Central Bank Cult Of Personality Colliding With Deteriorating Market Internals

by: John Lombardo, CFA


Over the last three years a low volatility rally has been supportive of naïve 60/40 stock/bond portfolio performance while being very challenging for sophisticated investment strategies.

This environment has been supported by a misplaced belief in central bank omnipotence.

Weakening market internals, including widening of high yield bond spreads, suggest faith in central bank infallibility is waning.

The decline in the Cult of Personality of Central Bank Omnipotence is likely to end with a dramatic decline in equity prices.

On the last trading day of November, the NASDAQ Composite closed at the highest level in more than 14 years while on December 5th the S&P 500 and the Dow Jones Industrial Average each closed at record highs. Despite the strong benchmark performance, market internals have been deteriorating for months. In The Truth About US Equity Valuations I noted that nearly half of the stocks in the NASDAQ Composite were down 20% from their 52 week highs while about 40% of the stocks in the Russell 2000 were down at least 20%. Since then, the advance/decline line has continued to deteriorate as has the volume of advancing issues relative to those declining. Despite the recent benchmark highs, a rather disturbing percentage stocks are reaching new lows. On Friday, December 12th, 11% of all stocks traded on the NYSE hit new lows while 6.5% of those trading on NASDAQ did so.

Not surprisingly, we are beginning to see significant differences between the equal and cap weighted performance of US equity benchmarks. While the Russell 1000 is up 9.94% year-to-date, the equal-weighted version of the benchmark is up just 7.08%. While the Russell 2000 is up 0.24% year-to-date, on an equal weighted basis the benchmark is down 4.29%. In short, the average stock is underperforming the cap-weighted benchmarks. Finally, we have begun to see a rather dramatic widening of high yield spreads, particularly in the energy sector, which comprises 15-20% of high yield benchmarks, as oil prices have crumbled.

The last three years have been an interesting time, one in which naïve allocations to simplistic 60/40 stock/bond portfolios have performed exceptionally well while the performance of more sophisticated strategies have dramatically underperformed. A low volatility rally, which until recently, has lifted all boats, seaworthy or not, has been brutal on hedge fund managers. Maybe we shouldn't be surprised that HFR reported 461 hedge fund closures through the first half of 2014, the most since 2009, when 1023 funds were liquidated. Simply put, having a deeper understanding of economics and the markets has been anything but helpful in managing portfolios over the last three years.

The obvious question is why? The answer lies in what I refer to as the Cult of Personality of the Omnipotence of Central Bankers. Markets hang on every word each time a central banker speaks. As just one example, but a very good one, note how the market rallied on October 16th when St Louis Fed President James Bullard suggested that the Fed could delay ending QE3. US equities had been in decline for a month prior to Bullard's statement and were significantly lower on the 16th prior to it. They subsequently rallied, ending the day essentially flat, and moved dramatically higher over the next seven weeks. Of course this is the same James Bullard who a week or two earlier was advocating for the end of QE. Simply put, markets are addicted to the central bank liquidity pump and move higher, or lower, on any comments by central bank officials that indicate more, or less, liquidity, respectively. With central banks of nations accounting for more than 50% of global GDP running ZIRP (zero interest rates policy) and QE, markets have been supported by a tsunami of liquidity. Numerous central banks across the globe, including the Bank of Japan, are actually buying equity ETFs, which pushes equity prices higher but has no demonstrable impact on bank lending or economic growth. So what is the rationality for such policy? Apparently nothing more than the often discussed but seldom seen wealth effect. Yet rising stock prices most benefit the wealthiest members of society, those whose spending is not dependent upon stock market performance. On the other hand, ZIRP and QE negatively impact the spending of those with median and lower incomes and retirees, whose savings and investments are more likely to reside in banking and fixed income assets. Somewhere along the way, global central bankers forgot that economic growth is built on savings and investment, not wealth effects from liquidity fueled stock rallies, wealth that is all too likely to be lost in dramatic fashion.

Simply put, global central banks have no ability to fix the major structural imbalances that plague many of the world's developed economies and a number of emerging ones as well. Japan is again in recession and its massive QE program subsidizes exporters at the expense of importers while devastating savers and consumers. Furthermore, while it has increased the value of exports as measured in Yen, the volume of Japanese exports has barely budged. Europe is once again teetering on recession after what can be called recovery in name only. Italy, the third largest Eurozone economy, remains in recession and its unemployment rate continues to rise. The currency zone's economy will likely grow about half as much this year as was initially anticipated and estimates for 2015 and 2016 growth have been slashed. The US has recovered nicely from the first quarter's collapse (and please, can we stop with the weather excuse? The winter of 2009-2010 was not dissimilar, yet first quarter 2010 GDP growth was 3.80 percentage points higher!), but fourth quarter growth looks weaker. At the end of the day, 2014 GDP growth will look very much like that of 2012 and 2013. If this is the economic growth that ZIRP and trillions of dollars in QE begets, what is argument for the efficacy of such policies? The answer is simple, there isn't one. Are central bankers truly unaware that they are powerless to impact the structural issues facing their economies? No, the more likely answer is that they simply don't know what else to do. Sadly, they seem to have forgotten the old adage that the belief that something must be done is the father of many ills. While there massive liquidity pump has had little economic impact, we have seen a significant return to sub-prime auto lending, rising covenant-lite high yield loan issuance, rising sovereign debt levels, the third US equity bubble in 15 years, and, in general, a massive misallocation of capital.


While I don't know that we have seen the untamed level of adulation of central bankers that we have witnessed of late, this basic theme has played out time and again and the arguments are indistinguishable from one market epoch to another. I distinctly remember an article written early in the 2000-2002 bear market that included quotations from the late 1920s, late 1960s, and late 1990s, extolling the virtues of those dying bull markets in nearly identical language. All lauded the Fed and its supposed new found ability to control economic cycles. Of course those bubbles collapsed and this one will as well. The Fed and its cohorts are no more able to control the economy or the markets today than they were in the 1920s, 1960s, or the late 1990s.

The deterioration in equity market internals, collapsing oil prices, a rally in US Treasuries, and the widening of credit spreads all suggest that market participants are beginning to question the omnipotence of global central bankers. The market is becoming more fragile, indicating rising risk aversion. When a Cult of Personality ends, it often does so in a bloody and violent manner. Rising risk aversion in one of the most overvalued US markets in the last 100 years is a recipe for a violent decline in equity prices.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.