Echos and Rhymes

While it's true that a bell doesn't ring at market tops (or bottoms) it is also true that valuation and psychology matter when determining prospective returns and risks in markets.  Complacency implies more (not less) uncertainty about future outcomes as some probabilities are excluded a priori. Stretched valuations in asset markets imply lower (not higher) expected returns in the medium term.  At high levels of valuations and high levels of complacency I have low conviction that the near term returns will be sustainable; the current speculative returns on capital will risk becoming negative returns of capital in the median term.

China is unraveling, one tenuous, credit woven thread at a time. Seemingly insignificant corporate / trust defaults, a weakening currency (piloted or not) and the devaluation of debt collateral (see copper and iron ore futures).  Problems aggravated by rampant rehypothecation.

The Shiller CAPE is at 25, a level associated with mediocre (0% to 2%) stock market returns in the subsequent 5 to 7 years. Margin debt is unsustainably high as is bullish sentiment (85% bulls).

Credit markets are very active. Corporate IG grade issuance to finance stock buy backs is exploding at spreads that leave little room for protection when the credit cycle turns. New High Yield bond issues have increasingly fewer protective covenants, at low absolute yields and insufficient spreads.

Risky assets in general are not inexpensive, risk is the crowded trade. We're closer to the end than the beginning of a large cyclical bull move in stocks (S&P 500 666 in 2009).  I'm not calling a top, I simply believe that the easy money has been made and at these valuation levels there are insufficient prospective returns for the risks assumed.  Markets may continue to levitate but the speculative returns in this phase will probably prove temporary and I think it's better to have less capital at risk until valuations and psychology become more favorable to investing.

January Avalanches

In my post on July 28, 2013 "Early and Wrong?" I wrote :

When central bankers and central planners meddle in financial markets and market economies (or quasi market economies) they pervert the price discovery mechanism and distort the risk and liquidity premiums that are fundamental to the efficient allocation of capital and resources. In the near term interventionist policies can alleviate some pain or create apparently favorable market conditions (QE induced rallies) but in the longer term these policies create complacency at the cost of superficial and incomplete analysis of underlying micro and macroeconomic activity and risks.

I'll speculate that fundamentals eventually will matter again and when they do it will be imperative to have estimated how much systemic risk, because of the mispricing of risk, has been created by manipulative policy.  Start your (independent) analysis early.  Where are we? How did we get here? Under which conditions are the current  risk premiums and valuations sustainable? And most importantly how much can I lose if I'm late to the party and wrong?

Forget about looking for a catalyst to explain what we saw in world financial markets in the month of January, it's really not that important. Unstable and unsustainable conditions create corrections and dislocations in financial markets, much like avalanches are inevitably created not by the the skier but by the amount of snow on the slope and the climatic conditions preceding the event. 

Don't look for the next skier. Have conditions changed enough to alleviate the disequilibrium / distortions  in valuations and risk premiums, the excess leverage and the overconfidence in markets?  I'm preserving capital and thinking about the reversal of the flows of the past five years that brought us to these conditions. Is it possible that what was erected in five years (malinvestments) can be demolished in five weeks? Perhaps, but I can't know that and I'm not betting on it.

Change and positioning

Change happens at the margin (periphery)…ice doesn't melt from the inside.  In the developed world we often don't consider that the margin of an interconnected system is part of the system and that changes at the margin can provoke changes throughout, including the core.  And then there are the initial conditions of the complex system which influence the possible paths and outcomes as the system evolves. (future returns)

Consider : valuations, multiple data points, sentiment AND contextualize these initial conditions.
Add apparently insignificant / unconnected change at the margin : Argentina, Turkey, Venezuela, Ukraine, shadow banking in China (trust and wealth management products).
Then think. What possible outcomes could there be? How is our portfolio positioned, does it take into account our ignorance about the future or does reflect overconfidence in our ability to predict uncertain outcomes?

More things can happen then will happen but we can't know a priori, with certainty, what will happen and we shouldn't pretend that we can. What is certain is that we'll create a narrative ex-post that will have explained with precision exactly what has happened.