“With a cross-asset view (emerging market currencies, eurodollar/Fed funds, gold, and silver); bets on a “one and done” Fed have dramatically outperformed U.S. equities in Q4 and are all pointing to early signs of a softer Fed policy path. Looking down the road ahead, the U.S. equity market will CRASH in 1987 style if the Fed plays tough guy, it’s that simple. Similar to the March 2016 landscape, the market is about to embarrass the Fed yet again. As we have stressed over the last few months, they will capitulate in our view. As we stressed in September, stay long gold GLD and the gold miners GDX.”

Bear Traps Report, November 15, 2018

Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

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Spending nearly $1T on deficit overloading tax cuts, then lighting it on fire with 8 rate hikes (nine since December 2015) and an experimental $430B of Fed balance sheet reduction, will go down as one of the most destructive policy mistakes in the history of the Republic. From 2010-2016,  central bankers enabled run-away corporate borrowing, now credit markets are telling them they’re pulling away from the steroids far too quickly.

More Rate Hikes?
There have been far more rate hikes than meets the eye. As we can see above, financial conditions are already as tight as found during the 2015-2016 oil credit crisis / China currency devaluation equity market sell-off. Back then, the Fed went on (rate hike) hold for 12 months. Fed fund futures are now pricing in just under 10% probability of just one rate hike in 2019. The Fed and U.S. economists are saying 2-3, high yield (credit markets) market saying zero. Who do you believe?

Credit Risk Veto of the Fed Policy Path

Credit markets are freezing up, recently companies have NOT been able to raise capital through the $1.6T US high-yield bond market. The first full month since November 2008 (just after the failure of Lehman) that not a single junk bond has been able to price in December.

Redemption

Junk bond maturities will soar to $110B in 2019 from $36B  in 2018, according to Moody’s Investors Services. And we expect that number to double to near $200B in 2020. For highly-levered companies who must roll their bonds over when the principal payments come due, a sharp rise in borrowing costs will catch them grossly ill-prepared, it’s a death sentence. When Chair Powell tells you the Fed will hike 2-3 times in 2019, he’s being Pollyannish, to say the least. In the real world, credit market functionality runs Fed policy, NOT backward looking U.S. economic data.  If you give us a colossal debt maturity wall vs. a Fed chair, the wall wins EVERY time.

Junk Bond Maturity Wall

2018: $36B
2019: $108B
2020: $191B
2021: $293B
2022: $385B

*Moody’s data, combined leveraged loan and high yield bond maturities. Two to three more rate hikes? Who are they kidding???

Investment Grade Debt Maturity Wall also in the Ugly Category

“In the US, investment grade debt outstanding has grown from $2.3T in 2007 to $6.1T heading into 2019. In the next 3 years, a large load of $1.3T is coming due, which is 3.5x greater than what we faced in 2007. ” With our associate Ed Casey.

*U.S. LOAN FUNDS SEE RECORD $3.53B WEEKLY OUTFLOW: LIPPER

Mr. Powell, are you listening to Leveraged Loans?
Credit spread contagion on stage here, the beast inside the market keeps moving from one victim to the next. Price discovery in the loan market found religion last week. For most of Q4, while investment grade bonds (see LQD above) suffered a bloody nose, secured bank loans were seen as a safe haven – then prices collapsed after the Fed meeting. Leverage is a very dangerous beast, the larger it becomes the more perfection it demands in capital markets functionality (the ability of HIGHLY leveraged companies and countries to sell investors more bonds, debt obligations). Leveraged loan sales in November dropped to $21B, while there was just $5.1B of high-yield bond issuance. That’s the lowest combined volume of speculative-grade debt supply since February 2016, according to LCD, a unit of S&P Global Market Intelligence.  And that was BEFORE the Fed rate hike. December’s new issuance is close to zero, “the betting window is closed, Sir.”

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The True Cost of  Rate Hikes, a Fed Smoking in the Dynamite Shed

The global debt markets – especially US credit – have ballooned in size since the financial crisis. If you think of the reasons behind a rate hike (besides reloading the stimulus quiver), they basically boil down to the Fed’s ability to reprice assets and slow capital formation to stave off inflation. The repricing of assets is first felt in the debt markets. The fact that these markets are now substantially larger than they have ever been (having grown at a double-digit clip in corporate credit and even faster in government-issued bonds), makes the impact of even a modest hike exponentially more powerful than ever before! With this fact in mind, Why are U.S. economists sooooo focused on domestic economic data? Their eyes should be on credit risk. This is a major flaw in our view – in the post-Lehman era credit risk has been driving the Fed policy path bus.

It is not hard to calculate the amount of monetary value being repriced by a mere 25 basis point hike and see that it is far more powerful than ever before. The term duration refers to the percentage of gain or loss in bond prices for a given shift in interest rates, usually 100b basis points. So, for instance, a  pool of bonds with a duration of 2.5 would have about a 2.5% gain in value for a 100 basis point cut in rates and about a 2.5% loss in value for a 100 basis point hike in rates.

Colossal Losses, Impact of Fed Rate Hike in the Market

One of the most popular bond indices, the Barclay’s U.S. Aggregate, has a market value of $20.9 trillion today. This compares to a market value of $8.3 trillion at the time of the last rate hiking cycle kick-off on June 29, 2006. A look around the world is an eye opener; the Barclay’s Global Aggregate has a market value of $46.2 trillion versus $21.9 trillion on June 29, 2006. Some of this is already priced in of course, but the quick and dirty calculation tells you that for the U.S. Agg, a 25bps hike has 2.53x the impact of a 2006 era move and for the Global Agg, the impact is around 2.36x a 2006 era move in terms of the value of immediately repriced assets. This gives the adage “interest rates up, bond prices down” profound new meaning.

Put another way, the amount of losses by global bond investors in percentage terms for a given hike in rates is around 2.5x as powerful as it was the last time the Fed hiked rates over nine years ago. So might 25bps act a bit more like 62.5bps? Over the last few months, credit markets have been screaming this fact, are you listening?

Economic Data Still Strong?We must keep in mind, there are public and private economists who actively try and sell investors on economic modeling and follow-on equity market impact. Well, this crowd has been embarrassed in recent months. In November, ISM Manufacturing PMI came in with a healthy 59 handle. During the 2015-2016 equity market sell-off, she printed down at 48. There was NO warning for U.S. equities here. Bottom line, listen to credit markets, not economists.

Recession in 2019 or Does that Even Matter?

A 2019 recession will be more than an inconvenience for companies who rely on an easy money gravy train, or access to capital markets to stay afloat. Rolling over the debt during an economic downturn is no fun, especially when rates for high-yield paper shoot up, only adding to the pain of keeping debt on their already stretched balance sheets. “What blows my mind are the U.S. economists who are so focused on backward-looking economic data. With leverage this high, you need perfectly functioning capital markets period. Credit markets ALWAYS trump economic forecasting” said Larry McDonald, founder of the Bear Traps Report. Think of it this way, the St. Louis Fed and Goldman Sachs are both calling for 2.5-2.6% Q4 GDP growth, but does that even matter while companies cannot roll-over sky-high piles of debt?

Interest Coverage Ratio High Yield Junk Bonds

2018: 3.20x
2017: 3.50x
2016: 3.80x
2015: 4.50x
2014: 4.70x
2013: 4.75x

Bloomberg data, with leverage like this, there’s little room for error.

Colossal Losses, Impact of Fed Rate Hike in the Market

One of the most popular bond indices, the Barclay’s U.S. Aggregate, has a market value of $20.9 trillion today. This compares to a market value of $8.3 trillion at the time of the Fed rate hiked rates during the last credit cycle on June 29, 2006. A look around the world is an eye opener; the Barclay’s Global Aggregate has a market value of $49.2 trillion versus $21.9 trillion on June 29, 2006. Some of this is already priced in of course, but the quick and dirty calculation tells you that for the U.S. Agg, a 25bps hike has 2.53x the impact of a 2006 era move and for the Global Agg, the impact is around 2.36x a 2006 era move in terms of the value of immediately repriced assets. This gives the adage “interest rates up, bond prices down” profound new meaning.

Put another way, the amount of losses by global bond investors in percentage terms for a given hike in rates is around 2.5x as powerful as it was the last time the Fed hiked rates over nine years ago. So might 25bps act a bit more like 62.5bps? Recent price action in the stock and corporate bond markets are screaming this fact at us today.

Credit Leads Equities
From late October to late November, U.S. equities were flat, but junk bond credit spreads over U.S. Treasuries were nearly 50bps wider, or higher in yield. Credit was telling you, there’s more pain ahead for U.S. equities. Goldman Sachs just shaved its growth forecast for the first half of next year, from 2.50% to 2.00%, once again credit markets have been two steps ahead here. Listen to credit risk, NOT economists.

Unintended Consequences

Junk bond companies trying to refinance their hefty debt load, also have to deal with the tax bill passed through Congress and signed by President Trump a year ago. The new legislation raised the cap on how much an issuer could deduct in interest payments from their profits. As a result, highly levered companies, who no longer qualify for the tax loophole, will have less cash to pay back the interest on their bonds. “Diminished ability of highly leveraged companies to service high-interest costs would worsen their refinancing opportunities,” warned analysts at Moody’s Investors Service.

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“The global political risk surge has dramatically altered the Risk-Reward in U.S. equities. Our focus is on the risk connections across the EU, Germany, Italy, Sweden, China (trade) and the United Kingdom (Brexit). Our analysis of the financial path forward centers around a number of catalysts, and their impact on global markets and central bank promises. Bottom line: Look for stress in emerging markets (trade) and Europe to dramatically alter the Fed’s policy path. To us, 2018 looks a lot more like 2011 (Grexit) or 2015 (China Currency Devaluation) than 2017’s “risk on” (low equity market volatility) party. U.S. equities will move 10-15% lower, the beast inside the market will break the Fed over its knees. Once again, credit risk is about to veto the Fed’s policy path (far fewer rate hikes than the Street expects). “

Bear Traps Report, July 2, 2018 – “Credit Risk Veto”

How does one spot the end of a great bull market and the birth of a bear’s mauling? We can start with the Dow Theory.

The Dow theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation (or absorption) phase, and a distribution phase. Bottom line; it’s a classic indicator of real selling. Just before the genesis of a bear market, the weak hands are flushed out. Fast money investors without deep investing commitments run for the hills first.  In July, we did a solid job for clients in getting them out of the FAANGs (shorts as well), another classic, fast money hang-out. To us, what makes this indicator so important is meticulously measuring signs of real money selling. In many instances historically, the real selling doesn’t begin until there’s a Dow Theory signal. Beware, we may have touched a trigger Friday, just as the Fed continues to pursue their beloved rate hikes.  Pick up our latest report here. 

The Dow Theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from Wall Street Journal editorials written by Charles H. Dow (1851–1902), journalist, founder and first editor of The Wall Street Journal and co-founder of Dow Jones and Company.

Since the Mid-September US Equity Market Highs

Brazil EWZ: +24%
Utilities IDU: +6%
Gold GLD: +4%
China FXI: +3%
Consumer Staples XLP: +2%
US Treasuries TLT: +2%
Emerging Markets EEM: -2%
UK EWU: -10%
Dow Industrials: -10%
S&P 500 SPY: -11%
Italy EWI: -12%
Biotechs IBB: -12%
Germany EWG: -13%
Consumer Discretionary XLY: -14%
Eurozone Financials EUFN: -14%
Dow Transports: -18%
Russell IWM: -19%
Energy XLE: -20%
Retail XRT: -20%
Regional Banks KRE: -24%
Apple AAPL: -27%
Oil USO: -27%

*Deeply embedded in a bear market: Eurozone banks EUFN are 35% off their 2014 highs, German equities EWG are 30% off their January highs, Italian equities EWI are 32% off their 2014 highs, UK equities EWU are 32% off their 2014 highs. US retailers are on course for their biggest quarterly sell-off since the financial crisis. It’s important to note, US economically sensitive sectors (transports, regional banks, home construction, consumer discretionary) dramatically underperforming above. Credit markets are freezing up. This month companies have NOT been able to raise capital through the $1.2tn US high-yield bond market. This would mark, the first full month since November 2008 (just after the failure of Lehman Brothers) that not a single junk bond was able to price.

Dow Theory’s Ambassador

Over the years the Dow Theory had many ambassadors, none more prominent than Richard Russell. He was born in New York, the son of Hortense (Lion) Russell, a novelist, and Henry Harold Russell, a civil engineer. He began publishing a newsletter called the Dow Theory Letters in 1958. The Letters covered his views on the stock market and the precious metal markets.

Ahead of the Trend

Some say the Dow Theory has been ahead of the market for nearly a century. One academic study from the 1990s calculated the theory’s track record over the prior seven decades, back to when it was created in the early part of the last century; the study found that the Dow Theory beat the broader market by an average of 4.6% points a year.

Risk Indicators and Economic Philosophy 

People conflate the Dow Theory sell signal and the philosophy behind it. The overarching idea is that transports fall before industrials because the timing of their business cycles is different. But that isn’t the same as the Dow Theory sell signal. It’s the underlying theory supporting the Dow theory sell signal and buy signal. Dow theory should not be confused with Dow Theory signal.

Trannies Don’t Lie
Dow Theory Triggers: Above you can see three lower lows in the (yellow) Dow Jones Industrial Average, -10.3% off her September highs and two lower lows in the (white) Dow Transportation Average, -18.3% off her September high.

“With a cross-asset view (emerging market currencies, eurodollar/Fed funds, gold, and silver); bets on a “one and done” Fed have dramatically outperformed U.S. equities in Q4 and are all pointing to early signs of a softer Fed policy path. Looking down the road ahead, the U.S. equity market will CRASH in 1987 style if the Fed plays tough guy, it’s that simple. Similar to the March 2016 landscape, the market is about to embarrass the Fed yet again. As we have stressed over the last few months, they will capitulate (call off future rate hikes) in our view.”

Bear Traps Report, November 15, 2018

The Flush to Come

There have been significant tops that Dow Theory sell signals did not catch. So paying attention to the philosophy may prove more important than catching a classic signal.  Market participants need to review the theory at this point, there’s too much on the line. Friday,  we closed right at major support on the industrials. A flush from here would bring colossal real money selling, and confirm the beginning of a new bear market in our view.  What we found particularly troubling about yesterday was that we had good news on China and the market still flopped.

Bullish Signals for US Equities
One important risk indicator we use is the Index of NYSE stocks % above their 200-day moving average. On Friday, she touched 23%. In the Post-Lehman era, this level has only been breached three times; 2011, 2015 and 2016. US equities as measured by the S&P 500 bounced 31%, 16% and 21% in the six months following these HIGH capitulation levels.

Triggered or Not?

Some argue the Dow theory isn’t triggered until the averages (Dow and Dow Transports) go to a new high and the other DOES NOT.  The idea being you have an UNCONFIRMED new high FOLLOWED by CONFIRMED new lows. To our eye that has not happened.

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A Wall St. Legend Leaves Us with Timeless Lessons

Larry McCarthy 1964-2013

We lost a legend five years ago this week.  Over the last two decades, Larry McCarthy was probably the most respected junk bond trader on Wall St., 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). “Colossal Failure of Common Sense” is now published in 12 languages, with over 650,000 copies sold – one of the best-selling business books in the world, a CFA Institute top 20 all-time.

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.”   A year before the U.S. housing market crash, McCarthy placed over $1.5 billion of bets against Countrywide Financial and Beazer Homes, he was a trader with unique market instincts and 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.

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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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Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 3:05pm ET

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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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Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

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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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.