Welcome To the Desert Of The Real: Investors Wake Up

- Morpheus

There is a scene in The Matrix (1999) where Neo gets his mind blown. Morpheus shows Neo he has been living in an artificially constructed dream world.

This realization sends Neo into shock, nearly killing him, before he comes to grips with it.

In similar fashion, for the past few years investors have been living in their own blissful alternate reality — architected not by sentient machines, but central bankers. Endless rounds of QE (quantitative easing), ZIRP (zero interest rate policy), and various stimulus policies have allowed risk assets to levitate far above a barren and blasted economic landscape.

The “Real” world, in which Western economies continue to stagnate (or flirt with outright recession), where unemployment remains sticky, record high corporate profit margins (built on cost-cutting) are vulnerable, and deflation is a still-persistent threat even as emerging markets break down, is a Matrix-like dystopia for long only investors.

Last week, the dream world finally short-circuited… as the “Desert of the Real” loomed into view…

A Sentiment Tipping Point
In his June 19th policy statement, Ben Bernanke did not mean to crush anyone’s hopes. The Federal Reserve was no doubt surprised — shocked even — at the ferocity of the market’s response.

The mini-meltdown was in part driven by external factors: In hinting at tapering, Bernanke failed to account for a China SHIBOR shock and concentrated ETF selling, two elements we will address shortly.

In our opinion, though, the real driver behind last week’s carnage (with China etc as amplifier) was a tipping point change in sentiment. Investors responded as if woken from a pleasant dream, only to contemplate a nightmare world waiting for them (relative to bliss now left behind).

This excerpt from “The Philosopher,” a multi-billion-dollar hedge fund manager quoted in Invisible Hands, captures the dynamic superbly:

Although beliefs tend to be driven by fundamentals, people and markets are very slow to fully incorporate macro information, and when they do the results can be overly dramatic. The uncertain nature of the economic future and our flawed attempts to understand it are a permanent source of market mispricing. The economy is not easily predictable, but the reactions of policy makers and the persistent errors in human expectations are. The natural extension of Keynes’ beauty contest is that animal spirits are not irrational and because they are not irrational they can be anticipated. To illustrate this idea let’s imagine there are two states of the world, and although each is quite reasonable, one is more likely than the other. Unfortunately, the human brain is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Such shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.

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Hence confusion on the part of market observers. The Fed’s stance did not change all that much… and tapering will not come for a while if it gets here at all… so why did markets panic?

Because the mind’s eye vision changed… from endless bids and central bank support (the old world) to the Desert of the Real…

Chinageddon?
But it wasn’t just BB showing glimmers of a dystopian future. It was China too. Here is a quick analysis roundup (we remain short FXI):