Here's How We 'Keep The Party Going'

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by: The Heisenberg

Summary

What you thought was "good" is actually "bad."

And what you thought was "bad" is actually "good."

One bank explains why.

There are two ways to look at the influx of retail money into stocks that we've seen in the first three months of 2017.

One interpretation is that the idea of the central bank "put" has become so ubiquitous that even "Sharon" understands it.

The other interpretation is that "mom and pop" are reading headlines about the supposed correlation between record high stock prices and the Trump administration's plans to boost growth and are trying to catch the wave.

The first interpretation suggests that the retail crowd understands the important role $400 billion/quarter in central bank liquidity has in supporting risk assets. That's implausible. And not because the home gamers aren't capable of understanding it. Rather, because if they did understand it, they'd know that the central bank backstop is on its way out the door.

If you've looked into the situation enough to understand the concept of central bank QE "flow" providing a near constant bid for risk, then you've almost surely come across an article (or six) explaining that the monetary powers that be are currently plotting their exit. Armed with that knowledge, you'd be unlikely to buy into a market that Goldman recently described as follows:

After the inflation in P/E multiple, the S&P 500 now trades at the 90th percentile of historical valuation relative to the past 40 years. Current consensus forward P/E of 18.1x is the highest level since 1976 outside of the Tech bubble. The median stock trades at the 99th percentile vs. history.

By extension, the retail bid almost surely emanates primarily from the excitement generated by headlines 'Trump'eting Dow 21,000 and the like.

Hopefully the rally into Wednesday's close made some new investors think. That is, perhaps it occurred to more than a few of the folks who have recently bought in via popular equity ETFs (NYSEARCA:SPY) that there was a reason why the market rallied after a Fed hike.

That reason, of course, was that the hike wasn't really a hike. It was a cut. Almost literally, as the following charts from Goldman illustrate:

(Goldman)

Here's how JPMorgan's quant wizard Marko Kolanovic explained things on Thursday:

The dovish Fed outcome implies that the 'Fed Put' is likely still alive and well, so investors should buy on potential market weakness that we think could occur over the next month or so. This approach of buying on weakness is known as "BTD - Buy the Dip" (last two years virtually all of the market's returns occurred one day after any the pullback i.e. 'the Dip'). Success of the strategy is often attributed to the dovish resolve of central banks.

Right. But that "dovish resolve" is on its last legs. Or at least it is if you believe in the idea that the global economy is finding its footing. Consider the following, out this week from BofAML:

We think that if the Fed is handcuffed by its primary mandates of managing employment and inflation (not to mention potential fiscal stimulus and Fed leadership changes), it would no longer have the luxury of being credibly dovish in the midst of the next exogenous shock to markets. This would push the strike of the "Fed put" lower and in turn weaken one of the key supports for the buy-the-dip trade. In other words, a 10% sell-off in the S&P 500 would not alter the reality of stronger - and slow-moving - employment and inflation data, thus constraining the Fed's capacity to adhere to its adopted "third mandate" of targeting asset volatility.

And therein lies the absurdity of this whole situation. We don't know how risk assets will behave in the absence of a central bank backstop. That hasn't been tested in nearly a decade.

Sure, we'd like to think that if global growth picks up and inflation expectations continue to rise that stocks and other risk assets can stand on their own two feet. Put differently, the training wheels Bernanke put on in 2008 can safely be removed. But again, we can't be sure.

All we know for certain is that central banks can artificially inflate financial assets. So given the choice between trying to see what happens if the "put" is removed and sticking with the dovish program, we would, all else equal, prefer to just sit back and watch as central banks levitate the assets we own.

Given that (and this speaks to the bolded passages from BofAML cited above), it stands to reason that we should hope the incoming data disappoints. That way, to quote BofAML, central banks wouldn't be "constrained" in their capacity to buoy risk assets by "annoyances" like "the reality of stronger data."

If this sounds ridiculous, that's because it is. But welcome to the post-crisis reality.

With the above in mind, consider the following from Morgan Stanley, who explains things from the perspective of the high yield credit market (my highlights):

At 93 months, the current cycle is already longer than all but two post-war recoveries (out of 12 total). We could certainly debate why this expansion is already longer than normal, but strong growth is clearly not the reason. In fact, quite the opposite - a lackluster economic backdrop for years, leading to massive central bank support, has likely kept the cycle going more than anything else. Last year is a good example. As we show below, early in the year, with oil collapsing and the economic data rolling over, recession risks were seemingly rising. As Exhibit 3 shows, central banks across the globe responded. Even the Fed provided stimulus (verbally) by allowing the market to go from pricing in almost three rate hikes at the end of 2015 to almost zero rate hikes in summer 2016. Markets recovered, and the economic data followed.

In our view, for the cycle to last another several years, we want to see more of the same - a continued environment of 'ok' growth and low inflation, which allows central banks to keep the party going.

You read that correctly. If you want the risk asset "party to keep going," you now need to recalibrate your definition of "good" and "bad" when it comes to incoming data.

The correct way to look at things apparently amounts to this: the worse it is, the better.

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.

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