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Gravity

April 7, 2014 1 comment

Is there anything different about the current downturn in stocks, already two whole days old?

It is difficult to get terribly concerned about this latest setback when in one sense it is right on schedule. The modest down-swings have occurred at such regular intervals that the chart of the VIX looks quite a bit like an EKG (see chart, source Bloomberg).

vixekg

A rise in the VIX to the 19-21 zone happens approximately quarterly, with minor peaks at the same intervals. Eerie, ain’t it?

So is there anything particularly ominous about the current pullback? There is no clear catalyst – I am reading that the selloff is being “led” by tech shares, but the tech-heavy indices look to me as though they have fallen similarly (adjusted for the fact that they have higher vol to begin with. The S&P is down around 3%, and the NDX is down 4.6% over the same period. To be sure, the NDX’s recent peak wasn’t a new high for the year, and it has penetrated the 100-day moving average on the downside, but it doesn’t look unusual to me.

Nor do the economic data look very different to me. The Payrolls number on Friday was in line with expectations, and beat it comfortably when including the upward revisions to the prior two months. The generation of 200k new jobs is not exciting, but it is pretty standard for a normal expansion. My main concern had been that the “hours worked” figure in the employment report had plunged last month, but it rebounded this month and assuaged my concerns (although Q1 growth is probably still going to be low when it is reported later this month, it will be reasonably explained away by the weather).

Two things are different now from previous setbacks, but one is positive and one is negative. They are related, but one is somewhat bullish for the economy and the other is somewhat bearish for risky assets.

We will start with the negative, because it segues nicely into the positive. It is nothing new, of course, to point out that the Fed is tapering, and will be steadily continuing to taper over the next several meetings. Despite the well-orchestrated chorus of “tapering is not tightening,” such Fed action clearly is a “negative loosening” of policy – if you don’t want to call that tightening, then invent a new language, but in English it is tightening.

Now, I never want to short sell the notion that President Clinton taught us all, including market denizens, that if you say something ridiculous often enough, it comes to be regarded as the truth. At times, the market meme clearly has kept the market moving upward even though rational analysis argued for a different outcome. For example, in the early part of the equity bear market that started in 2000, the market meme was that this was a “corporate governance” crisis or a “tech selloff”, when in fact it was a broad-based and deep bear market. In the more-recent credit crisis, it started off as a “subprime” crisis even though it was clearly much more, from the beginning.

So I am loathe to bet about how long markets can run on air before the market meme falters. The challenge, obviously, is being able to distinguish between times when the market meme is correct; when the market meme is incorrect, but harmless; and when the market meme is incorrect, and obfuscating a deeper, more dangerous reality.

“Tapering is not tightening” is one of those thoughts that, while not as serious as “this is a corporate governance problem” or “this is about subprime,” is also clearly mistaken, and possibly dangerous. The reason it might actually be dangerous is because the effect of tightening doesn’t happen because people are thinking about it. Monetary policy doesn’t act primarily through the medium of confidence, any more than gravity does. And, just as gravity is still acting on those aboard the “Vomit Comet,” monetary tightening still acts to diminish liquidity (or, more precisely, the growth rate of liquidity) even when it appears to be doing nothing special at the moment.

The eventual effect of diminished liquidity is to push asset prices lower, and (ironically) also may be to push money velocity higher since velocity is correlated with interest rates.

Now, don’t be overly alarmed, because even as Fed liquidity provision is slowing down there is no sign that transactional money growth is about to slow. Indeed (and here is the positive difference), commercial bank credit has begun to rise again after remaining nearly static for approximately a year (see chart, source Enduring Investments). (As an aside, I corrected the pre-2010 part of this chart to reflect the effect of recategorizations of credit as of March 2010 that caused a jump in the official series).

cbc_mb

If you look carefully at this chart, by the way, you will see something curious. Notice that during QE2, as the monetary base rose commercial bank credit stagnated – and then began to rise as soon as the Fed stopped buying Treasuries. It rose steadily during late 2011 and for most of 2012. Then, commercial bank credit began to flatline as soon as the Fed began to buy Treasuries again (recall that QE3 started with mortgages for a few months before the Fed added Treasuries to the purchase order), and began to climb again at just about the same time that the taper began in December.

I don’t have any idea why these two series should be related in this way. I am unsure why expanding the monetary base would “crowd out” commercial bank credit in any way. Perhaps the Fed began QE because they forecast that commercial bank credit would flatline (in QE1, credit was obviously in decline), so the causality runs the other way…although that gives a lot of credit to forecasters who have not exhibited much ability to forecast anything else. But regardless of the reason, the fact that bank credit is expanding again – at an 8% annualized pace over the last quarter, the highest rate since 2008 – is positive for markets.

Of course, an expansion and/or a market rally built on an expansion of credit is not entirely healthy in itself, as to some extent it is borrowing from the future. But if credit can expand moderately, rather than rapidly, then the “gravity” of the situation might be somewhat less dire for markets. Yes, I still believe stocks are overvalued and have been avoiding them in preference to commodities (the DJ-UBS is 7.3% ahead in that race, this year), but we can all hope to avoid a repeat of recent calamities.

The problem with that cheerful conclusion is that it depends so much on the effective prosecution of monetary policy not just from the Federal Reserve but from other monetary policymakers around the world. I will have more to say on that, later this week.

Tempest in a Microsecond

April 1, 2014 3 comments

News flash! High-frequency trading (HFT) is happening!

The “60 Minutes” piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even “60 Minutes” has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently the FBI is now suddenly concerned over this “latest blemish.”

Again, this is hardly new. Here is the record of Google search activity of the term “high frequency trading.”

Capture

So why is it that, for years, most of the world knew about HFT and yet no one did anything about it?? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?

To put it simply: this is a crime where it isn’t clear anyone is being hurt, Lewis’s panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let’s be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as “the big banks buy the stock and then the retail investor buys it 5%-10% higher.” This would be a problem, if that’s what was happening. But it isn’t. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from – if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That’s not a loss to you – it’s a gain.

High frequency traders aren’t just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see “What Do We Know About High Frequency Trading?” from Charles Jones of the Columbia Business School.

So, if you’re being ripped off, it’s far more likely that you’re being ripped off by commissions than that you’re being ripped off by the robots.

But let’s suppose that the robots do push prices up 5% higher than they would otherwise be. Either that’s the right price to pay…in which case they made the market more efficient by pushing it nearer to fair value…or it’s the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that’s you, then the robots aren’t the problem – you are. Stop giving them a greater fool to sell to, and they will lose money.

Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than “you’re getting ripped off by robots”: yes, the market is full of very, very smart people. And yet, on average returns cannot be above-average! This means that if you don’t know everything there is to know about TSLA and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don’t have to have inside information to beat you – they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don’t know everything there is to know about TSLA. I am the sucker at that table.

Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren’t always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of “client first;” although that doesn’t mean the culture is “me first,” it means the client’s needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.

And I don’t really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.

The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size – often billions – on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.

Ex-Communication Policy

March 19, 2014 6 comments

Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.

To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.

The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.

Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.

Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.

Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.

Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.

Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…

A Growling Bear is Bad for Everyone

March 3, 2014 3 comments

I was convinced last week that the stock markets, as well as the inflation markets, were underestimating the importance of the Ukrainian conflict. I thought that I had a little more time to write about that before the crisis came to a head, which turned out not to be true. However, it seems that markets are still underestimating the importance of the Ukrainian conflict.

About the best possible outcome at this point is that Putin stops with an annexation of the Russian equivalent of the Sudetenland, with the episode merely pointing out (again) the impotence of Western leaders to respond to Russian aggression but not actually damaging much besides our pride. Even in that case, to me this signals a dangerous new evolution in the development of Russia’s relationship with the West. But the worse cases are far worse.

The angry fist-shaking of the old democracies is moderately amusing; less amusing are the stupid threats being made about economic sanctions. Let us stop for a minute and review what the West imports from Russia.

According to this article from Miyanville (from early 2013), Russia is the world’s largest producer of chromium (30% of the world market), nickel (19%), and palladium (43%), and is the second-largest producer of aluminum (10%), platinum (12%), and zirconium (19%). It has the largest supply of natural gas (although we are gaining rapidly), the second largest supply of coal, and the 8th-largest endowment of crude oil. The Ukraine itself is the third largest exporter of corn and the sixth-largest exporter of wheat. Meanwhile, the top 10 exports to Russia include engines, aircraft, vehicles, meat, electronic equipment, plastics, live animals, and pharmaceuticals.

So, we are fundamentally exporting “nice to haves” while importing “must haves.” Who needs trade more?

Let me make a further, suggestive observation. I maintain that the tremendous, positive trade-off of growth and inflation (high growth, low inflation) that the U.S. has experienced since the 1990s is at least partly a story of globalization following the end of the Cold War. Over the last couple of years, I have grown fond of showing the graph of apparel prices, which shows a steady rise until the early 1990s, a decline until 2012 or so, and then what appears to be a resumption of the rise. The story with apparel is very clear – as we moved from primarily domestically-sourced apparel to almost completely overseas-sourced apparel, high-cost production was replaced by low-cost production, which dampened the price increases for American consumers. It is a very clear illustration of the “globalization dividend.”

Of course, mainstream economic theory holds that the inflation/growth tradeoff suddenly became attractive for the U.S. in 1991 or so because inflation expectations abruptly became “anchored.” Why look for a good reason, when you can simply add a dummy variable to an econometric model??

But suppose that I am right, and the fall of the Soviet Union in 1991 played a role in the terrific growth/inflation tradeoff we have experienced since then. Incidentally, here are some data:

  • Cold War (1963, immediately following the Cuban missile crisis, until the fall of the USSR): U.S. annual growth averaged 3.4% (not compounded); inflation averaged 5.4%. The DJIA rose at a compounded nominal rate of 5.6%.
  • Post-Cold-War (1991-2013, including three recessions): U.S. annual average growth 2.6%; annual average inflation 2.4%. The DJIA rose at a compounded nominal rate of 7.5%.

This is not to say that globalization is about to end, or go into reverse, necessarily. It is to illustrate why we really ought to be very concerned if it appears that the Bear appears to be back in expansion mode – whether it is something we can prevent or not. And it is also to illustrate why putting a firm end to that expansion mode, rather than sacrificing global trade and cheap energy to a resurrection of the Cold War, is probably worth considering.

I still don’t think that equity investors understand the significance of what is going on in the Ukraine.

What Do You Care What Other People Think?

February 18, 2014 3 comments

In reflecting, over this weekend, about the markets of the last week, I wonder if we haven’t seen a subtle – and subtly disturbing – shift in the markets’ behavior.

Before the Fed began the taper, and even after the Fed began the taper but before we were really sure they intended to maintain it through at least mild economic wiggles, bad news was treated as good news in the markets (both stocks and bonds) because it implied more QE, or a longer QE, or a slower taper. This was lamentable because it suggested that the Fed was more important than global market fundamentals, but understandable at some level. All other forces summed to just about zero, so one big institution with a very big hammer was able to make the market vibrate the way policymakers wanted it to. So, while lamentable, this behavior was at least understandable.

But recently, as the Fed has started ever-so-slowly receding to the back pages, we have started to see behavior that is less unusual, but still not “normal.” Over the last couple of weeks, despite manifestly weak data – from the Employment report to Thursday’s surprisingly weak Retail Sales data and Friday’s weak Industrial Production data (which would have been even weaker if it hadn’t been for the utilities sector humming away) – the stock market has continued a marked rally. However, this is something we’ve seen before: a rally not because weak data would precipitate bullish policy, but because the weak data had a ready excuse in poor winter weather. In this sort of environment, good news is really good news, and bad news can be discounted (even if the cause to do so is sketchy).

There also is some “kitchen sinking” going on even among economists. “Kitchen sinking” refers to when a company takes advantage of a bad quarter to write off all sorts of expenses, all attributed to the “one time event” whether due to it in fact or not. This makes it far easier to score great earnings in the future. It’s understandable (if of questionable legality) in corporate accounting, but when economists do it then we should look askance. Without my naming names: on Friday one well-known macroeconomic advisor told clients that cold weather in November, December, and January will lower Q1 GDP by 0.4%. I am not sure how November’s weather would lower GDP in Q1…in fact, it seems to me that by lowering Q4 GDP, bad weather in December would tend to increase GDP in Q1 because it would be building from a lower base. Whatever the reason for the forecast, though, it certainly lowers the bar for the actual Q1 GDP report and increases the odds of a stock market-bullish surprise (although that’s way out in April).

Much more than the former mode of taking weak data as good because it implied more liquidity from the Fed, this sort of thing – kitchen sinking by economists, and markets taking all news as either neutral or good – is a signature of unhealthy bullishness. The concern is that when the reasons to ignore bad news have passed, the market will not be priced at a level that can sustain actual bad news. And, unlike the QE-baiting, it is something we have seen before. It is a weaker signature, and it’s entirely emotional rather than the twisted but at least debatable reasoning that investors employed when bad news was Fed-good.

It seems almost unfair to continue to list anecdotal signs of frothy behavior, because it’s so easy to do so these days. One that sprang into view last week was the incredibly vitriolic response to the chart that has been making the rounds showing the parallel in equity market action between 1928-29 and 2012-14. For example, here was one objection, which was perhaps a reasonable objection … but note the tone. And this was just one example among many.

Come on, is it really so horrible, such a threat to civilization, to have someone trot out this chart? I will take either side of the argument with no acrimony. Personally, I don’t think it’s almost ever useful to think of the past as an exact roadmap (although if I ignored this chart, and the market did crash, I hate to think of how I would explain that insouciance to my clients after-the-fact), but I also don’t care if someone else does do so. Especially if it leads them to the right conclusion, and I happen to think that if investors start being cautious right now it is the right result, whether it happens because they were scared of a spooky chart or because they understand market valuation metrics.

But again: who cares? This is not a fact which is right or wrong – unlike, say, the claim that the government made a change to the CPI in the early 1980s which subtracts 5% from CPI every year. That is a verifiable statement, and it is demonstrably false. But saying “chart A looks like chart B” can’t possibly be wrong…it’s opinion! My concern isn’t about the chart; it is about the vehemence with which some people are attacking that opinion.

It is like I tell my daughter when someone calls her a dunderhead, or whatever the 7-year-old equivalent is these days. I ask “well, are you a dunderhead?” If the answer is yes, then you have bigger problems than what they’re calling you. If the answer is no, then as Feynman said what do you care what other people think? Similarly, if you’re bullish, what do you care if someone runs that chart? If it’s right, then you have bigger problems than the fact they’re running the chart. And if it’s wrong, then what do you care what they think?

Do Data Matter Again?

February 3, 2014 Leave a comment

In normal times, by which I mean before actions of the Federal Reserve became the only data point that mattered, the monthly ISM report was important because it was the first broad-based look at the most-recent month’s data.

Now that the Fed’s taper has begun – right about the time that the uncertainty of the impact of Obamacare implementation was at its peak, curiously enough – the ISM data seems to have taken on importance once again. I must say that I did not see that coming, but since guessing at the Fed’s actions every six weeks and ignoring all intervening data was so all-fired boring, I suppose I am glad for it. Looking at economic data and trying to figure out what is happening in the economy is more like analysis and less like being on The People’s Court trying to rule on a he-said, she-said case where the hes and shes are Federal Reserve officials. And that is welcome.

That being said, the January ISM report isn’t one I would necessarily place at the head of the class of importance, mainly because it is January. Still, it was an interesting one with the Manufacturing PMI dropping 5.2 points, matching the steepest decline since October 2008. The New Orders subindex plunged to 51.2 versus 64.4 last month, and Employment and Production indices also declined significantly. It’s clearly bad news, but I would be careful ascribing too much value to any January number – especially one based on a survey.

Also standing out in the report was the increase in the (non-seasonally adjusted) “Prices Paid” subcomponent, to 60.5. the jump was initially somewhat surprising to me because as the chart below – which I tweeted shortly after the number – seems to show, we have had a jump in Prices Paid that is not being driven by a concomitant jump in gasoline prices – and Prices Paid is predominantly driven by gasoline prices.

ismpric and gasoline

However, as I noted in that tweet, the Prices Paid index is measuring the rate of change of prices (the question posed to purchasing managers is whether prices are increasing faster, slower, or about the same as the month before), so just eyeballing it may not be enough. The chart below plots the 3-month change in gasoline prices versus the ISM Prices Paid subindex. What you can see is that the first chart is slightly deceiving. The change in gasoline prices has accelerated – back to zero after having been declining since February of 2013. And “unchanged” gasoline prices is roughly consistent with about 60 on the Prices Paid indicator. So, this isn’t as much of a surprise as it looked like, initially.

ismvsgas

Still, whether it was the data or because of continued concern about emerging markets (though the S&P fell nearly as far in percentage terms as did the EEM today, leaving open the question of which is following which), stocks didn’t enter February with much cheer. But never fear, I am sure there is “cash on the sidelines” that will come charging to the rescue soon.

The past week has given a great illustration of one important difference between the price behavior of equities and commodities. That is that stocks are negatively skewed and positively kurtotic, while commodities are positively skewed and negatively kurtotic. That is to say, in layman’s terms, that stocks tend to crash downward, while commodities more frequently crash upwards. This happens because what tends to drive severe movements in commodities is shortages, where the short-term supply curve becomes basically vertical so that any increase in demand pushes up prices sharply. Exhibit one is Natural Gas (see chart, source Bloomberg), where inventories were above normal as recently as October and now are the lowest in a decade.

natty

Exhibit two is Coffee (see chart, source Bloomberg), where drought in Brazil has lifted coffee prices 8-9% today and 35% from the five-year lows set in November. There’s an awful lot of coffee in Brazil, I understand, but there may be less this year.

coffee

In my view, stocks remain very expensive even after this quick 5.75% loss (-2.3% today). Obviously, less so! Commodities have outperformed stocks by basically remaining unchanged, but remain very cheap. Bonds have rallied, as money has shifted from stocks to bonds. This is fine, except that 10-year notes at 2.57% with median inflation at 2.1% and rising is not a position to own, only to rent. The question is, when investors decide that it’s time to take their profits in bonds, do they go to cash, back to equities, or to commodities? If you are one of the people mulling this very question, I have another chart to show you. It is the simple ratio of the S&P to the DJ-UBS (source: Bloomberg).

stockscomm

I think that makes where I stand fairly clear. If both stocks and commodities represent ownership in real property, and both have roughly the same long-term historical returns (according to Gorton & Rouwenhorst), then the ratio of current prices should be a coarse (and I stress coarse) relative-value indicator, right?

But let’s shift from the long-view lens back to the short view, now that a retreating Fed makes this more worthwhile. I am not sanguine about the outlook for stocks, obviously (and here’s one for the technicians: for the first time in years, exchange volume in January was higher than last year’s January volume). However, bulls may get a brief reprieve later this week when the Employment Report is released. Yes, it’s another January data point that ought to be ignored or at least averaged with December’s figure. And that’s the point here. Last month’s Employment Report showed only a 74k rise in Nonfarm Payrolls. That weakness was likely due to the fact that the seasonal adjustments (which dwarf the net number of jobs, in December and January) assumed more year-end and holiday hiring than actually occurred. But the flip side of that is that if fewer were hired in December, it probably means fewer were fired in January. Thus, I expect that the 185k consensus guess for new jobs is likely to be too low and we will have a bullish surprise on Friday. That might help the bulls get a foothold…but it is a long three trading days away.

Shots Fired

January 29, 2014 8 comments

This isn’t the first time that stocks have corrected, even if it is the first time that they have corrected by as much as 4% in a long while. I point out that rather obvious fact because I want to be cautious not to suggest that equities are guaranteed to continue lower for a while. Yes, I have noted often that the market is overvalued and in December put the 10-year expected real return for stocks at only 1.54%. Earlier in that month, I pointed out and remarked on Hussman’s observation that the methods of Didier Sornette suggested a market “singularity” between mid-December and January. And, earlier this month, I followed up earlier statements in which I said I would be negative on stocks when momentum turned and added that I would sell new lows below the lows of the week of January 17th.

But none of that is a forecast of an imminent decline of appreciable magnitude, and I want to be clear of that. The high levels of valuation make any decline potentially dangerous since the levels that will attract serious value investors are so far away. But that is not tantamount to forecasting a waterfall decline, which I have not done and will not do. How does one forecast animal spirits? And that is exactly what a waterfall decline is all about. Yes, there may be precipitating events, but these are rarely known in prospect. Sure, stocks fell sharply after Bear Stearns in the summer of 2007 liquidated two mortgage-backed funds, but stocks reached new highs in October 2007. What happened in mid-October 2007 to trigger the top? Here is a crisis timeline assembled by the St. Louis Fed. There is basically nothing in October 2007. Similarly, as Bob Shiller has documented, at the time of the 1987 crash there was no talk whatsoever about portfolio insurance. The explanation came later. How about March 2000, the high on the Nasdaq (although the S&P 500 didn’t top until September)?

What two of these episodes – 2000 and 2007 – have in common is that valuations were stretched, but I think it’s important to note that there was no obvious precipitating factor at the time. It wasn’t until well into the stock market debacle in 2007-08 that it became obvious (even to Bernanke!) that the subprime crisis wasn’t just a subprime crisis.[1]

Here is my message, then: when you hear shots fired, it isn’t the best idea to wait around to figure out why people are shooting before you put your head down. Because as the saying goes: if the enemy is in range, so are you.

And, although it may not end up being a full-fledged firefight, shots are being fired, mere days before Janet Yellen takes the helm of the Fed officially (which may be ominous since Fed Chairmen are traditionally tested by markets early in their tenure). Last night, Turkey was forced to crank up money rates by about 450bps, depending which rate you look at. When Argentina was having currency issues, it wasn’t surprising – when you have runaway inflation, even if you declare inflation to be something else, the currency generally gets hit eventually. And Russia’s central bank was established only in 1990. But Turkey, about 65% larger in GDP terms than Argentina, is relatively modern economically and has a central bank that was established in the 1930s and has been learning lessons basically in parallel with our Fed since the early 1980s. Heck, it’s almost a member of the EU. So when that central bank starts cranking up rates to defend the currency, I take note. It may well mean nothing, but since global economics has been somewhat dull for the last year or so (and that’s a good thing), it stands out as something different.

What was not different today was the Fed’s statement, compared to its prior statement. The FOMC decided to continue the taper, down to “only” $65bln in purchases monthly now. This was never really in question. It would have been incredibly shocking if the Fed had paused tapering because of a mild ripple in global equity markets. The only real surprise was actually on the hawkish side, as Minnesota Fed President Kocherlakota did not dissent in favor of maintaining unchanged (or increased) stimulus – something he has been agitating for recently. Don’t get too used to the Fed being on the hawkish side of expectations, however. As noted above, Dr. Yellen takes the helm starting next week.

The Treasury held its first auction of floating rate notes (FRNs) today, and the auction was highly successful. And why should they not be? They are T-bill credits that reset to the T-bill rate quarterly, plus 4.5bps. In the next few days I will post an article explaining, however, why floating rate notes don’t provide “inflation protection;” there has been a lot of misinformation about that point, and while I explained why this isn’t true in a post from May 2012 when the concept of the FRN program was first mooted, it is worth reiterating in more detail.

So we now have a new class of securities. Why? What constituency was not being sufficiently served by the existing roster of 1-month, 3-month, 6-month, and 1-year TBills, and 2 year notes?

I will ask another “why” question. Why is the President proposing the “myRA” program, which is essentially a way to push savings bonds (the basics of the program is that if you sign up and meet certain income requirements, the government will give you the splendid opportunity to put your money in an account that returns a low, guaranteed rate of interest). This is absolutely nothing new. You can already set up an account with http://www.TreasuryDirect.gov and have your employer make a payroll direct deposit to that account. And there’s no income maximum, and no requirement to ever roll it into an IRA. Yes, it’s true – with Treasury Direct, you will have to pay federal taxes on the interest, but the target audience for the myRA program is not likely to be paying much in the way of taxes so that’s pretty small beer.[2]

The answer to the “why” in both cases is that the Treasury, noticing that one regular trillion-dollar buyer of its debt is leaving the trough, is looking rather urgently for new buyers. FRNs, and a new way to push Treasuries on middle-class America.

Interest rates have declined since year-end, partly because equities have been weak, partly because some growth indicators have been weak recently, and partly because the carry on long Treasury securities is positively terrific. But the Treasury is advertising fairly loudly that they are concerned about whether they’ll be able to raise enough money, at “reasonable” rates, through conventional auctions. Both of these “innovations” cause interest payments to be pegged at the very short end of the curve, where the Fed has pledged to control interest rates for now, but I think interest rates will rise eventually.

Probably not, however, while the bullets fly.


[1] In a note to Natixis clients on December 4th, 2007, entitled “Tragedy of the Commons,” I commented that “M2 has grown only at a 4.4% annual rate over the last 13 weeks, and that’s egregiously too little considering the credit mess (not just subprime, as I am sure my readers are aware, but Alt-A and Prime mortgages, auto loans and credit cards too),” but the idea that the crisis was broader than subprime wasn’t the general consensus at the time by any means. Incidentally, in that same article I said “We have not entered a recession with core inflation this low in many decades, and this recession looks to be a doozy. I believe that by late 2008 we will be confronting the possibility of deflation once again. And, as in the last episode, the Fed will face a stark choice: if short rates don’t get to zero before inflation gets to zero, the Fed loses as they will never be able to get short rates negative,” which I mention since some people think I have always been bullish on inflation.

[2] I wonder how the money is treated for purposes of the debt ceiling. If the Treasury is no longer able to issue debt, then surely it won’t be able to do what amounts to issuing debt in the “myRA” program? So if they hit the debt ceiling, does interest on the account go to zero?

Get A Grip

January 26, 2014 6 comments

What I am about to write will probably not be terribly popular in this equity-centric culture of ours, but it needs to be said.

On a number of business news shows this weekend, I’ve heard about this week’s “equity market debacle.” Fox Business News on Saturday noted that “retirees depending on their savings are very nervous right now” because of “serious damage to portfolios after the big sell off this week.”

Get a grip, people!

To be sure, the 3% decline this week is the largest 5-day decline since June, but the real implication of that fact is that we have been in a frighteningly one-way market for a while now. I recently documented that we hadn’t had a drawdown of more than 5% from a previous peak since June 24th, and nothing more than 2% for a couple of months. However, 3% declines over 5 days should not be unusual. If implied volatility, e.g. the VIX, is at 13%, which is was until this selloff began, then a 5-day decline of 3% is only a 1.67-standard deviation event and it should happen about three or four times a year. The 2-day selloff of nearly 3% was a more unusual event, but hardly financial Armageddon.

Here’s the bigger point. You’ve laid out all your plans for the remainder of your life. If, one week ago, you were going to achieve your goals, but today with stocks 3% below all-time highs you are not, then you should not be in stocks. You’re 3% away from success – why would you risk that?

If, on the other hand, you’ve laid out your plans but you need stocks to rise 30% per year to make your plans work – your retirement goals, or your kids’ college education, or whatever – then you shouldn’t be in equities either. The problem here isn’t the market – it’s your plans. I blame financial television for this one, for the popularizing of the absurd term “putting your money to work.” Your money doesn’t work. Money is inert. The best you can hope for if you prod it with a stick is that it doesn’t blow away. Sometimes stocks go up, and sometimes they go down. From these valuation levels, it has long been the case that down was more likely than up over the next few years. Your money is “at work,” but it’s working in a wind tunnel and it’s not tied down.

Stocks are risky assets, folks! A gambling metaphor is probably inappropriate, and investing is different from gambling in that with gambling, the gambler generally loses over time while with investing – smart, patient investing – the investor generally wins, but here is one way in which the metaphor works: when you enter a casino, you only gamble what you can afford to lose. In the case of stocks, you should only invest as much as you can afford to lose 60-70% of. So your first question, in thinking about your asset allocation, should not be “how much do I need my portfolio to return,” and then spin the risk dial so you get the answer, but “can I lose 70% of this and still accomplish my goals?” If the answer is no, then you are risking too much because stocks sometimes do fall 70%.

And if you can’t accomplish your goals with the cash you have unless you have a strong equity market, then you have two prudent choices: 1) work harder, and longer, or 2) save more during the same period of work. The third choice is to gamble it on stocks and hope it turns out well.

If you’re over-committed to equities, this is an excellent time to reconsider that commitment. If you have ridden stocks up, then pat yourself on the back and think hard about reallocating. You haven’t lost much and it shouldn’t be keeping you up at night…because the ‘carnage’ just isn’t that bad. The chart below (source: Bloomberg with my annotations) is of the ETF EEM, which tracks the MSCI Emerging Markets Index. Repeatedly on Thursday and Friday, we heard that US stocks were suffering because of the “rout” in emerging markets. Some currencies took a hit, yes. But emerging equity markets were hardly “routed.” Again: if 12% is going to destroy you financially, then you should count on being destroyed with some regularity.

eem

I have to say the carnage isn’t that bad yet, because stocks might still drop precipitously and in any event probably won’t perform like they did for the last six months again for some while. But if you have the right, prudent plan, then not only do you not have to panic now, you won’t have to panic then.

Catching Up on the Week

January 17, 2014 4 comments

Friday before a long weekend is probably the worst time in the world to publish a blog article, but other obligations having consumed me this week, Friday afternoon is all I am left with. Herewith, then, a few thoughts on the week’s events. [Note to editors at sites where this comment is syndicated. Feel free to split this article into separate articles if you wish.]

Follow the Bouncing Market

In case there was any doubt about how fervently the dip-buyers feel about how cheap the market is, and how badly they feel about the possibility of missing the only dip that the equity market will ever have, those doubts were dispelled this week when Monday’s sharp fall in stock prices was substantially reversed by Tuesday and new all-time highs reached on Wednesday. Neither selloff nor rally was precipitated by real data; Friday’s weak jobs data might plausibly have resulted in a rally (and it did, on Friday) on the theory that the Fed’s taper might be downshifted slightly, but there was no other data; on Tuesday, December Retail Sales was modestly stronger than expected but hardly worth a huge rally; on Wednesday, Empire Manufacturing was strong – but who considers that an important report to move billions of dollars around on? There were some memorable Fed quotes, chief among them of course Dallas Fed President Fisher’s observation that the Fed’s adding of liquidity has done what adding liquidity in other contexts often does, and so investors are looking at assets with “beer goggles.” It’s not a punch bowl reference, but the same basic idea. But certainly, not a reason for a sharp reversal of the Monday selloff!

The lows of Monday almost reached the highs of the first half of December, before the late-month, near volume-less updraft. Put another way, anyone who missed the second half of December and lightened up on risk before going on vacation missed the big up-move. I would guess that some of these folks were seizing on a chance to get back involved. To a manager who hasn’t seen a 5% correction since June of last year, a 1.5% correction probably feels like a huge opportunity. Unfortunately, this is characteristic of bubble markets. That doesn’t necessarily imply that today’s equity market is a bubble market that will end as all bubble markets eventually do; but it means it has at least one more characteristic of such markets: drawdowns get progressively smaller until they vanish altogether in a final melt-up that proceeds the melt-down. The table below shows the last 5 drawdowns from the highs (measuring close to close) – the ones you can see by eyeballing a chart, by the date the drawdown ended.

6/24/2013

5.80%

8/27/2013

4.60%

10/8/2013

4.10%

12/13/2013

1.80%

1/13/2014

1.60%

I mentioned last week that in equities I’d like to sell weakness. We now have some specificity to that desire: a break of this week’s lows would seem to me to be weakness sufficient to sell because it would indicate a deeper drawdown than the ones we have had, possibly breaking the pattern.

There is nothing about this week’s price action, in short, that is remotely soothing to me.

A Couple of Further Thoughts on Thursday’s CPI Data

I have written previously about why it is that you want to look at some measure of the central tendency of inflation right now other than core CPI. In a nutshell, there is one significant drag on core inflation – the deceleration in medical care CPI – which is pulling down the averages and creating the illusion of disinflation. On Thursday, the Cleveland Fed reported that Median CPI rose to 2.1%, the first 0.1% rise since February (see chart, source Bloomberg).

median and coreMoreover, as I have long been predicting, Rents are following home prices higher with (slightly longer than) the usual lag. The chart below (source Bloomberg ) shows Owners’ Equivalent Rent, which jumped from 2.37% y/y to 2.49% y/y this month. The re-acceleration, which represents the single biggest near-term threat to the continued low CPI readings, is unmistakeable.

whoopsOERSorry folks, but this is just exactly what is supposed to happen. An updated reminder (source: Enduring Investments) is below. Our model had the December 2013 level for y/y OER at 2.52%…in June 2012. Okay, so the accuracy is mere luck, but the direction should not be surprising.

sorryfolksFor the record, the same model has OER at 3.3% by December 2014, 3.4% for OER plus Primary Rents. That means if every other price in the country remains unchanged, core inflation would be at 1.4% or so at year-end just based on the weight that rents have in core inflation (of course, median inflation would then be at zero). If every other price in the country goes up at, say, 2%, then core inflation would be at 2.6%. (Our own core inflation forecast is actually slightly higher than that, because we see other upward risks to prices). And the tails, as I often say, are almost entirely to the upside.

Famous Last Words?

So, Dr. Bernanke is riding off into the sunset. In an interview at the Brookings Institution, the “Buddha of Banking,” as someone (probably himself) has dubbed the soon-to-be-former Chairman spoke with great confidence about how well everything, really, has gone so far and how he has no doubt this will continue in the future.

“The problem with Q.E.,” he said, with more than a hint of a smile, “is that it works in practice, but it doesn’t work in theory.” “I don’t think that’s a concern and those who’ve been saying for the last five years that we’re just on the brink of hyperinflation I would point them to this morning’s C.P.I. number.” (“Reflections by America’s Buddha of Banking“, NY Times)

Smug superiority and trashing of straw men aside, no one rational ever said we were on the “brink of hyperinflation,” and in fact a fair number of economists these days say we’re on the brink of deflation – certainly, far more than say that we’re about to experience hyperinflation.

“He noted the Labor Department’s report Thursday that overall consumer prices in December were up just 1.5% from a year earlier and core prices, which strip out volatile food and energy costs, were up 1.7%. The Fed aims for an annual inflation rate of 2%.

“Such readings, he said, ‘suggest that inflation is just not really a significant risk of this policy.’“ (“Bernanke Turns Focus to Financial Bubbles, Instability”, Wall Street Journal )

And that’s simply idiotic. It’s simply ignorant to claim that the policy was a complete success when you haven’t completed the round-trip on policy yet by unwinding what you have done. It’s almost as stupid as saying you’re “100 percent” confident that anything that is being done for the first time in history will work as you believe it will. And, of course, he said that once.

I will also note that if QE doesn’t have anything to do with inflation, then why would it be deployed to stop deflation…which was one of the important purposes of QE, as discussed by Bernanke before he ever became Chairman (“Deflation: Making Sure “It” Doesn’t Happen Here”, 11/21/2002)? Does he know that we have an Internet and can find this stuff? And if QE is being deployed to stop deflation, doesn’t that mean you think it causes inflation?

On inflation, Bernanke said, “I think we have plenty of tools to manage interest rates and tighten monetary policy even if (the Fed’s) balance sheet stays where it is or gets bigger.” (“Bernanke downplays cost of economic stimulus”, USA Today)

No one has ever doubted that the Fed has plenty of tools, even though the efficacy of some of the historically-useful tools is in doubt because of the large balance of sterile excess reserves that stand between Fed action and the part of the money supply that matters. No, what is in question is whether they have the will to use those tools. The Fed deserves some small positive marks from beginning the taper under Bernanke’s watch, although it has wussied out by saying it wasn’t tightening (which, of course, it is). But the real question will not be answered for a while, and that is whether the FOMC has the stones to yank hard on the money supply chain when inflation and money velocity start heading higher.

It’s not hard, politically, to ease. For every one person complaining about the long-run costs, there are ten who are basking in the short-run benefits. But tightening is the opposite. This is why the punch bowl analogy of William McChesney Martin (Fed Chairman from 1951 to 1970, and remembered fondly partly because he preceded Arthur Burns and Bill Miller, who both apparently really liked punch) is so apropos. It’s no fun going the other way, and I don’t think that a wide-open Fed that discourses in public, gives frequent interviews, and stands for magazine covers has any chance of standing firm against what will become raging public opinion in short order once they begin tightening. And then it will become very apparent why it was so much better when no one knew anything about the Fed.

The question of why the Fed would withdraw QE, if there was no inflationary side effect, was answered by Bernanke – which is good, because otherwise you’d really wonder why they want to retreat from a policy that only has salutatory effects.

“Bernanke said the only genuine risk of the Fed’s bond-buying is the danger of asset bubbles as low interest rates drive investments to riskier holdings, such as stocks, real estate or junk bonds.But he added that he thinks stocks and other markets ‘seem to be within historical ranges.’” (Ibid.)

I suppose this is technically true. If you include prior bubble periods, then today’s equity market valuation is “within the historical range.” However, if you exclude the 1999 equity market bubble, it is much harder to make that argument with a straight face, at least using traditional valuation metrics. I won’t re-prosecute that case here.

So, this is perhaps Bernanke’s last public appearance, we are told. I suspect that is only true until he begins the unseemly victory lap lecture circuit as Greenspan did, or signs on with a big asset management firm, as Greenspan also did. I am afraid that this, in fact, will not be the last we hear from the Buddha of Banking. We can only hope that he takes his new moniker to heart and takes a Buddhist vow of silence.

Which Consensuses Are Worth Fading?

January 6, 2014 7 comments

A new year is upon us all, and with a five-day work week this week there is no longer any ignoring it. Markets were definitely more lubricated (and traders less so) on Monday than they were last week.

And so, as we return to full alertness, it is time to consider the recent trends and ask ourselves just what is going on. But before we do, I want to remind readers who missed the year-end series of “classics reposted” that they are worth some time to peruse if you still have time in the new year! A quick summary of those posts is here.

The only new data of the new year so far has been the ISM reports (Initial Claims was reported on January 2nd, but ‘Claims in the few weeks around year-end are so noisy that they ought to be simply ignored). The Manufacturing report came out last week, and the survey at 57.0 remains at levels similar to that of early 2011. Today’s Non-Manufacturing ISM was only 53.0, and actually closer to the lows of the last several years (see chart, source Bloomberg).

bothisms

Be careful, though, how you interpret either the “strongest since early 2011” or “nearly as weak as it has been since 2010” readings. The ISM reports don’t measure activity but rather the rate of change of that activity – so higher numbers don’t indicate better growth, but more improvement in growth. Respondents are asked a question that is essentially “are things getting better or worse?” with sub-questions covering new orders, employment, and so on. So a high ISM number may mean that things are growing well, or it may mean that things were looking pretty grim but are now looking up. In either case, of course, we want to see bigger numbers but a high ISM now means more than a high ISM in 2010!

And the internals of the ISM (Manufacturing) report, which came out last week, were positive. For example, the “New Orders” component rose to 64.2, indicating good expectations of forward growth and perhaps giving some hope that the large rise in Q4 inventories may be more intentional inventory accumulation than many thought. In any event, I tend to lean more on the Manufacturing number than the non-Manufacturing number, even though the manufacturing economy is a smaller part of the economy, because there is more history to the former. I am not optimistic that economic growth will surge this year, and indeed I think the chances that we’ve seen the best growth of this cycle are not negligible. But the current readings from the ISMs are encouraging.

Less encouraging is the level of encouragement we are getting.

For example: On a new-year outlook news show last weekend, I saw one guest opine that oil is obviously going to fall further in 2014 because traders are going to see the shale oil boom, the Keystone Pipeline, etcetera and “sell, sell, sell.” Now, a good rule of thumb is that institutional oil traders aren’t hearing about those things for the first time when they hit the weekend news shows. If the news of the shale oil production and the Keystone Pipeline would make them sell…then they have already sold. That doesn’t mean that oil won’t go down, but one reason it will not go down is because of information that all of the professionals had months ago. In fact, if it is just now becoming consensus on news shows that oil could go down, then I suspect that’s a consensus worth fading.

If I had to guess at the consensus view on various asset classes, I’d surmise based on the opinions I’ve been reading and seeing that analysts generally are bullish on equities, bullish-to-neutral on credit, bearish on rates generally, bearish on commodities, bullish on economic growth, and bearish on inflation. In general, it pays well over time to fade the consensus, (although it pays better when it’s a very strong consensus but momentum is fading), so it is reasonable to ask whether the consensus views are vulnerable. So my question is, what are the odds that the consensus prognostication (whatever it is – perhaps some may disagree that these are the consensus views) is wrong on all particulars? I mean, sometimes the dragon wins. I think that it is more likely that they are wrong on all particulars than right on all particulars, but if it is some of each – and that is of course the most probable outcome – I’d say my confidence that the consensus is wrong is, from strongest confidence (most likely the consensus is wrong) to weakest (least likely the consensus is wrong) is:

Inflation (I think it will go up)

Commodities (I think they’ll go up, and downward momentum has ebbed)

Equities (I think they’ll probably go down, but upward momentum remains)

Credit (I suspect spreads will widen but I am not confident of that)

Growth (I think we have a reasonable chance of recession but I don’t see the signs yet)

Rates (they might well go up even though that’s the consensus. In fact, I am probably in the consensus)

I think the biggest question from here, investing-wise, is how the market responds to the year-end moon shot in equities. Does the parachute open or does the rocket come crashing back to earth? Or, I guess, does the rocket’s next stage fire? I am highly sensitive to the fact that a number of smart investors are extremely near-term cautious here, so I am watchfully flat and would look to sell weakness in stocks.

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