Major Storms Are Brewing

The chart above shows the S&P500 volatility over the past eighteen years.  The chart since 1990 doesn’t look a whole lot different.  The volatility of the stock market tends to revert to certain basic patterns.  The bottom of the long-term range tends to stabilize between 11% and 13% annualized volatility, and the periodic spikes nearly always top out between 35% and 40%.  Typically, after several years of basing around the lower volatility levels, spikes in volatility follow. 

The extreme meltdowns in equities during the Great Recession and during Covid saw incredible spikes above 80%, and even above 90%, but those were unusual.  Prior panics such as what we experienced during the bursting of the Dot-com bubble and during the Russian debt crisis and Long-Term Capital collapse were more typical, reaching about 40%. 

For a variety of reasons, we need to prepare ourselves for volatility levels that will, at a minimum, approach those of the Dot-com levels. 

Sustained periods of extreme quiet are certainly possible, but there are a number of reasons that a spike in volatility might not be far off.  In the current situation, however due to certain macro considerations, I expect the next spike to be more violent and more sustained than usual.

In fact, the actual realized volatility levels in the stock market today are even lower than the implied volatility levels of 13%, coming in around 10%.  This means that the market is behaving like all is good with the world.  Fewer things could be further from the truth.  The S&P500 goes up nearly every day at a remarkably slow pace.  This steady performance, however, is totally misleading.  Even as the stock market posts new all-time highs over and over, the indices are filled with laggards and losers.

The S&P500 has now posted its 37^th all-time high this year, while at the same time roughly 40% of the individual stocks are down for the year.  The stock market’s stellar performance is misleading on several counts.  First, it is being driven by a small basket of stocks which have carried the entire market higher.  Very few stocks are even close to making new all-time highs!  Second, the market rally exposes us to some dramatic downside risk because the valuations of the Magnificent Seven and some other outperformers are so extreme.  Nvidia, for example, is trading at roughly forty times sales.  Forty times sales is mind-boggling.  Even forty times earnings is high.  Does it make sense that Nvidia’s market cap is larger than the entire stock market in UK, or Germany?   That is an astonishing statistic that implies a future of largely uninterrupted growth in revenues and profits at a parabolic rate, with no significant hiccups along the way.  Even Microsoft’s 15X sales is extreme.  Sorry, but this is simply not how markets behave, no matter how sound the company might be.  Markets need to correct and rebalance.  It has been over 350 days since the S&P500 had even a 2% down day.  There is nothing normal about this market behavior.

When the Dot-com bubble burst in 2000, it took nearly fifteen years for tech stocks to fully recover.  When the DJIA topped in 1929, it took more than twenty-five years for the stock market to make a new high.  (Yes, allowing for dividends the recovery took less than five years, but even that is a long time.)  Am I forecasting these sorts of crashes right now?  In a worst-case scenario, these sorts of meltdowns are possible.  In a best-case scenario, we will still have a vicious correction.  Let’s review the macro picture in greater detail and see how it is all shaping up.

In prior newsletters I wrote at some length about the trend in unemployment in the US.  It is precariously close to triggering the Sahm Rule, confirming that we are already in a recession.  The job market is not tight right now.  In fact, the job growth we are seeing month after month is highly deceptive.  Part-time employment has been the primary motor behind the increase in the jobs numbers, and even those numbers have been grossly overstated.  Unemployment is slowly, but steadily climbing.  We have pretty much stretched out the economic boost from the Fed’s net huge balance sheet expansion and the federal borrowing and deficit spending.  With several more months of rising unemployment, we will officially be in a recession. Unfortunately, we have already been using deficit spending to the tune of many trillions of dollars to artificially boost the growth numbers, so what will the authorities do next to try to artificially boost economic growth still further?  Spend even more?  Borrow even more?

We have previously delved into the massive debt levels in the US, along with the dangerous fiscal spending patterns of the leaders of both parties in Washington.  I am alarmed and disgusted by the short-sighted, selfish behavior of our leaders who have sacrificed the financial future of generations to come for their short-term political gains.  Federal spending is, quite frankly, out of control, and it has been for a long time.  I have no political agenda, and I won’t address the specifics of one political party versus another.  I will, however, address the accumulated fiscal deficits to which both parties have been willing and able contributors.  Our federal debt levels will be a burden for us to carry for a very, very long time, and they actually put the stability and safety of our country at risk.  It is the height of deceit for our government leaders to claim that they are promoting the well-being of our nation by spending money as if we are in a crushing recession.  Sure, it might be a clever political strategy in the short run to have huge government spending supporting all the whims and wishes of the various constituencies, but the long-term damage will be very hard to heal.  We pride ourselves on having the very best defense forces in the world, but our irresponsible deficit spending has exposed our nation to potentially perilous foreign forces, and we need to wake up to this reality before we suffer a catastrophic blow.

If I were to be cynical, then I might suggest that the US likes to be number one in everything, so perhaps our leaders in Washington are jealous that Japan has managed to build up a shocking 264% debt-to-GDP ratio while we are only at 124%.  Therefore, Washington feels an intense need to borrow and spend at a maniacal pace in order to catch up with the Japanese debt levels.  The good news is that this will take some time, and hopefully we will have some responsible Congressional restraint in the interim.

I raise the issue of Japan not just to poke fun, but for a very important reason, i.e. it is time that we start to take stock of an ever-growing risk that Japan is going to decide to finally bring home their huge amount of savings from America. My fear, and my growing conviction, is that this decision may not be that far off in the future.  Unlike the US, the Japanese have actually funded their government pension plans, as well as their corporate pension plans.  They have massive net savings, including well over $1,200,000,000,000.00 (One Trillion Two Hundred Billion US Dollars) of US Treasury bonds currently held by their government and their corporations.  They also have hundreds of billions of dollars of money invested in the S&P.  How likely is the risk of the Japanese liquidating massive dollar-based holdings right now?  Whereas I would have put this risk below 10% prior to 2023, I now put this risk at 35% to  40% – and rising.  The risk is real, and we need to be ready to act.

Based on decades of trading very large size in the currencies, my experience is that four billion to five billion dollars of net sales can drive dollar yen down about one yen.  The problem in the current environment is that if a dollar drop is initiated by several hundred billion dollars of net sales, we would also be triggering absolutely massive stop loss orders from speculators who are stuck with losing short yen positions.  This combination would create a cascading effect and cause the yen to surge in value. Yes, depending on the speed and volumes of the sales, we could easily see dollar yen trade well below 100 yen per dollar in a relatively short period of time.  I have seen sixty plus yen moves occur in relatively short time periods before, and they could certainly occur again.  Sixty yen drops within twelve to eighteen months are certainly possible, and one hundred yen drops over a few years are certainly plausible.  

The sudden dumping of these assets would send shock waves through our system, crashing the debt market and driving interest rates higher, as well as causing a violent drop in equities.  It would be chaotic and incredibly disruptive.  Higher interest rates would in turn worsen our debt problems, raising the cost of financing our ever-growing deficits.  The dollar would absolutely get crushed, causing all sorts of further reverberations through the markets.  Geopolitical tensions would rise, and countries like China would be tempted to follow suit and accelerate what has been to date a  methodical sale of treasuries over the past five years.  We would then understand the real risks of a politicization of our markets coupled with dangerously large fiscal deficits.

It is clear with the US imposition of tariffs over the past two administrations that confronting China is one of the few areas of bipartisan unanimity in Washington.  China’s gentle unwinding of treasuries could easily be accelerated into a wholesale dumping, causing still more problems for the US to manage.  We should not be naïve and think that China has not thought about ways to retaliate against our tariffs.

Are these two developments likely?  I would absolutely place them on my list of real and present possible dangers to our nation’s security.  Japan’s decision would be driven by a need to prop up their currency and support their domestic economy.  China’s decision would be driven more by a blend of malice and self-survival. The Chinese economy is showing tremendous strains and some cracks, but they can likely weather their economic storm.  The level of debt and overextension in their economy is extreme, but they have sufficient resources to carry on for a while.  Japan’s economic situation is more dire.

There are plenty of other signs of economic weakness coming into our economy.  Wholesale pricing of used cars and trucks is falling off a cliff.  In June, these prices dropped by more than 10%.  Home sales are stagnating.  Commercial real estate is hemorrhaging losses.  Credit card delinquencies are rising sharply.  Surplus savings have dwindled over the recent years.  Expectations about real wage growth over the next five years are abysmal.  Inflationary pressures are abating somewhat, but the price levels that we have attained due to the prior years of inflation are already extremely painful. The one bright spot in the picture has been the performance of the equity markets, and many people are participating in this rally.

Don’t be surprised to see the Fed panic and cut by fifty basis points in September if we get a few bad numbers next month.  Powell and Yellen are well aware of the economic headwinds hitting our economy.  Europe is already slowing.  In fact, nearly every major economy is slowing.  The US has held up better than most due to our insane deficit spending, but at some point, that will be self-defeating. 

In shifting to the markets, what I see developing over the coming months is first and foremost a huge pick-up in volatility across many markets. This will bring us many fantastic trading opportunities.  The downside of this scenario is that many people are about to get hurt.  I stick by my forecast that we might have one more surge in stocks before the stock market has a blow-off top and a major reversal.  

I have been asked to provide a bit of a scorecard for a number of my recommendations and forecasts.  Unfortunately, my crystal ball gets murky sometimes, so I will absolutely get plenty things wrong over time, although most of the errors tend to be tied to my timing, rather than my direction.  I tend to be early.  Sadly, I just haven’t figured out how to recalibrate that crystal ball.  

I have been writing for over a year about the strength of gold, and I am still very bullish on the yellow metal.  I am also bullish on silver.  My recent buy recommendations remain firmly in place.  Just today gold is closing at a new all-time high, and the impending rate cuts by the Fed and deficit spending by the government are convincing me to run this position for quite a while longer. 

I remain bullish on Bitcoin.  Last week I put out a strong buy recommendation on Bitcoin and the market has complied with a tremendous rally.  It is already up over $10,000, but it should have a lot further to go.  It is the first time I have written about Bitcoin since I warned my readers to take profits on their longs in early March.

I have been early in forecast about dollar yen putting in a top.  I am not sure yet if I am just wrong, or just early.  Due to my admitted tendency to be early, I almost always prefer to use limited risk option strategies with a long duration.  I give up some of the upside through these structures, but I am able to stay in the trade this way even if I am too early.  Therefore, I can make money over time, but not necessarily immediately.

I have given a few recommendations on the euro versus the Canadian dollar, and they have been quite alright.  I caught an initial rally from the 1.4300 up to 1.5000.  I then caught the move back down to 1.4300 before again getting long.  I now feel that instead of taking profits at 1.5050, we should look to possibly run this position for a much bigger move higher. In fact, I think that cross might continue its rally from the current level of 1.4900 all the way to 1.5800.  This will take some time, so it is a trade for patient investors.

I have been bullish on the Australian dollar versus the Canadian dollar, and overall, I remain constructive.  It should be a slow grind higher, so just like with eur/cad, this is a position that requires patience.  My target there is around the .9500 level. I actually prefer the British pound against the Canadian dollar right now, but I will write about that in more detail over the next several weeks.  

Regarding stocks, I have been ok with some individual stock forecasts, and my trend following strategies are doing well.  Overall, however, I need to give myself a poor grade on forecasting the S&P500.  I don’t have any specific recommendations right now except that I want to see a blow-off top before piling into a heavy short exposure.  I know it just isn’t time yet.  

Finally, as a special treat for my readers, I will write about the New Zealand dollar in the next few weeks.  I have a big picture idea that I am still fine-tuning.  I don’t play in that currency that often, but when I do play, I always go all in.  I am waiting for a special set-up to occur, and then I will let you know what I see developing there.  It is close.  Considering I once had a short position that was larger than the country’s money supply, when I say I like to go all in when I play in New Zealand, I really mean it.  

In the meanwhile, I want to wish you all the best of luck with your trading.

Andy Krieger