Worst-case scenario ahead.
The S&P 500 has more than tripled over the past eight years; the Nasdaq has more than quadrupled. Practically everyone knows – even the Fed has gingerly admitted it – that the stock market is way overvalued, that price-earnings ratios for companies that have earnings have reached dizzying heights, and that the market is primed to unravel either on Tuesday or next year or whenever.
And there are lots of people who have pointed at the triggers, such as Trump’s inability to deliver on his tax-cut and infrastructure promises or the moment when the market finally gets it that the Fed is watering down the punch bowl.
Given the inflated levels of the market, and the amounts of liquidity that would suddenly evaporate, it would be an epic crash. That’s the theory. And it would make an equally epic buying opportunity for those with the liquidity to do so.
So the smart money is preparing for it. Among them are hedge fund manager Paul Singer and his clients. In his recent letter to investors, cited by MarketWatch, he explained how “all hell will break loose” and how he wants “to take advantage of it”:
Given groupthink and the determination of policy makers to do ‘whatever it takes’ to prevent the next market ‘crash,’ we think that the low-volatility levitation magic act of stocks and bonds will exist until the disenchanting moment when it does not. And then all hell will break loose (don’t ask us what hell looks like …), a lamentable scenario that will nevertheless present opportunities that are likely to be both extraordinary and ephemeral. The only way to take advantage of those opportunities is to have ready access to capital.
Elliot’s hedge fund, Elliott Management Corp, had raised “more than $5 billion in about 24 hours” for just that event, Reuters reported on May 5. The firm has $33 billion under management not counting the $5 billion. That it took him only 24 hours to raise this much money shows how eager investors are to capitalize on the next crash. The money is set up to be drawn from investors over the next few years. They see it coming; they just don’t know when, and they want to be ready to benefit from it when it comes.
The market is like a “coiled spring” after eight years of QE and interest rate repression, Singer said in the email announcing the $5-billion offering. His firm wants to have the liquidity to capitalize on a “possibly large opportunity set that could emerge when investor confidence is impaired, recent correlations and assumptions don’t work, and prices are changing rapidly.” He added:
“The nature of modern markets is that rich opportunity sets seem to be ephemeral, providing surprising volatility, bargains and dislocations for only brief periods of time before governments, aware of the politically destructive effects of extreme volatility, rally to take stern actions to keep the balls up in the air.”
So they’d have to act fast to front-run the Fed.
Others too are preparing for this obvious opportunity. It will be an event that could produce extraordinary returns by picking up the pieces before central banks jump in and once again bail out stockholders and bondholders. That’s the theory.
But here’s the thing: the more investors prepare for this by putting large amounts of money aside to plow into a crashing market to pick up the pieces, the more likely they will be to stop the crash in its tracks.
As a sharp sell-off unfolds and after regular dip-buyers are crushed, the nervous crash buyers that don’t want to miss this opportunity will start buying. They’re nervous because the Fed could jump in and reverse the crash, and they want to pick up the pieces before that happens. So they’ll jump in early and the intense buying will stop the crash.
This includes short-sellers who want to take profits and cover their positions during a crash. They’re the most nervous bunch of them all.
Under this buying pressure, asset prices would begin to bounce before the Fed steps in, and given the bouncing prices, it might not step in, though prices might not reach prior highs. Then, after a period of calm which the smart money will use to unload these positions and take profits, the sell-off would start all over again until crash-buyers pile in again to front-run the Fed.
This can go on for many years – a brutal zigzagging lower that never quite offers the buying opportunities because too much money jumps in too soon to turn selloffs into rallies that then fail. Japanese stocks have gone through this since 1989 despite the Bank of Japan’s umpteen rounds of QE and endless interest rate repression. And they’re still going through it, with the Nikkei down nearly 50% from its peak almost three decades ago.
Given the smart money’s fervent intentions to capitalize on these crashes and given investors’ eagerness to put a lot of money behind this strategy in advance, I think a long drawn-out Japan-like downtrend in asset prices with dizzying ups and even bigger downs is a likely if terrible scenario that may well crush how investors feel about buying and holding these assets, as it did in Japan.
A stock or bond market tantrum might stop the Fed in its tracks. But the opposite is happening. Read… Are Markets Blowing off the Fed?
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.