Why "Brexit" Shock Could Be a Good Thing

All eyes will be on the upcoming "Brexit" vote in the United Kingdom next week, now that polls are showing that the Brits are more likely than not to shock conventional wisdom and exit the European Union.

Wherever she is, Margaret Thatcher will be beaming at the wisdom of her former constituents seeing the wisdom of exiting the deeply flawed and ultimately unsustainable confederation of European countries.

Markets will no doubt react very badly if the vote tracks the current polls, but this type of short-term pain is child's play compared to what has to happen to return the global economy to some semblance of sanity and growth in the years ahead.

Take the U.S. stock market, for instance...

Wanted: Strong Corrective Measures

Something radical is certainly required to snap investors out of the complacency.

While stocks sold off sharply on Friday, they were flat on the week with the Dow Jones Industrial Average rising 58 points or 0.3% to 17,865.34 and the S&P 500 losing 3 points or 0.15% to close at 2096.07.

The Nasdaq Composite Index fell 1% to 4894.55. The Dow danced above 18,000 a couple of times during the week, giving rise to the predictably idiotic CNBC news flashes despite the fact that this was not news (unless you believe that profound investor stupidity is news, but unfortunately it is all too predictable).

Junk bonds also kept rallying despite deteriorating credit quality with the average yield on the Barclays High Yield Index moving closer to 7%, which in case anybody asks you is an oxymoron since 7% is a low yield, not a high yield.

Investors have clearly checked their brains and good sense at the door; when they check out, they are going to leave a good deal poorer.

Here's What's Ailing High-Yield

Junk bond yields are being dragged down by high grade and sovereign yields. There are now more than $10 trillion of sovereign bonds trading at negative yields.

Last week, the European Central Bank began its latest assault on the lunatic asylum by buying high grade European corporate bonds, pushing the average yield on European investment grade debt below 1%.

This means, of course, that buying these bonds produces a negative inflation-adjusted yield, indicating that the era when bond investors were considered the "smart money" has conclusively passed.

Of course, investors no longer buy bonds for yield - there is none - but instead for capital gains when the next cock-eyed pessimist comes along to buy it at an even lower yield.

Now why would someone buy a bond that they have to pay for the dubious privilege of owning?

Sophisticates will tell you that these certificate of confiscation will generate profits if there is deflation.

But until the final hammer comes down and debt deflation erases the value of financial assets as it did in 2008, the only deflation in the world is in the size of central bankers' cerebellums.

In the real world, the price of everything that matters (except commodities) is rising - goods and services, financial assets, etc.  And even oil prices have doubled off their lows of earlier this year. The point is that buying any fixed income instrument in today's world is like flushing money down the toilet - where it can sit comfortably beside consensus thinking on economics, markets and politics.

There's plenty more circling the drain, too...

Flattening Yield Curves Mean Rising Danger

One important indicia of economic health is the shape of the Treasury yield cursve, specifically the difference between the yield on two-year and 10-year Treasuries (the "2/10 spread").

That spread has dropped by nearly 200 basis points over the last couple of years to 91 basis points, a flattening that coincided with the strengthening of the US Dollar Index (DXY) from around 80 in early 2014 to as high as 100 last year to 94.66 today, along with the slowing of China's economic growth and the collapse of commodities prices.

The flattening of the yield curve is consistent with slowing economic growth but some argue that it is the result of foreign investors pouring money into Treasuries due to the lower yields on their own sovereign bonds (i.e. European and Japanese bonds).

This argument is simply not supported by the evidence.

First, as my brilliant friend Peter Boockvar of The Lindsey Group reminded me, Treasury data for years has shown a dramatic reduction in foreign buying of Treasuries.

What's more, such an argument is illogical - more demand for Treasuries from foreigners or any source (for example, domestic buyers or even the Fed) would account for lower absolute yields but not for lower relative yields (i.e. curve flattening).

Finally, Treasury yields are being dragged down by lower yields on Japanese and European bonds which are themselves the result of those regions' weak economies, which is negatively affecting U.S. growth.

The idea that the U.S. can remain immune from foreign economic weakness in a globalized world is a myth.

The flattening yield curve is a sign that economic growth is slowing, that the Fed's policies are not working, and that the U.S. is moving toward a recession.

Normally, a recession requires an inverted yield curve (when short-term rates move higher than long-term rates) or aggressive Fed tightening.

Now, Janet Yellen's Federal Reserve is clearly not aggressive about anything other than perhaps ordering lunch at its monthly meetings, but the yield curve is not waiting for it to act.

If it continues to flatten, investors should see that as a sign that the probability of a recession is rising sharply.

In addition to suppressing interest rates and returns generally, central bank policies are suppressing volatility.

This is extremely dangerous. Like an earthquake zone, markets needs to relieve pressure on a regular basis.  Failure to do so allows pressure to build up to dangerous levels until it explodes and inflicts severe damage.

Investors need to read the signs that point to rising volatility and prepare for eruptions. Last week, the CBOE Volatility Index, familiarly known as the VIX, spiked up by 2.39 or 16% on Friday to 17.03 after hovering at very low levels for the last few weeks. This coincided with Friday's sharp stock sell-off where the S&P 500 lost nearly 20 points (nearly 1%).

If the VIX keeps rising and hits 20, the recent rally could be in trouble. In view of the fact that the rally was wholly unsupported by fundamentals, this should not surprise anybody.

Finally, there was news on two companies that I have been warning investors about - and naturally none of the news was good...

Short Profits Are Piling Up Here

Valeant Pharmaceuticals International Inc. (NYSE: VRX) continued its path into oblivion this week after announcing poor first quarter earnings and disappointing future guidance.

Readers can refer to the company's news release for the gory details, but suffice it to say that the company's broken business model has left its financial condition in tatters.

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Many of the hedge funds who were pimped into the stock by its former CEO J. Michael Pearson (who reportedly signed a lucrative monthly consulting agreement with the company) have exited and are licking their wounds while large shareholder-turned-board member Bill Ackman, who doubled and then tripled down on his position as the stock collapsed, is keeping a brave face while trying to forestall redemptions from his own fund.

This story isn't over, but it won't end well. This will go down as one of the most disgraceful episodes in a long list of disgraceful Wall Street episodes.

As for grossly overvalued Tesla Motors, Inc. (TSLA), it was reported that the company asked owners who experienced serious problems with suspensions on some of its vehicles to sign non-disclosure agreements.

While it is too soon to know whether the suspension problems are serious, the company's attempt to silence customers in exchange for repairing their cars raises serious questions about how the company does business. Coupled with its financial statements, which are basically fraudulent by relying on fanciful non-GAAP adjustments to create profits where none exist, as well as founder Elon Musk's PT Barnum-esque pronouncements about the company's capabilities and its Ponzi-like deposit scheme on the new Model S vehicle that doesn't yet exist, Tesla has all the warning signs of an accident waiting to happen.

Investors need to wake up and realize that Tesla is a cult rather than a sound investment and get out while they can- or short the stock as I recommended.

Another one of Michael's recommended shorts, a play on massive Euopean bank in even bigger trouble, has already returned more than 40%. It has much further to fall, which means the profits are just getting started. Click here to get Michael's recommendations on how to play these bad banks and you'll get his Sure Money, too, at no charge.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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