The markets and I have challenges to overcome this week. For the markets, it's deciding what they think the Fed's (FOMC) minutes mean. For myself, it's first to tell you that I'm not going to try to explain what the minutes mean - that's the easy part - and then try to avoid telling you anyway. I would recommend both Seeking Alpha and CNBC.com for some lively exchanges on the subject. I would also recommend taking the obligatory look at John Hilsenrath's column over at the Wall Street Journal, as he is one of the FOMC's preferred back channels for policy exposition.
Perhaps the most interesting aspect of it all is how it highlights Keynes's old dictum about the parallel between asset markets and beauty contests. Keynes found that he couldn't make any money investing solely on his knowledge of data and the economy; to succeed at it he had to correctly anticipate what the market's reaction would be first. If you want to pick the winner of a beauty contest, he suggested, forget about trying to decide who is most attractive and instead try to figure out who is going to most appeal to the other judges. It's also how bookies generally work, setting the odds according to how much money is being wagered rather than trying to pick the winner themselves (though they are no more averse to a bit of inside information than their brethren on the Street).
Indeed, one of the great conundrums of investing is that since prices are set at auction and the latter is subject to the rule of the crowd, one is often right for the wrong reasons, and less often - much less often - one is wrong for the right reasons. Human nature being what it is, we tend to have trouble accepting any evidence of the former, and very readily believe in the latter - in other words, we ascribe our gains to our cerebral genius and our losses to the silly markets.
It would be easy to wander off into pious abstractions at this point, so let's look at a chart instead, one of my favorites: comparing the latest Chicago Fed's National Activity Index with the stock market:
I think this neatly illustrates the dilemma for the Fed: if you look at the activity index, there is very little reason to taper (one might also argue that it shows there isn't much point to QE either, but that's another topic). If you instead look at the line of stock market prices and the yawning chasm between the two, you might want to ask yourself how the two will reconcile. If you're a voting member of the FOMC, you might be wondering if it isn't time to take that consulting job in the private sector.
The dilemma for the investor is that Keynes's theory, like so many other trading maxims, works until it doesn't. The discovery that you weren't right after all, just suffering from a variation on the same general crowd delusion as everyone else, is almost always a very expensive one, more often than not accompanied by a market crash.
You have almost surely noticed the turmoil in bond prices lately - as the Hilsenrath article noted, bond fund outflows have been at very elevated levels. It would be hard also not to have noticed the heating up of rhetoric about what it all means.
The market action often looks different to veterans like me who've been at it for decades - we usually have a jaundiced eye when it comes to the meaning of short-term price action. There are two guiding principles - one is that big moves are nearly always driven by trader momentum, and the other is that they are always accompanied by attempts to sell you a completely different story. People love to interpret short-term moves in pricing as declarations by the market that some pet theory is now being proven. What's usually being proven is that a lot of money is trying to get in or out of a trade, often for reasons opaque to the public.
The point in this case is that the bond market is NOT telling you that inflation is about to accelerate, or that the economy is taking off, or that you have to stock up on gold coins. What it's telling you is that after some quick losses, a lot of people are afraid bond prices are going to keep going down - probably for the wrong reasons.
The size of the original losses in Treasury bonds on the heels of Bernanke's May remarks surprised the Fed. Commentators noted solemnly that the futures market was pricing in an imminent raise in interest rates. Monetarists have been arguing ever since then that the day of hyper-inflation and retribution is at hand for those dastardly Keynesians at the Fed.
All it really showed was how much derivative money was stacked up on the side of the easy trade - following the crowd, as it were. There are trillions of dollars in derivative bets tied to Treasury bonds. When derivatives have to unwind in a hurry, it makes a big wave - in stocks, bonds, commodities, mortgage-backed securities. What the futures market was really pricing in was lots of sellers and not many buyers.
Those losses were accompanied by remarks that the multi-decade bull market in bonds is over, which is true. With short rates at zero and yields at record lows, where else were bonds going to go? But when people got their quarterly statements in July, they started listening to those remarks for the first time, and the move for the exits began to attract more followers.
Now the bond market is deeply oversold, but here's the rub - inflation isn't picking up, nor is it about to (see the Chicago Fed chart above again), unless Middle Eastern politics sends the price of oil soaring. Nor is the economy accelerating, contrary to what many are steadfastly proclaiming (though not at the Fed, it would seem). First review the earnings results from Wal-Mart, Kohl's, American Eagle, Staples, etc. Then check last week's column for the chart on the declining growth in retail sales.
All of that data tells you one story, but many are convinced (or trying to convince you) that the Fed has to taper, and do so quickly, because the economy is accelerating so much. Well, here's the latest chart on the year-on-year increase in industrial production. The data is compiled by the Fed itself, so you can see why the committee must be in a hurry to take the foot off the gas.
source: Federal Reserve, Avalon Asset Mgmt.
In December of 2007, it stood at 2.3%. July 2013: 1.4%.
So it's the bond market vigilantes come to punish the Fed, thunders another group. Rates are rising, but not for the implausibly sophisticated reason that falling prices are panicking investors into selling. No, your retired uncle is selling his bond fund because he thinks that the Fed has lost control of the yield curve and the country will soon be engulfed by hyper-inflation fueled by all that money that the banks won't lend to anyone. The fact that it's down five percent in two months and has gone negative on the year never crossed his mind.
Hesitate before buying into the theory of the week. Stocks are oversold right now - they nearly always are at this time of the year. I've been making the point for weeks that August usually starts out badly. We could still lose a little more to nerves, but in the absence of external events, prices should have begun to rally before this time next week. What might happen the rest of the year is another story, but something really bad will have to happen to derail the usual rally into Labor Day.
Bonds are oversold too. First, the biggest buyer of Treasury bonds, our central bank, announced it might buy less. The price came off, a real shocker. Then the derivative boys and girls immediately got blown out of their leveraged positions, followed by panicky retail investors bringing up the rear with mass withdrawals. Doesn't this script seem familiar to you? It's really all one trade.
Yet as soon as those outflows ebb, traders are going to rush in to buy bonds again, because the ten-year will be back up to around 3% with no inflation in sight and no growth to be found either. Yes, I saw the news about the Chinese manufacturing PMI, and read the inevitable Bloomberg article about how it "jumped" as the economy strengthened, "fueled by domestic demand." But that's not what a reading of 50.1 means - it only means no change from last month. That doesn't mean stock prices won't move up with it, even if for the wrong reasons.
I'll leave you with some challenges to think about. To begin with, the stock market has a very good chance of making new highs in the next couple of months, despite the recent weakness. One implication of the Hilsenrath article was that the Fed might opt for a very small increment in its first steps towards tapering - "taper light," as Art Cashin called it. Consider the effect of a $5 billion decrease in Treasury purchases at the next meeting, along with a statement assuring the markets the Fed stands ready to do more if necessary. The relief rally would be impressive indeed.
Next, the longer-term outlook for the market is growing more ominous. The Wall Street Journal noted Wednesday morning that short-sellers are getting killed this year. If you can't read it, I'll tell you this - it's never good for stocks when the last short-sellers are being carted out. It may seem counter-intuitive, but trust me, when these guys leave, there's basically no one left to buy.
The last item is the rise of the "certified genius," which brings me back to one of my original points. Part of the cycle of the bull market that gives birth to the bear is that the length of the average bull market is between four and five years, thereby increasing the success rate of everyone who sticks their toe in. By the end of the cycle, making money has become so easy for people that they simply ignore any evidence contrary to what they "know." They scoff at any notion that they might be right for the wrong reasons - just look at my statements, thank you very much, I certainly don't need your help.
The genius population has increased sharply this year. Certainly no one reading this article could possibly be guilty of such a thing, but even so, think about whether or not you might not have a friend or two in that position. If so, you might just want to whisper one little something in their ear: Pigs get slaughtered.