Elliot Wave Meets Populist Rebellion

“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

*Our institutional client flatform includes; financial advisors, family offices, RIAs, CTAs, hedge funds, mutual funds, and pension funds.

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The Recurring Highly Improbable

Great Panics and S&P 500 Drawdowns

Lehman Subprime 2008: -57%
Dotcom Crash 2000: -49%
Wuhan Pandemic 2020: -36%
Trade War, Rate Hike Panic 2018: -20%
Grexit Panic, Credit Default 2011: -20%
Oil Crash 2016: -16%
China Currency Deval 2015: -15%

That’s right, over twenty years – seven drawdowns from 15 to 57%. Bear Traps Report data, Bloomberg terminal.

“The only problem with losing 50% of your money? You need a 100% return to get it all back.”

Former Lehman Trader, Larry McCarthy

Passive Investing Victims

Why does the “highly improbable” happen with such predictive regularity? Complacency and hubris have cost investors billions of dollars over the last twenty years. Sure, the “buy and hold” crowd says if you stay invested it’s all good, but the facts tell a very different story. The average daily volume of the SPY SPDR S&P 500 ETF Trust reached nearly 300m shares in late March, close to 5x February levels.  In March 2020, “long term” investors in the largest passive index fund on the planet were selling with both hands and two feet. Keep in mind, there are 916 million shares of the SPY ETF outstanding, so 300m shares a day speaks to a lot of fannies running for the hills. Unfortunately, much like the December 2018 swoon – a large swath of market participants, sadly “puked in the hole.”

“Always remember, human nature is your great enemy near market lows. At your absolute climax of fear, you must do the exact opposite of what you want to do.”

Charlie Munger

Since 2010, with conviction, we have stressed this core belief to our clients globally. “Fine, stay invested with 50%-60% of your equity market allocation, but cash MUST be put to work when stocks go on sale.  This is where the best risk-adjusted returns are found.” It all comes down to buying stocks ahead of the policy response coming from central banks and government officials. In March 2020, we issued more trade alert buy recommendations than any other month in the last decade. As our old friend Seth Klarman likes to say, “buying right, NEVER feels good.”

A Policy Response and the Counter-Trend Rally
In our New York Times bestseller, “A Colossal Failure of Common Sense,” (now published in 12 languages) we made this important point. It rings true, year after year since Lehman’s failure. More often than not, the beast inside the market will provide the ultimate incentive for policy-makers to act. Lehman, a Greece default and the COVID19 pandemic; all violently tightening financial conditions, and literally forced the policy response from bureaucrats, politicians,  and central bankers.  Over the last 15 years, Fed governors have gone from firing bazookas to tactical nuclear weapons. See Mr. Powell’s new toolbox, it makes the 2008-2009 variety look like child’s play. At the same time, politicians have tossed aside austerity, running right into the arms of reckless fiscal spending at any cost. After all “with interest rates so low, it’s free money” they tell us over and over and over, again. MMT (modern monetary theory) is the new magic potion, governments don’t have to find buyers for their bond sales when central banks will finance run-away deficits.

Observation from a Friend

“Daily, we get consistent news about the economic devastation that is inflicted on the global economies together with the continuous and innovative efforts that governments and central banks are doing to do to minimize the impact of this devastation on markets and on people. As always, trying to stabilize markets is always easier, but whether that means that the people will be better off as a result is another issue. ”

See our Q2 Trade ideas here:

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A Fourth Turning, the Elliot Wave and Populism’s Rage – All Converge

We must keep a critical observation in mind. In the same way financial market stress brings upon the fiscal and monetary policy response, it also acts as a possible accelerant when it comes to political inertia surrounding populism.

Debt D-Day in Italy

Italy has a $2.4T debt problem, along with a likely 30% GDP contraction coming in Q2 2020 – the country is insolvent in our view, Greece squared. We know COVID19’s grave economic threat was a policy (fiscal and monetary) catalyst/accelerant. But we MUST ask ourselves, how much does COVID19 accelerate populism’s rage? Decisions that politicians would have had to make over the next 2-3 years are NOW brought forward, dramatically accelerating near term risks in our view.

Heavy NPLs

Total non-performing loans (NPLs) across the largest 123 eurozone banks are still near $530B, by the end of last year. But Greek, Cypriot, Portuguese and Italian banks still have NPL ratios above 6-8% – UGLY.

New Term Debt Maturities – OVERLOADED
With $800B in debt maturities coming due between now and 2024 there are some tough decisions to be made. Germany now owns Italy’s $2.4T debt profile, political leaders just don’t know it yet. The $1.6T stated above is the public debt, there’s another trillion behind the scenes.  The Eurogroup has proposed corona-bonds, but there’s serious pushback in northern Europe (Holland could leave the EU in a near-term showdown). In the south, Italy’s populist sensation Matteo Salvini will use any pushback as a reason to threaten to walk (finance our debt or we exit, take it or leave it – all of this is VERY sterling bullish by the way). Fratelli d’Italia, a party that is further right than Matteo Salvini’s Lega, has reached a new high of 14.5% (up from 4.4% six months ago) in Tecnè’s latest poll.

Political Risk is Drawing Forward Bank Credit Risk
Alert: Italian bank credit risk spiked in recent days, see the five-year credit default swaps – the cost of default protection for UniCredit. See the credit divergence away from Morgan Stanley and Goldman. 

Sovereign Credit Risk – Italy vs. Germany
Italy’s ten-year bond yield spread is pulling away from Germany, spiking wider in recent weeks as populists’ demands surge.

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Beware, the Elliot Wave is Starting to Line Up with Political Risk Trends
After the counter-trend rally, the green line represents the future Elliot Wave trend, this chart from Aleksandar Koprivica. The point 5 target is near 1834, close to 1000 handles below this last week’s high near 2800 (S&P 500). Elliot Wave doubters make a lot of solid points. Stand-alone Elliot Wave signals mean little – but when corroborated with cross-asset class (credit markets, forex, etc..) signals and large shifts in political risk, they mean a lot.

Fourth Turning

In their book, The Fourth Turning, published in 1997, Strauss-Howe proposed a generational theory of history in which societal cycles repeat every 80 to 100 years. The cycle is composed of four generations: the first generation builds (think post-WWII), the second generation is one of cultural awakening (think the ‘60s); the next generation exploits and unravels (think yuppies); and then follows crisis leading to a new order for the fourth generation (think now and the immediate future). After giving several centuries of examples, in the third to last chapter they predicted the rise of a blunt, populist-nationalist given prior precedents. And indeed Mr. Trump was elected president – the nailed it. Their description of the hypothesized leader reads almost exactly like the president of today. As per the theory, we should be heading into a crisis from the ashes of which will rise a new vision of what society is and should be, differing markedly, in our case from the 1950s. They further posit a gray-haired old man prophet who would point the way (Bernie Sanders?). Sure, thanks to some help from Elizabeth Warren’s early exit and a creative DNC (Democratic National Committee), Bernie is history, but this is still a remarkably prescient call. Now, this may fit in with Elliott Wave theory.

S&P 500, a 3400 to 2200 Drawdown – and the 50% Retracement
It is obvious to everyone that the recent sell-off in the S&P 500 from the February highs near 3400, has all the characteristics of a primary impulse wave down. In our view, this is clearly Elliott Wave 1, with a powerful countertrend rally, a 50% retracement on the mark.

Great Counter Trend Rallies in Bear Markets
If we look back at all the great U.S. equity market drawdowns; from 1929, 2008 and 1999 – in each there were massive, counter-trend rallies, some lasting quite a while.

April 2020, the 50% Retracement after the Policy Response

In recent weeks, with conviction we felt a wave two rally to the midpoint of the prior decline (50% retracement) would follow the $6T fiscal and monetary policy response coming from Washington.  Last month in our Bear Traps Report,  we emphasized a follow-on standard a-b-c format of two waves up with a pause in between. This occurred and constitutes wave two. The prior “wave one” decline that bottomed this past March 24, was a classic “shock” decline. The ensuing “wave two” move higher is a classic, follow-on, “hope” rally. The shock was the virus and lockdowns. The hope is based on pandemic following bell curves in South Korea, Italy, and Germany which projects a much more manageable crisis by April end. Not over, but a lot less bad.

We are now approaching Elliott Wave 3-lower, which is the “recognition” phase decline, the “gig is up” sell-off when the mad mob realizes “it is all over”. There follows another wave 4 up or sideways. Then, there’s a final decline wave 5 which is the “exhaustion” decline, in one word; despair.

Uncertainty, about to Take on New Meaning

We are about to enter a period where the largest % of U.S. corporations during an earnings season will withdraw forward guidance. Above all, our functional recognition of unemployment is about to change dramatically – a true secular change. Unemployment will be either double or triple (or maybe more) what it used to be. Governments will have to find ways to fund the spending of former service sector employees. Governments have out-lawed casual consumption and will have to replace that former reality. We estimate, 5-10% of service sector employment will transition into entirely new fields like infrastructure. As you can see, this landscape does not paint a picture of high animal spirits.

Headfake After Headfake – Spring into Summer

The most likely cause for a “recognition” wave three – a substantial move lower – will be the realization that re-starting the economy will be more than difficult. See the second wave of infections (above), expected in the mid-November 2020 to Mid-January 2021 time frame. The recovery process won’t be impossible, but a sentiment killer. The U.S. economy’s multiplier effect desperately needs the defibrillator after a violent sudden stop, that’s NOT happening anytime soon.  Not every U.S. state will open economic activity up simultaneously. As lockdowns partially and intermittently relax, not everyone will return to work. Federal and state unemployment insurance plus the stimulus legislation effectively pay people $22 an hour on a forty-hour week. Many will receive $15 an hour on a 30 to 35 hour week. So they won’t return to the workforce until August. Furthermore, crowded venues will be far less in demand. Over 60% of the U.S. economy is service-based, and much of that will come back very slowly – over 36 months. As the populist threat surges, a certain, $1T plus infrastructure bill will create lots of jobs, but if successful it will trigger mass migration out of urban centers. Society won’t be the same for years, NOT months. So the recovery will be halting and fitful. That is the stuff wave three sell-offs are made of, when everyone recognizes “this ain’t gonna be easy.”

Alternative Count

Now, the problem with Elliott Wave Theory is that it purports to be exact. Sometimes it is. But sometimes it’s fuzzy. It is part and parcel to posit an “Alternate Count” which re-characterizes the prior wave formations.

So in the instant case we have lived through, described above, the Alternate Count would label the March low as the end of wave A, the recent rally wave B, and the upcoming smash will constitute wave C. Under standard practice that would be the end of it and a sustainable bull market would ensue, though again, there are caveats, variations and complications even with the Alternate Count too exhausting to detail for present purposes.

But here is the real point of both the Preferred Count and the Alternate Count: get out of the way. Hall of fame tactician Marty Zweig used to say that he didn’t care if it was a correction or a bear market, he didn’t want to be “long” or “own” either one.

From a tactical point of view, it doesn’t matter if the next decline is wave three of a five-wave formation initiating a secular bear market, or wave C of an a-b-c correction that will be over soon enough and will lead to a new secular bull market in a couple of months. Both are devastating declines leading to significant new lows.

That said, there are reasons to favor the Preferred Count for a long term bear market. One is the Fourth Turning. If indeed we are going through a once in a multi-generational socio-economic transformation, it should be gut-wrenching and time-consuming, fraught with career-ending risks, volatility, and surprise. A quick a-b-c selloff a few months in duration doesn’t fit the bill for such vast and permanent multi-generational socioeconomic transformation.
Furthermore, the Fourth Turning and the Preferred Count in Elliott Wave Theory are mutually reinforcing. If there is to be multi-generational socioeconomic transformation, then the bear market should last years, peppered with mind-blowing rallies along the way.
On the other hand, if the Preferred Count in Elliott Wave Theory is correct, then we are in the early stages of a protracted and devastating bear market symptomatic of a painful, fundamental and permanently transformative mutation in the economy and in society.
The Fourth Turning reinforces the Preferred Count and vice versa.
But that is not all. There is a basic rule in trading: parabolic rises are followed by parabolic declines. Think when the Hunt brothers cornered silver. It shot up to $50 an ounce only to collapse to $5. Think when the dotcom bubble burst. The NASDAQ closed the month of March 2000 at 4572 only to decline to 1172 by the close of September 2002.

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Dow Parabola

Now, if you look at a long term chart of the Dow Industrials, you see a clear parabola. The snap-off of a parabolic top is unsubtle and unmistakable. We are in the decline phase of the parabola.

*In mathematics, a parabola is a plane curve which is mirror-symmetrical and is approximately U-shaped. It fits several other superficially different mathematical descriptions, which can all be proved to define exactly the same curves. 

Dow Jones Industrial Average
During the 2008-2009 drawdown, the Dow Jones Industrial Average broke its 200-week moving average, today this number sits down at 15,229.

Gold, MMT, and Central Banks
In recent years, buying gold miners when they’ve gone on sale has led to exceptional profits. As investors put less trust in central bankers to control asset prices (deflation or inflation), gold comes into high demand. The latest  Fed Balance sheet tally printed on Thursday at $6.08 Trillion, that’s up from $3.85 trillion just 6 months ago. The lesson from the 2008 financial crisis comes down to a Fed not taking their foot off the asset purchases accelerator until the economy is well into an expansionary era. In this environment, precious metals remain HIGHLY attractive. We remain long 1/3 gold miner position, with more significant exposure to silver and copper. We have seen massive and coordinated fiscal/monetary response to this crisis, and one who’s footprint will outlast the current issues plaguing the global economy. The other side of this? The capital to be issued (bond sales), MUST be taken up by respective central banks via substantially increased asset purchase programs. The age of MMT* has arrived, and a lot sooner than most had projected. Pretty much every developed country in their response to COVID19 is going to be engaged in some form of MMT, where government deficits are largely financed by
the central bank. We believe the implications of this are enormous, and the beneficiaries should be commodities and cyclicals especially as the Fed and U.S. Treasury seemed determined to keep a cap on the U.S. dollar. Email tatiana@thebeartrapsreport.com for our latest report.

*Modern Monetary Theory (debt monetization) is a macroeconomic theory and practice that describes the practical uses of fiat currency in a public monopoly from the issuing authority, normally the government’s central bank. Using a central bank to finance bond sales, in other words, a Ponzischeme.

Lessons from Bretton Woods

What happened? What caused the parabola in the first place? A little history…

The US left the gold standard in 1933 to combat the depression. The dollar’s ties to gold were cut, allowing the government to provide monetary liquidity to the financial system, and assisting the Fed in its effort to lower interest rates. But the dollar was still not completely a fiat currency. The U.S. still allowed foreign governments to exchange dollars for gold. In 1971 the Bretton Woods monetary system arrived, the Nixon adminestration put an end to foreign governments from liquidating their dollar holdings into gold, thereby depleting our own gold reserves. If you think about it, that act shows little faith in the fiat currency. The motive should have been to maintain dollars in circulation to maintain a liquidity preference for the dollar. But in fact – it was the spectre of depleted gold reserves that caused the final and full transformation of the U.S. dollar into a fiat currency.

After the dollar went full fiat in 1971, the Industrials traded in a wide sideways range for over a decade. A month-end high was made December, 1972 at 1020, followed by month-end low of 608 on September 1974, in turn followed by a month-end high of 1004 on December 1976, with a final monthly low set end of June 1982 at 812, albeit an intra-month low followed at 780.

But then the market began to truly rally. That summer seasoned veterans were leaving the floor mid-day their faces literally drenched in tears. Unforgettable. Suddenly the Volker interest rate shock was working. Inflation at long last was moderating. And if high interest rates worked, that meant they wouldn’t need to last. Thus began the great bull market in US treasuries that still endures down to the present day.

The resultant improvement in economic conditions and relaxation in monetary policy fueled a super-trend long term bull market that indeed was interrupted by bear markets but went parabolic with Quantitative Easing from the Great Recession. That super-trend long term bull market started in that summer of 1982. That super-trend bull market ended in February 2020. A thirty-eight year run. Remarkable.

The chart on the Industrials shows the foothills of the parabola. When the Industrials first closed over 1200, everyone knew. “This is it!” It was an amazing moment of renewal of optimism and confidence.

True, there was a large sweeping sideways motion from the burst of the dotcom bubble to the end of the Great Recession. Thus were completed the foothills of the ensuing parabola.

From a monthly closing low of 7698.92 on the Industrials, set at March 2009, to the closing all-time high of 29,551 on 2/12/2020, an astonishing run of 21,942 points!

A parabolic decline should retrace roughly 80% of the parabolic rise. It has happened that 100% has been re-traced. An 80% decline would be 17,554 points off the top, for a target of 11,997 in two to five years.

What could cause such a catastrophe? The death of fiat money. Note that in the entire history of civilization, no fiat currency has lasted even 90 years. Ours started in 1933…

The first record of fiat currency is found in the Travels of Marco Polo. He described paper money as “a kind of magic.” The liquidity it provided the Chinese Empire created the incredible wealth in city after city, as detailed in his chronicle, which was intended as a map for trader merchants. Alas, the prosperity didn’t last – deficit spending paid by the printing press collapsed into a debauched currency and unprecedented economic devastation. What ensued? A return to gold as the medium of exchange.

The USA now has a debt to GDP ratio of over 100% for the first time since WWII, which, say what you will, caused more death than the current pandemic.

How long will the economic collapse following the death of fiat money presaged by the end of the parabolic rise of stock prices fueled by Quantitative Easing? Years, thus requiring the Preferred Count in Elliott Wave Theory, thus fulfilling the prophecy of the Fourth Turning.

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Mortgage Market Meltdown 2.0, Implications are Far and Wide

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“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

Destructive Unintended Consequences 

The Federal Reserve’s response to the Coronavirus crisis is having a significant impact on the mortgage industry. Some industry players believe capital losses within the sector could be on par with the 2008 financial crisis. The epicenter of risk is focused on capital requirements (mortgage lenders need to function) and covenants allowing them to do business. Lets us take a look…

One Loud Backfire
From March 2nd to March 19th, the brain-trusts at the Federal Reserve took the Fed Funds target rate from 1.75% to 0.25%. During the financial crisis, they made a similar move but it was over a 3-month period, NOT 17 days. The unintended consequences of Fed policy are more than significant, the yield on the 30-year mortgage soared. Unintended Consequences:  housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.

Three Year Break-Even

Mortgage servicers typically pay 1% of the mortgage loan amount for the privilege of typically earning 0.30% of the loan amount and the responsibility for forwarding the mortgage payments to the loan originator or secondary investor, taking care of insurance, taxes, and records. Thus the break-even for the servicer is a little more than three years.

Black Swan Drawdowns
Countless ETFs in the mortgage sector have crushed investors, large and small alike. Since non-bank financial companies now service most mortgages but don’t have access to the funding window at the Fed like banks do, aren’t these companies in for a massive liquidity shock once people start defaulting on mortgages?

Wipe Out

With the recent overnight collapse in interest rates, these mortgage loans will pre-pay rapidly. Thus the loans the servicers paid for vanish and the servicers see a loss from a wipe-out of their performing loan portfolio. Normally changes in interest rates are gradual enough such that pre-pays are gradually replaced with new mortgages. Not this time!  On the other hand, unemployed mortgagers will default. When that happens, servicers still have to pay the interest to the secondary owner of the mortgage. And most servicers are levered to boot. In sum, the good loans go away, and the bad loans that remain leave no way to pay interest to secondary owners or their lenders. Most banks don’t own the mortgages. They package them up and sell them to ETFs that are bought by retired people. They sell them to pensions and insurance cos. Banks get paid to originate, not to carry them. A holiday would have minimal if any impact on Wall St., but CRUSH servicers.

“The Federal Reserve and its master (Too Big To Fail
Banks) are trying to thin [knock-out] the nonbank servicer
herd through margin calls. As usual Fed economists are too
theoretical to understand markets. Killing one, in crisis
leads to broad failures.” 

Josh Rosner, New York Times Bestselling Author – Reckless Endangerment 

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Be Careful

In recent weeks, there is a meaningful amount of well-intentioned discussion about the suspension of payments (mortgage, car, student loans, etc); keep in mind contract rule of law, protection of private property (creditors) is constitutionally protected – a large reason investors flock to the USA.


Furthermore, the government has granted forbearance of mortgage payments. It is not clear that this is constitutional. Back in the depression, the Frazier-Lemke Act forbade banks from foreclosing on farms. The Supreme Court ruled that law unconstitutional.  The good news is that a Mortgage Services Facility has been created to bridge mortgage servicers through this difficult period. The bad news is that it’s too little, too late.

Many mortgages were already in pre-payment and replacement just as the homeowners became unemployed. The new facility doesn’t contemplate that challenge. Defaults are not deemed collateral and the servicers are left holding the bag.   Additionally, service fees have dropped from 1% to half that. While this means new portfolios may be bought less expensively, the servicers themselves are less creditworthy thus increasing their cost of capital. This loan conduit for the mortgage industry is a shadow of its former self.

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Finally, lenders and servicers alike have hedged their portfolio risk against default by shorting mortgage-backed securities or their derivatives. But the Fed is buying MBS in its new QE program! Thus their portfolios have deteriorated while their hedges have run-up in their faces. The situation is so bad we believe the Fed* is about to reduce the pace of its former announce MBS buying program.  The net result of the above is that the Fed’s actions restrain lending, the exact opposite of what the Fed intended. Whether or not the road to hell is paved with good intentions is a matter for debate. But the road to hell is certainly paved with the corpses of mortgage servicers.


“The Fed bought $21B today and reduced the plan for the week from $40 to $30B, no more short settlement either. There should be a liquidity facility for the originators especially since the regulators caused this problem. They can’t allow the basis to blow back out though.”

Barry Knapp

“NY Fed task force to help servicers being formed and trying to figure out how to support servicers who will have to province timely interest and principal payments to investors from those who cannot pay their mortgages (forbearance).”

“The ramp-up in MBS TBA prices has led to unprecedented levels of margin calls on mortgage originators who use the TBA market to hedge their loan production and eliminate any interest rate risk. The situation became acute Monday leasing the Fed to announce a reduction in their daily MBS purchase: the pace of its MBS buying program. Housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.  TBA prices did end the day lower than Friday’s close after being up 1/2 point in the late morning. Independent mbs issuers are over 500 firms, the entire industry with 2 more days of ramped up MBS would have been insolvent. “

Larry McDonald

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A Wounded Federal Reserve, a Lehman Era Tool Box sits on the Shelf

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“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.

Financial Times, February 20, 2020

In September and October of 2008, the Federal Reserve showed the beast inside the market their body armor.  With a newly minted – creative toolbox, they stood tall and stared down a large group of short-sellers in what was the most prolific “bear raid” since 1929.

In a strong bull market a larger and larger group of participants “buy the dip” taking stocks to places oftentimes they shouldn’t go.  In a ferocious bear, short-sellers pound overnight futures in an effort to shake the confidence of investors. As stops (stop losses) are triggered – a larger and larger collection of long term investors get placed on the sidelines, confidence is lost and some investors won’t return to stocks for years to come.

LQD Investment Grade Bond ETF

Some would say,  global central bank’s multi-trillion-dollar asset purchases in recent years sowed the seeds of this financial crisis. In early 2020, nearly every asset class was dramatically mispriced relative to encroaching risks. Now losses are in the trillions and we’re handing over more power to the enablers? Unfortunately yes, they hold all the cards.



Leveraged Loans and the New Shadow Banks

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Breaking: *N.Y. FED’S 42-DAY REPO OP. OVERSUBSCRIBED; $42.55B OF BIDS – Bloomberg, December 2, 2019


Q: Who’s the Fed financing here? Leveraged loans??? Global hedge funds???

A: Fed financing lev loans: Why wouldn’t they? Easier to soak the ground now than be trying to put out the fire later (credit fund).

Looking Down the Road Ahead

Our 21 Lehman Systemic Risk Indicator Index (LSRII) was developed in 2007. It focuses on tracking the contagion effect and provides good and bad signals in terms of effectiveness with one important finding. Like a reliable caddie in golf, the longer you’re together – the better he / she is. There was a group of revolutionaries who tried to stop the madness at the ill-fated bank, but one by one they were silenced. We explore the legendary lessons below, enjoy.

The Crow’s Nest
We know elephants leave footprints. Looking over the calm seas across markets, from the crow’s nest if a hedge fund manager David Tepper sees something meaningful risk wise, the first thing he does is takes 0.25% of this year’s p/l and deploys it at the cheapest, relative value protection. If David Einhorn joins him, Seth Klarman’s head trader as well, that’s fairly detectable. Of course, we have no idea what hedge funds are leaving the footprints, just using those three veteran investors as an example.

Our Global Bloomberg Client Chat

In daily interaction with over 300 institutional investors globally, our live Bloomberg client chat helps to provide clues throughout the year. From time to time we’ll hear about a large “print” either in HY CDX, S&P Futures, Forex vol futures, Eurodollar futures, etc. We’re attempting to measure the accumulation of hedges. More size, the more encroaching risk.

At Lehman, our team attempted to hedge the $6B ish of leveraged loans the bank got stuck with, so the origin of the idea comes from that painful experience.

Over the years, we have altered the index weightings relative to parts of the world where risk is most concentrated. In 2011, CDS on Eurozone banks (exposure to Greece debt) were an outstanding leading risk indicator for US equities, much the way US banks were in 2007-8.

Today, the index has been much more Asia focused. Italian bank CDS is still a decent Salvini political risk indicator as well. Above all it’s important to note, we’re starting to shift the focus – back on the US.

US high yield, leveraged loans, and CLOs are near $3.2T, add the $2.6T of BBBs, you get nearly $6T of risk assets. In the QT (quantitative tightening) world, the Fed cluelessly over-cooked the goose. They pulled too many dollars out of the system and tightened FCIs (financial conditions) far faster than they were aware of at the time (Q4 2018). The beast inside the market literally broke the Fed over its knee like kindling being thrown into the fireplace. It was a beautiful capitulation.

We MUST keep in mind – during the 2000-2002 credit cycle flame out, over 45% of the investment-grade universe oozed into “high yield” bond territory. Today that’s the equivalent of $1.2T of “fallen angels” (vs. $195B in 2000-2002)  – a flood of junk near unimaginable proportions. It’s no surprise the Fed caved in such embarrassing fashion, they had a large gun pointing at their legacy (head).

Today, they’ve deployed the QE fire hose (term repo + $60B/m tbills) but when the mark-to-market of say $150B (20 or so idiosyncratic events) of HY, CLOs, loans and junk IGs falls quickly, the ability of banks / hedge funds to hold these assets is highly unknown, untested. It doesn’t matter if $5.5T of the risk pool is just fine, come near year-end everyone has to put some cards on the table.

U.S. Credit Risk Rising

In our view, leveraged loan funds and ETFs are the new shadow banks, outstanding debt in this dark corner of Wall St. has surged to nearly  $1.5 trillion in the US. While Collateralized Loan Obligations are the largest buyers (about 50%), leveraged loan mutual funds and ETFs are the second-largest buyers comprising around 30% of the demand. Over the years we’ve learned, there’s a waterfall effect across credit markets. Stress in one pocket often leads to two and three fairly quickly.  Credit spread contagion MUST be meticulously monitored, especially with an accommodative Federal Reserve. After 3 rate cuts and a $400B balance sheet reversal from contraction to expansion – why are we seeing stress on the rise? Let’s explore.

A Federal Reserve, Juicing Leverage on Leverage on Leverage
As you can see above, debt to EBITDA multiples at issuance > 5x have surged dramatically. It’s clear to us, the longer the Federal Reserve doesn’t allow the business cycle to function – clearing out the bad actors – leverage on leverage continues to pile up. Look at 2019 relative to 2007, it’s screaming moral hazard at Mr. Powell. Debt multiples < 4x make-up just 10% of loan sale volumes vs. close to 30% in 2007.

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The Liquidity Mismatch

Our friend Rod Dubitsky points out, leveraged loan funds offer the promise of daily liquidity, yet the underlying asset is fairly illiquid and the time to sell could be lengthy. Leveraged loans could take up to 21 days to settle, while the funds are required to meet redemption requests within 7 days, but in practice are expected to provide liquidity in one or two days. Innovation in financial products and ETFs has incentivized the unsustainable in our view. How can ETFs and mutual funds offer realistic liquidity on financial instruments inherently illiquid?

Cash Flow Coverage Fleeting in US Loan Market

It’s a clear liquidity mismatch in our view, one that takes us back to the mid-2000s.

A Lehman Visionary

It was a morning in June 2005, one we’ll never forget. Michael Gelband, a Lehman Brothers managing director and the firm’s head of global fixed income, gave a presentation to our team of traders about the dark side of the real estate market. The meeting began just after 6:45 a.m. Each attendee was handed a dossier of about 30 pages.

In our 2009 global bestseller –  A Colossal Failure of Common Sense (now published in 12 different languages), there’s an epic scene where Gelband described the stunning proliferation of “no-doc” mortgages and other toxic loans, sold by commission-driven salesmen and then purchased by Lehman and other Wall Street banks.

Steve Jobs once said of Einstein, “talent hits a target no one else can hit, genius hits a target no one else can see”. A true visionary, Mike could see the train wreck a mile away.

“He cited the shadow banks, the vast complex network of mortgage brokers that were not really banks at all but managed somehow to insert themselves into the lending process, making an enormous number of mortgages possible while having to borrow the money themselves to do so. He cited outfits such as Countrywide, New Century, HBOS, and NovaStar, among others, and he accused them of creating well over $1 trillion in economic activity that was comprehensively false money and would never be converted into genuine economic power.”

Gelband predicted that the house of cards could soon collapse — perhaps in 2007 or 2008 — producing serious consequences for the U.S. economy.  After the meeting, Gelband didn’t stop pressing the issue. He used his position on Lehman’s executive committee to try to persuade the firm to pull back from its massive bets on the real estate market.  But warnings from Gelband and others with similar concerns were largely ignored by senior management at Lehman Brothers.

We MUST NOT ignore the current signals coming from the leveraged loan market – they are screaming loud and clear.

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Are funds set up to meet a severe liquidity challenge in a distressed environment? We agree with Rod, “no way Jose”. While there have been redemption spikes (a surge in the number of people wanting their money back) even within the last year or so, they have been fairly brief, shallow and occurred during relatively robust economic times.

Fed’s Fire Hose
In recent years, the Fed has saved the day numerous times. First on ending rate hikes after promising to march on, then on quickly shifting to rate cuts, and finally a colossal capitulation on their beloved balance sheet reductions plans ($2.5T in reduction promises to recent $400B expansion of their balance sheet). There have been runs on leveraged loan funds, but each time the Fed put out the fire with a reversal toward far more accommodation. Even so, with all the Fed love, stresses are NOT going away!

Even after 3 Rate Cuts, a Downgrade Surge
We believe the market is underestimating this liquidity risk should the market face a true, prolonged downdraft. In 2019, defaults in the U.S. leveraged loan space are approaching $30B. In October and November, defaults are nearly $10B, that’s about 40% of last year’s total in JUST two months.

Fitch Problem Loans of Concern Index

November: $112B / 8% of the market
July: $71B / 5% of the market
January: $71B / 5% of the market

*Fitch Leveraged Loan data, defaults spike to the highest level in 2 years, forecast year-end 2020 retail and energy default rates at 8% and 13%, respectively. A five-year-old can tell you the rating agencies are the last to get the joke in any default cycle.  Looking back over the last 70 years, credit cycles are littered with embarrassing flashes of rating agencies playing catch up on defaults. Hence, if the Fitch “problem loan” basket is up to $112B, it’s safe to assume that the number is substantially higher in reality.

Cash vs. Low Quality “B” Holdings

To assess the risk for redemption fails, we looked at two key measures for the top 10 leveraged loan funds (about $60B in total). Specifically, pay attention to the percentage of holdings of Single-B rated and below assets and the percentage of cash held by the fund (cash being a proxy for the ability to meet a spike in redemptions).

Houdini Liquidity, now You See it Now You Don’t
As the chart above shows, most funds have over 60% invested in single-B and lower-rated assets, yet typically have cash positions at just 5% on average. One fund held only 0.32% in cash and yet had over 70% in single-B and below assets. In a prolonged sell-off, the 5% cash would likely prove grossly inadequate in the face of reduced overall market liquidity, lengthening settle times and a spike in redemptions. In a severe downturn, it’s likely that a significant percentage of the loans would be downgraded to CCC, rendering sale much more difficult and all the while prices likely would be collapsing.

Cash Shortfall, Implications

While some funds may supplement cash liquidity with access to a line of credit and/or holdings in more liquid bonds, it’s not clear either of these would be sufficient. Lines-of-credit may not be available when needed and even if they are drawn they may create a senior claim on the remaining assets thereby amplifying risk for those who remain in the funds.

Credit Leads Equities
The Blackstone GSO credit fund is loaded with lower quality (B rated) leveraged loans. It’s interesting with stocks ripping to new highs, B rated loans are under meaningful selling pressure as downgrades mount. If credit is weakening at this pace with a U.S. economy near full employment, what will happen when stresses mount?

Redemption Risk isn’t Theoretical

There is a history both during the financial crisis and more recently of funds having to freeze redemptions due to lack of asset liquidity (most recently the Neil Woodford managed funds in the UK). In fact, in 2015 the Third Avenue Focused leveraged loan fund collapsed amidst a flood of redemptions.

Finally, cascading redemption freezes would likely reverberate through the entire leveraged loan markets including CLOs which would face greater difficulty in trading distressed loans and a deterioration in recoveries.

Rod Dubitsky has over 30 years of experience in the financial services and global development sectors.  Founder of The People’s Economist (TPE).  The bulk of his career had been spent in financial services working for rating agencies, wall street dealers, banks and money managers developing a range of market-leading, award-winning research, and analytical platforms. Frequently quoted in the media including Time Magazine, Forbes, NY Times, WSJ, FT, and Bloomberg.  While working in finance, he was a top-ranked analyst for Credit Suisse in the consumer ABS finance sector and led the newly create advisory analytics division for PIMCO with responsibility for overseeing some of the largest post-financial crisis bailout consulting engagements.

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Dollar and Election 2020, the X-Factor

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US Dollar Carrying Outsized Macro Risk Factors

In our view, just 30 counties will determine the next President of the U.S., memories of 2016 indeed. If you look closely, the U.S. dollar’s labor market sensitivity in these key regions is the most compelling development of all. This unique data offers a “looking glass” into the 2020 election outcome. With our partners at ACG Analytics in Washington, we’re spending a lot of time focused on the most revealing inputs and locations across the United States. Four years ago we made some important discoveries for clients pointing to a Trump upset win. Today, we’re looking to add alpha down a path less traveled. Let’s explore.

What’s the True Price of a Strong Dollar?

Like a loud vacuum, a strong dollar sucks important U.S. manufacturing jobs overseas. Votes in all-important States with the most significant election-outcome influence are on the line. This is a major problem for the White House and it’s receiving substantial attention around the halls of the West Wing we’re told. The higher greenback raises the price tag of U.S. manufactured goods around the world. In response, President Trump desperately wants a softer USD, and he will do just about anything to get it.

Wrecking Ball Policy Divergence
In an attempt to support the Eurozone economy, since 2014 the European Central Bank has expanded its balance sheet by $2.7T and kept its deposit facility rate between -0.20% and -0.50%, suppressing the Euro currency. If there was a score for cheating on the global trade playing field, ECB chair Mario Draghi has a perfect “10”. Over the same time period, the Fed hiked interest rates 9x and reduced its balance sheet by $600B, per Bloomberg (since this clear policy error, the Fed has recently expanded its balance sheet by $200B and cut the Fed funds rate upper bound from 2.50% to 2.00%). This bizarre policy divergence between the Fed and ECB has empowered the global wrecking ball that has become the U.S. dollar. Trump’s bid to stay in the White House hangs in the balance.

U.S. Election Risk and the Dollar

As we look down the road ahead, this factor is forging significant macro-risk. A sharp blade hangs over markets. Day after day, asset managers are asking us more and more questions. “It’s like Argentina on roids. The candidates are just as far apart, but the possible wealth destruction in the United States with an incoming left-wing government – after Trump fueled bull-market is unimaginable”, our Larry McDonald told an audience at a conference in Latin-America last week. Enormous tails indeed. Unlike previous U.S. elections, the risk-dynamics for investors are LARGE given the colossal spread between market-friendly and un-friendly candidates in 2020. We must keep a trained eye on these developments. In our view, U.S. stocks could fall more than 40% if the probability of a – Warren, Sanders, Harris – election win starts to rise meaningfully. Watch the U.S. Dollar, here’s why.

President Trump pulled off a historic 2016 Electoral College upset with a 304 to 227 margin of victory. There are a total of 538 votes in the Electoral College and a candidate must win a simple majority (270) of those votes to win the election.

*Trump garnered 304 electoral votes and Clinton 227, as seven faithless electors, two pledged to Trump and five pledged to Clinton, voted for other persons. – Wiki

The Key States and Key Counties, Electoral Votes

20 PA Pennsylvania*
18 OH Ohio
16 MI Michigan*
10 WI Wisconsin*

*That’s 64 total electoral votes in these all-important States, Trump pulled off an inside straight, winning MI, WI, and PA by just 77,744 votes (per NYT, Wiki data).

Into 2020, the Greenback is Wearing Outsized Risk Factors 
In Q3, the U.S. Dollar’s surge to its October 1st peak of 99.67 (97.28 today) did some serious damage to manufacturing jobs in MI, WI, and PA (see the image below). This places TRUMP in a meaningful risk position, far more than U.S. equities are currently pricing-in. If you do the math, Trump CANNOT win these states in 2020 with a strong dollar. U.S. equities are at grave risk unless the White House / Fed can get the greenback down, and down fast.

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The 2019 Dollar Surge Higher Comes with a HIGH Price for TrumpSimilar to 2015-2016, this year as the dollar soared, U.S. export products to other countries became far more expensive and manufacturing jobs in Michigan, Wisconsin, and Pennsylvania plunged. 

Trump Tweets and the Dollar

In August, Trump tweeted yet another message of worry focused at Federal Reserve Chair Jerome Powell. That included yet another mention of how strong the dollar is, with Trump saying “highest Dollar in US History.” It was the latest entry in Trump’s crusade for a weaker dollar, which he says will give the US a leg up in the ongoing global trade war. He’s continuously lashed out at the Fed and Powell (see October 1, 2019, above) as the reasons for the greenback’s strength.

Important Lessons from 2016
After the 2015-2016 US Dollar surge, manufacturing jobs in the U.S. came under serious pressure. We believe this factor, among others, cost Hillary Clinton the election. Heading into 2020, there are few things Treasury Secretary Steven Mnuchin and of President Donald Trump want more than a weaker Dollar.  It’s probably not too much of a stretch to say that the Dollar’s 2014-2016 surge delivered Michigan, Wisconsin, and Pennsylvania to Trump on the back of undermined manufacturing and exports (see the above image, Dead Zone). The President clearly knows this and it’s part of the reason for his regular tweets and comments lamenting Powell’s interest rate 2018 rate hikes and the strong USD. Stay tuned.

US Labor Force Size, Millions of Americans Employed

October 2019: 164.5m
November 2016: 159.5m

*Seasonally adjusted, US Bureau of Labor Statistics data.

There’s is one very large bright spot for Trump coming out of the labor market. Roughly 5 million more Americans are employed today relative to November 2016.

“Are you better off today than you were four years ago?”

In the final week of the 1980 presidential campaign between Democratic President Jimmy Carter and Republican nominee Ronald Reagan, the two candidates held their only debate. Going into the Oct. 28 event, Carter had managed to turn a dismal summer into a close race for a second term. And then, during the debate, Reagan posed what has become one of the most important campaign questions of all time: “Are you better off today than you were four years ago?” Carter’s answer was a resounding “NO,” and in the final, crucial days of the campaign, his numbers tanked. On Election Day, Reagan won a huge popular vote and electoral victory. The “better off” question has been with us ever since. Its simple common sense makes it a great way to think about elections. And yet the answers are rarely simple.


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The IPO Restricted-Share Unlock Schedule

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This morning WeWork junk bonds touched a 13% yield, earlier this year the brain trusts on Wall St. talked up a possible $60B valuation. Then, SoftBank purchased private shares, completed in connection with a $5B primary investment into WeWork that valued the company at $47B, more than double its previous valuation, according to Pitchbook. Today, the equity is near worthless, oh how quickly sentiment can change.  That’s the problem with leverage – when equity stands behind a colossal pile of debt, it can evaporate far faster than most realize. SoftBank better pull-out the checkbook, $10B of fresh cash is needed. In our view, WeWork has the capacity to issue a little more than $1B in secured debt and $2.56B of unsecured debt. This is substantially less than some of the estimates floating out there regarding potential loan commitments., working with Xtract Research on the numbers. Above all, we must think about the follow-on side effects in today’s equity market. These events are harbingers of things to come in our view. A meaningful re-pricing is in the works.

“If the company is unable to raise new financing before the end of November, the people said it could face something that executives within WeWork never thought was an option just weeks ago: bankruptcy.” – FT

Central Banks Funding Fraud?

We must ask ourselves. After wide-open capital markets, an endless gravy train of nearly free cash, are the side effects in venture capital playing out? How can WeWork eviscerate $50B of equity value in less than six months? What are the follow-on implications? Postmates, Lyft, DoorDash, WeWork, Peloton, Uber, and Casper will lose nearly $15B this year. A near-endless supply of cash is needed to fund many of these businesses. The financial media’s story of the year is WeWork’s implosion. The larger narrative will be found in SoftBank’s Vision Funds impairment – if the market isn’t there for them, they will have to fill the capital hole.

A Wave of Sellers

The restricted shares from the respective IPOs of Zoom Communications (ZM) and Pinterest (PINS) were ‘unlocked’ on Tuesday. Both stocks are lower despite over a 1% rally in the S&P 500. ZM is down -2.6% while PINS is down -4.4%, both are on-track for their largest volume days in months. In our view, this shows across the IPO space, there is a herd of restricted-shares just waiting to sell. See below for the restricted share expiration schedule…

The IPO Unlock Graph

Out of the $31.2B of restricted IPO shares becoming unlocked from now until the end of the year UBER is 71% of the total. ($22B vs. $31B). However, what is very interesting is the amount unlocking relative to the current float…While most unlock packages are smaller than the current float or near a 1:1 ratio, UBER’s is 4x the size! UBER float is currently 195M shares and worth $7.4B. Meanwhile, 764M shares worth $22.3B of UBER are unlocking on November 6th… That means up to 424% of the current float could be for sale.

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WeWork Contagion and a Lyft Benefit:

Given what just happened to WeWork and the performance of LYFT and UBER IPOs, you have to think a large portion of the $22B unlocking wants out… Meanwhile, some clients are thinking this will be a positive for Lyft, as the company was used as a hedge for restricted shareholders…

UBER Currently has a $49B Valuation

The series G funding round was at a $68B valuation in 2016, (FortRoss Ventures, Saudi Arabia’s Public Investment Fund). In August 2018, Toyota Motor Company came in with a $500M investment at a $76B valuation… Last man on the deal team?

Lyft Restricted-Shares Unlock

Notably, Lyft is down -42% since they announced the early unlocking of their restricted shares. Although the increase in float does not directly influence the valuation, it does bring a herd of likely-sellers.

Since August 15th

LYFT -26%
UBER -5%

*IPO Lock-Up Impact… Bloomberg data


Zero Sum Game
Ridesharing companies LYFT, and UBER don’t have a moat in our view. It’s like “Chinese capitalism” (that funnels lots of profits to consumers, thus poor performance in the company’s stock prices). It’s a subsidy of consumers (Uber riders) at the expense of Uber shareholders and Uber Drivers.

IPOs Shelved

Endeavor Group Holdings

In Limbo

Palantir Technologies

Drawdowns from IPO

Lift -53%
Slack -49%
Smile Direct -43%
Uber -36%
Peloton -18%

*Equity valuation drawdown near 80%.

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Madness of Crowds in Bonds

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June 2017

Since early 2017, the European Central Bank has purchased another $1T of assets, blowing their balance sheet up near $5T. Most of this capital has flown into government and corporate bonds with meaningful implication. Let us explore.

Each day that goes by, there are fewer and fewer bonds for investors to buy.  The ugly side effects of this experiment are now oozing through bond markets around planet earth.

It was an all you can eat buffet. Back in 2017 with the ECB distorting global bond prices, Argentina found loads of buyers for an ultra-long dated – 100 year – bond. Today, with this pile of debt approaching 36 cents on the dollar, investors have been left holding the bag to the tune of a $2B loss. That’s nothing, senior secured lenders to Argentina at the IMF are sitting on $56B of capital that has just been lit on fire, while U.S. taxpayers are on the hook for $20B of that loss.

If you sit back and think about the current dynamic playing out in the global bond markets, you see a circular beast eating nearly everything in its path. Central banks have been preventing the cleansing process of the business cycle from functioning by buying assets, near $15T between the Fed, ECB, and BOJ.  The good news is, trillions of dollars in new wealth has been created that needs a home, with the top 1% getting richer by the day.  On the other hand, with fewer choices to buy, bonds with negative yields have climbed from $5T in September to $17T today. Bottom line, investors are being “shoe-horned” into places they just shouldn’t be.

Years Argentina has been in Default


Amazing, with this track record, investors bought $15B of bonds in 2016-2017. This week,  the Macri government in Argentina announced it will postpone paying $7B of short-term local debt for up to six months while pursuing a “voluntary reprofiling” of $50bn of longer-dated debt, the majority of which is owned by foreign investors. The government also said it plans to delay the repayment of loans already disbursed by the IMF. Argentine bonds plummeted to record lows on the news, with the once-popular “century bond” maturing in 2117 plunged near 36 cents on the dollar. The shorter-dated dollar debt coming due in 2021 fell below 50 cents on the dollar, pushing its yield to nearly 60%, per the FT.

A Tale of Two Countries
The double-edged sword of duration is on stage here.  Some investors like ultra-long maturities with low coupons because their prices rise dramatically when their yield falls. In the great race away from negative yields, over the last year, Austria’s long bond has doubled in value, while Silver is 32% higher, and gold up more than 29%.

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Have and Have Nots in U.S. Corporate Bonds
The junk of the junk, why has CCC-rated paper dramatically underperformed while capital is flying into BB credits in the U.S. In the middle of the ‘everything rally’ – one would expect beta-chasing to drive demand for the highest yield, worst rated high bonds. That’s NOT happening. To us, this is an important signal, we’re very close to the ugly credit saturation point. Even with colossal pressure from central banks to reach for yield, rising default risks are keeping investors away from CCCs. What does this mean for U.S. stocks?  Pick up our next report, just click on the link below.

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