The Telegraph
by Ambrose Evans-Pritchard
28 May 2015

 The global asset boom is an accident waiting to happen as the US prepares tighten monetary policy and the Greek crisis escalates, the European Central Bank has warned.

The ECB’s financial stability report described a “fragile equilibrium” in world markets, with a host of underlying risks and the looming threat of an “abrupt reversal” if anything goes wrong.

Europe's shadow banking nexus has grown by leaps and bounds since the Lehman crisis and has begun to generate a whole new set of dangers, many of them beyond the oversight of regulators.

While tougher rules have forced the banks to retrench, shadow banking has picked up the baton. Hedge funds have ballooned by 150pc since early 2008.

 Investment funds have grown by 120pc to €9.4 trillion with a pervasive “liquidity mismatch”, investing in sticky assets across the globe while allowing clients to withdraw their money at short notice. This is a recipe for trouble in bouts of stress. “Large-scale outflows cannot be ruled out,” it said.

The ECB warned that a rush for crowded exits could set off a wave of forced selling and quickly spin out of control. “Initial asset price adjustments would be amplified, triggering further redemptions and margin calls, thereby fueling such negative liquidity spirals,” it said.

 Adding to the toxic mix, the shadow banks are taking on large amounts of “implicit leverage” through swaps and derivatives contracts that are hard to track.

The issuance of high-risk “leveraged loans” reached €200bn last year, nearing the extremes seen just the before the Lehman crisis. Half of all issues this year had a debt/EBITDA ratio of five or higher, implying extreme leverage. The number of junk bonds sold reached a record pace of €60bn in the first quarter.

“A deterioration in underwriting standards is evident in the increasing proportion of highly indebted issuers, below-average coverage ratios and growth in the covenant-lite segment,” the report said, warning that this nexus of debt is primed for trouble if there is an interest rate shock.

 While banks are in better shape than five years ago, their rate of return on equity has dropped to 3pc, far lower than their cost of equity. They remain damaged.

The immediate trigger for any market rout is the nerve-racking crisis in Greece, with just a week left until the Greek authorities must repay the International Monetary Fund €300m.

Vitor Constancio, the ECB’s vice-president, said it is impossible to rule out a default since Greek officials themselves have openly threatened to do so, and this in turn could set off bond market contagion across southern Europe.

The ECB’s report said the former crisis states still have extremely high levels of public and private debt and have yet to clean up government finances. “Fiscal positions remain precarious in some countries,” it said.

“Financial market reactions to the developments in Greece have been muted to date, but in the absence of a quick agreement, the risk of an upward adjustment of the risk premia on vulnerable euro area sovereigns could materialise,” it said.

The warnings echo cautionary words by the US Treasury Secretary, Jacob Lew, who said EU creditors were playing with fire if they thought a Greek ejection from the euro could be contained safely.

“No one should have a false sense of confidence that they know what the risk of a crisis in Greece would be,” he told a forum in London.

Yet the ECB said the bigger worry is what happens once the US Federal Reserve begins to raise interest rates, resetting the cost of long-term credit across the international system. It will be an ordeal by fire for those emerging markets with the highest dollar. The total exposure is $4.5 trillion.

 Less likely, but equally worrying, is a “sudden slowdown” in the global economy that would bring Europe's unresolved debt problems back into focus.

The report said aggregate debt levels are much higher than in 2008 at the onset of the last recession. A fresh relapse would change the trajectory of nominal GDP and play havoc with debt dynamics.

 Simon Tilford, from the Centre for European Reform, said the latest cyclical recovery in the eurozone is too weak to undo the damage caused by the crisis and is unlikely to be enough to restore debt sustainability before the next recession hits.

Nor has the currency bloc sorted out its essential deformities or embraced any form of fiscal union. “As it stands, the eurozone is a mechanism for divergence among its members, not convergence: real interest rates are highest in the weakest countries, lowest in the strongest,” he said.

He warned that the region will probably go into the next downturn with rates still at zero – and therefore with no powder left – along with contractionary fiscal rules, and with unemployment already corrosively high.

“Many eurozone governments could face the prospect of further deep recessions despite having barely recovered, amid persistently strong support for populist parties. The politics of this is likely to be combustible. The euro is not out of the woods,” he said.

by Jared Dillian
Maudin Economics
28 May 2015

This piece requires some knowledge of option pricing, so I’m going to bring everyone up to speed.

This is the P&L diagram of a long call option:

As you can see, there is a premium paid for the option. If the underlying asset rises above the strike price, the profit available to the option holder is unlimited. Above the strike price, the option essentially behaves like stock (a $1 change in the stock price results in a $1 change in the option price). Below the strike price, the option behaves like nothing at all.
But this is actually the P&L diagram of the option at expiration.

The P&L diagram of the option today looks like this:

The red line is where we are today. Notice that the line is smooth, not the “hockey stick” shape the option has at expiration. At $25 in the chart above, the stock has about an equal chance of finishing in the money or out of the money.
The slope of the red line is about 0.5. We would call this a “50 delta” option—meaning that the stock has a 50% chance of finishing in the money. It’s actually a partial derivative.

We call this the “delta.” It’s defined as the change in the price of the option for a given change in the price of the stock, as shown below.

The delta is super important to option market makers. They typically hedge the “delta” of the option with stock so as to remain “delta neutral” (for reasons that are a little too complex for this discussion). If the market maker has a portfolio of options and the underlying asset moves, he will have to re-hedge his delta.

Why? Because the delta itself changes due to gamma. The delta is the first derivative of the change in option price due to the change in the stock. The gamma is the second derivative. It is the curvature of that red line above.
If I am long an option and I hedge the delta, if the stock goes up, I am going to get longer delta, and I will need to sell stock. If the stock goes down, I will get shorter delta, and I will need to buy stock, as shown below.

Buying low and selling high is good, right? In this example, someone who is hedging a long option is said to be long volatility. If the asset moves around more than he thought it would, he makes money. This is called being long gamma.
The opposite is true with respect to being short options. Through delta hedging, you’re forced to buy when the market goes higher and sell when the market goes lower, so you want the market to move as little as possible. This is called being short gamma, and leads us to our next topic.

Portfolio Insurance

Most people know that something called “portfolio insurance” is blamed for the Crash of 1987, but they don’t really know what it is.

Basically, it was a hedging technique marketed to asset managers that allowed them to limit their losses and participate in the upside. Say you were a mutual fund—basically, you would pretend you had a portfolio of short options, and you would hedge this invisible gamma by selling when the market went down and buying when the market went up.
Pretty ingenious, right? Except, like a lot of things in capital markets, portfolio insurance might work fine if one person does it, but not if everyone does it.

So on that day in October 1987, when the market started going lower, the portfolio insurance programs kicked in, and waves of sell orders hit the market, which triggered more portfolio insurance programs, etc.
I actually like to call this “Covert Gamma.” There was a lot of short gamma out there in the market, but you would never know by looking at the open interest of index options. It was hiding.

Covert Gamma

It is sort of an old equity derivatives parlor game to try to figure out if the Street is long or short gamma, and by how much. Generally the Street is short gamma, because customers tend to be net buyers of options. That means volatility generally is exacerbated, with dealers selling on the way down and buying on the way up.
But sometimes it is worse than others.

I like to think about covert gamma a lot. Like, for the past few years, when everyone has been making jokes about BTD. Buy The Dip. Sometimes they say BTFD, but that is impolite.

So if buyers come in every time the market goes down 5%, the market is really long gamma, right? It’s covert gamma, but it’s still gamma.

And maybe they sell if the market goes up a few percent, further suppressing volatility.

I think we’ve had a lot of volatility suppression in the last six years, principally from the Fed. The Fed has done a lot of things to suppress volatility (QE, ZIRP) and many people, including myself, think that if you keep suppressing volatility, it is going to come out someday, in a big way, and that will lead to even more volatility.

STD

That’s when Buy The Dip turns into Sell The Dip. It’s funny—nobody ever talks about when we cross over into Sell The Dip. It happens. This is a psychological construct, and you can’t measure it. But at some point, people will get sufficiently spooked (by whatever) that they don’t stand there and bid with both hands. They grab a can of peaches and head for the hills.

Well, let me just say this: When things are quiet, that’s when people start putting on portfolio insurance-like structures that require everyone to sell at once.

It’s human nature. People want to protect gains, so they put on stop losses (covert short gamma) or maybe even structured equity derivatives that take them out of the trade if the market goes down x. These are short gamma trades.
In its most basic form, it’s market psychology. I know a few smug longs on Twitter who constantly berate the bears. I don’t know what they’re thinking—probably that they’ll be able to get out if the market goes down 5% or 10%. The liquidity might not be there when they need it.

The very important conclusion here is: I think at any point in the last six years, the market has never been short more covert gamma, and I think tail risk is very high. I am not bearish, per se. But I think the probability that we will get some sort of market dislocation is too high to ignore.

I generally don’t buy tail risk protection, because I think it is overpriced and usually a waste of money. But I will be buying it soon—whether it’s SPX puts, VIX call spreads, VXX calls, or put spreads in HYG, I am going to make sure I’m covered.
I’m not scared. Think of it as putting on a seatbelt. Take it from the guy who usually rides around without one.

13 Insights From Paul Tudor Jones:

1. Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape (and proud of it).

2. Younger generation are hampered by the need to understand (and rationalize) why something should go up or down. By the time that it becomes self-evident, the move is over.

3. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. (Why work when Mr. Market can do it for you?)

4. There are many more deep intellectuals in the business today. That, plus the explosion of information on the Internet, creates an illusion that there is an explanation for everything. Hence, the thinking goes, your primary task is to find that explanation.

As a result of this poor approach, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust price action. The pain of gain is just too overwhelming to bear.

5. There is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it.

6. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.

7. That cotton trade was almost the deal breaker for me. It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather than pain?’

8. If I have positions going against me, I get right out; if they are going for me, I keep them… Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.

9. Losers average down losers

10. The concept of paying one-hundred-and-something times earnings for any company for me is just anathema. Having said that, at the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?

11. The normal progression of most traders that I’ve seen is that the older they get something happens. Sometimes they get more successful and therefore they take less risk. That’s something that as a company we literally sit and work with. That’s certainly something that I’ve had to come to grips with in particular over the past 12 to 18 months. You have to actively manage against your natural tendency to become more conservative. You do that because all of a sudden you become successful and don’t want to lose what you have and/or in my case you get married and have children and naturally, consciously or subconsciously, you become more conservative.

12. I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.

13. I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.

by Stephen S. Roach
Project Syndicate
April 30, 2015

NEW HAVEN – The world economy is in the grips of a dangerous delusion. As the great boom that began in the 1990s gave way to an even greater bust, policymakers resorted to the timeworn tricks of financial engineering in an effort to recapture the magic. In doing so, they turned an unbalanced global economy into the Petri dish of the greatest experiment in the modern history of economic policy. They were convinced that it was a controlled experiment. Nothing could be further from the truth.

The rise and fall of post-World War II Japan heralded what was to come. The growth miracle of an ascendant Japanese economy was premised on an unsustainable suppression of the yen. When Europe and the United States challenged this mercantilist approach with the 1985 Plaza Accord, the Bank of Japan countered with aggressive monetary easing that fueled massive asset and credit bubbles.

The rest is history. The bubbles burst, quickly bringing down Japan’s unbalanced economy. With productivity having deteriorated considerably – a symptom that had been obscured by the bubbles – Japan was unable to engineer a meaningful recovery. In fact, it still struggles with imbalances today, owing to its inability or unwillingness to embrace badly needed structural reforms – the so-called “third arrow” of Prime Minister Shinzo Abe’s economic recovery strategy, known as “Abenomics.”

Despite the abject failure of Japan’s approach, the rest of the world remains committed to using monetary policy to cure structural ailments. The die was cast in the form of a seminal 2002 paper by US Federal Reserve staff economists, which became the blueprint for America’s macroeconomic stabilization policy under Fed Chairs Alan Greenspan and Ben Bernanke.

The paper’s central premise was that Japan’s monetary and fiscal authorities had erred mainly by acting too timidly. Bubbles and structural imbalances were not seen as the problem. Instead, the paper’s authors argued that Japan’s “lost decades” of anemic growth and deflation could have been avoided had policymakers shifted to stimulus more quickly and with far greater force.

If only it were that simple. In fact, the focus on speed and force – the essence of what US economic policymakers now call the “big bazooka” – has prompted an insidious mutation of the Japanese disease. The liquidity injections of quantitative easing (QE) have shifted monetary-policy transmission channels away from interest rates to asset and currency markets. That is considered necessary, of course, because central banks have already pushed benchmark policy rates to the once-dreaded “zero bound.”

But fear not, claim advocates of unconventional monetary policy. What central banks cannot achieve with traditional tools can now be accomplished through the circuitous channels of wealth effects in asset markets or with the competitive edge gained from currency depreciation.

This is where delusion arises. Not only have wealth and currency effects failed to spur meaningful recovery in post-crisis economies; they have also spawned new destabilizing imbalances that threaten to keep the global economy trapped in a continuous series of crises.

Consider the US – the poster child of the new prescription for recovery. Although the Fed expanded its balance sheet from less than $1 trillion in late 2008 to $4.5 trillion by the fall of 2014, nominal GDP increased by only $2.7 trillion. The remaining $900 billion spilled over into financial markets, helping to spur a trebling of the US equity market. Meanwhile, the real economy eked out a decidedly subpar recovery, with real GDP growth holding to a 2.3% trajectory – fully two percentage points below the 4.3% norm of past cycles.

Indeed, notwithstanding the Fed’s massive liquidity injection, the American consumer – who suffered the most during the wrenching balance-sheet recession of 2008-2009 – has not recovered. Real personal consumption expenditures have grown at just 1.4% annually over the last seven years. Unsurprisingly, the wealth effects of monetary easing worked largely for the wealthy, among whom the bulk of equity holdings are concentrated. For the beleaguered middle class, the benefits were negligible.

“It might have been worse,” is the common retort of the counter-factualists. But is that really true? After all, as Joseph Schumpeter famously observed, market-based systems have long had an uncanny knack for self-healing. But this was all but disallowed in the post-crisis era by US government bailouts and the Fed’s manipulation of asset prices.

America’s subpar performance has not stopped others from emulating its policies. On the contrary, Europe has now rushed to initiate QE. Even Japan, the genesis of this tale, has embraced a new and intensive form of QE, reflecting its apparent desire to learn the “lessons” of its own mistakes, as interpreted by the US.

But, beyond the impact that this approach is having on individual economies are broader systemic risks that arise from surging equities and weaker currencies. As the baton of excessive liquidity injections is passed from one central bank to another, the dangers of global asset bubbles and competitive currency devaluations intensify. In the meantime, politicians are lulled into a false sense of complacency that undermines their incentive to confront the structural challenges they face.

What will it take to break this daisy chain? As Chinese Premier Li Keqiang stressed in a recent interview, the answer is a commitment to structural reform – a strategic focus of China’s that, he noted, is not shared by others. For all the handwringing over China’s so-called slowdown, it seems as if its leaders may have a more realistic and constructive assessment of the macroeconomic policy challenge than their counterparts in the more advanced economies.

Policy debates in the US and elsewhere have been turned inside out since the crisis – with potentially devastating consequences. Relying on financial engineering, while avoiding the heavy lifting of structural change, is not a recipe for healthy recovery. On the contrary, it promises more asset bubbles, financial crises, and Japanese-style secular stagnation.

ConvergEx
Nicholas Colas

Today we compare two competing frameworks for understanding market behavior: the “Random Walk hypothesis” and the “House money effect”.  The first states that markets move in random patterns, with prior activity having no bearing on future price action.  The latter shows that individuals do actually consider prior gains and losses when making economic decisions.  That dichotomy is useful in parsing out the recent flurry of volatility. Investors are clearly in a bit of a no-man’s land of market narrative, with the dollar weakening and U.S. corporate earnings slipping.  Market participants, like all pack animals, appreciate clear direction and leadership – and we don’t have much of either right now. On the plus side, investors have a lot of “House money” built up after half a decade (or more) of gains. They can therefore mentally afford some losses. Bottom line: yes, there are choppier markets ahead until the storylines clear (especially regarding the U.S. economy).  But it would take a real shock to dislodge fundamentally bullish risk appetites.  It’s still the house’s money, after all.

Years ago, I worked for one of the best ‘Tape readers’ on Wall Street.  He could – and presumably still can – determine market sentiment and direction the same way mere mortals see a red light turning green.  It didn’t matter if it were a single stock or the market as whole.  His ability was uncanny, but he also knew his limitations.  He was often early by a few hours.  And on a trading desk, that can feel like years.

One day, set up very short for a Fed meeting, things weren’t going his way.  The market was ripping higher and at 11:00am he was down several million dollars. What did he do? He called his wife and had her bring in the family for lunch at the cafeteria downstairs.  I saw him at about 12:30pm, sullenly dipping food service fish sticks into tartar sauce as his children happily munched on theirs.  He reappeared on the desk at 1:30pm, down even more than when he went to lunch.

The Fed did their thing at 2pm, and markets ground higher.  We all held our breath.  The entire room was short as well.  Then, around 3pm, the futures turned.  Hard, and lower.  Much lower.  It was as if someone had pulled the plug on a very large tub of water.  By the end of the day, markets were off 1% and my guy was up over ten million dollars.  At 4:01pm he stood up and said (to no one, and everyone), “That’s how you do it, boys”.  We gave him a standing ovation as he walked out for the day.

I haven’t believed that markets are unpredictable since that day.  Hard to call, yes.  Humbling?  Certainly.  Impossible?  No.  I saw it done, not just on one day but day after day and week after week.  And, I might add, by anyone’s definition: legally.

Not that it should happen the way I’ve just described.  One of the bedrock notions in modern finance is the “Random Walk Hypothesis”, which essentially says that every day is a new one.  Markets are like Buddhist monks in this paradigm, waking up with nothing and taking their begging bowl into the streets to see what fate brings. If markets are up 5 days in a row, the sixth day may be up or down in line with long term trends.  And long term here means the life span of a Galapagos Island tortoise.

After +6 years of a bull market in U.S. stocks, it’s hard to remember about “Random Walks”, but another market paradigm can help fill the void – something called the “House Money Effect”.  This is newer than the “Random Walk”, which was popularized by Burton Malkiel in his 1973 book “A Random Walk down Wall Street”. The seminal work on “House Money” is a 1990 paper by Richard Thaler and Eric Johnson, and it showed that gamblers change their attitude to risk based on prior wins and losses.  Get on a winning streak, and you bet more heavily since you are playing with the “House’s money”.  Hit a bit of hard luck and you pull in your horns (except when given the chance to break even, when you grasp at any passing chance).  It shouldn’t work that way – every spin of the proverbial wheel has its own independent outcome – but in practice the “House Money Effect” is measurable.

If there is one single argument for why investors have stuck with risk assets like U.S. stocks this year, the “House Money Effect” is as good as any. After all, the domestic economy has slowed and not even the Federal Reserve is sure whether that is seasonal, secular, or the result of lousy measurement tools.  Corporate earnings haven’t matched those of a year ago.  And U.S. stocks are not cheap by any objective measure.  Yet, after a long run of gains, it’s the house money on the table.  And we know that’s more risk-prone capital than what investors may consider their own.  That also explains the remarkably low levels of both actual price volatility and the CBOE VIX Index. The VIX close today of 14.6 is still one standard deviation away from the long run average of 20, even after all the stress of the day.

It has suddenly become fashionable to call the recent volatility the start of a broader correction for U.S. stocks. Somehow 5% is the benchmark level for such a move, presumably because the human hand has 5 fingers.  If dogs traded stocks, 4% might be the level.  For octopi traders, it might be 8%...

The point is that the percentage move matters less than how we get there, if you use the House Money paradigm. A one-day 5% move would leave investors wondering if the next day would bring another.  That would likely be enough to shift risk appetites and cause a broader sell off.  A grind lower for a month might not, especially since there would no doubt be some random-walking positive days to give investors hope.

The hardest single issue for investors and traders to absorb in May will be the fundamental lack of clarity regarding two issues: the state of the U.S. economy and global interest rates. On the former, the now-famous Atlanta Fed GDPNow forecasting model is now the single most important barometer of economic growth expectations.  It has a Q2 estimate of 0.9%.  The next update will be Friday, incorporating the ISM manufacturing data out at 10:00am. On the issue of global interest rates, the German 10-year will be the instrument to watch. It began the year at 0.54%, got as low as 0.08%, and closed today at 0.36%. Yes, those all sound basically like zero to me as well, but on a percentage change basis it is enough to cause some excitement.  And higher U.S. Treasury yields, which is generally bad news for domestic equities.

The bottom line is that risk asset volatility is likely to trend higher from here. There simply are not enough solid narratives for investors to confidently value anything on the risk continuum from sovereign debt to biotech stocks. Is the U.S. tipping into recession, pulled over by a stronger dollar?  Are bond investors finally waking up to the notion that buying long term debt with negative yields is a bad idea?  Will bond buying by the Bank of Japan and the European Central Bank improve those economies, or simply increase the price of financial assets?  Are U.S. stocks still priced to perfection in an increasingly imperfect world?

Let’s just hope investors hold to their belief that it’s the house’s money at work here, and that they don’t walk randomly out of the market.

Monthly Investment Outlook from Bill Gross
May 4, 2015

Having turned the corner on my 70th year, like prize winning author Julian Barnes, I have a sense of an ending. Death frightens me and causes what Barnes calls great unrest, but for me it is not death but the dying that does so. After all, we each fade into unconsciousness every night, do we not? Where was “I” between 9 and 5 last night? Nowhere that I can remember, with the exception of my infrequent dreams. Where was “I” for the 13 billion years following the Big Bang? I can’t remember, but assume it will be the same after I depart – going back to where I came from, unknown, unremembered, and unconscious after billions of future eons. I’ll miss though, not knowing what becomes of “you” and humanity’s torturous path – how it will all turn out in the end. I’ll miss that sense of an ending, but it seems more of an uneasiness, not a great unrest. What I fear most is the dying – the “Tuesdays with Morrie” that for Morrie became unbearable each and every day in our modern world of medicine and extended living; the suffering that accompanied him and will accompany most of us along that downward sloping glide path filled with cancer, stroke, and associated surgeries which make life less bearable than it was a day, a month, a decade before.

Turning 70 is something that all of us should hope to do but fear at the same time. At 70, parents have died long ago, but now siblings, best friends, even contemporary celebrities and sports heroes pass away, serving as a reminder that any day you could be next. A 70-year-old reads the obituaries with a self-awareness as opposed to an item of interest. Some point out that this heightened intensity should make the moment all the more precious and therein lies the challenge: make it so; make it precious; savor what you have done – family, career, giving back – the “accumulation” that Julian Barnes speaks to. Nevertheless, the “responsibility” for a life’s work grows heavier as we age and the “unrest” less restful by the year. All too soon for each of us, there will be “great unrest” and a journey’s ending from which we came and to where we are going.

A “sense of an ending” has been frequently mentioned in recent months when applied to asset markets and the great Bull Run that began in 1981. Then, long term Treasury rates were at 14.50% and the Dow at 900. A “20 banger” followed for stocks as Peter Lynch once described such moves, as well as a similar return for 30 year Treasuries after the extraordinary annual yields are factored into the equation: financial wealth was created as never before. Fully invested investors wound up with 20 times as much money as when they began. But as Julian Barnes expressed it with individual lives, so too does his metaphor seem to apply to financial markets: “Accumulation, responsibility, unrest…and then great unrest.” Many prominent investment managers have been sounding similar alarms, some, perhaps a little too soon as with my Investment Outlooks of a few years past titled, “Man in the Mirror”, “Credit Supernova” and others. But now, successful, neither perma-bearish nor perma-bullish managers have spoken to a “sense of an ending” as well. Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others warn investors that our 35 year investment supercycle may be exhausted. They don’t necessarily counsel heading for the hills, or liquidating assets for cash, but they do speak to low future returns and the increasingly fat tail possibilities of a “bang” at some future date. To them, (and myself) the current bull market is not 35 years old, but twice that in human terms. Surely they and other gurus are looking through their research papers to help predict future financial “obits”, although uncertain of the announcement date. Savor this Bull market moment, they seem to be saying in unison. It will not come again for any of us; unrest lies ahead and low asset returns. Perhaps great unrest, if there is a bubble popping.

Policymakers and asset market bulls, on the other hand speak to the possibility of normalization – a return to 2% growth and 2% inflation in developed countries which may not initially be bond market friendly, but certainly fortuitous for jobs, profits, and stock markets worldwide. Their “New Normal” as I reaffirmed most recently at a Grant’s Interest Rate Observer quarterly conference in NYC, depends on the less than commonsensical notion that a global debt crisis can be cured with more and more debt. At that conference I equated such a notion with a similar real life example of pouring lighter fluid onto a barbeque of warm but not red hot charcoal briquettes in order to cook the spareribs a little bit faster. Disaster in the form of burnt ribs was my historical experience. It will likely be the same for monetary policy, with its QE’s and now negative interest rates that bubble all asset markets.

But for the global economy, which continues to lever as opposed to delever, the path to normalcy seems blocked. Structural elements – the New Normal and secular stagnation, which are the result of aging demographics, high debt/GDP, and technological displacement of labor, are phenomena which appear to have stunted real growth over the past five years and will continue to do so. Even the three strongest developed economies – the U.S., Germany, and the U.K. – have experienced real growth of 2% or less since Lehman. If trillions of dollars of monetary lighter fluid have not succeeded there (and in Japan) these past 5 years, why should we expect Draghi, his ECB, and the Eurozone to fare much differently?

Because of this stunted growth, zero based interest rates, and our difficulty in escaping an ongoing debt crisis, the “sense of an ending” could not be much clearer for asset markets. Where can a negative yielding Euroland bond market go once it reaches (–25) basis points? Minus 50? Perhaps, but then at some point, common sense must acknowledge that savers will no longer be willing to exchange cash Euros for bonds and investment will wither. Funny how bonds were labeled “certificates of confiscation” back in the early 1980’s when yields were 14%. What should we call them now? Likewise, all other financial asset prices are inextricably linked to global yields which discount future cash flows, resulting in an Everest asset price peak which has been successfully scaled, but allows for little additional climbing. Look at it this way: If 3 trillion dollars of negatively yielding Euroland bonds are used as the basis for discounting future earnings streams, then how much higher can Euroland (Japanese, UK, U.S.) P/E’s go? Once an investor has discounted all future cash flows at 0% nominal and perhaps (–2%) real, the only way to climb up a yet undiscovered Everest is for earnings growth to accelerate above historical norms. Get down off this peak, that F. Scott Fitzgerald once described as a “Mountain as big as the Ritz.” Maybe not to sea level, but get down. Credit based oxygen is running out.

At the Grant’s Conference, and in prior Investment Outlooks, I addressed the timing of this “ending” with the following description: “When does our credit based financial system sputter / break down? When investable assets pose too much risk for too little return. Not immediately, but at the margin, credit and stocks begin to be exchanged for figurative and sometimes literal money in a mattress.” We are approaching that point now as bond yields, credit spreads and stock prices have brought financial wealth forward to the point of exhaustion. A rational investor must indeed have a sense of an ending, not another Lehman crash, but a crush of perpetual bull market enthusiasm.

But what should this rational investor do? Breathe deeply as the noose is tightened at the top of the gallows? Well no, asset prices may be past 70 in “market years”, but savoring the remaining choices in terms of reward / risk remains essential. Yet if yields are too low, credit spreads too tight, and P/E ratios too high, what portfolio or set of ideas can lead to a restful, unconscious evening ‘twixt 9 and 5 AM? That is where an unconstrained portfolio and an unconstrained mindset comes in handy. 35 years of an asset bull market tends to ingrain a certain way of doing things in almost all asset managers. Since capital gains have dominated historical returns, investment managers tend to focus on areas where capital gains seem most probable. They fail to consider that mildly levered income as opposed to capital gains will likely be the favored risk / reward alternative. They forget that Sharpe / information ratios which have long served as the report card for an investor’s alpha generating skills were partially just a function of asset bull markets. Active asset managers as well, conveniently forget that their (my) industry has failed to reduce fees as a percentage of assets which have multiplied by at least a factor of 20 since 1981. They believe therefore, that they and their industry deserve to be 20 times richer because of their skill or better yet, their introduction of confusing and sometimes destructive quantitative technologies and derivatives that led to Lehman and the Great Recession.

Hogwash. This is all ending. The successful portfolio manager for the next 35 years will be one that refocuses on the possibility of periodic negative annual returns and miniscule Sharpe ratios and who employs defensive choices that can be mildly levered to exceed cash returns, if only by 300 to 400 basis points. My recent view of a German Bund short is one such example. At 0%, the cost of carry is just that, and the inevitable return to 1 or 2% yields becomes a high probability, which will lead to a 15% “capital gain” over an uncertain period of time. I wish to still be active in say 2020 to see how this ends. As it is, in 2015, I merely have a sense of an ending, a secular bull market ending with a whimper, not a bang. But if so, like death, only the timing is in doubt. Because of this sense, however, I have unrest, increasingly a great unrest. You should as well.