Updated: Aug 12, 2019
Lifeguard Lawton issued an out of the financial water warning two weeks ago. Now? Same. Stay out.
That is hard to do around Lunada Bay and Redondo Beach in the middle of summer on a clear day. Or when people have been hypnotized by a sunny 10 year bull market.
I got grumpy several weeks ago when the whole China thing hotted up. That got me thinking about all the other market things bothering me which included:
2. Negative interest rates;
3. Mismanagement of the financial system by regulators;
4. Concentration of gains in tech stocks;
5. Computer dominated trading systems;
6. Large accumulation of debt and leverage in the financial system;
7. Many risk markets near historical high prices.
So, what did we learn from last week to keep us out of the water? Well, quite a bit.
To start with, market price action told us a lot last week. Volatility is up. But for all the ups and downs, with all the market had to deal with, especially related to China, the Dow only gave up -3/4% for the week and is down only -3.3% from its all-time high two weeks ago. That is impressive. This price action tells me that there may not be an over-abundance of leverage in the system. That is good. It also tells me there is not that much fear in the system if people are willing to step in and buy even in light of potentially long term negative information on the China front. That is bad because I think the news is already out that growth is going to be slower in the US and China. But the stock market is not fully discounting this information, but will in the future. I learned that the way down off the financial cliff we are on is not necessarily a fall, but it could also be a slow grind down the goat trail until we get back to Lunada Bay beach and a little sanity.
The next thing I learned is that the US remains clearly in deflationary mode. How do I know? I have a simple indicator. If 10 year treasuries yield less than 3% then you are in a deflationary period. Perhaps the big headline for the week was, "Yields Collapse!" Ten year treasuries started the week at 2.06% yield and ended the week at 1.74% yield. This is very disturbing. Yields broke above 3% late last year, and I was wondering if the Trump tax cuts moved the economy out of deflation. But no. Rates poked above 3% for a brief period to drop all the way to 1.7%. However, the fact that the 10 year is a positive 1.7% relative to Europe and Japan which have negative yields says things are better here than there. That is the good news. The bad news is potentially very bad.
The bad news is that we are looking more and more like Japan the lower and longer 10 year yields remain below 3%. Study the long-term 10 year treasury yield chart below:
Looking at the chart it is easy to imagine the market testing the previous low in yield. Several analysts were saying the US 10 year yield would turn negative like Japan and Europe. Let's see if we get to new lows first, around 1.35% yield. If you go through that level, Katy bar the door.
But, what is the big problem about looking like Japan, anyway? Personally, Japan is one of my favorite countries. Love everything about the people and the place, except the fact that the population is shrinking, and it is in a deflationary mode. So what? Because it is hard to make money if there is no pricing power. No profit, asset prices tumble.
Case in point, the Nikkei stock index peaked in 1989 near 39,000. It then crashed all the way to almost 7,000 to finally close yesterday at 20,685, a loss of 47%, after 30 years!! Take inflation out and your real loss is 62%. Better than the over 95% real loss a while back though.
When people tell me stocks always go up in the long-run, I tell them to look at Japan. 30 years is pretty long run for most people. Imagine the pain caused by that financial wipe out. And the US is looking a lot more like deflationary Japan. Not as extreme, but the direction is wrong. That 3% thing. Lots of downside, truncated upside.
Finally, and perhaps most disturbing, is that Hong Kong just will not settle down. Several weeks ago I put Hong Kong at the top of my Potential Black Swan List. Every day that goes by with more unrest raises the probability that China will send in police or troops from the mainland. If that happens it will usher in a new era that will have a variety of market negative impacts. Nothing positive in it for anyone. Markets are not set up for this, so keep a close eye on what is going on in Hong Kong, and pray for a speedy and non-violent solution.
We learned a lot this past week from the markets. China is becoming a bigger problem and Hong Kong a potential Black Swan. Collapsing treasury yields indicate the US is becoming Japan which is a red flag that US equity markets may be in for a long period of sub-par return and low yields are here to stay.
So last week Ranger Bill told you to move back from the edge of the risk cliff. This week Lifeguard Lawton is telling you to stay out of the shark infested financial waters. If you miss a wave, so what? I would rather be on the beach eating a sandwich than be in shark infested waters and be a sandwich, or drown in one of the many financial rips tides out there. Best to work on your tan sand side.
There is always another wave.