How Will This End?

As readers will know, I believe we have entered a bear market in equities. I am frequently asked: “How can you say that…look at where the market is trading!”

This response shows you how far we have come from an understanding of the markets. The term ‘bear market’ does not refer to how much a market is down. It refers to the psychology of the investor. Confident, risk-taking investors make bull markets. Nervous, risk-averse investors make bear markets. Investors are nervous. The herd is trembling and sniffing the wind for trouble.

Where’s my evidence? Investors are now stampeding into bonds despite all-time high prices and interest rates at all-time lows. And I mean all-time. Bill Gross, the bond king, says that we now have the lowest sovereign borrowing rates in 500 years of recorded trading data. Other researchers say that it’s more like 3,000 years if you infer historical interest rates from other data. It looks to me like we may be headed into a bond blow-off.

What’s a blow-off? It’s when investors panic into a market, driven by fear or greed, leaving behind all rational measures of profitability, driving prices to absurd levels based on the greater fool theory…tomorrow someone else will be stupid enough to pay more for this stuff than I paid today.

There are now $10 trillion in sovereign bonds trading at negative interest rates…you have to pay interest for the ‘opportunity’ of investing in these securities…up from $7 trillion last month. This is insane. And it is getting worse. Yesterday, Japanese Government 10 year bond yields traded down to a new historic low of -0.21% and both German and Swiss 10 year bond rates also set new record lows as well.

Why? Investors seem to be fleeing a slowing world economy and falling corporate profits. They are hiding out in sovereign bonds because they are supposed to be risk-free and the move is turning into a stampede that is feeding on its own momentum. Treasuries used to be called certificates of risk-free return. We agree with Jim Grant that today they are really certificates of return-free risk. A very small increase in interest rates will destroy this market. Perhaps the one thing that everyone thinks is impossible is the very thing that will happen. I have seen it before.

All that needs to occur is buyer exhaustion. Nothing else needs to change. When the last buyer has piled his last dollar into this market, it will fall of its own weight, interest rates will rise and the rout will be on, not just in bonds but also in equities. The bond bubble will end in exhaustion the same way that stocks blew off and crashed in March of 2000 and real estate in 2007. When the last “marginal” buyer had finally acted, those markets collapsed in on themselves. This is what happens in a mania. Think tulips.

Is this for real? We will know soon enough. If bond prices continue to accelerate, the blow-off is probably on and it will only be a few weeks or months before we have a collapse.

Equity bulls can’t see what could possibly derail their bull market. The market has shrugged off poor economic data and rallied despite an earnings recession. They think that it’s bullet-proof. Maybe they are looking in the wrong direction. Maybe they should be looking at the bond market.