When the Music Stops……

The S&P500 inched up 0.17% last week on typically weak volume. Volatility went the other way; the VIX rose over 8%. Amazingly, the US equity markets suffered their worst losses of the year on Monday,   after getting spooked by the election results in Italy, but then spent the rest of the week brushing off that concern and any others that have been building up for months.

The US economy continues to struggle. One of the most important, but largely unknown, leading indicators of GDP growth fell substantially. The Chicago Fed National Activity index fell from a former 0.25 reading to a negative 0.32 reading. The Dallas Fed and the Kansas City Fed manufacturing surveys also disappointed. Durable goods orders missed; but durable goods ex-transportation beat expectations. Revised 4th quarter GDP also missed badly, coming in at only 0.1% instead of the hoped f or 0.5%. Initial jobless claims beat expectations, but un-adjusted claims still high. Personal spending met expectations, while personal income collapsed. That means that the personal savings rate sank as more and more Americans are scrambling to pay for essentials. While ISM manufacturing beat consensus estimates, construction spending fell the most in almost two years.

Technically, the S&P500 is weakening on the daily charts. While it is still severely overbought on both the daily and weekly resolutions, it appears to be losing momentum on a day-to-day basis. Breadth is also weakening. The percent of stocks above the 50 day and 150 day moving averages has started to turn down notably.

Back in early 2007, when many insightful financial experts were warning that the credit bubble, and the possibility of its bursting, could lead to deep financial market problems, several leading executives rejected the warnings by asserting that they had the wisdom to see and the agility to react to any troubles….if they were ever to hit.

The current CEO of Citigroup famously asserted that it the music is still playing, then we have no choice but to keep dancing. Surely, the experts at Citigroup were smart enough to know when the party was about to end, if it ever were to end at all, and then they could surely be quick enough to sneak out the back door  before the music stopped and chaos ensued.

Of course, Citigroup failed. It failed to see the Global Financial Crisis arrive in early August 2007, and it failed to react properly by not being able to ‘leave the party’ before getting ensnared in the ensuing financial collapse. For all intents and purposes, Citigroup failed as a financial institution, and the only reason its doors did not close was because the US taxpayer (directly through programs like TARP and indirectly through money printing programs courtesy of the Fed) kept in alive.

So why was the CEO’s assurance so blatantly false, especially in retrospect?

One reason is that it’s almost impossible to know for sure when a crisis will hit precisely. Almost all of the experts on Wall Street got it wrong. Citigroup was by no means alone.

But the more important reason is this—if everyone is buying and holding overpriced securities (the core component of the ‘dancing’ analogy), and even if everyone holding these securities knows that the music is about to stop, then WHO will everyone SELL to when the music stops.

By definition, when the music stops, all the marginal buyers will presumably also be aware that the party is over. WHY would they buy securities at artificially inflated bubble prices?

The obvious answer is that they wouldn’t.

Would new buyers step in and buy at any price? Of course, but that price is often 20%, 30% or even 40% LOWER than the price prevailing at the bubble peak.

And the higher the bubble prices keep climbing, then typically (as demonstrated countless times in history) the greater the subsequent discount must be to entice new buyers.

So if you continue to cheer on the rally, great. Enjoy the ride. But try not to forget that you will almost certainly not be able to sneak off the dance floor when the music stops.

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