Global Macro Notes: S&P 400? The Deflation Shock Scenario

June 2, 2011
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Stock market bulls were rocked by global slowdown fears this week.

But for a true bearish wake-up call, consider this — stock market historian Russell Napier thinks the “real bear market in the S&P is yet to come,” and that the ultimate target could be S&P 400. As in, roughly 70% off current levels.

Napier is not a crank. You can catch his reasoning in this Financial Times video interview. Albert Edwards of SocGen also has an S&P 400 target (as noted by ZeroHedge).

As Mercenaries, we don’t put much faith in long-range forecasts. Our preference is to ignore the predictors. And as far as market moves go, we feel it is wiser to remember that even the earthquake itself does not know how big it will be.

With that said, though, we are VERY strong proponents of probabilistic assessments and credible market scenarios. If there are smart guys who think the stock market could fall by 70%, we want to know why — not so we can back a “prediction,” but so we can understand the economic drivers that could lead to an “extreme bear” scenario as one of multiple possible outcomes.

So what is the encapsulated case for a scenario in which the stock market winds up much, much lower — as much as 70% lower?

Perhaps something like this:

  • The forward strides in the global economy are revealed to be the byproduct of a “sugar high” — a temporary phenomenon, born of massive stimulus from the U.S., China et al.
  • Speculative excesses built up through central bank reflation efforts lead to another ‘supernova debt collapse’ — the painful aftermath of an unproductive debt boom. (Revisit our explanation of the inflationary boom-bust cycle for more understanding on this.)
  • With a perception that “Quantitative Easing” has failed as the global economy contracts, a great fear takes hold that “QE3, QE4, QE5″ etcetera won’t work either. The Fed is revealed to be “pushing on a string,” in the classic sense of the Keynesian liquidity trap.
  • Stagflationary side effects of stimulus — $100-plus oil, out-of-control food and raw materials costs etc. — take hold, even as growth stalls.
  • Goldilocks turns vicious as the magic juice becomes poison.
  • Alternatively, if oil does not hold $100 but instead falls through the floor on speculative unwind, “portfolio contagion” ravages risk assets of all stripes as overexposed managers bail assets over the side in the face of a near-term commodity bust.
  • Corporate profits, boosted by aggressive cost-cutting and temporary stimulus tailwinds, come off their peaks as inflation erodes profit margins (and/or slowdown curtails spending). The top 30% of U.S. consumers, once supportive of the global recovery, pull in their horns and snap their wallets shut.
  • China implodes, for ponzi reasons well documented (Chanos, Hendry et al). The euro zone runs out of rope with which to hang itself. Frantic reflation efforts (QE3, 4 etc.) merely boost the price of haven assets.
  • Investors suddenly remember that the Business Week “Death of Equities” cover in 1979 was predicated on corporate profits being killed by inflation, which, in too big a dose, is lethal for stocks — and then recall that deflation, the outcome if all stimulative measures fail, is just as fearsome.
  • Mix in mass margin calls and the withdrawal of speculative leverage, an aggressive outflow of capital from equity markets as funds get hit with a sea of redemptions, and season all to taste with an utter and complete collapse of faith in the competence of monetary fiscal authorities. Voila — S&P 70% off.

Or, to summarize even more tightly:

If the global recovery thus far has mainly been the product of artificial stimulus… and if we have passed a ‘tipping point’ where further stimulus from the Fed, China etc. merely contributes to destructive inflation pressures, while ‘pushing on a string’ in respect to underlying economic drivers… then a scenario arises where the Federal Reserve is truly “out of bullets,” and stocks become vulnerable to massive multiple contraction, or even a crash, as corporate profits erode via (1) margin compression and (2) reduced private spending.

Are we predicting the above will happen? Certainly not. We are traders, not predictors. As such, we always reserve the right to change our minds — or adjust our worldview — at any point in time.

But the point is, the scenario is far from implausible. It could actually happen.

Furthermore, we shouldn’t get hung up on a doomsday outcome like S&P 400. A drop to, say, S&P 1,000 would be plenty hellacious for those unprepared (and plenty sweet for bears).

Listen to the Bond Market

So now we have a rough blueprint for a possible scenario — a failed stimulus / global slowdown / deflation shock scenario — in which profit margins and multiples massively contract, in a sort of reverse Goldilocks feedback loop, as the global economy withers and central banks push on a string. Deflation is not dead, the fear of it is alive and well, and a deflationary shock could (at least temporarily) crush risk assets to powder.

So how do we assess the odds of a scenario like this playing out? What should we pay attention to?

Well, one thing to watch is the bond market.

And with yields on the 10-year falling below 3 percent for the first time in six months, the bond market is saying, “DUDE — DEFLATION.”

An irony regarding bonds — in an early march GMN we wondered aloud, “Did PIMCO Mark a Bottom in Treasuries?” Looks like that may have been the case.

“But, but,” the inflationistas sputter, “How the @#$@#$ can we not get inflation with all this printing and speculating going on?”

Easy. It’s the flip side of the inflationary boom-bust cycle. When you pump up a balloon until it pops, you don’t just go back to the pre-pumped state. After the pop, your once intact balloon is now shredded. Similarly, the aftermath of a speculative credit binge tends to feed a greater deflationary vortex than existed in the first place. In the long run, bad medicine (or too much good medicine) makes the patient worse off.

And, mind you, the slowdown threat we face is not just U.S. centric, it is global, as Peter Boockvar nicely summarizes (via TBP):

The slowdown in manufacturing is not just being seen in the US as Europe and Asia also reported moderation. China’s two mfr’g indices fell to 9 and 10 month lows, Taiwan’s PMI fell to a 5 month low, India to a 4 month low and South Korea to a 6 month low. Thailand raised interest rates by 25 bps to 3%. In Europe, the final euro zone PMI was slightly below the initial report and now matches the lowest in 8 months. UK mfr’g PMI fell to the lowest since Nov ’09.

Who Cares About the Debt Ceiling?

Something else notable about the big bond rally: Washington’s debate over the “debt ceiling” is being completely ignored. Investors are buying the heck out of treasuries even as America is at supposed risk of default.

What does this tell us? At least a few things:

  • USTs are still good in times of true fear. No other market is as big, deep or liquid as the U.S. Treasury market, and a lack of comparable true “safe havens” in this world makes it a go-to place to hide (gold also qualifying, but microscopic in liquidity comparison terms).
  • The idea of America “defaulting” on debt obligations is a joke. As Cullen Roche likes to say, “America is not Greece.” The U.S. can always pay off its debt in nominal currency. The only true default America will ever face would be “de facto” default, through out-of-control inflation as bonds are sold off en masse and monetized by a panicked Fed. But bonds aren’t being sold off (i.e. crashing) right now, they are soaring as scared investors buy them!
  • Guaranteed inflation forecasts may be largely in speculators’ minds. In Market Wizards, Michael Marcus tells the story of his big going-bust trade. Marcus had risked “everything” — even borrowing from his mother — to “bet on the blight,” i.e. corn blight anticipated by grain traders at the CBOT. Things were okay at first — then the WSJ came out with a headline that read: “More Blight on the Floor of the Chicago Board of Trade Than in Midwest Cornfields.” Marcus got killed and learned the risk management lesson of a lifetime. Those today who are “all in” on inflation may be in a similar situation as with Marcus’ corn blight.

The “One Trade” Problem

This further leads to the problem of one-way speculative participation in markets. So many traders have become convinced of inflation, and of the “Bernanke Put” (successor to the Greenspan Put) keeping stock market valuations high, that  a massive one-way bet has been placed — of the sort that could viciously unwind and surprise the hell out of many an overleveraged money manager.

In other words, when the “one trade” is “Risk On,” as expressed through abnormally high correlation across all risk assets, a heightened possibility of bust ensues. Via FT Alphaville, two B of A analysts put out an excellent research note on this:

It is very unusual, however, to see high levels of cross-asset correlation together with declining volatility [as we have seen lately - JS]. This is because cross-asset correlations tend to rise during times of market stress, and these times normally experience high volatility. We have found only two historical episodes where high correlations coincided with declining volatilities: May-August 1998 and June-July 2010. In both cases, however, volatility subsequently jumped higher: in the first episode it was the collapse of Long Term Capital Management; and in the later episode it was capitulation of growth expectations and onset of QE2. Although this time may be different, we believe high cross-asset correlations are signaling two important systemic risks which might bring higher market volatility:

  • * It’s all one trade. When cross-asset correlations are high, it means that many investors are essentially in one trade, even though they may not be aware of it. As a result, there may be more crowded trades than most investors realize. If investors exit at the same time, market movements could be chaotic.* Focus on one risk factor only. High risk-on/risk-off correlation implies that investors are increasingly focused on a single risk factor that affects all asset classes. Although our correlation analysis is silent about the nature of what this factor may be, we suspect it is related to global growth risks. The focus on a single factor, however, suggests that investors may underestimate other risks. If another major risk factor suddenly arises, for example something related to the US debt ceiling, we could see a great increase in market volatilities.

What explains high cross-asset correlation? As we just mentioned, one potential explanation is that investors are ignoring other risk factors. Another explanation is that the environment of very low interest rates created by highly accommodative Fed policy has prompted investors to search for higher returns in more risky assets. This is known as “portfolio rebalancing” channel of monetary policy, as defined by Fed officials. Logically, this should lead to growing capital and leverage allocated to riskier assets and trading strategies.

Turning Point at Hand?

One of our all-time favorite summations of market guidance comes from George Soros, paraphrased thusly: Volatility is greatest at turning points, diminishing as a new trend becomes established.

So how about that vol in the S&P this week?

We Mercenaries were prepared for this development, as Live Feed members can attest. Less than four weeks ago, for example (near the S&P’s recent top) we established a “Long-Dated Volality Trade,” on thesis logic as documented here.

We have also been “jockeying for position” with a bearish trading book these past few weeks, in anticipation of developments as now appear to be unfolding.

The thought processes behind our positioning have further been articulated via GMN pieces such as “Commodity Carnage and Speculative Froth” and “Not Today,” as well as Mike McD’s excellent View From The Turret updates.

Key point being, you don’t have to be roadkill when markets turn vicious. The beauty of proper trade structures and aggressive risk management is that, when you are wrong, you can step aside and only lose a little — but when you are right, you can ramp up at inflection points and make a whole hell of a lot.

For those with plenty of dry powder and the means to execute, that is what we see if the “deflation shock” scenario continues to unfold.

JS

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2 Responses to Global Macro Notes: S&P 400? The Deflation Shock Scenario

  1. syoung on June 4, 2011 at 2:21 pm

    Marc Faber's June Gloom/Boom/Doom report also looks at the S&P 400 prediction. In a nutshell, he doesnt see it going there in nominal terms (mainly since he believes the Fed etc. will just keep printing), though in real terms (ie. with S&P measured against gold, CHF, AUD, or even Yen, in many ways it is well on its way there already).

    • Jack Sparrow on June 4, 2011 at 9:32 pm

      Agree the reflation case is a powerful one.

      With that said, certain low probability / high consequence game changers (like a full on China meltdown) could have surprising implications if they come to pass.

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