W. Ben Hunt, Chief Risk Officer of Salient Partners, described a fascinating phenomenon – and one with a potentially dreadful outcome.
He’d spent a few weeks traveling across the country to meet with Salient clients – investment advisors and professional investors – to understand their thinking about the markets in what he called “the Golden Age of the Central Banker.” And what surprised him was how widespread, how near universal that phenomenon has become among these professionals.
He explains it in his firm’s blog, Epsilon Theory (his emphasis):
Today, everyone believes that market price levels are largely driven by monetary policy and that we are all being played by politicians and central bankers using their words for effect rather than direct communication. No one requires convincing that market price levels are unsupported by real world economic activity. Everyone believes that this will all end badly, and the only real question is when.
Among these investment advisors and professionals, “everyone believes” that fundamentals no longer drive this market, but that monetary policy does. The Fed is the only thing that matters. In a prior report, he called it Narrative of Central Bank Omnipotence. But these professional “were weary of the game,” which they considered a “big charade,” and they were “weary of being told what to think.”
Not one to mince words:
They’re not suckers. They know they’re being played by Authority, whether it’s a Famous Investor talking up his book on CNBC or a Central Banker jawboning the entire market for the umpteenth time or a Chief Economist pushing his latest prediction from some macroeconomic crystal ball, and they’re playing the game right back, usually pretty well. But OMG are they sick and tired of the lack of authenticity in the investment world today!
So why haven’t they gotten out of the market? Why aren’t they fleeing this game, this charade en masse?
Turns out, they aren’t ready yet. They still have “plenty of confidence” in their ability to play this game, they know how this charade works, and armed with this “confidence in their knowledge of how the game is played,” they aren’t bailing out of this charade yet.
On the contrary, everyone is pretty much fully invested because they feel like they have to be. But there’s no faith in markets, which is a totally different thing than knowledge or intellectual confidence.
And now that their faith in markets has collapsed, what happens when, armed as they are with the knowledge of how the game is played, they do want to run for hills? This is the point when it gets tricky. Even the Fed is afraid of it. Because trading volumes have been “abysmal.”
Since the outbreak of the Great Recession, with a few exceptional months marked by panic selling, trading activity in US equity markets has done nothing but go down. And when you take into account the growth of algorithmic trading and other machine-to-machine activity, which now accounts for as much as 70% of daily trading volume, the decline in actual human beings buying or selling stock in order to acquire a fractional ownership share in an actual real-world company is much more dramatic than this chart shows.
And this lack of trading volume has dried up liquidity not only in the stock market but also, or perhaps even more so, in the bond market (chart). Rather than being just seasonal or temporary, it represents are “a fundamental change in the behavior of advisors and investors…. It’s a buyer’s strike, a massive ‘meh’ about public capital markets, and it’s growing.”
So this believe among professional investors and advisors that central banks run the show and drive markets, that in fact, markets have become a charade that has been separated from economic and corporate fundamentals – a condition I’ve been lamenting for a long time in numerous articles – has turned these professionals off, and they lost interest in doing much of anything.
This is a psychological phenomenon – what professionals believe and feel. And if Mr. Hunt’s assessment is correct and as widespread and “overwhelming” among these professionals as it seems, it poses a terrible risk for the markets: it can turn at the blink of an eye.
One minute, they’re confident they can master the game and play along with the charade, the next minute they get spooked, and their believes and feelings flip around, and then they’ll be trying to salvage what they’ve earned, and they start unloading their assets. And in a bout of mass psychology, where they’re all influencing each other, they might start selling at the same time, when economic fundamentals have long ago stopped providing support, when liquidity has dried up, when buyers have gone on strike.
If this happens, technical analysis will kick in just in time and do its magic because “everybody,” to use Hunts term, relies on the same tools, on the same lines in the sand, which triggered buy signals on the way up and powered stocks higher, and which will trigger sell signals just when stocks are already falling in a market where buyers are on strike and where liquidity has evaporated.
It will be madness.
And the worried Fed, after driving these markets to insane heights, is having second thoughts. In an interview, Dallas Fed President Richard Fisher reported about the dynamics inside the FOMC: It’s getting more hawkish and will hike interest rates sooner than expected, he said. Markets are in denial. It’s not going to be pretty. Read…. Fed’s Fisher: End of ZIRP moved ‘further forward’