All Clear or a Pause in the Deleveraging Trend

The Human mind looks for patterns. It can't help itself. Patterns allow our brain to bundle, classify, interpret, and store an enormous complexity of information. Market psychology is incredibly prone to this mode of thinking. Truly analyzing the data from international finance, currency relationships, inflationary causes or trends, economic fundamentals, etc. will likely puzzle even the brightest minds. Patterns or narratives take the center stage in market psychology. A misapplication of particular patterns can lead to valuations far from fundamentals. Consider the common market psychology from 2000 to present that housing prices always appreciate. Or consider the parabolic rise in oil prices despite the fact that commodity bubbles often are the last to crash in periods of credit contraction. A narrative, a pattern, a synopsis often drive market trends.

The panicked wave of selling that hit all markets (currencies, commodities, equity, emerging markets, leveraged loans, corporate debt, municipal debt, asset backed securities, etc.) in October was quite alarming. The narrative and pattern that has captivated the market is de-leveraging. De-leveraging, is simply a process where highly levered balance sheets sell assets in an effort to reduce their asset to debt ratio. This kind of selling is chaotic and subject to market panic because there is a race to get out as fast as possible considering that everyone knows which direction prices are moving. The narrative is inherently unstable and fearful. The other aspect to this story that the market is well aware of is that a market wide de-leveraging process implies that there is no balance sheet left to buy assets.

I am not arguing that the fundamentals of all market narratives are inherently flawed. Our unique human ability to select the apt pattern is the primary cause for our success as a species. But, when these narratives are shared or mutated within a group, a movement, a market trend, a political movement, or other social contexts they can lead to ridiculous extremes. Case in point genocide.

So when do these extremes resolve or more importantly turn the tides? Typically when the self reinforcing elements of the narrative lose footing. I fear that the self reinforcing nature of the current panic hasn't fully played out. The US government has cleared nearly $1 Trillion dollars of balance sheet, but the US consumer, banks, hedge funds, and municipalities have not been resolved. More scary, is that another wave of selling could be faster and appear more bottomless considering that nearly all central bank efforts have been expended. A narrative of no relief. A narrative of zombie banks. A narrative of Japan's lost decade. A narrative of no lender of last resort. A narrative of defaulting sovereignty and the fall of the American empire. A narrative of selling that cannot be stopped.