Juggling Dynamite

The video below from the Wall Street Journal offers a helpful refresher on how asset bubbles move. Worth the 7 minutes.

Asset bubbles are easy enough to define, but not so simple to identify. WSJ’s Gunjan Banerji explains what bubbles are exactly, how they form and what happens when they burst. Here is a direct video link.

It is pretty easy for clear-eyed analysis to see asset bubbles. The challenge is in predicting when they will burst. But the bust is assured. The chart below shows the price cycle during some of the most infamous bubbles since 1977. Bitcoin (and the crypto-mania around it) is genuinely a standout. Also, see The fire burning beneath crypto’s meltdown:

The irony in all this is that part of the original appeal of crypto was the cap on how many bitcoin can ever exist, something supposed to prevent the sort of unlimited money creation that worries many critics of government-issued, or “fiat,” currencies. Rather than unlimited creation of bitcoin, crypto ended up with unlimited proliferation of new tokens. The new structures of intermediaries and defi tools allowed even bitcoin to be reused or lent on, meaning multiple people thought they owned the same token. Lender Celsius Network is an extreme example: Those who deposited bitcoin and other tokens there were promised high interest rates, but have been unable to get their coins—which Celsius lent out—back.

Cryptocurrencies are bid this morning, and US markets are reopening with a bounce following the steepest losses since March 2020 (the S&P fell 5.8% last week, -10% this month so far). As shown below, courtesy of The Daily Shot, the Dow Jones Industrial Average (supposed to be more ‘conservative’) has fallen 11 of the past 12 weeks for the first time since at least 1926.

Short interest bets have now piled on, which can set the stage for a sharp rebound. It’s important to remember that interim rallies tend to get more extreme as bear markets proceed to lower lows. As shown below, courtesy of Michael Kantro, the 2000-02 bear had six counter-trend rallies (the final three being more than 20%), while the 2007-09 bear had five (the last two being more than 18%).

So far, the 2022 bear has had three rallies, as shown here.

As noted yesterday in Bear Market Update, rebounds will likely be fleeting as long as central banks remain in monetary tightening mode (not yet loosening), a recession is just beginning (not 2/3rds through), and retail investors are not yet liquidating. As shown below, courtesy of the Daily Shot, while the average retail investor is sitting with a 35% drawdown in their portfolios year-over-year, they have not yet become net sellers of equities (like they were during the pink bar periods below since 2018).

Lastly, risk assets remain far from historically cheap even with the recent declines, and the consensus is still expecting economic expansion and S&P companies to report double-digit earnings growth through 2022 (source: FactSet). So, negative surprises are set to hit hard.

Starting a new week with US markets unplugged today offers a moment to review the bear market progress to date. From their most recent highs:

• • S&P 500 -23%
  • Nasdaq -32%
  • Russell 2000 small caps -32%
  • TSX -14%
  • Cdn $/USD -7.8%
  • Canadian financials -17%
  • Canadian oil and gas stocks -15%
  • US oil and gas stocks –20%
  • US Banks: –32%
  • Asset manglers managers –37%
  • Consumer finance –29%
  • Canadian REITs -22%
  • industrial REITs -33%
  • office REITs: –35%
  • retail REITs –27%
  • home furnishings: –44%
  • autos –46%
  • airlines –44%
  • gambling –57%
  • retailers –37%
  • consumer electronics: –47%
  • hotels/cruise lines/resorts –34%
    
  • trucking –32%
  • rails –24%
  • software/services –32%
  • tech hardware –28%
  • restaurants –24%
  • Bitcoin -70%
  • copper –19%
  • aluminum –36%
  • nickel –47%
  • silver -21%
  • gold -11%
  • gold miners -27%
  • food price index –9%
    
  • oil (WTI) -12%
  • lumber –60%
  • steel rebar –25%
  • consumer staples –15%
  • utilities -15%
  • homebuilder stocks–42%
  • hi yield bonds (JNK) -16%
  • Cdn preferred shares -13%
  • Cdn investment-grade bond index -18%
  • US 20-year bond index -33%

Theoretically, 60% equity and 40% bond benchmark accounts are -20% year to date (assuming 100% reinvestment of all income with no fees or withdrawals). In reality, many portfolios are faring worse because they came into this bear market with equity weights greater than 60%, leverage, little cash, and things like perpetual preferred shares and low-quality debt and funds (with no maturity dates) as fixed income (aka reaching for yield).

It’s worth noting that the S&P 500 has never been down this much over five months without a recession recognized within 6 to 12 months of the market peak (which was January 2022).

Recessions have always killed inflation and commodity prices. Stocks typically don’t bottom until sometime in the final third of the economic decline, when central banks are back to easing monetary conditions, the masses are liquidating in losses, and government bonds are rising sharply.

Today, a recession is not yet confirmed, most central banks are trying to tighten aggressively, cash balances are low, risk allocations are still near historic highs, and government bonds are not yet rebounding.

Remember, the average S&P 500 decline accompanying a recession has been 42% over 16 months, and the TSX has roughly tracked along for the ride. In their peak to trough decline this cycle, US stocks and corporate debt might be halfway, Canadian stocks may be a third, while government bonds are due for a renewed period of strength.

Patience, cash and investment discipline will define full-cycle outcomes, as always.