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6 Critical Money Making Rules

Credit and Volatility Signal That Financial Conditions Are Very Overheated

Stock-Markets / Financial Markets 2017 May 18, 2017 - 03:11 PM GMT

By: John_Mauldin

Stock-Markets

BY JARED DILLIAN : Around the summer of 2006, when I was at Lehman Brothers, I started bellyaching in my notes to clients about how the market went up every day.

I am a pretty creative guy, so every day I had very colorful (and irreverent) things to say about how stocks went relentlessly higher and how my life sucked.


This went on for a couple of months.

Then, one day I sent out a whining email about stocks and I got back a three-word reply from a hedge fund trader: “Bull market, dude.”

In almost 20 years in the investment business, I think those are the most profound words I have ever heard. There is a lot of wisdom in “bull market, dude”:

  • Stop fighting it.
  • It will turn when it turns, not before.
  • In bull markets, you can only be long or flat, not short.
  • Everyone is making money except for you.
  • Stop being a putz.

Etc.

Incidentally, here is a chart of the S&P 500 around that time—the arrow points to the “bull market, dude” email.

The “bull market, dude” guy ended up top-ticking himself, but it doesn’t mean he wasn’t right.

The Situation Today

We have all the classic warning signs of a big stock market top:

  • Extra-tight credit
  • Extra-low volatility
  • FANG
  • Complacency in general
  • Retail looking smart, pros looking stupid
  • Short rates rising, curve flattening
  • Pain trade is probably lower, not higher

And yet people are mostly ignoring them.

I’m not kidding about credit and vol. The same thing happened pre-financial crisis. Same thing. The VIX dipped below 10 and options were still a sale because realized vol was even lower.

There was nothing to do.

As it turns out, that was a pretty good leading indicator of some major financial stress.

Unpredictable Bear Markets

There are a lot of people who say that you can’t predict bear markets, so you might as well just ride them out and dollar cost average.

Also true—for most people. If you drill teeth for a living, you probably don’t have any business trying to time market cycles.

Perhaps you rely on me for that. Better than nothing.

But it is true that if your time horizon is basically infinite (retirement 40 years away), it doesn’t make a lot of sense to try to avoid a 20% speed bump.

If you’re a professional investor, then you care very much about avoiding (or capitalizing on) bear markets. Problem is, the timing is still impossible.

“Professional” investors have been buying cheap stocks and selling expensive ones for the last four years, and they keep getting carried out, because nobody has that kind of staying power.

You might be right in 2017, but if you were early in 2013, it doesn’t really matter.

All of investing is a push/pull between being early and being right. Smart guys are always early. Very smart guys are always very early. The smartest guys can see stuff years in advance.

And their returns are often the lowest because they shoot before the squad is ready.

Silly Example

Amazon has been a joke since 2012. Unless you think it will someday raise prices, it doesn’t matter if it is the biggest company in the world, it is still a zero. Finance 101—discounting cash flows.

The nature of markets is that sometimes markets care about cash flows in the future, and sometimes markets care about cash flows today.

Do you remember 2001–2002, during the dot-com bust? If the stock in question didn’t have real earnings and pay a real dividend, it was taken out with the trash. And that will happen again.

Stocks and bonds are securities. They give off cash flows.

Currencies aren’t really securities, but they also give off cash flows (these days, sometimes negative).

Stocks, bonds, and currencies are “things.”

Credit and volatility are different. They are not things. They are a force.

Let’s put this in physics terms: If stocks and bonds are matter, then credit and volatility are gravity—the force that holds matter together.

Except gravity is not constant in the universe (or finance). It can vary across time. Right now gravity is very strong. Someday, it may be very weak.

That’s why market experts pay so much attention to credit and volatility to gauge the health of the financial markets. When credit gets rich, people are willing to receive 4.5% coupons on cov-lite pik-toggle deals.

At the top of every cycle, the cov-lite stuff comes out. Remember, “credit” comes from the Latin “credere,” which means trust. There is no shortage of trust going around these days.

The Most Over-Interpreted Market Statistic

It’s volatility (as a measure of the price of options). In general terms, it is a measure of fear or complacency. But it is also driven by other concerns: When interest rates are low, people are incentivized to sell options for income.

You know that the Fed suppresses volatility—well, this is how it happens in practice.

Credit and vol tell us that financial conditions are very overheated.

Do with that information what you wish. It may not be the best time to initiate a new position in a stock like Amazon. It might be a good time to accumulate cash, which gives you the option to buy something cheaper at a later date.

People are always so derisive of cash in the bank. Your money isn’t “doing” anything. Actually, my money is just waiting for a better opportunity.

Grab the Exclusive Special Report, The Return of Inflation: How to Play the Bond Bear Market, from a Former Lehman Brothers Trader

Don’t miss out on this opportunity to cash in on the coming inflation.

Jared Dillian, the former head of Lehman Brothers’ ETF trading desk, reveals why inflationary price increases could be much higher than 1% or 2% and how you can position yourself for big profits as the bond market falls.

Download the special report now. 

John Mauldin Archive

© 2005-2018 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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6 Critical Money Making Rules