Trading, and to some extent investing, is all about knowing when markets are moving with the wisdom of the crowds and when they’re moving with the madness of the crowds. In recent years, there has seemed to be much more madness than wisdom (a statement which can probably be generalized beyond the financial markets themselves, come to think of it). Where do we stand now?
I think a recent letter by John Hussman of Hussman Strategic Advisors, entitled “An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities,” is worth reading. Hussman is far from the only person, nor even the most august or influential investor, questioning the valuation of equities at the moment. Our own valuation models have had the projected 10-year compounded real return of equities below 3% for several years, and below 2% since late April. For a time, that may have been sustainable because of the overall low level of real rates, but since the summertime rates selloff the expected equity premium has been below 1.5% per annum, compounded – and is now below 1% (see Chart, source Enduring Investments).
Hussman shows a number of other ways of looking at the data, all of which suggest that equity prices are unsustainable in the long run. But what really caught my eye was the section “Textbook speculative features”, where he cites none other than Didier Sornette. Sornette wrote a terrific book called Why Stock Markets Crash: Critical Events in Complex Financial Systems, in which he argues that markets at increased risk of failure demonstrate certain regular characteristics. There is now a considerable literature on non-linear dynamics in complex systems, including Ubiquity: Why Catastrophes Happen by Mark Buchanan and Paul Ormerod’s Why Most Things Fail: Evolution, Extinction and Economics . But Sornette’s book is one of the better balances between accessibility to the non-mathematician and utility to the financial practitioner. But Hussman is the first investor I’ve seen to publicly apply Sornette’s method to imply a point of singularity to markets in real time. While the time of ‘breakage’ of the markets cannot be assessed with any more, and probably less, confidence than one can predict a precise time that a certain material will break under load – and Hussman, it should be noted, “emphatically” does not lay out an explicit time path for prices – his assessment puts Sornette dates between mid-December and January.
Hussman, like me, is clearly of the belief that we are well beyond the wisdom of crowds, into the madness thereof.
One might reasonably ask “what could cause such a crash to happen?” My pat response is that I don’t know what will trigger such a crash, but the cause would be the extremely high valuations. The trigger and the cause are separate discussions. I can imagine a number of possibilities, including something as innocuous as a bad “catch-up” CPI print or two that produces a resurgence of taper talk or an ill-considered remark from Janet Yellen. But speculating on a specific trigger event is madness in itself. Again, the cause is valuations that imply poor equity returns over the long term; of the many paths that lead to poor long-term returns, some include really bad short-term returns and then moderate or even good returns thereafter.
I find this thought process of Hussman’s interesting because it seems consonant with another notion: that the effectiveness of QE might be approaching zero asymptotically as well. That is, if each increment of QE is producing smaller and smaller improvements in the variables of interest (depending who you are, that might mean equity prices, long-term interest rates, bank lending, unemployment, etc), then at some point the ability of QE to sustain highly speculative valuations goes away and we’re left with the coyote-running-over-the-cliff scenario. Some Fed officials have been expressing opinions about the declining efficacy of QE, and Janet Yellen comes to office on February 2nd. I suspect the market is likely to test her very early.
None of this means that stocks cannot go straight up from here for much longer. There’s absolutely nothing to keep stock prices from doubling or tripling from here, except the rationality of investors. And as Mackay said, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Guessing at the date on which the crowd will toggle back from “madness” to “wisdom” is inherently difficult. What is interesting about the Sornette work, via Hussman, is that it circles a high-risk period on the calendar.
For two days in a row now, I’ve discussed other people’s views. On Wednesday or Thursday, I’ll share my own thoughts – about the possible effects of Obamacare on measured Medical Care inflation.
I guess we have to add to the list of uncomfortable comparisons to 1999’s equity mania the Twitter IPO. A widely-known company with no earnings…and no visible way to produce any revenues of note, much less earnings…went public and promptly doubled. Hedge funds which were able to get in on the IPO allocation cheered this nice kick to their performance numbers, and the backers of the now-$25bln-company are surely elated. But the rest of us have got to be thinking about Pets.com.
It was an article by Hussman Funds (ht rich t) that got me thinking more deeply about these comparisons. Although the article was referred to me partly because of the insightful comments about the Phillips Curve, which echo similar comments I have made in the past, I kept reading to the end as I usually do when trapped in a Hussman article! While there are a number of us (including Hussman, Grantham, Arnott, e.g.) who have been concerned for a while about equity market valuations since we use similar metrics, I really haven’t been terribly concerned about the possibility of an imminent and steep market decline for a while, though I think returns from these levels over the next decade will be close to flat in real terms as they were after the 1999 peak. However, Hussman had me thinking about this.
I do think that there is one key difference from 1999, and that is that not everyone is talking about stocks. That is, not yet…the Twitter IPO might get us there – on Fox Business News today a young talking head (who was no more than 10 years old in 1999) made sure that viewers were informed that anyone could buy Twitter, just by calling their broker. (Not just anyone, though, could get in at the IPO price…a point the cub reporter neglected to mention).
The counter-argument to “is this a 1999 set-up?” takes two forms. The less-sophisticated form is “nuh-uh”, although usually said in a slightly more elaborate way that implies the questioner is a mindless, not to mention soulless, Communist who isn’t getting enough loving at home. The more-sophisticated argument is worth considering, but isn’t particularly soothing to me. This hypothesis is that this isn’t 1999, it’s 1997, before the parabolic blow-off and with lots of room left to run. It wasn’t as if there was any lack of skepticism about the stock market’s levels (which, sweetly, we considered lofty at the time):
“Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such “new eras” that, in the end, have proven to be a mirage. In short, history counsels caution.” – Alan Greenspan, February 26th, 1997
The bubble, of course, did not pop in 1997. It popped in 1999, after Greenspan had abandoned his prior skepticism (in late 1998, as he came to believe that “I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible”). Between 1997 and 1999, there was plenty of time for investors to make money, and as long as they realized they were taking money for the future and got out before 2000…alas, very few of them did.
But, speaking from experience, the 1997-1999 period was very lonely. While investors who gradually sold their long positions out in 1998 and 1999 did much better than the ones they were selling to, they were also very unpopular at cocktail parties. The bearish analysts were put on the street, begging for tuppence. Which, considering that most of them were in the United States, was also unsuccessful.
The 1999 bubble…and the later property bubble…also did not burst until the Fed was actually tightening policy. It is on this point that many bullish arguments depend, but it is a weak one I believe. To be sure, there is no chance that the Fed will be tightening policy any time soon. The taper is not going to happen until 2014Q2 at the earliest, and I think it will take until later in 2014, when inflation figures will become uncomfortable, before they will start pulling back on QE. Some observers believe it will be much later. A Wall Street Journal article on Wednesday detailed a recent research paper written by the head of the monetary affairs division at the Fed; it argued that it may make sense for the Fed to lower its Unemployment Rate threshold and said that “an ‘optimal’ policy might keep rates near zero as late as 2017.”
The activist Fed continues to be one of the biggest risks to the market and the economy. As a trader, I know that 90% of trading is just sitting there, waiting for the ‘fat pitch’ you can do something about. It boggles my mind that a central banker doesn’t sit around at least that much, considering that they know even less about the complexities of the global economy than I know about the complexities of the market. And, unlike the global economy, the market doesn’t fight back when I act on it.
I actually have a feeling that we won’t be worrying about those Unemployment thresholds, either the old ones or the ones proposed in that paper. As I wrote late last month, the expansion is getting a bit long in the tooth and I would not be surprised to see another recession looming in 2014. I don’t have any reason for that outlook other than the calendar, but sometimes these reasons become obvious only in hindsight.
In any event, though, I wouldn’t wait around for the Fed to be tightening. It isn’t overnight funding rates that I would worry about, but longer-term interest rates, and there has already been a warning shot fired that indicates the Fed is not wholly in control of those rates.
So, it may be too early to be out of equities. Maybe even a lot too early. But one thing I am sure of is that it isn’t too late. It is the latter condition, not the former, that is the most damaging to one’s financial position.
The data has started to arrive.
Tuesday’s Employment report (gosh, it seems strange to write that) was weaker-than-expected with Payrolls +148k versus expectations for +180k. As I wrote back at the beginning of August, something in the realm of 200k is about as good as you’re going to get, so we’re not very short of that…we’re just very far short of what the consensus seems to expect we’re eventually going to get. No doubt, 148k isn’t 200k, and the six-month average of 163k is the lowest of the year. But it is also not a calamity, on the growth front.
And yet, 10-year interest rates are 50bps below the highs of early September. (Real yields are actually down 60bps, which means inflation expectations have risen slightly during that period). Interest rates are down because everyone knows that the trajectory of policy, with Yellen as likely to be the next Chairman of the Fed, is going to be “lower for longer.” But why? This goes back to the observation that growth is not far short of the best that it is likely to get. The only point of “lower for longer” is to support asset markets – housing, equity, and the bond market whence our nation’s interest burden is determined – and it seems to be doing this quite well. The alternate theory is that the Fed still fears deflation, despite all evidence (and copious theory) that the risk arrow is pointing in the other direction. In neither case does the Federal Reserve come out looking particularly on top of things, but more and more we are expecting that from Washington whether the officials are elected or appointed.
I really thought at one point that the bond market was going to be where the profligate monetary policy was going to first come unglued, but I am now wondering if it isn’t that denizen of hair-trigger shooters, the foreign exchange markets. The dollar index is plumbing the lows of the last two years, although it remains considerably above the lows of 2008 and 2011. As the chart below shows, the dollar has actually left behind the commodity markets where, as we know, investors suffer from the delusion that growth is more important for the nominal price of commodities than is the overall price level. Weak-ish growth means that commodities are only weakly above its August lows, although the buck is quite a bit lower since then.
I don’t think we can learn much right now watching stocks, where investors are simply playing Icarus. We all know where it leads, but any words of warning are laughed off as they soar with Fed-induced wings. Of course they’ll turn away in time!
I think housing is interesting. Having gotten back barely to fair, or maybe just a smidge cheap, compared to incomes, housing is expensive once again. But it isn’t in bubble territory yet, at least in the sense that when it cracks it could cause the carnage it did once before.
Bonds are on tenuous footing. With the consensus currently in place that the Fed might keep QE in place more or less forever, there are a lot of ways to disappoint the status quo: Fed speakers might suddenly try to start sounding stern again and imply that QE might not last forever; inflation might continue to tick higher and make obvious the unsustainability of the current course; or growth numbers might surprise to the high side.
The barbarians are already overrunning the dollar, and I suspect only the fact that Japanese monetary policy is far worse is keeping the descent slow. But people plugged into the supply and demand for currency are probably most likely to understand what happens when too much is supplied (hint: it’s the same thing that happens to the price of corn when too much corn is supplied). For a while, monetary authorities have been chasing each other to see which could be the least respectable, but it now seems that Japan wins that race and the US is likely to place.
As the chart above shows, reasons for increasing exposure to broad-based commodity indices (especially those that do not overweight energy, as the GSCI does) continue to accumulate.
There is much more data to come, of course, but to me it seems the battle lines have been more or less drawn in this fashion.
I haven’t written recently because it is hard to figure out what to do here. Market action at this point seemingly has little to do with fundamentals, and isn’t even in “risk on/risk off” mode because no one seems to be sure how the government shutdown affects risk (the debt ceiling debate is another issue, which I will discuss later).
I often get comments to the effect that “political uncertainty is a fact of life,” or “the Fed always manipulates markets,” implying that we cannot simply refuse to invest because markets aren’t trading cleanly off of economic fundamentals (which don’t directly translate into market action even in the best of times anyway). This is true, but I always hearken back to the notion that uncertainty implies a smaller bet size (a long time ago I wrote an article in which I discussed the implications of the Kelly Criterion for thinking about how one invests). When the economic signals are clear but the market isn’t pricing them properly, then you have a great edge and the market is giving you good odds, and most of your chips should be on the table. When the economic signals aren’t clear, or when stochastic political events are likely to overwhelm them, then your bet should be small because your edge is lower even if you are getting good odds.
In this case, of course, no matter what market you are talking about it isn’t at all clear how the debate (perhaps calling it a “debate” is generous) about the continuing resolution to fund government operations, the ACA, and the debt ceiling will be resolved.
We can speculate about what various outcomes might mean to the markets, but even here our analysis is fraught with uncertainty. Would an extended shutdown be good for equity markets because it would imply a greater chance of lower ACA costs and a lengthier period of Fed quantitative easing? Or would it be bad because of the short-term impact on growth as government spending is delayed? Would bonds rally because there would be no incremental supply, or sell off because of the implied risk of default? A lengthy government closure might be bad for the dollar because it implies more monetary ease, but might be good because it represents “fiscal discipline” (admittedly, in this case it’s discipline in the fetishistic sense rather than in the self-control sense). The only thing I am certain about is the uncertainty, and that spells a smaller bet.
Retail investors are especially at a disadvantage, because of the huge amount of misinformation that is out there about likely scenarios and the results of various outcomes. This misinformation is often unwittingly disseminated by media outlets, but I suspect it is rarely unwittingly initiated by the original sources.
For example, a recent New York Times blog was pretty good at discussing the possible outcomes, but flunked on at least one aspect when it stated what would happen to the economy as a result of a federal default. I don’t mean to pick on the Times here, and in general it is a good article. But at one point the writer said that a default could cause a spike in Treasury yields (likely true), but then continued “The price tag on a huge range of other debt products is benchmarked to the cost of Treasuries. That means a spike in the federal government’s borrowing costs would translate into pricier mortgages, car loans and corporate borrowing costs.”
Well, that’s wrong. It’s not offensively wrong, but it’s wrong (and I’m pointing it out partly as an example of how even simple stuff is confused right now). The interest rate on any nominal debt instrument consists of several components: the real cost of money, a premium for expected inflation, and a premium for the riskiness of the credit. Normally, with Treasuries we can say the credit spread is effectively zero, so that we refer to the spread that a corporate bond trades over Treasuries as “the” credit spread because that spread minus zero equals that spread. But there is no reason to think that spread would remain constant if the Treasury’s credit was diminished, any more than it would remain constant if the corporate’s credit was diminished. If Treasury rates spiked because the government’s perceived credit spread was no longer zero, then unless that also affected the perceived credit of, say, Caterpillar then there is no theoretical reason that CAT yields should also rise.
In any event, a federal default is not going to happen unless someone in the Administration wants it to happen. The government’s $2.9 trillion in revenues is quite a bit more than is needed to pay the $300bln or so in interest costs per year, so unless the Treasury simply decided to default (see an excellent article here by my friends at TF Market Advisors) it isn’t going to happen. The Treasury has made some mystifying statements about how they don’t have the capability to pay some expenses and not others, but in the worst case someone can sit down and manually wire the money to every holder. So that’s nonsense that is meant to scare us.
So I don’t have any decent “trading opinions” on the basis of the government shutdown. What I do believe is that this is an unmitigated positive for inflation (positive in the sense of pushing it higher), and thus for breakevens and inflation swaps. The longer the government stays shut, the longer quantitative easing will be in force as the Fed attempts to counteract the short-term contraction of economic activity (the fact that monetary policy is ineffective at affecting growth rates never seems to enter their minds); furthermore a long shutdown will more likely to push the dollar lower in my opinion – although, as I said above, I can argue the reverse position as well. On the other hand, if the Republicans cave quickly, as is likely in my view, and the ACA goes into effect, prices for consumer-purchased medical care will rise rapidly. This is less a statement about whether the ACA will push aggregate health care costs higher, although I believe that it will. It’s more an observation that controlled prices in the government-purchased sector will produce higher prices outside of the controls, and it is this latter group that will be sampled for consumer prices (since the price the government purchases at is not a “consumer” price). Since it is the Medical Care subgroup of CPI that has been pressing core CPI to be lower than median CPI, any rebound in Medical Care inflation will push aggregate core inflation higher.
Was that said in a confusing-enough manner?
TIPS should do well while the government is shut, because there is ongoing growth in demand for TIPS while the supply will be drying up. Unlike with the nominal Treasury market, there is no corporate inflation-linked bond sector that can replace the inflation exposure (although there should be) demanded by investors, so TIPS will tend to outperform nominal bonds in the event that both sets of auctions are canceled.
 There are other costs, such as the discount to the interest rate that the Treasury pays as a result of the status of Treasuries as superior collateral in repo and similar exchanges, but they are not relevant to this point.
 There may be a practical argument that there might be a substitution effect, but that’s also saying that investors would bet the selloff in Treasuries makes them a better risk-adjusted bet than CAT bonds. However, if the Treasury’s credit spread moved permanently higher, it would not affect the equilibrium bond yield of a corporate bond.
When I remark, from time to time, that I think the Fed has made a mistake in increasing transparency of its deliberations and actions, people occasionally look at me as if I had come out opposed to motherhood or apple pie. But my point is that transparency is good if it permanently decreases risk…but it doesn’t.
What matters is how market actors respond to increased transparency. It is much like the old debate about whether football players ought to wear helmets. It is clear that helmets decrease the likelihood of brain damage in any given collision, compared to the un-helmeted rider in an identical collision. But it is also clear that as helmets have gotten better and better, football players have played faster and faster, with more abandon, and lead with their heads a lot more than they did when all they had was a leather cap. The net effect is indeterminate.
In markets, increased transparency from a central bank or regulator leads to increased leverage in a very direct way. The central bank’s dial is for transparency, but the investor’s dial is for risk appetite and when the central bank turns its dial it does not change the investor’s risk preferences. The result is that increasing transparency, which decreases the risk at any given leverage and at any particular moment, leads to higher levels of leverage, which lowers the tolerance for error. And, as we have seen, central banks and regulators are quite prone to error.
In an interesting way, this is tied into the volume question. The chart below (source: Bloomberg) shows rolling 250-trading-day volume for the NYSE in billions of shares. As has been well-documented, market volumes have been steadily declining for years.
As we have mentioned here before, there are lots of excuses for lower market volumes on the major exchanges, and probably many of those excuses are part of the answer. But we can no longer simply attribute this to the movement of volumes to “dark pools.” There is simply less going on in the markets, whether in rates or in equities. Ask the dealers. Dodd-Frank and the Volcker Rule are simply decimating volumes. And this is not just bad for dealers, it is bad for everyone.
When a trade happens, there is information revealed. Indeed, in some markets a meaningful proportion of the volume transacted is between dealers who are testing the market to get more information. More trades means that there are more quanta of information. More quanta of information produces more confidence in prices. More confidence in prices means more support for the current prices, and more de facto liquidity.
Think of it this way. If a bond has never traded, and two counterparties come together to trade some at a price of 103, what is your estimate of the true market for another trade? Is it one tick around 103? If so, then you are displaying almost outrageous overconfidence – one data point between two counterparties, about whose motivations you know precisely nothing, tells you almost zero about what the true market (by which I mean, the prices at which you could buy, for an offer, or sell, for a bid, a typical-sized transaction) is, and even less about what the support market (by which I mean the prices at which you could transact in substantially larger sizes) is. And so bid/offer spreads, whether quoted on-screen or over-the-counter from a dealer in the security, must be wider since the market-maker just doesn’t know as much as he would if volumes were higher – and, more to the point, the market must be wider because the client who initiates the trade is likely to know more than the market-maker does about the right price. This is because the market-maker must make a market whether or not he knows the fair price, but the buyer or seller doesn’t have to trade unless he/she believes the fair price is outside of the quoted range. Of course, that’s where the information comes from: if the offer is lifted, it means someone is saying “I think the fair price is higher than your offer,” and that is information.
I mention this today for several reasons. First, because it has been a while since I showed the NYSE volumes chart in a while. Second, because there was an article on Bloomberg today entitled “Professor Who Helped Pop Junk Bubble Says Trace Slows Trade” which ties transparency to diminished volumes. To the extent that Trace produces true transparency and reduces the need for “testing” trades, it is a good thing…but then we should see tighter spreads for size, and while the study is suggestive it isn’t conclusive on this point. More interestingly, the professor in question also made the point that “less trading may hurt investors if, instead of reducing ‘noise’ from the market, the reduction slows how quickly new information alters prices.” And this point is also key:
”…if the decrease in trading activity is the result of dealers’ unwillingness to hold inventory, transparency will have caused a reduction in the range of investing opportunities. That is, even if a decline in price dispersion reflects a decrease in transaction costs, the concomitant decrease in trading activity could reflect an increased cost of transacting due to the inability to complete trades.”
So transparency, it seems, is not an unalloyed positive like apple pie. But lower trading volumes, which are partly the result of transparency (and partly the result of poorly-conceived rules like Dodd-Frank, the Volcker Rule, and Basel III), are very probably bad for everyone. This doesn’t just affect hedge funds. Markets which are deep and liquid are much less prone to sudden price breaks. With the US equity market still floating near the highs despite rapid increases in nominal and real interest rates and worst-ever outflows from ETFs last month, this is a point that may be more than academic at the moment.
 However, no one disputes that the faster game is a lot more fun to watch. What I suspect has happened is that the introduction of hard-sided helmets probably increased injuries until players essentially reached maximum speed/recklessness, after which point the further improvements in helmet design probably started to make the game safer again. But it is really hard to prove that.
It didn’t seem when dawn broke in New York today as if the stock market would spend some time during this first post-summer session fighting to record a positive mark on the close. The S&P opened up 1% higher, partly because Chinese economic data was modestly stronger-than-expected, but mostly because hot money types sought to use the thin overnight session to try and create the impression that returning investors were flocking to buy “these cheap levels.”
But whatever the proximate cause of the overnight rally, it was met immediately with selling and three hours later the indices were flirting with unchanged on the day before a late charge produced a +0.4% finish for the S&P. I don’t think the turnaround had anything to do with the fact that Israel fired ballistic missiles into the Mediterranean as a test of anti-ballistic-missile technology last night – that information was known when we walked in, although there was some confusion about whether the U.S. was involved or not and whether it was supposed to be secret or not.
Indeed, the whole U.S. market seems far more interested in whether the Employment number this Friday is 160k or 180k than whether the U.S. or Israel attacks Syria, prompting a response from Iran and/or Syria on Israel and generally provoking the situation in the Middle East like a Mentos candy dropped into Diet Coke. This is why 10-year notes were down on the day, despite the fact that the terribly low float outside the Fed means any flight to quality could be explosive.
The odds of a flight to quality may be low, but the expected payoff is (probability of event) * (value given that event happens), the latter of which is quite high. This is one reason I would be more comfortable being cautiously long bonds at this point. I guess the counterargument is that any taper will have a disproportionate effect on the sectors with less float, but I would think that should be mostly priced in by now. Well, perhaps the Syrian conflict is priced in as well…after all, little is likely to happen very soon, unless Congress acts quickly to validate the President’s request for authorization of military action. The President doesn’t seem to be looking for a quick answer and would probably like the whole issue to just go away, so probably the most likely event is still that nothing happens in Syria that impacts U.S. interests very much.
But do keep in mind that the part of the value of a particular strategy that comes from a particular state of the world is, as I said above, (probability of the state of the world) * (value given that state of the world happens). For many financial options, the value of the option is determined not by the likely or median outcome, or even the distribution of likelihood of outcomes around the strike price of the option, but rather the outcomes in the tail, where there is very low likelihood and very high value. These are all “unlikely” events, in the sense that their independent probabilities are less than 50% and in most cases markedly less:
- a hot war in the Middle East,
- an abrupt taper from the Fed, or a decision from the Fed to increase purchases,
- Merkel’s party loses the vote and is unable to form a pro-Euro coalition,
- the Yen suddenly collapses,
- the US borrowing ceiling isn’t extended without fierce brinkmanship (in mid-October, the US won’t be able to pay for everything it wants to pay for, although it will still have plenty to make debt service and entitlement payments and so is not in even remote danger of an actual default unless the Treasury simply refuses to direct its ample revenues to debt service),
- …and others.
How does your asset allocation perform under each of these scenarios? Are there tails you have unhedged? If so, then you are doing what hedge funds have been doing for the last couple of decades: selling implicit options, earning a better return today as long as a bad event doesn’t hit. In hedge fund land, we talk about being short implied credit or liquidity options, but even retail investors have this sort of position on. What happens to your portfolio if oil goes to $200, or the US suddenly drops into recession, or the Euro breaks up over the weekend? What about if inflation goes from 2% to 6%? (Interesting fact: over the last 100 years, inflation accelerated by at least 4% from one year to the next fully 10% of the time. And the probability that inflation is over 10%, given that it is over 4.5%, is 37%…so in other words, the inflation tails are very long).
Don’t ask me for answers about what you should do in these cases – my purpose in these articles is not to distribute free answers to intricate questions that depend on your personal situation. My purpose is to present the question, and the question is, have you thought about how your portfolio will perform in the case of unlikely events?
If not, spend some time doing so. My fundamental belief is that a 70% or 80% equity position is almost never the right answer for any investor. If you are sufficiently wealthy that you could lose that 80% and have it not affect your lifestyle, either now or in the future, then you truly can plan for the long haul and ignore such risks (although even then I would not ignore valuations because you can add to your long-term returns by paying attention to them). For everyone else, “long term” is probably 10 years or less, and severe impairment of the portfolio does not admit to a certain 10-year cure. Just ask the people who had most of their retirement assets in Enron, or for that matter in the NASDAQ circa March 2000.
Watch your tail. The next month or two will be interesting.
 Technically, this is only true if all of the enumerated states of the world are distinct. To the extent that they are not, a covariance structure comes into play…for our purposes you can think of each separate event as creating option value, but you can’t simply sum those values.
I am disinclined to take victory laps when most people are losing money, but the recovery in commodities prices over the last week at the same time that bond and equity prices are both declining is a taste of success for my view that has been rare enough lately. That is, of course, the burden that a contrarian investor bears: to be wrong when everyone else is having fun, and to be right when no one wants to go out and celebrate. In fact, if you find yourself sharing your successes too often with other people who are having the same successes, I would submit you should be wary.
It is worth noting that the commodities rally has not been led by energy, despite the terrible violence in Egypt which threatens, again, to ignite a spark in the region. Today, the rise in commodities was led by gold and grains; yesterday by cows and copper (well, livestock and industrials).
I don’t think that this is because of a sudden epiphany about inflation. In fact, although breakevens have been recovering from the oversold condition in June (more on that in a moment), the inflation data today did nothing to persuade inflation investors that more protection is needed. I gave some thoughts about the CPI report earlier today in this post, but suffice it to say that it was not an upside surprise. (And yet, there are starting to appear more-frequent smart articles on inflation risks. I commend this article by Allan Meltzer to you as being unusually clear-eyed.)
And commodities are not moving higher because of renewed enthusiasm about growth, I don’t think. Today economic bell cow Wal-Mart cut its profit forecast because higher taxes are causing shoppers to be more conservative (perhaps in more ways that one). And, while today’s Initial Claims figure was good news (320k versus expectations for 335k), weakness was seen in Industrial Production (flat, with downward revisions, versus expectations for +0.3%) and both Empire Manufacturing and Philly Fed came in slightly weaker than expectations. None of this is apocalyptic, but neither is it cause for elation about domestic or global growth prospects.
While the nascent commodity rally makes me personally feel warm and fuzzy, the more-momentous move is in what is happening to interest rates. And here I need to recognize that until very recently, I thought that bonds would follow the typical pattern of a convexity-exacerbated selloff: after a rapid decline, the market would consolidate for a few weeks and then recover once the overhang had cleared. I’ve seen it aplenty in the past, and that was the model I was operating on.
But I believe rates are heading higher. Although the overhang from the prior convexity selloff has probably been distributed, there is a new problem as illustrated by the news today about Bridgewater’s “All Weather” fund. The All-Weather Fund is an example of a “risk parity” strategy in which, in simplified form, “low-volatility” strategies are levered up to have the same natural volatility as “high volatility” strategies. The problem is that levering up an asset class with a poor risk-adjusted return, as fixed-income is now, doesn’t improve returns or risks of the portfolio at large. The -8% return of the AWF in Q2 illustrates that point, and makes clear to anyone who bought the great marketing of “risk parity” strategies that they probably have much more rate risk than they want (although according to the Bloomberg article linked to above, Bridgewater “hadn’t fully grasped the interest-rate sensitivity” of being long 70% of net assets in inflation-linked bonds and another 48% in nominal bonds. I do hope that’s a mis-quote).
The unwinding of some of that rate risk (Bloomberg called the panicky dumping of a relatively cheap asset class, TIPS, into the teeth of a retail and convexity-led selloff “patching” the risk) helped TIPS bellyflop in May and June, and to the extent that institutional investors wake up and reduce their levered long bets on fixed income we might see lower prices much sooner than I expected across the entire spectrum of fixed-income. Indeed, without the Fed or highly levered buyers, it’s not entirely clear what the fair clearing price might be for the Treasury’s debt. I was at one time optimistic that we would get a bounce to lower yields after a period of consolidation, but this news is potentially a game-changer. Although the seasonal patterns favor buying bonds in August and early September, the potential downside is much worse than the potential upside.
Before I descend into the mundane discussion of economies and markets, let me first congratulate the Duke and Duchess of Cambridge on the birth of their son. In watching the pictures of the royals leaving the hospital with their child, I was struck at the fact that when his wife passes off the child, Prince William looks as uncomfortable holding a baby as most first-time fathers are. He did, however, have more luck with the mechanics of the car seat…as, again, most new fathers do.
However, when he drives home, he won’t have to worry about the rising cost of housing, and probably doesn’t fret much about whether his child will be able to afford a comfortable life in an inflationary future. “Will my son be better off than I am?” is a question for non-royals!
I have no idea what the rents are for a Kensington Palace apartment, but I will bet they are rent-controlled. Meanwhile, housing prices in the U.S. continue to rise rapidly. Today’s announcement of the FHA Home Price Index suggested prices have risen 7.3% over the last year (the fourth month in a row over 7%), while the median price of a home in the Existing Home Sales report yesterday was 13.2% above the year-ago level (see chart).
Aside from inflation, however, where the future trajectory is clear, the performance of the economy is probably best characterized by the word “muddled” (thank you, John Mauldin). Last Thursday, the Philly Fed index was published at 19.8 – a two-year high – versus expectations for 8.0; on Monday the Chicago Fed index showed -0.13 versus expectations for flat, and today the Richmond Fed index was -11 (the second-worst since 2009) versus expectations for +9.
And, in the meantime, Microsoft (MSFT) and Google (GOOG) missed earnings badly and Detroit declared bankruptcy. Apple (AAPL) is just out with earnings and pulled the old trick of “beat on current earnings, match on revenues, but guide lower for next quarter.” The current consensus for Q2 GDP (the advance estimate is due out next week) is a mere 1.3%.
With all of this, equity prices are doing well with stocks up 5.4% for the month. Bond yields are fairly flat, with 10-year yields up 4bps from the end of June, but TIPS are doing relatively well (10y real yields -14bps; 10y breakevens +18bps). And even the DJ-UBS Commodity index is +4.3%. Gold is up nearly 10%.
Three weeks do not a turn in sentiment make, but I do find it interesting that real estate, inflation breakevens, gold, and commodities generally are all enjoying a renaissance right after inflation-linked bonds and commodities were buried in late June, with large outflows especially from TIPS funds (the shares outstanding of the TIP ETF went from 183 million at year-end, to 165 million in late May, to just 139 million now). It got so bad that my company reached out to customers in late June with a thorough explanation and presentation of why we thought the market was ‘getting it wrong.” Investors were throwing out the baby with the bathwater.
To be sure, I think real yields, breakevens, and nominal yields will eventually be much higher. But if nominal yields can simply avoid breaking higher for the next few weeks, I think the stage will be set for a fixed-income rally into September and October. As I have written before, in the aftermath of a convexity event such as we have just seen, a “cool down” period of a few weeks is usually necessary to work off the bad positions induced and trapped by the market’s sudden slide. Once these positions are worked off, I think the weak economic growth and weakening corporate internals will pressure stocks lower and the stock and bond markets will get back into some semblance of what static-equilibrium types think of as “fair value” relative to one another.
Even so, I think that commodities, breakevens, and even gold might have already seen the worst of their markets. In this suspicion I have been wrong before. Money velocity in Q2 will have declined further (probably to about 1.50 from 1.53 in Q1), but I think it will be higher – or at least not much lower – in Q3. And once velocity turns, time has run out. I am reminded of an old quote from Milton Friedman, from his book Money Mischief: Episodes in Monetary History.
“When the helicopter starts dropping money in a steady stream – or, more generally, when the quantity of money starts unexpectedly to rise more rapidly – it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long-run desired balances, partly out of inertia; partly because they may take initial price rises as a harbinger of subsequent price declines, an anticipation that raises desired balances; and partly because the initial impact of increased money balances may be on output rather than on prices, which further raises desired balances. Then, as people catch on, prices must for a time rise even more rapidly, to undo an initial increase in real balances as well as to produce a long-run decline.” (p.36)
When this happens, stocks will take a beating. But it may be the final beating in this long, drawn out, secular bear. I guess it is far too early to say that, but I recently saw two news items that I have long been waiting for. The first is that CNBC is having ratings “issues,” and it is starting to get bad enough that the producers are thinking about “tinkering with primetime.” The second, which is clearly related, is that Maria Bartriromo is thinking of leaving business news to take her inestimable talents elsewhere.
As with commodities and inflation breakevens recently, a sine qua non for the start of a new bull market of substantial magnitude – not a 100% rally from the lows, but a 100% rally above the old highs – is that everyone stops thinking that stocks are smart and exciting investments, that they are “where it’s at,” and that all the cool people are buying stocks. And I have never been able to figure out how an environment sufficiently depressing to germinate a new bull market can occur if the cheerleaders are televised 24/7. Honestly, I had just about given up. While we still need cheap valuations and rotten sentiment to start a bull market (and we are very far from both of those standards in equities), a move towards general indifference among investors would be a good start.
 As the quote marks suggest, I don’t think that they will be right when you hear people declare that “stocks now offer good value relative to bonds again.” I think the people who use the “Fed model” tend to overprice stocks generally…and they tend to be much more diligent disciples of the model when yields are falling than when they are rising. When yields rise, they tend to say that stocks are better values than bonds because bond yields are going to rise, while when yields are low they tend to say that stocks are better values than bonds because of the current level of bond yields.
Ah, it is so nice to be in this illiquid period right before quarter-end, when interested parties can easily ramp up prices to where they need them to be in order to get good end-of-period marks. One would think this game would diminish somewhat, given the crusades against the LIBOR and possibly FX price-setting conspiracies, but there’s no conspiracy here. There’s no need for investors and dealers to discuss putting the stock market up; everyone knows it happens and everyone knows why. The hedgies who flush microcaps higher because they can ought to be stopped, but there’s no way to stop the general tendency, especially when you have very clear indications of when that trade is supposed to begin…such as when Fed officials show up and start chanting “stocks shouldn’t go down!” in unison.
For the last couple of days, Fed officials have been out in force saying that the “market overreacted.” (Mostly, they mean the bond market, but for many people “the market” equals “stocks” because they think CNBC is about “markets” rather than “stocks”.) Today, New York Fed President Dudley, Fed Governor Powell, and Atlanta Fed President Lockhart pursued the overreaction theory in separate speeches, echoing Minneapolis Fed President Kocherlakota’s sentiment from yesterday. Yes, yes, we all know that everyone else will treat that as a signal to get long again (both stocks and bonds) into quarter-end, but what it really shows is that utter cluelessness of the people in charge at the Fed. Powell said that “Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy.” Well, duh. As I pointed out a while ago – before the real selloff – such a virulent selloff was entirely to be expected at some point due to convexity demands. The most-virulent part of the selloff may have coincided with Bernanke’s statements last week, and that might have triggered some of the convexity selling, but the degree of selloff had nothing to do with the Fed.
Someone should tell these guys that not everything is controlled by the Fed. Sometimes, rates move for other reasons.
To be sure, the Fed is correct about the fact that their communication is helping to cause the volatility. But it isn’t because they haven’t been clear enough, or that what they said was misinterpreted. The problem is too much communication, and making the path of policy (and any inflections in that policy path) crystal clear. When policymakers are opaque about monetary policy, then investors change their opinions stochastically, at random intervals; when policymakers set off a flare for every minor change in the trajectory, all investors change positions simultaneously. Transparency not only doesn’t reduce volatility, it is a prescription for creating volatility.
Clarity on the fiscal and regulatory front, incidentally, is quite different. Volatility in business ventures is high enough already to ensure that entrepreneurs don’t have an incentive to get too far out over their skis no matter how clear the regulatory environment, and decisions made in a business context don’t have the hair-trigger half-life of decisions in financial markets. Uncertainty, when long-term decisions have to be made, impairs that decision-making. But uncertainty is good when decisions are easily reversible and the cause of volatility is that consecutive orders to sell aren’t spread out enough. For stable markets, you want buys and sells to come all jumbled up, rather than all the buys together or all the sells together. For maximum economic growth, you want risk-takers to have the ability to make long-term decisions with confidence.
So while equity markets have rallied as we approach quarter-end, I don’t think this rally will far outlast quarter-end, because there are just too many negatives at the moment for equities – high multiples, rising interest rates, softening global growth, a less-benign regulatory environment etc. The selloff in stocks was never very bad (compared to bonds), because there’s not the same kind of convexity problem in stocks, but it also has a lot further to go than bonds do.
Fixed-income markets have rallied along with stocks, with TIPS leading the way up as they led the way down. The interpretation here is different, because in the case of the bond market we are looking at the well-known phenomenon of convexity selling. My advice for fixed-income investors, from long and painful experience, is this: don’t jump in with both feet yet. These bounces are normal in this kind of flush. It does probably mean we are closer to the end of the flush than to the beginning, but usually you need a period of a couple of weeks of sideways action before you can start to retrace the “convexity selling” damage and get back to something like fair value.
The healing period is necessary because every prospective bond buyer knows (or should know) that there are large trapped sellers out there who are waiting to pitch bonds overboard (at the new, improved levels!) if there is any sign of further market weakness. The rally over the last few days is fast money, doing what they think the news is telling them to do, and they will be back out as quickly as they got in.
We’ll see what happens next week. On the one hand, dealers will have more ability to hold positions (although they’re not supposed to, under the Volcker Rule); on the other hand, quarter end will be past and any inclination to hold off to avoid making a bad situation worse will be past as well. It will still be fairly illiquid, with a half-day on Wednesday, the Independence Day holiday on Thursday, and then Payrolls on Friday. I suspect we will see a resumption of prior trends in fixed-income and equities – although I hasten to add as a reminder that there will eventually be a rally off these rates. I just don’t think we’ve exhausted all of the sellers yet.