Home Forex Beware: Markets Can Remain Irrational Longer Than Most Bears Can Remain Solvent

Beware: Markets Can Remain Irrational Longer Than Most Bears Can Remain Solvent

by SuperiorInvest

Keynes once said that markets can remain irrational for longer than one can remain solvent.

I love this quote because it speaks to the power of narratives, and my humble adaptation of it would be:

“Narratives can dominate the macro for longer than one can remain solvent.”

That is why today we are going to cover the two strongest narratives that exist:

  • China is doomed;
  • AI is the new revolution and American technology will dominate forever.

The two narratives are visualized in a simple graph:

To understand what is happening in China, we must take a small step back.

Why have Chinese markets been in free fall?

The Chinese stock market has been in virtual free fall despite regular attempts by authorities to stabilize the markets.

Meanwhile, the property market continues to suffer and Chinese authorities are grasping at straws to try to stimulate the economy.

To understand what is happening in China we need to talk about the concept of balance sheet recession.

A balance sheet recession is a toxic economic loop in which, having been burned by deleveraging and falling asset prices, households and corporations refuse to accept new credit and focus solely on paying down their debt. and reduce their balance sheets.

That causes a vicious cycle of greater deleveraging, lower asset prices and lower economic activity that cannot be stopped with lower interest rates.

Economic activity

Economic activity

First, let's quickly cover how our credit-based system works in normal times.

The top of the chart above shows what happens then:

  1. The private sector likes leverage (especially if it's cheap), so lending activity is strong;
  2. Banks grant new loans/credits, so new money is created in the real economy;
  3. That drives economic growth and asset prices higher.

But what happens during balance sheet recessions (bottom of chart)?

  • After Xi's drastic measures, housing prices began to fall, thus affecting the capital position of highly leveraged Chinese households;
  • The lack of relaxation of this stance and the continued weakness of the property market led developers and households to rush to remain solvent: pay off their loans/mortgages as quickly as possible: deleveraging underway.
  • The lack of new credit, coupled with real deleveraging, further affects housing and asset prices in a vicious cycle also known as a balance sheet recession.

How is a balance sheet recession structurally solved? Is China moving in the right direction?

Surely it cannot be solved by lowering interest rates and Japan shows us why.

In the early 1990s, the Japanese housing bubble burst and the world's most famous balance sheet recession developed: the Bank of Japan lowered and kept rates at 0% for decades and nothing happened.

When the balance sheets of businesses and consumers are hit hard through a deleveraging process, asking them to accept… more credit won't work even if interest rates are low.

For example, between 1999 and 2007, interest rates in Japan were mostly at 0% and the Bank of Japan was implementing QE (red line), but Japanese banks were unable to expand any credit to the real economy (blue line ).

Despite 0% interest rates, bank lending actually contracted.

Bank of Japan Quantitative Easing

Bank of Japan Quantitative Easing

The People's Bank of China can cut rates further, but that won't do much good.

The best chance to stop a balance sheet recession is through targeted fiscal stimulus.

Exactly as the United States did in 2009 and stealthily ever since, the Chinese government can step in and use its balance sheet to pump fresh resources into troubled property developers and households.

This is basically a capital injection that stops the bleeding and allows the private sector to repair its balance sheets over time.

The problem is that China is not doing anything fiscal, not even seriously considering it so far.

Chinese asset valuations are getting cheaper by the day, but China needs serious fiscal support to avoid a more serious downturn in its balance sheets and convince investors that the worst is over.

Today, investors can easily convince themselves that AI will be a human revolution and that there is no price high enough to buy stocks like NVIDIA (NASDAQ:).

NVIDIA trades at a price-to-sales ratio of over 30 times and is now apparently worth more than Canadian GDP or the entire Chinese H-share market.

The NVIDIA chart looks a lot like the CISCO chart from 1999-2000, and one wonders if we are in extreme euphoria given the parabolic move up:

Cisco Systems Weekly Chart

Cisco Systems Weekly Chart

The other side of the coin is that NVIDIA is a very profitable company that is growing aggressively: Its free cash flow (FCF) per share continues to rise and some analysts expect it to generate more than $100 billion in FCF in the coming years.

This means that NVIDIA will not have any suitable competition in the future:

NVIDIA Corp stock price chart

NVIDIA Corp stock price chart

I don't even claim to be a stock analyst and therefore have no opinion on NVIDIA, but there is a big lesson to be learned here.

“Narratives can dominate the macro for longer than one can remain solvent.”

Shorting the tech bubble in the first half of 1999 would likely have wiped him out before he could benefit from the sharp decline in dot-com stock prices.

The impulse is very powerful and arriving early can be tantamount to making a mistake.

Buying Alibaba (NYSE:) at $76 in early December looked great ex ante with a cheap 10x P/E for a tech company; However, three months later it is trading at $72.

In a balance sheet recession, assets are sold indiscriminately to repair balance sheets.

If you're looking to fade extreme narratives without being quickly removed, options can be an interesting way to do so.

A long call or put option has a fixed, limited downside (the option premium), but a potentially large upside.

The trick here is that this is not free: you are often charged for the luxury of “sleeping at night” due to the expensive implied volatility generated in option prices.

In addition, options provide another dimension: time.

If you buy 1 month of NVIDIA puts you have to get it right quickly, not in 3 months.

Today, the cost of covering a decline of just 1.5% over the next month is low: with implied volatility of 11.5%, it is on the low side of the pre-pandemic range.

Downside protection on SPX

Downside protection on SPX

That doesn't mean this hedge will necessarily make money, but it does mean its ex ante odds aren't bad.

As a friend would say: protect when you can, not when you have to.


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