While we constantly look for short-term opportunities, literally navigating the weeds while keeping an eye on the forest, the big picture is a constant reminder of where we are. With recent market turmoil, and the emerging markets taking the blame, the reemergence of an old message was predictable: Keep the long-term goal in mind, and pay no attention to the daily market volatility. At some point that approach will fail, again! In addition, the common saying that "corrections are healthy" -- never understood why -- implies that rallies are unhealthy even though they are celebrated, and the commonly accepted definition that a correction is 10% and a bear market starts after a 20% market drop is well entrenched into people's psyche. Well, I am not a prince but I'll turn into a frog before I wait for a 20% loss without taking preemptive action. Then there are the arbitrary lines on the sand.
"Now that 1768 was broken on Monday," John Kosar, director of research at Asbury Research, said, "the next support level in the S&P 500 is 7% off the highs at 1730."
Why 7%? Why not 7.5%, or half way between 5% and 10%%? Actually 7% from the high of 1,848.38 on January 15, 2014, is 1719, and 11 points is enough to change perceptions, even if temporarily! The truth is that everyone has magic thresholds, with some being projected as authoritative without good reason. But all numbers are meaningless when sentiment reaches extremes. Another amusing common chorus is "looking for an excuse to sell," as if one must answer to somebody after disposing of some assets. "But mom, I had to!" Who makes this stuff up?
What if it looks like a correction but it's nothing more than the arrival of the USS Reality? Corrections and rallies are driven by news and data that shape perceptions of the future, and the dilemma lies in whether we use the dictionary's definition of correction as "a change that makes something right, true, accurate," implying that something was wrong, or the harsher "act or process of punishing and changing the behavior of people who have committed crimes?" Life sentence? For some it always is.
Then there's the options market revelation as 2013 delivered the goods, showing an increased appetite for leverage by common folk, and I doubt that risk management is the driver.
US retail investors are accelerating their use of listed options as part of strategies to manage risk, in stock replacement strategies and as part of more complex strategies that have traditionally been the sole domain of sophisticated institutional investors.
On the emerging markets topic, it's all about debt, risk and exposure, not to mention their dependence on developed markets. Compare the wardrobe of a middle-class American woman with the wardrobe of her counterpart anywhere in Europe, never mind emerging markets, and you'll see the difference. Now that's consumption, whether it's right or wrong. As far as the U.S. is concerned, a grand total of 10% of GDP is derived from exports, and emerging markets are truly not that important, considering that the aggregate consumption of beef, snacks and beer in America account for 1.5% of GDP.
Earnings and economic data have contributed far more to the change in perceptions than anything else, while QE is being unwound as promised. Thus far, 250 members of the S&P 500 (SPY) have reported earnings, with 68.8% beating estimates and 20.4% missing. The results are quite good, but everyone knows by now how the earnings game works. As a matter of fact, "operating earnings" per share for the group are up 21.4% from one year ago, and "as reported earnings" increased 39.8%. However, revenue is up a meager 2.73% over the same period and the overall estimates for the entire S&P 500 show earnings growth of 9.98% and revenue growth of 1.7% for Q4-2013. The simple question stands: How much more can be squeezed from virtually flat revenue? Considering that economic data is less than inspiring, such as U.S. job creation, PMI and housing, the hope here is that the Fed reverses course, or bad news are good news.
Which brings us to the other, less visible issue as far as headlines are concerned: Global Government Debt, which is outpacing global GDP growth by a ratio of 1.5/1, and forecast to reach $52.6 trillion in 2014 and $55.3 trillion in 2015. After looking at the numbers, debt is much higher than shown, but we'll play along.
The map below, courtesy of The Economist, clearly shows how widespread the debt disease truly is, especially among the most developed economies, upon which the emerging markets depend. Let's say that it's a red hot world for all the wrong reasons.
At the risk of repeating myself, an important point to make is that governments registered deficits and accumulated debt while the good times rolled, and that in itself is a perversion, which, as stated before, was never anticipated by Keynes. The problem is not so much that Keynesian theory has failed us, but rather the complete disregard for common sense that is pervasive in governments the world over. However, and on the receiving end, I never met anyone, rich or poor, that refused a government handout, and we end up getting what we paid for, or promised to pay, that is. Certainly the argument exists that, still according to Keynes, government stimulus (spending) primes the economic engine, but that can only be politely viewed as patently false, because the continuous "stimulus" that took place during the early part of the past decade, and has now accelerated beyond the point of no return, has not delivered measurable results. We should be paying down debt by now with the fruits from our investment, and that is not happening.
Fiscal conservatism and liberalism continue to lock horns, while the key word must be fiscal efficiency. Think of government adopting the homeowner's association model, where a consensus is reached on what's required for the common good, how to deliver it efficiently, and how to pay for it. Anything that is unreasonable, or downright stupid, is voted down because those making the decisions are directly affected. Not so with government.
Absent funny money or debt monetization by central banks, which is not viable in a large scale because it would destroy the trust we have on the monetary system, who's going to pay for this? If the problem was easy to solve, why not print money for government needs and skip taxation. I am certain that it would appeal to some highly "regarded" and ill informed economists!
While the argument exists for lower interest rates going forward based on recent data and normal economic mechanisms, the condition is anything but normal, and the "stimulus" shown above continues to expand government debt supply that competes with private credit/debt requirements, and will be met by continually shrinking demand that must price increased risk. How does it go in the debt world? Increased supply compounded with higher risk drives prices down and rates up. In addition, high debt is ultimately deflationary, and no fancy formulas or obscure analysis needed. As bizarre as it continues to sound, HYDE -- High Yield in Deflationary Environment -- is still in play, and if anyone believes that economic growth will eventually address government deficits and debt, I have an undiscovered Picasso that I want to sell you (my daughter painted it, but you couldn't tell the difference).
A common reference is made to trade as it relates to exports and how the revenue contributes to the economic well being of a nation. Many European countries, not to mention other continents, love to bank on it. But trade is a zero sum game, and for someone to have a surplus somebody must have a deficit. I still remember the cries that QE was bad for emerging markets because the dollar dropped, their currencies rose due to capital inflows and exports were hurt. Now ending QE is bad for emerging markets because capital outflows depreciated their currencies, and they couldn't handle capital flight. Which one is it? The answer lies in gradually developing economies that are less reliable on exports while the sun shines. Was it Argentina, Turkey, China's PMI or all of the above? Maybe they're guilty of contributory negligence, but my impression is that there's an underlying uneasiness about the U.S. economy that market participants can't shake off. Something doesn't add up.
If history is a good guide and as far as markets are concerned, the future is as unpredictable as the past. From an economic perspective, the formulation is far simpler, and despite the sporadic rays of hope that manage to pierce the clouds, we're still paying for yesterday's mistakes while trying to ignore how we arrived here. State of denial is extremely comforting but is emotionally consuming. After all, straight lines are not a market or economic feature, and, as it stands, the risk is on the upside, sweeping short positions with the Nasdaq 100 (QQQ) leading the way despite some nasty earnings surprises that took the wind from some well known sails. If the market gets up off the floor, it will deliver the much needed verdict to support the crowd that viewed the recent decline as "crying wolf", cementing complacency well into Q2-2014 that will be met by USS Reality II.
The ever controversial Harvard professors Carmen Reinhart and Kenneth Rogoff penned a working paper for the IMF, an institution notorious for being behind the eight ball, and the headline was "IMF paper warns of "savings tax" and mass write-offs as West's debt hits 200-year high." We shall continue to play by the shore while keeping an eye on that killer wave that continues to gain strength beyond the horizon. The script is in and although the actors will deliver varying performances that will mask the substance at times, the end result is that the film will be made. Lastly, contingency plans must be on the drawing board, especially if the ship is bigger and harder to turn around.