Tuesday, October 28, 2014

The right way and wrong way to hate the Fed

In these pages, I have tried very hard to remain apolitical in my writings. While I hold certain political positions, I don't let them affect my investment views.

It it with some alarm that I am seeing more instances of investment pundits expressing their political views. In such cases, I start to wonder whether their politics are affecting how they invest. It can lead to an attitude  of "the policy is wrong-headed and will end in tears, so it's time to get bearish." Such approaches can be fatal to portfolio returns.

Mauldin the Republican
My antennae started to tingle when I read the writings of well-known newsletter writer and author John Maudlin, who has revealed his Texas Republican ties in the past. What I found disturbing was the way Mauldin wore his political views on his investment sleeve in this article entitled "Where's the Growth?" in which he attributed everything that`s wrong with the US economy to Keynesians and neo-Keynesians. Mauldin went on to attack Larry Summers for his secular stagnation thesis this way:
Launched by Larry Summers last November, a meme is burning its way through established academic economic circles: that we have entered into a period of – gasp! – secular stagnation. But while we can see evidence of stagnation all around the developed world, the causes are not so simple that we can blame them entirely on the free market, which is what Larry Summers and Paul Krugman would like to do: “It’s not economic monetary policy that is to blame, it’s everything else. Our theories worked perfectly.” This finger-pointing by Keynesian monetary theorists is their tried and true strategy for deflecting criticism from their own economic policies.

Neo-Keynesians have, in effect, messed up everything and their theories are to blame:
Where orthodox neo-Keynesian policies like large-scale deficit spending and aggressive monetary easing have been resisted – as in Japan years ago or in the Eurozone debtor countries today – lingering depressions are commonly interpreted as tragic signs that “textbook” neo-Keynesian economic policy could have prevented the pain all along and that weak economic conditions persist because governments and central banks are not doing enough to kick-start aggregate demand and stimulate credit growth at the zero lower bound.

In places like the United States and Japan, where neo-Keynesian thought leaders have already traded higher public debt levels and larger central bank balance sheets for unspectacular economic growth and the kinds of asset bubbles that always lead to greater instability in the future, their policies have failed to jump-start self-accelerating recoveries. Even in the United States, when QE3 has been fully tapered off, I would expect to see the broader economy start to lose momentum once again.

We’ve tried countercyclical deficit spending to resist recessions, procyclical (and rather wasteful) deficit spending to support supposed recoveries, and accommodative monetary easing all along the way (to lower real interest rates and ease the financing of those pesky deficits); but growth has been sluggish at best, inflation has been hard to generate, and labor market slack is making it difficult to sustain inflation even when real interest rates are already negative.

Call me a heretic, but I take a different view than the economists in charge. To my mind, the sluggish recovery is a sign that central banks, governments, and, quite frankly, the “textbook” economists (despite their best intentions) are part of the problem. As Detlev Schlichter commented in his latest blog post (“Keynes was a failure in Japan – No need to embrace him in Europe”), “To the true Keynesian, no interest rate is ever low enough, no ‘quantitative easing’ program ever ambitious enough, and no fiscal deficit ever large enough.” It’s apparently true even as debt limits draw closer.
In essence, Mauldin is saying "my theory is better than your theory" (emphasis added):
While the academic elites like to think of economics as a reliable science (with the implication that they can somehow control a multi-trillion-dollar economy), I have repeatedly stressed the stronger parallel of economics to religion, in the sense that it is all too easy to get caught up in the dogma of one tradition or another. And all too often, a convenient dogma becomes a justification for those in power who want to expand their control, influence, and spending.

Whereas an Austrian or monetarist approach would suggest less government and a very light handle on the monetary policy tiller, Keynesian philosophy gives those who want greater government control of the economy ample reasons to just keep doing more.
In the following week`s article, Mauldin went on to criticize an over-reliance on monetary policy:
Monetary policy has been able to mask a multitude of our government’s fiscal sins. My worry for the economy is what will happen when Band-Aid monetary policy can no longer forestall the hemorrhaging of the US economy. Long before we get to 2024 we will have a crisis. In past years, I have expected the problems to come to a head sooner rather than later, but I have come to realize that the US economy can absorb a great deal of punishment. But it cannot absorb the outcomes depicted in those last two charts. Something will have to give.

And these projections assume there will be no recession within the next 10 years. How likely is that? What happens when the US has to deal with its imbalances at the same time Europe and Japan must deal with theirs? These problems are not resolvable by monetary policy.
Lower deficits and sound fiscal policy is the way to go, in his opinion. This will not end well (emphasis added):
An even scarier scenario is what will happen if we don’t deal with our fiscal issues. You can’t solve a yawning deficit with monetary policy.

Further, at some point the velocity of money is going to reverse, and monetary policy will have to be far more restrained. The only reason, and I mean only, that we’ve been able to get away with such a massively easy monetary policy is that the velocity of money has been dropping consistently for the last 10 years. The velocity of money is at its lowest level since the end of World War II, but it is altogether possible that it will slow further to Great Depression levels.

When the velocity of money begins to once again rise – and in the fullness of time it always does – we are going to face the nemesis of inflation. Monetary policy during periods of inflation is far more constrained. Quantitative easing will not be the order of the day.

For Keynesians, we are in the Golden Age of Monetary Policy. It can’t get any better than this: free money and low rates and no consequences (at least no consequences that can be seen by the public). This will end, as it always does
Notwithstanding the fact that the great austerity experiments in Europe have been unmitigated disasters, it seems futile to argue with someone for whom a theory represents a form of religious doctrine. From reading John Mauldin, I seriously question how much his views color the hedge fund managers and portfolios that he offers.

The Ritholz climate change obsession
I am not just trying to pick on John Mauldin and his conservative views. On the other side of the political aisle, Barry Ritholz seems to have an obsession with climate change, as evidenced by this recent tweet:

Here is just a small sample of the posts from his The Big Picture blog on this topic:
To his credit, I have not seen Barry's climate change concerns creep into his investment views. I have not seen him has write anything to the effect that current policies are likely to lead to disaster, so therefore portfolios should be positioned for that outcome. Nor have I seen him advocate for financing such *ahem* speculative projects like this in Boston.

As investors, I believe that we should always be aware and be flexible about the limitations of our models. When the data doesn't fit the model, what do you do? While I understand that ecological time frames are different from investment time frames, but consider this chart of the pause in warming trends over the past decade:

Imagine a manager who has an investment theme that isn't working out. What is the procedure for decide on whether to stick to his guns and what is the procedure for re-examining and re-validating his models? The answer can be revealing of the thought processes that drive that manager's investment philosophy and process.

The right way to be a Fed hater
To sum up, I reiterate my position that it`s perfectly normal to hold political views. Just don`t let them affect your portfolios.

I demonstrate this by singling out a very unique group - the Fed haters. Fed haters are a special species of investors who generally believe that what the Fed is doing is ultimately inflationary and, ultimately, the Fed will lose control of its policy and the US will get caught up in an inflationary spiral.

Again, it's ok to hold that view. Stan Druckenmiller is an example of an investor who is able to hold such views and effectively manage his portfolio. In 2013, Druckenmiller admitted that his models don't work anymore and he is a wash-up manager because Fed policies have distorted everything (via Business Insider):
In an interview with Goldman Sachs earlier this year, Druckenmiller sounded equally futile about his place in an easy-money, QE market. He, like a lot of hedge fund managers, has been critical of Fed Chair Ben Bernanke's policies.

Unlike other hedge fund managers, though, he's open about his own feelings of inadequacy because of those policies.
It has become harder for me, because the importance of my skills is receding. Part of my advantage, is that my strength is economic forecasting, but that only works in free markets, when markets are smarter than people....

It's not predicting anything the way it used to and that really makes me reconsider my ability to generate superior returns. If the most important price in the most important economy in the world is being rigged, and everything else is priced off it, what am I supposed to read into other price movements?
Bill Fleckenstein is another well-known investment professional who is a Fed-hater, but he also knows the limitations of his approach (via Business Insider).
In a new interview with King World News, long-time Fed-critic Fleckenstein addresses the startling shouting match he got into with CNBC anchor Jackie DeAngelis on Tuesday.

For years, Fleckenstein had been warning investors through interviews that the loose monetary policies of the various developed market central banks would end in financial catastrophe.

And the manner in which he sounded his warnings made it seem as if this doom would be somewhat imminent.
Despite his reservations about Fed policy, Fleckenstein closed his short selling fund in 2009 and he is in the process of re-starting it now:
"At what point are you willing to concede that you've misunderstood monetary policy?" DeAngelis asked point blank.

This had Fleckenstein understandably incensed.

"I don't misunderstand monetary policy," he responded. "I closed my short fund in 2009 because I knew the Fed would print money ... If you want to pursue idiots like the Fed, and their crazy policies, and you think you can get out in time, go for it."

Investing vs. policy
Ironically, one of the most interesting insights comes from the New York Fed at its blog, Liberty Street Economics. In this post, the author examined the differences in opinion in the future of interest rates between FOMC members (SEP) and the Survey of Primary Dealers (SPD):
The chart below shows the disagreement, as measured by the interquartile range, among participants in the SPD and the SEP for two-year-ahead projections of the FFR. While there is some dispersion among primary dealers’ forecasts, FOMC members have disagreed considerably more over the past three years.

Why are FOMC members more varied in their opinion of future interest rates than dealers? The answer is simple. Fed policy makers are more focused on how the economy is likely to change in light of their theories, which can vary widely. The dealers are just more pragmatic about the policy outlook (emphasis added):
Overall, the FOMC has tended to disagree more about the path of the FFR than market participants. One potential explanation for the difference is that FOMC members have disagreed more about the outlook for unemployment and inflation. However, we can’t rule out that private-sector participants disagree less about the outlook because they disagree less about the future path of the policy rate. That said, disagreement about unemployment in the longer-run should not be driven by policy expectations, and disagreement about this variable, at least until very recently, has been lower in the SPD than in the SEP. In addition, even if disagreement about the outlook in both surveys is the same, we should expect the FOMC to disagree more because private forecasters attempt to predict the most likely policy outcomes, whereas FOMC members report their views on the appropriate path for the FFR. That is, the dots represent policy prescriptions of each FOMC participant, rather than forecasts.

The 9 rules of investing
Academics focus on being right. Investment professionals focus on making money. Don`t confuse the two.

Ned Davis' nine rules of research are highly applicable in this instance:
Ned has 9 Rules of Research that all strategy team members follow and learn quickly when working at Ned Davis Research:

  1. Don’t Fight the Tape – the trend is your friend, go with Mo (Momentum that is)
  2. Don’t Fight the Fed – Fed policy influences interest rates and liquidity – money moves markets.
  3. Beware of the Crowd at Extremes – psychology and liquidity are linked, relative relationships revert, valuation = long-term extremes in psychology, general crowd psychology impacts the markets
  4. Rely on Objective Indicators – indicators are not perfect but objectively give you consistency, use observable evidence not theoretical
  5. Be Disciplined – anchor exposure to facts not gut reaction
  6. Practice Risk Management – being right is very difficult…thus, making money needs risk management
  7. Remain Flexible – adapt to changes in data, the environment, and the markets
  8. Money Management Rules – be humble and flexible – be able to turn emotions upside down, let profits run and cut losses short, think in terms of risk including opportunity risk of missing a bull market, buy the rumor and sell the news
  9. Those Who Do Not Study History Are Condemned to Repeat Its Mistakes

You can hold any political view you want. Just be pragmatic when it comes to managing your portfolio.

Monday, October 27, 2014

If you're afraid of the volatility...

In my most recent post, I indicated that I expected US stock prices to move up further, but in a choppy fashion (see Correction, what correction?).  For more risk averse investors and traders who are afraid of the volatility, I can suggest another way to approach this market.

Under these circumstances, directional market volatility could be mitigated with a pairs trade. Buy the outperforming sectors and groups and short the underperforming sectors and groups. There are a few that could be looked at.

One possible long position is Healthcare. The Healthcare sector and its industries have been fairly consistent outperformers in the last year, even in the recent correction. The chart below shows the relative performance of this sector and its industries compared to the SPX in the past year, as well as the SPX in the bottom panel.

I do have one caveat. The relative performance of the Medical Devices group, as represented by the ETF IHI, seems overly volatile and should probably be avoided as a long candidate.

Another long candidate might be the NASDAQ. The NASDAQ 100 has been on a tear since May. By contrast, smaller stocks, as represented by the Russell 2000 small caps (IWM) or mid-caps (MDY) have continued to underperform during the same period.

These charts suggest the follow long and short positions as pairs trades:

  • Long: Healthcare or any healthcare industry except Medical Devices
  • Long: NASDAQ 100
  • Short: Small or mid caps (IWM or MDY)

Disclaimer: Pairs trading represent a relatively exotic position and require a higher level of sophistication that is not appropriate for everyone. Do your own due diligence and know your own risk tolerances before entering the trade.

Disclosure: I have no pairs positions on at this time, but I could enter in any of the aforementioned positions at any time in the near future. 


Sunday, October 26, 2014

Correction, what correction?

Trend Model signal summary
Trend Model signal: Risk-off
Direction of last change (trading model): Positive (upgrade)

The actual historical (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

A fast-money inspired correction?
OK, I was wrong (see recent posts Getting close to a bottom, but not yet and A Bold Forecast: Today was not the bottom). The Trend Model trading call reversed itself and moved from a bearish to a bullish reading this week (see my tweet here). I had been applying a technical analysis approach to the latest round of market weakness when that framework was inadequate for the job.

For the last few weeks, I have been struggling with a rationale for the most recent episode of stock market weakness. Until we can diagnose what went wrong, it's virtually impossible to map of the road ahead. I believe that Gavyn Davies had the most reasonable explanation of what happened:
Overall, then, three separate factors have probably been at work:
  • a reversal of speculative positions, which has had temporary effects on asset prices;
  • a contractionary and deflationary demand shock in the euro area;
  • an oil shock that will also be deflationary, but will be expansionary for many economies.
The combined effects of all this should be unequivocally supportive for bonds, but ambiguous or even supportive for some global equity markets.
Note the first point Davies raised about a reversal of speculative positions. In the past week, I have seen a couple of indications that the weakness was attributable to hedge fund re-positioning their portfolios. At the Robin Hood Investors Conference, leading hedge fund investor Paul Tudor Jones was quoted as attributing the recent downdraft to "position clearing" and that he expected further near term volatility (via Business Insider):
As for last week's market activity, Jones said that on Thursday we saw a five standard deviation (that's a volatility measure) kind of movement in one day. He said we would see this kind of volatility in the future.

Speaking of the volatility of the past two to three weeks, he said that was due to position clearing and that it was similar to October 1998. (Our source pointed out that's when the Long-Term Capital Management event happened. Jones didn't explicitly say that, though.)
Dan Leob more or less said the same thing. Hedge funds had to de-risk because too many trades were going against them (via Zero Hedge, emphasis added):
In early October, a confluence of events transpired in relatively short order, including weaker economic data, political uncertainty, a potential global plague, and bureaucratic meddling, which caused fear to spike, sentiment to decline, and investors to de-leverage. The month got off to an especially rocky start for hedge funds when a court dismissed a claim in connection with the Fannie Mae/Freddie Mac GSE complex. Many investors were oversized in this trade and their forced selling kicked off the “de-risking” cycle. Next, oil prices declined sharply and many funds who had large positions in E+P companies suffered enormous losses. Then last week, AbbVie halted its announced inversion transaction with Shire, inflicting great pain on the arbitrage community. Opaquely blaming mysterious “meetings with the Treasury Department”, AbbVie walked away from an entirely lawful deal that it had touted as enormously accretive and strategic as recently as two weeks ago, incurring a substantial $1.6 billion break-up fee. A rational conclusion is that instead of a legislative solution that might require comprehensive tax reform, this Administration has decided to unilaterally curb inversions using whatever means are available. Needless to say, this regulatory uncertainty (along with prior detours from the rule of law) will be a wet blanket on top of investors until transparency and a level playing field are restored to the markets.
The hedge fund inspired correction thesis was partly confirmed by comments from Credit Suisse (emphasi:
The de-risking sentiment that prompted investors to dump stocks, however, is likely to lose steam sooner, according to Credit Suisse Head of Flow Equity Derivatives Trading Khoa Le. “A lot of people were caught on the wrong side of market volatility, and the majority of flows we saw were essentially closing positions,” he said on a recent conference call. “Effectively, you had the buy-side community saying, ‘We’re out.’” If volatility spikes again soon, they’ll probably stay out. But if it remains subdued, they will likely feel pressure to come back in.
Against this backdrop, European growth continued to slow. The BoAML Fund Manager Survey showed that institutional managers were overweight eurozone equities and were in the process of reducing their positions.

When the fast money crowd (read: hedge funds) were forced to de-risk and reduce their position sizes, the expectations of slower global growth set off a stampede for the exits.

The panic spread to NAAIM managers, who are RIAs managing individual investors' assets, to panic. They reduced equity exposures to historically low levels, which have since recovered, The last episode of panic and recovery was in 2011. The key question then becomes, "Can the uptrend in equities continue?"  (via Ryan Detrick annotations in white are mine):

The fast money market reaction is exemplified by the events on Thursday night and Friday. Late Thursday, news came across the wire that a New York doctor had been diagnosed with Ebola. ES futures moved down by about 0.5% virtually instantly, driven no doubt partly by trading algos monitoring news services for keywords and pushing a thin overnight futures market downwards. By contrast, the markets virtually ignored the story about a shooting at a high school just north of Seattle. (What if the news wires had reported shooter was a local 14 year-old boy who converted to Islam, would the algos have reacted differently?)

Earnings, earnings, earnings!
If the scenario that I outlined is correct, then we need to more or less throw out all the technical analysis around the brief correction as it was only a momentary panic. It's time to get back to fundamentals and the real world.

Where does the market stand today? Last week, I highlighted analysis from John Butters of Factset on the US earnings season and outlook. Here is the updated Factset chart of how consensus forward 12 month EPS estimates are evolving (annotations in red are mine).

I have highlighted in red previous episodes when the forward 12 month EPS estimates have rolled over. These periods have been associated with either bear markets or corrections as the market digests an uncertain earnings outlook. Further, Butters reported that while both the EPS and revenue beat rates have been better than the historical average, the guidance rate has been negative:
Earnings Scorecard: Of the 208 companies that have reported earnings to date for Q3 2014, 75% have reported earnings above the mean estimate and 60% have reported sales above the mean estimate.

Earnings Guidance: For Q4 2014, 29 companies have issued negative EPS guidance and 8 companies have issued positive EPS guidance.
For investors, the current period of stalling forward EPS growth is not a signal for panic, as forward EPS does not appear to lead the stock market. Rather it seems to be, at best, a coincidental indicator.

Where is the EPS weakness coming from? Diving further into the latest earnings reports and company conference calls, it seems to be coming mostly from worries about European growth. US large cap companies derive a significant portion of their sales overseas and global weakness inevitably weighs down the earnings outlook. Butters highlights company comments about the US, Europe and China. The US outlook remains robust (emphasis added):
On a quarter-over-quarter basis (SAAR), U.S. economic growth has been inconsistent in recent quarters. In Q4 2013, Q1 2014, and Q2 2014, quarter-over-quarter (SAAR) GDP growth rates for the U.S. were 3.5%, -2.1%, and 4.6%. According to FactSet Economic estimates, quarter-over-quarter (SAAR) GDP growth for the third quarter is estimated to be 3.0%. Despite the inconsistency, a number of companies to date have reported strong results from the U.S. and North America in their third quarter earnings releases and conference calls, or see continued strength going forward.
The worries are mainly about Europe:
On a quarter-over-quarter basis, economic growth in Europe has been weak in recent quarters. In Q4 2013, Q1 2014, and Q2 2014, quarter-over-quarter GDP growth rates in the Eurozone were 0.3%, 0.2%, and 0.0%. According to FactSet Economic estimates, economic growth in the Eurozone is expected to remain weak, as quarter-over-quarter GDP growth in the Eurozone is estimated to rise 0.2% for the third quarter. Companies have generally provided mixed comments regarding Europe. Some companies have commented on deteriorating conditions in Europe.
Surprisingly, American corporations are not that concerned about growth in China despite the signs of a slowdown:
On a year-over-year basis, economic growth in China has been declining in recent quarters. In Q3 2013, Q4 2013, and Q1 2014, year-over-year growth GDP growth rates in China were 7.8%, 7.7%, and 7.4%. In Q2 2014, there was a slight uptick in GDP growth to 7.5%. However, year-over-year GDP growth in China dipped back to 7.3% for the third quarter. Despite the slowing growth, most companies have been positive in their comments regarding China in their third quarter earnings releases and conference calls.

Watch Europe, not just the Fed
In the coming week, most American investors will be watching the FOMC announcement for clues as to the direction of future policy. While Fed policy is important to the markets, I will be keeping an eye on Europe for clues as to the longer term equity market outlook.

Indeed, the Federal Reserve has shifted its gaze overseas as well as domestically to determine monetary policy. In an unusual turn, New York Fed governor Bill Dudley recently referred to the US Dollar exchange rate in a comment about Fed policy (via the WSJ, emphasis added):
Mr. Dudley has elevated the strength of the dollar and soft global growth as factors affecting the Fed’s policy thinking. He said the strong dollar puts downward pressure on U.S. inflation and dims U.S. near-term export prospects, factors that keep the Fed patient about raising rates even as the job market improves. It’s unusual for a senior Fed official to speak so directly about the impact of the currency on his thinking, in part because the currency is supposed to be the domain of the U.S. Treasury.
In a recent speech to the IMF, Fed vice-chair Stanley Fischer discussed how and why the Fed pays attention to what happens outside US borders:
In a progressively integrating world economy and financial system, a central bank cannot ignore developments beyond its country's borders, and the Fed is no exception. This is true even though the Fed's statutory objectives are defined as specific goals for the U.S. economy. In particular, the Federal Reserve's objectives are given by its dual mandate to pursue maximum sustainable employment and price stability, and our policy decisions are targeted to achieve these dual objectives.Hence, at first blush, it may seem that there is little need for Fed policymakers to pay attention to developments outside the United States.

But such an inference would be incorrect. The state of the U.S. economy is significantly affected by the state of the world economy. A wide range of foreign shocks affect U.S. domestic spending, production, prices, and financial conditions. To anticipate how these shocks affect the U.S. economy, the Federal Reserve devotes significant resources to monitoring developments in foreign economies, including emerging market economies (EMEs), which account for an increasingly important share of global growth. The most recent available data show 47 percent of total U.S. exports going to EME destinations. And of course, actions taken by the Federal Reserve influence economic conditions abroad. Because these international effects in turn spill back on the evolution of the U.S. economy, we cannot make sensible monetary policy choices without taking them into account.
America is not an economic island:
Although the effect of the U.S. economy on other countries is of vital importance to this audience, I will briefly digress to remind you that developments in other economies also can have significant spillovers to the United States, which in turn prompt reactions from U.S. policymakers. For example, in the past few years, the deflationary environment in Japan, together with the fallout from the euro-area fiscal crisis, has entailed persistent weakness in those economies, which historically have been among our most important trading partners, are major recipients of our foreign investments, and loom large in the international credit exposures of U.S. banks. These effects have weighed on global growth, which needs to be taken into account in the setting of U.S. monetary policy.
Monetary policy has global spillovers. What the ECB does affects the US and what the Fed does affects the rest of the world:
Although much of the recent commentary on spillovers has focused on the United States, it bears mentioning that other countries' monetary policy announcements can leave an imprint on international asset prices, with market reactions to new initiatives announced by the European Central Bank (ECB) in the past few weeks the most recent example.13 However, event studies tend to find larger international interest rate spillovers for U.S. policy announcements than for those of other central banks.
No doubt, Fed officials are keeping a close eye on the events in Europe (also see my recent post The Draghi Grand Plan 2.0 which featured a video of a Mario Draghi speech where he shared the stage with, surprise!, Stanley Fischer).

A crucial week in Europe
To put European problems into context, Anatole Kaletsky wrote that the markets were disappointed by the ECB`s failure to follow the Fed and implement QE:
The European Central Bank bitterly disappointed investors who had expected the bank to follow the Federal Reserve’s example and announce dramatic monetary measures, combined with a convincing recapitalization of the European banking system, at European Central Bank President Mario Draghi’s press conference on Oct. 2.

The rout in global stock markets began the day after. Meanwhile, the German government has continued to demand immediate spending cuts from France and Italy while hobbling German industries with Russian sanctions — despite the evidence that both its European austerity drive and diplomatic policies were economically damaging and counterproductive.

It has begun to look as if Europe may stubbornly refuse to follow the U.S. roadmap for economic recovery. If that happens, the improving U.S. economy can no longer be treated as a leading indicator of European recovery.

With this, the prospects for the global economy would be much diminished. While the chances of a renewed financial crisis in the euro zone are greatly increased.
Europe is starting to look like 2011 all over again. To be sure, the eurozone was facing an existential crisis in 2011 as it appeared that Greece could have exited the euro during its debt crisis. Then, we saw the crisis and disagreements erupt publicly as summits progressed on an almost weekly basis.

Today, the problem is far more mundane as it faces a period of slowing growth and possibly deflation. While the threat isn`t immediate, the eurozone may be in for a Japanese style Lost Decade. In a separate column written last Friday, Kaletsky outlined why the next week is crucial to the future of Europe:
Europe is at a make or break moment. Two very different events on Sunday, occurring at opposite ends of Europe, will largely determine the entire continent’s direction for years ahead: the parliamentary election in Ukraine and the bank “stress tests” and Asset Quality Review conducted by the European Central Bank. Before explaining the significance of these two events, and their unexpected linkage, I need to mention a third announcement, due next Wednesday: the European Commission’s verdict on the budget for 2015 submitted last week by the French government.

The Commission will next week have to come up with a Solomonic judgment that somehow reconciles the French government’s determination to stimulate its economy by cutting taxes with the German-imposed “fiscal compact” that former-President Nicolas Sarkozy rashly accepted in a moment of desperation in the 2012 euro crisis and which requires France to raise taxes or drastically cut spending in order to reduce its budget deficit to 3 percent of GDP. The fiscal compact rules, if applied literally, would make economic recovery in France a mathematical impossibility. Yet bending these rules will provoke a German public backlash, and perhaps even a constitutional court challenge, that could even force Angela Merkel to renege on her commitment to support the rest of the euro-zone.

Depending on how these three events turn out, Europe will either be on the road to a moderate economic recovery next year or it will condemned to permanent stagnation, possibly leading to the break-up the euro or even the European Union as a whole.
Personally, I would downplay the threat from the first two events. The markets have largely discounted the Russia-Ukraine situation, much like it has discounted the Hong Kong pro-democracy protests. Nevertheless, there appears to be an upside surprise here as the latest reports indicate that pro-European coalition led by Poroshenko will dominate the new Ukrainian parliament.
Starting with the Ukrainian election, a victory for President Poroshenko’s moderate party should allow EU leaders to launch a genuine peace process that recognises the loss of Crimea as irreversible and acknowledges Russia’s vital interests in maintaining the military neutrality of its immediate neighbours. Once these basic conditions are satisfied, a rapprochement with Russia should become possible, allowing sanctions to be gradually dismantled or at least confirming that sanctions will expire by mid-2015, as currently legislated. Removing the threat of war or further sanctions in eastern Europe will have a major beneficial effect on businesses in Germany and Italy, which been hurt much more by the confrontation with Russia than European leaders expected.
The Asset Quality Review is important because it is a necessary pre-condition for launching QE:
Sunday’s completion of the AQR has always looked like a necessary, though not sufficient, condition for a substantial improvement in monetary policy. This is because the ECB wants to stimulate private borrowing, as Britain did with the sub-prime mortgage subsidies it announced in March 2013, rather than supporting public debt, as in U.S. and Japanese quantitative easing. For this plan to work, European banks must be recapitalized and cleaned up, which the AQR is designed to achieve. If Sunday’s AQR plan proves convincing (admittedly still a big “if”) the stage will be set for the ECB to announced some serious monetary stimulus at its next meeting on Nov. 6.
Since he wrote those words, the AQR results have been published and 25 banks failed the tests but 12 have already taken steps to address the capital shortfalls since then. The good news is there are no big German or French banks on either list and the problem banks are concentrated in the troubled peripheral countries, with Spain as the outperforming outlier. All that needs to be raised is €9.5 billion, which is in the low end of estimates.

Kaletsky thinks that we could also see an upside surprise when the Commission reviews the French budget. No doubt, we will at some point see the usual European grand bargain struck behind closed doors, where the letter of the rules are respected but possibly not their intent.
Finally, a U-turn on fiscal austerity is highly probable when the Commission delivers its verdict on the French budget on Oct. 29, or failing that, in mid-November after a symbolic “re-negotiation” leading to some cosmetic strengthening of French structural reforms.

Back to 2011?
If the events of 2011 are to serve as a template for the markets of 2014, then the big question becomes one of where are we in 2011. Are the markets in the shaded area when stocks tanked, rallied and chopped up and down during the period of uncertainty? Or have we seen, or about to see, the policy response like the LTRO announcement that eventually propelled equity prices to another bull phase?

On one hand, we have started to see a policy response from the authorities. The ECB announced that it may consider asset purchases of corporate debt. While it is technically not QE, which buys government debt and a no-no for the Germans, such an action does open the door to the expansion of the ECB balance sheet. As well, we saw a policy response from the Chinese the PBoC indicated that it would inject liquidity to the tune of 200 billion yuna on October 17. At about the same time, St. Louis Fed Governor James Bullard surprised the market by saying that the Fed should consider delaying the end of QE. Is that enough of a policy response?

The chances of a thaw in the icy Draghi-Merkel relationship may be forthcoming. On one hand, this Reuters story outlined Draghi's break with Berlin:
This tension is most obvious in the relationship between Draghi and Bundesbank President Jens Weidmann, which according to numerous officials who spoke to Reuters on the understanding they would not be identified, has almost broken down. But it goes further than that.

According to German officials, Merkel felt betrayed by Draghi's speech at a central banking conference in Jackson Hole, Wyoming in August in which he pressed Berlin for looser fiscal policy to stimulate the economy.

Her entourage is also deeply sceptical about Draghi's plan to buy up asset-backed securities (ABS) and covered bonds in the hope of encouraging commercial banks to lend.

Most of all, politicians in Berlin worry that if this scheme doesn't work, the ECB president will be tempted to launch full-blown government bond buying, or quantitative easing. This is a taboo in Germany and a step Merkel's allies fear would play into the hands of the country's new anti-euro party, the Alternative for Germany (AfD).
On the other hand, this Reuters story last Friday indicated that Merkel is softening her stance on fiscal stimulus and went out of her way to praise Draghi and the ECB:
German Chancellor Angela Merkel thanked ECB President Mario Draghi for spelling out to leaders at an EU summit that governments must play a role in boosting the faltering euro zone economy, and said it was their firm intention to do so.

"I am very thankful to Mario Draghi for holding up a mirror for us once again," Merkel told a news conference in Brussels on Friday, a day after Reuters reported tensions in the relationship between Berlin and the Italian ECB president.

"Monetary policy can do some things, that is the job of the independent European Central Bank. But if fiscal policy doesn't react simultaneously, if we don't improve our economic policies, our competitiveness and our investment climate, then we won't come out of this unsatisfactory situation," Merkel said.

She added that leaders had expressed their "clear intention" to do all this in response to the weak economy.
You have to love European theatre!

The week ahead
As we approach the week ahead, the SPX has rallied strongly from a V-shaped bottom. It sliced through the 200 day moving average resistance in a single day and it's now approaching the 50 dma. Momentum indicators remain positive and the 14-day RSI is not yet in overbought territory. Given the violence of the recent up and down moves, I would not be surprised to see some degree of consolidation in the week ahead with pullbacks to test any of the Fibonacci retracement levels or the 200 dma, though a further advance cannot be ruled out. In effect, the markets are normalizing after the downdraft and reversion of the last few weeks.

The behavior of the small cap stocks have also normalized as well. The relative performance chart below of the Russell 2000 against the SPX tells the story. The shaded area shows the outperformance of small caps during the market swoon and their reversal soon after. This pattern is consistent with the hedge fund re-positioning thesis. Many long-short funds buy individual favored stocks and then hedge with short positions in the Russell 2000. If forced to reduce their positions, they would naturally buy back their Russell 2000 short positions, which put upward pressure on the small cap index during the unwind. When they finished, the relative downtrend of small caps relative to large caps continued.

My inner trader is nervously long and prepared for volatility. My inner investor is asking, "Correction, what correction?"

Disclosure: Long TQQQ

Friday, October 24, 2014

How inequality may evolve in the next decade

I've been meaning to write about this topic, but I didn't get the time until now. In my post Inequality and the genetic lottery: Two views, I summarized the global inequality issue this way:
Branko Milanovic, the Lead Economist at the World Bank research group, said in so many words the Left in developed countries won the genetic lottery but they didn't even know it (my words, not his). The chart below shows who won and lost in the inequality race globally. The x-axis on the bottom splits the world population from the poorest on the left in subsistence economies to the richest on the right, while the y-axis shows the real income growth in PPP terms between 1988 and 2008. 

In the thirty years spanning 1988 and 2008, the winners in the inequality race were the middle class in emerging economies, because of the effects of globalization, and the very rich, who engineered the globalization revolution. The losers were the very poor in subsistence economies, who weren't able to benefit from and the middle class in developed economies, who did not receive the benefits of the productivity gains (see Rex Nutting's analysis above) in the last few decades.

Slowing EM growth
If the winners of the globalization drive were the emerging market countries' middle class, what would happen if EM growth were to slow? Writing in Beyond BRICS, that's exactly what George Magnus projects for EM economies:
It is now clear clear that the exceptional acceleration in emerging market growth between 2006-2012 is over.

Even if the IMF predictions from 2015-2019 turn out to be correct (see chart below), the Middle East and North Africa, and Sub-Sahara Africa would be the only geographic regions where growth in those five years would be comparable with the period from the mid-1990s to 2012, according to IMF statistics.
That`s because the low hanging fruit of globalization is gone and EM countries like China are facing their Lewis turning point:
Successful economic development now looks a much tougher challenge, and perhaps only a handful of countries can expect to join the select group of 35 high income countries (income per head over $20,000), not counting the 14 low population and small island states. Countries such as Poland and Chile are knocking at the door, but the countries in this universe look increasingly like the exception not the rule.

An American Renaissance?
Considering that the Milanovic study found that the middle class in developed market economies lost ground in the globalization drive, a reversal of that effect could mean those effects get slowly reversed in the next decade. In particular, if EM economies and China, in particular, were to see slower growth rates over the next decade, then I can see the following important global effects:
  • Slowing resource demand drives down commodity prices
  • A greater propensity for onshoring of manufacturing once moved offshore
Lower commodity prices would amount to lower input costs for US businesses. In addition, lower oil prices amounts to an implicit tax cut for the consumer. In addition, an onshoring trend would increase US employment. All these effects could amount to an American Renaissance.

The chart below from Boston Consulting Group shows the operating costs in each country. Note that the costs for China, once the preferred go-to country for offshoring, are not very different from the US and not competitive relative to Mexico.

BCG went on to summarize the recent winners and losers in operating costs. The main conclusion drawn from this chart shows that the losers were EM countries, while the US and Mexico were the winners.

The combination of rising middle class employment, income and lower fuel spending costs would therefore see greater gains by the developed market middle class - and moderate complaints about the income inequality in the next decade.

Problems of onshoring
To be sure, the transition may not be as smooth as I postulated in the seemingly rosy scenario that I outlined. There are reports that companies that tried to onshore manufacturing have run into difficulties, largely because either labor skills sets have disappeared or decades of offshoring has moved the supply chain offshore (via the Brookings Institute):
However, it is an instructive irony that although the trends are now right for U.S. reshoring, conditions on the ground are not always so favorable. That's because 40 years of offshoring have done a lot of damage to what Gary Pisano and Willy Shih have called the nation's "industrial commons"—the shared resource base of skilled workers and supply chains upon which all manufacturers draw.
Shih conducted a couple of case studies and found labor skill and supply chain problems:
Shih injects a dose of realism into the reshoring discussion. He notes that both GE and Google’s Motorola Mobility unit faced enormous difficulties in hiring adequate numbers of appropriately skilled people for their factories. Appliance Park started with 10,000 applications for an initial 2012 posting. Of the 6,100 who passed the screening, 730 were hired but 228 were terminated in the first year. Fort Worth had to hire 6,500 workers to yield the required 2,500 employees to begin volume production. In both cases, a lack of basic familiarity with modern precision manufacturing among new hires led to a lot of turnover.

At the same time, managers at both Appliance Park and in Fort Worth faced hollowed-out local supply bases. Almost all the parts for the MotoX had to come from China, Korea or elsewhere in Asia, while GE encountered reduced capacity in its supply base for appliance parts. As of now, Appliance Park has basically succeeded in Louisville (though GE has signaled that it wants to sell its appliance division) while the Motorola—which Google is selling—said recently it will close the MotoX facility in Fort Worth due to lackluster sales and high costs for labor and shipping.
In the long term, the story of slowing EM growth, falling commodity demand and onshoring will continue in fits and starts. Nevertheless, this trend is likely to result in better developed market middle class income growth over the next decade.

The reduction of inequality appears to spur growth potential. A recent paper by Price and Boushey entitled How are inequality and economic growth connected? conducted a survey of research on the issue of inequality. They summarized the conclusions this way (emphasis added):
This paper does not contain policy advice. Instead, it contains analysis that largely demonstrates there are direct, and possibly causal, relationships between economic inequality and growth—places that begin with a lower level of inequality subsequently tend to grow faster and have longer periods of growth than those with a higher level of inequality. In future research, we will focus on the channels through which inequality could or does affect economic growth.
If inequality were to be reduced in the developed market economies, then it would mean a brighter future for these economies in the decades ahead. The current level of concern expressed about economic inequality may therefore represent the generational high tide mark of this debate.

Wednesday, October 22, 2014

The Draghi Grand Plan 2.0

The parents fight and the kids hear everything. The younger, more naive ones, think that the parents are on the verge of a divorce, but nothing could be further from the truth. That`s the picture of Europe today. The outsiders are the young kids listening to the fights between European leaders.

Grand Plan 1.0
Recently, Mario Draghi outlined Version 2.0 of his Grand Plan for Europe. I have written about the first version before (see Mario Draghi reveals the Grand Plan and Draghi`s "growth pact" = Internal devaluation). To recap, Grand Plan 1.0 involves:

  • The ECB taking steps to temporarily hold things together and buy time so that member eurozone governments enact reforms.
  • The reforms include:
    1. Good austerity: Budget reduction through lower taxes and less government
    2. Structural labor market reforms to encourage labor flexibility and breaking the social compact of lifetime employment for entrenched older workers.
In a currency union, the peripheral countries cannot devalue their currency to become more competitive. They have to enact painful reforms that amount to internal devaluation. In effect, German wages go up and PIIGS wages go down. Despite the pain, those initiatives have largely pushed the eurozone in the right direction. As the chart from Ned Davis Research shows, progress continues as unit labor costs of most eurozone countries have declined YTD relative to Germany and indeed, EM manufacturing powerhouses like China.

Grand Plan 2.0
Now Mario Draghi has revealed his Grand Plan 2.0, which he outlined in a speech at the Brookings Institute while sharing the stage with the Fed`s Stanley Fischer (use this link if the video doesn`t work):

In his speech, Draghi outlined the third leg of Grand Plan. In addition to the components of Grand Plan 1.0, Grand Plan 2.0 includes infrastructure spending for member states that have the fiscal flexibility to do so. In practical terms, it's an infrastructure fiscal spending for structural reforms bargain within the eurozone.

"Infrastructure spending", them`s fighting words as they are evocative of the Keynesian solution of government make-work fiscal stimulus. The criticism of Jeremy Warner of The Telegraph is typical of the objection to such an initiative, which was also a growth strategy advocated by the IMF:
Infrastructure spending is a bit like motherhood and apple pie. Everyone can agree that it’s basically a good thing, serving the dual purpose of providing both a short-term boost to employment and, assuming it’s wisely allocated, a long-term increase in the economy’s productive potential.

But to think that in itself such spending provides a solution is a complete misdiagnosis of the problem.
Warner explained that many European countries don`t need more infrastructure, so why build more bridges to nowhere?
Nor, in any case, is it always worthwhile. No one would think that the economic stagnation which has settled on France is for want of infrastructure spending – it has some of the best infrastructure anywhere in the world.

Similarly, some of the other troubled economies of the eurozone – Spain, with its empty regional airports, and Portugal and Ireland with their traffic-free highways – hardly need more such spending. As in China, the problem in these countries has if anything been one of over-investment, rather than lack of it.

There is also a basic problem that afflicts all publicly initiated infrastructure spending – much of the time, it is guided by government vanity and pork barrel politics. Glamour projects, such as high speed rail, tend to assume precedence over more mundane, but perhaps better targeted, spending on improving the existing transport network.

A different kind of infrastructure
As you watched the video, Draghi proposed a more subtle approach to infrastructure spending that just building highways and bridges. He referenced digital infrastructure and categorized spending on education as infrastructure spending. He said that it is not a coincidence that underperforming countries also scored badly on global education standards (presumably like PISA tests). Draghi referenced the benefits of education in a Jackson Hole speech that he made this year:

Perhaps Draghi was thinking about the kinds of apprenticeship programs implemented in Germany as a model for the rest of Europe. Consider this Quartz story about these programs. While the focus of the article was transplanting apprenticeships to the US, the comments could be applied to other parts of Europe as well:
This doesn’t mean the system can’t be adapted if we start with our eyes open and a full understanding of the differences between the two countries. What’s likely to drive programs, in the US as in Germany, is the need for talent. “German companies want to train,” one trade association executive told us, “because they know the schools can’t do it. Especially in today’s tech economy, vocational schools alone can’t prepare the workers we need.”
As with the kind of reforms undertaken with Grand Plan 1.0, these kinds of initiatives are much harder to achieve than politicians deciding to write a cheque for more roads, railways and airports. These kinds of changes are hard and take a lot of work. Draghi was probably thinking of the kinds of achievements outlined in this Project Syndicate essay (Make your own Silicon Valley), where Finland created a cluster of gaming startups that export 90% of their products and the Dutch started a big-data hub that resulted in the Netherlands Institute for Radio Astronomy.

Looking through the Sturm und Drang
No one said that these changes are going to be easy, but my guess that Europe will eventually move in that direction.

Currently, there are numerous German objections to the plan for more fiscal spending, but the Germans will eventually waver. That`s because France is becoming the new sick man of Europe. The French-German alliance represents the heart of Europe. No doubt we will see lots of German protest and likely 2011-style emergency-summits-every-other-week before this is over, but everyone involved understands that France is too big to save.

In addition, German growth is starting to tank and that will create internal pressure for Berlin to act:
The German government on Tuesday slashed its growth outlook, saying the country's economy was navigating "difficult waters" because of worsening conditions around the world.

German Economics Minister Sigmar Gabriel said Berlin expected gross domestic product (GDP) to expand by only 1.2 percent in 2014, down from an earlier estimate of 1.8 percent. He also revised projections for next year to 1.3 percent annual growth from 2 percent.

"Geopolitical crises have also increased uncertainty in Germany with the only moderate global economic development acting as a drag on the economy," Gabriel added.
Even German states are pleading for the central government to take action in the face of slowing growth (via Bloomberg):
Germany’s state governments stepped up calls for infrastructure spending, adding another source of pressure on Chancellor Angela Merkel to boost investment as economic growth falters.

Much like Merkel’s national government, the states are caught between a deteriorating growth outlook and the balanced-budget drive that Germany started in response to the euro area’s debt crisis. It’s making the 16 regions set aside political differences to challenge the status quo, from rich Bavaria to rural Mecklenburg-Western Pomerania in the east, home to Merkel’s electoral district.

A day after the German government lowered its growth outlook, proposals to spend more on projects such as highways in Europe’s biggest economy are on the table at a retreat of state premiers starting today that Merkel plans to attend.

“To unleash growth impulses, additional investment is needed in infrastructure and other future-oriented sectors,” according to a summary of the states’ negotiating position in fiscal talks with the federal government that was prepared for the meeting in Potsdam and obtained by Bloomberg News. The states want a “lasting” funding boost, saying a lack of spending is holding back economic development nationwide.

The struggle in Germany parallels the international conflict pitting Merkel and Finance Minister Wolfgang Schaeuble against the International Monetary Fund and countries such as France and Italy that advocate spending to stimulate growth.
The theatre may be upsetting for some, but Europe is a place where the elite makes deals behind closed doors. Watch for Merkel et al to relent and effect a fiscal stimulus for structural reform bargain, but not before a lot of Sturm und Drang to show the hardliners that they tried but compromised for the sake of European unity. José Manuel Barroso wrote that unity is the "is a condition sine qua non of the EU’s economic prosperity and political relevance" and it is a quality that embedded in the DNA of every member of the European elite. Everyone understands those core values.

Watch for the endpoint. The Draghi Grand Plan 2.0 will implemented in some fashion.

Tuesday, October 21, 2014

The bullish and bearish implications of the midterm elections

In my weekend post, I wrote that the US equity market is getting close to a bottom (see Getting close to a bottom, but not yet), but I neglected to add the likely bullish effect of the US midterm elections in November.

As things stand today, the Republicans have lock on the control of the House. The latest FiveThirtyEight forecast is that the GOP has a 65% chance of controlling the Senate, though other polling organizations have higher odds. The sports books odds at PaddyPower shows a 79% chance of the Republicans taking the Senate.

In the past few weeks, Wall Street has been pre-occupied with other distractions, such as China, Europe, Russia-Ukraine, Ebola, etc. I have seen little discussion of the likely impact of the November electoral results on the markets. Therefore the election of a Republican controlled House and Senate, which are considered to be more business friendly than the Democrats, should provide a bullish boost for the stock market in early November. The response from the Barron`s Big Money Poll is confirms this view.

This scenario is also consistent with the one I indicated on Sunday of a market bottom in the next week or two.

Watch out for the bearish blowback
Assuming that the GOP does re-take control of the Senate, the short term bullish boost could be offset by the bearish effects of fiscal gridlock in early 2015. Bill McBride at Calculated Risk recently highlighted a note from Goldman Sachs on the risks involved:
In many policy areas, a shift in Senate control would simply result in a new flavor of the gridlock that has prevailed since the 2010 election. The split between Congress and the White House would still exist and, while Republicans would set the agenda in both chambers if they held a majority, a degree of bipartisan support would still be necessary in the Senate light of the 60-vote threshold necessary to pass most legislation.

The exception would be the annual budget resolution and legislation related to it. The budget resolution sets out annual targets for federal spending, revenue, and debt. More importantly, it can be used to clear a procedural path for legislation that includes policies to reconcile the level of spending, revenue, or debt under current law with the levels in the budget resolution. Such “reconciliation” legislation is not subject to filibuster and can therefore pass both chambers with only a simple majority (i.e., 51 votes in the Senate).
That's because of the market uncertainty surrounding another potential battle over the debt ceiling in March:
The result is likely to be less predictability regarding the process surrounding major fiscal deadlines. Since the confrontation between House Republicans and the White House over the debt limit in 2011, markets have gradually become inured to fiscal brinksmanship, as these debates have started to follow a predictable pattern. If Republicans win majorities in both chambers as polls currently suggest they might, that pattern seems likely to change, which could lead to renewed uncertainty ahead of future fiscal deadlines.
By all means, position for a tactical rally in US equities at year-end, but don't be so quick to celebrate. Be aware of another looming Washington budget crisis early next year.

Be forewarned: The market gods giveth and they taketh away.

Monday, October 20, 2014

What do the pros REALLY think about the market?

I was reviewing a few "institutional" manager polls and found a number of glaring discrepancies. On one hand, Ryan Detrick highlighted the level of panic among NAAIM managers in their equity exposure:

On the other hand, the newly published Barron’s Big Money Poll of money managers showed them to be super-bullish on equities. The table from the poll shows the pros to be tilted bullishly towards stocks, far more believe equities are undervalued than overvalued and, most importantly, 80% expect to be net buyer of equities in the next 12 months:
It’s going to take a lot more than the past month’s 5%-plus selloff in stocks for America’s money managers to change their upbeat tune. That’s what they’ve been telling Barron’s in the past two weeks, ever since 59% of participants in our latest Big Money poll said they were bullish or very bullish about the outlook for U.S. stocks through the middle of 2015. That’s up from 56% in our spring survey, but below last fall’s bullish reading of 68%.

The BoAML Fund Manager Survey (FMS) shows US equity exposure to be slightly above average and rising, but not excessively high:

WTF? How can managers be both bearish (NAAIM), mildly bullish (FMS) and extremely bullish (BM) on US equities all at the same time?

In addition, the NAAIM survey readings seem highly unusual to me. The swings in asset allocation in NAAIM sample do not correspond to the behavior of any institutional manager that I am familiar with. Most institutional managers have individual mandates, e.g. US large cap equities, HY bonds, etc., which require them to stay fully invested. A cash level of more than 5% is unusual under most circumstances (imagine how you would react if you bought SPY and its NAV underperformed in a market rally because the manager decided to hold 20% cash).

Comparing survey samples
It all became more clear to me when I read the survey sample discussions of each of the polls. My former Merrill colleague Walter Murphy indicated to me that the NAAIM sample consists of RIAs investing money on behalf of their clients. In other words, these are individual mom and pop investment advisors with discretionary authority over client funds.

By contrast, both the Barron`s and BoAML survey sample are more institutional in character. Barron`s describes their survey respondents this way:
THE BIG MONEY POLL is conducted twice a year, in the spring and fall, with the help of Beta Research in Syosset, N.Y. The latest survey drew responses from 145 portfolio managers from across the country, representing some of the largest investment companies in America and many smaller firms. Barron’s has been conducting Big Money for more than 20 years to get professional investors’ read on the financial markets and the economy.
By contrast, the BoAML sample is more global in nature as they conduct both global and regional surveys:
An overall total of 220 panellists with $640bn AUM participated in the survey. 176 participants with $508bn AUM responded to the Global FMS questions and 103 participants with $264bn AUM responded to the Regional FMS questions.

Highlights of macro risk
Now that the sample question are resolved, my conclusion is that the RIAs panicked during the recent risk-off period, while the US institutional managers turned more bullish on US equities and global and non-US managers drew back their risk profile a bit to benchmark.

The responses also highlighted the kind of macro risks involved in the forecasts. Consider that, according to Barron`s, manager expect 10-year Treasury yields to rise to between 3.0-3.5% next year.

Wow! That represents a rise of roughly 1% in the 10 year yield in the context of a rising stock market. That would suggest a very robust earnings and economic growth scenario, which is shown below. Here is the key risk: Either growth expectations be unrealistically high or the bond yield forecast wrong.

In addition, the BoAML survey shows a majority of managers expect a flattening yield curve. If both the Barron`s sample and the BoAML samples are correct, then that will imply 10-year yields will rise to 3.0-3.5% while the yield curve flattens - meaning an unexpected spurt in the short end indicating that the Fed will tighten far more aggressively than the market expects.

Somebody is very wrong, but there are undoubtedly opportunities in betting against the consensus here.

To be sure, the BoAML survey is far more global in nature and those survey results reflect the angst that managers feel over the non-US economies. Macro risk is rising in the eurozone and China in the form of growth slowdowns. The cautiousness shown in that sample stands in stark contrast to the bullishness to the US money manager sample of the Barron`s survey. That`s why it`s important to understand the differences in respondent populations before interpreting the data and jumping to conclusions.

Watch what they do
In the end, professional money managers are not that different than you or me. There are tall ones and short ones, white ones and brown ones, male and female and they come in all shapes and sizes. That`s why I do tend to tread carefully when I read these survey results. I prefer to watch either market based indicators, e.g. option premiums and skews, or focus on questions about what they`re doing with their money, e.g. AAII asset allocation survey, rather than what they think, AAII bull-bear survey.

Watch what they do, not what they say.

Sunday, October 19, 2014

Getting close to a bottom, but not yet

Trend Model signal summary
Trend Model signal: Risk-off
Direction of last change (trading model): Negative

The actual historical (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

The enigmatic bear
Is the correction over? Did we bottom last week?

I've been getting those questions all of the last week. To answer that question, I believe that we have to answer the question of why the stock market went down. The current bearish episode is highly enigmatic as there appeared to be no consensus fundamental reason for the swoon. In other words: Unless you know what your illness is, how can you know if you are cured?

As the stock market sold off last week, the narrative seemed to be rising worries over economic weakness in Europe and, to a lessor extent, China. Indeed, the US earnings outlook has finally started to deteriorate in response to the economic weakness abroad. The chart below, from John Butters of Factset (annotations in red are mine), shows that forward EPS estimates (blue line) are starting to roll over. Such episodes have been associated in the past with either corrections or bear markets.

To explore the implications of the global slowdown hypothesis, Gavyn Davies outlined a number of slow growth scenarios called the "new mediocre" (charts here). First, he outlined his baseline scenario of continued global growth. Note that the projections for US GDP growth is in the 2-4% zone:

He then modeled a China hard landing scenario, with a growth slowdown that could freak out the markets.

As much of the market concerns last week surrounded slowing eurozone growth, Davies highlighted how growth seems to be spreading to core eurozone countries like France and Germany:

He went on to model the effects of a eurozone recession, which showed a marginal growth slowdown in the US:

Just so that investors don`t go overboard on the bearish scenarios, Davies indicated that growth "nowcasts" are not showing any sign of slowdown:

If we were to accept the narrative that the markets fell because of concerns over slowing growth, the the latest BoAML Fund Manager Survey (FMS) should provide some comfort for US equity bulls. The FMS shows that global growth expectations are rolling over:

However, the downside is likely to be limited. The FMS shows that managers have not taken on excessive risk. Should a synchronized global growth scare occur, it woulcould cause cascading de-risking activity that would result in a crash, or even a bear market. True enough, global equity allocations are above average and they are falling, but levels are not excessive:

On the other hand, cash levels are high by historical standards:

As growth concerns are concentrated in Europe and China, the US is likely to be a safe haven for equity exposure. The FMS shows that US equity exposure is not especially high by historical standards. Should a crisis occur, managers that have the mandate flexibility to alter country equity exposure would likely gravitate to the US:

As well, the latest data on insider activity from Barron's shows that this group of "smart investors" have been buying on this dip:
Bottom line: If you were to accept the reasoning that the latest round of equity market weakness is attributable to slowing global growth, then US equities are relatively well insulated from a growth scare.

Blame the Fed?
The conventional wisdom explanation of this market correction seems a little too neat. I had warned about slowing global growth in July (see Global growth scare = Trend model downgrade) and others, like David Levy, warned about a possible US recession as well (also see What keeps me awake at night):
Just as the US economy strengthens, other countries threaten to drag it down. Employers in the US are creating jobs at the fastest pace since the late 1990s and the economy finally looks ready to expand at a healthy rate.

But sluggish growth in France, Italy, Russia, Brazil and China suggests that the old truism “When the US sneezes, the rest of the world catches a cold” may need to be flipped.

Maybe the rest of the world will sneeze this time, and the US will get sick.
Levy correctly warned us about the Global Financial Crisis. His record, as well as his family's pedigree of forecasting, is impressive:
His grandfather, Jerome, didn’t just call the great crash of 1929 – he sold his stock and liquidated his wholesale goods business in anticipation of it. Immediately after the Second World War, when many experts thought the US was sure to fall into another depression, his father, Jay, accurately predicted a rapid expansion. In late 1999, his uncle, Leon Levy, a hedge fund manager and collector of antiquities, invited me into his office and predicted a new generation of the wealthy would be laid low soon in a coming dotcom crash.

Those stocks began their long dive a few months later.
Despite the growth concerns raised during the summer, the stock markets kept going up. The equity market went on to shrug off the Russia-Ukraine conflict, impending deflation in the eurozone, news of slowing Chinese growth and protests in Hong Kong. The explanation that the markets suddenly freaked out over slowing global growth doesn't seem plausible.

A simpler explanation was advanced by Macro Man, who attributed the sea change in risk appetite to Fed policy:
By an amazing coincidence, the Federal Reserve is about to stop purchasing assets for the first time in a couple of years. In the QE era, there has been a very strong inverse relationship between the degree of policy accommodation and the level of equity vol. As such, from Macro Man's perspective, the current "collapse" merely represents a normalization in the Sharpe ratio for holding equities, credit, other risky assets etc.
He concluded that we are just observing the normalization of market volatility, but it is nothing to panic over (emphasis added):
From Macro Man's perch, this is not 2000, 2007, or any similar market-topping analogue. While there has been some financial excess, there is nothing like the kind of real economy excess to produce a proper meltdown/recession. As noted above, what we are observing is the start of a normalized volatility regime, at least in certain segments of financial markets. If anything, the proper historical analogue for next year will be 1994 or 2004- two years when stocks kind of scuffled as monetary policy was tightened for the first time in several years. (For fun, look what happened to USD/JPY on Valentine's Day 1994.)
In support of Macro Man's perspective, Izabella Kaminska at FT Alphaville highlighted analysis from Matt King at Citi. Citi's interpretation is that it's global central bank liquidity that matters, not just what the Fed does:

For over a year now, central banks have quietly being reducing their support. As Figure 7 shows, much of this is down to the Fed, but the contraction in the ECB’s balance sheet has also been significant. Seen from this perspective, a negative reaction in markets was long overdue: very roughly, the charts suggest that zero stimulus would be consistent with 50bp widening in investment grade, or a little over a ten percent quarterly drop in equities. Put differently, it takes around $200bn per quarter just to keep markets from selling off.
In some ways, this "blame central bankers" explanation may be a more satisfactory explanation for the most recent bout of market weakness. It could be said that the sell-off in risk assets was sparked by de-risking in the bond market and the downside volatility was magnified by a lack of liquidity. The weakness then spread to the stock market. David Keohane of FT Alphaville pointed to analysis from Nomura:

Do click to enlarge but what you’ll see is risk assets like US high yield, energy stocks and brent (at $80 yet?) getting hit while FX and peripheral Eurozone bonds, for the most part, have been admirably steady. For the lack of something more compelling, Nomura blame the lack of a clear liquidity backstop, QE4 notwithstanding, and global growth concerns, old-hattedness notwithstanding:
Nomura went on to say that the current risk-off environment is nothing to get worried about, largely because liquidity in the banking system remains ample and there is little risk of financial contagion (emphasis added):
Nevertheless, there is no doubt that many investors seem to be in full-on risk reduction mode currently. We are currently receiving a steady stream of questions about how bad it can get, with comparison to the 2011 sell-off and suggestions that QE4 may be needed. This illustrates how quickly sentiment has swung.

While we are concerned about the setup for risk assets in general this quarter, due mainly to liquidity and valuation considerations, we are less concerned about the actual impact of recent market dynamics on key global economies, for a number of reasons.

First, the type of risk aversion we are seeing now is not necessarily that powerful from a financial conditions perspective. Banks are actually outperforming in the sell-off, and liquidity indicators are well behaved. For example, dollar funding markets are stable, and short-duration credit instruments are holding firm, while the move in swap spreads has been moderate (relative to VIX moves). Hence, while high yield spreads are meaningfully wider (from a low base), it is not clear at this point that there will be strong feedback into the economy through tighter credit conditions. In fact, in the US, you can argue that lower mortgage rates will be a boost to an important component of the credit spectrum.

Second, the big move in oil prices can be interpreted in various ways. A delayed reaction to increased US supply? A function of weakening global demand? Due to Libyan production surprising to the upside? There will be winners and losers from this price shock (see Dissecting the Commodity Shock, 9 October 2014). But generally, the Eurozone and the US will see consumption potentially somewhat boosted by this dynamic, simply because the terms of trade are being boosted.

All told, there may well be a gradual downtrend in global growth, driven especially by EM growth trends. But it is unclear that the recent market tension is of a type that will put us into a downward spiral, as was the case during the Global Financial Crisis and during the Euro crisis.
The whole risk-off episode may have been sparked by fears of a US junk bond liquidity at Pimco (via Dealbook):
When it comes to high-risk bonds, the asset management giant Pimco has pretty much cornered the global market.

Be it bonds issued by the automotive financier Ally Financial or the student loan financier SLM in the United States, or government bonds in Spain and Italy, Pimco holds a commanding position in these high-yielding securities.

But as Pimco’s portfolio managers double down on their bet that high-risk bonds will thrive in a world of low interest rates, a growing number of global regulators are warning that the positions being taken on by the big asset management firms pose a broad danger to the financial system.

These concerns were amplified this week as stock markets gyrated, the yields of high-risk corporate and European bonds spiked upward and, crucially, trading volumes evaporated.

Regulators and bank executives have cautioned that an accumulation of hard-to-trade, risky bonds by a small group of fund companies could turn a bond market hiccup into a broader rout, in light of how illiquid many of these securities have become.

With a liquidity induced sell-off, where bond investors try to rush for the exits, the weakness then spread to equities, David Merkel wrote a must-read post showing how equity weakness could get amplified.

Whatever explanation you accept for the recent episode of market weakness, the conclusion is clear. This is not the start of an equity bear market. In that case, we should look to technical analysis to see the likely near-term path for US equities.

Equities oversold, but wait for the final bottom
From a technical viewpoint, where does the stock market stand today?

As the week closed, the SPX showed a high degree of technical damage and many indicators are highly oversold. As the chart below shows, the SPX has violated the uptrend that began in late 2011 and remains below its weekly Bollinger Band, which is a relatively rare occurrence. In addition, other indicators such as the NYSE HL and my favorite overbought-oversold indicator are showing oversold readings seen in past major bottoms.

Was last week`s flush on Wednesday emotional to be a bottom? Close, but not quite (see A Bold Forecast: Today was not the bottom). If we were to compare current TRIN and equity-only put-call ratios to past market bottoms of recent major market sell-offs in 2010 and 2011, the level of panic is vastly different.

Undoubtedly a bottom is near, but last week was probably not the final market low. Dana Lyons showed the pre-conditions for major market bottoms and the sell-off last week is indicative of a pending market low,

But not yet. Here are the historical return statistics of market sell-offs like the one seen last week:

Andrew Nyquist had a similar warning for traders who get prematurely bullish. Wait for the re-test of the lows:
One word of caution for those calling this the bottom: Markets almost always see retests. And quite often price gives way to brief undercuts or new lows/legs lower. Additionally, the Options Equity Put-Call ratio still hasn’t pushed above 1.00 and managed to drop to .78 today. That said, market volatility as measured by the VIX briefly spiked over 30. And the SP 500 pierced a key Fibonacci support level but managed to close above it.
I would tend to agree with Nyquist - wait for the retest of the lows, which will likely occur next week. The last few major corrective episodes were in 2010 and 2011. As this SPX chart from 2010 shows, the market made a W-shaped rather than a V-shaped bottom, and spent several weeks re-testing the lows before resuming the bull trend.

Here is the chart from 2011.

In addition, if you were to accept the central bank liquidity induced sell-off explanation, then Nautilus Research has a warning for you. Expect more volatility, but not necessarily a resumption of the bull:

Putting it all together, my base case scenario calls for greater market volatility in the weeks ahead .Tactically, I expect a second round of weakness next week to test and perhaps undercut last week's low. Friday's rally was halted at the first Fibonacci retracement level (1892), with further resistance at the 200 day moving average (1906) and the 50% retracement level (1920).

My inner trader remains modestly short and my inner investor is looking around to see what bargains he can pick up at these depressed levels.

Disclosure: Long SPXU