I am not a consumer of the big, bold predictions and the surprise lists that roll in this time of year. They mostly serve marketing purposes, or as a call option on self-aggrandizement, or our desire, at some level, to be told what to do. But many people like them. Uncertainty—the kind investors face daily—is draining and unpleasant. These things help fill that void. And they give us a reference point against which to calibrate our own views, however uncertain those views may be.
But, at the end of the day, whether you like forecasting or not, we have to make a call. Especially if your process is trading-oriented. Buy or sell. Long or short. Beta or alpha. Bonds, stocks or cash. Investing and trading require us to try to look out around the corner, even if only a little bit, and even if it is only probabilistic. So, with that caveat, this is what I am currently seeing around the corner:
Sentiment
On the Economy. The US economy is steadily improving, but expectations are catching up. You can see this in the Citigroup Economic Surprise Index for the US, which is stalling here and appears more likely to revert than not. (A positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.)
On Positioning. The short-term positioning seems to reflect (1) increased recognition of the improving US economy, (2) belief that Europe will remain in recession but not produce a Lehman II, and (3) that expectations with respect to Emerging Markets have finally receded to a place where it makes it safe to put a foot in the water. You can see this in the price action, in some of the sentiment surveys/technical indicators and in the chatter coming from other traders and investors.
Lastly, the discussion of the fiscal cliff seems to have morphed from “I think they get a deal, but I will wait to buy because they are likely to disappoint us first” into “the market will rip as soon as a deal is announced and it is too risky to be out and miss the move”. This changes the payoff structure.
The longer-term positioning, however, still reflects a fairly negative outlook, which is positive. Many investors, still clutching their rear view mirrors, are still afraid to commit to equities. The scars are just too deep.
Then there are the policy bears. They believe government intervention has made all this artificial and at some point “we will all have to pay the piper”. They disagreed with TARP, said the Stress test wouldn’t work, thought QE would be inflationary, asserted big deficits would drive yields higher, believed austerity in Europe would be good for growth, and compared the US to Greece. They have been wrong, underperforming and are increasingly angry. Rather than admitting they were wrong, many are pushing out the timetable for their forecasts to materialize, or quietly walking them back and hoping if the transformation is gradual enough no one will notice. Because when you’re wrong it is hard (and reputationally costly) to change your views. And, behaviorally, constantly questioning your own views requires much more effort than settling into certainty.
This is what the inner monologue of the policy bears sounds like right about now: “if I get long after fighting it for so long and the market turns around my clients will think I am a fool with no process”. Plus, it always sounds smarter to be bearish. And sounding smart helps underperformers hold onto assets.
So, what do they do? They play light, wait to go short, or take repeated stabs at the short side with stops. The takeaway, though, is that at some point they will recognize that below the surface of the policy drugs there is a healing process: household deleveraging. We are already seeing the effects of it. And as this becomes clearer both scarred investors and policy bears will get dragged into the market.
On Monetary policy. Sentiment surrounding monetary policy has done a 180 over the past year or two. A couple of years ago it was very hard to make the case that QE wouldn’t be inflationary as long as the household sector was deleveraging, and that the market effects from it were predominately psychological. I still have the scars from those debates. Using technical jargon like ‘endogenous money supply’, in an attempt to recover some credibility, only got you more dismissive looks.
However, since then, markets have been (for the most part) coming around to this view, and consequently the half-life of a market reaction to the announcement of fresh monetary stimulus has fallen to about zero. This is new.
It has two implications. First, assets that have rallied from the flight into inflation hedges will continue to leak. It is not a coincidence, in my view, that the ‘evolution’ in the understanding monetary policy began right about the time gold and silver prices peaked last year. Ever since, the diminishing market impact of Fed announcements has become apparent to all, and the commodity complex has correspondingly stayed well below its 2011 highs. Yet virtually everyone is still calling for gold to make new all-time highs in the coming year.
From where I sit, many people have crowded into gold and silver (and oil—don’t even look at cotton!) on, inter alia, this flawed understanding of the monetary policy transmission mechanism and this will create selling pressure for quite some time. Will it be enough to offset the diversification demand from central banks and the income effect from the Chinese and Indian markets? This is a harder call, but I think the answer is yes—virtually certain if the recovery in the US gains traction and the Treasury curve steepens. It also bears recalling that central banks since the 80s have tended to be net sellers of gold when prices were low and net buyers when prices were high. So I wouldn’t count on central banks being there below the bid for too long if prices really start to drop. But it really is hard to say whether this will be a drip, drip, drip or something more sudden.
Here’s a crude chart of silver to illustrate how far it could fall if my hypothesis plays out. (I confess: I am Tourist TA.) That support from the parabolic breakout in 2010 would correspond to a futures price of about 20.
The second implication is that just as everyone has bought into the “impotence” of Fed policy, we are starting to see signs of it having an effect. There has been a lot of head scratching and soul searching in the economic community (including Fed governors) about the efficacy of monetary policy. Has the transmission mechanism structurally changed? Are there new features we don’t understand? It is that policy is not aggressive enough?
It seems to me the answer is very simple: pretty much no amount of QE will work until (1) the household deleveraging is mostly over and (2) people feel better about job security and prospects. It is on these two factors that most people set expectations and consumption patterns, not on base money quantities or things like NGDP targeting. Expectations, in turn, set risk appetite and risk appetite drives the endogenous money supply.
And on a small scale this is happening. Prepay speeds in the mortgage market have picked up, indicating more refis, and there is more activity in the primary housing market. Household formation has picked up, too, as young adults are increasingly getting out from under their parents roofs for the second time. The job market, for its part, seems to be grinding in the right direction.
The simple way to look at it is that the Fed’s aggressively accommodative policy didn’t directly cause these things to happen. But by facilitating the deleveraging process, it likely moved forward the date by which households will have their balance sheets sufficiently repaired to normalize their rate of consumption, with knock-on effects to the rest of the economy. We are not there yet, but we seem to be getting closer, fiscal drag notwithstanding.
Price action
I know, I know. Buy or sell? Okay, here are a few more concrete markets observations.
First, it really is a stock-pickers’ market. It’s a phrase I don’t like because it is overused by guys on TV who want to sell you there stock-picking services. Somewhat fitting I guess that just as everyone scrambles to go macro, stock picking seems to be working. On what basis do I say this? Look at the index of implied correlation of the elements of the S&P, to start with.
The implied correlation amongst S&P components has been heading downward all year. In case you can’t make it out, it falls from just above 80 percent last January to just below 65 percent in December. This tends to be both a bullish sign as well as an indication of less ‘macro’ and more ‘stock picking’.
Second, we have seen of late many of the crowded positions underperforming and many of the hated positions doing better. Precious metals and AAPL crop first to mind, but there are many others. And some of the hated positions, e.g. RIMM, NOK, X, have been perking up. I don’t know how long this lasts, but it is the theme for now and it makes no sense to fight it.
While I’m here, let me make a quick, behavioral point on AAPL. AAPL has been THE story stock in the market over the past few years. It has been our collective obsession. It has sucked all the oxygen out of every financial chat room and could do no wrong. I can’t speak to the fundamentals, which may or may not have changed, but I do know this: once the fever breaks on a story that is so beloved, sentiment usually doesn’t stop deteriorating until the pendulum has overshot to the other side. And I get no sense we are near that point yet. I still see virtually all knife-catchers and no momentum shortsellers, and until this changes, it is probably not safe to buy the fruit.
Oh, and by the way, if the stock continues to go down, even if there aren’t good reasons for it, convincing-sounding reasons will be found. In the near-to-medium term story follows price more than price follows story more often than we are inclined to think.
Simple technical analysis suggests AAPL could go back to the area it broke out from in January, when the AAPL fever really took hold. That would correspond to price of about 425.
Finally, the other beloved sector that has just begun the beat-down process is the mortgage REITs. High dividends are a drug once you get used to them, and retail investors and high net worth individuals are in deep. With double-digit dividends it is easy to get lulled into believing that they will paper over any capital losses. However, the combination of reinvestment risk and a highly levered product means the cutting of dividends that we have just begun to see have a long way to go. And retail never leaves gracefully. (The closed-end muni funds will, I fear, have their reinvestment comeuppance pretty soon as well. The math there is brutal.)
The bottom line is that it makes sense to be balanced here, with a constructive bias. This is not the fat pitch for a directional view. But it does make sense to bet on balance sheet reparation, financial normalization, and continued recovery in the US, and against crowded story trades where the story may already have changed—no matter how much we may love them.
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