Worst-case scenario ahead.
The S&P 500 has more than tripled over the past eight years; the
Nasdaq has more than quadrupled. Practically everyone knows – even the Fed
has gingerly admitted it – that the stock market is way overvalued, that
price-earnings ratios for companies that have earnings have reached dizzying
heights, and that the market is primed to unravel either on Tuesday or next
year or whenever.
And there are lots of people who have pointed at the triggers, such as
Trump’s inability to deliver on his tax-cut and infrastructure promises or
the moment when the market finally gets it that the Fed is watering down the punch bowl.
Given the inflated levels of the market, and the amounts of liquidity that
would suddenly evaporate, it would be an epic crash. That’s the theory. And
it would make an equally epic buying opportunity for those with
liquidity.
So the smart money is preparing for it. Among them are hedge fund
manager Paul Singer and his clients. In his recent letter to investors, cited
by MarketWatch,
he explained how “all hell will break loose” and how he wants “to take
advantage of it”:
Given groupthink and the determination of policy makers to do ‘whatever it
takes’ to prevent the next market ‘crash,’ we think that the low-volatility
levitation magic act of stocks and bonds will exist until the disenchanting
moment when it does not. And then all hell will break loose (don’t ask us
what hell looks like …), a lamentable scenario that will nevertheless present
opportunities that are likely to be both extraordinary and ephemeral. The
only way to take advantage of those opportunities is to have ready access to
capital.
Elliot’s hedge fund, Elliott Management Corp, had raised “more than $5
billion in about 24 hours” for just that event, Reuters reported on May 5. The firm has $33 billion
under management not counting the $5 billion. That it took him only 24 hours
to raise this much money shows how eager investors are to capitalize on the
next crash. The money is set up to be drawn from investors over the next few
years. They see it coming; they just don’t know when, and they want to be
ready to benefit from it when it comes.
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The market is like a “coiled spring” after eight years of QE and interest
rate repression, Singer said in the email announcing the $5-billion offering.
His firm wants to have the liquidity to capitalize on a “possibly large
opportunity set that could emerge when investor confidence is impaired,
recent correlations and assumptions don’t work, and prices are changing
rapidly.” He added:
“The nature of modern markets is that rich opportunity sets seem to be
ephemeral, providing surprising volatility, bargains and dislocations for
only brief periods of time before governments, aware of the politically
destructive effects of extreme volatility, rally to take stern actions to
keep the balls up in the air.”
So they’d have to act fast to front-run the Fed.
Others too are preparing for this obvious opportunity. It will be an
event that could produce extraordinary returns by picking up the pieces
before central banks jump in and once again bail out stockholders and
bondholders. That’s the theory.
But here’s the thing: the more investors prepare for this by putting large
amounts of money aside to plow into a crashing market to pick up the pieces,
the more likely they will be to stop the crash in its tracks.
As a sharp sell-off unfolds and after regular dip-buyers are crushed, the
nervous crash buyers that don’t want to miss this opportunity will start
buying. They’re nervous because the Fed could jump in and reverse the crash,
and they want to pick up the pieces before that happens. So they’ll jump in
early and the intense buying will stop the crash.
This includes short-sellers who want to take profits and cover their
positions during a crash. They’re the most nervous bunch of them all.
Under this buying pressure, asset prices would begin to bounce before the
Fed steps in, and given the bouncing prices, it might not step in, though
prices might not reach prior highs. Then, after a period of calm which the
smart money will use to unload these positions and take profits, the sell-off
would start all over again until crash-buyers pile in again to front-run the
Fed.
This can go on for many years – a brutal zigzagging lower that never quite
offers the buying opportunities because too much money jumps in too soon to
turn selloffs into rallies that then fail. Japanese stocks have gone through
this since 1989 despite the Bank of Japan’s umpteen rounds of QE and endless
interest rate repression. And they’re still going through it, with the Nikkei
down nearly 50% from its peak almost three decades ago.
Given the smart money’s fervent intentions to capitalize on these crashes
and given investors’ eagerness to put a lot of money behind this strategy in
advance, I think a long drawn-out Japan-like downtrend in asset prices with
dizzying ups and even bigger downs is a likely if terrible scenario that may
well crush how investors feel about buying and holding these assets, as it
did in Japan.
A stock or bond market tantrum might stop the Fed in its tracks. But the
opposite is happening. Read… Are
Markets Blowing off the Fed?
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