The Myth of Rotating into Stocks

The S&P500, as encouraged by the Fed, continued its orderly march higher, this time rising by 1.1% on ever lower volume…..something the Fed can’t control as easily as price. In other words, the Fed can’t force an enthusiastic love affair with stocks, something that increasing—rather than decreasing—volume would imply. Volatility, a proxy for complacency, didn’t fall (actually rose a bit) but perhaps only because it’s as low as it can get, according to 20 years+ of historical data.

Unlike prices in risk asset markets, US macro data continued to deteriorate….markedly. The Chicago Fed National Activity Index (very much a leading indicator, rather than a coincident or lagging indicator such as unemployment) fell, when it was expected to improve. Existing home sales also fell, also after consensus predictions of a rise. The Richmond Fed manufacturing survey collapsed, as did the Kansas City Fed index—both of these are also key leading indicators. Jobless claims were better than expected but mainly because of huge seasonal adjustments (yes, even this number is manipulated by the government) and because key states like California provided estimates of claims (rather than raw counts). Leading indicators were slightly better than expected, but mainly because a key component, the stock market, has been rising (this implies a circular reasoning within this metric). Finally, new home sales disappointed.

Technically, the US stock markets are clearly overbought…..on a daily basis, a weekly basis and a monthly basis. To say that the stock markets are “stretched” at this point (even ignoring the poor economic and corporate fundamentals), is an understatement. Can this overbought condition continue to build? Sure. But making new stock market allocations at this point clearly means that you’d be “buying high” rather than what you should be doing which is “buying low”.

In the mainstream media, the story of the great rotation has been gaining momentum. In short, Wall Street has been trying to sell the idea that the average retail investor has been sitting on the sidelines for the past three years missing out on the stock market rally and is now starting to “rotate” his money into stocks, and that this will provide a surge of upward pressure on prices that everyone can profit from.

There’s just one huge problem with this story. It’s a myth. What these financial peddlers never mention is that if the little guy starts to buy stocks, then WHO will be selling him their shares?

For every new dollar entering the market from Joe Sixpack, there has to be a dollar LEAVING the market….most likely from large sophisticated investors who are looking to get out!

John Hussman, in his weekly commentary, describes this process very well:

The newest iteration of the bullish case is the idea of a “great rotation” from bonds and cash to stocks, as if the outstanding quantity of each is not held by someone at every point in time. The head of a “too big to fail” investment firm argued last week that stocks are “underowned” – as if every share of stock presently in existence is not actually owned by someone. To assert that stocks can be “underowned” seems to reflect either a misunderstanding of how markets work, or a desire to distribute overvalued institutional holdings onto the unwashed muppets. Likewise, the idea of a “rotation” out of bonds and into stocks begs the question of who will buy the bonds and sell the stocks, as someone must be on the other side of that trade. Similarly, to “move cash into the market” requires a seller of stock who becomes the new holder of said cash.

So don’t be fooled. Don’t become the unwashed muppet, the greater fool, and buy stocks now—very near their record highs—and become victims, again, for the benefit of those who are seeking to get out now.

The Fed Prints….Stocks go Up

In the face of a slew of disappointing sales and earnings reports, the S&P500 managed to log in another gain for the week. This time it was 0.95% on light volume, as usual. And the diminishing volume is important. Volumes in 2012 we lighter than they were in 2011 and volumes in 2011 were lighter than in 2010. What this strongly implies is that as stock prices are pushed higher and higher, the average retail investor is not buying into the rally, whether because he is favoring bonds instead or because he simply has fewer funds to invest due to his diminishing real wage.

And volatility is shoved down, clearly by large institutions that are selling it further and further into the ultra-complacent zone. The problem is that at these levels, history suggests that volatility has only one way to move….and that’s up, which would be very negative for stock prices.

Should anything in the US or the rest of the world cause the slightest disruption in today’s complacency, volatility could sky-rocket and push risk asset prices down.

In macro news, the US non-recovery continues to grind ahead. The Empire State manufacturing survey came in well below expectations. Producer prices and consumer prices, to the extent that one can overlook the downward manipulation of these results (via schemes such as hedonics and many more), were both tame. As long as you don’t have to buy gas, food and heating oil, then inflation is not a problem. Housing starts, now that the government-engineered recovery in housing has taken hold, is bouncing back nicely. Initial jobless claims dropped, but mostly due to seasonal adjustments. The Philly Fed survey was a huge miss, as was the consumer sentiment survey which plunged by the largest amount, relative to expectations, in seven years.

Meanwhile, the beat goes on. In what appears to be a simple replay of the key, by far the most significant driver, of risk asset prices, the more money the Fed prints, the more stock prices rise.

And sadly it seems to be as simple as that.

Nevermind that unemployment today is almost double the rate that it was 10 years ago. Nevermind that corporate sales and earnings are deteriorating badly. Nevermind that real personal income is stagnating at best, and dropping at worst. Nevermind that the average retail investor has long since abandoned the stock market.

As long as the Fed keeps expanding it’s balance sheet (ie. electronically printing money), the magic funds—funneled by the too-big-to-fail banks, and magnified by computerized trading shops—serve to push stock prices up (as well as bond prices and commodity prices).

So the privileged few who happen to own stocks, bonds and commodities continue to gain, at the expense of about 99% of the rest of the population.

What could be better than that?

What could go wrong?

Time will tell.

Equity Markets are Stretched

The S&P500 crept up slightly last week (up 0.38%) on light volume. And volatility dipped just a bit, taking a complacent market into even deeper complacency. Corporate sales and, more importantly, earnings are weakening, yet equities are shrugging off any concerns, and instead are implicitly projecting that record high earnings (as a percent of sales and as a percent of GDP) will continue into the future…..indefinitely.

Economically, the US continues to struggle. All leading economic reports are suggesting that Q4 2012 GDP will come in at the weakest rate since the Great Recession started. Last week, while light in the number of reports, was also not positive. Initial jobless claims came in worse than expected. International trade was far worse than forecast; this will translate into a direct hit to GDP.

Meanwhile, as US fiscal policy has officially switched into DE-stimulus mode, US monetary policy continues to pump 80 billion, or so, of dollars into the asset markets each month. But as Ben Bernanke stated a month ago, if Congress allows large spending cuts to take hold next month, then the Fed will NOT be able to offset the full impact of this additional fiscal penalty.

Technically, the US equity markets are now in uptrends, both on the daily and weekly charts. There’s one major problem–and risk–with this however. The stock markets are extremely overbought and overly bullish. The Fed has truly convinced the US equity markets that nothing, absolutely nothing, can go wrong with stock prices. Corporate earnings can fall. Euroland sovereign credit crises can erupt. Japan can teeter on the edge of fiscal insolvency, and China can continue to artificially prop up its economy. But US stock investors should pay no mind to such risks, because the Fed will have their backs covered.

This condition, the state of supreme complacency and one-sided conviction that nothing stock prices cannot go down, is usually a key sign that stock prices are extremely vulnerable to just that—going down. And not just slightly, but significantly. Think 20%, 25% or more.

When everyone believes that something can’t happen, then nobody is prepared for that “thing” to happen. This means that if it starts to happen, then a massive rush, or cascade, is likely to develop. And this will accelerate the downside as everyone rushes for the exists only to learn that it’s a tiny 0ne-person-at-a-time door.

Could markets go up some more? Sure. But anyone who can’t appreciate the extreme fragility and the huge risk of downside is simply ignoring the lessons of history and will, with 100% certainty, be burned…..badly.

Cliff Delayed

Last week we argued:

As a result of this {market sell-off] and public pressure in the first few weeks of January, it is very likely that some sort of compromise can-kicking deal will be reached reversing some, but most likely not all, of the revenue increases and expense reductions.

As it turned out, a mini “compromise can-kicking deal” was reached on December 31, not mid January.    And the deal was not even a true deal, in the sense that it addressed most of the outstanding issues that made up the fiscal cliff. The deal primarily addressed income taxes. While raising income taxes on top earners, it also raised the payroll tax on 77% of all wage earners. The net result is a REDUCTION in fiscal stimulus, which economists estimate will hit GDP by 1.0-1.5% in 2013. What was not addressed, but merely kicked down the road by only 60 days: spending cuts and the debt limit. And these two remaining “issues” will now create a larger “cliff” that will once again hit the markets and the economy in a few short weeks.

In the meantime, risk markets rallied—not so much due to enthusiastic buying, but mainly due to short covering and other hedge removals. In other words, by not going over the fiscal cliff (fully, but only partly due to the smaller tax increases) on January, traders and investors removed a lot of the insurance protection they had taken out in December to protect against losses if the fiscal cliff was not partly averted and delayed.

So the S&P500 jumped a whopping 4.57% and in an instant has become very overbought. Volume was not strong, supporting the argument that enthusiastic buyers were not rushing in to buy shares. Volatility slumped, or rather was crushed, in no small part due to the actions of the Fed which knows that by selling volatility (to drive its price down), traders and computers will then drive share prices higher.

The real economy however continues to struggle. ISM manufacturing just beat expectations but registered at barely over the 50.0 level dividing growth from contraction. Consumer sentiment badly disappointed. Jobless claims also missed estimates, by coming in higher than expected. The payrolls report was a dud, just meeting modest expectations, expectations that are typically associated with an economy that’s stalling, not growing robustly. One of the most disturbing, yet under reported, parts of the payrolls report was the employment-to-population ratio which FELL from last month. This is one of the few hard to manipulate BLS figures and the fact that this number fell again—almost four years after the supposed economic recovery began—suggests that the economy is struggling to create decent full-time jobs for the nation. Instead, prospective workers are continuing to drop out of the work force in droves. Not good.

So now let’s brace ourselves for another ‘fiscal’ showdown in six weeks or so. Meanwhile, fourth quarter 2012 earnings will begin to be announced this week; this should help to answer the question about how well corporations are doing, and to the extent that fundamentals still matter (not much lately since the Fed has taken temporary control of the stock market), the earnings reports could drive stock markets somewhat higher….or lower.