September 3, 2020

The Crash Of 2020: Into The End Game

[Forbes, Getty Images]

It is a little annoying when you see an obvious trading set up but you don’t press the button. This is one such instance I wrote about in July: “I should buy Berkshire Hathaway BRK.B, but again while the Nasdaq zooms with Fed new money, the time is not right. If inflation rips then all the hokey old Buffett businesses will do great because the one thing inflation does, is get things moving.”

Back then the chart looked like this:

The Nasdaq chart back in July

Now it looks like this:

The Nasdaq chart now

The reason you do not execute is ‘fear’ and while this is great news for Berkshire shareholders it is another reason to be very fearful in the market.

The market is meant to be a super-efficient valuation mechanism but it appears to be broken. In a nutshell, a company the scale of Berkshire Hathaway should not be performing this way. The stock market has lost its ability to value companies and is now a warehouse for cash.

It all goes back to the Federal Reserve and their bailout programs where the cash in the main is sequestered in the banking system. Banks have the wherewithal to lend vast amounts but won’t. It’s understandable, because who exactly do you want to lend new money to in this apocalyptic economic environment? But money is like honey, given the slightest chance it flows and pretty soon gets everywhere. The money is escaping into equities, initially the incredibly liquid big cap internet darlings and it is now filtering down the hierarchy to the next division.

One mechanism is said to be covered call trading. The incredible recovery in the market has brought in the “buy the dippers” and the FOMO (fear of missing out) crowd, which have fueled a big spike in trading in options. This has pushed up premiums that has driven call option sellers to sell calls and buy the physical stock to cover their upside risk. The call sellers, buyers of stock to cover their call sells, pushes the stock price up and draws more option call buyers in, which drives up premiums, which attracts call sellers, and the virtuous circle spins with a progression of ever higher stock prices.

If this is the loop driving this bubble there will soon be hell to pay.

However, it’s not the only factor at play. Warren Buffett himself is indicating another driver: inflation. He has bought into Barrick Gold (GOLD), an obvious inflation hedging move, and is focusing on buying into Japan, an economy of legendary deflationary tendencies. If you were to hedge your cash pile against the possibility of U.S. bailout-driven inflation, you too would want investments denominated in yen.

Not only is Japan a very Covid-resistant society, it is also the master of creating liquidity for its economy by enabling debt rather than dropping helicopter money on its citizens. The neutral effect of QE on inflation is ensured by matching new assets with new liabilities, and that stops cash quickly escaping into the hands of people who would obviously go spend it as fast as possible and drive up prices in the process. The latest batch of stimulus has plenty of helicopter money in it and that is why the Federal Reserve is adjusting its inflation stop signals and redefining them as green lights.

Reasonable inflation is great for stocks and if that inflation was to get hot but not too hot, it would mean stocks would be a fine place to stash cash. If rates stay low as promised then even if the indices just levitate by inflation the Federal Reserve is offering the world a simple carry trade to borrow cash and buy stocks. If institutions can borrow money at zip and buy stocks to let inflation raise stocks by 6% or 7%, they surely will.

So where is the problem?

The problem is fundamentals. They might be serving great martinis in the bar, but under the waterline the Titanic is split from stem to stern. While the rate at which the ship is sinking might have slowed it is still sinking. Until the day the world economy gets back to pre-Covid levels it will be building a Himalaya of debt. Getting back to sustainability is a long road and it will be hard to get there without a reset.

Whether the market is now an option market Ponzi scheme, levitated by bailout money trickle down or inflation expectations or all three, it makes the market incredibly dangerous, which is what options premiums are telling you. As such, I’m not too annoyed for not following my own Berkshire Hathaway chart and while I hope some of you did, it is just another of many red flags that the stock market is out of control.

We are in the end game of the bubble and it has to be underlined that the bubble can run and run. But it also must be understood that when the bubble bursts it will produce another calamity and it will be violent. This will undoubtedly be followed by yet another bailout. Whether this is sustainable is an open question but it certainly doesn’t seem conducive to low inflation.

This is a perfect traders’ market and the luscious returns for FOMO investors will remain irresistible, until suddenly they get crushed. Meanwhile buy and hold investors are in for a great stretch followed by another test of their resolve.

Personally I am risk off but probably not enough. The Nasdaq vertical is in place and how high and how fast that goes is anyone’s guess. I’m not chasing it.

(Of course this time is different, Nasdaq to 100,000. Two trillion dollar companies, why not $10 trillion. Printing money doesn’t create inflation. The stock market isn’t connected with the economy.)

One last thing:

The Federal Reserve’s balance sheet

The Fed built this bubble and for now it’s stopped pumping. That is at least a reason to keep a close eye on its website.

By Clem Chambers

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