How 2019's Market Top Parallels to the Time Right Before the 2008 Financial Crisis (w/ Sven Henrich)
SVEN HENRICH: Sven Henrich, been running Northman Trader for about six years. Originally, private investors, way background was corporate management actually in corporate strategy internationally, always been looking at companies and opportunities. Hence, the background and analyzing stock markets comes natural to me. Our business model is really looking at identifying the big moves. We're not day traders where we're looking at swings, so be it long be short. Of course, as part of that, we're looking at the macro environment markets in general-- central banks, what have you, although that's secondary, the key is technicals and being able to identify the big turns and that's what we do. You see me on Twitter, @NorthmanTrader or on the website, northmantrader.com. Yeah. In April, I had put out a piece called, "Combustion". It was this whole notion that both bulls and bears need to be mindful of potentially this really uplifting scenario. We had a big turn from the lows of 2018. We're literally all central bank policy combusted by them and the view was we're going to be raising rates, we're going to be having a reduction in the balance sheet on autopilot. Then of course, markets dropped 20% and then yields dropped, actually started the other way around. Basically, it was yields heading to 3.2% on a 10-Year in October, and that sparked a whole selloff in my mind, but basically, central bank's completely reverted policy. The Fed had this whole job owning operation all year long from tightening to easing and rate cuts are coming. That's what they've been doing all summer long. In April, what I said was we're going to keep going on this trajectory until something breaks. We had a quick correction in May, we had some of the same negative divergences that we have in the fall. Something interesting happened here, because we had a temporary high and then we had the correction. Then in July, we came to a new high and we had a correction. In June, actually, I had put out this piece called, "Sell Zone," this was at the end of June, just before the Fed meeting in July, and the notion was this period, this price zone between S&P 3000 to 3050 is a sell zone, listed a whole bunch of technical factors for that. We had the initial reaction. It was coming off the heels of the Fed rate cut, the first rate cut since the financial crisis. We dropped from 3028 down to about 2780 on the futures contracts. A snappy technical reaction. Then it all started again with trade optimism and more rate cuts coming and so we rallied again into September. My view in April was that would be this potential for a blow off top move and the ultimate target of that was about 3100 as an extreme case. Now, what I find interesting here is that in September, we got back to this 3000 zone that I had identified at the end of June as a sell zone, 3000, 3050. We got another rate cut. The ECB cut, and we got to 3022, just below the July highs and we dropped again and so now we have to rate cuts, two drops, potential for double top because we have these all new highs up and sold in the last year and a half. There's not been yet evidence that any new highs are sustainable so markets have been this wide range. In 2019, primarily driven by multiple expansion, either by trade optimism, or by the Central Bank put and my question in general has been, what's the efficacy? Is there a sign that central banks will actually start losing control of the price equation? We're at the edge of control here. We're still in this phase here with the China trade negotiations. Global macro has been slowing down throughout the year, the US was the island and the sun, if you will, because global markets actually peaked in January of 2018 and then the US decoupled from the rest of the world. Europe, very close to a recession here. The manufacturing data is maybe now spilling into the services sector. There is now risk that we're ultimately going into a global recession into 2020 and what central banks obviously, have clearly stated, their intent is to extend the business cycle by any means necessary, and we can talk about that separately. We're now at this critical point. Will we get a trade deal that's substantive? By substantive, I mean that actually impacts CEO confidence. Keep in mind, this whole year and a half year with this trade war going on, companies have been holding back on CapEx investments, business investments, and now, we're seeing a slowdown in hiring. Remember, with a 50-year low in unemployment, the official unemployment rate, and jobs growth has been slowing down. If you get a-- and I've been very consistent on this, if you get a substantive trade deal that addresses all the big issues and causes companies to say, "Okay, now we're more confident again," then yes, you can have a massive blow off rally and now, with easing central banks and the oldest liquidity coming in, you can have that run. The question is, are these parties really in a position to say we're going to have a substantive trade deal? There does not appear to be any sign of that whatsoever. We see a lot of positioning, actually this week even, we see China in the US aggravating the tactical battle, if you will. China is-- in this morning's indicating they may be open to a partial deal. What does a partial deal really mean? Is there probably a relief rally surrounding a partial deal? Probably. We can all speculate in the sense that, "Okay, well now, it's not going to get any worse." It's a stalemate. We've basically, everybody's waving the flag. Mr. Trump wants to get reelected in 2020. Can't afford a recession. The Chinese don't want things to get worse either. Everybody's holding back. Fair enough. That could happen, but is it enough to then get confidence back to say, now, we're ready to invest when the big issues remain unsolved? That's obviously the question that no one can answer. Now, of course, the flip side to this is there's not enough that the parties either can agree to that gives anyone any confidence because keep in mind, all the slowdown has perpetuated in the last year and a half. There has not been any sign of slowing down, maybe a little bit civilization in China but now, the US is slowing down. In fact, I think it was the Fed's Rosengren that came out last week, and says he's expecting 1.7% GDP growth for the second half of the year in 2019. Not exactly convincing when you have a market that has rallied on nothing but multiple expansion in 2019. There's a lot of risk both to the upside and the downside from my perspective. On the one hand, yes, there's some similar elements. On the other hand, people like to say it's different this time. Well, it really is different this time because, look, in the past, we've had situations where we've had high debt, and we've had yield curve inversions, we had all these things that are taking place at the end of a business cycle, but never before have we seen so much intervention, so much jawboning and never before have we come out of a business cycle where central banks have not normalized in any shape or form. This is uncharted territory. I think we're all-- I don't know what the expression is so maybe we're all mollified or pacified in a way because markets have changed so dramatically over the last 10 years as a result of permanent central bank intervention. I get it from any investor perspective, because we've all been trained, literally trained to know that any corrective activity in markets is contained. It's contained within a few weeks, within a few days, within a few hours. All bad news is priced in immediately. We saw it in December. This was the most substantial correction we've had since 2011. Why did that happen? It stopped right when Mr. Mnuchin came in with his liquidity calls to banks and with Mr. Powell flipping policy on a dime. We're flexible suddenly. This is this point where you never have anything that sticks from a price discovery perspective. My concern in general and the voices in the summer was that we're creating these markets that disconnect ever farther from the underlying size of the economy. Well, there's two trains of thoughts. First of all, this is a history part of it. History actually tells us that the inversion we have on the 10-Year and the 3-Months actually precipitates a recession every single time. The question is the timing of which. Now of course, you have other yield curves. Some of them which are inverted, some of which are not, but it's really the point of the steepening. Once that inversion reverts back into a steepening phase, that's when usually the recession comes. We're not at the point yet where that steep learning has taken place. However, the 10-Year and 3-Months, it's been inverted for several months now and that's typically one of these classic warning signs. There's another school of thought that says basically, well, none of this matters anymore because we have central banks intervening and blah, blah, blah, blah, blah. I'm not of that viewpoint. I think the signals are there. What's missing for the bear case, frankly, as I called it the missing link is the fact that unemployment is still okay. There's not been a minute where it's been slowing. We haven't seen that flip yet, where companies are suddenly really going into layoff mode. That's what interesting looking at Q3 earnings now, because a lot of companies will show either flat or actually negative earnings growth, which brings me back to this multiple expansion. We've been running to market highs, not because of great earnings growth. Earnings growth is flat to weakening here in this quarter and so companies are experiencing margin compression. Then there is that point where they want to start looking at the largest expense line item, which is jobs. What's been so interesting and the reason I kept saying that all new highs are sells is because all these new highs are coming on specific technical signals and sector divergences. Especially looking at this year, again, we see-- well, last year was basically again, this was tech, it was Fang-led. It was the big tech companies. All new highs came on negative divergences on the technical basis and they were sells. What was interesting, ever since 2018, the markup of the market has radically changed. Last year, the banks were leading, the small caps were leading, right into these September, October 2018 highs. That has completely changed in 2009. You overlay a chart with the SPDRs vis a vis small caps and transports and the banking sector, it's a horror show. When we're looking at the S&P like in September and again, within all-time highs, I can tell you if you go back to exactly last year, the banking sector small caps and transports, they're all down to 11% to 13%. They've not participated. In fact, they've been in months long ranges. It's amazing because you see these rallies go up as and hey, people get bullish again. Then they drop right back to the bottom but the bottom is holding. Even this week, again, the small caps, transports and the banking sector, right on the edge of support and they keep bouncing. Now, I look at this from a technical perspective, I say, "Okay, well, the more often you tag a certain area, the weaker it becomes either to the upside or to the downside." We've tagged these areas now multiple times and for a rally to convince, for new highs to convince and to be sustainable, we need to see those sectors partake and get above resistance. Until I see that, I'm very suspicious of any new highs if we get new highs and from my perspective, going back to this whole trade deal, unless we see a substantive trade deal, I view any rallies to new highs as sells because that's basically what they've been doing. Just one more thought on this whole sector piece, there's a chart I've been publicizing quite a bit that's called the "Value Line Geometric Index." It's a fascinating technical indicator because all these indexes are market cap based. The Microsofts, the Apples, the Amazons obviously have a dominant impact on an index like the QQQ because they're worth a trillion bucks each. If you take all the stocks and put the same dollar value on them, let's say everyone is worth 100 bucks, and now track their relative performance, you get a completely different picture. What we've seen since 2018, since the September 2018 highs, is that all new highs that were made on the S&P come on the lower reading on the value line geometric index. That's another one of those signals that tell you, "Okay, these new highs have been a sell." See that picture change, then you can have sustained new highs. To me again, it comes all about efficacy of what the central banks are doing whether we get a solid trade deal or not. Because in so far, none of these things have shown any impact or suddenly changing the growth equation in the economy. Volatility has been fascinating. I've been publishing quite a few pieces on the VIX in the last few months. The VIX, I hear this all the time and I keep having to push back. People are saying you can't chart the VIX because it's a mathematical derivative product. Yes, you can chart the VIX. In our job, what we do, obviously, we always have to look for what is relevant. We can all have our opinions. What markets should do or shouldn't do, they will do what they will do and what we have to do is keep ourselves on this and to see what is relevant. We know a lot of algorithmic trading is part of markets. They follow programs as well. You always have to look at, "Okay, what are they looking at? What are they sensitive to? What are they reactive to?" Because we want to be able to interpret risk reward short or long on that basis as well. What the VIX has done over the last two years is fascinating. There's been very specific what I call compression patterns in the VIX, especially on the low end. It can drive people nuts. It can get caught, consolidate on the low end and then boom, you have a spike. That seemingly comes out of nowhere, but it doesn't. It's in the charts. I call them these compressing wedges. Now, what's been happening on the big picture on the VIX is as the S&P has made new highs each time, the VIX and the in between periods has made higher lows. There's a trend of rising volatility. Obviously, December last year was the big spike. It's the lows, what happens during the lows? Remember, 2017 was the most volatile compressed year ever because we had global central bank intervention, we had the upcoming tax cuts, there's no volatility markets from a trading perspective, I hate that. I love volatility, I want to see things move, but now that we've had these selloffs, even the smaller ones, if not been able to contain volatility to the extent that they've been able to do in 2016 and 2017, since 2018, we have a trend of higher lows. Now, the VIX is again in a compression pattern that suggests the possibility of a sizable spike still to come this year so we may have one more hurrah before the yearend rally that we so often see in markets. I think this whole shift of passive is fascinating. Maybe a couple of comments on that. I haven't seen this discussed anywhere. Just my impression. I'm wondering how much of the shift from active to passive investment is actually a consequence of central bank intervention. What is driving passive? Well, you talk about management fees on the active side. Well, the main driver for the movement to passive is that people have given up. They see active investors lagging the indices. Why are they logging the indices? Because everything is geared towards the big cap stocks. The intervention-- if you're really careful in analyzing and you're smart and you have a smart team, if you diversify in the universe and you get hammered anywhere you lag in the indices, and passive allocations keep allocating passively. It's like this dumb machine that doesn't care how much it pays. It doesn't care what the valuations are, doesn't care about any of that. To your point about signaling, yes, it's amazing when you see-- and that's why I'm coming from a technical perspective, you see charts that are massively, massively historically overextended but no one cares because you have this passive machine that keeps investing. I think I mentioned this last year, too, it's like, are people actually aware what they're competing with? Because you and I may have a sense of, "Okay, this is getting very expensive," but a machine doesn't care what it allocates. The ETF doesn't care what it allocates. It just has to do rule based. You're sitting in the market with entities that don't care if they overpay. Classic example is Apple. Take that stock as an example. It's obviously hugely valued. It's a big company. It's a trillion dollar valuation, but it keeps buying back its own shares. Obviously, as a big company, it benefits from these passive allocations. What people don't realize is that Apple has the same amount of earnings that it had in 2015. Four years later. Absolutely no change in earnings, same amount of earnings, but people are paying almost twice the price for the same stock. Why? Because Apple's been buying back its shares, therefore reducing the float and save for the same amount of earnings produced a much higher EPS, earnings per share, bigger. It looks like it's growing, but it's not. That's my point about this whole pacified machine that has been created. You, since corrections are not allowed to take place for an extended period of time, you're looking at all of sudden at yearly charts. We have stocks, as I mentioned before, like a lot of sectors are lagging behind, and the big cap stocks keep holding everything together because all the money goes towards them. Because corrections are so short, we have yearly charts that show nonstop gains for 10 or 11 years. There's absolutely-- the December corrections even show up in these charts because they were still up on the year in many cases, so you look at Starbucks and Disney. Disney is a good example. Up 11 years in a row. Well, this is this fantasy that's being propagated now. Because I just put my money into passive funds, I don't have to think about it. It's risk free central banks always intervene and so we have these massive charts that are vastly extended. Even the technical indicator I watch. On any chart timeframe, you will find this useful. Be it on the daily chart, the weekly, the monthly, the quarterly and the yearly, it's the five exponential moving average. Even on a daily chart, you see vast extensions above it, it will reconnect either to the upside or the downside. If you see massive extensions on the weekly chart, at some point, it will reconnect. The reason I mentioned this is there are stocks like Microsoft that are 50% above the yearly five EMA. Why is that relevant? Because if you look at the history, look at a stock like Microsoft, you can go back to its inception and this stock always connect every single year like clockwork. There were two exceptions, Microsoft, my favorite example. One was the year 2000. It was in 1999. It was completely extended, did not touch the fire a yearly five EMA. Then the second year was 2001 when it went way above, and then it obviously plummeted down with the NASDAQ crash and reconnected, and now. It's now on its second year, it hasn't even touched it. It's vastly extended. From my perspective, I look at all this with what central banks are doing here. I see risk building that these reconnects, technical reconnects, will take place at some point. When they do all of these stocks all of the sudden have 30%, 40%, 50% downside risk. This is the undiscovered country. It really is. Look, I'm coming from a training perspective. I'm resentful of central banks simply because of the volatility compression that they have aimed to do. In fact, Jay Powell came out yesterday, made a very telling statement with regards to repo and overnight money markets. He literally said we have to calm markets down. We need to calm. Where's that in your charter? Where's that in your job description to calm markets down? Look, markets are supposed to be free flowing in price discovery, but it's telling because he has to control that aspect of the interest rate equations, he has to control it. That's the point. Everything is controlled. When I look at this experiment that has taken place over the last 10 years, and I'm just absolutely flabbergasted that this is not being pressed more critically by journalists, by the media and by the public discourse. QE, lower rates were emergency measures to deal with a crisis. That was the original intent. Ben Bernanke, QE1. Then came QE2, and then twists and turns, then QE3. It morphed into permanent intervention. The promise was always we're going to normalize, becoming come out of financial crisis, everything that we do, low rates were going to incentivize growth in the economy. They haven't. It was the slowest growth recovery in history. In the meantime, low rates have enabled this incredible debt expansion. Now, we also got eyes always glaze over with debt no one even-- the numbers have gotten so big and continue to get ever larger that no one even can fathom these numbers. Here's a fun one. In the last 10 years, the US has added more debt to its balance sheet than in the previous 42 years combined. That's this vertical curve we have and there's no end in sight. When the Fed, last year, tried to normalize its balance sheet and try to raise rates, which they managed to get to, basically, the lowest point of raising ever, it all fell apart. The 10-Year hit 3.2% in October of 2018. That was the end of it. The debt construct cannot handle higher rates and so they were forced to capitulate. My question and the answer to your question is, can they keep this going forever? Which is interesting to me, coming back to this point I made earlier about valuations of asset prices vis a vis the underlying size of the economy. In the year 2000, when the NASDAQ bubble burst, the overall market cap of the stock market got to about 144% of GDP. That was it. It was just too high above the economy. That's where the crash happened. That's where the recession came. Then we re-inflated. This was the lead up to the housing bubble. Cheap money, who caused the housing bubble? Well, we can argue it was the Fed with cheap money and this cheap money had to go somewhere and so we offered credit and subprime mortgages to people who can't really afford it. The stock market rose to about 137% of GDP. Guess where we topped in January of 2018? 144% market cap to GDP. Where did we top in September of 2018? 146% stock market cap to GDP. Where did we end this summer in July? 144% stock market cap to-- there seems to be this natural barrier that says, "Okay, well these valuations have to be justified somehow." When I now see the Fed saying, okay, well-- back in September, where we're back at 144%, what are you trying to do here actually? Obviously, what you have done, what all the central banks have done has not produced organic growth anywhere near the growth that we've seen in previous cycles. That's why the ECB still in negative rates and they're trying to do more than negative rates. For me, that the question is one of control, efficacy. Does this produce another lasting jumping an asset prices? There is no answer to that question yet, but there may be signs. For me, the first sign was, okay, this July rate cut when we had that sell zone of 3000, 3015. Does the Fed rate cut actually produced sustainable new highs? The answer to that was no. Then in September, we had the second rate cut. Did that produce sustainable new highs? No. Yesterday, Jay Powell talked about increasing the balance sheet again, but don't call it QE, wink, wink. We sold off. Those are those three specific signs, events where the Fed has not succeeded in producing new market highs or for that matter, new growth. I think the question is very much outstanding. Once we know what's happening with this trade deal, we need to keep reassessing the mechanics of markets and the technicals and see if we can actually see a sizable turn in the economy. I'm highly skeptical. Because all we're doing is just keep enabling more debt and demographics are not changing as a result of that. The deflationary cycle is not changing as a result of that. Beyond temporary highs, I have to see where that's producing anything on the macro form, and so far, it hasn't. I think we have to differentiate two things. The MMT part, it's your classic capitulation. We don't know how to solve any of the world's problems, because that equation is ongoing. Because we have demographics that are sending a very clear signal. Working age population, by the way, I've posted out a few times. I find it fascinating. For the first time ever, the growth in working age population is actually going negative. That tells you everything you need to know. There's a huge demographic change going on as the baby boomers were retiring, how do you produce growth with those numbers, unless you believe in some AI productivity fantasy, which we don't have evidence for that yet. MMT to me is the ultimate absurdity of it all. Free party, free credit. We keep printing money and there's no consequences. MMT adherence will obviously push back hard on this, but even central bankers like Jay Powell are very much opposed to MMT. I personally think is a fantasy, as well. In terms of your question about fiscal policy, can now governments come up with infrastructure programs or what have you to really push that equation? This is where I'm going to have a different take on everything. Now, this brings me back to what we're seeing in the political sphere in the United States and the United Kingdom, in Germany, everywhere across the west. We have social fragmentation, the likes we haven't seen in our lifetimes, at least. It's hard to see political cohesion anywhere. Germany, for example, used to have three or four parties, not a six, seven and no one has a majority of any sort. The UK Brexit is a classic example. It's impossible to come to any agreeable solution that's been going on for years. The United States is, impeachment aside, what's happening down that front, this fragmentation has been going on for at least 20 years. It just keeps getting worse and worse and worse, and how do you get to a complex policy solution that enables you to actually implement structural solutions if you can't agree on a common reality, and there's no common reality on anything right now. Although to be fair, Democrats and Republicans in the US always agree to spend more money, that's what we just saw again in this latest budget round. I remain unconvinced that fiscal-- even though I hear Draghi claiming for more fiscal spending, I don't see the political cohesion to bring something like that about-- German, interestingly, on a side note, they're actually running it surpluses. They're getting criticized for that, which makes actually, I think Germany really an interesting place to-- if we do have a global recession, what country is actually able to really deal and stimulate ultimately. They've been very disciplined and holding off on this point, but I suspect they may have more ammunition than anyone else when we do hit a recession down the road. How do you see the end of the cycle playing out? I am actually looking for a yearend rally, because I think what happened in December of 2018 was superbly rare. It happened only once before and that was in December of 2000. That's how rare these December dumps are. However, I'm just going by what I know now, and I don't know what's going to happen with the trade deal and this time, the other. What I do know now is basically what I see in the charts is there's just another very, very sizable volatility spike to come. I can't tell you when that comes, it would maybe make sense for that to happen in October or into November. Then that spike is probably be a buy in markets for a yearend rally, can see that happening. I expect the Fed to cut rates again in October, maybe throw another one in December. We'll see. I think ultimately, the question is, and I've been posting this chart for months now. It's this broad megaphone pattern. If they can get above it, we can have a massive all liquidity and ala March 2000. It was just crazy blow off the top. I'm not predicting this. I'd actually don't want to see that. I think stuff like that is just going to be horrid ultimately, because it will just exacerbate the pain on the downside. If markets cannot sustain new highs from here, I think going actually back to an earlier question you asked about historical example, look closely at 2007. We made a high in July, we made a high in July this year, then the Fed cut rates in September of 2007. Because that was their response when subprime was contained. Don't worry about-- there is no recession. That's the same narrative we're hearing now, there's not going to be a recession. The recession came only two months after-- three months after the Fed cut rates. It came in December of 2007, when no one saw or admitted a recession was coming. After that rate cut in 2007 in September, markets peaked in October, and that was it. No one-- this is the fascinating thing, see, market tops are only known in hindsight with enough distance. They're not apparent or anyone at the time. That's why I'm just using that as an interesting example and as a threshold to say we must make new highs from here or we're risking, we're actually made a double top in July and in September of this year, so I think people need to watch the price action very carefully from here. Just finishing up on 2007, when markets made on marginal new high in October of 2007, and the Fed was cutting rates, Wall Street projected price targets of 1500 to 1600 to 1700 for 2008. All of them. All of them were bullish in December, not knowing that the session officially actually started in December of 2007. The S&P close the year at 800, 880, something like that, cut in half, basically. I think what we all need to be closely watching for is efficacy of what happens on the trade front, efficacy on what happens with the central banks and the price action in the charts. Do we see participation coming from the small caps, transports and the banking sector? Yes or no? Will we see sustainable new highs or not? If we don't see new highs, risk for double top, watch what the VIX is doing and then it remains a range bound market for now with opportunities and both sides but I think there's some critical thresholds that have taken place. Punch line, no bull market without central bank intervention. It remains an artificial construct. I am worried that all of us have a warped perception of value of what markets should be doing because, let's be very clear here, we would not be at new highs in or we would not have hit these current levels of 3000 in the S&P were it not for complete central bank capitulation, four rate cuts, jawboning trade optimism, all these valuations have to be justified at the end of the day. You cannot lose one of these equations and so markets remain artificially inflated. The question is if, like in 2000, or in 2007, central banks efficacy loses out. Remember, they had to cut rates by over 500 basis points to stop the bleeding back then, and now, they barely have 200 basis points to work with.