Bad is Good Logic
The bad is good logic, where traders buy on the bad news and sell on the good news, is profitable again.
Stocks continue to bounce off their support levels in a backdrop of rising geopolitical risk and deteriorating economic fundamentals.
There is a negative divergence between the fundamentals and the trajectory of stock prices. Stocks are rallying into the abyss.
The front-end rate trade strategy is back in vogue and it is based on a whacky bad is good logic where bad news is good news
Gaming the front end rate trade was the play on the street during the post-2008 financial crisis. Back then, it was the collapse in mortgage-backed securities (debt) which created systemic risk. That forced the Fed to intervene with Quantitative Easing QE, unprecedented amounts of liquidity and Near-Zero Rate Interest Rate Policy ZIRP, to save (their) system.
The bubble of bubbles has its roots in the bad is good logic which spurred on the central bank to carry out the greatest monetary easing experiment in the history of finance.
So what are the mechanics of the bad is good logic?
Let me explain this mad logic by using the“insane rule”, it is a short and simple formula with just three variables.
A (pending financial crisis ), B (central bank intervention) and C (markets will go up)
Now, the rule states A=B and B=C, so A=C.
Therefore, applying the rule to contemporary markets a financial crisis means markets will go up, put another way bad news is good news under this warped logic.
So applying the “insane rule” any potential systemic risk whether it be an Italian debt default, a messy Brexit and or a Corporate bond downgrading to junk status all equal stocks will rally.
Put simply, the bad is good logic is based on a view that in a systemic crisis the Fed will always come to the rescue with QE to infinity.
Could the bad is good logic also be subject to the law of diminishing returns?
The Fed’s monetary normalization policy has ended with the Fed fund rates near record lows at a measly 2.5% and $4.2 trillion of assets on its balance sheet.
More than a decade of the central bank’s unprecedented monetary easing could also mean that QE and NIRP have lost its shock and awe with investors. In other words, QE in the next financial crisis could have less of an impact when it was first implemented more than a decade ago.
Morgan Stanley, American multinational investment bank with $851.73 billion (2017) asset under management is warning its investors not to bank on the bad is good logic this time around.
Global strategist at Morgan Stanley strongly disagree with this “bad is good” logic. The idea that “bad is good is ludicrous” said Andrew Sheets, global strategist at Morgan Stanley.
The American investment bank argues that the expectation that easing central bank policy can offset weaker data is at odds with both a broad swath of historical data and basic monetary theory.
But Morgan Stanley’s view, as logical as it sounds, is at odds with the “bad is good” logic
For example, last Friday the US economy produced significantly fewer jobs than expected. and the markets cheered. The S&P 500 jumped 1.1%, capping its best four-day run all year, credit spreads tightened, and bond prices rose.
What does the historical data suggest with regards to “bad is good” logic for stock prices going forward?
A recent study was conducted by Zero Hedge to see what impact “bad date and easy policy” had on stock prices over the last three decades?
“In the US, these “bad-data-but-easier-policy” periods saw the S&P 500 post-above-average returns only 38% of the time – a win rate that, if it were for a baseball team, would put it near the bottom of the current major league standings” writes Zero Hedge.
Stock performance In the UK was also similar in the same period. The FTSE 100 under performing 58% of the time when the BoE was cutting but unemployment was sideways or worse.
Historic data spanning 30 years of central bank easing dismisses the bad is good logic view
Don’t expect the central bank’s monetary policy to come to the rescue in the next financial crisis.
Moreover, monetary policy has a time lag of about 12 months. When the Fed eases the real economy feels the effects of monetary easing one year later.
Since the beginning of 2019, a raft of heavy weight billionaire investors are warning not to bank on the bad is good logic as it may now be old hat
Ray Dalio, founder, and co-chief investment officer of the world’s largest hedge fund firm Bridgewater Associates sees the next crisis being worse.
“They (the central banks) probably won’t have as much room as the Fed to hedge the risk of a full-blown financial crisis,” wrote Ray Dalio.
Safe haven, precious metals and anything where its value is not tied to debt is rising in value. Even the crypto tribe is advancing on the central bank’s waning fiat debt money system. The top-performing play in 2019 has been the cop-out trade.
Bitcoin is taking a moon shot as I write this piece, up over 150% year to date.
The bad is good logic could apply to any asset which value is not jacked up with debt and it could be something as unconventional as cryptos.