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What Has Changed (but Only a Little)

February 8, 2018 1 comment

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A ten percent decline in stocks is not exactly a big deal. Perhaps it feels like a big deal because 10% in one week is somewhat dramatic, but then so is +7% in one month, on top of already-richly-valued markets, in the grand scheme of things. But can we put this in perspective?

Oh dear! How awful!

I pointed out on Monday that saying “nothing has changed in the economy – it’s still strong” is useless pablum if we are entering a bear market. But it’s useful to remember that over a one-week period, literally almost nothing changes about the backdrop. We have no new information on inflation, not much new information on earnings, not much new on the interest rate cycle. Bob Shiller won a Nobel prize in part for pointing out that market volatility is very much higher than can be explained by changes in underlying fundamentals, so this shouldn’t be a surprise. What does change when the market move is expectations for forward returns. When prices are lower, future expected returns are higher, and vice-versa. (This is why anyone under 40 years old, for whom the lion’s share of their investing life is in front of them, should be totally cheering for a massive market rout: that would imply they have the opportunity to invest at lower prices).

So let’s look at how those forward returns look now, and how they have changed. Of course, we look at these things every day, and every day develop a forecast of expected real returns across a number of asset classes. A subset of these is shown below, for prices as of January 26th: the day of the market high.

On January 26th, our expectations for the annualized 10-year real return for equities was -0.39%. In other words, we expected investors to underperform inflation by about 40bps per year on average over the next decade. 10-year TIPS yields were at 0.57%, and we expected commodity indices to return about 1.57% per annum. So, commodities had an advantage of about 2% per year over equities – plus some inflation-protection beta to boot. Expected commodities returns have been fairly stagnant, actually, because while the indices have rallied (implying lower future spot commodity returns) they have also gotten a push from higher interest rates and carry. (I wrote in mid-January about “Why Commodities Are a Better Bet These Days” and that’s worth reviewing.)

After the debacle of the last ten days or so, here is where our expected returns stand, as of the close on February 8th:

The expected total real return to equities over the next decade is now positive, if only barely. Our model has equity expected real returns at 0.35% per annum over the next decade, compared to 0.74% for TIPS (so the equity risk premium is still negative, though less so) and 2.33% for commodities (higher interest rates and lower spot prices have helped there). Again, these are entirely model-based, not discretionary. It is interesting that the premium for commodity index investing is still about 2% over stocks. Also interesting is that the slope of the risk curve is steeper: in late January, you had to accept 11% more annualized real risk to get just 1% additional real return; as of today, that slope implies 7% as risky assets have cheapened up. But as recently as 2014, that slope was 3%!

A flattening of the risk/reward curve over the last half-dozen years was no accident. I’ve written over the years about the “Portfolio Balance Channel,” which is how the Fed referred to helping the economy by taking all of the safe instruments away so that people had to buy riskier assets. The result, of course, was that riskier assets got much more expensive, as they intended. (Back in July I wrote a piece called “Reversing the ‘Portfolio Balance Channel’” where I pointed out that unwinding QE implies that the Portfolio Balance Channel would eventually cause money to come out of equities and other asset classes to go into bonds.)

In my mind, an expected real return of 0.35% from stocks while TIPS yield more (with no risk at the horizon) is still not very attractive. I think the risk curve needs to steepen more, and we know that in the long run the expected return to equities and commodities should re-converge. Whether that’s from commodity returns coming down because commodity prices rally, or from equity returns going up because equity prices fall, I don’t know. But I would skew bets at the risky end of the curve to commodities, personally (it’s not like I haven’t said this before, however).

I started this article by pointing out how relatively insignificant the movement in the markets has been so far. I don’t mean, by pointing this out, that investors should therefore dive back in. No, in fact I think it is fairly likely that the decline has much further to go. Merely retracing 38% of the bull market – which is a minimum retracement in a normal Fibonacci sequence – would put the S&P back to 2030. This would also have the advantage from a techie’s standpoint of causing the decline to terminate in the range of the prior fourth wave…but I digress.[1] A decline of that magnitude would also, in conjunction with rising earnings, bring the Shiller P/E back to the low-20s – still above average, but not outrageous. And it would raise the expected 10-year real return up to around 3%, which is arguably worth investing in. It would also mean that, in real terms, the S&P 500 index would have had no net price appreciation since the peak of the tech bubble – your dividends would be your whole return, and not so bad as all that, but…that’s thin gruel for 18 years of “stocks for the long run.”


[1] Although I have used some technical analysis terms recently, I’m not really a technician. However, I recognize that many traders are, and having some knowledge of technical analysis gives one some guideposts around which a tactical plan can be formulated.

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Categories: Stock Market, Technicals

The Era of Bizarro Bill Gross is Beginning

February 2, 2018 2 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed.


It’s hard to believe that 10-year yields in the US have doubled in the last 18 months. It’s the last 50bps, taking us from 2.35% to 2.84% since December, that has received the most attention but 10yr Treasury rates have literally spanned the width of the nearly 40-year-old channel over that 18 months (see chart, source Bloomberg).

Such a long-term chart needs to be done in log scale, of course, because a 200bp move is more significant when rates are at 2% than when they are at 10%. I have been following this channel for literally my entire working career (more than a quarter-century now), and only once has it seriously threatened the top of that channel. Actually, that was in 2006-07, which helped precipitate the last bear market in stocks. Before that, the last serious test was at the end of 1999, which helped precipitate that bear market.

You get the idea.

The crazy technicians will note that a break above about 3.03%, in addition to penetrating this channel, would also validate a double bottom from the last five years or so. Conveniently, both patterns would project 10-year rates to, um, about 6%. But don’t worry, that would take years.

Let’s suppose it takes 10 years. And let’s suppose that velocity does what it does and follows interest rates higher. The regression below (source: Bloomberg) shows my favorite: velocity as a function of 5y Treasury rates. Rates around 5% or 6% would give you an eyeball M2 velocity of 2.1.

So, let’s go to the calculator on our website, and see what happens if money velocity goes to 2.1 over the next decade, but real growth averages a sparkling 3%.

Looking down the “2.1” column for velocity, we can see that if we want to get roughly 2% inflation – approximately what the market is assuming – then we need to have money growth of only 1% per annum for a decade. That is, the money supply needs to basically stop growing now. The only problem with that is that there are trillions in excess reserves in the banking system in the US, and trillions upon trillions more on the balance sheets of other central banks, and not only does the Fed not plan to remove all of those reserves but rather to maintain a permanently larger balance sheet, but other central banks are still pumping reserves in. So, you can see the problem. If money growth is only 3%, then you’re looking at average inflation over the next decade of 3.9% per annum. By the way, average money growth in the US since the early 1980s has been 5.9% (see chart, source Bloomberg). Moreover, it has been below 3% only during the recessions of the early 1990s and the global financial crisis, and never for more than a couple of years at a time.

The bottom line is that rising interest rates and more importantly rising money velocity create a very unfortunate backdrop for inflation, and this is what creates the trending nature of inflation and the concomitant ‘long tails’: higher rates create higher velocity, which creates higher inflation, which cause higher rates. Etc. The converse has been true for nearly 40 years – a happy 40 years for monetary policymakers. Yes, I know, there are a lot of “ifs” above. But notice what I am not saying. I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities. And if interest rates were to head much higher, we would get such a response in equities that would provoke soothing tones from central bankers. So tactically, I wouldn’t expect yields to go a lot higher from here in a straight shot.

I am also not saying that money velocity is going to gap higher, and I am not saying that inflation is about to spring to 4% (in fact, just the other day I said that it will likely be mainly the optics on inflation that are bad this year because some one-off events are rolling out of the data). Just as with interest rates, this cycle will take a long time to unwind even if, as I suspect, we have finally started that unwind. We’re going to have good months and bad months in the bond market. But the general direction will be to yields that are somewhat higher in each subsequent selloff. And some Bizarro Bill Gross will be the new Bond King by riding yields higher rather than riding them lower.

I am also told that mortgage convexity risk, which in the past has taken rallies and selloffs in fixed-income and made them more extreme, is less of a problem than it used to be, since the Fed holds most mortgages and servicing rights have been sold from entities that would hedge extensions to those who “just want yield” (unclear how this latter group responds to the same yield, at longer maturities). On the other hand, the Volcker Rule has gutted a lot of the liquidity provision function on Wall Street, so if you have a million to sell you’re okay; if you have a yard (a billion) then best of luck.

I will note that real yields are still lower (10year TIPS yields 0.70%) than they reached at the highs in 2016, which were lower than they got to in 2015, which were lower than they hit in 2013. The increase in interest rates is not coming from a surge in belief about rising real growth. The increase is coming from a surge in concern about the backdrop for inflation. For nominal interest rates to go much higher, real yields will have to start contributing more to the selloff. So I think we are probably closer to the end of the bond selloff, than to the beginning…at least, this leg of it.

A Short Remark About an Ominous Count

This will be a very short remark, partly because I am certain that someone else must have observed this already.

The Dow Jones Industrial Average declined on Tuesday after having risen in each of the preceding 12 days. I was curious, and the DJIA has data going back more than a century (unlike, for example, the S&P 500, the Russell, or other indices), so I checked to see how often that has happened before.

It turns out that only three times before in history has the Dow advanced in 12 consecutive sessions. The dates of those occurrences are (listed is the last day of advance before the first decline):

July 8, 1929

December 7, 1970

January 20, 1987

The latter of these three was actually a 13-day advance, and the longest in history.

Now, the 1970 occurrence seems to be nothing special. It occurred five years into a 15-year period that saw the Dow go nowhere in nominal terms, but there was nothing special about 1971. However, anyone who invests in the stock market ought to know the significance of 1929 and 1987. It also bears noting that current market valuations are higher (in terms of the Cyclically-Adjusted PE ratio) than on any of those three days – quite a bit higher, in fact.

None of which is to say that we won’t have another 10, 20, or 30-day streak ahead of us. I suspect the bulls will say “see? This same occurrence in 1929 and 1987 happened months before the denouement. We still have time to party!” And they may be right. This isn’t predictive. But it, especially when compared to valuation levels second only to those seen at the peak of the “Internet Bubble,” is ominous. This is a party I wouldn’t mind missing.

Walmart Traffic may be Down but Wall Street Traffic is Up

October 14, 2015 Leave a comment

Walmart (WMT) didn’t have its best day today. The bellwether retailer forecast a profit decline of 6-12% in its 2017 fiscal year, in some part because of a $1.5bln increase in wage expenses; the stock dropped 10% to its lowest level since 2012 and off about 33% from the highs (see chart, source Bloomberg).

wmt

I mention Walmart neither to recommend it nor to pan it, but only because in the absence of news from WMT I would have been inclined to ignore the modest downside surprise in Retail Sales today; September Retail Sales ex-auto-and-gasoline were unchanged versus expectations for a +0.3% rise. But Retail Sales, like Durable Goods, is a wildly volatile number (see chart, source Bloomberg).

retsales

This was a bad month, but it wasn’t the worst month in 2015. It wasn’t even the second or third-worst month in 2015. Looking at a monthly figure, it is difficult to reject any null hypothesis; put another way, you really cannot discern whether +0.5% is statistically different from +0.0%. [I didn’t actually do the test…I am just making the general statistical observation.] Today’s data will tweak the Q3 forecasts a bit lower, but isn’t anything to be upset about. Except, that is, for the fact that Walmart is bleeding.

There is something else that is different about this decline, and really about this whole year. I have documented in the past the steady decline in equity volumes that has been occurring for almost a decade now. The chart below shows the cumulative NYSE volume, by trading day of the year, for 2006 through present. Note the steady march lower in volumes year after year after year. 2014 and 2013 were almost mirror images, so you can’t see 2014. But notice the thicker black line: that is 2015.

volslongtermHere is another way to illustrate the same thing. By year, here is the number of days that less than 1 billion shares traded in NYSE Composite Volume.

Number of sub-billion share days
2005 4
2006 7
2007 7
2008 18
2009 35
2010 113
2011 166
2012 240
2013 246
2014 246

In 2015, we are on pace for a mere 228 sub-billion share days.

I guess by now my point is plain, but here is one more chart and that is the rolling 20-day composite volume for 2014 (lower line) and 2015 (upper line).

vols201415

In general, volumes have been higher this year, but the real divergence began at the end of July, when the lines began to move away from each other more rapidly. The equity breakdown started on August 20th.

What does this all mean? Rising trading volumes while markets are declining suggests we should consider imputing more significance to what many are calling a correction but which may be the beginning of something deeper. There are re-allocations happening, and outright sales – not just fast money slinging positions around. Technically, this is supposed to put more weight on the “damage” done by this correction, and raise a bit of a warning flag about the medium-term set-up.

Incidentally, you can buy warning flags cheaply at Walmart.

Proper Seasonal Gold Chart

In an excellent (and free!) daily email I receive, the Daily Shot, I ran across a chart that touched off my quant BS alert.

goldseasThis chart is from here, and is obviously a few years out-of-date, but that isn’t the problem. The problem is that the chart suggests that gold prices rise 5.5% every year. If you buy gold in January, at an index value of 100, and hold it through the flat part of January-June, then you reap the 5% rally in the second half of the year.

No wonder people love gold! You can get a 10% annual return simply by buying in July and selling in December!

The problem is that this is not the way you should do a seasonal chart. It has not be detrended. We detrend data because that way, we can express the expected return for any given day as (the normal expected return) plus (the seasonal component). This is valuable because, as analysts, we might have a general forecast for gold but we will want to adjust that forecast to a holding period return based on a seasonal pattern. This is very important, for example, with TIPS yields and breakevens, because inflation itself is highly seasonal.

Now, the seasonal chart done correctly still suggests that the best time to own gold is in the second half of the year, but it no longer suggests that owning gold is an automatic winner. (It is a separate argument whether we can reject the null hypothesis of zero seasonality altogether, but that’s not my point here).

goldseascorrectedIf I was doing this chart, I would also include only full calendar years, so if I move the start date back to January 1, 1982 and the end date to December 31, 2014 here is what I get:

goldseasthru2014Frankly, I would also use real prices rather than nominal prices, since it is much easier to make a statement about the expected real return to gold (roughly zero over time, although it may be more or less than that based on current valuation metrics) than it is to make a statement about the expected nominal return to gold, since the latter includes an embedded assumption about the inflation rate, which I would prefer to strip out. And I would also include data from the 1970s.

Categories: Gold, Quick One, Technicals

What Risk-Parity Paring Could Mean for Equities

October 9, 2014 14 comments

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).

vix

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[1], 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.

[1] 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.

Is A Bond Rally Due?

July 29, 2013 1 comment

As we head into a very busy week of economic data, the bond market remains drippy with the 10-year yield up to 2.59%. (Just writing that makes me laugh. Who would have thought, only a few years ago, that 2.59% was a high-ish yield?)

How we got here, from the ultra-low levels of the last two years, is well-traveled territory. The Fed’s swing from “QE-infinity” to “someday, maybe, we might not buy as many bonds” helped trigger a run for the exits, and then negative convexity inflection points kept the rout going for a long time. Most lately, the threat of muni bond convexity has been looming as the next big concern.

But my message today is actually one of good cheer. The worst of the bond selloff was now more than three weeks ago, without a further low being established. In my experience, convexity-inspired selloffs typically end not with a sharp rebound but with a sideways trade as “trapped” long positions gradually work their way out and buyers start to nibble. But it remains a buyer’s market for several weeks, at least.

We are getting far enough along in that process that I suspect we have a rally due. This has nothing to do with any economic data coming up. There is enough data coming this week, from Consumer Confidence to Payrolls to GDP to the Fed statement, that both bulls and bears will be able to find something to point to. And I am not pointing to technicals, exactly. I am just saying that markets rarely move in a straight line, and even bear markets – such as the one I think we have now entered, in bonds – have nice rallies from time to time.

But here’s a reason to expect this to happen relatively soon. The chart below is a neat “seasonal heat map” chart from Bloomberg showing the monthly yield change for the last 10 years and the average monthly change on the top line.

heatmapFor a long time, I have been following the rule of thumb I learned as a mere babe in the bond market, and that’s that the best time of the year to buy bonds is the first few days of September. From at least the late 1970s until today, September until mid-October has been the strongest seasonal period of the year (not every year, but with enough consistency that you wanted to avoid being short in September). But the heat map above shows that this tendency may have shifted. The month that has seen the best average bond market performance over the last decade has been August, with yields falling an average of 22bps with rallies in 8 of the last 10 years. If we were sitting with 10-year yields at 1.59%, I would be less interested in this observation, but at 2.59% I am looking for the counter-trade.

To be sure, yields in the big picture are headed higher, not lower. But I am looking for signs that the recent selloff has over-discounted the immediate threat of ebbing Federal Reserve purchases. And I don’t expect growth to suddenly leap forward here, either.

As an aside, 10-year TIPS yields have also experienced one of their best months in August, with the other clear positive month being January. But, because nominal yields have been so strong, August has been the worst month for breakevens, with 10-year breakevens falling 10bps on average over the last ten years. No other month has seen breakevens decline as much as 6bps, on average.

Now, although I am a bond bear in the big picture, I don’t think that the housing market is doomed because interest rates will go up one or two or three percent. I am fascinated by how many analysts seem to think that unless 10-year rates are below 3%, the housing market will collapse. I argued about six weeks ago that higher mortgage rates should not impact sales of homes very much as long as the interest rate is less than the expected capital gain the homeowner expects to make on the home. (Higher rates will, however, cut fairly quickly into speculative building activity, which is much more rates-sensitive). And here is another reason not to worry too much about the housing market. A story in Bloomberg last week says that adjustable-rate mortgages are booming again, with mortgagees taking them out at the highest pace since 2008. Faced with higher rates, and a Fed with is not likely to raise short rates for a long while – as they have taken pains to keep reminding us – homebuyers have rationally decided to take the cheaper money and let the future refinancing take care of itself.

Whether that is sowing the seeds of a future debacle I will leave to other pundits to debate. From my perspective, the important point is that higher rates are not likely to slow home sales, or the recent rise in home prices, very much…unless they get a lot higher.

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