A Wall St. Legend Leaves Us with Timeless Lessons

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A Wall St. Legend Leaves Us with Timeless Lessons

Larry McCarthy 1964-2013

Wall St. lost a legend five years ago this week.  Over the last two decades, Larry McCarthy was probably most respected junk bond trader, a man with fearless resolve.  He was one of a kind and touched so many people in positive ways. The only thing that outshined Larry’s inspiration to others was found in his generosity.

Stories of Larry’s passing have been widely read.  Over the last week, his profile was the most viewed globally across the Bloomberg terminal.  He will be missed by many, the man left a mark.

Authors Patrick Robinson (left), Larry McDonald (right) and Larry McCarthy (middle).

Best known for New York Times #1 Bestseller “Lone Survivor,” Patrick Robinson joined Larry McCarthy and Larry McDonald at speaking events across the U.S. in the summer of 2009.

 

McCarthy’s Legend Lives On

He’s best known as the former Lehman Brothers’ executive who predicted that credit-default-swap traders were “working on bringing down the whole world.”   McCarthy placed over $1.5 billion of bets against Countrywide Financial and Beazer Homes, he was a trader with unique market insticts, true vision.  Before the crash, he wisely left the doomed firm in 2007, and made his fateful declaration to a large audience at his retirement party.   It’s the stuff legends are made of.

 

“The debtors’ conduct, on its face, is suspect.”

Larry McCarthy

 

Classic Lessons

Hidden below, are some classic trading lessons that have more to do with psychology and attitude than anything else, virtues McCarthy mastered.

 As a tribute to Larry, this is an excerpt from the New York Times bestseller “A Colossal Failure of Common Sense.”

It was the Fall of 2005, the one person in all of Lehman Brothers who believed implicitly that analyst Jane Castle was correct, was Larry McCarthy. One of the most fearless traders ever to work on Wall Street, he would hear no word against her assessment of the Delta situation, and indeed had, working in concert with Joe Beggans and I, bought $750 million worth of the airline’s bonds during the company’s bankruptcy. He was keenly aware that it may be months before the price climbed to the levels Jane predicted. But he was sure of our position. And like all true gamblers, he was sure that his luck was running.

As a matter of fact he kept buying all through the next month, whenever an opportunity came up.  In truth, the situation at Delta itself did not really improve. Unrest in the Middle East continued, and the pilots were threatening to strike, which would blow Delta’s normal operations asunder, and cut off their cash-flow, which was, at this stage, their life blood. Larry was, however, adamant.

“It’s what Jane says. Those bonds are worth a lot more than 12 cents on the dollar. They got damn Boeings, hundreds of ‘em, parked all over Georgia.” (A year later the bonds traded at 65.)

It’s difficult to grasp the size of the gamble Larry was involved in, just as it’s difficult to grasp the type of man Larry was – it’s difficult to gauge his astuteness, the speed of his calculations, and the depth of his nerve. You’ll have to take my word for it, there was nothing ordinary about him. Larry McCarthy had stepped straight out of a scene from the Cincinatti Kid.

 

“Are you long because you like it, or do you like it because you’re long?”

Larry McCarthy

 

Hall of Fame Junk Bond Trader

He was world-class at both blackjack and stud poker. He was our very own Lehman Kid, cards or stocks, he had nerves of sprung steel, and a radar for those moments when Lady Luck was with him. He had a nose for victory, and an instinct for trouble. And when he scented the former, there was no shaking him off.

He and I used to go off gambling together. I suppose it was in our blood, and there’s a lot of guys like that on Wall Street, cold and determined with the firm’s cash, but addicted to the chase, calculating the odds, the risk reward ratio. I guess we’re all junkies for the thrill of being right, of winning, always winning.

Summer of 2013

“In trading, the pain and fear you feel is in direct proportion to the size of the opportunity.”

Larry McCarthy

One Unforgettable Night

I’ll tell you just one story about McCarthy, and then you’ll know precisely what manner of man held those Delta bonds. It was around that time in the year, as I said the Fall of 2005, and we had decided to have a couple of days up at Mohegan Sun, the spectacular Indian reservation casino in the deep woods of Connecticut on the banks of the Thames River.

These were days of immense prosperity for the investment banks and we were entertaining some heavy-hitting clients. After dinner at Michael Jordan’s Steakhouse, we headed for the tables for some high-rolling blackjack.

I settled into a modest corner where the stakes were around $50-$100. McCarthy went to $100-$500, a spot he had occupied many, many times before. But by any standards you’d have to say the cards were not running for him. He slogged it out, going head to head with the dealer, but nothing could change his luck. After two hours he’d blown a very large hole in $75,000. An hour later he’d lost $100,000. The dealer was pulling seven-card 21’s, and never busting.

I saw him three times double down on a 10, and then pull a 10; only for the dealer to hit 21 again, and then again. The pressure was relentless. The shocking bad luck apparently endless. But McCarthy never flickered, never stopped smiling, never stopped wisecracking his way through the evening. Never once did he lose his cool, laughing cheerfully with the pit bosses, and the dealers, who knew, to a man, the cards had turned against him, before he even started.

After four hours he had blown out $165,000. Nothing had gone right, nothing had been even reasonable. Lady Luck had sure as hell cashed her Delta bonds. But Larry stayed positive, once handing the cocktail waitress a $500 tip. Finally, I found it impossible, even if he could go on taking this financial bashing. I took him aside and told him, “Come on, Buddy, this is a disaster. I’ve calculated your losses. You’re $165,000 down. Let’s call it a night.”

I’ll never forget his reply. He stared at me hard, and he said, “This is all about positive staying power, old pal.  Most people quit in life when they’re just three feet from the gold. But you got to be there with the big bucks, for the turn. Because it always turns. Remember that. Everyone has good luck. Everyone has bad. Just don’t stampede for the f…ing exit when there’s a minor setback. Because it’s gonna turn. Trust me, it’s gonna turn, and that’s when you want to be there.”

 

“Always take a long look around the table for the sucker – if you can’t find him – it’s probably you.”

Larry McCarthy

 

Table Max

I just shook my head, at the sheer guts of the man. And he told me to call the pit-boss and get another $100,000. He was playing on, and his credit was good.

Both on the trading floor and in the casinos, most guys run for the hills when things aren’t going their way. Bad negative attitudes, whiners and complainers. But not Larry. On the trading floor and at the tables, he was always Captain Cool, waiting patiently, lying in wait for his moment.

He asked us to give him a little room. Then he collected his $100,000 and took over the whole table, all six slots. They roped off the area, except for him and me, and he started with $2,500 on each hand, that’s $15,000 on each round against the dealer. That gave him a very slight advantage, because there was no one else playing, catching the good hand. I watched him win a few, then lose a few. And then, suddenly, the dealer, ‘busted’ two hands in a row for the first time in close to five hours. Larry hauled back $15,000. Then he pulled something which was nothing less than a mind-blower.

He gestured to the pit-boss and requested permission to up the table-max from $5,000 a hand, $30,000 a table. “Let’s get this baby up to $10,000,” he said. “$60,000 a table.”

The pit-boss nodded, and came back with a new sign which read, “Table Max $10,000 a hand.” Larry proceeded to pile on his $1,000 chips, ten of them on all six slots. But the cards were not pretty. His best was a 16, but the dealer’s cards were worse.

There was a six, but when the second card turned, it was the dreaded five, and this meant if she drew a face-card she had 21, and Larry was down another $60,000.

The dealer, still under 17, had to go again. Almost 30 people crammed outside the ropes, watching this fight to the finish, holding their breath. The dealer turned the card. It was a three, which made 14. Larry never blinked. The dealer turned again, an ace, for 15. Larry stared straight ahead. And the dealer turned again, and pulled yet another ace. That was still only 16. This was sensational. But the dealer had to turn again. And it was as if the heartbeat of the entire casino had come to a halt. The pit-bosses had moved in and were standing watch with the crowd. Cocktail waitresses stopped serving, and a kind of telepathy swept around the gaming room. It was as if everyone was aware of the titanic struggle between the casino’s ace dealer, and Larry McCarthy from Wall Street, with $70,000 riding on the turn of a card.

I watched the dealer gasp, and then reach for the ‘shoe,’ selecting the card. For a split second, the hand that covered that card paused, and then spun it over, to reveal the Queen of Spades. Dealer’s bust – 26.

After five hours, Larry’s luck had finally turned, and he leapt at me, tackled both of us right off our stools, into the velvet ropes and on to the floor in front of all the spectators, both of us laughing fit to When we finally climbed back to our feet, Larry just said, “Okay, guys, let’s play some cards.” He swapped the $1,000 orange chips, the ‘pumpkins,’ for the $5,000 ‘Grey Ladies,’ and placed two of them on each spot, a $60,000 hand. And when the cards came up they were devastating – for the dealer. Four blackjacks and two 20’s for Larry ! Against the dealer’s pitiful 17.

In 35 minutes, Larry had come back from the dead to be $25,000 in front. “Remember this,” he said, “You’ve seen for the past four hours the best part of this game, trading and the very best part of life.  When you think things can’t get any worse, they always do, and when they can’t get any better, they always do.”

And what he said was true. I’d watched this man, beaten and beaten, and in the next two hours I watched him ride his luck, all the way back. When we walked out of there, he was $475,000 in front. I saw it with my own eyes. I think for the first time, I finally understood why Larry McCarthy was a full-blooded Legend of Wall Street, and his name would live for a long time.

On the way out, he told me one more truth, as applicable in the market as it had been at the table. “Never blow your powder too early,” he said. “Start nice and slow, nice and low. Get the feel of the market, get centered, make sure you got a ton of ammunition, and don’t quit too early. Never do that. When they’re running against you, keep going, because they’re gonna turn. And in the split-second they make that turn, hit it, buddy, hit it real hard. Because that’s when you’re gonna WIN.”

Larry McDonald is creator and editor of the Bear Traps Report, a weekly independent investment letter focusing on global political and systemic risk with actionable trade ideas. Larry serves as a political policy risk consultant to hedge funds, family offices, asset managers and high net worth investors. Larry was former Head of US Macro Strategy at Societe Generale, and frequent guest contributor on Bloomberg TV, CNBC, Fox Business, and the BBC. Larry is a NY Times bestselling author, his book “Colossal Failure of Common Sense” is now translated into 12 languages. He ran a $500 million proprietary trading book at Lehman Brothers, made over $75 million betting against the subprime mortgage crisis and was consistently one of the most profitable traders in the firm. His “Bear Traps” letter is one of the most highly regarded on Wall St. He’s participated in 3 major financial crisis documentaries: Sony Pictures, Academy Award winning documentary the “Inside Job,” BBC‘s “The Love of Money” and CBC‘s “House of Cards.” He’s delivered over 125 keynote speeches in 17 different countries, at Banks, Investment Firms, Conferences, Law Firms, Insurance Companies and Universities.

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US Nominal GDP, Breakout

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Year over year, US nominal GDP grew at a rate of 5.5% in Q3, the highest rate since Q3 2006. After almost 10 years of anemic GDP growth, the US economy is finally coming out of secular stagnation trap, the 2nd quarter in a row with pre-GFC GDP growth.

Breaking Out of Long Lunge Lower
The U.S. economy is chugging along. Gross domestic product climbed a better-than-expected 3.5 percent in the third quarter on strong consumer and business spending, according to Commerce Department figures released Friday. The annualized rate of gains marks the best back-to-back quarters of growth since 2014.

Moving Out of the Dead Zone
 The GDP picture is loaded with inventory, consumption and government spending, BUT light on investment. The capex (capital spending by companies) boost from tax cuts has been drowned out by tariff / trade headwinds.

  • Strong headline. That 3.5% third-quarter advance was better-than-expected, Bloomberg noted.
  • Robust consumers. They’re two-thirds of the economy, and they’re firing on all cylinders, with a 4% consumption pickup
  • Subdued prices. The core price gauge rose 1.6%
  • Lots of government spending. It increased at a 3.3% rate, adding 0.56 percentage point to growth
  • Savings rate slip. It eased to 6.4% from 6.8%
  • Trade drag. It was the most in three decades.

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The Herd is Running into Consumer Staples, Value Stocks

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A Structural Shift in Equity Markets

Since the financial crisis a decade ago, S&P 500 growth stocks have massively outperformed S&P value and defensive stocks.  Earlier this month something happened that took investors by surprise.

The outperformance of the SGX (S&P 500 Growth Index) vs. the SVX (S&P 500 Value Index) was right near the highest ratio ever recorded. The last time growth outperformed value to this extent was during the dot-com bubble, almost twenty years ago. Then it happened.

S&P Value vs. S&P Growth RatioBefore stocks began to sell-off last week, the ratio of S&P 500 growth vs. value nearly touched its all-time high set during the dot-com bubble. We are confident this structural market shift will continue and are bullish on the value (defensive stocks, consumer staples) vs. growth rotation.

Defensive Names Laying a Beating on Growth

With a plunge in global equities, this ratio has begun a powerful reversal.  We continue to see repeated signs of value and defensive outperformance, we believe this a structural shift and expect a continuation of capital inflows.

On October 24, the S&P 500 was beaten down -3.03%. Yet the QQQ, which is filled with high growth technology stocks, plummeted significantly further and closed off nearly 5%. Equities across the globe saw investors flee. Where did they go?  Capital had to flow somewhere, today the XLP consumer staples ETF closed higher by 42 basis points and was at one point 1.8% higher during intraday trading.

Consumer Staples Select Sector SPDR XLP  ETF vs. SPY S&P 500 ETFA significant divergence began between the S&P 500 and staple equities this week. Capital has to flow somewhere.

We believe a comeback in defensive stocks is just beginning and this is an area we have been overweight in positioning.

In mid-September our Larry McDonald gave the keynote speech at asset management conference in Toronto, speaking about this dynamic. Make sure to review our Toronto Presentation slides, here.

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The Last Straw

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Stocks Down, Bonds Down

Something occurred in markets this week that’s been very hard to find over the last twenty years. It was the last straw and triggered an avalanche of selling. Our awareness MUST be high around positive correlation, let’s explore.

QQQ Nasdaq Historic Volume
Just five FANG (Apple 13%, Amazon 11%, Microsoft 10%, Alphabet 9%, and Facebook 5%) stocks make up 48% of the QQQ ETF. We witnessed record capitulation volume on Thursday, an 11% draw-down in just six trading days, that’s nearly $700B wiped out across 605 ETFs and funds.

Recent Drawdowns and Rotation

Facebook -31%
Netflix -25%
FANG Index -20%
Amazon -17%
Google -17%
Banks XLF -14%
Russell 2000 IWM -13%*
Dow Transportation -11%
Nasdaq 100 NDX -11%
US Treasury Bonds -11%****
Apple -9%
S&P 500 -8%
US Investment Grade Corporate Bonds LQD -9%*****
Oil USO -8%
DJIA -7%
Staples XLP -6%**
Gold Miners GDX +14%***

*Now flat since Nov 2017
**Up 7% since early May
***Last 35 days
****iShares 20+ Year Treasury Bond ETF, Dec 15 to Oct 8 drawdown
*****iShares iBoxx Investment Grade Corporate Bond ETF

A Shift from Negative to Positive Correlation in Stocks and Bonds
In the past 3 years, there have only been 14 trading days (including today) in which the S&P 500 (SPY) was lower more than 1% and U.S bonds (TLT) were also lower on the day.  Keep in mind, eight of these 14 occurrences took place in 2018 alone.  Today, stocks are bonds are wearing a very rare positive correlation. Above, see the negative correlation period (stocks DOWN vs. bonds UP) in red and the positive correlation period (stocks DOWN vs. bonds DOWN) in green. This is one of the MOST important blogs you’ll read this month.

At the beginning of the year, we explored this dynamic in our report, “Paradigm Shift in Rates

“We believe inflation is set to finally pick up in 2018. Much of the passive and quant-side to asset management has become heavily invested in the “risk parity” model which involves being long equities and bonds on a risk-adjusted basis. One of the fundamental problems with this strategy is you’re effectively really long disinflation. Sure, it has worked very well in the post great financial crisis period, but it’s a grossly crowded trade and has all the makings of a gruesome slaughterhouse. So in this case, the risk tail is a period where equities and bonds fall together, which is not that uncommon in a late cycle inflationary environment. Other than out of the money puts in rates (or the *ProShares UltraShort 20+ Year Treasury TBT – we are long with a 2/3 position), a big way for these guys to hedge inflation is to increase commodity exposure. Given the current market structure, the only commodity market really big enough to absorb that colossal bid is oil. This is not to say all the big money longs have this in mind, but it could make an extended long position in the oil patch more durable than usual. As long-time
bulls, we’re now ‘pounding the table’ bond bears for 2018.”

Bear Traps Report, January 2, 2018

Stocks and Bonds, Friends No More

The stock market crash wiped out $7.2T in shareholder wealth in 2008, but bonds delivered investors a $2.9T profit cushion, that’s NOT the case today. Here are five Things You Need to Know about Positive Correlation.

Today, your standard 60/40 portfolio (60% stocks vs. 40% bonds) isn’t hedging any risk. Why? Rising domestic yields (in the USA) continue to pressure equity valuations. We must always remember, a company’s future cash flows are discounted by higher bond yields. Just look at the Nasdaq, it’s off nearly 11% this month with HIGHER bond yields.

Regime Change: S&P 500 Total Number of Days with 3%+ Losses

2018: 3
2017: 0
2016: 0
2015: 2
2014: 0
2013: 0
2012: 0
2011: 7
2010: 5
2009: 13

Bloomberg data. Clearly, we’re in a new volatility regime today. In 2018, emerging markets, bonds, currency/forex and US equities have all scored a substantial surge in vol.

Investment Grade Corporate Bond Yield Surge
In a classic side effect of global tightening in monetary policy, investment-grade bonds dramatically underperformed earlier in the year while equities largely ignored this early warning. As an asset class, investment grade US corporate bonds are far more sensitive to global (tightening) financial conditions. US equities finally woke up to these risks this week.

US Investment-Grade Bond Market, % BBB Rated

2018: 49%
2000s: 34%
1990s: 26%

*Today, there’s a colossal $2.5T of US corporate debt rated borderline Junk at BBB. That’s 3x levels seen a decade ago! We’re looking down the barrel of the mother of all default cycles. Bloomberg, Morgan Stanley data.

Correlation between Stocks and Bonds

2018: +0.16%*
2017: -0.51%
2016: -0.65%
2015: -0.73%
2014: -0.74%
2013: -0.82%
2012: -0.85%
2011: -0.84%
2010: -0.76%
2009: -0.45%
2008: -0.51%

*This is the first monthly positive correlation in a decade. We’ve witnessed nearly $2T in bond losses globally over the last 60 days, and now stocks are joining the plunge.

Rude Awakening

Across the country today, wealth managers are faced with a RUDE awakening. Clients are on the phone asking why their statements are in the red with stocks and bonds down together. For much of the last twenty years when stocks have sold off significantly, bonds have been the saving grace – not this time.

Number of Times, Stocks (S&P 500) have been Down and with U.S. 10 year bond Yields HIGHER (Bonds Down)

3 Weeks in A Row

2010-2018: 1
2000s: 3
1990s: 3
1980s: 19
1970s: 24

4 Weeks in A Row

1990-2018: 1
1980s: 4
1970s: 8

Deutsche Bank data

We must keep in mind that stocks and bonds were positively correlated for much of the 70’s, 80’s, and 90’s. In other words, in equity market drawdowns, bonds DID NOT offset the wealth destruction. Today, investors have become far too complacent around their assumptions that bonds will bail out stocks at all times, THIS IS NOT THE CASE. 

Regime Change

In a regime change, a period where stocks and bonds move lower together, the flight of assets out of passive bond / risk parity strategies will be ferocious.  Click here to get a peek at our winners in this new regime.

VIX Spikes above Twenty vs. US 10 Year Bond Yield

Oct 2018: 3.21%
Mar 2018: 2.76%
Feb 2018: 2.81%
Nov 2016: 2.29%
Jun 2016: 1.37%
Feb 2016: 1.68%
Sep 2015: 1.97%
Jan 2015: 1.67%
Oct 2014: 1.90%
Jan 2014: 2.57%
Oct 2013: 2.50%

Bloomberg data

Stocks Down, Bonds Down
Think of the dentist in Cleveland, Ohio with $1M in stocks and $1M in bonds in a portfolio.  For the first time in 30 years, he / she is looking at their brokerage statement and seeing NO wealth destruction OFFSET from bonds.   We have an eye on credit quality globally (AAA rated corporates / sovereign credits are off 30-40% in terms of the amount of high-quality paper last 10 years).  Next, shift your eyes on the debt to GDP in the G20, up from 70% to near 100% (maybe 110%). Then look at the EM dollar-denominated debt issued 2007-2017, in the trillions, there’s a new player at the table trying to sell / refinance a large debt load. All this speaks to a regime change, we’re in the 1-2 inning we believe, more to come.

Largest US Equity Market Wealth Destruction

2008: -$10.5T
2015: -$4.5T
2011: -$3.7T
2018: -$3.2T**
2010: -$2.4T

*Last 10 years, Bloomberg US Market Capitalization data.
**only instance in the last 18 years where bonds also lost value. In the 2018 equity drawdown, bond SOLD OFF from 2.05% to 2.85%, ADDING nearly $1.4T of ADDITIONAL wealth destruction. This occured in the month of February and we show it as an example as the wealth destruction that occurs when stocks and bonds move down together.

 

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Too Much Love

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Looking back over the last decade, stocks have only been this much loved four times.  After the last dance with extreme euphoria in January, stocks lost 11.3% from January 26th to February 12th.

Likewise, just before 2015-2016’s 14% equity market drawdown, investors were feeling so confident looking out into the future. Today, our sentiment indicators are screaming red. Over the last decade, those buying into market panics and selling euphoria were handsomely rewarded. Pick up our latest report here.

Cash as a % of Client Assets, Brokerage Accounts vs.  S&P 500

2018: 10.3% vs. 2913
2017: 11.7% vs. 2511
2016: 14.1% vs. 1810
2015: 12.3% vs. 2120
2014: 13.5% vs. 1975
2013: 14.9% vs. 1555
2012: 18.2% vs. 1292
2011: 19.1% vs. 1322
2010: 23.3% vs. 1031
2009: 25.4% vs. 667
2008: 12.5%  vs. 969
2007: 10.3%  vs. 1546

Charles Schwab, Bloomberg

Another classic sign of hubris oozing through investor confidence is found in small cash holders. As more late coming join the party, cash stockpiles come down substantially.

KBW Regional Bank Index in Correction
As the Fed continues their quest for higher rates, something happened on the way to the next rate hike. – regional bank shares entered a “correction” this week. The BKX Index above is 10.6% off it’s January highs and flat since late November. BB&T Corp, M&T Bank, and PNC Financial topped out in late-February and are now under “death cross” formations.

Builders and Rates
With mortgage rates at 84-month highs, the ITB iShares U.S. Home Construction ETF is 24% off its highs, in a deep bear market. At the same time, global oil prices have surged from $26 to $80 a barrel since 2016. Oil’s plunge created a massive $1.8T or 2.2% of global GDP income transfer between oil consumers and oil producers between 2014 and 2016, NOW that’s being reversed with major implications. Consumers globally are dealing with higher bond yields, higher oil prices and in many cases MUCH weaker local currencies in emerging markets. The global consumption DRAG is something we have NOT seen since at least 2008.

China PMI Drag, Tariff Impact
The trade war impact on China’s economy is now coming into focus. The official and Caixin manufacturing PMIs both are in plunge mode, missing expectations in September. The latter falling to 50 — the threshold separating improving and deteriorating conditions, Bloomberg reported. The declines were broad-based across major components. Most notably, new export orders registered sharp drops, signaling the crunch from U.S. tariffs on $50 billion in Chinese goods over July and August, followed by another $200 billion in late September. The non-manufacturing sector was among a few bright spots.  The private survey showed growth in the factory sector stalled after 15 months of expansion, with export orders falling the fastest in over two years, while an official survey confirmed a further manufacturing weakening. Taken together, the business activity gauges – the first major readings on China’s economy for September – confirm consensus views that the world’s second-largest economy is continuing to cool, which is likely to prompt Chinese policymakers to roll out more growth-support measures in coming months.

 

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Ten Years after the Crisis, Here’s a Look at What’s Around the Corner

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Here’s our interview with the Swiss business newspaper Finanz und Wirtschaft. 

Larry McDonald, Editor of the Bear Traps Report, predicts a full-blown crisis in the emerging markets and outlines why this also could offer some promising opportunities for investors. Keep in mind, McDonald is NO perma-Bear, The Bear Traps Report with Larry McDonald; Capitulation Climax in Energy – August 18, 2017-2.

See the latest on The Bear Traps Report with Larry McDonald; Late Cycle Mojo in Energy – March 28, 2018_4

His book has been published in 12 languages, over 650,000 copies sold.

Pressure on emerging markets has been rising for months. For the past decade, a river of easy money rushed into developing countries. Now, that trend is reversing. Rising interest rates and trade wars are creating havoc. The Turkish lira and the Argentine peso have crashed. China’s stock market is stuck in a bear market. For Larry McDonald, that’s only the beginning of a full-blown crisis. The renowned editor of the macro research platform Bear Traps Report knows what he’s talking about. As a former distressed bond trader at Lehman Brothers, he experienced the emergence of the 2008/09 financial crisis at the center of the storm. Now, his biggest concerns revolve around the massive debt binge which took place in the emerging markets. He warns that mega-cap tech stocks like Apple, Amazon and Google will be the most vulnerable when the crisis spreads to the financial markets of the developed world.

Mr. McDonald, as a former bond trader at Lehman Brothers you were one of the early voices (profits of over $120m) warning of the subprime mortgage crisis. Where do you spot the most dangerous risks in the financial markets today?

China on Steroids Now Facing Tariffs
In our view, the new subprime risk is found in the emerging market’s embedded leverage. There is a lot of concern about emerging markets debt, especially about the amount of Dollar denominated debt. For instance, the Chinese banking system is $44 trillion in size. That’s almost three times the US banking system and the Chinese economy is already weakening. Total global debt (sovereign, corporate and household) has surged by nearly 75% since Lehman’s failure ten years ago, per the McKinsey Global Institute. The great enablers, Central Banks have blood on their hands in my view.

Tariffs and Leverage

Since Lehman, government debt in China is 73% higher to near $40 trillion, with corporate debt and shadow leverage surging 65% to $75 trillion, per BofA above. We’re at the point where, if China keeps growing at 6-8% per year, that growth has to come from somewhere. G8 developed market countries (like the US) have finally figured out they’re holding the bag, they want that growth back. So, you have a highly leveraged situation where you’re putting tariffs on. I don’t think the Trump administration is aware of how dangerous this is. When you pull cash flows (tariff impact) from a highly leveraged entity, bad things happen.

China Manufacturing Leverage Panic

Manufacturing is under substantial stress. After a multi-year rally, plunging revenue and sharply declining profit growth led to a poor showing in the latest Beige Book in China. Manufacturing’s deteriorating sentiment has taken place before any meaningful American tariffs have been imposed. Without a trade deal, this situation will likely get worse. The pace of borrowing is near 42% percent of firms, that’s the highest since 2012. It sure smells a lot like panic indeed.  China fiscal and monetary stimulus is on the way, but so far we have NOT seen it in the data.

Why is this situation so dangerous?
It’s not just China. It’s Turkey, it’s India’s banking system*, it’s Brazil, it’s all these countries which have issued so much debt.  Since Lehman, there are trillions and trillions of new Dollar and Euro denominated debt issued globally and now it’s starting to come into a massive default cycle. Ten years after Lehman’s failure, global debt levels have surged from $170 trillion to $250 trillion, per BofA. At the end of the day, the Federal Reserve and the European Central Bank are going to get the blame because they have been far too accommodative. In the U.S., corporate credit quality is in the worst shape.

India Credit Risk on the Rise
*India’s banking system’s overhang of (near $400B in our view) bad loans is another full-blown crisis that stymies growth and shows no signs of an early resolution.

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What could trigger this wave of defaults?

The Dollar plays a key part. It’s like a global wrecking ball: when the Dollar moves up and emerging markets currencies drop their interest costs are exponentially more difficult to pay off. In the case of Turkey, the currency is down around 40% against the Dollar this year. So, if you’re a Turkish company and the interest payment was 1 million Dollars per quarter you are looking now at a payment of 1.4 million Dollars per quarter.

Emerging Markets, Taking a Beating

There has NEVER been this much capital hiding out in the USA.

Global Surge in Bond Yields in 2018

Turkey: 11.59% to 20.30% +871
Russia: 7.73% to 8.71% +117
Italy: 1.74% to 2.83% +112
India: 7.16% to 8.08% +92
Brazil: 10.94% to 11.78% +84
China: 3.44% to 3.69% +35
Canada: 2.09% to 2.43% +34
US: 2.80% to 3.06% +26
Germany: 0.30% to 0.46% +16

Move in basis points, Bloomberg terminal data

How dangerous is this for the global financial system?

When we talk about financial conditions we’re talking about the tightness of credit and the speed of the tightening of credit. Right now, financial conditions globally are tightening at the fastest pace since 2015 when we had the Chinese currency devaluation. At the Bear Traps Report, we also measure currency volatility and credit default spreads on emerging market banks versus US banks. In this area, we’re looking for divergences. Our Index of 21 Lehman Systemic Risk Indicators is rising at the fastest pace since 2011. For example, during a healthy “risk on” period, when everybody is taking risk, you typically don’t see divergences in credit quality globally. In contrast to that, in a market that’s about to turn “risk off” many times you see dramatic credit divergences ahead of it. Right now, the credit quality of European and Asian banks is substantially weakening relative to US banks, NOT a good sign at all.

Yield: Bonds vs. Stocks, Far More Competitive

US 10 year Treasury vs. S&P 500 Dividend

2018: +1.30%*
2016: -0.84%**

*Fresh seven-year high yield advantage for bonds, Bloomberg data
**July 1st 2016, post-Brexit rush into bonds

As bond yields rise, future cash flows thrown off by FAANGs are far less attractive. During the February bond yield surge, FAANGs dropped 12-14%.

What does this mean for investors?

Today, everybody in the US is hiding out in FAANG stocks like Facebook (FB), Apple, Amazon, Netflix (NFLX), Google and Microsoft (MSFT). That’s really concerning because there are more than six hundred ETFs which own 8 stocks – far too much wealth is concentrated in just a handful of stocks. The thinking is that the FAANGs are a safe investment because the US has decoupled from the rest of the world. But what’s happening is that the more money goes into passive investments the more these FAANG stocks get pumped up. For instance, think about the QQQ ETF which is based on the Nasdaq 100 Index. If a billion Dollars goes into the QQQ ETF than close to 400 million Dollars MUST BE squeezed into the FAANGs. That’s insane.

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Why?

Ten years ago, we were lectured again and again that the emerging markets had decoupled from the US and that our money was safe in emerging markets. That’s because as opposed to the developed markets like the United States, the so-called BRIC countries Brazil, Russia, India and China were growing at 8 or 9%. So, they were considered to be safe places to invest. The thinking was that their growth is so powerful that even if the US goes into recession the global economy is going to be OK. Literally, every single TV program, magazine, and newspaper were preaching this garbage.

But as a matter of fact, economic growth in the emerging markets was quite impressive over the last decade.

True, but the EEM iShares MSCI Emerging Markets ETF lost 60% of its value from 2008-2009. It’s ironic that today, basically the exact same story is being pitched to investors again. But now, the U.S. is the safe place and has “decoupled” from the rest of the world. So, there is safety in these FAANG stocks, the story goes. But that’s complete garbage. All these ETFs are a bit like shadow banks. They are like the CDOs on the eve of the financial crisis. There are so many people in them that there is not going to be enough liquidity when things turn bad. We saw this when Facebook dropped $122 billion in one day. That has never happened before. No one stock has EVER wiped out that much wealth in one day, not even during the financial crisis, not even during the dotcom era.  Our models point to this event as a large tremor BEFORE the quake.

How bad is it going to get?
We are going to see this across all the FAANG stocks. It’s going to get really ugly and it’s probably going to happen in the next six to nine months. It’s going to be close to a 20% drawdown for the entire US stock market. But the FAANGs, these crowded stocks, are going to drop 30 to 40%.

The last big stock market crash in the US happened ten years ago. What goes through your mind when you think back at the failure of Lehman Brothers?

Thanks to central bankers around the world, asset prices in the U.S. are pumped up on steroid levels. People blame Wall Street for the financial crisis of 2008. That’s fine. But the largest misconception has to do with the central banks. The Lehman senior management team never ever would have taken that much risk if the Federal Reserve was aggressively raising rates. In 1994, the Fed pre-emotively raised rates 50bps (0.50%). A surprise move like this might have prevented much of the aggressive risk-taking that brought Lehman down.  Central bankers have put us in such a bad place and now they have done the same thing again. If you look around the world, overall there is around $45 trillion of new debt* that wasn’t on the planet ten years ago (thanks to central bankers).

*tradeable debt in the public markets NOT private, Bloomberg Barclays Credit Agg data.

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What exactly happened at Lehman in the time leading up to the financial crisis?

I remember being on the trading floor in 2006 and 2007 and they were telling us, “take more risks, take more risks.” So, I was asking one of the senior guys, “why are they telling us to take more risks?” He said, “the Fed had kept interest rates super low for almost three years and then raised rates very slowly with too much visibility going forward.” This was the reason why the Lehman managers were going around and giving us orders to take more risk. They were doing it because the Fed had laid out an obnoxiously transparent policy path. But here’s the key: There is a beast in the market and in capitalism in general. So, the Fed gave the capitalist beast far too much visibility on monetary policy. In other words, when monetary policy is so visible it creates more risk-taking. And that’s happening again today. The central banks have created a dynamic where if things are starting to soften they are trying to contain the risk (see February 2016). But each time all they’re accomplishing is a build up of more risk.

How did the fall of Lehman Brothers change Wall Street?

There were so many bad apples on Wall Street at that time, but Lehman gets a crazy amount of the blame. Other banks were even more screwed up. For instance, Citi and Merrill Lynch were a total disaster, their bad assets were 6x Lehman’s. So, the most important change is that the major banks are much less leveraged today. Also, there are more people working at hedge funds, mutual funds and other asset management firms than there are people working at banks. This means there has been a transfer of talent from the banks over to money management firms.

Where do you spot the biggest risks in the global financial system in case of another crisis?

A lot of banks are exposed globally to this emerging market debt. Deutsche Bank (DB) could go down, but they had like ten years to prepare for this. So, it’s probably going to be financial institutions in Asia, Australia, and Canada which will get into trouble. But it’s not going to be one big Lehman situation. It’s going to be much more of a spread-out globally.

Junk Bond Orgy is Long in the Tooth
The Great Risk Transfer: Over the last ten years, all the risk has been transferred from the large US investment banks like Lehman, over to corporate (companies, BBBs above) and sovereign (government) balance sheets.

US  – Near Junk Rated – Corporate Bond Debt Binge

2018: $3.1T
2008: $0.5T

Ice Data, Bloomberg

Maturity Wall Beware
While the White House is playing games with tariffs and the global economy, $1.3 trillion of US corporate debt is coming due in the next two years. McDonald HAS NEVER seen a maturity wall of redemptions of this colossal magnitude.

How come?

Over the last hundred years inside financial markets, we’ve found in each crisis there’s a transformation into another serpent, a far different beast. In the 1970’s it was runaway commodity prices, a real energy crisis. In the 1980’s, it was Savings and Loans. The 1990’s brought us a currency crisis in Mexico, sovereign credit defaults (Russia) and the dot-com blow up. By 2008, a full-blown subprime mortgage crisis was upon us. At that time, the small banks were fine, but the big banks got into trouble. So, each financial crisis is followed by a metamorphosis into another beast and the next crisis is going to look much more like the one in 1998. It’s not going to look like anything like 2008.

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What could this mean for a global financial hub like Switzerland?
Right now, the most leveraged organization on earth might be the Swiss National Bank. They own all these FAANG stocks and it’s really concerning because the people of Switzerland are going to lose a lot of money when this crowded trade blows up. Just look at how much of that central bank’s money is in equities. It’s obscene. They don’t understand. In the last five years, $2 trillion has gone into passive asset management and there’s an untested liquidity mechanism when people head for the exits. A lot of that money has to go into the FAANGs. So, the Swiss National Bank has made a lot of money because of this passive revolution. They probably think they’re really smart. But they’re just benefiting from this move here in the United States where so much money has gone into passive strategies. Now, the Swiss National Bank is sitting on all these profits and they are going to look like complete imbeciles when the FAANGs blow up.

 

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Wage Pressures Driving North – Fed Tied in a Box

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The US economy took on more jobs than expected in August, and wage growth touched a post-recession high.  Nonfarm payrolls grew by 201,000 in August. Economists surveyed by Reuters expected a 191,000 increase.

Fed Impact?

The question remains, with emerging markets in flames  (currency volatility at ten-year highs), what does this do the policy path of the Federal Reserve?  More rate hikes and a stronger US dollar will only add fuel to the emerging market’s fire (EM equities are 20-40% off this year’s highs, they’re in flames).  Our investment thesis is laid out in our most recent note, join us here.

US Midterm Election Impact?

Ahead of the 2016 election, wages moderated lower in key swing States, but they’ve averaged nearly 2.8% in 2018, up from 2.4% the prior 3 years. The Atlanta Fed, which tracks the same workers over time, reported a 3.3% annual gain in wage growth in July.  We MUST connect the DOTS here.  What’s the impact of rising wages on the U.S. midterm elections in November?

First Midterm Election, Seats Won+ or Lost- in the House

2010 Obama: -63*
1994 Clinton: -54*
1982 Reagan: -27
1978 Carter: -15
1990 Bush: -8
1962 Kennedy: -4
2002 Bush W: +8
1972 Nixon: +12

*Lost control of the House Wikipedia.  We can talk about Russians and family separation all day long, but we MUST weigh the impact of surging wage growth.

Wage Pressures Driving North
Average hourly earnings jumped by 2.9 percent, above the 2.7 percent increase expected.  The unemployment rate held near a generational low of 3.9 percent.  The wage growth was the highest since April 2009.

Out of the Deadzone

Long-awaited wage growth posted its biggest increase of the economic recovery in August while payroll gains beat expectations and the unemployment rate held near a generational low of 3.9 percent, according to a Bureau of Labor Statistics report Friday.

Fiscal Stimulus in the USA Ends 15 Year Down Trend in Nominal GDP, now up at +5.4% Growth
Average hourly earnings rose 2.9 percent for the month on an annualized basis, while nonfarm payrolls grew by 201,000. Economists surveyed by Reuters had been expecting earnings to rise 2.7 percent, payrolls to increase by 191,000 and the jobless level to decline one-tenth of a point to 3.8 percent.

Working with CNBC.

 

 

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