Anecdotal vs. Measurable Sentiment
Over the weekend we had an opportunity to chat with a number of friends who are active in fund management and/or other financial industry professions. It was a very interesting discussion. Among other things we debated how likely a continuation of the recent stock market rally was.
The bullish argument that was brought forward was that one could – if one was prepared to ignore all the well known 'macro headwinds' – easily find individual stocks that look neither overly expensive nor too stretched from a technical perspective. Absent any major new upheavals from the macro-landscape, there seemed to be no reason not to buy such stocks. In addition, there is a strong undercurrent of negativity among investors detectable on an anecdotal level. This can be seen both in media reports and sensed in discussions with others in the industry. In other words, there exists a 'wall of worry' backdrop, even if it is not one that can be objectively quantified.
Another aspect worth considering in this context is that marrying one's economic outlook and one's market outlook is not necessarily as straightforward as it appears, especially not today when central banks continue to provide ample liquidity (or as the case may be, are promising to provide it soon).
The bearish arguments on the other hand can be summed up as follows: valuations are relative – with profit margins at a rare secular peak (a point frequently made by John Hussman), stocks may be more expensive than they appear. Global economic activity continues to exhibit all the hallmarks of a synchronized slowdown/contraction, there are several worrisome technical divergences in evidence and measurable sentiment data show that the enthusiasm of traders has reached an extreme.
The ratio of the NYSE Composite index to the S&P500. The broader market continues to woefully underperform the big cap index
(click charts for better resolution)
The dollar value of the net commercial hedger position in all stock index futures combined (plotted inversely). The near record hedger net short position is the mirror image of the near record net long position held by speculators (via sentimentrader)
In DJIA futures a new record high in the net speculative long position has been recorded (the same is true of NDX futures)
One can certainly legitimately argue that such extremes in quantitative sentiment data are only of tactical (i.e., short term) significance. To this it should however be noted that it usually doesn't take as long for the market to fall as it takes for it to rise, so even a short-term crack could be significant. Furthermore, how important such signals are is often only revealed after the market has in fact come down and one has an opportunity to observe how traders react. If an initial decline meets with equanimity, then the danger that something more serious in the works will be that much greater. If a majority of traders quickly becomes fearful and/or tries to jump on the downtrend bandwagon with directional bets, then one can be fairly certain that only a routine pullback is happening. So what about other signals? In the very short term, it is noteworthy that the NDX has recently weakened ever so slightly relative to the SPX before it could attain a relative strength lead in the course of the most recent advance (in an overlay chart, this will show up as a divergence, with the SPX making a new high that is unconfirmed by the NDX):
The NDX-SPX ratio chart – in the most recent 'QE' inspired advance, the NDX has failed to maintain its relative strength lead against the SPX
We are always looking at signals that are not too widely known, based on the idea that anything that is extensively discussed in the media has probably lost some of its relevance. The things everybody knows about are rarely the ones that one can rely on to provide reliable advance warning. In this latter category we find the recently widely debated Dow Theory divergence between industrial and transportation stocks, although it should perhaps be pointed out that we came across several articles last week that were dismissing the divergence (as an example see "A Broken Dow Theory" in Barron's), which according to the perverse way these things work means it should probably not be dismissed.
One lesser-known indicator we keep an eye on is the put/call open interest (as opposed to volume) ratio in OEX options. While it is well-known nowadays that the OEX put-call ratio is not a contrary indicator (as the buyers of OEX options are mainly professional hedgers, i.e., smart money), it is not necessarily a good short term timing indicator – and neither is the put/call open interest ratio as it were. The open interest ratio is in fact a much slower moving indicator exhibiting fewer spikes than the volume ratio and as such tells us something about the persistence with which hedgers are eager to hold OEX puts. In short, it is actually an indicator of medium- to longer-term significance.
The OEX put-call open interest ratio has moved into a higher range since 2011 and is currently once again approaching the upper limits of this range
One of the questions that came up in the above mentioned discussion was how probable it was that bond yields would rise as a result of 'QE3' actually being successful in increasing inflation expectations further and what effect this might have on stocks. More on this further below.
What Were They Thinking?
Many people were surprised by the Fed's decision to announce 'QE Forever' at the September FOMC meeting. As far as we are concerned, the surprise was blunted a bit by the broad hints Bernanke let slip at the Jackson Hole pow-wow and the subsequent 'confirmation' that something was afoot penned by Fed mouthpiece Jon Hilsenrath in the WSJ. As we noted at the time, if Hilsenrath says the speech means more money printing is coming, then one should probably take heed.
It was still a remarkable development considering stocks and commodities were already quite firm, the euro area debt crisis was clearly in 'pause' mode and U.S. economic data, while not much to write home about, at least appeared to be sort of plodding along (as opposed to falling off the proverbial cliff). Even the housing sector showed signs of stabilizing.
What made the decision all the more astonishing was the fact that „inflation expectations“ (this is to say expectations regarding the future rate of change of CPI) as measured by market data were in the upper range observed over the past few years.
U.S. 5-year inflation breakeven rates. They are calculated by subtracting the real yield of the inflation linked maturity curve from the yield of the closest nominal Treasury maturity. The result is the implied inflation rate for the term of the stated maturity
Inflation breakeven forward rates – these rates are comprised of generic United States breakeven forward rates: nominal forward 5 years minus U.S. inflation-linked bonds forward 5 years
Something Lies in Wait for Bonds
It is noteworthy that this increase in inflation expectations happened in spite of nominal treasury note and bond yields remaining rather low – in short, what investors did was to bid up the prices of "inflation-protected" (ha!) treasury securities. To this one must keep in mind that "Operation Twist" is ongoing and is lending support to nominal bond prices. It is difficult to gauge to which extent this support is driven by perceptions rather than the Fed's actual buying, but it seems likely to us that perceptions play a very big role. We are saying this because both QE1 and QE2 actually led to an increase in nominal bond yields instead of a decline. The Fed's unstated goal of raising inflation expectations was in fact achieved on these occasions, and bond yields reflected it. From the point of view of the planners it 'made sense' to announce these programs at a time when inflation expectations were very low. What train of thought informed 'QE3' is rather more difficult to understand.
This has also created a conundrum with regards to the stock market. As one of the participants in the discussion remarked, while the promise of additional liquidity could well put a floor under stock prices (the proverbial 'Bernanke put'), any further increase in stock prices could find itself limited by rising bond yields. Below is one reason why bond yields – in the wider sense, this is to say not only treasury bond yields, but corporate and municipal bond yields as well – could be setting up for a nasty longer-term reversal. Fixed income securities have become too popular:
Via EWI: total assets in bond funds of all stripes. There has been an unseemly rush into fixed income since the GFC.
It is instructive in this context to take a look at the Dow Jones 40 bond average (an index of corporate bonds) in the 1910's to 1930's, as this period encompasses both an inflationary and deflationary bond bear market – this is to say, in the first instance bond prices fell due to a sharp spike in inflation and in the second instance due to a sharp rise in defaults and growing worries about creditworthiness. Of course treasury bond yields only rose in the 1915- 1921 bond bear market, but decoupled from corporates in the 1930s.
Corporate bond prices from 1915 to 1933. An inflation-induced bond bear market, a 'disinflation' bull market and finally a bear market during a deflationary depression.
We're not sure what kind of surprise awaits bond investors around the next corner (rising inflation expectations or rising default worries – we can only rule out actual money supply deflation with certainty as long as "the Bernank" rules the roost, and very likely also under his eventual successor), but here is one item we would definitely avoid at the moment. Not even a team of wild horses could drag us into this arena as it were:
High-yield ETF JNK – at the moment everything seems fine, but this is probably the very tail end of another mindless 'yield chasing' exercise
The Official Inflation Forecast
The projections of FOMC participants of future PCE inflation (the personal consumption expenditure index, which is the index that tends to understate the decline in money's purchasing power the most and is therefore a favorite of our vaunted "inflation fighters") may also be worth considering. Given the fact that these guys and gals have a well-established record of being unable to forecast their way out of a paper bag it may prove to be a contrary indicator:
No inflation for as far as the FOMC members' eyes can see …
This type of forecast is based on an erroneous assumption as it were – at least as far as we are aware, judging from the remarks various Fed members have made in their speeches. The underlying idea is that money's purchasing power won't decline regardless of how much they print due to 'idle resources' in the economy. In short, it appears to be an error of aggregation. What they forget is that 'idle resources' are nothing but the left-overs of the investment errors made during the preceding boom. To the extent that such resources consist of relatively specific capital, they may not be usable at all, due to a lack of complementary capital on the one hand, and due to a lack of consumer demand for the products such capital can be used to produce on the other (recall the unusable construction equipment piling up in Spain).
On account of renewed credit expansion, relatively non-specific resources (say, the excess steel stockpiles filling warehouses all over China) may well be employed again as though the additional capital goods required to make such employment sensible actually existed. Unemployed workers in the steel industry may temporarily find employment again as well. In reality though this amounts to an unwarranted interruption of the economy's post bubble adjustment process – because the complementary additional increments of capital do not in fact exist. What instead exists is a mirage: the money supply expansion and concomitant decline in interest rates below the natural rate only make it appear as though such additional capital were available.
With regards to how the purchasing power of money is affected by production, a goods-induced increase in purchasing power depends on there being an increase in production. If more consumer goods are produced than previously, then consumer prices should ceteris paribus decline and vice versa in the event of fewer goods being produced. As far as we can tell, the main reasons why stronger price increases of consumer goods have been held in check thus far are an increase in the demand for money and a tendency for money to primarily flow into financial assets. This is no less an effect of inflation however (i.e., an effect of the increase in the money supply) – relative prices in the economy have definitely been distorted.
Economic Effects of Monetary Pumping
Lastly, although "risk asset" prices have been rising strongly, there is no sector in the economy that stands particularly out at this time as a 'bubble host'. During the technology and housing bubbles it was fairly easy to determine in which sectors of the economy the Fed's loose monetary policy was creating large scale capital malinvestment. Although Fed researchers apparently remain unable to spot bubbles even if they stare them into the face (to be fair, there is a debate over whether asset prices should become a focus of policy as well, see e.g. this recent Chicago Fed letter - pdf), or have adopted a consensus that the central bank should not 'lean against asset bubbles" even if they are suspected to exist, all it really took to recognize these bubbles was a dollop of common sense.
Currently it is not so easy to spot the bubble sectors, which suggests that the malinvestments are spread among several of them. Below are two charts that illustrate the relative amount of spending on the production of capital goods (business equipment) to non-durable consumer goods. First the long-term view of this data series:
When this ratio increases, investment in higher order stages of production (capital goods) is rising relative to investment in lower order stages of production (consumer goods, in this case non-durables). It has recently reached a new record high
As can be seen, the ratio has recently reached a new all time high. Although the longer term upward shift in the ratio can in part be explained by the increase in global trade and the relocation of many consumer goods industries to different parts of the world, it seems improbable that all of it can be so explained.
It remains noteworthy that prior to the abandonment of the gold exchange standard in 1971, the ratio was confined to a much lower range, reflecting a better balance between capital and consumer goods production. It seems highly unlikely to be a coincidence that the ratio began to take off right at the moment in time when the great unfettered credit bubble got going as well.
The same chart showing the period immediately prior and after the abandonment of the dollar's last remaining tie to gold
It is not possible for us to quantify the amount of real savings (the personal savings rate is misleading, it cannot really tell us anything about the state of the pool of real funding). However, we can state that the producers of consumer goods sustain the producers of intermediate goods and raw materials. One must always keep in mind that production is ultimately funded by real goods (the stock of unconsumed, i.e., saved, consumption goods). It doesn't matter how much money exists – without an adequate stock and flow of consumer goods, production activities in the higher orders can not be sustained. Money merely plays the role of medium of exchange, it serves as a means to acquire goods. Savings held in the form of money denote that one is exercising a demand for money (what one has really saved are the consumer goods one has abstained from consuming). It follows from this that when capital and consumer goods production are "out of whack," the economy will at some point begin to tie up more consumer goods than it releases. It is an unhealthy and unsustainable configuration that is suggestive of capital malinvestment due to money supply expansion from thin air. This will inevitably lead to another bust.
Charts by: sentimentrader, Bloomberg, stockcharts, St. Louis & San Francisco Fed, Elliott Wave International