I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.
But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.
If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).
But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.
What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.
So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.
Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.
What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.
I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.
Surprisingly, markets are treading water here. The dollar, interest rates, and stocks are all oscillating in a narrow range. In some ways, this is surprising. It does not shock me that interest rates are fairly boring right now, with the 10-year yield trading almost exclusively within 25bps of 2% since November. Market participants are divided between those who see the Fed’s cessation of QE as indicative that prices should decline to fair market-clearing levels (that is, higher yields) and those who see weakness economically both domestically and abroad. There is room for confusion here.
I am similarly not terribly shocked that the dollar is consolidating after a long run, especially when part of that run was fueled by the popular delusion that the Federal Reserve had suddenly become extremely hawkish and would preemptively hike rates before convincing signs of inflation arose. I am hard-pressed to think of a time when the Fed pre-emptively did anything, but that was the popular belief in any event. Now that it is becoming clear that a hike in rates in June is about as likely as the possibility that the Easter Bunny will deliver eggs at the same time, dollar traders who were relying on widening interest rate differentials are pausing to take stock of the situation. I will say that it certainly seems plausible to me that the dollar’s rally will continue for at least a little while, due to the volatility coming our way as the Greek drama plays out, but the buck is not an automatic buy either. Money growth in the U.S. continues to outpace money growth in most other economies (see chart, source Bloomberg), although it is a much closer thing these days.
An increase in relative supply, if the demand curves are similar, should provoke a decrease in relative price. Unless you believe that the Fed isn’t just going to increase rates but is also going to shrink its balance sheet so that money growth abates eventually, it is hard to envision the dollar launching continuously higher. More likely is that as more and more currencies see their supplies increase, the exchange rates meander but the whole kit-and-kaboodle loses ground to real assets.
One of those real assets is housing. An underpinning to my argument, for several years running now, that core prices were not going to be deflating any time soon was the observation that housing prices (and hence rents, with a lag) have been rising rapidly once again. The deceleration in the year/year growth rates in 2014 was a positive sign, but the increase in prices in 2012 and 2013 is still pressing rents higher now and any sag in rents is yet to be felt. However, today’s release of FHA price index data as well as the Existing Home Sales report suggests that it is premature to expect this second housing bubble to unwind gently. The chart below is the year/year change in the median price of existing homes (source: Bloomberg). The recent dip now seems to have been an aberration, and indeed the slowdown in 2014 may have merely presaged the next acceleration higher.
And that bodes ill for core (median) price pressures, which have been steady around 2.2% for a while but may also be readying for the next leg up. Review my post-CPI summary for some of the fascinating details! (Well, fascinating to me.)
This doesn’t mean that I am sanguine about growth, either domestic or global, looking forward. I thought we would get out of 2014 without a recession, but I am less sure about 2015. Europe is going to do better, thanks to weaker energy and a weaker currency (although the weaker currency counteracts some of the energy weakness), but the structural problems in Europe are profound and the exit of Greece will cause turmoil in the banks. But US growth is in trouble: the benefit from lower energy prices is diffuse, while the pain from lower energy prices is concentrated in a way it hasn’t been in the past. And the dollar strength pressures company earnings, as we have seen, on a broad basis. And that’s where it is a little surprising that we are seeing water-treading. It gets increasingly difficult for me to figure out what equity buyers are seeing. Profits are flattening out and even weakening, and they are already at a very high level of GDP so that any economic weakness is going to be felt in profits directly. Furthermore, I find it very interesting that the last time actual reported profits diverged from “Kalecki Profits” corresponded to the last equity bubble (see chart, source Bloomberg).
“Kalecki Profits” is a line that computes corporate profits as Investment minus Household Savings minus Government Savings minus Foreign Savings plus Dividends. Look up Kalecki Profit Equation on Wikipedia for a further explanation. The “Corp Business Prof After Tax” is from the Federal Reserve’s Flow of Funds Z.1 report and is measured directly. The implication is that if companies are reporting greater profits than the sum of the whole, then the difference is suspect. For example, leverage: by increasing financial leverage, the same top line creates more of a bottom line (in either direction). The chart below (source: Federal Reserve; Enduring Investments analysis) plots the 1-year percentage change in business debt outstanding (lagged 2 quarters to center it on the year in question) versus the difference between the two lines in the prior chart.
We might call this “pretty cool,” but in econometrics terms this is merely an explanatory relationship. That is, it doesn’t really help us other than to help explain why the two series diverge. It doesn’t, for example, tell us whether Kalecki profits will converge upwards to reported profits, or whether reported profits will decline; it doesn’t tell us whether it is a decline or deceleration in business debt outstanding that prompts that convergence or whether something else causes both things to happen. I think it’s unlikely that the divergence in the two profit measures causes the change in debt, but it’s possible. I will say that this last chart makes me more comfortable that the Kalecki equation isn’t broken, but merely that it isn’t capturing everything. And my argument, for what it is worth, would be that business leverage cannot increase without bound. At some point, business borrowing will decline.
It does not look like that is happening yet. I have been reading recently about how credit officers have been declining credit more frequently recently. That may be true, but it isn’t resulting in slower credit growth. Commercial bank credit growth, according to the Fed’s H.8 report and illustrated below, continues to grow at the fastest y/y pace since well before the crisis.
If credit officers are really declining credit more often than before, it must mean that applications are up, or that the credit is being extended on fewer loans (that is, to bigger borrowers). Otherwise, we can’t square the fact that there’s rapid credit growth with the proffered fact that credit is being declined more often.
There is a lot to sort through here, but the bottom line is this: I have no idea what the dollar is going to do. I am not sure what the bond market will do. I have no idea what stocks will do. But, if I have to invest (and I do!), then in general I am aiming for real assets and avoiding financial assets.
Retail Sales figures today were weak. Retail Sales ex-Auto and Gas (I usually just look ex-auto, but then they look really, really bad because of how far gasoline has moved) just recorded the two worst numbers (0.0% and 0.2%) in a year.
Retail sales are volatile, so one shouldn’t get too exercised by a couple of weak figures. Except for the fact that we also know that overseas sales are going to be suffering, thanks to the strength of the dollar. The disinflationary tendency imparted by a strengthening dollar is mild, and takes some time to be evident in the figures. However, the effect on overseas sales tends to be more rapid, and the effect on earnings more or less instantaneous (because earnings need to be translated back into the reporting currency).
So it isn’t just the weakness retail sales that should give an investor pause here. It is difficult to sell stocks in an environment of abundant liquidity, but perhaps this chart (Source: www.Yardeni.com) is one reason to do so.
I am not a fan of Yardeni’s analysis, as a general rule, but this is a great chart package showing the evolution of earnings estimates over time.
I understand that we have become conditioned to buy stocks on every dip, especially when the world’s central banks continue to supply boundless money to the system – an approach which, miraculously, seems to have no downside (leaving us to wonder how much better off the poor benighted peoples of last century would have been if central banks had only discovered this elixir earlier). And I am no bolder than the rest of you, so I won’t short stocks either.
But explain to me why the Fed is going to tighten? Headline inflation is low; core PCE inflation is low; even the measure that Dallas Fed President Fisher prefers (Trimmed-Mean PCE) is low. I have pointed out how the better measure, Median CPI, is actually near the post-crisis highs and is right around the Fed’s target, but if we are taking a vote then I lose. Market-based inflation expectations have recently rebounded, and will continue to do so, but remain very low. Growth appears to be weakening, although not yet alarmingly so. Finally, foreign central banks are all easing, which is one big reason the dollar has risen as it has. I have difficulty with the idea that with all of these arguments, the Federal Reserve is going to choose now to pull back on the reins, simply because they have sorta hinted about it previously.
Incidentally, any impact on growth from the strike over the coming long weekend at West Coast ports won’t help the argument to ease. Nor will the ongoing strike at nine US oil refineries (the biggest strike of oil workers since 1980). For all of these reasons, I don’t think the Fed is going to tighten any time soon. I do believe that US stocks are rich compared to European stocks for example, and rich on an absolute basis, but if I were going to play the short side because of the earnings estimates revisions, I would do so with options.
Money: How Much Deflation is Enough?
Once again, we see that the cure for all of the world’s ills is quantitative easing. Since there is apparently no downside to QE, it is a shame that we didn’t figure this out earlier. The S&P could have been at 200,000, rather than just 2,000, if only governments and central banks had figured out a century ago that running large deficits, combined with having a central bank purchase large amounts of that debt in the open market, was the key to rallying assets without limit.
That paragraph is obviously tongue-in-cheek, but on a narrow time-scale it really looks like it is true. The Fed pursued quantitative easing with no yet-obvious downside, and stocks blasted off to heights rarely seen before; the Bank of Japan’s QE has added 94% to the Nikkei in the slightly more than two years since Abe was elected; and today’s announcement by the ECB of a full-scale QE program boosted share values by 1-2% from Europe to the United States.
The ECB’s program, to be sure, was above expectations. Rather than the €50bln per month that had been mooted over the last couple of days with little currency-market reaction, the ECB pledged €60bln. And they promised to continue until September 2016, making the total value of QE around €1.1 trillion. (That’s about $1.3 trillion at today’s exchange rate, but of course if it works then it will be much less than $1.3 trillion at the September 2016 exchange rate). To be sure, a central bank always has the prerogative to change its mind, but on the risks of a sudden change in policy please see “Swiss National Bank”. It really is remarkable that Draghi was able to drag the Bundesbank kicking and screaming into this policy choice, and it is certain to end the threat of primary deflation in Europe just as it did in the U.S. and in Japan. It will likely also have similar effects on growth, which is to say “next to nothing.” But in Europe, deflation risks stemming from slow money growth had been a risk (see chart, source Bloomberg).
Interestingly, y/y money growth had already been accelerating as of late last year – the ECB releases M2 with a very long lag – but this puts the dot on the exclamation point. The ECB has said “enough!” There will be no core deflation in Europe.
Commodities: How Much Deflation is Enough?
Last week, in “Commodities Re-Thunk” and “Little Update on Commodities Re-Thunk”, I presented the results of using a generalization of the Erb & Harvey approach to forecast expected long-term real returns for commodities. It occurred to me that, since I have previously played with long-term real equity returns, and we have the real yield on 10-year TIPS as well, that it would be interesting to see if using these figures might produce a useful strategy for switching between assets (which doesn’t change the fact that I am a long-term investor; this is still based on long-term values. We merely want to put our assets in whatever offers the best long term value at the moment so as to maximize our expected long-term return).
The answer is yes. Now, I did a more-elegant version of what I am about to show, but the chart below shows the results of switching 100% of your assets between stocks, commodities, and TIPS based on which asset class had the highest expected real yield at a given month-end. Each line is an asset class, except for the blue line which shows the strategy result.
The labels at the top show the asset class that dominated for a long period of time. In 2005 there were a couple of quick crossovers that had little impact, but by and large there were three main periods: from 1999-2005, commodities offered excellent expected real returns; from mid-2005 through early-2008 the strategy would have been primarily in TIPS, and subsequent to that the strategy would have been primarily in equities. Fascinating to me is that the overall strategy does so well even though it would have been invested in equities throughout the crash in 2008. The crash in commodities was worse.
Now what is really interesting is that there is a vertical line at the far right-hand side of the chart. That is because at the end of December, the expected real return to commodities finally exceeded that of equities for the first time in a very long time. For this “selling out” strategy, that means you should be entirely out of stocks and TIPS and entirely in commodities.
As I said, that is the coarse version of this approach. My more-elegant version optimized the portfolio to have a constant expected risk in real terms. It was much less risky as a result (10.5% annualized monthly standard deviation compared to 15.5% for the strategy shown above), had lower turnover, but still sported returns over this period of 9.5% compounded compared to 11.2% for the strategy above. I am not, in other words, suggesting that investors put 100% of their assets in commodities. But this method (along with lots of other signals) is now suggesting that it is time to put more into commodities.
Balls: How Much Deflation is Enough?
Being a football fan, I can’t keep from weighing in on one mystery about deflate-gate (incidentally, why do we need to put ‘gate’ on the end of every scandal? It wasn’t Water-gate, it was the Watergate Hotel that proved Nixon’s undoing. “Gate” is not a modifier). Really, this part isn’t such a mystery but I have seen much commentary on this point: “How did the balls get deflated during the game since they were approved before the game?”
The answer is really simple in the real world: the official picked up one of the balls, said “fine”, and put them back in the bag. He has a million things to do before the championship game and in years of refereeing he has probably never found even one ball out of spec. This sort of error happens everywhere there are low reject rates, and it’s why good quality control is very difficult. (Now, if you fired the ref every time a bad ball got through, you damn betcha those balls would be measured with NASA-like precision – which is perhaps a bad metaphor, since similar issues contributed to the Challenger disaster). The real mystery to me is: if the Patriots truly think they are the better team, why would they cheat, even a little? As with the CHF/EUR cross that we discussed yesterday, the downside is far worse than the gain on the upside.
Or, is it? The NFL will have a chance to establish the cost of recidivism in cheating. Maybe the Patriots were simply betting that the downside “tail” to their risky behavior was fairly short. If the NFL wants to put a stop to nickel-and-dime cheats, it can do that by dropping the hammer here.
Serendipity often plays a role when I am considering a blog post. In this case, I wasn’t even planning a post but was updating old spreadsheets for current data to see how things have developed. In the past, I have documented how NYSE Composite volume has been falling fairly steadily since at least 2006. It is difficult to tell whether this is important or not, since some of this is due to the fact that more trading occurs off of the NYSE these days. Still, there was a significant drop-off in 2010 and 2011 and 2012 which seemed more than coincidental (2012 total volume was about half of the volume traded in 2008, in terms of shares, and probably lower than that in terms of volume).
In 2013, volume fell a small amount further. But I was interested to see that in 2014, NYSE volumes look to be just about exactly the same as they were in 2013 – for the first time in a long while, volumes have not declined.
But what was even more interesting to me was the pattern of volume over the course of the year. I put together the following chart to compare the rolling-20-trading-day volume for last year and this year.
You can easily see the increase in volume in the “taper tantrum” of May/June 2013, and the summer lull in both years. You can also see how volumes recovered in September and then fade into year end. But what stands out is how the summer was significantly quieter than in 2013, but since the end of September volumes have been quite high.
For fun, I decided to look at the data for 2006-2013 in its entirety (that’s all the data that I have). For each day, I computed the share of the year’s total volume and then averaged that across all eight years. By taking percentage of the total, I removed any tendency to overweight 2006’s much higher volume compared to 2013…it was the pattern I was looking for. Then, I computed a rolling-20-day sum. The line in blue below is the percentage of the year’s volume represented by any 20-day window ending on the day in question (since there are roughly 12.5 such windows in a year, we would expect 8% = 1/12.5 in a steady line if there was no seasonality). I then did the same thing for 2014 (but adjusting for the fact that we don’t know the year’s total volume yet).
Several things jump out as interesting. First is that there seems to be a general pattern that volumes generally decline after June. The summer volume swoon is mainly in August, there is a flurry of trading in September and early October, and then volume ebbs from there. Second, and more interesting at the moment, is that volumes in 2014 haven’t picked up just compared to 2013, but are quite a bit higher than the norm, and even quite a bit higher than for most of the rest of this year! By contrast, in 2013 the pattern was fairly normal except for the spike around the taper tantrum.
What causes me to scratch my head is the implication. There is no clear cause I can think of that would trigger a rise in equity trading volumes since mid-September. The end of the Fed’s taper was becoming clear, but I don’t know why that would trigger higher equity volumes. There haven’t been any unusual geopolitical events (at least, no more unusual than in any other year).
I am reluctant to declare this as yet another sign of a frothy and overbought equity market, with swelling participation at the highs. But I am open to the possibility.
The stock market, the bond market, the commodities markets (to a lesser extent), FX markets – they are all experiencing a marked increase in volatility.
Some observers want to call this bearish for equities, mainly because they already are bearish. This is a very bad reason. While really bad equity returns almost always occur coincident with a rise in volatility – the old maxim is that stocks go ‘up on the staircase and down on the escalator’ – that does not mean that volatility causes bad returns. Or, put another way, there are also periods of increased volatility that do not precede and are not coincident with bad returns.
However, there actually is a reason that increased volatility might lead to poor short- to medium-term returns, that isn’t based on technical analysis or spurious correlations. Moreover, a relatively new phenomenon (the rise of so-called ‘risk-parity’ strategies) is starting to institutionalize what was already a somewhat natural response to volatility.
In ‘risk-parity’ strategies, the weight of an asset class (or a security within an asset class, sometimes) is inversely proportional to the risk it adds to the portfolio. Generally speaking, “risk” here is defined as variance, because it is easy to estimate and there are markets where symmetrical variance trades – i.e., options markets. But what this means is that when volatility (sometimes realized volatility, and sometimes option “implied” volatility) rises in stocks, then risk parity strategies tend to be shedding equities because they look riskier, and vice-versa. Right now, risk parity strategies are likely to be overweight equities because of the long period of low realized and implied volatility (even though the valuation measures imply quite high risk in the sense most of us mean it, in terms of the probability of return shortfall). Risk parity strategies are probably superior to ‘return-chasing’ methodologies, but by being ‘risk-chasing’ they end up doing something fairly similar when they are all operating together.
Note that while risk-parity strategies are comparatively new – well, not exactly because it is an oldish idea, but they have only recently become a big fad – this general phenomenon is not. The natural response to greater equity market volatility is to pare back exposure; when your broker statement starts to swing around wildly it makes you nervous and so you may start to take some profits. This is also true of other asset classes but it seems to me to be especially true in equities. Nobody who gets involved in commodities is surprised at volatility: the asset class suffers from a midguided belief that it is terribly volatile even though commodity indices are just about exactly as volatile as equity indices over time. But equity investors, contrariwise, seem perennially surprised at 2% moves.
So, while the recent volatility doesn’t mean that a move lower in equities is assured, it increases the probability of such because risk-parity strategies (and other investors reacting nervously to overweights in their equity exposure) will begin to scale back positions in the asset class in favor of positions in other asset classes, probably mostly bonds and commodities. At this point it would be good for me to point out that only the very short-term volatility measures have moved up dramatically; the VIX is well off its bottom but only up to 18.8 and it has been there numerous times in the last few years (see chart, source Bloomberg). But the longer the volatility continues like we have seen it for the last week or two, the bigger the chances that the asset-allocation boxes start to make important shifts (and the quant hedge fund boxes will probably move a bit before those asset allocation boxes do).
As an aside, the tendency for asset allocation shifts to follow volatility shifts is not the reason that the VIX displays a strong inverse directionality. Neither is the main reason for this inverse directionality because the VIX is a “fear gauge.” The main reason is that the VIX weights near-the-money options more heavily than out-of-the-money options. Because options skews almost always imply more downside volatility for stocks than upside volatility, when the market declines it tends to bring more “high volatility” strikes into play and so part of the VIX increase in a down market is simply mechanical.
I am not calling for a sharp decline in stocks, nor for an extended decline in stocks. My position and view is as it has long been, that the prospect for attractive real returns from equities over the next 5-10 years is quite small and beaten handily by commodities’ prospective returns at that end of the risk spectrum. I don’t think that most investors (me included!) should swing asset allocations around frequently in response to technical indicators or such things as “momentum”, but rather should focus on evaluating expected long-term returns (which are somewhat predictable) and invest for value. And I must admit I also think that “risk-parity” is a clever marketing gimmick but a pretty absurd way to assemble a portfolio for almost everyone. My point here is to highlight one little-considered aspect of herd behavior, and how that herd behavior may have become more institutionalized as late, and to consider the risks that herd behavior may create.
 This in turn is not due so much from the tendency of markets to have more downside volatility than upside volatility, but from the fact that buying protective puts and selling “covered” calls are both considered “conservative” options strategies. So, out-of-the-money puts tend to be too expensive and out-of-the-money calls too rich.