Where the Smart Money Goes When the Bubble Bursts

Where will all the money go when the bubble bursts, The Daily Reckoning’s Charles Hugh Smith wonders?

A simple question. Without an easy answer.

Typically — typically — bond prices and stock prices move like a seesaw. One goes up. The other goes down. And vice versa. If one of them gets walloped, investors sprint for the other.

But a typical market this is not. These days, stocks and bonds are piled on the elevated side of the seesaw. They’re both expensive. And when one legs higher, the other chases.

In the lingo of the trade, stocks and bonds are tightly “correlated.” And according to The Wall Street Journal, Treasury bonds and the S&P 500 are now more correlated “than anytime in a decade.”

And that way trouble lies…

Beware when stocks and bonds are overly correlated. It usually means central banks have thrown so much sand in the gears, the market machinery’s broken. The normal give-and-take between stocks and bonds is off. And a major corrective “event” might not be far behind.

The Fed’s half-inch-off-zero interest rates have investors beating every bush in search of yield. Smith:

One of the consequences of eight years of central bank easing and intervention is that these asset classes are tightly correlated. Free money for financiers has sought a yield wherever it can find one, and the result is every asset class with a yield has become tightly correlated.

Both stocks and bonds are overbooked. And that means no flight to bargain-priced bonds if stocks run into a pin:

When all the major asset classes are in bubbles, there is no “cheaper” asset class to shift capital into.

That’s when things get “interesting.” As R.J. Grant, director of equity trading at KBW Inc., puts it, “When trades get too crowded, they generally go through a short period of a violent unwinding.”

“The way to think about it is as a coiled spring,” explains Vadim Zlotnikov, chief market strategist at AllianceBernstein Holding LP. “Because the margin of safety is quite low, you can get these significant moves on relatively little incremental news.”

It might not take much of a trigger. A worrying rumor… a snatch of overheard conversation… a rate hike…

Markets expect the Fed to raise rates in December. But even a fairly minor rate hike could uncoil the spring, as billionaire investor Ray Dalio of Bridgewater Associates explains:

If interest rates rise just a little bit more than is discounted in the curve, it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate.

So, says Dalio, “the risks are asymmetric to the downside.”

Are there any asset classes without “asymmetric to the downside” risks? Charles Hugh Smith says yes. And the only asset classes not in bubble land are those that don’t offer yields: precious metals and commodities.

Tens of trillions of dollars are tied up in stocks and bonds. Only a tiny fraction of that in precious metals and commodities. If the floor gives way, Smith asks, what would $10 trillion seeking safe haven do to small asset classes such as precious metals and tradable sectors of the commodities markets?

His answer:

The chaos that will arise as trillions of dollars, yen, yuan and euros, etc., try to crowd through the fire exits as the asset bubbles pop will be monumental, and the spikes in small asset class prices as the hot money floods in will be equally monumental.

HSBC just issued a warning that recent stock market moves bear an uncanny resemblance to 1987’s “Black Monday.” That happened in October too. We mention it only in passing, of course.

But now might be the time to beat the crowd to the exits.

Regards,

Brian Maher
Managing editor, The Daily Reckoning

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