Unsound Credit And Risk Assets – How Serious Is The Situation?

There is thus a significant danger that the so-called “portfolio channel” effect that central banks have encouraged with their loose monetary policy after the GFC will substantially reverse. This will eventually affect an ever wider circle of borrowers and creditors if forced selling and disappearing liquidity continue to feed on each other in a vicious cycle. In spite of the presumed greater resiliency of the banking system, banks will definitely not be immune to such a development. Their direct exposure to energy loans is only one of several potential problems.

Remarkable Equanimity and Ominous Patterns

We get the feeling from reading articles in the mainstream financial press that there is still a lot of complacency in the markets. For instance, we have come across sotto voce assertions that “this is not 2008” or variations thereof several times already. This is of course true, as every downturn is inherently different (even though Tom McClellan shows that there is an eerie similarity between the 2007/8 and the 2015/16 chart patterns).

We feel however reminded of something Paul Singer of Elliott Management pointed out a while back in this context. He noted that the 2008 experience has probably taught investors to act more quickly once they sense that danger is in the air. In other words, once a decline in risk assets that looks like it is not a run-of-the-mill pullback is underway, it could very easily and quickly accelerate.

As we have recently mentioned, the currently still prevailing complacency is also reflected in “fear measures” such as the VIX. Meanwhile, the deterioration in market internals, the market’s overall technical condition, as well as long term positioning and sentiment indicators continue to look quite dangerous – even if the market is oversold in the short term.

John Murphy of stockcharts has recently pointed out that a well-known bearish technical pattern has become visible in the S&P 500 Index over the past 18 months. Specifically, since October of 2014, the SPX has formed what looks like a slanted head & shoulders pattern. We would add to that observation that the “head” of the pattern looks like a diamond pattern to boot. Both of these patterns are reversal patterns of some statistical significance. Naturally, they can and do occasionally fail (which is bullish if it happens), but their appearance definitely increases the likelihood that a major trend reversal is underway.

4-SPX h&s

Slanted H&S pattern in the SPX. The “neckline” has already been slightly undercut – click to enlarge.

Murphy also reminds us that the “All World ex-US” index is by now clearly in a bear market, after having put in a widely spaced double top:

5-All World-ex-US

The FTSE All World ex-US Index has declined below both its October 2014 and August 2015 lows. Recently it has even fallen below the lowest close of 2013, to a level last seen in late October 2012. This was incidentally shortly before the beginning of the Fed’s QE3 program – click to enlarge.

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Gary Anderson 5 years ago Contributor's comment

So bank funded investors have been fooled into thinking that the junkiest bonds are not so junky? Wow, that story played before. Amazing that the Fed probably thought all this structured finance was good risk. I wonder if they had their hand in the mispricing of this risk too, just like the subprime bonds back in 2008?