Finance

The Laws Of Mean Reversion Have Begun Their Summer Offensive

The Laws Of Mean Reversion Have Begun Their Summer Offensive

Authored by Bill Blain via MorningPorridge.com,

“When valuations are extreme, “Mean Reversion” towards historical norms is likely. Once value stocks turn, the recovery can be fast and intense.”

We’re officially in a bear market, but markets are still massively overvalued. The laws of Mean Reversion are immutable – some stocks are going lower. Inflation, Bond Markets and Confidence are all flashing danger signals.

It was messy out there y’day! Stocks prices down and bond yields up! It’s officially a US Stock Bear Market! 20% down this year. Ouch!

There is little to suggest it won’t be much the same today. Recessionary indicators are nailed on. When all around are losing their heads….. and all that. The whole market feels like it’s going to hell in the proverbial handbasket – which is exactly as predicted.

Get over it. Hard Hats on. Hunker down. This is what happens in markets. They get over-exuberant, they rise, they fall. Get used to it. Remember… things are never as bad as you fear, but seldom as good as you hope.

The reality is the Laws of Mean Reversion have begun their long-awaited offensive! Their strategic objectives are simple: push back stocks to sane levels in line with long-term market average valuations, and re-establish bond yields at the optimal level to discount the most efficient allocation of capital across the economy. That’s the way the economy should work – but hasn’t since 2009.

Mean Reversion makes sense. For the last 13 years, monetary experimentation has led us to this corrective moment. It’s created a massive imbalance in the Force of markets (yep, ok.. only joshing about the Force, but you get the drift.) By distorting all financial asset prices through ultra low interest rates, an imbalance in the Force was created. That is now going to be rectified. Unfortunately… it will hurt. Consequences. Consequences.

Ultra-low interest rates (NIRP and ZIRP) and QE led the whole financial economy to binge on chaotic mispriced financial assets. The chaos spawned a host of insane valuations and fantabulous get-rich-quick schemes on the back of easy money. Some day we shall laugh at the madness of Buttcon, Crypto, NFTs and SPACs.. but today, they are being crushed. There is massive pain still to come in Tech valuations.

Prices are going to correct further.

The trigger has been inflation. The reality is inflationary pressures are still rising vertically. The immediate stresses are exogenous: the war in Ukraine is set to ensure Energy and Food dislocations remain long-term, while China looks certain to continue lockdowns and thus broken supply chains remain the norm. The second derivative of these exogenous inflation shocks is organised labour is getting ready for a second half of industrial strife and double-digit wage demands… Their demands will be fuelled by the massive rise in income inquality we’ve seen develop since 2009.

The bottom line is this inflation and all its consequences are probably unstoppable.

So….  Ask yourself a very simple question: How will the Fed hiking 75 bp (which has been well-briefed after last week’s CPI shocker) tomorrow, and The Bank of England raising rates by 50 bp on Thursday, actually help?

The inflationary genie is already out the bottle! Trying to stop inflation now will be like catching a 1000 ton boulder rolling down a hill, even as it builds momentum with every bounce..  It might be better to see where it stops and then repair the damage?

This morning everyone is watching the stock markets for clues on what happens next. If you are, you are looking in the wrong place. Bonds are far more important at time like this. 

When bond markets break, they break big, and they break fast. They could trigger a one-way liquidity crisis across all financial assets with massive consequences for banks and markets. Perversely, because the US treasury market is so big, and notionally so liquid, it tends to disguise bond market weakness elsewhere.

This is where this Morning’s Porridge gets deeper and more philosophical. This is where we need to have a deeper series of discussion about the Virtuous Sovereign Trinity: the relationship between Confidence, Bond Yields and Currency. Call it VST. (VST is my theory a nation will remain in broad balance while it can maintain confidence in the management of its economy, the stability of its currency, and keep its bond yields under control.)

But, if any of the three legs crack – if confidence evaporates because of political expediency, or the currency tumbles on the back of economic distress, or the bond yield rises creating a funding crisis, any of these can destabilise the whole VST and the economy, leading to the kind of Sovereign crashes now spreading in the EM markets – Sri Lanka is just the first – which could well become systemic as they spread.

One of my fears is the VST will crack in Southern Europe, forcing the ECB to re-embark on a massive QE programme to shore up Italy and Spain debt – leading to yet longer-term distortion. Europe is a “Speshul” case when it comes to the relationship between sovereign credit, currency and confidence. I predict it will be tested in coming months.. all of which will act to Russia’s advantage in Ukraine.

Unfortunately, there isn’t time to fully explain how VST, bond market weakness, (particularly in corporate bonds), and a spate of sovereign crises are now a rising risk, but be aware how the rising inflation tide, concurrent political confidence and currencies will impact economic stability as the correction that’s under way deepens.

This week’s higher interest rates this week will further spook markets, crush upside expectations, and go a long way to cut frothy financial asset valuations – which may have been Central Banks’ plan all along – a managed inflationary period to address the debt loads taken on through QE and then the pandemic. As usual.. plans seldom survive contact with reality.

Higher interest rates this week are unlikely to do much to address the inflationary path – it’s here, it’s already burrowed deep into the economy. Eradicating inflation at this stage, following the pandemic/war endemic shocks is not only challenging, but probably impossible – everyone will want made good, but as corporate earnings take a tumble on falling consumer spending.. not everyone will get a pay rise.

The result is Strife and Tension. Rising domestic political tensions across the west ahead of the US and UK electoral cycles? Nasty. Ouch. Do you think Putin and Xi might have planned this way, or did they just get extraordinarily lucky? Think about the VST. But, I distract myself…

Back to this morning’s topic: Mean Reversion:

If there is one theme on where stock markets are now going.. its Mean Reversion. As I warned a few months ago, it was time to refamiliarize yourself with the Crash of 29 and the wasted decade that followed. Where are markets going?

At this point recall Warren Buffet’s stock market capitalisation to GDP rules – the Buffet Indicator. His dictum was the US equity market is overvalued at 90% of GDP. Today, the value of US stocks is about $40 trillion while GDP is $25 trillion = 163%.

The 90% fair value number is subjective. We should factor in just how low interest rates still are, which makes stocks look better relative value to bonds. Let’s say the Buffet Indicator of fair value in a low interest environment is 110% – in which case stocks are still overvalued by around 30%.

Funnilly enough, my base case is the stock market still has a 30% correction to come. That won’t impact every stock equally. Many value stocks look buyable. Some others have much further to fall as economic common sense breaks out. Many stocks may already be close to fair value. Guess which side of value Tesla lies?

Tyler Durden
Tue, 06/14/2022 – 08:06

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