Liquidity Trumps Everything – For Now
The stock market chugs ever higher, but there seems to be little to support this run-up from a fundamental standpoint. For instance, fourth quarter corporate earnings for the SPX are expected to grow by 1.9%. Only three months ago, they were estimated to grow by 9.9%. A little over six months ago, the estimate was for 13.7% earnings growth. Three regional Fed business surveys in a row have come in way below expectations, and the NFIB small business confidence index has just hit a three year low.
The main reasons why stocks keep getting bid up are probably the growing conviction that the euro area crisis is over (more on this below) and the acceleration in U.S. money supply growth from an already elevated level. Below is a chart of the consolidated asset side of the Fed's balance sheet:
Assets held by the Federal Reserve – the central bank's balance sheet has hit a new high.
This is expected to grow by another $1 trillion over the course of this year. Given the wobbly state of the economy – three of four major coincident indicators have topped out last summer already and are in decline – it is a good bet that the "QE4" program will indeed continue for the remainder of this year. From 2014 onward, the Bank of Japan intends to monetize U.S. T-bills to the tune of 10 trillion yen per month, according to its latest inflationary plan announced yesterday.
Note here as an aside that Japan's money supply growth is actually decelerating markedly of late. Yen bears are so far relying on perceptions and announcements alone – but not on reality. The reality is that as of December 2012, Japan's true money supply (defined as currency plus all money substitutes exchangeable into standard money on demand) grew by a paltry 3.1% year on year, by an annualized 2.3% in the fourth quarter and actually shrank by an annualized 0.2% during the month of December. In short, money supply growth in Japan is slowing down from already very low levels. So far, no matter how fast the BoJ attempts to inflate, Japan's commercial banks are even faster in pulling back outstanding credit.
However, the U.S. stock market is obviously driven by the Fed's inflationary ministrations, which are, on the whole, far more successful than Japan's. As of December 2012, broad U.S. money supply TMS-2 growth has accelerated to 11.2% year-on-year, to 17.7% annualized in the forth quarter (note this is even before the Fed's "QE4" program kicked in) and 29.6% annualized in the month of December. Now that's inflation!
Euro Area Fundamentals
A brief comment on the fundamental situation in euro-land: As we have already mentioned in our 2013 outlook piece, the most important positive development is that the periphery is regaining some of its lost competitiveness as its wage and price differentials with Germany narrow. A recent chart by Morgan Stanley illustrates the situation:
Euro area competitiveness indicators – the periphery sees a marked improvement.
Obviously, financial market pressures on the debt of peripheral sovereigns have declined markedly as well, as can be seen in the 10-year government bond yields of Spain and Italy depicted below. Recently, there has been extremely strong demand for Spain's sovereign debt at auctions, as the carry trade, respectively, interest rate convergence speculation, heats up.
Spain's 10-year government bond yield: it's all good… but it hasn't yet broken below the major shelf of lateral support.
10-year government bond yield of Italy. At about 4.25%, it is at its lowest since 2010, also hitting a level of lateral support (given by the 2010 summer highs).
So what's the problem? For one thing, although the pace of the economic contraction has recently slowed down somewhat, it still is a contraction. The main problem, as far as we can see, will be that the planned deficit targets will probably be missed – in some cases, by a big margin. Especially Spain is set to miss its overoptimistic target, in all likelihood, by up to 50%. Will the markets "look beyond" such a miss as well? We actually doubt it.
The Dow Jones Transportation Average has recently hit an all-time high. Somehow, we felt reminded of May 2008, when it also hit an all-time high that was not confirmed by the DJ Industrial Average. Of course, the fundamental backdrop cannot be compared, but it seems that such moves in the transportation stocks can at times turn out to be a late-cycle phenomenon.
The DJ Transportation Average hits a new all-time high.
The DJ Industrial Average – close, but no cigar.
John Hussman points out in his weekly rant that the suite of indicators he is watching exhibits the “overvalued, overbought, overbullish, rising-yields syndrome” that has historically almost always led to major market declines. The "almost" qualification comes from two instances in 1964and 1997, when the signal didn't precede a major drawdown. According to Hussman, these were, however, still not necessarily propitious times to invest:
“For optimists, there is a false one-week signal in 1997 – during the internet bubble – that was not associated with a negative follow-through. That is, as long as one ignores that the S&P 500 was essentially unchanged 5-years later, underperformed Treasury bills for the next 12 years, and even through last week’s advance, has outperformed Treasury bills by less than 2% annually in the nearly 16 years since then (all of which would be surrendered by even a run-of-the-mill bear market decline – and then some). There is also a fairly uneventful signal in mid-1964 that was not followed by near-term losses, though the market was still lower two years later and would underperform Treasury bills for the next 20 years.”
There is, of course, one reason why this time could turn out to be different – the Fed's massive monetary pumping. After all, the great monetary experiment in train at the moment is a historic first (for the Fed, at least). However, if we look at the classical indicators of positioning and sentiment, it is quite clear that the current juncture is eerily similar to the situation near major historical market peaks. For instance, if we combine NYSE margin debt (which is only a smidgen below its 2007 all-time high) with the net speculative long position in stock index futures (close to an all time high as well), it looks like market participants are "all in" and then some. This is also reflected in record low cash holdings. Hedge fund cash reserves are at a record low, while the mutual fund cash-to-assets ratio is only 20 basis points above a record low.
Hedge fund cash holdings: a record low.
The mutual fund cash-to-assets ratio: at 3.6%, it is only 0.2% above the record low recorded in 2011.
The 2-week average of responses to the NAAIM survey of fund managers shows the bullish consensus close to a new high as well (the high was made in late December). Not every sentiment survey is close to a new high in bullish consensus, but that may actually be a reason for caution – divergences between the surveys are actually always seen near market peaks. In 2007, there were very marked divergences between the various surveys – and interestingly, it was the individual investors survey that showed the greatest lack of bullishness at the time (and these respondents turned out to be correct with their skepticism).
The two week average of the NAAIM fund manager survey (purple line). Note that this is the net exposure that is calculated from a range of responses that lies between “200% short” and “200% long.” In other words, leveraged positions are considered as well. A net long exposure above 80% is well within the highest readings recorded in the survey's history.
Not surprisingly, the Hulbert stock sentiment measure (which measures the net long exposure recommended by stock market newsletter writers) is at an extreme level as well, but it is noteworthy that there is now actually a divergence between the sentiment measure and prices:
Hulbert's stock sentiment index is very high, but it was already higher when prices were still lower.
Why such divergences between sentiment measures and prices can be important can be demonstrated by looking at a very long-term chart of Market Vane's bullish consensus measure. There are two divergences marked on the chart: the one between the 1990s bull market and the 2007 high, and the one between 2007 and today:
Market Vane's bullish consensus: two long term divergences.
Along a similar line of thought, we find it noteworthy that the yields of so-called "safe haven" (ha!) bonds continue to remain extremely low. It may well be possible that the yields on U.S. Treasury bonds are suppressed by the Fed's buying. However, experience actually says that this is not a good explanation – after all, yields rose markedly during "QE1" and "QE2," a sign that rising inflation expectations normally trump the Fed's buying. In any case, no such argument can be forwarded in the case of Germany's bond yields. Yes, they have risen a little bit – but not by a whole lot. If everything is hunky-dory, why is the market not putting more pressure on these bonds?
Germany's 10-year Bund yield. Why is it still so low?
To summarize, in spite of abundant central bank provided liquidity lending support to the stock market, there continue to be plenty of reasons to be wary. If one dismisses the data presented above, one is in effect saying "it is different this time." That has invariably turned out to be a very costly attitude, regardless of the circumstances.
As John Hussman remarks, it is "easy to dismiss" the warning signs, but then again, it always is. As Hussman notes, the idea that the Fed has removed all risk has become so widely embraced that this fact alone should ring alarm bells:
“My concerns here are understandably easy to dismiss given that the S&P 500 is now more than 5% higher than it was in March of last year, when our estimates of prospective return/risk (on a smoothed horizon from 2-weeks to 18 months) first plunged into most negative 1% of market history. Yet despite the intervening monetary heroics, history suggests not that these conditions will persist without resolution, but instead that their resolution is likely to be that much worse.
Anyone who followed me in 2000 or 2007 will easily recall a similar frustration before the bottom fell out of the market on each occasion. I can’t assure that the same will occur in the present case, but I believe it would be reckless to assume that the Fed has these risks covered. With margin debt over 2% of GDP as it was on three prior occasions – 2000, 2007 and early 2011 – it’s clear that investors are all-in when it comes to faith in the Fed. Still, when an investment thesis becomes so universally embraced and so apparently easy to follow that anyone who resists is considered foolish (as was the case with tech stocks in 2000), my risk aversion needle hits the red zone.”
This is indeed the crucial question: can the central bank remove all risk from the market? Hussman doubts it, and so do we. After all, the artificial low interest rate distorts prices across the economy and malinvestment and capital consumption therefore continue apace. At some point the economy will have to readjust no matter how much money is printed.
Charts by: Sentimentrader, BigCharts, NAAIM, St. Louis Fed, Morgan Stanley