The Perfect Storm

In markets as in real life, the crazier things get the more human beings attempt to "normalize" absurdity. It's a form of mental defense intended to create a sense of calm while enduring mass confusion. Today in markets, what in prior eras would have been considered irrational has now become business as usual. Which explains how the market distortions over this past decade of continuous central bank bailout have grown in magnitude and lethality, even while complacency has grown commensurately.

Case in point is the S&P 500 VIX which remains muted while stock market concentration reaches beyond Y2K levels. In 2023, the pandemic Tech bubble was winnowed down to "The Magnificent 7" and in 2024, the Magnificent 7 has been further winnowed down to Nvidia and Meta.

Nvidia's year-to-date return is DOUBLE Meta's 44% return.

However, the same level of complacency can be seen in the bond market - investors are reaching for ever-more risk while accepting a lower and lower risk premium, which I will show in the next chart below. Which seems counter-intuitive until we remember that cycle dynamics demand a continuing stream of growth at all points in the cycle, even when risk is the highest. Worse yet is the fact that the Fed has yet to figure any of this out. They are currently relying upon the fourth iteration of their useless financial stress index which combines 18 measures of stock/bond/money market "risk" into one composite indicator. Unfortunately, as we see below their stress index registered its lowest reading right before markets imploded in 2007. How can this be so? It's because their stress index isn't measuring risk, it's measuring the market response to risk, which at the end of the cycle is the most complacent.

In the graph below I overlay the stress index with the home price / income ratio which provides a consistent benchmark of real-world economic risk across time periods. As we see the ratio is now at the same level as 2007, but once again, the Fed stress index is currently at a decade low. Make sense? The Fed has learned nothing since 2008

What this means above is that the Fed is caught in the feedback loop between markets and speculative appetite. They are viewing increasing speculative appetite as a reduction in risk. Which is asinine.

Case in point, this week the AI-driven semiconductor bubble reached new overbought extremes last seen in March 2000 which was the Y2K top. Then as now, the market sold off in the Fall of the prior year (1999/2023) and then sky-rocketed at the dawn of the new year. In 2000 it was because the millennium date change had passed and no planes were falling from the sky due to anticipated computer errors. When we watched the fireworks in Sydney Australia at noon U.S. time it was clear that it was going to be a non-event. So, when the new year dawned, markets took off for their final melt-up higher.

We are seeing a similar global melt-up ahead of this year's widely anticipated rate cuts. A global synchronized reach for risk. Semiconductors are up +70% since they tagged the 50 week moving average in October.

On the topic of complacency, this week NYC bank further collapsed but then was "rescued" with a massively dilutive capital injection that sold a controlling share of the company for a Bear Stearns inspired $2/share i.e. a 90% discount to where the bank traded a year ago. Of course the deal was presented as a "win" for the banking sector, but it was yet another example where the FDIC chose to find a buyer for the bank's assets rather than to shutdown the bank. In the old days, the FDIC would have no problem terminating a bank and returning money to depositors, however, the FDIC's deposit insurance fund is running dry and would in no way be adequate for a continuing bank run.

What doesn't get said in all of this "good news" is that in 2008 and again in 2020 during the pandemic, Congress essentially wrote a blank check to the FDIC. However, that required a coming together of both parties. Currently, the U.S. government is enduring almost continuous threat of shutdown. So the idea of them agreeing to bailout the FDIC in an election year is pure fantasy. This current toxic level of partisanship which grows by the day towards the election will in the end prove to be highly "deflationary".

Under the new paradigm of all news is good news, the FDIC forcing banks to raise capital at the 2009 lows is intended to restore investor confidence in the banking sector.

In summary, post-pandemic the Fed kept rates too low for too long because they were bailing out the wealthy. Now, they are keeping rates too high for too long because asset inflation is totally out of control. Which has created a perfect storm of over-valued assets and a middle class that is imploding due to high asset prices and high interest rates. All while investors are told that Bitcoin is a safe haven from Fed policy error.

Few if any pundits consider what could go wrong.

Home Prices x 30 year Mortgage Rate