Theater of the Absurd
The Expert View
Featuring Sven Henrich
Published on: April 22nd, 2019 • Duration: 31 minutes • Topic: Monetary policy, Financial System, Technical Analysis, Positioning, Global Outlook, Equities, Macro, Sentiment, LiquidityGlobal equity markets look poised to break higher, according to Sven Henrich of the NorthmanTrader. These markets have been continually juiced by central banks, but each rally is becoming increasingly fragile. Policy normalization has reached its limits, leaving little ammunition to prevent the next panic from turning into a crisis. Filmed on April 12, 2019 in London.
SVEN HENRICH: That's what the market said to the Federal Reserve. This attempt to finally normalize was stopped dead in its tracks. We always intervene. We will never stop. We can't stop. The moment we try to be non-accommodative, everything blows up in our faces. For example, right now I don't like the long side here. I've made no secret about it. At the same time, I recognize the factors that play that say, yes, we can get this crazy blow off move.
Most people know me on Twitter under NorthmanTrader, the website I operate, looking specifically at market direction. We analyze market from a technical perspective as well as the macroeconomic perspective that includes politics, central banks, what's happening with the economy, and all that good stuff. Prior to trading, many years ago for 20 years, I actually was in the corporate world. And this is probably where I picked up all my analytical skills, if you will, sharpened the skills. Mostly corporate finance, but also operations management, did a lot of international corporate development in Europe, Asia, South America, and we looked at valuation of companies, obviously the build out of companies. So I had always had a good knack for analyzing business plans.
What's driving this hated equity rally?
SVEN HENRICH: Well, it's very simple. We've had basically three drivers. The first and most obvious driver was central bank capitulation. Obviously, we came from a period where the Federal Reserve claimed they were on autopilot and the balance sheet roll off. They were projecting rate hikes for 2019 and obviously caved on every single aspect of that. And it brings back the same spiel, basically, that we've seen in equity markets for the past 10 years. You see a little bit of trouble in the equity markets. In this case, maybe a bit more serious trouble because we had a 20% correction. And then immediately, central banks back off or intervene.
In this case, they backed off completely reverse policy. And that had a dramatic effect on expectations, on rates, and of course, getting back into the regular mode of, OK, the central banks have our backs and therefore we rally back into equity markets. It's been really well documented script that we've had in markets now since the financial crisis. And hence, every corrective activity doesn't last very long.
The second aspect, of course, is also the amazing amount of jawboning that we've seen on the side of the administration with regards to dangling a China deal, right. Because a lot of the growth slowdown globally is now blamed on trade wars, if you will. And so there was hope that a China trade deal will miraculously return the growth curve around. And we've seen it. I mean, many of you may have seen me on Twitter documenting it and others do as well, you know. You see constant headline coming out. We had a phone call tonight, or there's going to be a phone call tomorrow. And the algos react to that, or they have been reacting for a long time in this first quarter.
And then, of course, the third aspect is buybacks. Record buybacks. We have $270 billion in buybacks in the first quarter. Mind you, we had a record buybacks last year as well, and that did not stop selling at the end of the day. But when you see, again, an environment where you have low volume being predominant marking the landscape, buybacks obviously make a difference because they maintain a steady bit in the market.
How long can the rally keep going?
SVEN HENRICH: First of all, there's technical factors that I'm watching, and what I see in the rally specifically now is it's kind of repeating the pattern that we've seen last summer, actually. And what you see is a lot of gap ups, you know, tight intraday price ranges. These gaps not getting filled, volume declining, and one of the patterns I am watching is a rising wedge.
Now these wedge patterns can last for months. Last year it lasted for months. It actually was an aggressive wedge pattern into January 2018 highs. So what happens is price compresses ever more. Volatility compresses, and at some point, you get a trigger and the pattern breaks, and then you have that volatility explosion. Specifically, we see it on the NASDAQ, and it keeps rising. And what I said last summer too is that as long as these things keep rising, they can stretch the imagination, if you will. I think this is probably the biggest challenge for traders to, frankly, also for me, you know. You see something, and you have to have the patience to wait for it to happen. But then of course, it can happen so fast then you're either in the move or you're not. That's one of the big challenges.
So from that perspective, as long as the pattern structure holds, it can keep going, you know. When it breaks, I think that's when we ultimately have the first challenge for this market in 2019. Because so far, this rally-- and this is probably to your point, the most hated rally-- it does not correct in any shape or form. This has been completely uncorrected from day one. We had this initial blip in early January when Apple announced earnings warning, and then Jay Powell came in with his flexibility on the balance sheet. And since then it's been nothing but up, right. NASDAQ had one down week in all of 2019.
And that's concerning. You're on a trajectory that's not sustainable for the rest of the year. So at some point that pattern will get tested. The question is what happens then, right? I mean, as long as markets can retest some moving averages and stay above them in some key levels, then we can gather more energy, right. You currently a classic v pattern. You can see maybe some sort of cup and handle, if you will. And then off you go to two massive new highs. That's a possibility unless you break particulate levels. Then of course, you can make the case we're still in the bear market rally, which sounds absurd at this point, because we're so close to new all time highs. But that's a really important consideration as well. That's why I like to tell myself and my clients, we all need to keep an open mind here, because what's happening here is in many ways unprecedented.
So we'll have to gauge this here during this earnings season, obviously in the next few weeks. On the S&P, I would say we're kind of at a key point here and the pattern has to prove itself one way or the other. On the NASDAQ, I can still see it going higher. But the issue is because these patterns are so steep, there's really no room for error. This is one of the reasons we have continued levitation, because if you break the pattern then a technical overreaction will take place. I mean, if you look at just the last couple of weeks, you know, prices have been extremely tight, and you got to observe what's actually happening in the marketplace, and what's the actual action. The action has been gap ups and then very tight intraday price range. You see two, three, four handle price ranges, and then nothing happens. I don't like staring at dead screens for hours on end. We like volatility, right. And so obviously, this is probably one of the reasons I'm critical of what's happening with central bank intervention, and buybacks, and everything else, because it always compresses volatility. It did in 2017, did it during portions of 2018, and then-- at least in 2018, we had some nice snaps, and we had some explosions in volatility. And that's where traders love that. That's where we can certainly make good directional moves in either direction.
What could be a catalyst for reversal?
SVEN HENRICH: You always can assess maybe potential triggers that are out there, and then there are the ones that no one sees coming that surprise you. My general view on these things is if the technicals line up, market will find an excuse to validate the technicals, right. So I mean, if you're talking about known triggers or potential known triggers in the immediate front, it would be earnings. So far markets have basically ignored everything on the earnings front in terms of reduced growth expectation. It's basically this replay that we've seen in 2015, 2016. We had this earnings recession. Markets dropped hard into early 2016, and then central banks intervene. This is where we saw this massive intervention of $5.5 trillion. We saw Janet Yellen pausing the rate hikes. And basically, I think the market's hope here is that we're seeing a repeat, right, because Jay Powell is following the same script. He immediately backed off of everything, and earnings recession is going to temporary. After all, China is again intervening, right.
So we do still have this whole liquidity game in place. And I think this is the big challenge now to see whether that program shifts, because at the end of the day, what we saw here in 2018 is a big wall put in front of central banks. Your experiment has failed. I mean, that's what the market said to the Federal Reserve. This attempt to finally normalize was stopped dead in its track. And I think that's the larger concern here if you look at credit. One of the big drivers of this rally has been this move into high yield credit. I mean, it's absolutely incredible when you look at that chart. And so the entire market, basically, is trying to replay the game of cheap money, the Tina effect, there is no alternative, buybacks. And then of course, you have this whole concern of people being left behind, the FOMO effect.
That's why I wrote about this week about this potential combustion effect, because everybody may feel the need for speed forced to chase the ever rising equity market that does not correct. That to me is always a very dangerous environment, because it's very unpredictable in nature. I mean, we've seen this in 2000, right. These things can go absolutely wild even though they're not inrooted in any fundamental reality. And so we're finding ourselves here in a really interesting point, right, because equity markets are near all time highs, and the economy has slowed down. So we have we have a gap, right.
So either you're going to see some growth re-emerging, maybe through a China deal. And then there's hope that all this growth will come in the fourth quarter and, basically, bail everyone out. Because the reality is here, this rally is not based on fundamentals at all. So it's basically the hope that central banks reversing will again provide the same script as they have done for the last 10 years. And you have to ask yourself, how long can this repetitive game that disconnects equity markets from the underlying growth bases of the economy further, and further, and further?
Can central bank liquidity override future inflection points?
SVEN HENRICH: Here's the fascinating aspect to me. I mean, look just historically where we've come from. 2009, obviously, we have the great financial crisis, and central banks had to do what they had to do to save the financial system. Fine. I totally get that. But keep in mind, originally, this was supposed to be a temporary move. It was supposed to temporarily intervene, and then we will normalize at some point. And I think all of us now have to-- and I don't know if central bankers are willing to admit this or not, but this is basically the reality that this has morphed into. We always intervene now. We will never stop. We can't stop, because the moment we try to be non-accommodative, everything blows up in our faces. That's exactly what we saw in 2018.
Keep in mind, the Federal Reserve policy was accommodative from 2009 all the way into the fall of 2018. Jay Powell still had an accommodative language in the Fed's statement, and it was only in the fall that they removed that for the first time in 10 years. And markets dropped 20%, and the economy started slowing. And you can argue out markets dropped because the economy slowed down. Really? Then why are they rising now? Because the economy is slowing down. It's not that. It's the fact that yields rose in 2018. They reached a historic trend line, technical trend line. Got to a little over 3.2%, and that was it. This debt laden construct that's been created over the last 30 years and exacerbated vastly in the last 10 years cannot handle higher rates. It just simply can't. And that's why they reacted.
And so to me the question is-- a lot of people are now asking, well, maybe there will no longer be a cycle, because central banks will always intervene. I'm sorry, then we're creating a spiral to Neverland, right. Because it takes ever more debt to sustain the system. In fact, this year now-- I mean, just look at the US government side of it. We're exploding deficits ahead of a recession. $1.1 trillion dollars already in 2019. We're basically double deficits in the last two years. 68% deficit increase in the last 12 months. Obviously, we're seeing interest rates being a major decisive factor on how you manage budgets. The US government's interest payments on debt are skyrocketing as well.
And so lower rates are basically needed to sustain this system. And by the way, that's why you can justify this rally right now, because rates dropped again. The cheap money game is back in town. Central banks flipping. Dovish staying dovish has worked to sustain the system. But we also have now learned an important lesson. We know where the red line in the sand is it. Again, cannot sustain higher rates. And so for the last 30 years, we're on a process-- look at the Fed funds. Lower highs, lower highs, lower highs, lower highs. And hence, it's no surprise that we now see from the political side pressure for the Fed to cut rates and to start QE again.
Can central banks prolong the rally for another two to three years?
SVEN HENRICH: It's certainly the way markets are reacting at the moment, right. Because a rate cut, actually, was high probability priced in the last few weeks for the end of the year. And the market, again, is reacting to that. However, historically, and this is interesting, at the end of a rate hike cycle when the Fed starts cutting rates, it's actually a bearish sign. We saw it in 2007. They were able to raise rates to a certain amount, then they stopped a rate hike cycle. Markets kept rallying for a while longer. They did the same thing in 2000, right. Markets kept rallying for a while longer. But then they had, they were forced to cut rates as the economy was entering a recession. And none of this was was bullish.
So I think a lot of what's going on right now is Pavlovian reflex behavior. This is what we've been trained to do. Fed's go dovish. We buy stocks, right. This is the game. The question is, basically, do we have sustainability on that front? And I, somehow, doubt that. Because remember 2016, the case we just mentioned earlier, it came with $5.5 trillion of central bank and intervention. There is no such intervention at the moment. There's a wait and see approach on the side of the ECB, on the side of the Fed. Chinese are certainly intervening.
What are the key signals you're looking for?
SVEN HENRICH: Well, first of all-- again, I'm coming to patterns and structures, you know. One thing you see in markets reacting-- you can see it virtually every day-- is how price reacts to gaps. So far this year, we've had seven open gaps on the S&P that have now completely unfilled, and we keep building them, you know. We get now to the point where if you have an eighth or ninth unfilled gap, markets come back, and they fill that, and then the algos react to that.
It's a fascinating game. I mean, I'm watching it from a technical perspective, obviously, and looking at the larger structural trend lines, for example. But you can see it on the shorter term time frames as well. And you see where the algo are a printing their past. It's quite fascinating. On the short term time, you can intraday, basically. I hate to say it, but if markets are as compressed as they are right now, you can even look at 10, 15 minutes. In fact, a 15 minute chart has ruled so far this year. You've got an RSI oversold reading on the 50 minutes chart, bang. The buying comes in, gets overbought, negative divergence. There's some pulling back. It's a very, very tight game.
For what we need to see to see some sort of evidence of a larger pullback evolving, it starts with the basic, easier, daily 5 exponential moving average dropping and closing below. Need to drop below the 10 ma, and it'll below the 20 MA. And then the big one to me is actually not only the 200 MA but the 50 MA.
As long as you can stay now above these larger MAs, I think bulls are fine. Ultimately, you get a pattern break that forces price below key supporting levels and averages, and fills some of these open gaps. You get this volatility explosion again. Keep in mind, it can happen fast. We saw that in February of 2018. Boom, we had within four or five days 10% down.
That is the danger in compressing volatility, and you see a lot of people being net short the VIX again, right. It's this unfalsifiable belief that volatility is compressed, that central bankers control now the price liquidity equation again. My wife, by the way, she's like the swing chartists excellence. She has an eye for these larger structural patterns, and she has seen some things right now, for example, on volatility, and knows a lot of people saying, you cannot chart volatility. Yes, you can. It's quite fascinating. And we're seeing some structural patterns that lead us to believe that there is going to be a larger VIX explosion coming in 2019.
The problem with these patterns is, especially when the VIX is very low, it tends to consolidate. It can consolidate for weeks. And it can be extremely frustrating if you want to fade it. And of course, we see the monthly OPECS program as well, you know. VIX gets crushed every time doing futures expiration each month. But watching larger structural patterns and being patient to see them evolve, and seeing all of the elements come together, this is obviously where we risk saying, OK, now we want to be very cautious about any longs. So, for example, right now I don't like the long side here. I've made no secret about it.
At the same time, I recognize the factors that are at play that say, yes, we can get this crazy blow off move into the 3,100 area even.
Which assets or regions look most at risk?
SVEN HENRICH: Well, first of all, I'm just looking just from a pure fundamental structural basis, I find fascinating what's happening with the small caps right now. Small caps are massively in debt. Some of the highest EBITDA vis-a-vis valuation ratios are completely out of sync with what we've seen before. We're also seeing you have a large portion of small caps being non-earners. This is your classic red flag sign. Here's a market that keeps diving into an asset class that has