Lottery ticket

WHAT HAPPENED? – It is way too early in the game to be calling a top, but at the same time, US equities are showing the first legitimate signs of a reversal. The bearish Thursday close was impressive, after the S&P took out some key support at 1750 and finally started to show some follow through from the previous weekly close, warning of a potential top. Though not the focus of my analysis, the nasty jacknife reversal in the DAX was quite the sight and if you have some time, take a look at that daily chart. So what happened? Well – as you all know by now, the ECB caught markets off guard and cut rates, while shortly after, US GDP came out on the better side of expectation. Risk assets initially rallied on the news of the surprise rate cut, with the same free money = more incentive to buy risk mentality, fueling the gains. But once this rally had fully asserted, the stronger than expected US GDP, hinting at the potential for a sooner than later Fed taper, combined with a feel that perhaps now would be a good time to book profit on artificially supported record high stock prices, opened the door for a sizable retreat into the close.

LOTTERY TICKET - For quite some time I have highlighted the major disconnect between the financial markets and real economy, and perhaps on Thursday, we finally got that bearish financial markets/real economy cross. The Fed mandate of extended, emergency ultra accommodative policy has been the major driver of the rally in US equities to record highs, despite some severely contrasting fundamentals in the real economy. But the strategy has been to force the purchase of these risk assets so that ultimately, the benefits from a surging equity market will trickle down into the real economy. Yet the real economy has seen little benefit from this risk rally to this point and has been forced to go it alone. We are left with this awful feeling that the rich just get richer, while the less privileged fend for themselves. Back in 2009 the Fed handed out a lottery ticket to the wealthy, betting it would eventually rub off on the 99% that could not afford the lottery ticket. But how much has it rubbed off? Perhaps the most unsettling thing about the implementation of such policy, is that it is aimed at rewarding those responsible for perpetuating the initial crisis.

OPTIMISTIC SIDE – So what happens now? What happens when the market has priced in the end of the line for the Fed? Do stocks continue to rally? Probably not. At some point, these beneficiaries will look to cash in that lottery ticket, and the result will be a violent liquidation in risk assets. Everyone will be running for the exit at once and it will probably get real ugly. Who knows…maybe these profits will finally then trickle into the real economy and all will be well. But the prospect of a falling stock market and Fed exit is quite scary. If you were struggling to get by in a free money environment, what will happen when money starts to become expensive. The optimist in me believes that this will all be for the best and that just as we had this disconnect between risk assets and the real economy on the way up, we will have the same disconnect on the way back down. The real economy will continue to slowly recover as it has, while the financial markets will be forced to deal with their day of reckoning. Technically, the stock market is well overbought on the medium and longer-term charts, and even without all of this hodgepodge, a healthy pullback of 10-20% would be quite normal.

A BETTER EXAMPLE – One final insight for today – Keep an eye on EUR/CHF. This cross rate has historically been very well correlated with risk. The most fascinating and potentially disturbing thing about this correlation is that the cross has failed to benefit from the rally in broader risk assets in recent years despite its shared association. Maybe if we really think about the markets over the past several years, EUR/CHF is the perfect reflection of how things should be. If you were struggling out there and someone came to help you out, you would expect them to help support you, but you wouldn’t then go and try and take everything you could get from the person trying to help you. This seems like the more appropriate reaction to me and exactly how EUR/CHF has behaved. EUR/CHF has been supported in recent years, but at the same time, has not exploded to the upside like other risk assets. So if these spoiled risk assets do in fact start to come back under intense pressure, what then happens to EUR/CHF and that critical SNB barrier at 1.2000. If this barrier is in fact threatened and broken, it could then send a message to markets that as much as artificial intervention might be effective for a period of time, at some point, we need to learn again how to stand on our own two feet and feel good about going it alone. It may be scary at first, but ultimately, this is where the real rewards are.