Crossing The Rubicon

| About: SPDR S&P (SPY)

By Amareos

The summer swoon in US equities that we warned about in mid-May appears to be over[1]. In fact, Wall Street has managed not only to recover fully from the 6% slump witnessed last month, but to break to fresh highs for the year and indeed the cycle. This is an impressive performance considering the slew of recent negative shocks including Brexit and last weekend's terrorist attack in Nice and the attempted military coup in Turkey[2]. Driving this move higher in US equity markets is a combination of solid, if not spectacular, corporate earnings with the Q2 reporting season now underway and improving underlying macroeconomic fundamentals; a combination that has boosted investor sentiment.

According to CNN's Fear & Greed Index (see exhibit below) the predominant emotion in US equity markets at present is "extreme greed." This sounds concerning because emotional extremes typically mark turning points in asset markets[3] and, as mentioned, equities are at record highs. Given this, why are we more sanguine?

Exhibit 1. CNN Fear & Greed Index

1

Source: CNN Money

The CNN index[4] is based upon seven market indicators, but they are all price based. As we have noted on several prior occasions, market prices are not necessarily good proxy measures of the prevailing crowd mood because prices are impacted by numerous non-emotional related factors. Differing secondary market liquidity conditions is one of the most cited factors, but of growing importance over recent years has been the activities of official entities, such as central banks, whose financial market impact is motivated by achieving certain policy objectives as opposed to profit-maximisation. This is an important point we will come back to later in this post.

By way of contrast, compare this price-based measure of Wall Street's mood with the sentiment measure derived from the analysis of millions of mainstream and social media articles posted online every day. As shown in the exhibit below, on this alternative measure, US equity market sentiment has increased in recent weeks, but is far from overly buoyant (or extremely greedy to borrow CNN's lexicon).

Exhibit 2. US Equity Market Sentiment/Optimism

Click to enlarge

Source: Amareos

Looking at the exhibit, it is readily apparent that the three significant market corrections witnessed in 2014-2015 greatly unnerved investors as both sentiment and optimism[5] slumped to their lowest levels since the depths of the Great Recession[6]. It also unnerved the Fed as evidenced by the ungainly gyrations in their forward guidance language over the past year or so - "rates up," "rates on hold," "rates up" - you get the idea![7]

The low sentiment readings observed in March this year were a strong indication that a great deal of bad news was already incorporated into the US equity prices, implying that the marginal market impact of additional negative news would be significantly lower than for positive news. That the recent shocks already mentioned have had such a negligible impact - the nascent recovery in equity market sentiment and optimism has continued and the subsequent price rebound swift - is testament to that observation.

Obviously no indicator, sentiment or otherwise, generates perfectly reliable signals of future market trends because such financial infallibility is something only found in economic models. Nevertheless, that the measures of equity market sentiment/optimism that we track at Amareos are not materially different from its long-run average provides some measure of comfort that irrational exuberance has not pushed up US equity prices to unsustainably high levels as the CNN index would lead one to conclude.

That said, even if US equity markets are not vulnerable because of excessive crowd optimism, many investors worry that judged on the basis of standard metrics, US equity market valuations are not terribly attractive. For the S&P 500, the PE ratio stands a shade under 25, which is high relative to history, with an associated earnings yield of roughly 4% that is, consequently, relatively low.

In dismissing such worries, some commentators have argued that this fails to take into consideration the positive effect on equity valuations resulting from government bond yields having fallen to record lows (we are loathe to use the term risk-free rate as nothing is risk-free), which serves to mitigate the impact upon the equity risk premium[8]. A counterargument has met with resistance by those that argue that government bonds are in a bubble, making such relative asset comparisons nonsensical.

So who is right?

To answer the question we need to conduct a little[9] thought experiment; one that begins with the assumption that policymakers successfully engineer an economic recovery, which we will define as nominal GDP growing in line with the summation of the central bank's inflation objective (2% almost invariably) and the economy's potential growth rate[10].

Unless one judges that the potential growth rate has collapsed, not just fallen as many assume but collapsed, this must mean that nominal GDP growth will be higher than the current level of the nominal government bond yield[11].

Faced with this prospect, the rational response of bond investors would be to sell down their holdings of government bonds until the two nominal rates (GDP growth and bond yield) come back in sync. After all, the whole point of investing is to maintain future purchasing power not see it diminish[12]. For the sake of argument, let's put this somewhere between 3.5-4% - a little lower than the average growth rates witnessed since central banks began to adopt inflation targets in the early 1990s.

This may not sound like much of an increase (roughly 200-250bp higher than today's government bond yield) but it would imply significant losses for bondholders, especially those with long duration assets. It also likely implies a significant correction in equity markets because it would increase their relative "expensiveness." A combination of falling equity and bond prices is the ideal recipe for a growth toxic tightening in financial market conditions, jeopardising the economic recovery assumption that we began this thought experiment with.

For those that might consider this thought experiment esoteric or farfetched, it is one of the major preoccupations of the Fed, which explains their forward rate guidance vacillation and their tiptoeing away from ZIRP.

Surely the decision by central banks to deploy negative nominal interest rates (NIRP) to inject growth supportive monetary stimulus mitigates this bearish effect? Unfortunately, it does no such thing, if for no other reason than as long as cash exists there is a natural limit as to how far below the zero line nominal interest rates can be reduced[13] as many central banks are now finding out. This limitation is most pressing for the BoJ, which is why there has been renewed interest in the policy alternative colloquially known as "helicopter money"; former Fed governor Bernanke's recent "private" lunch with governor Kuroda did much to fan the flames of such speculation[14].

At this point, it would appear that economic logic implies that the bears are right, success at bringing about an economic recovery will push long-term bond yields higher and hit equity prices as valuations would be more challenging. However, this conclusion has one fatal flaw; it fails to take into account that central banks have the ability to break the link between nominal economic growth and the nominal government bond yield[15]. Specifically, central banks can shift their interest rate target from the short end (as we have become accustomed) to the long end of the curve. Indeed, there is historic precedent for such action as the Fed adopted just such a policy starting in the 1930s until the Fed/Treasury Accord of 1951[16].

The reason why central banks have not already implemented such a dramatic policy change is because it crosses at least two important monetary policy rubicons. It would result in a lack of operational independence for the central bank and it would also mark the end of inflation targeting because there are not enough degrees of freedom for the central bank to target nominal bond yields and inflation simultaneously[17]. Previously, these would have been considered taboos but given the failure of QE to generate a self-sustaining recovery, and the limitations in NIRP, the number of policy alternatives is rapidly dwindling[18].

Making such a radical change to the operation of monetary policy would certainly have a dramatic impact upon the financial landscape. Indeed, we already have a hint of its effects in the latest Japanese sentiment data. Even though the implementation of "helicopter money" by the BoJ is nothing more than speculation at this stage[19], we note that Japanese stock prices, equity market sentiment and inflation expectations jumped sharply higher almost immediately after the Kuroda/Bernanke lunch. This should provide a salutary warning to those of a more bearish persuasion.

Exhibit 3. Japanese Sentiment Indicators

Click to enlarge

Source: Amareos

*Sentiment Analytics are based on Thomson Reuters MarketPsych indices.

[1] See here:

[2] We covered the topic of political risk in last week's blog post - see here.

[3] The interaction between crowd emotions and the asset price cycle was shown in an exhibit in a previous blog post - see here.

[4] Another issue we have with the CNN index is its overly simplistic assumption that investors are driven by just two emotions - greed and fear. Investors are, as if we needed to be reminded, people and even when aggregated up into a crowd, the emotional spectrum is much broader and richer than this basic two-state classification.

[5] To reiterate: sentiment measures contemporaneous references of positivity or negativity while optimism measures future references of positivity or negativity.

[6] Although we only show sentiment data going back to 2010 on the Amareos website, the data is available daily back to January 1, 2005.

[7] We discussed the beta dependency of the Fed previously - see here. While writing this article it occurred to us that one possible explanation for the low sentiment readings in US equities, despite prices being at record highs, is that it could be a reflection of public concern about the degree to which US asset markets are dependent upon the Fed.

[8] One measure of the equity risk premium is derived from so-called Fed model, which is based on the difference between the earnings yield on equities and the yield on long-term government bond yields.

[9] Possible complex as well - you have been warned!

[10] The rate at which an economy can expand that keeps aggregate demand and supply in balance and hence does not generate either accelerating or decelerating inflation.

[11] USD 10t of which now trade with a negative yield.

[12] Such an outcome may well occur by accident due to forecasting errors but we are considering a situation where it would be deliberate.

[13] We made this point in a BSEC research note published last year, which is available to Amareos subscribers upon request.

[14] See here.

[15] The other possibility is that the central bank must continue to force real (i.e. inflation-adjusted) long-term interest rates lower by pushing up inflation via additional monetary stimulus so as to offset the previous rise in nominal long-term interest rates. Like a Ponzi scheme, however, this process has a finite lifespan; one that ends in hyperinflation - an outcome no central banker wishes.

[16] See here.

[17] Bernanke has written about using a government bond yield peg as an operational tool in his blog and raised the concern about the impact upon the central bank's balance sheet. His worry is that by setting the price it has no ability to control its balance sheet growth as it becomes endogenous, but we would question the degree of exogeneity of a central bank's balance sheet given that economic conditions have required ongoing QE operations that has pushed the BoJ's balance sheet to almost 90% of Japanese nominal GDP - levels rarely seen in peacetime. Moreover, the impact on central bank balance sheets can be mitigated by the tools of financial repression including commercial banks and pensions funds being coerced into holding government bonds for macroprudential reasons.

[18] We accept that it may take another asset price swoon to act as a catalyst galvanizing central banks and governments into action.

[19] Kuroda has explicitly ruled out helicopter money, but it is worth recalling he also did the same for NIRP on January 21st this year, and barely a week later the BoJ adopted this very policy.