That is the Deguello, it is known as the Cut Throat song composed by Dmitri Tiomkin. It is the Mexican bugle played before the Alamo, and it means no quarter. It means there will be no mercy, and it means you have been warned. In Rio Bravo, Dean Martin’s “Dude” sobered up real quick when El Deguello played down the street in the saloon. In April, we wrote about the Alamo and how the tsunami of debt will be like Santa Ana’s soldiers. A wave that will not stop coming, engulfing everything, making resistance futile and eventually fatal. We pointed out that we are in a three headed bubble of massive proportions: bond, equity, and real estate. The bond market has already tanked. Returns are down 50-60% on some bond funds and I don’t think the worst is over. Real estate is frozen up and the stock market rallied through the summer before having a downturn through October and is now bouncing once again and looking like it wants to go to all- time highs again. This is El Deguello. We wrote that bankruptcies would rise, and they are up 61% and are threatening to end the year with the highest level since 2010. We are having trouble selling a 30-year bond, and that inability is exactly what happened in the UK Gilt markets and led to the end of poor Liz Truss. It happened in an afternoon, and like Santa Ana’s attack, it will be swift and sudden when it happens but until then we get the same haunting melody over and over. I might be the Deguello, in fact.
Since April, we have gone through $32T and then $33T and we currently sit at $33.7T in national debt, I can’t believe I am writing this, but our national debt has jumped 7% in the last six months. $2.2T added in 6 months, that is more than the total national debt of Australia, Spain or Brazil. The bank term funding program was put in place in April to help provide 1 year of liquidity to banks that were having difficulty and it jumped almost 4% in the last two weeks to the highest level it has been at $133 billion. More banks are having to use the program for liquidity, and this is after bonds have rallied in the last month. They were down 50-60% and now they are down a little less, but they still can’t sell them, or they take a huge loss. Banks only have about 10% capital so taking huge losses like that threatens their solvency as we have discussed. That doesn’t even take into account the commercial real estate market that has already started being a Walk-away Joe. Mr. Banker, here are the keys, the building is yours. It is happening every week and we brought up the Barry Sternlicht’s that were some of the first ones, but it is happening every week. Wework’s bankruptcy has thrown lighter fluid on the situation and the result is the banks will lose without another bail out program. Add in depositors still taking their money out of banks and putting it in money market funds or T-Bills and yes, I would say the banks are El Deguello.
We mentioned how the reverse repo facility was the slush fund that the Treasury was using to keep the train on the tracks. It was the source of demand for the bond sales that the Treasury was offering. The bond sales keep getting bigger as our debt gets bigger, seemingly weekly. Last week almost $100 billion flowed out of the reverse repo. We were at almost $2.4 trillion in April, but now we stand at $935 billion. At this rate, the facility will be empty by the end of January. The US Treasury is selling $776 billion worth of debt this quarter, but it jumps to $816 billion next quarter because the debt is getting larger and larger. The 30-year auction has already been poor and now the auctions will begin getting worse, shorter and shorter in duration as liquidity dries up from the reverse repo. You see, it is just another can that has been kicked down the road. The Fed bought most of the debt during Covid and it will have to step in again or the market will face a slowdown. What this slowdown will do is seize up the liquidity in the economy like a man’s innards after eating nothing but Brussel sprouts for two days. The bond market is El Deguello.
The housing market is just starting to play its tune. Reventure Consulting has a dashboard where you can select a city and see how overvalued a home is compared to the average annual wages of workers in that area. It shows how much the market will have to decline just to get back to average and in some cities like Phoenix and Austin, it will be at least 30%. There is a constant droning narrative that we have a housing shortage right now, and folks if we see a 30% decline in home values, the large Wall Street investors and Airbnb jocks will flood the market with a Tsunami of inventory that is currently not available for sale which is why people say we have a shortage. The cap rate is about 4% and you can get 5.25% on a T-Bill right now with no headache and no risk. Do you think these investors want to buy or sell right now? They are selling and it is starting to come in waves. The longer their homes sit unbought or unrented, the worse their P&L looks when their interest refinancing costs are going up and up. They aren’t having to act as yet, but they are starting to. You are seeing the cracks forming in the dam. That trickle is El Deguello.
That brings us to the last leg of the Tulip mania invoking tripod: the stock market. The S&P 500 Gaap earnings yield less the three-month Treasury yield has the stock market the most overvalued since the Dot.com bubble almost 25 years ago. The earnings yield is the reciprocal of the P/E ratio and gives an investor how to measure a stock return versus a bond’s yield. The link from Business Insider shows NED Davis Research’s chart with a huge drop in earnings yield, which is surprising because stocks are basically flat this year, but TINA is gone. Tina stands for there is no alternative. Well, there is now, and investors are starting to like getting 5% yield in the short term. If we look at Robert Schiller’s CAPE ration which measures the cyclically adjusted price to earnings ratio to the long-term market equilibrium, we see that the stock market needs to drop 31% before it is back to normal run rates. The 2021 high was at 79% and the all time high was the dot com bubble at 89% overvalued. The market sold off 50% in the next 2.5 years according to Estimite research. This is El Deguello.
We have covered these in some detail and with this Deguello we will let it be for a while, but there is one particularly troubling Deguello that could be the spark of this whole powder keg. In Business Today, Amit Mudgill writes ”Christopher Wood of Jefferies in his latest GREED & Fear note said he finds potential similarities between the prevailing market action with that of historic Wall Street crash in October 1987, which was preceded by a selloff in the 10-year treasury over the summer months.
The 10-year US bond yields have jumped to 4.7 per cent from around 3.3 per cent in May this year. Wood noted that 10-year treasury bond yield had jumped 203 basis points to 10.23 per cent on October, 15, 1987 from 8.2 per cent on June 17, 1987.
Amit continues quoting Jeffries discussing a Bank for International Settlements (BIS) paper,
“The BIS report, Jefferies said, goes on to argue that excessive reliance on government bonds as collateral can “reduce incentives to screen and monitor borrowers” while raising aggregate leverage. It also notes that the widespread use of government paper as collateral raises liquidity risks in the event of a risk-off event.
“This in turn raises the issue of the declining liquidity in the treasury bond market which Fed officials have been warning about of late, as also discussed here last week. Such an outcome, where the “risk free” status of Treasury bonds is questioned, even if only temporarily, may seem to many an extreme event. But in GREED & fear’s view it is no longer far-fetched to think about, as is also evidenced by the fact that such a paper has been written,” Jefferies said.”
This is just part of the equation though folks- this is kindling. The treasury bonds that we have already discussed having a liquidity problem on the horizon is known as the risk-free rate, it is the collateral that underlies so much of the borrowing in financial instruments. This is a tinderbox if the treasury itself becomes questioned and it is by the Bank of International Settlements. The spark could be 0 DTE options, or zero days to expiration options. These are very short-term options that now make up almost 50% of the option market volume. It reminds me of the portfolio insurance trading strategy at the center of the 1987 crash. Computer programs would automatically sell short stock index futures as a hedge when the market sold off as it did on October 19, 1987. This selling led to more stops being taken out as the market fell which led to more selling, and in such chaos no computer was programmed to buy. This lack of buyers’ market ended the day down 22%, the worst in history. Today there are some circuit breakers that halt trading for a while, but let’s compare portfolio insurance to 0 DTE options. 0 DTE options are options whose expiration date is very short term from a couple days to the same day. Any option contract that is traded will end with a 0 dte conclusion. It makes sense if you are a business, rather than go out a month or two and have to pay for that time value you can hedge your business shorter term. There are some hedgers and lots and lots of speculators. These converted meme stock and now day traders that began trading 0 DTE options during Covid have been making a lot of money selling options and collecting premium with just a couple days worth of risk. They have become emboldened, and the market has grown enormously large. When you sell an option, it means that your risk can be very large, but very rarely. The traders collect and make money most of the time, but if it was always this easy everybody would be doing it. But now seemingly everybody is doing it.
People love to use stops thinking that this limits their risk, but they have no idea what can happen in “an event.” Many of these algos or algorithm modeled trading systems rely on these stops and even the exchanges themselves rely on stops for their risk management and margin requirements to be sufficient. If an event happens, a terrorist attack during market hours, an assassination of a world leader, a war starts or any of a number of black swan events this immediate sudden move could cause waves of stops to be hit simultaneously triggering massive selling instantly. Even the bond market moves are approaching 25 basis points in a day, and these are historic moves, what about Google or Walmart selling off 10-20% in a day, which has happened recently. What about if Elon Musk gets margin called in his Tesla stock to meet his loan requirements in Twitter? If we get a big enough sudden market shift, the stable and liquid markets of 0 dte options becomes very unstable because there is very low liquidity as the market resets away form the current price level. Down 10% in any of these markets the volume is almost non-existent so putting a new position back on becomes almost impossible. It is an air pocket. There is no way that the current margin requirements are large enough to cover these positions because if the traders had to put up that kind of margin, it would make the trading volume dry up. These exchanges are loving this liquidity and volume and they are making money by making markets, but remember as always with something new that doesn’t have a rule, once something breaks then the rules and regulators come in, not before. If the collateral underlying these markets turns no good then a Mt. Helens size shift lower is possible, and if that happens the markets themselves seize up. Yes, I’d say the stock market is El Deguello.
Sincerely Yours,
C Thomas Printer
On this date in history…60 years ago to be exact, a black swan event, John Kennedy was assassinated in Dallas, Tx.
Fun factoid- a group of porcupines is called a prickle. That is also the nickname of former presidential candidate John Kerry, although the l and e are silent.
Also born on this date, the Baroness, Lady-Haden Guest, formerly known as Jamie Lee Curtis.
https://www.estimite.com/post/is-the-us-stock-market-overvalued/