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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?

Madness or Wisdom?

December 3, 2013 2 comments

Trading, and to some extent investing, is all about knowing when markets are moving with the wisdom of the crowds and when they’re moving with the madness of the crowds. In recent years, there has seemed to be much more madness than wisdom (a statement which can probably be generalized beyond the financial markets themselves, come to think of it). Where do we stand now?

I think a recent letter by John Hussman of Hussman Strategic Advisors, entitled “An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities,” is worth reading. Hussman is far from the only person, nor even the most august or influential investor, questioning the valuation of equities at the moment. Our own valuation models have had the projected 10-year compounded real return of equities below 3% for several years, and below 2% since late April. For a time, that may have been sustainable because of the overall low level of real rates, but since the summertime rates selloff the expected equity premium has been below 1.5% per annum, compounded – and is now below 1% (see Chart, source Enduring Investments).

realequitypremHussman shows a number of other ways of looking at the data, all of which suggest that equity prices are unsustainable in the long run. But what really caught my eye was the section “Textbook speculative features”, where he cites none other than Didier Sornette. Sornette wrote a terrific book called Why Stock Markets Crash: Critical Events in Complex Financial Systems, in which he argues that markets at increased risk of failure demonstrate certain regular characteristics. There is now a considerable literature on non-linear dynamics in complex systems, including Ubiquity: Why Catastrophes Happen by Mark Buchanan and Paul Ormerod’s Why Most Things Fail: Evolution, Extinction and Economics . But Sornette’s book is one of the better balances between accessibility to the non-mathematician and utility to the financial practitioner. But Hussman is the first investor I’ve seen to publicly apply Sornette’s method to imply a point of singularity to markets in real time. While the time of ‘breakage’ of the markets cannot be assessed with any more, and probably less, confidence than one can predict a precise time that a certain material will break under load – and Hussman, it should be noted, “emphatically” does not lay out an explicit time path for prices – his assessment puts Sornette dates between mid-December and January.

Hussman, like me, is clearly of the belief that we are well beyond the wisdom of crowds, into the madness thereof.

One might reasonably ask “what could cause such a crash to happen?” My pat response is that I don’t know what will trigger such a crash, but the cause would be the extremely high valuations. The trigger and the cause are separate discussions. I can imagine a number of possibilities, including something as innocuous as a bad “catch-up” CPI print or two that produces a resurgence of taper talk or an ill-considered remark from Janet Yellen. But speculating on a specific trigger event is madness in itself. Again, the cause is valuations that imply poor equity returns over the long term; of the many paths that lead to poor long-term returns, some include really bad short-term returns and then moderate or even good returns thereafter.

I find this thought process of Hussman’s interesting because it seems consonant with another notion: that the effectiveness of QE might be approaching zero asymptotically as well. That is, if each increment of QE is producing smaller and smaller improvements in the variables of interest (depending who you are, that might mean equity prices, long-term interest rates, bank lending, unemployment, etc), then at some point the ability of QE to sustain highly speculative valuations goes away and we’re left with the coyote-running-over-the-cliff scenario. Some Fed officials have been expressing opinions about the declining efficacy of QE, and Janet Yellen comes to office on February 2nd. I suspect the market is likely to test her very early.

None of this means that stocks cannot go straight up from here for much longer. There’s absolutely nothing to keep stock prices from doubling or tripling from here, except the rationality of investors. And as Mackay said, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Guessing at the date on which the crowd will toggle back from “madness” to “wisdom” is inherently difficult. What is interesting about the Sornette work, via Hussman, is that it circles a high-risk period on the calendar.

For two days in a row now, I’ve discussed other people’s views. On Wednesday or Thursday, I’ll share my own thoughts – about the possible effects of Obamacare on measured Medical Care inflation.

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