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Investment Tectonic Pressure Building

Updated: Aug 6, 2019

It is a summer afternoon and the sun is moving toward Asia from the Southern California Coast at Lunada Bay (above), one of California's hidden treasures.

Looking out over Lunada Bay, one could be lulled into a false sense of security, just as looking at financial markets today. Be not seduced. Investment tectonic pressure is building, just as tectonic plate pressure is pushing unseen beneath Lunada Bay.

When I was a young derivatives trader in the 1980's I used to drive up to Lunada Bay at night from Manhattan Beach to help clear my head. It was so beautiful, many years later I moved to Lunada Bay. No regrets, still here.

Lunada Bay is 20 miles south of Los Angeles International Airport on the Palos Verdes Peninsula. It is an idyllic place to live. Off the beaten path for global finance, but I never followed the crowd. Those cliffs are 300 feet high, and the peak of the Palos Verdes Peninsula is over 1,700 feet. Great for cycling, hiking, running swimming and clear headed independent thinking.

Lunada Bay used to be flat like the rest of Los Angeles, until the tectonic plates right under the Bay started pushing to literally raise the beach 300 feet up and create this enormous peninsula of unusual beauty and geographic complexity.

But every place has its drawbacks, and we saw a little of that recently in Southern California with some nice tumblers topping 7 on the Richter scale. We felt the shakers here as the tectonic plates moved to adjust to enormous pressures but were OK.

The nature of plate tectonics is that the plates can relieve tension slowly with numerous smaller quakes. But if they get jammed up and stop moving tension builds until there is a larger scale earthquake like we had last week here. Kinda like financial markets when you have no corrections. Everything is calm, price pressures build, and then the big one hits when everyone has been lulled to complacency, like in 2008.

It is difficult to know exactly how much built up pressure there is in financial markets. But a 10 year bull market in stocks with new recent highs in the indices, as well as near record lows in interest rates do not make for a great entry point. Plus, there are a number of current market conditions which are disconcerting, some that have been building since 2008.

Here are a few of the issues I am tracking that may contribute to the next big negative market move:

1. Deflation/inflation- We have been in a deflationary period. How do I know? The ten year treasury yield is below 3% (closer to 2%, about the same rate of inflation for a real yield of 0%). In normal market conditions no one would buy a 10 year bond at less than 3% yield, 2% for inflation and 1% for return. Last year 10 year yields poked above 3%, the Fed started to tighten as if we were in a normal recovery, only to have the economy slow and real estate markets slow to the point the Fed is now considering cutting rates again. Current markets are priced to the lower yields which are anchored by relatively low inflation. So, what happens if inflation picks up and the Fed has to aggressively tighten? Are inflationary pressures building? If so, watch out below, markets are totally offside for this. If deflation is to remain, are we becoming Japan and destined for a generation of negative returns? Both outcomes are negative.

2. Negative interest rates- Over 20% of the global bond markets are trading at negative yields. In the history of the world we have never had a period of negative interest rates. My HP 17B financial calculator is not even programmed to work using negative interest rates. Serious pressure indicator here. This is not normal, and in reality, should not exist. There will be a lot of pain when rates normalize. 4%-6% is a "normal" range for 10 year investment grade government bonds. A move from 0% to 5% on a 10 year bond causes a 39% loss on a "safe" investment. Equities would do worse.

3. Ill-conceived financial regulations- Politicians and financial regulators crashed the financial system in 2008, then the same people were put in charge to fix the damage they created. Their work has been questionable . They have structured the system with a handful of super-banks like Deutsche Bank at the center (increasing, not decreasing systemic risk), increased regulatory risk based capital, and layered in onerous rules on anti-money laundering (AML) and know your customer (KYC) laws and regulations. It is very difficult now to open a business checking account overseas, funds cannot be wired easily, operations in many countries have been curtailed by large banks as a result. My back of the envelope cost of this mismanagement is an unseen tax of 1% of global GDP per year.

4. Tech nexus- This whole tech nexus is accelerating, creating amazing new products, services, medical treatments, etc. Humankind's future rests on technological innovation. But as a practical matter investors have to deal with this geometrically accelerating wave of innovation which is creating big winners, and big losers. So far tech stocks are winning big. Around 50% of gains for US stock indices over the past five years have been from tech stocks, and 37% from FANG+M (Facebook, Amazon, Netflix, Google and Microsoft). Tech stocks receive much higher valuations. We had a similar situation in 2000 before the dot com bust. Not there yet, but definitely on my radar. Anti-trust laws meant to protect people from the negative results of concentrated economic power have not yet been enforced which is hollowing out parts of Main Street and exacerbating income inequality. The Trump Administration has said they are looking at enforcing the anti-monopoly laws which could cause a market event, or valuations can continue to move up as in 2000 and then crash. We will see. Something is seriously out of whack here and sooner or later there will be a financial quake with tech stocks at the epicenter.

5. China- The development of China is the single most significant economic event in the past 30 years and it fundamentally changed every major financial market in one way or another. Phase 1 and 2 of that development process are now over, and we have moved on to Phase 3 which is less salutary, being manifested by a re-concentration of political and economic power to the state, military buildup, trade wars, much slower GDP growth, saber rattling, defaults in over-leveraged Chinese markets and a retrenchment of China overseas investment. The people of HK are showing their displeasure in the streets. There are many less obvious negative reactions going on as well. China Phase 3 is a paradigm shift that is a strong candidate to be the pressure point for the next financial tumbler.

6. Computer trading- Over 80% of US stock market trading is done by high frequency computer trading according to Morgan Stanley, while just 10% of stock market activity is due to stock picking. Think about that for a minute. Pretty sobering. Has the earmarks of portfolio insurance that caused the 1987 stock market crash when everyone was trading the same strategy at the same time. To what extent is a lot of this activity front running at the expense of everyone else? This kind of market structure seems to be benefiting the dark pools of money and those with access to big data, but is it really making markets more efficient or simply less fair and more unstable? Stay tuned.

7. Debt and leverage- The US and the world as a whole continue to grow debt at an unsustainable pace. Public global debt has doubled to over $60 trillion since the 2008 crisis. And that is just public debt. To think that Deutsche Bank's derivatives book alone is almost as large as the entire public global debt market, while DB is slowly sinking, is definitely disconcerting. Governments and markets seem oblivious to the risks of this growing pool of debt. Serious pressure building here.

8. Overpriced assets- We have had a 10 year party of reflating the financial system from the 2008 collapse. It worked. Now we have negative yield bonds, overpriced real estate (especially at the luxury end), equity PE's near historically high levels while central banks around the world continue to print truckloads of money. At some point something has to give.

There are other things as well, but these are on the top of my investment pressure radar screen right now.

The flip side is that the US economy is doing pretty well. Growth is above the Obama years, many people are working, innovation is thriving. Trade wars and skirmishes yes, but no hot war. The US pro-growth policies are working. Political gridlock means the politicians cannot mess things up more than they already have.

Nobody wants to leave the party when the band is swinging, the dancers are all on the dance floor and the punch bowl full. That is not what we have now. The party has been going on for 10 years, and the stimulative bunch bowl is much closer to empty than full.

One would never know the violence beneath the earth that created Palos Verdes looking out over a tranquil Lunada Bay this summer afternoon. Likewise looking on the surface of financial markets today it is easy to be hypnotized into thinking everything is just fine. But under the surface negative investment pressure is building. It doesn't mean another crash is imminent, but investment pressure is building as markets continue to notch new highs.

For me, before the party ends and the shaking starts, which it ultimately will, now is a good time to diversify assets into investments that are not highly correlated, or even negatively correlated, to global financial markets. They are hard to find, but they are out there.

My favorite diversifying investment is safe government backed deals in off the run investment grade countries like Malaysia that are fundamentally strong, benefit from the slowdown in China, and need additional capital to grow due to the inefficient global financial system. Equity like returns without equity risk. We will talk more about this in future blogs.

Oh, one other thing. The picture above? My neighbor's house. He listed it for sale over a year ago for $23,888,888. No takers. De-listed. Zillow Estimate? $14 million. Too low, maybe. But serious downward price adjustments are under way in high end real estate from the Hamptons, to yes, even tranquil Lunada Bay, a sign investment tectonic pressure is building.

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