The Music at the Stock Market Party is Still Playing

March 31, 2014

In a low volume week, the S&P500 lost almost half a percentage point. Volatility, already near record lows, dipped only slightly. An interesting pattern emerged last week where every session in the US stock market opened positively, and often very strongly, only to close the day either in the red or with most of the gains being given up. So did this pattern in the supposedly “efficient” equity markets have anything to do with fundamental information (as it should, if these markets were really efficient)?  Not at all. Almost all of this daily yo-yo movement was the result of major currency movements….mostly the Japanese Yen and the Australian dollar. Go figure.

In the US economy, away from Wall Street, the data was mixed. Flash PMI was weaker than predicted. Durable goods orders beat expectations, but when the volatile transportation component is stripped out, durable goods orders missed badly. Fourth quarter 2013 GDP was revised to 2.6% growth, missing the expected 2.7% growth. But initial jobless claims were better than expected, as was the Kansas City Fed manufacturing index and personal income. The pending home sales index disappointed. The Richmond Fed manufacturing survey missed badly, and consumer sentiment also missed.

Technically, the uptrend in US stocks continues to hold. While last week’s loss was a setback, it was nothing other than a mild scratch. No serious damage was actually inflicted. On both the daily and weekly resolutions, stocks are comfortably above their respective 50 day moving averages their 200 day moving averages.

So the music is still playing at the stock market party. And most investment managers will keep dancing because they do not want to lose assets to other managers who stay at the party and continue to record quarterly gains, even if they’re not realized gains.

But one legendary investment manager, Jeremy Grantham of Grantham Mayo van Otterloo, recalls (in a recent interview) how back in 1999—near the height of the internet and tech bubbles—he refused to keep dancing at a party that he was convinced was going to end badly. And because he scaled back his clients’ equity exposure, he suffered a 60% loss in total assets under management before the bubble finally burst in 2000-2002.

In this interview, he recalled how difficult it was for anyone to listen to, much less follow, his warnings that US equities were extremely overpriced and were priced to deliver negative returns over the next 10 years.

So what happened?

Well, as already mentioned, he lost more than half his client money. But what about the subsequent returns? From 1999 to 2009, equity markets did exactly as he predicted—they delivered losses (actually big losses) for everyone who simply “held on” during that 10 year period.

More importantly, what is Grantham projecting today….for the next 7-10 year period?

Losses. In other words, his analysis—the same analysis that was totally accurate in 1999—is projecting that most buy and hold investors in the general stock market indices will incur losses over the next seven hear holding period, and that doesn’t take into account intervening short-term drops that could  be extremely severe.

So what do you thing most folks who hear this projection do? That’s right—completely ignore it. Human nature will overwhelm most people’s desire to avoid long-term pain (larger losses tomorrow) by satisfying people’s desire for short-term pleasure (smaller paper gains today).

History rhymes because people, being people, do not change.

The Taper is On; Will Stocks Survive?

March 24, 2014

The S&P500 managed to gain another 1.4% last week, even though most of the gains accrued at the beginning of the week, before the Fed made its latest policy announcement. Volume was light, and volatility dropped back to even more complacent levels.

The technicals are still screaming “over bought” on both the daily and weekly charts. But since most traders and investors believe that the Fed simply will not let the US stock markets fall, ever again, the technicals don’t seem to be scaring anyone into taking any precautions. Most investors are bullish and are on the same side of the boat—-they’re all-in with stocks—-making the market also “over bullish” relative to long-term historical surveys of bullishness vs bearishness. And at current prices, the US stock markets have reached valuations that, since 1929, have only been higher near the peak of the tech bubble in 2000.

But why worry?  The Fed will make sure stocks keep on rising, without any meaningful, if only temporary, corrections.

US macro data last week were weak, as usual. The Empire State survey disappointed. The housing market index missed. Existing home sales only met expectations, as did consumer prices—both headline and core. Industrial production beat expectations, and so did the Philly Fed survey.

But the big story of the week was the Fed announcement, which sparked a sell-off going into the close of the week. The Fed announced that it will taper its open-ended QE program by another $10 billion per month. And, in the post-announcement interview, the new chair—Janet Yellen—hinted that not only is QE on track to be shut down by year end,  but that actual short-term interest rates might rise—gasp—by 2016…….fully 8 years after they crashed to near-zero levels under Bernanke’s management.

But there’s one big problem with this ‘outlook’. Every time that the same projection has happened over the last 4 years (namely, that QE will be ending and that rates might rise), US stock markets promptly beat a hasty retreat.

So if this were to happen, then expect US stock prices to drop, possibly by a lot, given that they haven’t so much as correctly mildly for the past two years. And expect the hot money leaving stocks to rush into the ‘safety’ of US Treasuries. driving rates right back down.

So regardless of the plan, recent history suggests that the Fed may not have the stomach to withdraw the punch bowl for very long. And the main question becomes—how far will US stock prices have to fall before the Fed stops the taper, and even possibly ramps the QE program back up?

According to this latest announcement, it’s very likely that this test will occur this year….over the next six months.

And regardless of where equity prices finally do end up, it’s very likely that volatility will surge. So at the very least, equity markets should become much more interesting, instead of creeping up month after month in an almost mechanical way.


US Treasuries don’t agree with US Equities

March 17, 2014

The S&P500 dropped almost 2% last week in fairly light trading. VIX, as one would expect, jumped, but still not closing in any sort of clear zone associated with panic selling.

Technically, the sell-off last week brought a bearish tone to US stocks, but only on the daily charts. The uptrend on the weekly charts is still fully in tact. And even on the daily charts, in spite of the downturn, some sort of subsequent bounce would be very possible.

Several breadth indicators also turned down notably. For example, the new highs minus new lows index almost went negative at Friday’s close. Also, the percent of stocks  trading above their 50 day moving averages dropped significantly.

So while the US equity markets are still severely overbought on the weekly and monthly resolutions, they did ease off somewhat after last week’s 2% loss.

US macro news, meanwhile, continues to disappoint. The small business optimism index, the JOLTS survey, core PPI, import prices, and consumer sentiment were all worse than experts had predicted. Retail sales and wholesale trade, on the other hand, beat expectations. So the US economy continues to trudge forward lacking any robust growth, growth that’s been predicted to return every year starting in late 2009.

An interesting observation can be made by comparing the US equity markets to a few other markets to see if these other markets ‘confirm’ the equity market’s amazing exuberance.

Notably, the VIX index appears to be diverging—bearishly—from stocks. While stock markets were at or near their all time highs about a week ago, the VIX index failed to return back to the level it usually fell back to (around 12) when equity prices were peaking throughout 2013. Instead, the VIX fell back only part of the way. This suggests that investors are not so confident about these most recent equity highs.

More importantly, the US Treasury market in the fall of 2013 saw the 10 year Treasury creep up to 3.0% two times as equity markets peaked. The rise in rates makes sense if investors believe that the economy will be truly recovering and that paltry Treasury returns are inadequate when equity prices are poised to rise much more, by comparison. But in late February and early March, when equity prices returned to their peaks (and actually set new highs), the 10 year Treasury came nowhere near the former 3.0% level. What does this mean? One answer is that very big money (and the Treasury market is very big!) and very smart money (how many mom and pop Treasury traders do you know?) is worried that this most recent equity peak is not sustainable. And therefore, these big money traders are hanging onto, if not adding to, their safe harbor investment in US Treasuries.

So it seems that the US Treasury market is diverging—bearishly—from the US equity markets. Very shortly, we will see if these Treasury traders were onto something.

US Treasuries Beckon….Again

March 10, 2014

In a week filled with negative news reports, economic and otherwise, the S&P500 continued its march to higher highs, ignoring all the speed-bumps along the way. The index rose another 1.0% on light volume. And volatility, while rising slightly, remained at very complacent levels.

Technically, if the S&P was overbought the prior week, it is even more overbought at the close of the most recent week. Investors who are putting new money to work are literally gambling that with prices at all-time highs, not only will prices rise much further (because if they expected prices to rise only a slight amount, then why take the risk?) but also that there will be lots and lots of buyers at those much higher prices willing to give them their cash for those shares. The problem is, history is not on their side.

So as the S&P continues hugging its upper Bollinger band, very much like it did in the late 1990’s and in 2006-2007, the question—which nobody can answer—is simply how long will stock prices continue to stretch higher before the inevitable correction, or worse, takes hold.

US macro news was mixed to weak, as usual, last week. Personal income and spending both beat expectations, but spending rose more than income. How did that happen? Simple—consumers just took on more debt, or drained their savings. This is good for today’s spending, but bad for tomorrow’s economy. PMI services and ISM services both missed expectations. In fact, the ISM figure was the worst in four years. Thankfully, ISM manufacturing beat estimates. But productivity rose less than predicted. And factory orders fell more than expected. The big number of the week was the payrolls report, which beat expectations by only 25,000 (in a country where the total population exceeds 310 million), and Wall Street cheered. Never mind the fact that the unemployment rate ticked up (missing expectations) and the average work week plunged. Worse still, the labor force participation rate and the employment to population ratio (both of which tell the ultimate truth about the US labor market) did not improve at all; both hovered at multi-decade lows.

Several months ago, we highlighted a trading opportunity in the US Treasury market. When interest rates on the 10 year note hit 3.0%, the opportunity for low risk profit presented itself. How did this turn out? Well rates proceeded to fall to under 2.6% in only two months. The return on this trade (price appreciation and interest earned by buying the 10 year note) was over 3% in those two months, so on an annualized basis, this was a 20%+ return.  This isn’t bad especially when one considers the downside, which is limited by the Fed’s promise to keep rates low for an extended period of time. This means years.

Today, rates on the 10 year note have returned to 2.8% creating another opportunity to go long medium term US Treasury notes. With stock market prices at all-time highs, any type of correction (moderate to strong) would likely create a flood of dollars into the Treasury market driving prices up much higher. Also, US Treasury rates are now about 100% higher than they were at their lows in 2012 and 2013. This means that rates wouldn’t have to fall into uncharted territory for significant price appreciation to happen. Finally, the German 10 year note is yielding only 1.6% and the Japanese 10 year note is yielding a mere 0.6%. And the finances of both these states (certainly not Japan’s) are not better than that of the US. So if these two sovereign notes are yielding a fraction of the US note’s yield, then there’s a lot of room for them to converge—for the German and Japanese rates to rise and/or the US rate to drop.

Once again, there’s no guarantee that this will work out, but buying the US 10 year note today—for a trade—may turn into a rewarding trade……again.

Will Ukraine be the “Trigger” for the Next Risk-Off Phase?

March 3, 2014

In a continuation of the rebound that began in early February, the S&P500 climbed another 1.3% last week. Volume was fairly light, so there was again no huge rush of new buyers coming into the equity markets. And volatility barely changed, again suggesting that buying was done with only tentative conviction.

Technically, the S&P500 is now firmly over-bought. Prices have jumped right back up to the upper Bollinger bands on both the daily and weekly charts. Interestingly, however, several breadth indicators were turning bearish. For example, the difference between new highs and new lows plunged last week. This is not something you would expect to see in a market that’s surging to new all-time highs. The same conclusion can be drawn from the percent of stocks above their 50 day moving average; while this gauge rose, it hasn’t recovered to the peaks it reached in 2013, so this is another negative divergence…..also known as a warning sign.

Meanwhile, in the real economy, things are still fairly grim. Last week, a slew of reports missed expectations, starting with the Chicago Fed National Activity Index, which turned negative last month. Flash PMI missed, and the Dallas Fed manufacturing survey plunged to register its worst reading in 9 months. Consumer confidence missed, as did the Richmond Fed survey. Initial jobless claims were worse than expected. US GDP results for Q4 of 2013 were weaker than experts had predicted. And finally, the pending home sales index also missed. On the positive side, new home sales, durable goods, and the Chicago PMI all beat expectations.

Now that the crisis in Ukraine is growing—-the UK Telegraph called it the worst crisis in Europe in the 21st century—investors around the world are asking the obvious question: could this crisis be the trigger that finally causes global (and especially US) risk assets to sell off meaningfully, not necessarily crash, but correct by 10-20%?

The answer is nobody knows for sure. We will only know the answer with the benefit of hindsight.

But the more important answer is that it really doesn’t matter if Ukraine is THE actual trigger. Why? Because asset prices (stocks, bonds, and real estate for example) are so over-priced relative to their long-term historical benchmarks (thanks to the perceived benefit of central bank intervention), that it really doesn’t matter WHAT the trigger is.

Prices are ripe for a correction, a big correction. Whether or not the crisis in Ukraine triggers the correction is less important than the fact that prices are extremely vulnerable to suffer a meaningful drop. And investors would be far more successful, in the long-run, if they focused on long-term valuations not short-term events and their potential impact on risk asset prices in the short run.