'I'm extremely concerned': A former Goldman Sachs hedge-fund chief says a flood of troubling signals shows the stock market is teetering — and warns a small correction could soon morph into something much larger
- Raoul Pal, the former Goldman Sachs hedge-fund manager who founded Real Vision, sees the S&P 500 carving out "a potentially large top pattern."
- Pal says the global economy is working it's way through three distinct phases in the wake of the coronavirus-induced rout: liquidation, hope, and insolvency. He says we're currently transitioning into the latter.
- Time is a crucial component of Pal's call. He says the longer the global economy remains downtrodden, the more likely it is that a negative snowball effect hits global markets.
- "Be careful, keep your eyes open," he says.
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Raoul Pal, the former hedge-fund manager who founded Real Vision, has never been one to sugarcoat his perspectives.
In fact, if you take a stroll down memory lane, at the beginning of the coronavirus-induced fallout, Pal was early in his appraisal, saying "the whole world's f—ed."
One stock bear market, a double-digit unemployment reading, and a 30%-plus annualized drop in GDP later, and it doesn't seem like a stretch to say his evaluation was sufficient.
To bring you up to speed, Pal retired at 36 after quitting jobs at Goldman Sachs and GLG Partners. He lives comfortably on a 140-person island in the Cayman Islands and spends his days writing market research, which comes with a hefty price tag of $40,000 per year.
Although the landscape is much calmer than it was at the beginning of the unwind, it's safe to say that Pal's apprehensiveness has persisted.
"I'm extremely concerned by the potential for this to unravel rather fast, because, as you know, everybody's one side of the boat — and that side is V-shaped recovery and growth," he said in a recent Real Vision webinar. "When large parts of the market, including the truthfulness of the bond market, is whispering at you ' Hey, that's not right; they're all going bust."
Underpinning Pal's thesis is something he refers to as: "The Unfolding" — a framework he leans on to make sense of the fallout and gauge the overall environment. It all comes down to three phases: liquidation, hope, and insolvency. In theory, Pal expects the phases to play out consecutively, and says they already have to an extent.
Here's how he denotes each:
Liquidation: The Federal Reserve and global central banks step in to provide "massive liquidity" into paralyzed markets. Then, fiscal stimulus comes in to "paper over the cracks." According to Pal, this phase has already occurred.
Hope: Pal says this phase is "very typical in extended bear markets or recessions." In a nutshell, it's a time period where investors prematurely declare victory and sentiment shifts to a more sanguine outlook. Pal provides examples of the 1929, 2001, and 2008 market crashes to bolster his thesis. In each scenario, investors experienced a brief reprieve before enduring a deeper drawdown.
Given the stock market's torrid recovery from multiyear lows back within shouting distance of record highs, Pal sees equities currently being set up in the same manner.
Insolvency: This is where the rubber meets the road, and when markets have to face the underlying economic reality associated with pandemic, which has caused a contraction in global growth.
To him, time is a crucial component of the equation that "really worries him." The longer it takes for the global economy to recover, the worse. Business start closing, more workers are laid off, and that effect snowballs creating structural problems within the entire economy.
In Pal's mind, the transition from the hope phase to the insolvency phase is playing out as we speak — and the repercussions will be widespread.
Trouble on the horizon
When it comes to sniffing out potential warnings signs, Pal leans on a unique duo — banking stocks and heavily indebted companies — to take stock of the situation.
Pal constructed a propriety index of equities that embody the lion's share of triple-B bonds — or issues with investment-grade creditworthiness that sit just one rung above junk. When he compares this index to the performance of banking stocks, what he finds is a stark pattern that's roughly the same.
"They're all telling you that the economy is slow," he said.
Pal continued: "You see, what we're starting to see — and this is what the banks are picking up and the bond market is picking up, and the BBBs are picking up — is that corporate cash flows are impaired; household cashflows are impaired; small enterprises and medium-sized enterprises are all impaired. The rising NPLs [non-performing loans] are now becoming evident across the United States."
His comments echo those made by Scott Minerd — the global chief investment officer at the $270 billion financial-services firm Guggenheim Investments — back in March. The CIO expressed similar concerns of financial contagion stemming from BBB-rated bonds, saying as much as $1 trillion worth of high-grade bonds could head to junk status if the economy remained weak, in a vicious a "domino" effect.
Pal says that's creating a precarious scenario that's manifesting itself in the equity market.
"Up until recently, I kept the equity markets off my screen because I just didn't want to involved," he said. "But we started carving out what could be — could being the key words — a potentially large top pattern."
Pal notes that when he zooms out and looks at the S&P 500 on a monthly interval, he sees a "megaphone top" pattern — a marking that he says generally proceeds a reversal in trend.
"If we're going to find a top, it might be here," he said. "This is exactly the point where the Fed have stopped stimulating. It's exactly the point where most of the checks have stopped being mailed. It's exactly the point where the structural unemployment is starting to become a problem. It's exactly the point that the US election paralyzes parts of the system. That's interesting to me."
To Pal, that's creating "a gap of uncertainty" — and markets hate uncertainty.
"Now, I'm looking for what I call the GMI crash pattern," he said. "There's one, a smaller version of it playing out in front of our eyes today."
Pal denotes this pattern as follows: A market that drops quickly, retraces about 50% to 75% of the initial plunge, then succumbs to pierce through the inaugural low.
"If I look at the magnitude of it, it still looks like a relatively small one so it could be just a corrective move — something I've been expecting," he said. "But I think it could morph into something bigger."
Pal is clearly intrigued by this series of red flags, but he's quick to note that his call is by no means a guarantee. So far, his hypothesis has been somewhat accurate, but no one has a crystal ball.
With everything that's been laid out above, it's important to note that Pal's outlooks are markedly more pessimistic than those held by major Wall Street institutions.
From the perspective of stocks, while the median 2020 year-end S&P 500 price target for all Wall Street equity strategists is slightly below current levels, their forecasts certainly don't suggest a major market crash.
Further, their consensus S&P 500 earnings-per-share forecast for 2021 would mark a roughly 17% year-over-year increase, according to Bloomberg data. Considering profit expansion has historically been the biggest driver of stock gains, that's a positive sign.
On the economic front, the International Monetary Fund recently boosted its 2020 global growth forecast. In addition, Deutsche Bank said global to return to pre-virus levels by mid-2021, while Goldman Sachs upgraded its third-quarter GDP forecast due to encouraging labor-market data.
But none of that is damping Pal's skepticism. He offers a final warning:
"Be careful, keep your eyes open. I think The Unfolding is still unfolding, and the insolvency phase is to come."
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