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

Saturday, October 18, 2014

A "smarter" way of reaching for yield

In general, I am not in favor of reaching for yield as the practice can entail a high degree of risk that income oriented investors cannot tolerate. I do understand, however, the dilemma facing such investors who need a regular stream of income.

For those who are forced into stretching for yield, buying emerging market bonds may mitigate some of the risks involved.

HY bonds a crowded long compared to EM bonds
The latest BoAML Fund Manager Survey shows that many managers believe that US high yield, or junk bonds, are getting to be a crowded long. On the other hand, emerging market bonds, which carry similar levels of risk, are not. So if you're going to take extra risk and reach for yield, EM bonds may be a better alternative than US HY.

Falling USD = EM currency bullish
Moreover, the survey indicates that US Dollar is a crowded long whose price seems to be in the process of reversing itself (see my recent posts Overbought USD = Commodities poised to rally? and Get ready for the resource rally). The chart below of the weekly USD Index finally moved off its overbought RSI reading, which historically has signaled a decline. Such a decline should be bullish for EM currencies.

EM vs. HY bond relative returns
The top panel of chart below shows the relative performance of EMB, the EM bond ETF, against HYG, the US HY bond ETF.

However, the duration of the EMB and HYG are different and buying one and selling the other involves an interest rate sensitivity bet as well as a bet on the relative credit quality as well as a bet on the USD (see my post Returning to high school, investment style for an explanation of duration).

Investors who want to keep a risk-adjusted yield maximization strategy simple can just buy EMB. A more sophisticated strategy might be to buy EMB and short HYG, but that would involve taking on interest rate risk. An interest rate neutral strategy would be to buy long EMB/short IEF pair and then short the HYG/IEI pair (long EMB, IEI, short HYG, IEF).

In any case, investors should be advised that reaching for yield can be highly speculative and these strategies are on the higher risk end of the investment spectrum. Nevertheless, I believe that, on a risk-adjusted basis, EM bonds might be a better way of reaching for yield in the current environment for those who can accept the risks involved.

Wednesday, October 15, 2014

A Bold Forecast: Today was not the bottom

Wow! Mr. Market certainly took us for a wild ride on Wednesday. At one point, the Dow cratered over 400 points, but closed the day down only 173, or 1%.

At first glance, the market action seemed to have the elements of a capitulation bottom. As the chart below shows, two of my trifecta of bottom spotting indicators are flashing oversold signals (see  the discussion in A tradable bottom and my most recent post In the 7th inning of a correction). In addition, the SPX kinda, sorta formed a doji on the day, where the close was approximately the same level as the open. Such Japanese candlestick formations are often indications of market indecision and can mark reversals. Moreover, the pattern where the market trades falls at the open and rallies near the end of the day to close at or near the high is also a sign of bearish exhaustion - another bullish sign.

A bold forecast
Despite these promising bullish signs, I will make a bold forecast here. Today, Wednesday, October 15, 2014, was not the bottom of the market decline. While the market is very oversold and we are likely to see a market bottom within days, the bulls will have to be prepared for more pain in the near future.

Looking beneath the surface, the tape did not feel right to me for a capitulation bottom. Consider this chart below of the relative performance of the different major sectors against SPY for the day. If I told you that the market action in a day was marked by downside leadership was in Financials and Utilities,  and traditional high octane sectors and groups, like small and mid caps and NASDAQ, outperformed, would you expect to see a day where the major averages were down over 2% at the worst points of the day? These are not the normal signs of a panic capitulation sell-off.

Given the change in technical tone of the market, where the SPX violated the 200 dma without even a pause, we can definitely conclude that we are not in the steady uptrending market of the past two years. Perhaps better analogues of the current market weakness can be found in the pre-2012 period, in the market sell-offs of 2010 and 2011.

I went back to those two years to see what happened during the market weakness episodes of that time. As the chart below of 2010 shows, notwithstanding the unusual Flash Crash, there were two instances circled in red of dojis or hammers, where the market fell at the open but rallied to close above the open. Neither case marked the bottom of the decline.

Here is the chart of the SPX in 2011. Same thing - neither instance marked the bottom of the decline.

With the caveat that the sample sizes are small, these charts nevertheless show that the kind of market action we saw today, especially with the unusual nature of the leadership, do not indicate that the stock market bottomed today. For a true capitulation bottom, we may need to see a "margin clerk" market, where everything goes down on high volume, all sectors including gold, and correlations converge to 1.

You know when you go to the hospital for a medical procedure that you know to be painful and the doctor tells you, "You're going feel a bit of a pinch"? I am afraid that's what going to happen to the bulls for the next few days.

Tuesday, October 14, 2014

How wars can affect long-term returns

I had a number of discussions with readers in response to my post The one Big Bet made by most buy-and-hold portfolios.

To recap, I wrote that most studies of asset returns contained severe survivorship bias. Based on the data from the Credit Suisse Investment Yearbook 2014, I showed that most US studies of equity returns used long term data like this to estimate asset returns:

Despite having over 100 years of data, the drawback to that approach is that the US was only one country out of many at the dawn of the 20th Century and many countries and political regimes have disappeared in that time frame. Instead of US-like asset returns, how do you know that your returns won`t look like UK returns like the chart below. Note that US equity returns in the above chart showed a cumulative return of 1248, compared to 372 for the UK.

Worse still, how do you know your long term returns look like German assets in the same period? What if you had been invested in (*shudder*) Russia instead, where your asset prices likely went to zero after the Russian Revolution?

Here is the key conclusion from that post:
In summary, most investment policies today are Big Bets on world peace. For Americans, they represent an even bigger bet - the continuation of Pax Americana.

How war destroys asset values
Much of the feedback that I received agreed that most investment plans were indeed a bet on world peace and Pax Americana. However, it was a reasonable assumption to make given the geopolitical outlook for the continuation of US dominance in global affairs. As long as we don't see any world wars, everything is going to be fine.

While that statement is intuitively appealing, it is not true that asset returns are damaged if you get into a world war, or even worse, lose a war. While being on the losing side of an all-out war certainly destroys asset values - that is more or less an evident fact, being on the winning side can weaken an economy as to inhibit growth and impair asset values as well.

War is expensive
The simple fact of the matter is, wars are expensive. Consider this chart of the British debt-to-GDP ratio starting from the dawn of the 19th Century (via Global Financial Data).  The British debt burden ballooned enormously during the Napoleonic Wars (imagine if Napoleon had won at Waterloo!) and she spent the next century paying off that debt, aided by burgeoning growth and her overseas colonies. British debt rose sharply again during the 20th Century in response to World War I and, later, World War II.

The experience of the British empire shows that wars are very expensive. A decision to go to war can significantly weaken national finances. If a country with fragile finances were to experience a shock, whether it be the catastrophe of losing a war or other blow to the economy, it would most likely greatly impair asset returns.

Outspending the enemy 40 million to 1
Fast forward to today. While it is true that the world has not seen any major conflict on the scale of a world war in my lifetime, modern wars remain expensive affairs.

While this post is not meant to be a discussion about the pros and cons of engaging in any specific war, consider what happened the 9/11 attack of 2001. A handful of suicide attackers with a reported budget of roughly 100K provoked a US response that included an invasion of Afghanistan and Iraq, which is estimated to cost $4-6 trillion. On an inflation adjusted basis, that's roughly how much the US spent on World War II.

Erico Matias Tavares wrote the following about the Chinese general and strategist known for his treatise The Art of War:
Sun Tzu had something to say about this: “Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.” Seen in this light, has the Post 9/11 military strategy made the US a victorious warrior?

Source: Congressional Research Service (June 2010), Boston University (June 2014).
(a) US$ billion, in constant 2011 dollars, except for Post 9/11 which is in current dollars.
(b) Union and Confederacy added together.
(c) Includes $1 trillion in future obligations for care of Veterans through 2054.
In effect, America is telling its enemies: "Don't mess with us, we'll squash you by outspending you by 4 million to 1". While that tactic may be effective against a relatively insignificant insurgent group, what would happen if several adversaries banded together? Can the US continue to outspend all of its enemies by such an enormous amount?

Already, I see that the cost of the military campaign so far against ISIS is about $1 billion (does ISIS even have a total budget that approaches that amount?) and the estimated ongoing cost is $40 billion per year.  To put those figures into some perspective, a single raid into Syria costed more than the India's entire Mars mission.

Already, the latest Geneva Report entitled Deleveraging, what deleveraging? warns about the "poisonous combination" of debt and slow growth could derail the global recovery and may lead to another financial crisis (see Business Insider and The Guardian).

Don't just count on the absence of world wars
In conclusion, even though we are fortunate to experience a prolonged period of world peace where there are no World War style conflicts, the budgetary demands of American foreign military adventures are similar in scale to past global conflicts. Such levels of spending will undoubtedly put pressure on the US debt outlook and could pressure asset returns over the long run.

Imagine what the US government could do with $4-6 trillion. Think of the benefits it could provide tp its citizens, either in the form of incremental services such as healthcare and education or, if you don't like the idea of government services, tax cuts.

Or better yet, think of the number of bankers Washington could bail out. No doubt, JP Morgan is so starved for funds that they can't be afford to inform affected customers of a cyberattack data breach.

Monday, October 13, 2014

The Ebola correction? Oh, PUH-LEEZ!

I know that I had a bearish bias in my last post (see In the 7th inning of a correction), but the late day stock market sell-off Monday was getting a little overdone.

In that post, I noted that the SPX closing below the weekly Bollinger Band is a rare event. In the chart below, I have highlighted instances where the dual condition of 1) the SPX at the lower Bollinger Band and 2) an oversold on the 5-week RSI have existed. We have seen five instances in the past five years and we are seeing a sixth now. I have also drawn vertical lines marking those episodes, where the blue lines indicating that the market rallied soon after and red indicated that the market continued to decline. In only one instance did the SPX continue to fall and that was during the eurozone crisis of 2011.

Not convinced? Here is the chart of the SPX for 2005-2010. Unless there is a clear fundamental trigger for the market weakness, these dual oversold conditions have marked near-term bottoms.

Is Ebola the bearish trigger?
So what's the trigger for this latest round of market weakness? Ebola? Oh PUH-LEEZ!

Imagine the following conversation:
"I'm really worried about the news about ____A____".

"Yeah, if ____A_____ gets you, you're pretty much a goner. I hear that about 10,000 people die a year from it."

"We should quarantine people from _____B_____, where most of the problem comes from. That way we could protect ourselves."
For some perspective, try A="getting shot by a gun" and B="the United States" instead of "Ebola" and "West Africa". Get a grip, people.

While the fatality rate from Ebola is horrendously high, the economic impact of SARS (though not necessarily the human impact) was no doubt higher because of the much higher level of commerce done in Asia. The main economic impact of the Ebola outbreak so far has been on cocoa prices.

Instead of panicking, investors would be far better served by watching earnings reports in the days to come.

Given the obvious lack of a bearish trigger for the market weakness, the odds favor a market bounce that could start at any time. After the reflex rally, however, I remain cautious on equities as global growth appears to be rolling over (see my last blog post In the 7th inning of a correction).