This Ends Badly and Abruptly. If Only I Knew When

This Ends Badly and Abruptly. If Only I Knew When
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"On the road from the City of Skepticism, I had to pass through the Valley of Ambiguity."

--Adam Smith

Before starting this missive, I want to touch on the importance of skepticism in a marketplace that is more susceptible than ever to exaggerated moves both on the upside and the downside.

Skepticism is an important historical tool. My commentary and my ongoing market narrative is laced with skepticism.

Large skepticism leads to large understanding. Small skepticism leads to small understanding. And no skepticism leads to no understanding.

With that, why did the markets rally after an unsurprising move by the Federal Reserve?

To begin with, the answer to the question can't be proven by me or anyone else.

We only can make an educated guess.

I believe it was a confluence of three factors (my response is in italics):

No Fed Surprise: As Jim "El Capitan" Cramer expressed, there was no surprise in the Fed's comments and investors are no longer hostage to our monetary authorities. So, with the economy improving, Jim and bullish investors may feel that the Fed did nothing to derail the capital markets yesterday -- that the skies are now all blue and the transition from easing to tightening will be seamless.

As you all know I have a less optimistic outlook for the domestic economy, which the Atlanta Fed, the Federal Reserve (forecast of roughly 2% GDP growth in 2017-2018) and the bond market apparently agree with. 

I think Jim is partially correct that the Fed has removed a market hurdle. But, when we look at the amount of debt that has been created, the market valuations that have been built and the economic growth that has been pulled forward during the last eight years, Jim and others might be giving too much credit that the withdrawal from zero interest rates will be benign. I would arbitrarily attach a 20% causality of the afternoon ramp to "No Fed Surprise."

Players Offsides: Traders and some investors remain "offsides" -- either short or under-invested.

To me, this is a significant reason for the market's post-Fed rip. I would arbitrarily attach a 30% causality of Wednesday's rally to "Players Offsides."

The Role of ETFs and Quants: Systematic investors and funds -- in passive ETFs, CTAs, risk-parity and volatility-trending quant strategies -- are influencing the markets more than any time in history. They are agnostic to price and beholden to price momentum. They believe the concepts of private and/or replacement market value of equities are inconsequential and they lack knowledge and ignore the importance of balance sheets and income statements. Those systematic vehicles and strategies all likely conspired to buy and fed on each other yesterday afternoon, because they base their decisions on price momentum.

To me, as outlined in "Don't Think the Machines Could Turn to Selling? You've Forgotten 1987," this is the primary reason for the market's rally on Wednesday afternoon. But, arguably, the robotic effect of rebalancing and strategies that worship at the altar of price and momentum are producing the impact of increasing risk and creating assymetric reward versus risk. When the trends change, it will likely be abrupt and brutal. I would arbitrarily attach a 50% causality of yesterday's rally to "The Role of ETFs and Quants."

Bottom Line

"The same principles which at first view lead to skepticism, pursued to a certain point, bring men back to common sense."

--George Berkeley

On Wednesday Fed Chairwoman Janet Yellen reminded market participants just how dovish the governors truly are, where the most we will get out of this rate hike cycle is three hikes out of eight meetings this year and in the two years to follow after just one and one in the two prior years. In my view, Yellen mistakenly believes that she somehow can avoid the pain of tightening the slower she goes. Unfortunately, former Fed Chairman Alan Greenspan thought the same thing when he went slowly, relative to his previous hike cycles, in the mid 2000's.

Greenspan's policy ended badly, with the deepest economic contraction since The Great Depression.

By contrast with the bullish consensus, I see the withdrawal from eight years of monetary largesse as not likely being smooth or seamless.

There will be casualties. There are always casualties.

From my perch, we are in a high danger level in which animal spirits are elevating, valuations are expanding, complacency reigns and the yield curve is flattening . The latter is usually a sign of slowing economic growth, not accelerating growth that embodies the consensus view.

A flattening yield curve might be based on the notion that the Trump administration's regulatory and tax reform policy implementation -- and, as I suspect, that the "E" (earnings) in "P/E" (price/earnings) may not be forthcoming. I feel my skepticism may be justified based on the already-rocky road thus far in the president's failed attempt at a "travel ban," and in the problems currently encountered by Trump's attempted repeal and replacement for Obamacare. As well, the president's recent attempt to muddy the waters through the accusation that the former president (Obama) had committed a crime of wiretapping runs a further risk that his other major fiscal policy initiatives could be jeopardized, delayed or diluted.

The tension created by rising financial asset prices, ever higher P/E ratios and a flattening yield curve is growing ever more conspicuous.

This confluence of factors/results is occurring at a time when machines (ETFs, risk-parity and volatility-trending strategies) dominate the investment landscape. Among other things, when the dominant investors are all on the same side, operating with similar algorithms as they "buy higher (and sell lower)" -- while playing against each other and against the markets -- the outcome almost always results in a tripped-up, unexpected aftermath, a "flash crash" or something worse.

This ends badly and abruptly.

If only I knew the timing.

Doug Kass is president of Seabreeze Partners Management Inc. This essay originally appeared at  

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