By Joseph Y. Calhoun
Stocks pulled back a bit last week based on the re-emergence of turmoil in Iraq (did it really ever subside or did we just stop paying attention?) and if you believe some of the pundits, Eric Cantor’s loss of his primary in VA. That’s the first time a House majority leader has ever lost a primary in trying to retain his seat and some see that as a potential problem for Republicans in the fall elections. That would seem to imply that some people have been buying stocks in anticipation of a Republican wave in the mid-term elections, the logic of which completely escapes me. Even assuming a Republican takeover of the Senate and retention of their majority in the House, I am at a complete loss as to how that would translate into a positive for stocks.
That doesn’t mean that I prefer Democratic economic policies but is merely a recognition that changing the composition of Congress isn’t going to address the problems that plague our economy. A Republican Senate would, if anything, only further polarize the parties and continue the policy paralysis that prevails today. An Obama administration confronted with a Republican majority is not likely to suddenly change its stripes and start agreeing to policies that conflict with their most dearly, deeply held beliefs. If anything it would just reinforce their belief that they can accomplish through creative interpretations of regulatory policy what they can’t accomplish through legislation. A Republican wave would just reinforce the status quo that already exists. How is that positive for fiscal, regulatory or monetary policy?
But enough about politics; the subject bores, upsets and angers me and everyone I know. My hope is that the Cantor defeat is an indication that people are finally so fed up with the current crop of politicians that they feel no compunction about tossing out one and all. But that is probably wishful thinking and not worth getting excited about. What is more interesting and pertinent to these weekly missives is the state of the markets and the economy, so let’s move on.
As I said at the beginning, stocks did pull back a bit last week but certainly not in a manner that would be upsetting to the bulls, the population of which is moving into extreme territory once again. The sentiment readings I follow are all flashing warning signs again and while they have done so periodically over the last year, they are now approaching Alfred E. Neumann heights. Investor’s Intelligence reports 62.2% bulls in their latest survey and with bears down in the teens, the spread between the two at over 40 points is near an all time high and above 96% of all historical readings. The American Association of Individual Investors shows bulls at nearly 45% and bears at 21.3 (and an all time low for cash in their asset allocation survey). Consensus reports 70% bulls and Market Vane 66%. The equity put/call ratio at .53 shows bullish calls almost twice as popular as their bearish cousins, puts. And as everyone else has been reporting, the volatility index is getting close to single digits, a level associated with extreme complacency.
Sentiment is not a short term timing signal and so extreme readings of this nature do not mean the market is about to crash. Indeed, the market has performed quite well in such conditions at times in the past, last year being a great recent example. 1999 also stands out as a period when the consensus, the crowd, got it right for a while and more than a few basis points. And that may be the case again for a while but this does tell you that being bullish is hardly contrarian and as such is unlikely to lead to large, sustainable gains. The key word there being sustainable of course; those who believe they can identify the turning point when it comes should feel free to carry on swimming with the current and watching the same technical signals as everyone else.
Neither does it mean that there are no places to invest in the world as there are still a few markets that are viewed with considerable skepticism. China is reckoned to be on the verge of a credit meltdown and no one thinks Brazil can do anything right except on the futbol pitch. Russia, it goes without saying I suppose, is considered a leper in the global financial system, something that hasn’t prevented its ETF (NYSEARCA:RSX) from rallying a smart 25% over the last month or so. Those aren’t recommendations by the way, just observations. I do find it interesting that both China and Brazil have seen their currencies rise recently, an indication that at least some investors are willing to overlook their current, well publicized troubles. As I’ve said a number of times, currencies tend to move on growth expectations and while currency markets aren’t infallible, it is often a self-fulfilling prophecy as the capital inflows that raise the currency also create the growth that is anticipated by the currency markets.
On the whole though, markets around the world offer few bargains and investors are generally bullish about all things financial. Or maybe resignedly bullish is a better way to put it. Investors are faced with a world where returns on safe investments are mostly negative in real terms. Investors faced with known liabilities and a finite amount of capital are being forced to accept risks they probably wouldn’t in more ordinary times. That applies to pension funds, retirees and near retirees almost equally. Central banks have been able to create the impression that not only is this embrace of risk something that is necessary for economic growth – almost patriotic in that sense – but also something over which they exercise considerable influence.
Central banks have embraced – none more so than Janet Yellen – the idea that they can control irrational exuberance through what they call macro-prudential policies, something Mohamed El-Erian commented on in a commentary carried at Bloomberg last week. The world’s central banks and other regulators have taken some steps designed to reduce the potential for financial instability – or created policies designed to clean up afterward if they are unable to identify problems in advance – but overall, it seems to me that there are way too many moving parts in the global financial system for them to control what their monetary policies have created. A more logical and conservative approach would be to conduct monetary policy in a way that avoids creating destabilizing situations in the first place but that would mean admitting their limitations and that has its own implications at this point.
The biggest bubble in the world right now is the belief in central bank omnipotence. The biggest risk takers in the world right now reside within the confines of the global central banks, especially the US Federal Reserve. They are taking huge risks with policies they barely understand and while one could excuse them for at least attempting to do what other policymakers won’t, it is hubris to believe they will see in real time what they have until recently denied even with the benefit of hindsight. This belief in omnipotence is not just something the general public has swallowed but extends even to the people who run the world’s central banks. The bulls of the world believe the world’s central banks have it all under control. So Don’t Worry, Be Bullish. You’ll probably be right until the myth of central bank omnipotence, one the Fed has fostered and has no macro-prudential policy to offset, is finally punctured.