Jenga. Intentional Instability, Buybacks, Unicorns, and Zombies.

Building a tower with blocks of wood can only go so far. It seems to work well in the beginning but at some point you know that every block you add is just one step closer to creating collapse. You are intentionally making the tower increasingly unstable.

In the same way, central banks interventions are at the point where economic and market function are showing increasing signs of dysfunction and instability.

Many believe this has been going on for some time.

Stanley Drunckenmiller spoke about this on CNBC in 2017.

The longer this goes on, the worse it’s going to be, the sooner they can stop what’s going on … the better.” 

https://www.cnbc.com/2017/12/12/druckenmiller-central-banks-are-financial-worlds-darth-vader-creating-exploding-asset-bubbles.html

It appears Druckenmiller’s statements continue to play out, with market function going increasingly “out of sample”.

http://chrisbelchamber.com/q1-2019-review-out-of-sample-market-experiences-accelerate/,

Since my last week’s blog on “Global Financial Zombification” comes what I believe are remarkable decisions and statements from Nomura’s chief executive, Koji Nagai, on the Japanese fixed income markets. It seems that some of the biggest markets in the world have become zombified.

Last week, Mr Nagai stated that there are macroeconomic “megatrends” that have affected the industry as a whole:

There is no liquidity any more so the market is dead because of the central bank’s monetary policy …. The fixed-income market is dead due to the zero interest rate.

https://www.armstrongeconomics.com/world-news/central-banks/naghi-of-nomura-confirms-japan-destroyed-the-bond-market/

I believe that where markets still have liquidity they appear to have either too much or too little, depending on central bank activity. Even then the correlations that markets used to have with underlying data  increasingly appears broken.


https://twitter.com/LizAnnSonders/status/1121796701117800449

The charts above show that markets are now often moving diametrically opposite from economic data. This shows how little economic data now seems to matter relative to policy induced corporate buybacks.

Reinforcing this point, and what in my opinion is even more bizarre, has been the performance of semiconductors.

The two charts below show that semiconductors stocks have rallied 40% off this years lows to new highs, at the same time as semiconductors revenues have fallen 25% this year to the same level as 2 years ago.

SOXX is 56% higher than 2 years ago on no change in revenue!

http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=soxx


https://wolfstreet.com/2019/04/30/did-someone-turn-off-the-spigot-global-semiconductor-sales-plunge-most-since-the-financial-crisis/

Even the bond market has diverged significantly from US Stocks this year. The bond market sees weaker growth and lower interest rates, but the S&P 500 explodes higher with only one down week in 4 months!

https://twitter.com/biancoresearch/status/1122569980355260416

Intentional Instability

I believe that instability, and out of sample experiences have broken out across markets for a very simple reason, which is that policy is failing to deliver a genuine sustainable recovery.

Buybacks have the effect of boosting the stock market, through the scale of purchases involved and their impact on earnings per share by reducing the share count.  However, this is clearly engineering not economic growth, and to the extent that it creates increasing market distortion or long term economic dysfunction it is really “Intentional Instability”.

Buybacks have created massive distortions to both markets and corporate balance sheets.

The chart below shows that over the last 10 years, corporate net buying has overwhelmed all other investment activity.

https://dailyshotbrief.com/the-daily-shot-brief-april-20th-2019/

This buying is fueled by massive amounts of debt. So much so that, as shown below, earnings are covering interest payments at an even worse level now than during the worst stages of the 2008/9 debacle! Yet, at the same time, high yield credit spreads are still very tight, both in absolute and relative terms.

Another “out of sample” market experience.

https://twitter.com/VrntPerception/status/1116293905450962944

The Federal Reserve’s low interest rates and liquidity management have a primary role in altering BBB credit spreads. BBB credit spreads have a tight relationship with buybacks.

https://twitter.com/TeddyVallee/status/1116028025135685632

I believe that the stock market gains have only been possible through record levels of corporate debt created to finance these buybacks. In addition to deteriorating interest payment coverage, my last blog showed that credit quality has deteriorated very significantly and zombies are proliferating.  

http://chrisbelchamber.com/global-financial-zombification-russell-2000-junk/

In my opinion, this is not a sustainable process as it depends on continued credit quality deterioration.

I believe this is intentional instability in service of engineering higher stock prices.

Unicorns exceed 1999/2000 highs

Another sign of excess liquidity comes from Unicorns, the number of IPOs being issued with negative earnings. It seems that, in addition to corporate debt excess creating zombies, the private equity market is now producing even more negative earnings companies at a record rate.

https://humblestudentofthemarkets.com/2019/03/31/could-a-unicorn-cull-tank-the-us-economy/

Central Banks Repeating Policy Errors

So far across all major developed economies the pattern has been the same. The long term effect of exploding debt has been weaker growth and lower interest rates. The stimulus effects of central banks may work briefly in the short term, but there has never been more “stimulus” before, and yet global growth is at a 10 year low, and global interest rates have never been this low before.

This kind of “stimulus” can’t work without ever lower interest rates, and has contributed to a continued long term decline in global growth.

http://chrisbelchamber.com/q3-2018-quarterly-review-debt-cycles-and-mindset/

In the link below, Dr. Lacy Hunt brings this phenomenon up to date both in the US and globally.

http://www.hoisingtonmgt.com/pdf/HIM2019Q1NP.pdf

Central banks so far show no signs of changing their policy approach. It seems it’s full steam ahead until “The fixed-income market is dead due to the zero interest rate”.

Portfolio Strategy may never have been so difficult and complex as it is right now.

The very long term macroeconomic trends are relentless and negative in terms of long term global economic growth, which reached a 10 year low early this year, shown in my Q1 2019 Review.

No amount of policy “stimulus” since 2008 has been able to generate sustainable global economic growth even with massive support from central bank purchases, record low interest rates, and continued explosive growth in debt.

Economic policy has gradually shifted from being a credible solution to the 2008 crisis, to a temporary makedo that now has to be perpetuated because there are no new ideas.

The US stock market has had a remarkable rally over the last 10 years but it stands alone globally, and it is clear that buybacks alone could account for the entire rally.

Underneath the surface, degenerating function both in markets and the economy is evidenced by the following:.

1. With well over $10 TRILLION of negative interest rate bonds. This is uncharted territory across financial history.

2. Debt growth is challenging its own mathematical limits.

3. Zombie corporations continue to grow in number.

4. Unicorns are at new all time record levels.

5. Natural market function has become compromised.

6. Global growth is at a 10 year low.

7. Earnings coverage for interest payments in the US is at worse levels than at any time during the 2008/09 financial crisis.

8. Corporate credit ratings in the US have continued to deteriorate.

In my opinion, continuing with current policies will only lead to more and more dysfunction.

Don’t play Jenga with your finances

Investors need to very carefully assess not only their portfolios, but also their whole investment philosophy and principles.

The principles I set out last year in the “Investment Mindset Bootcamp” series offer a prudent way to do this.

Investors should review their portfolios to ensure that they are not moving into AVOID and GAMBLE categories.

http://chrisbelchamber.com/investment-mindset-bootcamp-stop-gambling-start-accumulating-long-term-wealth-step-5/

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