Does Yesterday's Selloff Have Legs?" - Morgan Stanley Answers

Does yesterday's modest - if sharp - selloff in stocks have legs? That is the question Morgan Stanley's Institutional Equity Division director Chris Metli asks in a note to clients overnight. As Metli writes, the moves have been exacerbated by the lack of protection investors have on and their rising equity exposures over the last month.

The below charts update the positioning in options and futures that QDS noted two weeks ago – in general investors have continued to get more bullish. Meanwhile, as MS Equity Strategist Mike Wilson has noted 3Q earnings are now largely in the price and with the SPX rally overextended, earnings season should be a 'sell the news' event as there is "greater risk for a correction than we've seen in a while".



So "does this move lower have legs?"

The above charts suggest that there are a good amount of recent positions put on that are offsides and need to come off, and that suggests that this may not just be a one-day move lower. As noted previously there is a lack of protection on in the 2400-2500 range so if the market can break 2500 there could be an 'air pocket' on the downside until there is ammo to actually buy the dip.



However, whether the market can move lower could come down to whether the consensus positions under the surface of the index (i.e. long / short trades) feel more pain and cause broad based de-risking.

The selloff will help clear out some of the faster money put to work recently, but the real pain would come from consensus long / short trades reversing (largely Tech vs Energy and cyclicals). As a proxy for this pain trade QDS tracks the MS Momentum baskets and the MS Passive basket (which tends to rally when active managers underperform). None of them are melting down, but their performance will be key to watch going forward.



As noted two weeks ago, as the end of year approaches the risk of unwinds should increase. Investors still benefit from a positive performance 'cushion' this year and most positions are in-the-money. But nobody wants to give that alpha back and underperform peers, meaning traders could be quicker on the unwind trigger from here on out. This should contribute to moderately higher volatility levels in general, and whether it accelerates into a full on pain trade will be driven by whether there is a catalyst. With Tech and Growth stocks the biggest crowded positions, earnings over the next week will be a key test.

With risks rising into the end of the year, but fundamentals still strong and still plenty of upside to MS Equity Strategist Mike Wilson's 2700 price target, QDS suggests:

Hedging QQQ (given crowding in Tech) and IWM (given tax reform risk) with ratio put spreads given volatility is relatively elevated in both vs SPX:

Buy QQQ Dec 145/140 1x1.5 put spreads for ~$0.50c (33 bps) which have a max risk / reward of 9x while not taking downside risk unless QQQ falls more than 12% to levels last hit in April
Buy IWM Dec 145/140 1x1.5 put spreads for ~$0.45c (30 bps) which have a max risk / reward of 10x while not taking downside risk unless IWM falls more than 12% to levels last hit in Nov 2016
Rotating long beta / broad-market positions into upside SPX calls (i.e. stock replacement)
Buy SPX Jan 2625 calls for ~50 bps, 8 implied vol

Mario Draghi Explains Why The ECB 'Taper' Is So Positive

Following the announcement of an 'as expected' dovish taper, markets have moved but not nearly as much as we suspect Mario Draghi would have liked. Therefore we expect him to drop a few tapebombs duiring the press conference in an effort to reassure 'investors' that 'whatever it takes' is still alive and well and buying negative-yielding bonds is still a no-brainer...

Draghi has not surprised, and is following the dovish QE taper announcement earlier, although the Q&A will likely be interesting. 

Draghi is emphasizing that rates will not be changing until "well past" the end of QE, and reiterates the terms of the QE tapering (EUR30bn per month, until September 2018). Draghi discussed inflation, highlighted that domestic prices pressures "remain muted", and even that inflation is "slowing, due to energy-price effects". He also said that "core inflation has yet to show convincing upward trend"

Still, he does note that "wage growth has increased somewhat" and as some have noted there has been an interest addition to the language, namely "very substantial" has been subtly changed to "ample" with regards to necessary stimulus.

Here are the key headlines: 

DRAGHI SEES RATES AT PRESENT LEVEL WELL PAST END OF QE 

DRAGHI: ECB WILL REDUCE MONTHLY BOND BUYING TO EU30B IN JAN. 

DRAGHI SAYS ECB WILL BUY BONDS UNTIL AT LEAST SEPT. 

DRAGHI REITERATES PLEDGE TO BOOST QE IN SIZE, LENGTH IF NEEDED 

DRAGHI SAYS ECB WILL REINVEST FOR EXTENDED PERIOD AFTER QE END 

DRAGHI SAYS REINVESTMENTS WILL HELP DELIVER APPROPRIATE STANCE 

DRAGHI EXTENDS FULL ALLOTMENT IN REFIS THROUGH END 2019 

DRAGHI SAYS DECISIONS WILL PRESERVE FAVORABLE CONDITIONS 

DRAGHI SAYS DOMESTIC PRICE PRESSURES REMAIN MUTED 

DRAGHI SAYS RECALIBRATION OF QE REFLECTS CONFIDENCE ON PRICES.

The Consent of the Conned

Every single line item in our entire Bernie Madoff scam of a system is cooked.

This moment theme is The Great Unraveling, by which I mean the unraveling of US , and our, social-political-economic system of hierarchical, centralized power. Let's start by looking at how the basis of governance has transmogrified from consent of the governed to consent of the conned.

In effect, our leadership leads by lying. As we know, when it gets serious, you have to lie to preserve the perquisites and power of those atop the wealth-power pyramid, and well, it's serious all the time now, so lies are the default setting of the entire status quo.

But all too many of us are willing to accept the lies because they're what we want to hear.

As any competent con-man knows, you can only con those who want to be conned. You can only scam the marks who want to believe that what's obviously too good to be true is in fact true.

The story of scams such as Bernie Madoff's isn't that canny Bernie victimized helpless wealthy people; the untold story is that all those "victims" wanted to believe that something that was obviously too good to be true--incredibly high returns, logged month after month and year after year like clockwork--was in fact true because their greed made them more than just vulnerable to being scammed--they wanted to be bamboozled by Bernie.

Victims of scams naturally deny their own culpability. It's extremely uncomfortable to admit that greed didn't just blind us to a patently impossible yield; we wanted to be conned because it felt so wonderful to believe we richly deserved unearned wealth.

All wealth is "earned" to those doing the skimming. The greatest con machine of all time, Wall Street, judiciously refers to every skim and scam as "earnings."

And so the "victims" blame our lying leaders for telling them what they want to hear. You see how the webs of self-interest reinforce each other: those atop the wealth-power pyramid secure their position by lying persuasively enough to gain The Consent of the Conned--those who give their consent to a visibly corrupt and unsustainable status quo because that status quo is promising to provide too good to be true goodies.

In other words, the lies are constantly compounding: the leadership lies to themselves-- we have to lie to keep everything glued together for the good of the people--when their real motivation is to keep the system glued together because the system gives them wealth and power.

If we can be honest for a moment, we might admit that representational democracy encourages leaders to issue too good to be true promises because those promises win votes.

Those on the bottom of the wealth-power pyramid accept the too good to be true assurances because that's exactly want we want to hear: that we all deserve a piece of the unearned wealth that, like Bernie Madoff's painfully impossible scam, flows in permanent abundance via some sort of financial magic.

The books are cooked, people; we embrace a gigantic too good to be trueBernie Madoff scam of a system because it's what we want to believe and what we want to hear. Then, when the whole phantom-wealth con collapses in a heap, we quickly pull on the tattered cloak of victimhood: we were promised, we were lied to, we trusted our leaders to lead us wisely, and so on, as if the con wasn't obvious to anyone who was skeptical of too good to be true claims.

Now that the whole Bernie Madoff scam of a system is unraveling, two self-reinforcing dynamics are in play: our leadership, elected and unelected alike, are doubling down on the lies because there is no alternative--TINA. What does a liar gain by confessing the whole prosperity thing is illusory, and darn it, we can only spend what we produce in real-world surplus? Short answer: nothing, because that's not going to win elections or gain the consent of the governed.

So lies are piled on lies to the point of absurdity. But just as Bernie Madoff's wealthy marks ignored the warnings of the skeptical and mounting evidence that they were being conned, the electorate wants to believe the magical thinking is real, and so they accept the latest statistical flim-flammery as "proof" that the con is not a con.

Once again, we worship the Goddess TINA--there is no alternative. Just as our leaders are now trapped in their web of lies and false assurances, the governed are also trapped in the con because it's too painful and unnerving to admit we've willingly bought into a complete con: we're too smart to be conned, we protest; look, it's not a con, the GDP is growing and unemployment is low--and so on.

Bernie Madoff's marks made the same defensive protests: it can't be a con, look at my statement: the monthly "earnings" keep pouring in.

The books are cooked, folks, at every level of our Bernie Madoff scam of a system: the federal books are cooked; state, county and city books are cooked; corporate books are cooked; the statistical metrics are all cooked; the projections are cooked, and the estimates are cooked.

Every single line item in our entire Bernie Madoff scam of a system is cooked.Wanting to believe a con is true doesn't make it true. The power of a con rests in our great desire to believe that what's too good to be true is magically true. It isn't, but it feel so reassuring and, well, deserved for it to be true.

It's tempting to blame our leadership for perpetrating this systemic con, but every con requires marks who are willing to accept that what's too good to be true is magically true.

Can - paradoxically - Marxist Theory (NOT Practice!) Save Capitalism? Yes.

Karl Marx, the famous Socialist philosopher, discussed the idea of class consciousness. The theory of class consciousness has two distinctions, "class in itself", which is defined as a category of people having a common relation to the means of production, and a "class for itself", which is defined as a stratum organized in active pursuit of its own interests. Now Marx saw the working-class as slaves to the producing class. But he felt that through a revolution of consciousness (a class for itself), the oppressed could confront the economic mechanisms of exploitation.

Marx saw real power in the collective of the working class oppressed through organized revolt against the producing class. While the unions were able to achieve a great deal of leverage at given points through the 19th and 20th centuries, the 'free' trade agreements have all but diminished any power once enjoyed by the collective of the working class. The producers have simply moved labour offshore to undeveloped economies where working class members of society have no collective voice. Problem solved for the producers.

But what if Marx had the concept right but the details wrong? That is, what if I told you that in a capitalist economic model the working class are the gods and the producing class are the slaves? You'd think I'd finally lost the plot. But let me explain why this is in fact true. And because it is true all that is required is a revolution of consciousness and a bit of technology to reverse the roles of owners and slaves.

It is really very simple. As working class members of society we are receivers of money. That is, we trade our labour for money, which is our means of survival. And so we are reliant on the producers to distribute capital to our labour income. But producers have a choice between allocating to labour income, capital expansion and profit. And what we find when we look at the historical observable data is that of the available capital, producers have been allocating less and less to labour income and capital expansion while allocating more and more to profit. 

And so clearly the issue that Marx and other socialists have with capitalism is that it always seems to deteriorate into a system of greed and corruption where wealth and income become concentrated among fewer and fewer. What we find is this is not just a morally corrupt strategy but is a mathematically unsustainable economic strategy. The reason is that labour income and capital expansion have very high economic multipliers while dividends and buy backs have almost no economic multiplier. Logically then when capital is shifted to low or no economic multiplier allocations the economy will eventually slow to a halt. This is exactly what we've seen over the past 40 years and the period around the Great Depression.

But what probably has been missed by almost everyone, including Marx, is the fact that while we the people are slaves in our roles as laborers we wear another hat. People are also consumers and in this role we are gods. You see producers are providers in their role as employers but they are receivers in their role as investors. That is, shareholders and corporations are receivers of profit and that makes them reliant on those gatekeepers of profit. But who then are the gatekeepers of profit? Consumers. You see you can increase earnings through cost structure 'efficiencies' but only given you have a top line. More bluntly stated, if a business has no customers it has no sales and if it has no sales it has no profit. That is absolute for all businesses.

And so what we discover is that consumer spending, by way of consumers, is the air by which producers breathe and without which they die. This makes consumers the gods and producers the slaves. From this comes an extraordinary revolution of consciousness. Specifically that the proletariats are in fact in control of the capitalistic model but have simply failed to recognize it and perhaps never had a mechanism to apply it.

The Institute for Sensible Economics developed a mechanism by which the proletariats can control the capitalistic model. That means, they will, at a very high level, determine how and why capital is being allocated by the producers. We have built out and continue to expand the development of technology platforms that will activate the existing but currently passive power of aggregate consumption.

Because we as consumers are 70% of the economy and because we are the deliverers of profit, when we begin to apply our power there is simply no other force in the economy potent enough to withstand what we are demanding. And so the role of slave and owner will soon reverse. What we have essentially done is tied together the mathematical viability with the moral justifiability to create an entirely new macroeconomic policy platform controlled and enforced by we the people. The econometric basis of our model has been has been substantiated by various studies done at the best economic schools in the country. We expect to unleash these technologies this summer.

This is how Marxist theory will save capitalism for true capitalism is a social economic model whereby no stakeholder in the economy can prosper unless all stakeholders prosper (profit can only exist without income if it is subsidized by debt and welfare – which is no longer capitalism but corporatism). Capitalism has existed very rarely in human civilization and gets a bad rap because of the misuse of its name.

Did Junk Bonds Just Signal the End to This Credit Cycle?

Stocks are now in very serious trouble.

The S&P 500 has fallen to test its "election rally" trendline. If the market breaks down here, there's essentially one giant "air pocket" down to 2,200 or so.



The bad news is that high yield credit (HYG), which leads the S&P 500, has already broken its respective trendline. This is a serious "risk off" signal.



Indeed, it gets worse. HYG is in fact breaking out of a massive rising wedge pattern that could very well mark the end for the 9 year bull market in risk.



What would this mean for stocks?

The 3rd and biggest Crisis 20 years.

A CRASH is coming.