Let us begin with this: there is nothing inherently healthy about a series of +2% and -2% days within a range.
Having some grey hair (just a little!) is helpful in times like these because markets go through repetitive phases and it helps to have some historical comparisons to be able to guide an investor. At the same time, experience can be limiting if we try to force everything we are seeing into a particular historical comparison.
So, for example, I never view with anything but amusement the charts of day-by-day comparisons between this year’s market action with, say, that of 1929. Or, as another example I have seen: comparing a market to the Nikkei crash in the early 1990s. These are interesting an amusing market parallels, but there is no road map to markets. There is only a contour map.
The contours of this market are reminiscent to me of the end of the tech-led bull market in 2000. The valuation parallels are obvious, but I am not talking about that. In 2000, as the market crested in March and began to head lower, we started to have very large overnight moves – sometimes higher, sometimes lower – followed often by a sharp open, directionless trading during the day, and often a sharp move at the close. This was the signature of fast money, which tends to get more timid during the daylight but which enjoys monkeying about with buy and sell stops overnight. In general, as the market headed lower, it seemed like Mondays tended to be pretty good, and Fridays tended to be pretty bad as no one wanted the weekend risk. There was a lot of volatility, and some spectacular up days. But month after month, the market was more likely to end the month lower than it began.
I think we are in that mode again, although it is hard to tell if we have anything like that kind of bear market ahead of us. Certainly, we can make that point valuation-wise. Also, interest rates have much more room to move higher from here than to move lower. While I think the economy is slowing, and any Fed action is likely to be small, tentative, and probably delayed, my point is that interest rates are not likely to provide a following wind to valuations.
Indeed, while nominal interest rates are still locked near 2% on the 10-year note, real interest rates are near the highest levels in five years (see chart of 10-year real interest rates, source Bloomberg).
The flip side of stable nominal interest rates and rising real rates, of course, is declining inflation expectations. By our calculations, the market is currently implying core inflation to be below the Fed’s target for at least a decade. And this is despite the fact that, measured by median inflation, it is already at target.
I once believed that the Fed could not really control long-term interest rates, although at least in principle they can control Treasury rates like they did in WWII, by simply buying or selling whatever it takes to keep rates at their target (it was easier then, as the market was a lot smaller!). And I guess that, deep in my gut, I still believe that. But I must admit that the evidence that they can control nominal interest rates, at least in normal times (that is, when the weight of the market doesn’t strenuously disagree), is starting to look pretty strong. There is absolutely no rationale for 10-year nominal interest rates at 2% in an environment where real interest rates are 0.65%, current inflation is 2.3%, and there is a large amount of money in circulation – with no plans in place to drain it.
(For anyone claiming a fear of deflation, I just shake my head in disbelief. Choose: Do you want to be a monetarist, in which case you have to construct a case for deflation from 6+% money growth and money velocity that is already at levels below any previously measured; or do you want to be a Keynesian and explain how you get deflation with unemployment at 5.1%? The third way is hand-waving, claiming that large amounts of debt lead mystically to deflation. But large amounts of public debt have never led to deflation in the past, and there is no obvious mechanism for it to do so.)
My reading of the contour map suggests a market valley ahead. It is a deep valley, but the good news is that there is a mountain on the other side of it. There always is.
I may have the lay of the land wrong, but I have been over this ground before. Watch your step.
Here is a quick follow-up on yesterday’s column, along with an administrative note (at the end). Yesterday, I noted there that momentum investors will begin to lose interest in being long equities as the year-over-year price return goes towards zero. I thought of another way to illustrate the same point, which maybe gets to something more like the average investor thinks.
The average “retail” investor wants big returns, but has a very non-linear response to losses. The reason that individual investors as a whole tend to under-perform institutional investors is that the former tend to exaggerate the effect of losses while underestimating the probability of losses. So, what tends to happen is that individual investors are perennially surprised by negative equity returns (don’t feel bad – financial media is set up to reinforce this bias), and react harshly to mildly negative returns – but not harshly enough to significantly negative returns.
So, the chart below shows a simple calculation of the probability of an equity loss over the next twelve months assuming that the expected return is just the return of the last 12 months, and the standard deviation of the return is the VIX (and assuming distributions are normal…just to complete the list of improbable assumptions). This doesn’t seem unreasonable with respect to assessing a typical investor’s expectations: returns should continue, and volatility is forward-looking.
Maybe it’s just me, but in these terms it seems more amazing. For much of the last few years, the trailing 12 month return was so high that it would take around a one-standard-deviation loss (16% chance) to experience a negative year – if, that is, we use prior returns to forecast future returns. In general, that’s a very bad idea. However, I can’t argue that this naïve approach has failed over the last few years!
What is the trigger that makes investors want to get out? After years of gains are investors going to act like they are “playing with house money” and wait until they get actual losses before they get jittery? Or will a 30-40% subjective chance of loss be enough for them to scale back? I think that this way of looking at the same picture we had yesterday seems much more promising for bulls. But, again, this is only true if valuation doesn’t matter. Stocks look less scary this way…but this is probably not the right way to look at it!
**Administrative Note – I have just agreed to write a book for a terrific publisher. The working title is “What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind.” I am very excited about the project, but it is a lot of work to turn the manuscript out by late August for publication in the fall. My posts here had already been more sporadic than they used to be, but now I actually have an excuse! If you would like to be on the notification list for when the book is published, simply send an email to WWWM@enduringinvestments.com and I will put you on the list!
This week, I am participating in a school-style debate at the Global Fixed Income Institute’s conferences in Madrid where the question before the house is whether or not inflation will resurface in major world economies in the next five years. As you might imagine, I feel that my part of the debate is the easy part, especially as inflation is pointing higher in the US and core inflation just surprised higher in Europe. However, I am sure the other side feels the same way.
The Institute is interested in this discussion partly to illuminate the question of whether the substantial rise in yields over the last three months or so in all developed bond markets (see chart, source Bloomberg, showing 10y yields in US, UK, Germany and Japan) is indicative of a return of fears of inflation.
The ironic part of this is that I do not believe that the rise in yields has much if anything to do with the expectation for higher inflation. Partly, it is due to a subtle sea change in the way investors are thinking about the prospects for central bank policy – to wit, the possibility (which I see as slim) that the Fed chooses to raise rates meaningfully above zero in the next year, starting in September. But to some degree, the market has been discounting higher forward rates for a very long time. It has been consistently wrong on that point, but the steeply sloped yield curve (the 2y/10y spread hasn’t been flatter than 120bps since early 2008 – see chart, source Bloomberg) implies higher forward rates.
The rise in yields, in my view, is partly related to the prospect for changes in central bank policy, but also partly (and more sinisterly) related to the continuing intentional destruction by policymakers of the ability of large banks and dealers to make markets. We see worse liquidity in more and more markets almost by the day (as predicted five years ago in this space, for example here and here, as well as by many other observers). Less liquid markets tend to trade with more volatility, as it gets harder to move institutional size, and at lower prices since holders of assets need to factor in the difficulty of selling a position. Higher yields are going to happen in any event, and when institutional holders of bonds decide to diversify into commodities or into other real assets, interest rates could rise quickly depending how quickly that meme spreads. Of course, the same is true of equities, and commodities. Asset-allocation shifts will get messier.
I actually think this isn’t a bad time tactically to enter long positions in fixed-income. The Fed isn’t going to be as aggressive as people expect; also, bonds will get some support from investors fleeing fading momentum in stocks. The chart below (source: Bloomberg; Enduring Investments calculations) shows the 52-week price change in stocks. This is one measure of momentum, and a very important one as lots of investors look at their returns in annual chunks. Incredibly, since the latter part of 2012 investors have always been able to see double-digit returns from stocks when they looked in the rear-view mirror. Today, that number is 7.5%.
That’s still a terrific real return of more than 5%, but (a) many investors have very screwy return expectations, (b) many investors are well aware that they’ve been living on borrowed time with a liquidity-inspired rally, and (c) certain quantitative investors place significant weight to momentum, over value, in their investment models.
It’s just another red flag for stocks, but it has become passé to point them out. From the standpoint of a bond investor, though, this is good news because all of those equity owners, when they decide to take their chips off the table, will become bond buyers.
And when that happens, the liquidity issues in fixed-income might cut the other way for a while.
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.