Investment Landscape's Fabric Is Fraying

Another day, another dump in equities. Hard as it is to believe, the sense that the (financial) world is coming to an end is becoming almost commonplace. While such resignation is perhaps the stuff of which bottoms may eventually be born, Macro Man isn't willing to countenance much more than a small short-covering bounce at this juncture.

As February comes to an end, more interesting to him is the comfortable fabric of the investment landscape may be fraying somewhat. It's that time of year; Macro Man literally cannot remember the last March that did not bring (at least temporary) reversals and breakdowns of usual relationships. In his experience, January and February are for making money, and March is for playing defense. (Not that it should work that way, per se...it just seems to happen every year.)

In that vein, it's perhaps worth touching on a couple of points that suggest some fractures in the thematic monolith that is Financial Armageddon. Macro Man has already highlighted one issue in recent days, but it's worth touching on again. Given that equities are near or at new lows, and that the economic newsflow remains execrable (Taiwan's exports and IP both dropped more than 41% y/y in January!), one would normally expect USD/JPY to be on its knees. Yet here it is, up nearly 10% from last month's lows, showing a clear correlation break with its supposed anchor, the SPX.

Similarly, one might rationally expect that an equity meltdown would prompt a safe haven bid for government bonds. Yet Treasuries have barely budged with the last 10% in the SPX, and have yet to put much, if any, dent in the step-jump rise in yields at the beginning of the year. While it's true that German govvys have performed quite well, this probably has more to do with intra-European spreads than it does with outright longs.

Now, Macro Man isn't sure what all of this means, other than that he has to be very, very wary of other correlation breakdowns, which could potentially submarine a previously smoothly-running portfolio mix. Correlation breakdowns are among the most difficult and frustrating things to trade from an established book of positions, so Macro Man is trying to keep an especially close eye on his assumptions...which will hopefully save him another frustrating March.

One notable development last night was JP Morgan (JPM) slashing its dividend from 38c to 5c. Now, this would appear to be common sense, particularly for a bank, but it nevertheless highlights the frailty of one of the major arguments in favour of equities- namely, attractive dividend yields. A quick survey of his Bloomberg shows the SPX with a divvy yield of 3.8%; the FTSE has a yield of 6.4%; the Nikkei has a yield of 3.0%, and the Eurostoxx has a yield of 8.2%. Yowsah! Who needs bonds when you can buy equities and, if not wear diamonds, clip divvys?

JP Morgan highlights your answer. Dividends represent a claim on an earnings stream that a) may be lower, or at least more uncertain, in the future, and b) need not be paid out to the same degree at all times. While it is true that earnings recessions generally see payout ratios rise, it is also a case that there is a limit to everything. Macro Man would humbly submit that an S&P 500 paying out 113% of earnings in dividends is ripe for the type of divvy cut that JPM delivered last night.

More broadly, there is no guarantee that dividend yields will fall. It could be the case that stocks get "cheap" and stay "cheap" for a long, long time. Indeed, time was that divvy payments represented a substantial portion of an equity's total return, and Macro Man has maintained for some time that there is a risk that we return to that regime. It is perhaps worth re-posting a chart that Macro Man showed last autumn; there is a long and glorious history in the US (which ended in roughly 1957) of dividend yields trading above government bond yields. This party could just be getting started.

This little wander down memory lane stoked Macro Man's imagination. The first month of the Obama administration has come and gone, and the results from both a policy and market perspective have been underwhelming. (This is an observation, and is not intended to spur unrewarding political debate.) This got Macro Man thinking.....how does the equity market's performance in the first month of this administration compare with that of previous Presidents? With the aid of Bob Shiller's excellent online database, he took a look.

The chart below sets out the equity market price change during the first month of a President's tenure. Grover Cleveland, with two separate terms, is counted twice. The short answer is that while equities have performed poorly during Obama's first month, he has plenty of company; indeed, during Macro Man's lifetime, only Bush I and Clinton have seen the stock market go up during their first month of office.

More broadly, since Rutherford B. Hayes, the first month of a president's tenure has seen stocks go down. Some of this may reflect a "shock value" deriving from presidents who die in office, but that doesn't appear to be the case; Truman and Johnson saw sparkling returns during their first months in the White House. A more cynical theory might be that when new presidents fail to walk on water, markets express their disappointment...and then recover as expectations are set to a more realistic level (and, one might add, a new president's policy platform has time to gain traction.)

Macro Man leaves it to the reader to judge for himself which of these has been in play for the past forty years or so......

Comments

[morph366:]

You make an interesting point about correlations breaking down and how it can play havoc with previous assumptions about inter-market trading strategies.
Could it be that these strategies are no longer being practiced to anything like the same extent because of the declining role of the hedge funds all following similar correlation based strategies?

Feb 24 10:42 AM

[glassbox:]

The market's gone crazy with allowing anomalies which does not help in value building. Equities value are allowed to be brought down unnaturally with the allowance of short sellers (whether borrowed or not) whilst bonds are slightly better with no direct shorting - although one can attempt to set up a proxy exposure via the CDS markets.

At this rate, its no wonder equities have been seeing the 'tail wagging the dog' phenomena - values are being established by a small group of players to the detriment of the larger group that chooses to stick by an investment.

Feb 24 10:45 AM

[Bartlesby:]

While equity price declines are often exacerbated by short sellers, this is by no means "unnatural". This is the free market at work, painful thought it may be.

Short selling is a mechanism born of free markets to hedge risk exposure, as well as to speculate on market direction. If we use language like "Equities values are ALLOWED [emphasis mine] to be brought down" - then we are crossing the sacred line between properly regulated free markets and government control.

If you believe regulators/government should "allow" market participants to behave only in a way that benefits the larger group, then you are playing the wrong game.

Let's inforce the uptick rule and "allow" the markets to run their natural course. If that scares you, park everything in cash and wait for the dust to settle.


On Feb 24 10:45 AM glassbox wrote:

> The market's gone crazy with allowing anomalies which does not help
> in value building. Equities value are allowed to be brought down
> unnaturally with the allowance of short sellers (whether borrowed
> or not) whilst bonds are slightly better with no direct shorting
> - although one can attempt to set up a proxy exposure via the CDS
> markets.
>
> At this rate, its no wonder equities have been seeing the 'tail wagging
> the dog' phenomena - values are being established by a small group
> of players to the detriment of the larger group that chooses to stick
> by an investment.

Feb 24 11:27 AM

[HiSpeed:]

Another bottom caller? Get on cnbc with the rest of them. "Buy buy buy" is getting old.

Valuations need to come down to historically "cheap" levels before we can get a "new bull".

Feb 24 11:46 AM

[drbob66:]

Funny, I didn't get the impression that Macro Man was calling a bottom at all in this article.


On Feb 24 11:46 AM HiSpeed wrote:

> Another bottom caller? Get on cnbc with the rest of them. "Buy
> buy buy" is getting old.
>
> Valuations need to come down to historically "cheap" levels before
> we can get a "new bull".

Feb 24 12:14 PM

[Larrysyr:]

There's an argument I've read recently that equities are returning to long-term trend lines established before the internet and housing bubbles.

While it's extremely painful to endure this bear market, there is no mystery that assets were over-valued. The real market anomalies were housing prices outstripping incomes and equities priced at P/Es over 20. What we're seeing now is a correction, albeit a drastic one.

Selling short is a strategy to make money in bad times and has an honorable place in the spectrum of investments. What would be wrong would be price manipulation, but such manipulations are already illegal and are equally wrong whether done by shorts or longs.



On Feb 24 10:45 AM glassbox wrote:

> The market's gone crazy with allowing anomalies which does not help
> in value building. Equities value are allowed to be brought down
> unnaturally with the allowance of short sellers (whether borrowed
> or not) whilst bonds are slightly better with no direct shorting
> - although one can attempt to set up a proxy exposure via the CDS
> markets.
>
> At this rate, its no wonder equities have been seeing the 'tail wagging
> the dog' phenomena - values are being established by a small group
> of players to the detriment of the larger group that chooses to stick
> by an investment.

Feb 24 12:55 PM

[Jason Rines...:]

Brilliant


On Feb 24 10:42 AM morph366 wrote:

> You make an interesting point about correlations breaking down and
> how it can play havoc with previous assumptions about inter-market
> trading strategies.
> Could it be that these strategies are no longer being practiced to
> anything like the same extent because of the declining role of the
> hedge funds all following similar correlation based strategies?

Feb 24 06:56 PM

[prudentinve...:]

The notion of owning a share of a company was fundamentally premised on the notion of receiving a share of its profits, in the form of dividends. As your graph shows, that dividend yield used to be higher than bond yields, to compensate for the fact that stocks are less secure than bonds.

Over time, this has been gradually replaced in people's minds by the notion that the share owner does not need to get a share of profits, but just be content with the expectation that someone, in the future, will pay him more for his shares. This expectation is premised on the company's value continuously outpacing inflation, which is possible for a limited period, and for companies that have novel and proprietary technologies. However, as decades went by, people began to expect this of all companies, in perpetuity; which is patently illogical.

I suspect that the realisation that for most companies, most of the time, the main return to the shareholder is a share of the profits, in the form of a dividend competetive with bond yields, is going to return sooner or later. Perhaps the current crisis will be the catalyst for such a return to logical fundamentals.

Feb 24 08:36 PM

[fleeing omega:]

Correlations do seem to be breaking down. Precious metals being the example that I noted recently, in addition to USD. In any given case one is tempted to rationalize the behavior based on particulars, but it is harder to figure when it is happening in a variety of asset classes that are less clearly related to each other. Woundn't surprise me in the least if both gold and USD get slammed too at a time not too distant from now.

It is my observation (and others) that this deflationary market seems intent on destroying wealth, and if there are any patterns that lend themselves to arbitrage, then the market will sniff them out and whipsnap the corresponding position at the most inopportune moments.

A bit anthropomorphic, I grant you, sort of like an omniscient yet wrathful diety punishing the world for running up so much debt.

But I guess that risk was grossly discounted and that since November lows we see hope still springing eternal, only to be whacked down again, until finally, at some time point in the future, risk is finally overvalued and that ultimately gives a strong backdrop for a recovery.

Feb 24 11:51 PM