Strategist Note Excerpt: How We Arrive at Capitulation in 2016

Strategist Note Excerpt: How We Arrive at Capitulation in 2016
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By 4am Friday EST, 15-January, for the first time since 2003, WTI Oil had pierced below the psychological $30 barrier, inside the $20-30 range first previewed in my 24-Feb-15 Seeking Alpha report, “Run with the Bulls in 2015.”

By contrast, for a 2016 Outlook, I would be hard-pressed to make such a bullish statement, as heralded by that 2015 Year Ahead title, about any of the risk-asset markets today, especially from a timing standpoint. Rather than predict target prices out one year, my 3-Jan-2016 Year Ahead focused strictly on the matter of Trust in the Central Bankers, allowing scions of finance, situated at leading institutions, to do most of my talking.

To clarify, the culmination of the seven-year Bull Run has finally come down to the confidence that market players have in the ability of Central Banks to continue propping up all markets in the face of the economic wreckage left in the tribulation of 2008, and the 2001 trial before that, when policies first began to benefit the few at the top, at the expense of the far more at the bottom.

Following a critical OPEC meeting, in the early morning hours of 1-Dec-14 in Santa Fe-NM, suffering insomnia from my first bout of altitude sickness, and with a full day of meetings in-tow, I first discerned that plunging oil would be the catalyst for the next financial crisis. True, dropping the phrase “Black Swan” in my meetings that day probably did nothing good for my personal finances.

However, my clear perception of the same feeling that I had experienced in the summer of 2005 at Merrill, tasked with the responsibility of studying subprime pools in the prolonged absence of an ABS Research team, was finely enlightening for me. Piling through documentation of what the market termed “liar loans” and “optional pay” loans, then quantifying the true nature of “cliff risk” in ABS CDOs (my own product) was probably the driving force behind my “Long-Short Trade” recommendation, or net-short ABS Correlation Trade (e.g., buy the subprime CDO equity; short much more of the rated debt tranches).

Back to 2014-15, for the next two months, I did little else meaningful but study the energy market and oil producers and finally concluded, once Q4 2014 earnings had been released, the following: Just like the actual losses in subprime pools were delayed by a myriad of factors not worth getting into here, so to would US HY energy company defaults be delayed by overproduction meant to make up for the halving in Oil prices. Then, in my 5-Mar-15 Seeking Alpha report, “The Long-Short Trade in Bond ETFs,” I outlined the earliest timing of the collapse to be the second half of this year (2016).

At this point; so many cracks have appeared in the system globally that really anything could become the lynchpin collapsing the House of Cards. Outside this ever-expanding multitude of ‘Black Swans’ unrelated directly to Oil, US shale oil defaults and/or EM contagion from the many oil-exporting nations, e.g., the fundamentals, would trigger a collapse, in 2H 2016, or in 2017, as per my 1Q 2015 forecast.

Just like back in the period 2005-08, today I do not attempt to estimate the timing of the final capitulation because such an exercise is futile and virtually guarantees failure. Still, given the notorious “7 Year Cycle,” or “Itch,” as some commentators on Wall Street and The City call it, in existence since at least 1903 (or 16 cycles ago) as described in the first three issues of this Note, some finality in 2016 is virtually guaranteed.

This near-truism became apparent when US HY spreads, as measured by the Merrill OAS index on the St. Louis Fed’s FRED database, gapped a full 129 bps to 6.83%, in the space of the final two weeks of September, exactly when the 7-year cycle had expired. In the 2-Nov issue, archived on my Linkedin page, I warn readers of the fact “that the full impact of a correction does not always occur in September or October of the seventh year in the cycle.” In my 5-Mar report, I had written that “once the [Merrill OAS] index reaches 6%, you should be out of your ETFs (and your stocks probably) and have begun shorting some combination of the three ETFs outlined in the article, or buying Bear Market bond ETFs.”

There are several views on what exactly drives the so-called ‘7 Year Itch;’ however, arguing on these theories is entirely unimportant. The only aspect where one needs focus is the fact that the cycle exists and it is Real. Of course, as one would expect, the nature of the crash varies cycle to cycle. Whereas the prior two market crashes each occurred in the Sept/Oct time-frame of 2001 (once the market first opened following ‘9-11,’ an event in and of itself) and of 2008 (Lehman), 1994 was trickier to decipher outside of fixed income, where skyrocketing interest rates caused havoc on both bonds and derivatives, putting many out of a job. Then, most adults have read plenty about the crashes of 1987, 1980 and 1973.

As the Merrill OAS index is now approaching a lofty 9% (as of 12-Feb), last seen briefly in Sept-Oct 2011, my advice is to eliminate all exposure to US High Yield, and reduce all other risk assets to a minimum. This recommendation is far easier to execute for your personal investments and far more difficult for long-only portfolio managers, probably the plurality of the investors reading this report. Given the near-zero liquidity in riskier HY bonds, many funds, over the past quarter, have shut their operations and/or gated redemptions, a trend explored in my 14-Dec report, “Throwing Junk at US Bond Funds.”

Our reputations for the next bull market is really all that we have. We have no control over our jobs in a financial crisis; however, we CAN sell all of our personal risk assets and buy cash, which will be the best performer in 2016, but in a far more exaggerated fashion than it was in 2015. As for gold and silver, absent continued mystical intervention, these last vestiges of Real Money are likely to skyrocket to the stratosphere. The surge that I envision for gold has already begun, and may make the two prior historical surges – 486% in 2001-2011 and the even more impressive 917% in 1970-1980 – look like child’s play.

By Lang Gibson of Spread Research

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