The pendulum of the mind alternates between sense and nonsense. ~ Carl Jung

Politics is a pendulum whose swings between anarchy and tyranny are fueled by perennially rejuvenated illusions. ~ Einstein

Stephen Buhner wrote in his book “The Secret Teachings of Plants” the following:

The physical Universe is an aggregate of frequencies. – Buckminster Fuller

All living organisms receive electromagnetic signals all the time. And like the signals received by our radios, many of them contain extremely large amounts of information, which can be used for a great many things. These range from regulating the opening of little doors in cells to let food in and waste out, to healing, to the beating of the heart, to birds orienting themselves to the magnetic lines of the Earth when migrating, to the communication between pollinators and their flowers, to the communications between members of the same family who have bonded with each other — and, of course, a great deal more.

Electromagnetic spectrum signals, like those we know as a particular radio station, can and do contain very large amounts of information… Every time life flows through a frequency in the electromagnetic spectrum, it fractalizes that wave differently, because the flow of life is always nonlinear. What is interesting is that unique information is always embedded or encoded within the way the oscillating sine wave is fractalized.

Fractalized sine waves seem to be encoded into the very fabric of our reality; like the Golden Ratio and the second law of thermodynamics. They appear throughout the universe on nearly every level of scale and function. It’s no surprise then that they underlie the very structure of our market, which is just fractalized sine waves overlaid on fractalized sine waves of various temporal scales.

This makes intuitive sense because a sine wave is just a continuous pendulum swing. And crowd dynamics naturally follow the path of a pendulum, swinging from one local extreme to another.

The market is in effect a large complex information transmission system. All acting participants make bets using their particular knowledge set which then in aggregate moves the market, providing new information for the actors to incorporate into their decision-making process where they then make new bets. Creating a neverending information feedback loop.

The infinite feedback loops in the structure of the market, not to mention the way group psychology evolves, necessitate this constant back and forth, like that found in every natural system.

Every rally sows the seeds for a reversal and every reversal sows the seeds for a rally. Ad infinitum.

Michael Mauboussin discussed a critical driver behind why this process plays out in his recent paper titled “Who is on the other Side?”. In it, he shares work done by economist Blake LeBaron which animates this concept using an agent-based model (here’s a link to the original paper).

The model is computer generated and the “agents” are imbued with decision-making rules and objectives similar to those that drive market participants (i.e., make money, try not to lose money, don’t underperform the average for long periods, etc…)

Here’s a section from the paper (emphasis by me):

LeBaron’s model replicates many of the empirical features of markets, including clustered volatility, variable trading volumes, and fat tails. For the purpose of this discussion, the crucial observation is that sharp rises in the asset price are preceded by a reduction in the number of rules the traders used (see exhibit 5). LeBaron describes it this way:

During the run-up to a crash, population diversity falls. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market. The economic mechanism here is clear. Traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies. In the Walrasian setup used here, this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity.

Because the traders were using the same rules, diversity dropped and they pushed the asset price into bubble territory. At the same time, the market’s fragility rose.

Mauboussin goes on to note the important lessons this model underscores about our market structure, which can be broken down into three primary points.

1. Falling agent diversity initially leads to agents making more money which creates a feedback loop of higher prices -> agents in the ‘herd’ make more money -> less agent diversity -> higher prices… This is why fighting trends, even ones based on faulty prepositions, can be so dangerous over a short timescale.
2. A reduction in agent diversity is non-linear. Meaning, as diversity falls, market fragility rises exponentially. This is more often than not initially obscured by rising market prices. But, as Mauboussin points out “crowded trades work until they don’t” and eventually an incremental change in diversity will lead to an outsized drop in market price. This is the age-old liquidity problem. When a large portion of the market is using the same buy and sell rules there conversely becomes a disproportionately small population to sell into and the market needs to drop significantly for prices to clear.
3. Lastly, the model highlights the importance of understanding how beliefs propagate across a network. Like a disease, a belief’s level of virality is based on its contagiousness (how compelling it is), its degree of interaction (how many high-density nodes in a network adopt it), and the degree of recovery (how supported is the belief by the unfolding reality).

The Palindrome George Soros was perhaps one of the best at playing the player and identifying these belief-diversity cascades when in his prime. He applied an entirely new vocabulary to financial markets with terms like reflexivity, feedback loops, false trends and so on.

Soros would break down reality into three sub-categories:

1. Things that are true
2. Things that are untrue
3. And things that are reflexive

He said that “Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited.”

Soros was exceptional at reading where the market was in its pendulum swing (i.e., gauging the level of extremity of  consensus narratives and their subsequent positioning) relative to the quality of assumptions in which they are based on (true, untrue, reflexive).

An example of the type of pendulum swing Soros would try to exploit is the clear narrative shift in bonds last year.

Remember back in the middle of 18’ how the popular belief had become that “we’re in a new secular bear market in bonds”.

Both “Bond Kings” we’re shouting about the “game changer” in rates….

Here’s a few excerpts from a Bloomberg article in October of last year when the bearish bond narrative reached its pitch — which also happened to be right when yields peaked. The article is aptly named “Bond Bears Popping Champagne Say U.S. Yields Have Room to Rise”.

Thirty-year Treasury yields pushed above the 3.25 percent level that fixed-income veteran Jeffrey Gundlach identified as a “game changer.”

“Solid data releases, higher oil prices and a technical backdrop that suggests there are not a lot of obstacles for yields to continue to push higher will have many wondering how far this new push higher can go,” said Rodrigo Catril, a Sydney-based strategist at National Australia Bank Ltd.

Short sellers were already positioned for more pain in the Treasury market. Speculative net short positions on 10-year notes climbed to a record, the most recent Commodity Futures Trading Commission data showed. An update to those figures comes Friday.

“In hindsight, we wish we were even shorter on U.S. rates,” said Raymond Lee, a fund manager at Kapstream Capital Pty in Sydney.

“That gradual withdrawal of liquidity is causing yields to rise,” Bob Baur, chief global economist at Principal Global Investors, said in an interview with Bloomberg Television in Tokyo Thursday. “We look for 10-year Treasury yields to hit 3.5 percent at some point — later this year, early next year — and I think that’s going to be a real problem for stock markets.”

The famous speculator of the early 20th century, Bernard Baruch, used to say “Something that everyone knows isn’t worth anything.”

The “Bond Bear” narrative was predicated on a false trend. It wasn’t a sustainable move. Our leveraged balance sheets combined with a decelerating China and a responsive Fed ensured it. Crowding in both positioning and narrative combined with a textbook technical breakout in late October made for a perfect buying opportunity — something we pitched in our November MIR at the time.

Not only was the move in bonds not much of a “Game Changer…” but it was also clearly a local extreme on the swing of the pendulum. The narrative was on the front pages of ALL the financial newspapers and shared by nearly ALL the talking heads on CNBC.

And how quickly that narrative pendulum has swung back. It’s now accepted wisdom that yields won’t and can’t rise. The global economy is simply too weak and the Fed too dovish… Subsequently, investors have been stampeding in droves into bonds since the beginning of the year. More on this in a minute. 

Something that everyone knows isn’t worth anything…

 Equity markets too, have seen a full swing of the pendulum over the last six months. Back at the end of December when we put out a number of reports explaining why it was an excellent time to buy, the dominant belief was that a vicious bear market had started and a recession was around the corner.

I mean, the Yield Curve had inverted!!!! Everybody was fretting about the yield curve and a recent drop in retail sales…

Five months and a vertical runup in stocks later and there’s hardly a whisper of either. Now, the talk is of a Fed Put, a low growth low inflation Goldilocks economy, and a Melt-Up in equities.

One more time: Something that everyone knows isn’t worth anything…

Viewing markets — also history, politics, culture, and on and on — through the lens of a swinging pendulum is a useful heuristic. Look for local extremes and compare it to alternative possible outcomes, ones that aren’t being discounted by the market. Then wait for a break in the technicals and you have yourself a trade.

Doing this, you’ll find that the market, especially when at pendular extremes, is more often than not suffering from acute myopia. It tends to overly discount what’s happening now while not accounting for a future that could look any different than today.

Stanley Druckenmiller (aka The GOAT) put it like this:

[My] job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.

Too many investors look at the present; the present is already in the price. You’ve got to think out of the box and visualize 18 to 24 months from now what the world is going to be and what (level) securities might trade at… what a company has been earning doesn’t mean anything, what you’ve got to look at is what people think a company’s going to earn and if you can see something in 2 years that’s going to be entirely different than the conventional wisdom, that’s how you make money.

I want to talk Minsky and the Levy/Kalecki Profit Equation

This may sound a bit heady, but don’t worry. We’re going to break it all down Barney style and then walk you through how you can use the frameworks for understanding the current environment in order to better assess the probabilities of potential outcomes (ie, gauge the general conditions).

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.  ~ Jesse Livermore

Let’s kick things off with the Levy/Kalecki Profit Equation.

The Profit Equation is just a macroeconomic accounting identity for how the global economy actually operates. Specifically, it answers the question as to where “Profits” come from and thus, growth.

If you’ve ever heard of The Jerome Levy Forecasting Center where a number of talented economists work. Well, that’s the same Levy. The center performs analysis using the Profits Equation framework developed by Jerome Levy in 1908 (side note: Kalecki was a renowned economist who developed the same framework as Levy years later and received credit initially for it because Levy was a relatively unknown name).

Now, you can read the full white paper on the equation here, which I highly suggest you do so. We’re just going to cover the gist of it today, because it’s relevant to potential macro risks and constraints we’ll be facing in the coming year(s).

The actual accounting identity looks like this:

Profits before tax = + Investment – Nonbusiness saving + Dividends + Corporate profits taxes

This accounting identity, which like any identity holds true under any circumstance, is just saying that corporate profits are the direct result of net investment minus nonbusiness (Households + Government + rest of world) saving before dividends and corporate taxes are paid out.

Confused? Don’t worry. I’ll break it down even more.

We all know where profits come from at the individual level, right? A company earns more in revenue than its costs and the excess is profit.

Well, if you pull back and look at the global economy as a whole, it’s a closed system. Its closed in the sense that profits aren’t magically appearing from anywhere outside of the global economy. But profits obviously aren’t a zero sum game. If one company earns profits it doesn’t necessarily mean that another company somewhere has to be operating at a loss. There wouldn’t be any growth if that was the case. So, where do profits come from then?

The answer is in net investment, which is a positive sum game. If we divide the economy into our four aggregate entities (1) US Corporations (2) Households (3) All levels of US Government and (4) the Rest of the World (RoW) and look at them as a whole, there needs to be net positive investment as a whole for their to be profits.

This means that an economy’s ability to produce profits comes down to the net expansion of the aggregate balance sheet in the macro accounting identity. For instance, if the US Government is running a budget surplus (shrinking its balance sheet), like it did in the late 90’s. Then either the Household, Corporate, or the RoW needs to take up the slack and expand their balance sheets to make up for the fall in demand. Or else demand will fall and profits will contract.

In the late 90’s, US Corporates made up for the government’s demand deficit by expanding their balance sheet. In the 2000s it was Households and the RoW (led by China) who borrowed money and invested — US Households in homes and China in building entire cities.

Understanding that profits are essentially the residual of the net balance sheet expansion/contraction of the entire global economy is helpful because (1) we can look at the trends in the balance sheets of our four macro aggregates to see if net demand (profit) is being created and (2) we know that their are natural limits to how much balance sheets can expand and therefore whether the global economy may be headed for a contraction in profits.

This is essentially a more nuanced framework for understanding how the debt cycle (as put forth by Bridgewater) works. Profits are essentially the result of expanding balance sheets (increases in debt). The more balance sheets expand the lower interest rates need to drop in order to decrease debt servicing costs and keep the cost of capital down for marginally profitable firms — essentially keep the economy from going into free fall.

Enough with the theory… How does this apply to the present day?

Well, think about what’s been the source of profits in the US economy the last couple of years.

The Household sector has been deleveraging since the Great Financial Crisis (GFC). They’ve been contracting their balance sheets and thus have been a negative source of profits/demand in the economy. The demand then has come from both the Federal Government and the Private Sector, both of which have been rapidly expanding their debt.

The RoW, primarily the Eurozone and China being the two economies large enough to matter, have been either a wash or net drag on global demand over the last few years.

China has pretty much maxed out its balance sheet limits where it now takes extraordinary injections of credit from the government to produce a relatively modest and short-lived economic impulse — the whole “pushing on a string” thing. And European consumers and corporates are fairly weighed down by debt and haven’t been helped much at all by their governments, who unlike the US decided to go with German imposed austerity following the GFC (though this may be starting to change, which we’ll discuss soon).

And this brings us to a growing concern of mine. Where is net demand going to come from in the future?

The fiscal impulse from the US tax cuts and increased budget deficit is starting to wear off. And on the corporate side, with corporate debt to GDP at all-time highs, how much more credit driven demand can we expect?

Things actually look worse when you disaggregate the corporate data. Taking a look under the hood we find that debt is actually much higher and there are a number of “zombie” firms that aren’t profitable even in such a low cost financing environment which means its going to take just a small tightening of financial conditions to cause these firms to go belly up, potentially kick starting a chain reaction of defaults.

Check out the following notes from Financial & Insurance Firm, Euler Hermes (emphasis by me):

• Between 2009 and Q3 18 the US total debt has declined from a peak representing 350% of GDP in Q1 09 to 311.5% in Q3 18. While the US as a whole has been deleveraging, the business sector (corporate and non-corporate) has re-leveraged, standing at 72.6% of GDP or USD 15tn today. This represents a 2pp deviation to trend. Past recessions in the US have coincided with positive deviations ranging from 2-8pp of GDP.
• According to our calculations, the true level of non financial corporate debt in the US may be 30% or USD 3.9tn higher than officially reported, primarily because of leveraged loans bought by non-banks. We estimate that the debt-to-EBITDA ratio would thus be close to 4.6 instead of 3.9. As a consequence, the BAA-Treasuries’ spread (to AAA) should be about 120bps higher than currently observed (~ 230bps today) if hidden debt were factored in.
• The Trump Administration’s fiscal stimulus has boosted demand in the US over the past couple of years. According to our model, a correction of this excess demand, back to potential output growth, could trigger an increase of the corporate delinquency rate from 1% in Q3 18 to 2.32% (highest level since Q2 11). This adjustment could follow strong disagreement about fiscal policy as we enter 2019-20 budget discussions. Corporate spreads will thus continue to hover around 230-250bps as seen today, still underestimating hidden debt, but aware of looming risks in the corporate sector. In a stress scenario (likelihood to switch estimated at 35%), which could correspond to a series of defaults for instance, the delinquency rate would jump to 3% and credit spreads would very quickly increase by 70bps higher than today.
• The bottom line is that be it from scoping (hidden debt) or for cyclical reasons, we believe that corporate spreads are underestimated today, and that unfortunate events (rapid downturn, market defaults) could end up pushing up spread by 70-190bps, by sheer realization by market actors of intrinsic risks in that segment.

The Bank for International Settlements (BIS) put out a research paper last Fall, titled “The rise of zombie firms: causes and consequences”, where they discuss the pervasive rot in the developed market corporate sector, especially here in the US.

Here’s a few of the notable highlights from the paper.

• 12% of all companies globally are now “zombie firms,” meaning that they can barely pay the interest on their debts. The number is 16% in the US, which is an eight-fold increase since the 90s.
• These zombie firms have been kept alive by low interest rates along with investor demand for “leveraged loans”.
• The leveraged loan market is now in the trillions (the exact number is unknown) and consists of low-quality corporate debt that’s at risk of being downgraded — which would cause forced liquidation — should interest rates rise too much.

It seems we’re on a clear course of transition from what Minsky would call the “speculative financing” stage to the “Ponzi Financing” stage of the financial cycle.

For those of you not familiar with Hyman Minsky, here’s a brief summary of one of his more popular theories, which applies to our discussion today.

Minsky came up with the “financial-instability hypothesis” which stated that long stretches of prosperity sow the seeds for an eventual crisis. Economic stability breeds instability.

Minsky understood that recency bias drives myopia in the human decision making process. Economic actors end up extrapolating low volatility into the future which leads to more risk taking in the present through the use of leverage (credit).

The theory was established by defining what investment is, and its role in an economy. Which, put simply, investment is the exchange of money today for money in the future. That money (investment) can come from one of two sources: the economic actors’ (consumer, company, government) own cash flows, or from the cash flows of others (lenders). And it’s the balance between these two sources of investment that comprises the stability of the financial system.

According to Minsky, the financial cycle typically follows three stages of financing; these are:

1. Hedge financing
2. Speculative financing
3. Ponzi financing

Hedge financing is the most stable of the three. It’s when the economic actor relies on its own stable cash flows to repay any borrowings. It’s when the actor’s earnings far outweigh its limited borrowings.

Speculative financing is when the actor uses its own cash flow to pay the interest on its debt, but must assume more debt to repay the principal; thus rolling its debt over. This stage of financing is less stable than hedge financing.

And lastly, there’s Ponzi financing, which is the most unstable of the three stages of financing. Ponzi financing is where the actor’s cash flows do not cover either the principal or interest payments on its debts. The actor is completely reliant on the appreciation of the underlying asset in the hopes that it’ll be enough to cover its liabilities.

Minsky argued that financial cycles naturally progress from each stage of financing to the latter; driven by human greed and carelessness. When economies enter the Ponzi stage, they become increasingly unstable and eventually experience a “Minsky Moment” which is a sudden collapse in asset values, leaving both lenders and borrowers exposed. This is the deleveraging phase of the debt cycle as put forth by Bridgewater.

So we have a diminishing US fiscal impulse, a nearly tapped out corporate sector riddled with zombie firms in an economy transitioning from speculative to ponzi finance, all which sits atop a leveraged loan market that measures in the trillions. Great…

The Game Masters (Policy Makers) are well aware of this threat. Former Fed chair Janet Yellen remarked in an interview with the FT last Fall that “I am worried about the systemic risks associated with these loans. There has been a huge deterioration in standards; covenants have been loosened in leveraged lending… There are a lot of holds. We should not feel the financial stability glass is full.”

I believe it was the market’s concern (rightfully so) that drove the large selloff at the end of last year. With the Fed acting as if they were on rate hiking autopilot, a painful recession and zombie killing field was all but assured if they had not changed course. But, they did, and here we are. The game is still going and may very likely go on for a while longer.

This is all rather big picture stuff. It may or may not be actionable in the near future. But it’s certainly something we need to be aware of because it will eventually matter and be actionable.

I’m still bullish the market but I do think the longer-term risk/reward is less positively skewed than it was just a few months ago.

There’s some deteriorating data that’s linked to the leveraged loan market as well as our zombie firms that will eventually cause a domino effect of economic pain should the data not reverse following the Fed’s easier stance. The two charts below are evidence front and center for this. We have the Fed Senior Lending Officer (SLO) survey showing banks are increasing the spreads on loan rates to large and medium firms (a reading above zero means lending conditions are tightening).

And the BAA/AA corporate bond spread has failed to reverse with our other indicators of financial/liquidity conditions. This tells me the market is finally starting to sniff out the brewing trouble we just discussed.

Thanks for reading! I’ll have additional updates as the data unfolds.

Yesterday, I talked about the massive vol compression I’m seeing across a number of major macro instruments —  most notably FX dollar pairs and gold — along with how these compression regimes set the stage for expansionary ones (i.e., Giant Macro Trends).

Here’s the chart of gold again which shows its volatility (as measured by the width of its monthly Bollinger Bands) recently hit ALL-TIME lows. The last time gold vol was anywhere close to being this contracted was in 2002, right before the yellow metal busted out the gates and ran for a decades-long bull market.

Now, compressed vol isn’t a bullish or bearish signal. It just means a big move is coming.

But one of the great things about compression regimes is that we can be directionally agnostic. A tight coiling market is the epitome of an inflection point. This means that we don’t have to discern any big macro narrative to try and guess where things are headed. We can just wait for the market to tip its hand and then play the cards…

With that said, let’s take a look at the gold market anyways and see what our data and indicators are telling us to see if we can get a jump on the trend.

We’ll start with another excerpt from Bigg’s Hedghogging. This time from his chapter on “Peter”. An investor that Bigg’s refers to as “the most knowledgeable gold analyst in the world”. Bigg’s writes (emphasis by me).

As he studied the literature, Peter focused on a long scholarly piece written in 1988 by Lawrence Summers (later secretary of the treasury and now president of Harvard) and Robert Barsky entitled “Gibson’s Paradox and the Gold Standard.” Summars and Barsky argued that the relative price of gold is driven by (and is the reciprocal of) the real rate of return from capital markets and that this relationship has strengthened since the price of gold was floated.

“Gold is a highly durable asset, and thus, as stressed by levhari and Pindyck (1981), it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return of available assets. We assume the alternative assets are physical capital and bonds.” ~ “The Pricing of Durable Exhaustible Resources” The Quarterly Journal of Economics

Since 1988 the price of gold has had a negative 0.85 coefficient of correlation with the S&P 500 and an R2 of 72%. As things got crazier since 1994, the negative correlation rose to 0.94, with an R2 of 88%. In other words, the stock market explains 88% of the weekly price fluctuations of gold over the past eight years. The long-term correlation with Treasury bonds is not as high but still very significant.

As Peter explains it, the so-called problem with gold, which causes its erratic price behavior, is that “the elasticity of a positively sloped investment demand function overwhelms the inelasticity of supply.” I didn’t understand it either until he explained. You see, only 18% of the gold mined throughout history is held in investment form, or slightly more than $200 billion. The investable capital markets of the world are estimated to be about $60 trillion.

In a low return cycle for stocks and bonds, monetary and investment demand for gold turns positive, and there is a dramatic shortage of available metal. This large differential can only be solved by much higher prices. The point is that it is not inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particularly equities. Peter’s model of this relationship is shown in Figure 19.1. As you can see, in times of bleak returns, gold beats everything else.

There are two key points to take from Peter (1) is that over the long run (and this is one of Dalio’s “principles” regarding gold, as well) the price of gold will approximate the total amount of money in circulation divided by the size of the gold stock and (2) it’s not “inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particular equities.”

With that in mind let’s think about the world we’re in.

Is the total amount of money in circulation set to expand or contract in the coming years?

Well, the major central banks appear to be cornered into continuing easy monetary policy. The ECB effectively can’t reverse course and the Fed just announced they’re ending QT prematurely, are ready to cut rates soon if needed, and are willing to let inflation materially overshoot their target of 2%.

Then we have China who has the centenary anniversary for their glorious communist party coming up in 2021. This raises the odds that we’ll see them ease significantly in the second half of this year in order to pull their economy out of the doldrums and get things running hot in time for the celebrations.

Oh… Then we have the US running its largest non-recessionary fiscal deficit in peacetime plus Europe who’s about to see their biggest fiscal impulse in a decade. I, of course, could also mention the popular rise in MMT amongst Western policymakers, which essentially gives politicians the license to print. But I’ll save that discussion for another day.

Markets and their respective Game Masters (Central Banks and Governments) are still very much being influenced by the Event Echo of the GFC. An event echo is a:

Powerful psychological event (think crypto boom/bust or the GFC) that echos through time and affects the thinking and actions of the market for years. The 08’ financial crisis created a collective disaster myopia that is still prevalent today, 10-years on. This is not only noticeable in the psychology of market participants but also in the policymakers who pull the levers on the economy (ie, central bankers).

There’s a deep-seated fear around experiencing another deflationary “liquidity crisis” like the GFC. This fear will continue to drive the impulsive reaction function of creating ever more liquidity. This is bullish for gold.

What about the expected returns from other asset classes?

Here’s the 7-year asset class real return forecasts from GMO. US large cap stocks, which comprise the vast majority of global equity total market cap, have a projected real return  of -3.7% over the next 7-years. That’s not good…

It seems we have the two necessary ingredients for a major bull market in gold. These are (1) low expected returns for long-term financial assets and (2) a global money stock that is likely to keep growing (potentially by A LOT).

When we combine this with the current low vol regime + the textbook long-term inverted H&S bottom pattern forming, we get a clear trading opportunity.

There’s also positioning which remains relatively neutral considering the recent run up in price.

And TIPs, which had bearishly diverged from gold last year, have now completely reversed course and are now confirming the trend upwards in gold.

And finally, the gold/silver ratio has risen to levels that have marked significant bottoms every time over the last 20-years.

Looking at the tapes of a number of gold miners I can’t help but salivate. There’s a few stocks here that look ready to explode (I’ll share my preferred ones in a Trade Alert going out to Collective Members tomorrow).

One of my favorite historical figures, Miyamoto Musashi (the deadliest Ronin Samurai to have ever lived), wrote this about the importance of timing:

There is timing in the whole life of the warrior, in his thriving and declining, in his harmony and discord. Similarly, there is timing in the Way of the merchant, in the rise and fall of capital. All things entail rising and falling timing. You must be able to discern this. In strategy, there are various timing considerations. From the outset, you must know the applicable timing and the inapplicable timing, and from among the large and small things and the fast and slow timings find the relevant timing, first seeing the distance timing and the background timing. This is the main thing in strategy. It is especially important to know the background timing, otherwise, your strategy will become uncertain.

The background timing of the current macro environment tells us something big is coming, something that’s not yet fully known or fully discounted by the market…

This means some major trends are on the horizon. And along with major trends come major opportunities to profit.

Gold is just one area I see that’s ripe for exploitation. There are others which I’ll cover later this week.

If you want to see the exact gold stocks my team and I are interested in buying then check out the Macro Ops Collective.

Click here to enroll in the Macro Ops Collective!

It’s happened…

The 10yr/3m yield curve has inverted. The party is over folks. Sell your stocks, horde your cash, pack your bags and go home. Recession is imminent…

The mainstream financial news and twitter “market experts” have nailed it. The top is in.

It’s nice knowing that calling a recession is this easy. There’s really nothing to this game. Buy the dip when the curve is positive and sell when it inverts, sidestepping a recession and bear market. It’s so easy your grandmother could do it.  

Alright, enough of the sarcasm.

You can probably tell that I don’t quite agree with the above sentiment. Last time I checked, investing and calling macro tops isn’t quite so simple.

Let me give you a different interpretation.

First, I’ll explain what an inverted yield curve actually means. Then I’ll lay out why there’s almost certainly more upside in stocks (much more). And then I’m going to use the four dirtiest words in finance to explain why context matters in this game, especially now.

So what does an inverting yield curve actually mean? And why is it an excellent predictor of recession (though not omnipotent)?

I’ll tell you.

The yield curve reflects the pricing of bonds (and inversely their yields) from the front end rate which is set by the Fed all the way out to the long end of the curve, which is set by the market. Obvious, I know.

The yield curve shows us how interest rates are being discounted through time; from the present to decades out into the future.

It’s important because all assets are priced off this curve.

When the front end interest rate, which is set by the Fed, rises faster than what the long end is pricing in (ie, it flattens and/or inverts), it impacts markets and the economy in two ways (1) it has a negative present value effect on asset prices and (2) the flatter/negative curve causes a constraint on lending as well as the broader economy.

The first one is simple. When front end rates become equal to or exceed those of longer end interest rates, moving out of duration assets and into cash/cash-like instruments makes sense (why take on duration risk when you don’t receive compensation for doing so). This applies to stocks as well, as stocks are essentially long-duration assets.

The second part refers to how the curve — the spread between front end and long end rates — sets the price of money, and therefore incentivizes or de-incentivizes lending in the real economy. Here’s the following from Hedge Fund manager Ray Dalio, writing in his book Big Debt Crisis on the subject:

Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates (i.e., the extra interest rate earned for lending long term rather than short term), lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted (i.e.. Long-term interest rates are at their lowest relative to short-term interest rates), people are incentivized to move to cash just before the bubble pops, slowing credit growth and causing the previously described dynamic.

Early on in the top, some parts of the credit system suffer, but others remain robust, so it isn’t clear that the economy is weakening. So while the central bank is still raising interest rates and tightening credit, the seeds of the recession are being sown.

The fastest rate of tightening typically comes about five months prior to the top of the stock market. The economy is then operating at a high rate, with demand pressing up against the capacity to produce. Unemployment is normally at cyclical lows and inflation rates are rising. The increase in short-term interest rates are rising. The increase in short-term interest rates makes holding cash more attractive, and it raises the interest rate used to discount the future cash flows of assets, weakening riskier asset prices and slowing lending. It also makes items bought on credit de facto more expensive, slowing demand. Short rates typically peak just a few months before the top in the stock market.

There’s also a market/Fed disagreement component to a flattening/inverting yield curve which is where the signaling comes from.

When front end interest rates (which are set by the Fed) rise above long end rates (which are set by the market) it essentially means that the market disagrees with the central bank. The market is saying that the Fed has gotten ahead of itself and will soon have to reverse course (cut interest rates) due to slower growth and inflation in the future. That’s why investors take on duration even when it’s offering an equal or lower yield than the front end; they expect yields to continue to trend downwards.

I’ll explain in a bit why the dynamics of this have changed and why the signaling quality of the curve has deteriorated due to some very explainable reasons.

Before we get to that though, I want to show you quickly why even if the recession signaling value of an inverted yield-curve hasn’t been distorted, it’s still no reason to panic over the short-to-intermediate term.

The reason being is that the curve tends to invert well before a recession and depending on which specific curve you’re using, long before a market top as well. See the 10yr/3m curve chart at the top. It inverted years before the last two market tops.

The graph below shows that the standard 10yr/2yr yield curve has inverted on average 19-months before a recession, going back to 1968, whereas a top in the SPX has preceded recession by only an average of 7-months.

The 10/2yr curve hasn’t even inverted yet.

This chart via Sentiment Trader shows that the return picture following curve inversions is on balance positive going out to two years.

Okay, so maybe take the rising calls for recessionary doom and gloom with a shaker of salt.

More importantly, let’s talk context, which is something that so many market commentators seem to not care about.

There have been two very important changes this cycle that make present-day conditions unique and the signaling value of the yield curve diminished. Yes… I’m saying This Time is Different.

I know, I know, you’re never supposed to utter those words in finance. But excuse me if I think that’s the most overused lazy and abused adage in this game. The truth is, it’s always different this time. No two cycles are exactly alike. So, yes, we still have to use our little monkey brains to try and understand what things like yield curve inversions mean in the context of present-day reality.

Let’s start with the first change: Banking and Financial Regulations.

Following the GFC new financial regulations (ie, Dodd-Frank & Basel III-IV) were enacted to ensure a more robust and resilient banking system during times of significant market stress. One of the many byproducts of this new regulation is the liquidity coverage requirement (LCR) which requires financial institutions to hold a certain amount of high-quality liquid assets (HQLA) that’s sufficient enough to withstand a significant stress scenario.

What this means in practice is that banks have to hold a higher level of HQLAs (ie, sovereign bonds) than before. When you couple this with the need for duration matched assets from pension funds and insurance companies in a world where there’s $10trn+ in negative yielding developed market debt, we get price blind buyers for bonds. And when you have price-insensitive buyers (institutions who buy because they have to) well, the impact on that market’s signaling value should be obvious.

This has never been the case before in past cycles. This is why the yield curve may not serve as much of a valuable recessionary signal as it used to in the past. This is why THIS TIME IS DIFFERENT.

Then there’s the second and more recent change, which is within the Fed itself.

Fed Watch Tim Duy wrote in Bloomberg about the Fed’s recent and total about-face, writing (emphasis by me):

It is hard to understate the importance of this shift. The Fed’s models haven’t worked this way in the past. In previous iterations of the forecasts, the expectation of unemployment remaining below its natural rate would trigger inflationary pressures. To stave off those pressures, the Fed perceived the need to raise rates above neutral to slow the economy enough to nudge unemployment upwards. Now the Fed believes it can let unemployment hold persistently below the natural rate without triggering inflation and without Fed policy becoming restrictive.

Duy goes on to note that, “The Fed apparently has finally realized that persistently low inflation remains a problem.” And “to avoid the problems of the zero lower bound for as long as possible, the Fed needs to ensure that inflation stays sufficiently high to hold expectations at its target and that they act to avoid a recession. The policy implication is that they need to err on the dovish side.”

In practical terms, this means that the Fed has essentially thrown out the models that it’s relied on in past to help make interest rate decisions. Jerome Powell and team are making it clear that they need to see an actual and sustained spike in inflation before raising interest rates. And they’re willing to cut rates and even resume QE to get there, even at near full employment and stable growth.

This is a BIG deal. The Fed has learned some lessons from past cycles and doesn’t want to kill the party. So why fight the Fed?

I sure don’t want to.

Okay, so far I’ve explained what an inverted yield curve typically means along with why things are different this time. I’ve also laid out why context always matters and why one should never just lock onto a single input and form a market view. We want to put as many pieces together in our market puzzle. And most importantly, we need to be weighing the data we see against what’s already being priced in.

We need to always be asking ourselves: What’s part of the common narrative and what is the market blind to?

So let’s play the common knowledge game.

Everybody knows that the yield curve is inverting. And everybody knows what this historically has meant (hint: the news headlines at the start of this piece).

Everybody also knows that global growth has been slowing, for a while now. NDR’s Global Recession Probability Model (via CMG Wealth) shows that much of the world has been in recession since the latter part of last year.

Most global markets are already reflecting this. Take Europe for example where German equities are trading at 50-year lows relative to the US. And emerging market stocks spent all of 18’ in a gut-wrenching bear market.

It seems to me that there remains a pretty low bar for the global economy to clear in order to cause a shift in the popular market expectations.

There are a number of catalysts which could this.

We have the coming 100-year anniversary of the Chinese Communist Party which we believe the CCP will want a strong economy for. In which case, they’d likely have to start easing significantly in the second half of this year.

There’s also a potential for the trade war to get settled. We are entering election season after all and the President has made it pretty clear how important the stock market’s performance is to him.

And then there’s also the little-noticed changes going on at the margins which I’ve been discussing recently.

There’s the possibility that the atrocious econ data in Europe bottoms soon. At least for a while. After all, we are about to see the biggest fiscal boost our of Europe in a decade (charts via MS).

And European dataflow is already beginning to slowly improve.

Turning to the US, we are seeing some slowing growth. But our confluence of recession indicators are not flashing red, as of yet.

The labor market is still strong and signs of financial stress remain mum. Our liquidity indicators are all miles away from indicating recession and in fact, are very supportive of risk-assets moving higher.

NDR’s Credit Conditions Index (via CMG Wealth) shows that credit conditions are near cycle highs and a loooong ways off from signaling recession.

I understand that this may not be a very popular take — which means it’s more likely to be true — but I think the current macro conditions continue to set up to be extremely bullish for stocks. Note that I say stocks and not the economy. Remember, the two are not the same.

Trading legend Bruce Kovner once remarked that “As an alternative approach, one of the traders I know does very well in the stock index markets by trying to figure out how the stock market can hurt the most traders.”

Fund manager cash holdings are the highest they’ve been since January 09’.

Their allocation to equities are at some of the lowest levels this cycle.

So, let me ask you… Where is the pain trade? Higher or lower?

I think it’s pretty clear where I think it is.

On December 18th of last year. When the market was in total panic. I wrote the following.

The following week, on December 24th. The day before the very low of the selloff was reached, I sent this out in a note.

I’m not trying to gloat here. I get things wrong ALL the time and don’t mind doing so. That’s not the game I’m playing. I’m playing the game of making money, not being right.

But I show this to prove a point. When I wrote the above I was ridiculed. I got emails and comments from readers saying what a “sheep” I am and how I was about to get steamrolled and yada yada yada…

I personally love this kind of feedback to my work. It means I’m onto something. I have a feeling this piece will invoke similar cries of hysteria. Especially when the market moves a little lower in the week(s) ahead.

The market will be talking about the yield curve inversion, collapsing growth, and a coming recession. But I’ll be focusing on flush liquidity, a solid Fed put, and a normal technical pullback that was easy to spot (see chart below showing semis on the weekly piercing their upper BB. A move back down to around the orange line is expected).

While most will be selling into the hole, we’ll be looking to add to our risk in a number of areas of the market where we see extraordinary asymmetric opportunities.

So, yeah… This time IS different and the world probably isn’t coming to an end. If you’ve been offsides on this year’s face-ripping rally then you may want to use the coming small pullback as a chance to get back in.

Everybody else will be shorting into the hole…

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