The shroud surrounding the European banking system is fading. It’s not pretty. No one ever said it was. A lone knight promised he would defend it to his last breath and no one dared challenge him.

For four years he remained unchallenged, but now the deflation dragon has come and it is not afraid. It wants a sacrifice, a fine Italian bank that has never defaulted – a bankruptcy virgin.

The lone knight, appears no match for the mighty dragon. He has slain countless dragon children but no adults. He will need help if he is to withstand. He must call on his Queen to send in the helicopters.

But the Queen refuses. The Dragon changes its mind. Now it wants all the Italian banks, pure or not.

The lone knight begs the prince to rally his personal guard and stand by him. So the prince gets his men, they dress in fire proof suits made from the silver-black hair of the under belly of Swiss unicorns.

In the barracks they are set upon by the Queen. She won’t let them rally to the lone knight’s side. He must earn his name. He who has lived by his sword must now die by it.

There was never any question. If confronted the lone knight knew he would fail, but he believed he had to try. Someone had to do something he thought.

He now trembles before certain death. Out of forks in the road of destiny, he walks the straight path to the dragon.

A whirlwind of smoke and fire buffet the lone knight. His shield melting, his lungs wheezing, his skin roasting, he presses on. On presses he, who must, because he has to.

He chants the words in his mind.

On presses he, who must, because he has to. On presses he, who must, because he has to.
On presses he, who must, because he has to. On presses he, who must, because he has to.

It powers him, driving him through each excruciating step towards oblivion. He sees the edge but can’t turn back. Not now. Destiny holds him by the strings.

It’s an out of body experience for the lone knight. Constantly alone and living in his own mind he now sees himself from the outside for the first time.

The lone knight’s eyes betray him. He has no armor. There is no sword. Just a man in bright colored tights and matching jester’s hat. The lone knight is a fool.

He watches the fool cower underneath the mighty dragon, its head coiling ready to strike. The hint of a smile on the beast’s face chills the fool to his very soul.

But then…

The beast’s face explodes. 3 million rounds a second of depleted uranium .50 caliber shells rip the dragon to pieces. It’s over in seconds.

The smoke, and dust clear as the 27 EU issued helicopters land in a circle around the fallen dragon. The fool remains, shivering, his soul returned to him.

The Queen steps out of her helicopter, escorted by half a dozen real knights draped in gold embroidered white cloaks.

They surround him, their tall statures blocking out the sun. They part for the mighty Queen.

“Lift him,” she commands.

Much to the fool’s dismay, his injuries are not considered as the knights pull him off the ground. His raw skin tears under the grip of their cold gauntlets.

Now eye to eye with the Queen, she looks at him, hard and unflinching like she’s trying to read the fine print of a royal decree. After a moment, she smiles.

“You will share no part in this victory. It was I who saved the kingdom but at great cost. A door that cannot be closed has been opened. On the other side of that door, dark and powerful outcomes exist. Outcomes we cannot even hope to control, but must still overcome. There will come a time when you will pay for your foolishness, but not today. You will go back to pretending that you are a knight, but from now on, you will always know what you really are. A fool. A fool who thought he was a knight.”

And that is my best case scenario for the European banking system.

Italian banks cannot be allowed to fall. They are systemically important banks. Italian debt holders cannot be wiped out. There’s too much leverage in a fragile system and if the credit cycle swings down, it will swing down devastatingly hard.

If one Italian bank fails, then another will fail, and then another and then a German bank , and by the time Germany comes to the table every bank in Europe will be closed. That is why the best case scenario is for immediate action by the ECB at the permission of Germany and the rest of the EU.

If they act now, and bailout the banks, effectively wiping the bad debt off their balance and by the end, the amount of Euro’s required will number in the hundreds of billions if not trillions, but Europe may finally be able to grow again. Of course that last part is a ways away and we should worry about the more near term impacts of European bank bailout.

The first effect of a large systemic recapitalization of Europe’s fragile banking system would be a dramatic drop in the Euro. The inverse of a falling Euro is a rising dollar. A dollar that would put pressure on both the Yuan and China’s own fragile banking sector. The consequences of this chain reaction alone are horrifying.

But let’s not forget what risk assets would do (are doing right now) in a European bailout environment. Capital would flow into the dollar and US treasury yields would fall even further. Falling global rates push up gold, thus gold should head higher as well in the face of a rising dollar.

I’m not sure what US equities do in all of this. I’m short the S&P, which obviously hasn’t done well (new intraday highs as of this writing), but my mediocre instincts tell me a strong dollar and an uncertain investment environment will not be net positive for US equities that are near all time highs.

The fact that the S&P continues to make new highs led by defensive sectors and FANG is not bullish.This should be an obvious indicator that capital flight from incredibly fragile economies is flowing into the US. It is not a sign of faith in the US economy but a sign of fear and uncertainty in the rest of the world.

Much has been said about the quality of the cooperation between central banks and governments. One tightens while the other eases and so on and so forth. These petulant children have seesawed their way through the “post” crisis era for far too long.

The mechanical disconnect between their incongruent policies has become so deafening that it is difficult to verbalize. Instead I must ask you to look. Look at the sovereign bond markets of the world. Look at the rates. Look at their trajectory.

What do you see?

Record low interest rates in every major developed country in the world. From Australia to France and from the US to the UK and every place in between record low bond yields continue to plummet with no signs of abating.

Before I continue, I must bring this back to our petulant little kids who appear to have made a very big mess in the collateral markets.

Banks, pension funds, institutions and insurance companies used to be able to count risky assets as collateral, but since the crisis governments have regulated away this practice. In essence, the governments shrank the overall pool of good collateral and forced them to hold more government bonds, which deceased the liquidity and availability in the government bond markets.

Unfortunately for us, governments are about as accurate as a Salvador Dali clock and after decades of fiscal profligacy governments suddenly found religion and decided cut deficit spending which further reduced the already shrunken supply of good collateral.

Central banks then went in and bought a lot of the remaining debt, once again shrinking the pool of available good collateral, drying it from a once vast lake to a now empty crater.

Then all of a sudden…

BOOM! Brexit!

This cherry lands on top of the proverbial three scoop sundae delight. The plucky underdog who came from a poor house in a rough neighbor on the wrong side of Leeds. No one gave this guy a shot. But damn did he show them.

So now the world is in a “risk on” environment. Everyone is running for the exit, searching for safety but finding a barren desert with scattered fat central banking fish helplessly flopping in the dried pools.

The result is a massive supply and demand imbalance, with prices going one way. Bond yields around the world are accelerating into negative territory.

We live in a world where people buy equities for yield and bonds for appreciation and as bond valuations sky rocket despite underlying fundamentals, the game of the greater fool approaches its climax.

In light of these recent dynamics it seems prudent to entertain the possibility of a blow out top in sovereign bonds.

First, the psychological impact of crashing rates could become a self-fulfilling prophecy. As more and more people cram into bonds yields will fall and the global economy may actually start to believe what the rates are telling it – there’s a crisis brewing.

Try to imagine what equities would do if the US 10 yr dropped below 1.00% after falling 70 bps in under a months time. What the heck does the SPY look like in that environment? Do you think it’s still at 2100?

How does gold behave when Japan, Germany and Switzerland can’t muster up a positive yield between the three of them?

What happens if we have a huge snap back rally in yields? What if the game of the greater fool ends quite abruptly? People awake from their foolish trances and start selling but with French paper negative out to 9 years, this sell off is incredibly steep. Potentially steeper than the rally itself. Trillions in losses pile up quickly and this bond market volatility now spreads to other asset classes.

The number of outcomes, and the negative convexity to each of them is worrying. Based on the incredibly foolish excitement this bond rally has generated, I believe that people are not prepared for the consequences.

In light of this revelation, I further added to my S&P put position while holding my gold and treasury holdings steady. If you want to wait for the S&P to break 1800 be my guest but at this point, I’m done adding equity exposure and am looking to trim what parts I can.

Italian bank shares hit new lows after plans for a $150B bailout leaked. Deutsche Bank isn’t far behind. This is a not paper over situation here. #BankHealthMatters.

The EU is structured in such a way that Italian bond and equity holders have to take a loss before there can be a bailout. Which doesn’t sound SO bad, a bunch of Italians take a haircut then the ECB comes in and papers the rest over.

Except, virtually Italy’s entire banking system, with NPLs at 18 %, is in dire need of a bailout. If people start taking losses on their bonds or their deposits, others will panic.

The average person believes the government has their back in these matters.“Banks are complicated murky institutions but the government knows what its doing,” they’ll say.

What they really mean is that the outcome if the governments fail is so horrific and destructive that they don’t want to think about it. They don’t want to even entertain the possibility of what that would mean for their lives. And it’s normal. It’s natural. It’s a human response to shield one’s self from unnecessary pain especially if you don’t think that pain will ever happen.

Unfortunately, the Italian banking system is an incredibly unstable and interconnected ball of debt and if one bank is forced to do a bail in, others will follow and eventually the average person’s unimaginable nightmare becomes a reality.

And that’s how this gets ugly very fast, because in a crisis, people are forced to make decisions in the very environment they were too terrified to even imagine.

Meanwhile, the most concerning trends continue to flash red. I say that in almost every post, but right now they are inescapably bright, like I’m trying to drive at night with a dozen flash lights on in the car.

1. Surging Yen – USDJPY 101.77
2. Declining Yuan – USDCNY 6.67
3. Gold and Silver hit new multi year highs
4. Falling interest rates hit record lows – US 10 yr 1.38
5. Falling EU bank stocks hit record lows
6. Outperforming S&P 500 that can’t break to all time highs.

The last one is both new and more abstract. The S&P 500 is displaying RECORD out performance against all other developed equity markets.

And yet, the S&P has failed to break to new all time highs. Think about that. The US stock market is out performing the globe at a level only seen once in the previous 100 years, but the stock market actually has gone no where. The entire out performance is due to a crashing global equity markets. US equities remain the last man standing, but I fail to see how this is a bullish signal.

If anything, the buoyant US equity market seems to be giving bulls and more importantly the Fed a false sense of confidence. I look forward to taking advantage of this mistake.

Another interesting market day. Don’t really have a comment because I don’t understand the price action. According to the S&P and the FTSE 100 the Brexit apparently never happened. It’s almost like their memories were erased…

I bought some more shorts after Brexit, and those have definitely not performed to my liking. It’s no secret that I’m bearish on the global economy. Just as it’s no secret that I’m scared of a huge black swan event.

My biggest fear is a mass liquidation and indiscriminate selling where all assets become directly correlated. I believe that it will happen, but I have no idea when. I’ve found it incredibly difficult to detach myself from this fear and as a result, until (if) my fears are confirmed I will be handicapped by said fears.

I understand that the US is the cleanest dirty shirt, and its banks are the safest in the world on top of having the most liquid asset markets on the planet. But that still doesn’t give me the confidence to go in and buy a Brexit dip when I see Deutsche Bank hovering near all time lows.

I understand the Chinese leadership doesn’t want to be blamed for the next global recession but when I see the Yuan making new lows against the dollar while the Yen simultaneously hits new multi-year highs I get very scared.

There have been multiple times this year, when my fear has prevented me from heeding my own advice and although one of those times I was battling the lovely cocktail made with one shot mononucleosis and two shots of lyme disease it still happened.

Recently, I read a very enlightening quote from Jesse Felder:

“I’ve found that… allowing macro concerns to prevent me from taking advantage of micro opportunities is a mistake.”

I learned that the hard way (oil in February 2016) and yet it took Jesse’s own words to solidify that for me. I still have my fears, but I’ve become a little more aggressive in seizing opportunities.

In order to combat those fears, whether rightly or wrongly I have only invested in companies whose long term prospects dramatically outweigh any short term declines. So much so that if any of these companies were to lose up to 50% of their value, I would have the confidence to step in and double down.

If you were wondering whether my investment personality is hedgehog or fox, the previous sentence should leave very little doubt. This frame of mind certainly limits the number of companies I can buy, but for a one man army, that’s not necessarily a bad thing.

To be fair, the majority of my funds are positioned based on global macro trends, and maybe I could sit back and call it a day, but when you are my size and have the confidence to find the right companies at a great price then you have to take a shot.

Well this is interesting… and strange. Very strange. Did I expect a rally? Yes. Did I expect it to be this quick and this strong? No.

Global equity markets have virtually shrugged off any worry associated with the Brexit. By looking at the S&P and the FTSE100, you’d assume nothing happened at all.

But it looks like this rally forgot to bring something with it.

https://twitter.com/FerroTV/status/748178253479829504

It’s not just Barclays. All other EU banks including the infamous DB (pictured below) is still hovering near the lows.

USDJPY also hasn’t recovered from its Brexit tumble.

Meanwhile in the land of the insane, the Irish 10 year yield hit a record low. Just 5 fookin’ years ago these guys were on the verge of selling their children into slavery to pay off their debts but now somehow they can borrow at 0.603%.

And it’s not just Ireland. Around the globe sovereign bond yields continue to rally. Just this morning the US 30 yr was just 3 bps away from a new record low. Something is going on. I don’t know what, but this bright brown cocktail of risk off and risk on signals tastes funny.

Yesterday I expected that if there was a rally that EU banks would be some of the best performers. The fact that the opposite is true leads me to believe this rally is a bunch of bollocks. #BankHealthMatters folks! And compressed yield curves only intensify the pressure these banks are feeling. This is a rally to sell.

I’ll be surprised if there isn’t a post Brexit rally. That is once the market calms down, and realizes that this is a non-binding agreement which no one in England has the conviction to carry out. But that doesn’t change the fact that the cat is out of the bag.

The market’s weakest links have been exposed. European bank shares have sold off. Sovereign bond yields have hit new lows. The entire Swiss curve is negative and Japan is not far behind. The Yen hit a new multi year high. I keep coming back to the Yen, because this shooting star is doing the exact opposite of what the BOJ intends.

Now Grant forgot to mention sovereign bonds, but he’s 100% correct. The assets most heavily influenced by central banks are going haywire, and if that doesn’t terrify you, I don’t know what will.

I don’t think this is the end, but my positioning is already quite defensive. I’m not quite at the nuclear fallout underground bunker stage that my fellow O’Dea (although he spells it differently), Crispin, is, but if things implode I should do quite well.

As I said in my previous article, I believe the Brexit is a single catalyst in a chain that is growing at an accelerated rate. This certainly won’t be the last event that pushes the globe into a recession or even a crisis but it is a loud and noticeable one that is finally forcing the market to face the fact that its been running on air for the past few years.

Until that next catalyst arrives, things may stabilize and I could take a hit on a lot of my positions. Especially considering that US GDP for Q2 is still tracking above 2.5%, and a good jobs number with higher revisions from previous months could lead to a lot of flows into US equities which I am heavily short.

I’ve learned it’s important to psychologically prepare for such events so that I do not panic and stick to my convictions which have done quite well so far. If there is a big rally I will be ready to add to my current positions. Another idea, which I won’t do, but will closely follow is buying English banks which have had their worst 2 days in history. If there is a relief rally, these stocks could outperform.

Despite the Brexit referendum being a non-binding agreement that won with 52% of the vote, the entire world is on the verge of hysteria. If you believe everything you see in the media you truly would believe the world is ending which brings me to this point:

And yet we see as a direct result of this vote what the weakest links in the global economy are – European banks and Japan. Spanish and Italian banks sold off by more than 20%. USDJPY went from 106 – 100 in a matter of hours which chopped off another 6% from the  Nikkei. Now these trends were obvious before the Brexit vote even took place.

From my article written just 4 days before the vote:

“Similar to the predictable no freeze deal at the OPEC meeting in Doha, BREMAIN is the most likely outcome, but the oil market still rallied because it was already headed in that direction regardless of a meaningless gesture. Although a BREXIT would certainly be a disaster for EU banks, I would argue that a BREMAIN would offer no real support to EU banks.”

So now that the unthinkable has happened, what happens next? From a political standpoint I haven’t a clue, and neither does anyone else it seems. The Brexit camp made the potentially fatal mistake of not having a plan. It appears they didn’t even expect to win. Looking back at history, it was the Federalists who had a plan that was written out that allowed them to push forward and “defeat” the anti-federalists.

This political uncertainty is abhorrent to markets which hate vacuums and will look to fill the void any way it can which could potentially force the politicians’ hands. I look at Brexit as a catalyst that accelerates the trends that were already in place. In my previous now somewhat prescient post subtitled “Something Big Is Coming” I pointed out that a lot of scary indicators were flashing red:

“Global bond yields continue to make record lows at a seemingly record pace. Bitcoin rockets through the clouds hitting 2.5 year highs. European banks plumbing new post crisis lows. The Chinese Yuan hits new multi year lows reinforcing this massive deflationary push. Gold rises above 1300 again. USDJPY plunges into 103 territory. The Nikkei plunges 3% for the second time in a week. And now the Fed has balked at hiking rates (again) and the market is starting to lose confidence in the most powerful central bank.”

Now all those indicators have gone from red to “plaid”.

As I mentioned above the Yen ripped higher and European banks sold off. But perhaps what is most troubling is that gold and the dollar rose together, with gold breaking to a new 2 year high. Sovereign bond yields continue to plummet with the whole Japanese curve crashing with its rising currency, this sort of move scares the shit out of me but perhaps its even scarier to the BOJ who will most likely be forced into action before USDJPY touches 100. As of writing this article, US 10 yr now yields 1.488% a new multi year low.

On top of all this madness, China, who has never needed global stability more than it does now as it “transitions” its economy, has been steadily devaluing the Yuan. China’s Premier Li Keqiang has gone so far as to warn of a “butterfly effect” that would arise from the Brexit vote.

The post crisis global economy was already a fragile creature, giving it an unexpected Brexit shock will reverberate through it, weakening and destabilizing it even further so when the next shock comes, and I do believe there will be another, that it will be much bigger than a non binding vote for a nation to leave a poorly run supranational union.

After a 4 day 55 km hike over snow covered mountains and through raging glacial melt rivers, I arrive exhausted, beat up, smelling worse than a New York City back alley radioactive sewer rat when I stumble across a German couple animatedly shouting and amidst my weary ears a thick German accented word that sounds an awful like “Brexit”.

I stopped in my tracks, and asked “did you say Brexit?” What followed was an American jumping for joy in front of two Germans who had not realized that their European Union was past its peak.

Anecdotes aside, I had a lot of free time after my daily hike and decided to write my next blog post on the trail. What follows is a brief overview of my investment edge that allows me to compete with the big boys.

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What is my Edge? What do I do better than anyone? What do I do that no one else does or is willing to do? After all, I’m just one man against an army of hedge funds, family offices, endowments and central banks, filled with algorithms, models, high frequency trading machines and people with more experience and intelligence than I possess.

I must be crazier than the central banks I constantly ridicule to believe that I have an edge. Maybe I am crazy, or maybe just maybe I can take advantage of opportunities that they can’t.

I’m one man, managing a small fund which makes me agile and quick. I can change my opinion and perhaps more importantly my positions faster than anyone else can. But my real edge lies in something less obvious.

Everyone knows central banks have flooded the world with liquidity that has  pumped into virtually every asset class known to man. But that’s not entirely true. The flood gates have been open for years, but the liquidity hasn’t gone everywhere. There are nooks, crannies and other hard to reach places that have been ignored.

This isn’t surprising. After all, the biggest beneficiaries of QE are the big guys. It’s hard to convince a firm with billions of dollars to put a few hundred thousand dollars which equate to less than 0.1% of their fund into a micro-cap graphite or lithium mining company. This means these companies are untouched by the Midas touch of central banking liquidity and leads me to believe there’s still opportunities for deep value in micro-cap illiquid stocks (IF you can find it).

Just like Peyton Manning, I’m playing where my opponents can’t touch me because they aren’t even on the same field as me. If I played their game on their terms on their field I would lose, 100% guaranteed. I’d rather make money on the side field than lose it on the big stage.

Most importantly, the fact that no one plays on my field means the assets on it are neglected, ignored and above all incredibly cheap. This allows me to find a uranium company one week from publishing a massive find that has been ignored by the market. Or how the entire uranium mining space can be down 90% from its highs yet have some of the best fundamentals on earth with a total market cap of less than $6B. Better yet, I can find a graphite company with assets that make it incredibly well positioned for the coming battery boom.

So don’t tell me there’s no value out there. Because there is. It’s just not where everyone is looking and arguably has never been harder to find. But then again, if there’s no value going long something, there’s probably value taking the opposite side. Hence I hedge and have been net short equities through puts and shorts on the largest and most liquid stock indexes and companies that have seen the largest benefits of misguided central banking policies.

If I’m wrong about the state of the global economy and we enter a new technological renaissance then my micro-cap stocks (if I did my research right) should more than make up for my short and defensive positions. If I’m right, and the global economy is headed for big trouble (will talk about Brexit in next post) then my puts/shorts and US treasury bonds should do quite well and hopefully allow me to double down on some of these companies, which I think will do really well long term. And if I’m really wrong about everything, then that’s why  god invented gold, so idiots like me can be right some of the time.

In the end, I feel like I’ve created the all weather portfolio that fits my style, portfolio size, and experience level. I can’t tell you whether Facebook will outperform Apple in Q3 of 2016 and I don’t really care. That’s not my game. Let the hedge funds run momentum fading circles around each other while I pick up extremely under priced stuff they’d never dream of touching.

The term BREXIT is sort of an oxymoronic term for Britain’s (remain leaning) referendum to leave the EU. With polling favoring a slight lead for BREMAIN and the belief that people on the fence are less likely to vote for such a sharp change in their daily lives the odds of a BREXIT are not so high. Of course there are a lot of other factors BUT the market “remains” (see what I did there?) incredibly nervous over the vote. Perhaps the status quo fear mongering is actually working, just not on the right people.

Similar to the predictable no freeze deal at the OPEC meeting in Doha, BREMAIN is the most likely outcome, but the oil market still rallied because it was already headed in that direction regardless of a meaningless gesture. Although a BREXIT would certainly be a disaster for EU banks, I would argue that a BREMAIN would offer no real support to EU banks.

The banks are dying a slow but accelerating death at the hands of NIRP and over regulation not because half of British citizens don’t want to cede their sovereignty to a superstate. However, the risk off BREXIT trades are hurting their equity at a time when they can least afford it. Even if BREXIT turns into a BREMAIN will the banks be any better off?

Now I don’t like to day trade but I do like to manage risk although it is certainly not my strong suit. I believe long duration US bonds and gold have had an amazing run these past few weeks on fears of a BREXIT and it seems quite justifiable in selling some of each here.

To be honest, I won’t sell more than 13% of each position. I don’t have the conviction in my abilities yet (especially in these increasingly volatile times) to buy back at the right price and would rather hold on and hedge with other risk on trades such as beaten down natural gas companies. I still believe this natural gas rally has some legs to it and perhaps this is a great time to add some more exposure.