Monday, July 22, 2013

This is How Bull Markets End

I'm not saying the top is in.  In fact, I think in the next 6-12 months we will see higher prices punctuated with your usual <10% corrections.  But the next big drops, ie >20% "bear markets" have been finally made possible thanks to shift in underlying sentiment of market participants.  First a truism that we have all heard before: buy low sell high.  People take this too literally, forgetting that relative peaks and troughs are only obvious afterwards and what you thought was low two months ago could be a relative high now.  What it really means is to understand the cyclical nature of sentiment--to be wary of x when others worry about y.  When others finally get wise to y, start scrutinizing x again.

In market cycles, one of the biggest factors, particularly today, are the actions of our central bank as they guide the banks in the private sector by setting the fed funds rate.  Since loans that those banks make are by large our money supply and thus driving money flows and transactions, we need to analyze the Fed to analyze the economy.  This is not as complicated as it looks.  The Fed is basically concerned with the same thing any other entity is concerned with--survival and growth.  Its credibility and reason to exist grows when our economy does well, as measured via inflation (CPI) and unemployment.

In a nutshell, when the economy does well and employment is high, the Fed is wary of inflation.  As inflation expectations rise, the Fed begins to hike rates, making borrowing money more expensive.  Thus, transactions slow down and some companies fail when they cannot secure financing.  (In fact, this is why most financial frauds only go bust during recessions.  During bull markets, money is easy and even shady companies can get loans.  It is only when rates begin to rise that they start losing friends.)  Failed companies lay off workers and laid off workers stop consuming as much and we transition into a recession.  Now the Fed worries about unemployment and thus lowers rates and the cycle continues.  

What's interesting is that right now rates are already at 0%, but inflation and unemployment are not being affected like they used to be.  When rates first went to 0% and long term rates started to go down due to QE, many pointed out how inflationary that would be and thus went long gold and inflation hedges.  However, the inflation never came and many of them have finally thrown in the towel.  Thoroughly embarrassed and envious of those who were just simply long stocks, these sad sacks are your best market timers.  

Markets hate crowded trades and the hyperinflation trade was one of the most crowded of all time.  It seemed so simple: the Fed prints money, value of money goes down.  But even if they did thoroughly misunderstand how our monetary system works, they are still not far off.  Low rates are inflationary if there are qualified and willing borrowers.  Just because there weren't any in the past few years doesn't mean there won't be any very soon.  The fact that most have given up on this trade has made it that much more attractive.  This is how bull markets end as market participants are giving up on the high inflation theme.  And thus finally inflation can arrive, alongside higher rates and the next bear market and recession.