second, when the price action is bad in the face of significant inflows, it is historically a very, very bad sign.

In April 2013 I had been short gold and was vocal about it. A mutual fund executive who is a friend of mine, and with whom I regularly discuss markets and economics, said to me, “Just be careful, Mark, with your gold short. The industry is seeing meaningful inflows there.” Of course, we know what happened the following week. I don’t want to draw too tight a parallel on anything that anecdotal, but the similarity to the info in Josh’s post did jump out at me.

Now, I’m not competent enough to tell you how far down this descending triangle “measures to”. I will leave that to the expert TAs. But I do know we closed on Friday below the previous 1200 floor and on big volume.

One has to be humble when dealing with markets, but you do have to take positions. And when you do you want to take them when you think odds are overwhelmingly in your favor–Like, right here, right now.

This is supported by the fundamental side. There, we’re seeing that almost all the elements of the framework laid out in early 2012 are working against gold. If I were very bearish bonds (I’m only moderately bearish), the framework would be firing on all cylinders. In short, it looks like this: CB QE has lost its psychological punch, emerging markets have tepid income growth, the dollar is trending stronger, and USD rates can only be a headwind.

When I’m asked how far do I think gold can ultimately fall, my answer is I don’t know. I can only guess. The guess I’ve been working with is—as a minimum–a return to pre-crisis levels, based on the notion that the post-crisis investment theses have pretty much all turned out to have been wrong. (And, for the record, the statute of limitations on ‘not wrong, just early’ ran out a long time ago. By the time this is over only Peter Schiff, Zerohedge and Jim Grant will be waving their arms.)

On this basis a pre-crisis level would come out at somewhere around 700-750. Of course, bubble unwinds do overshoot, often by a lot. But the 700 area seems to me a reasonable, even conservative expectation, if the broader thesis is right.

Here’s a chart of the asset formerly known as gold. For fun, try flipping it upside-down and imagining it were a stock. Then ask yourself if you would buy it.

 

Yeah, me too.

Markets are hard. One of the main reasons they’re hard is because it’s in our nature to overthink. We’re tempted to believe deep thought is our value added, how we justify our fees. It’s also how we impress clients.

But market reality is usually far simpler. Investors chase returns. We fall for stories. We’re masters of belated overreaction. And we have a hard time sticking to a game plan in the face of the huge emotional swings that come with managing other peoples’ money. For these reasons (inter alia), trends tend to be more powerful and go much further than would seem reasonable.

It took me years to curb my impulse to fight trends. The temptation to engage in counter trend trades can be overwhelming, especially if performance is lagging and/or a trend is new or not well established. But it’s rarely worth it. It’s especially not worth fighting something that looks like it might be a new trend.

I don’t know for sure if the rise in short-end Treasury yields or the breakdown in metals constitutes a new trend. All I know is the odds are massively against you if you try and go against it.

Below is a graph of the 2 year Treasury yield. Note that unlike the long end where all the Fed buying has been taking place, the front end has been creeping higher since the Taper Tantrum of May 2013.

The 5 year Treasury yield shows a more interesting pattern: it looks like it just broke higher after a long period of consolidation. Yes, if in the short term we get more risk aversion this yield would likely tread water or pull back. But this chart tells us that the odds favor higher yields. And soon. I’m not one who fears a pernicious rise in inflation as the cycle strengthens, and I also think many market participants have mentally anchored on equilibrium levels for both policy rates and Treasury yields that are too high. But, all this notwithstanding, this is still a train I wouldn’t dare stand in front of.

The 5 year Treasury real yield tells an even more powerful story. It shot up in the Taper Tantrum and when sideways until a few weeks ago. It tells us yields are going up, and not because of inflation fears.

Then we have the metals. When we see a sustained fall in metal prices, most people think “weak global growth”. We systematically read too much about economic fundamentals into commodity price moves. Again, we overthink. The market has made this mistake time and time again. Instead, my first thought is financial liquidation/deleveraging, because financial operators have come to dominate commercial hedgers over the past 15 years.

Specifically these days, I think about Chinese financial liquidation. We know there was a boom in China. We know there was a boom in commodities. And we know Chinese entities were stockpiling commodities and in many cases pledging them as collateral. They are now unwinding. They are not alone, but they’re the most salient example.

My fundamental view is that commodities got overhyped and over loved over the 2004-2011 period and we’re going through a long period of mean reversion. Initially, the hype was based on emerging market economies plugging into the grid and consultants convincing slower money that it was its own asset class and a great diversifier. The second phase of the ramp came from misunderstanding QE.

Now, however, we’re in the down cycle. We saw the first leg of the great commodity unwind and the second one may be upon us. The first shakeout was mostly tourist dollars getting shaken out of the gold tree. Many of the investors who bought gold as protection against QE-induced inflation were forced out over 2011-2013, as it became clear they got it wrong. The second phase, will come as higher real rates drive the wooden stake the rest of the way through, shaking out the long term money, the asset allocators and the true believers. And based on the charts above, if this is not happening now, it is likely to happen very soon.

The charts below, to my mind, confirm what the charts above were suggesting. I know short term positioning is more supportive of metals, and sentiment is more bearish than bullish, but look at the charts below. If an experienced market participant were to flip these charts upside down and imagine they were stocks, I’d be hard pressed to think they wouldn’t want to do some two-fisted buying. Whatever the short term may bring, you do NOT want to step in front of the break down train.

Here’s copper:

Gold doesn’t look any better:

And silver looks to be the worst of the bunch, have arguably already broken down:

Again, there’s a chance that this is a big head fake and not a new trend. But managing money is about pressing your bets when the odds are in your favor—either the odds of being right or the odds of an asymmetric payoff, or, in a dream sequence, both. And right now—whatever the ultimate outcome—being long bonds and long metals doesn’t meet that criterion. Simple money management only gives you two choices here: be short, or get the hell out of the way.

Here’s the link to the full interview with Yahoo Finance on the ECB, the euro, and the US bond market.

Hedge funds are chopped and flat. Real money managers are more worried about getting caught out in a downdraft than missing an upside breakout. Risk positioning is light. The decline is bond yields is more about bad positioning and a shortage of AAA assets than it is about the bond market “knowing something”.

But the vulnerabilities are also there: markets have had a big run, economic fundamentals are still tepid and falling on the short side of expectations. Implied volatilities are low. Market internals are bad. Bottom line: It will take a growth breakout into escape velocity or something like it to get a resumption of the rally, or, more serious disappointment to get the washout that so many are already expecting. Unsatisfactory though this is, the right move is to be patient. The bull market is not over, but it’s not a smart time to press your bets. The longer we twist in this limbo, the more attractive the upside will become. Time heals. Keep your strategic positions and hedge out market beta as best you can. Sometimes you have to keep your bat on your shoulder—something guys collecting two percent management fees have a hard time doing.

Happy Mother’s Day.

Peter Schiff and Mark Dow do battle on gold

Peter Schiff and Mark Dow disagree on the long-term outlook for gold, but that’s not the only thing they take opposite sides on. In a passionate and charged debate on Thursday’s episode of ” Futures Now,” Schiff and Dow presented divergent views on the Fed, government data and inflation.

I guess I should have posted this interview on Gold and Silver back on December 12th when it aired. I get a lot of questions on my views, and I had been meaning to write a piece. But, because I never got around to it, my views are reflected in this interview, and it is turning out to have been more or less right, I was reminded by this tweet from Rich Ilczyszyn that I should’ve posted the video. Plus, I love their headline.

$SI_F $SILVER making moves https://t.co/trRknK41zU

— Rich Ilczyszyn (@iiTRADER) February 17, 2014

Here’s the vid:

Gold bear Mark Dow turns bullish

Gold drops on the day. Is it due for a bounceback? Has the market become too bearish, with Mark Dow, Behavioral Macro Blog, CNBC’s Jackie DeAngelis and the Futures Now Traders.

For me the EM switch flipped in 2012. We’d had inflows and bull markets for 12 years–well before QE. Now, the outflows come. Doesn’t matter what the trigger was. It’s on. It was just a matter of time.

The path, the tricky part, will be in fits and starts. Valuations won’t matter until we can tell a compelling growth story, and too many EM countries have to work through all the domestic debt they built up during the boom. Currency spasms and deleveraging raise the risk of policy errors in certain cases. EM fixed income is most vulnerable because outflows haven’t really even started there. And it would be worse if I were really bearish Treasuries, which I’m not. 

People will overstate how bad fundamentals are as price action worsens. Tourists (crossover investors), who are in control of the flows, will mostly revert to old school EM biases, even though many things, fundamentally, are different (better) this time. Gone is the fixed FX regime and the original sin. Domestic EM financial markets are deeper. Reserves are higher. But don’t try and fight the Old School and their anachronistic biases. They are bigger than you are.

Broadcast live streaming video on Ustream

Covering in this interview with FXStreet a lot of the latest macro developments–and there are a few important ones, with the recent evolution in the cyclical/secular growth debate in the US being at the top of the list.

I need to start off by saying I am a big fan of Robert Shiller’s. “Irrational Exuberance” and “Animal Spirits” were excellent books, pointing out so many of our cognitive shortcomings in all things financial. And “Irrational Exuberance”, which was strongly recommended to me by David Lipton in March of 2000, about a month before the peak of the Tech Bubble, probably saved me a good deal of money as well. Moreover, these books came at times when the reigning ideology was ‘the freer the market the better’. Shiller was certainly swimming upstream by driving home the point that markets fail. The growing relevance of behavioral finance owes a lot to his work.

At the same time we have Robert Shiller, financial evangelist. He has long been a font of ideas on how financial education and innovation might make our lives better. And this brings us to the problem: How can a man who believes human nature is magnetically drawn to stories over facts, momentum over mean reversion, believe, for example, that encouraging the average person to hedge his/her home value in a futures market will not likely, at some point, end badly? If markets do fail, and if the frequency of market failure seems to be positively correlated to financial innovation, why would anyone want to give people even more weapons with which to hurt themselves?

This at its core is really a version of the very same problem Alan Greenspan had some years back. On the one hand, Greenspan asserted that financial innovation in general and derivatives in particular would be used to dampen market risk, not increase, because banks’ were profit maximizers, and their incentives meant we could trust them to self-regulate. And we know how that turned out. On the other, however, his book “The Age of Turbulence” explained various market crises under his watch by pointing out that the psychology of crowds, when under pressure, cannot be counted on to do the rational thing. Often, he argued, this negative psychology was self-reinforcing and there was little one could do to stop it.

It is conceivable that Shiller is at some level just being naïve, and that he believes with sufficient education we can overcome our animal spirits. Personally, I think it is a bridge too far, and Robert Shiller, like Greenspan, by advocating democratization of financial innovation while arguing that human nature is hard wired to make bad decisions, has succumbed to his own little version of cognitive dissonance.