But what if I fail of my purpose here? It is but to keep the nerves at strain, to dry one’s eyes and laugh at a fall, and baffled, get up and begin again – Robert Browning
I think we’re going to find out the answer to this question before long because we’re starting to see some of the same markers that preceded the meltdown in 2008. It’s not just the blow-up in quant funds, which happens when correlations between asset prices break down, it’s also the marginal weakening of consumer spending, a noticeable increase in layoffs, talk of credit losses at banks, and conservatism in corporate reports.
Unlike 2008, the stock market is running hot, the Vix, or volatility index, is approaching lows, and bank stocks are making money. It’s as if fundamentals don’t matter in the slightest.
I believe the rally off the 2009 lows represents a financial experiment whereby the government empowers agents to systematically prevent sell-offs in the equity markets to maintain confidence in the inherently less risky credit markets. It has worked for 16 years but have we reached the end?
Give It a Try
When you ain’t got nothing, you got nothing to lose – Bob Dylan
I wrote about the above in early June in my Bizaro World piece where I explained the portfolio management theory behind driving the equity markets higher when faced with a negative credit cycle. Here’s a link: https://geovestadvisors.com/bizaro-world/
I posited this theory around ten years ago to help me understand why the stock market continued higher despite the massive (and growing) inherent leverage in the system. Financial leverage, or using increasing amounts of debt instead of equity when funding a capital structure, adds to risk. This is because borrowers MUST pay interest on the money they borrowed at legally specified intervals, otherwise the borrower goes into default where the debt holders can restructure the ownership of the economic entity. Basically, debt holders can eliminate the ownership rights of equity holders and divide the value of the entity among themselves.
This is why debt is considered less risky than equity which is critical because the debt markets are vastly larger and far more critical to our country than the equity markets. In financial terms, the value of equity lies in the residual value left over from liquidating a company after debt holders have been satisfied.
My theory is working like a charm, whether it represents reality or not. The chart below measures the spreads between what corporate bonds pay in interest versus what treasury bonds pay in interest for the same maturity. The lower levels on the graph represent extreme confidence that credit will remain strong while high levels represent extreme pessimism.
We’re currently at extreme levels of optimism; perceived risk levels are even lower than the good times that preceded the crash in 2008. What could go wrong?
The table is set for a crash but it will only happen if the fundamentals prove to be far too weak for government agents to withstand. We’re not there yet.
The Fed’s Dilemma
You’ll be damned if you do – and you will be damned if you don’t – Lorenzo Dow
The Fed needs to slash interest rates to save the US economy. But what will happen if the Fed slashes interest rates aggressively? It will send a message that not all is well in the US economy – and it’s not. In this scenario, Jay Powell is damned no matter what he does which is why he’s doing nothing.
Since it’s all about the data, everyone knows that the markets experience their worst performance when the Fed starts slashing rates because historically, the Fed is ALWAYS late. Fed chairmen have a habit of shutting the barn door after the horses escape and Jay Powell is among the tardiest, having missed the inflation in 2022 and ignoring economic weakness today.
JP is going to be remembered much like Mrs. O’Leary’s cow after the infamous bovine kicked the kerosene lamp that started the fire that burned down Chicago. The world economy runs on Eurodollars and he’s set the price of obtaining dollars too high. The 2 year Treasury note is telling us that interest rates are headed lower as it’s inverted to Fed funds but not much lower – maybe 50 bps.
China Joins the Party
60% of the time, it works every time – Paul Rudd (Anchorman)
The chart below of the Shanghai Composite is right out of the US government’s playbook. In fact, both Europe and China are following the same playbook. Again, I wrote about this is Bizaro World, linked above.
Apart from Deepseek’s brilliant copy/redux of ChatGPT that they are selling for pennies on the dollar, China is collapsing – not figuratively but literally. Xi Jinping bet the ranch on electric vehicles and green energy and the world isn’t buying. The electricity needs of AI means that we can’t afford to hook our cars up to the grid – Nvidia’s gpu’s are electron guzzlers. Furthermore, green energy isn’t dependable enough to power AI – baseload capacity is needed and that’s going to be coal, gas, and nuclear.
Worse yet, BYD attempted to dominate the Chinese market by starting a devastating price war. Now the industry is financially on death’s door, especially the supply chain. And did I fail to mention that auto shippers are increasingly turning away Chinese EV’s because EV fires are impossible to extinguish at sea and some giant car carriers have already been lost to Davy Jones locker.
Adding to the losses in automobiles and green energy, housing is still in deep decline. High-speed rail is hemorrhaging close to a trillion yuan annually. Air carriers and airports are losing billions each year. Steel, aluminum, and other primary industries are in extreme states of overcapacity and losing billions annually.
80% of employment is in small businesses that are being destroyed by excess taxes and fees by revenue-starved local governments, declining consumer spending and extraordinary levels of competition. Food delivery operations like Alibaba are putting small restaurants out of business.
China is losing export markets to Asian competitors and South America. All of this before tariff’s take their bite out of China. Finally, losses in their Belt & Road initiative are close to $1trillion. I’d say it’s “hitting the fan” in China but the fan has already been re-possessed.
If China can make the market intervention blueprint work, then it truly is a panacea for the world. Call me a Luddite but I suspect it will prove to be yet another tofu-dreg project and fall apart before year-end.
Conclusion
You can put lipstick on a pig but it’s still a pig – Unknown
I am a fervent believer in the max pain thesis in options trading which posits that the maximum number of options contracts eventually expire worthless. I also fervently believe that the marginal transaction in the equity markets is set in the options markets.
If and when these markets are set to melt down will depend on when the maximum number of investors are sitting on long positions and when the number of people betting against the market is virtually zero. Only 5% to 10% of investors will get through this unscathed.
The global economy is experiencing a paradigm shift away from trade – and growth. The full impact of US tariffs have not yet been felt but it’s coming in the third and fourth quarters – just when the markets enter their historic danger zones.
If governments can maintain their control over the markets, then we’ll be fine. But what if………they can’t? Are you ready?
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley.
Philip M. Byrne, CFA
