All was going according to the normal script until two things happened :
1. Donald Trump enacted an exceptional tax cut that handed individuals and corporations immediate profits and extra liquidity overnight. They used these windfalls to consume more for the former and to buy back their expensive own shares expend for the latter.
2. Donald Trump launched his Trade war against China in February 2018. By questioning the long-established logic of global supply chains and by singling out individual corporations like HuaWei on National Security grounds, Donald Trump sent shivers down the spine of CEO’s around the world and triggered a global collapse in investments and manufacturing, breaking the global growth momentum that had been finally reached in 2017.
On December 24th 2018, the FED announced that it paused its normalization policy, that it would not raise rates any more, and that it stood ready to lower interest rates again and resume bond-buying if economic conditions were to worsen.
The impact of this announcement on equity markets was immediate. Investors rushed to buy back equities, making January 2019 one of the best months on record while the three rate cuts engineered during 2019 sent all asset prices flying, registering one of the best year ever for equities, sending interest rates and bond yields to record low and even record negative yields worldwide, real estate prices to new highs and precious metals to new highs as well.
Having all four asset classes rising at the same time and sending completely contradictory messages is a very rare occurrence that is entirely due to excessive liquidity in the system as we highlighted in our various pieces since the year-end.
In several of our research pieces, we warned about the devastating crisis that is looming on the horizon because of the excessive global leverage in an environment of ultra-low and artificially low interest rates and the high probability of stagflation ahead.
WE WARNED INVESTORS THAT WE WILL SOON BE ENTERING A MULTI-YEAR PHASE OF DEBT DEFLATION IN THE USA THAT COULD CREATE HAVOC POLITICALLY AND SEND THE US DOLLAR AND US ASSETS REELING.
In our latest piece on Central Banks, we highlighted the extraordinary impact their focus on growth and narrow definition of inflation had on feeding asset bubbles and we fear that the latest turn of events with the Wuhan Coronavirus will lead them to even more monetary easing and liquidity creation ahead.
In our assessment of equity markets, and the US equity market, in particular, we highlighted the sudden taking off of equity markets on October 20th 2019 after the Fed’s third preventive rate cut of the year.
In our piece dated January 25 we highlighted TWO possible scenarios from here:
. Either we made THE secular top in January 2020 following the Wuhan Pandemic and the whole move between October and January was a massive bull trap before the unfolding of a devastating secular Bear market
. Or equity markets would experience the last bull leg – the Melt-up – before peaking sometimes over the summer or the fall of 2020 from much higher levels in some cases, after a brief correction from now till March.
In January 2020, we first had a significant confrontation between Iran and the USA that culminated with the assassination of Iran’s second most important individual, Qassem Suleimani, then we had the outbreak of a deadly virus that has killed 1150 and contaminated more than 45’000 people to date, bringing to a standstill enormous chunks of the world’s second-largest economy, severely disrupting the world’s global supply chain.
Equity markets barely budged and individual investors jumped on stocks taking indexes to new record highs irrespectively of the fundamentals of even the risks to the world economy ahead. The leaders of the secular rally – the overvalued FAANG + Miscrosoft of which we had been short all along – kept on rising AND outperforming the larger indexes.
TODAY, THERE IS NO DOUBT THAT WE ARE IN THE SECOND OF OUR EQUITY SCENARIOS.
WE ARE CLEARLY IN A MASSIVE EQUITY MELT-UP THAT STARTED IN OCTOBER 2019 AND HAS THE POTENTIAL TO TAKE US INDEXES TO MUCH HIGHER LEVELS.
As a consequence, we finally cut our strategic short positions in the FAANGS having reached the maximum 10 % drawdown that we allow ourselves in the Model Portfolio, have replaced them by Index short products to trade the coming limited drawdown and stand ready to go long the stocks and sectors that we see favorable in the coming melt-up.
What are Melt-Ups ?
In the week of March 20, 2000, the Nasdaq “dot-com bubble” reached its peak.
So many people were making so much money, the last thing they wanted to do was sell. It seemed like hundreds – perhaps thousands – of new millionaires were being minted each month.
For most people, it was hard to believe this engine of wealth creation – the stock market – could grind to a halt. And that tech stocks could collapse by 75%. But that’s precisely what happened.
The Nasdaq imploded… And millions of investors lost a huge chunk of their life savings.
Now, it is going to happen again. We are in the middle of the greatest stock market bubble in history and when it bursts, it will devastate millions of investors.
We have been warning about it for two years now, but the point here is to determine when and from what level the bear market will start and we have been wrong for the past four months.
If you have been kicking yourself for sitting in cash since 2017 and you have missed out on the recent bull run, you are not alone. Most institutional investors have like you as we showed repeatedly in our “Dumb” Money “Smart” Money indicators.
Some of the smartest hedge fund managers have made the same mistake, focusing on value and indictors but the characteristic of melt-ups is that they are totally irrational.
Right now, we’re on the verge of a massive panic.
But not the kind of panic most people expect, a Buying Panic
If history is any guide, BEFORE stocks collapse, we will witness an event that will send the Dow Jones soaring past 40,000 or even 50,000 – as people who have sat on the sidelines so far panic into the markets.
This type of phenomenon has happened many times before and in many countries around the globe. It is usually the hallmark of excesses and of secular trend-ending phenomenons. It happens when long-established trends are extended beyond reason by abnormal liquidity and psychological conditions.
We thought American investors and the FED were rational and that it would not take happen in the US in this secular bull market, but the events of the past four months show that it is happening right there right now in America.
When that happens, there is no point in fighting the wave and this is why we cut our short positions. One can then either ride the wave or stay in cash, but the coming phase is usually one that is extremely profitable.
Japan in the 1980s
We started our career in finance in 1984 trading and making markets in Japanese Warrants and convertible bonds. We witnessed first hand the powerful forces that drove the last part of the mania and the subsequent crash of the market.
Between 1984 and 1989, the Nikkei 225 rose from 4’000 to almost 40’000, a level NO ONE ever imagined could be reached in those years. As the chart below shows, In the last 18 months alone, the index doubled from 20’000 to 40’000 without a respite, fueled by panic buying.
P/E ratios climbed to 40x – the US is trading at 24x now – and Price-to-book ratios were all but forgotten and cross-shareholdings were having the same effect on earnings as share buybacks are having today in US equities,
This final, furious stage of a bull market has a name… it’s called a “Melt Up” and it is precisely what is happening in the U.S., right now with the Nasdaq and the FAANGs and Microsoft.
The Dow Jones in 1927
The same exact thing happened in America, 100 years ago. Back then, the United States’ economy was booming. This was the era of “The Roaring Twenties” and of the prohibition, of the American Dream, of oil and of electrification.
Form 1920 to 1927, the Dow Jones had risen from 75 to 200, a 266 % increase, very similar to the one of the Dow Jones currently. In the last 18 months of the rally, the Index rose from 220 to 375, a 70 % increase fueled by panic buying.
But the majority of these gains came in the FINAL year or so before the big crash.
But, as was the case in Japan, after the bubble burst, it took 26 years for the index to recover its peak and the average buy-and-hold investor never got back to “breakeven.” In Japan, more than 30 years later, we have not yet recovered the 39’800 level that marked the peak of 1989.
The fact of the matter is that the phenomenon is neither an exceptional nor an isolated pattern. You can trace it back to just about EVERY major bubble in history.
All the manias and bubbles end the same way – with a furious Melt Up, then a final crash.
Until a couple of weeks ago, we did not think the US was in a mania.
Iran, the Wuhan coronavirus and Tesla just confirmed to us that we are and that there are probably another 6 to 9 months of the mania to go.
One ingredient is missing
We are in October 2019. The stock market has been rising for 10.5 years making it the longest in history, the economies are slowing down, corporate earnings are declining and a lot of professional investors including ourselves are skeptical that it can go much higher.
Valuations are exceptionally high, and the resilience of stocks is attributed to Trump’s exceptional tax breaks and to the FED’s too lenient policies. The bond markets had just delivered the worst possible advanced signal in August 2019, an inversion of the yield curve heralding a recession to come.
Clearly most institutional investors were bearish and either protected or with high levels of cash.
But this is not how bull markets end. Bull markets do not end when so many investors are on the sidelines.
Bull markets end when everyone is invested…
When there is no one left to buy. And that is precisely why they end… because with no one left to buy, prices have nowhere to go but down.
And this is NOT what we are seeing today.
The one ingredient that is missing is when all investors will be bullish and scrambling to buy stocks, including your taxi driver.
This has not happened yet but we are probably in the final stages of the most phenomenal bull market of US history.
And if that is the case, there are probably large gains lying ahead.
There is something truly exceptional with this particular mania.
All the manias that we know, from the Dutch Tulip, to the French Mississipi Mania, to 1920s America to 1980s Japan to 1990s Nasdaq – were all driven by the same speculative mania present today. FOMO, Greed, Lack of attractive alternatives
But there is something truly unusual happening today that we have highlighted many times. And if Merrill Lynch is right, it has never occurred in 5,000 years of human history
Never before have we seen a Melt-Up start with interest rates THIS close to ZERO
The lowest interest rates in 5000 years
Even Worse, Never before have we seen a Melt-Up start with REAL interest rates in NEGATIVE territory
In many of our publications, we have highlighted the fact that almost everywhere around the planet and for the first time in history, the ENTIRE interest rate structure is negative in REAL terms.
Taking the case of the USA, the Core CPI stands at 2.3 % when every bond yield at every maturity is actually lower than that.
NEVER IN HISTORY HAVE WE SEEN 30-YEAR REAL RATES IN NEGATIVE TERRITORY
And Never before have we seen Central banks Buying equities
And this may well trigger a stock-buying panic the likes of which we have never seen the day the US FED announces it is joining other Central Banks in buying equities.
For the first time ever – central banks are now funneling trillions of dollars directly into the stock market. These institutions have an awesome power: The power to print money.
Over the past decade, they have been printing money to buy humongous amounts of bonds and have driven bond yields to negative territory.
Since April 2018, the Swiss National Bank owns MORE shares of Facebook than the social media company’s founder, Mark Zuckerberg, the Bank of Japan is now the No. 1 buyer of Japanese stocks. China’s central bank one of the largest shareholders in the biggest stocks in Shanghai.
And the U.S. Federal Reserve cracked the door open. Former Fed Chair Janet Yellen said, “There could be benefits to allowing the central bank to buy stocks.”
In sum
What makes this mania different is that
NEVER before have interest rates hit 0% (or negative).
NEVER before have central banks taken a direct, multitrillion-dollar stake in the stock market.
And not since 2001 have institutional investors been so bearish in stocks.
Conditions are probably in place for the most spectacular stock market Melt Up in history!
In the coming months, a tidal wave of cash worth trillions of dollars may be chasing stocks as investors are panicking.
If the market Melts Up 109%, as it did during the Roaring Twenties, the Dow would top 50,000. If it repeats the pattern we saw during the Nasdaq’s Melt Up of the late 1990s, it would explode to 60,000-plus. And if the market were to leap an insane 228% as it did in 1980s Japan, the Dow could rise to 80,000-plus.
The Melt-Up started in October 2019
As our readers know, we have been highlighting the insane performance of the FAANgs. and Microsoft in the past year and in particular since October ( and we were shorting them )
As discussed, the Melt Up is the final phase of a bull market. In fact, in every blow-off phase, It is when the leading companies of the secular rally REALLY take off that the melt-up starts and they propel the overall market dramatically higher.
And this started in October.
Importantly though, the Melt Up won’t necessarily lift all stocks. In fact, the last time we saw a Melt Up in U.S. stocks, most stocks did not soar. That could be true this time, too.
The last true stock market Melt Up in the U.S. happened during the tech bubble of the late 1990s.
The entire market had soared through the ‘90s. The old economy companies made huge gains right alongside the exciting new Internet stocks. But that changed as the bull market neared its end and the Melt Up took over.
This chart shows the final 12 months of the 1990s bull market.
You can see that the Dow Jones Industrial Average stopped keeping up with the Nasdaq Composite Index in October 1999. The Dow basically went nowhere for the final 12 months of this stock market Melt Up, while tech stocks soared triple digits.
The beginning of that major outperformance is what signaled the Melt Up was getting fully underway. And that’s happening again, right now.
In recent years, the boring stocks and exciting tech stocks soared together. The tide lifted all ships. The chart below shows that the Nasdaq started accelerating precisely in October 2019 as the FED was granting the markets a third “preventive” rate cut.
This is exactly what we saw in the late 1990s. It’s what signaled the final stages of the Melt Up back then… And it’s what happened right before a massive triple-digit boom in tech stocks in just 12 months.
The Melt Up is officially underway.
The final stage of this bull market is likely to play out over the next 12 to 18 months as a result.
It took us three months of suffering to understand what was happening, but better late than never.
Moreover trading the markets will be much more rewarding now that we know what scenario is playing out.
How to time the final top?
Considering the excesses that are prevalent and that will be exacerbated in the coming months, there will be a time to re-instate our shorts on the FAANGS and Microsoft as well as on the major indexes.
Equity markets will collapse then and the downside will be anything from 60 to 80 % in a matter of a couple of years.
Timing the turning point will be paramount
If history is any guide, Melt-up phases last between 12 and 18 months and this one has started in October 2019. That pushed the top to between October 2020 and March 2021.
But there is another indicator that has predicted the end of every boom over the past 30 years and that will probably predict the end of this boom as well.
And it has been stunningly accurate.
This indicator predicts recessions – well in advance. Recessions typically happen right after stock market peaks…
So if you have an indicator that can predict the next recession, then you have an indicator that can predict the next stock market peak. The indicator is straightforward. It is the structure of interest rates
For the past 10 years, the Fed and the other major Central Banks has kept rates artificially low
Stocks have soared more than 300% during this bull market as the Fed has artificially kept interest rates near zero.
However, every time the Federal Reserve pushed short-term interest rates ABOVE long-term interest rates, the stock market has peaked and the economy has gone into recession.
This is called a YIELD CURVE INVERSION
The past three times that short-term interest rates moved above 10- year Treasurys were in 1989, 2000, and 2007. Those were the past three recessions in the U.S.
We had two yield curve inversions recently, one in August 2019 and the second one right now.
Considering the fact that it takes between 9 and 18 months before inverted yield curves translate into recessions, the peak in equities is to be expected between the summer and the end of 2020.
In 2000 for instance, the yield curve inverted in late 1998 but we did not see U.S. stocks peak until March 2000.
In 2007, the yield curve inverted in December 2005 but the bull market ran until October 2007. It was almost another two years before the party ended.
The second condition is that the FED actually raises rates or announces it will do so.
It was rate hikes in 2000 and 2007 that led to the turning point and major stock market crashes.
Likewise, in 2018, equity markets turned because the Fed had started raising rates in 2017. Likewise, rates rose in 1999 and in 2006.
Finally, there are typical market top formations on weekly and monthly patterns that will indicate that the top has been completed.
Waiting for these indicators is probably better than riding the rise excruciatingly.
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