Indecisiveness is often mistaken for complacency.
Complacency entails a lack of participation and/or interest on the part of the (non)actor who is complacent. The outward appearance and the inward bias are the same. The person appears complacent and the person is complacent.
Indecisiveness is different. It entails participation and/or interest on the part of the actor. The outward appearance and the inward bias are not the same. The person appears complacent but is actually active. The activity is introspection. The outside world cannot see introspection. Hence the tendency for indecisiveness to be interpreted as disinterest.
So we have to consider that when we think about the apparent lack of interest on the part of US equity markets. Last month was, as I habitually remind everyone who will listen, the third calmest January on record as measured by average VIX level. Realized volatility for the month was 6.5, the fifth lowest since 1929.
To be sure, I'm not buying my own argument here. That is, I don't think we are mistaking indecisiveness for complacency.
Or at least not completely.
I think the trend has been investors' erstwhile friend and that friendship has acted as a kind of psychological novocaine. Beyond that, the trend is likely attracting CTAs (the trend followers) and the low volatility environment has almost certainly allowed risk parity and volatility targeting strats to run highly leveraged positions. Indeed, any trend worth its salt has an embedded self-feeding mechanism.
All of that said, there's undoubtedly a "deer in headlights" dynamic at play. That is, markets aren't able to function as a discounting mechanism because the outlook is even more uncertain that usual.
The readily apparent policy paralysis gripping the Eccles building is a reflection of just how vexing the situation truly is.
On Sunday, we got the latest from one of my favorite analysts, Deutsche Bank's Aleksandar Kocic. Regular readers will recognize the name. Kocic penned a note in 2015 that compared the Fed's explicit mention of international financial conditions to the removal of the "fourth wall" - a reference to theatre. For those interested, you can read an excerpt from that note here.
In the piece linked above, I also included a few passages from Kocic's Sunday note. In what I called a "fantastically metaphysical market metaphor," Aleksandar describes the post-election dynamic as follows:
Initial expectation was that change would cause a move in the right direction and improve things. The connection between the change and improvement looked simple and the path straightforward. However, when viewed at higher resolution, the path from the first essential steps to the final stages of stimulus has become much more complicated and contentious. While in the short run we could see some signs of caution and skepticism, in the long-run, the likelihood of disappointment in our view remains considerably higher than the market is willing to price in.
Kocic goes on to outline the multiple "nested contingencies" along the path to the stimulus promised land. Here is Deutsche's decision tree:
(Chart: Deutsche Bank)
And here is Kocic to guide us through it (my highlights):
In the near term, it is all about the border tax being passed. This is supposed to finance (at least partly) the rest of the stimulus (e.g. corporate tax cuts and infrastructure building). If it doesn't get passed, than additional stimulus would require high deficit spending. These are the lower branches of the decision tree. Irrespective of whether Fed stays hawkish or dovish, it is likely that deficit spending would remain inflationary and aggressive Fed hikes could probably only make things worse by going against growth. This scenario is bearish for currency and risk as well as for bonds.
Dovish Fed and additional monetary accommodation without fiscal stimulus is unlikely to yield anything new. Most of the optimism that has been priced in since November would get unwound with sell off in risk assets and USD and bull flattening of the curve. We believe that this is not a politically viable path.
Things become interesting in the upper branches, if the border tax is approved.
Along this path, the reaction of the Fed is essential. The main point is that hawkish and dovish Fed paths lead to rather different final destinations. Hawkish Fed, in the traditional sense of this term, is likely to bullish for USD and potentially bearish for equities (sideways at best), which could be a problem because strong currency neutralizes the effect of the border tax.
Dovish Fed, on the other hand is risky. Although it is bearish for USD, running an aggressive deficit spending program with Fed behind the curve runs risk of getting inflation out of hand. Because of this, monetary policy would have to be very finely tuned and coordinated with fiscal stimulus in order to walk the fine line between too much and not enough (dotted line in the Figure).
Clearly I was mistaken last week when I said that even Kocic couldn't fathom the entirety of the policy dilemma.
Here's the key point (my highlights):
In the near- and mid-term, the market is likely to be prepared to embrace positive outcome of the stimulus. Based on what we saw so far, the current administration is unlikely to give up until all possibilities are exhausted. This could keep an upbeat tone in the markets. Rates could even break out of the range in the next step, while equities sustain their bid. However, probability of not seeing a collaboration of all the forces along the recovery path will remain significant, and with it, the likelihood for disappointment.
In other words (and this is something of a gross oversimplification), if everything goes right, rates can rise while equities (NYSEARCA:SPY) remain buoyant.
But any deviation from the optimal path (i.e. if any of the many nested contingencies ends up taking us along one of the suboptimal branches in the decision tree shown above), equities fall.
All paths (with the exception of the one that assumes no fiscal stimulus) lead to higher rates (NYSEARCA:TLT).
If you feel numb after reading the above, you are experiencing what the market is collectively experiencing. Your numbness is a microcosm of the indecisiveness that's kept stocks from efficiently pricing policy risk.
It's ok to be indecisive. I suppose that's better than overreacting.
Just make sure you're inwardly active (i.e. introspecting) even if you're outwardly inactive. The former is indecisiveness. The latter is complacency.
And you don't want to be complacent.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.