Posts published in August 2014
On Tuesday this week the S&P 500 closed above 2000 for the first time ever. When we say “above”, we mean “right on top of”: the actual closing price was 2000.02. On Wednesday the index inched slightly upwards to a close of 2000.12. Of course, there is nothing inherently special or magic about a round number like 2000 versus any other kind of number. But perception creates its own reality. Along with moving price averages, signpost numbers like 1900 and 2000 often act as important support and resistance levels for short-intermediate term asset price trends. We call these “event numbers”.
The Event Number Corridor
The following chart provides a snapshot of pullbacks in the S&P 500 in the current year to date. They have been fairly short, shallow and infrequent (only three with a magnitude of 3% or more). Interestingly, all three have occurred around an event number: 1850, 1900 and 2000 (there was a pullback of a smaller magnitude at 1950).
What seems to happen here is that the event numbers act as a sort of catalyst for investors to trade on whatever risk factors may be prevailing at the time. Consider the three 2014 pullbacks shown above. At the beginning of this year the S&P 500 had just come off one of its best years ever, leading to general chatter about whether the market was overbought. The market was trading in a corridor just below 1850. The release of a surprisingly negative jobs report early in the year gave traders the excuse to pull money off the table. A -5.8% pullback ensued taking the index to 1750, where it found support and sharply rebounded.
In April the market stalled for a few days just below 1900, then growing concerns about the situation in Russia and Ukraine helped fence-sitting investors to hop off. Again the fear period was brief, and this time support was found at the 100 day moving average level. In July, the risk factors swirling around in the market were for the most part the same as in April: Ukraine, Middle East, Eurozone…and an event number corridor just below 2000 broke in the last week of the month. That too found support around the 100 day average and rebounded sharply…right back up to 2000, where another corridor is playing out.
The current event number corridor is particularly interesting because we are heading into to the final months of the year, a time when a strong positive or negative trend formation can propel the market right through to the end of the year. Which way do the tea leaves point?
The short term, of course, is unknowable with any kind of surety: every rally and every pullback is different. Given how long it has been since the market last experienced a real correction, in 2011, each new pullback heightens fears of a slide from mere pullback to secular reversal. But we are still seeing daily volatility levels more typical of a middle-stage than a late stage bull market.
In both of the last two secular bulls, from 1994-2000 and 2003-07, volatility started to head higher some time before the market reached its respective high water marks. Late-stage bulls tend to be frenetic, with hold-outs piling in to belatedly grab some of the upside. It is only after those net inflows subside that the reversal tends to gather steam. Even in the immediate wake of the late-July pullback, though, we still appear to be in one of the calmer risk valleys, with the CBOE VIX index not far away from its ten year low.
Still, anything can happen. Summer is over. We expect trading volumes to pick up and, sooner or later, a late-year trend to emerge and test more event number support and resistance levels. We head into the new school year vigilant and focused.
European Central Bank Chairman Mario Draghi is spending a few days this week in the pleasant late-summer climes of Jackson Hole, Wyoming, site of the annual central bank symposium hosted by the Kansas City Fed. Chances are, he won’t be spending too much time savoring the many recreational delights of this Rocky Mountains resort as he tries to present a strong, consistent and reassuring message to the world about Europe’s financial and economic prospects. Those prospects look anything but promising these days. Talk of a “lost decade” brings to mind the specter of Japan: stagnant growth, waning competitiveness and mounting debt. Draghi has done a masterful job to date in projecting confidence: his “whatever it takes” pronouncement in 2012 was arguably the most important three-word utterance by a Roman since “veni, vidi, vici”. But words and confidence alone may not suffice in navigating the current rough waters.
Bond Market Surrealism
All those problems would logically make the Eurozone a riskier bet for investors than the more stable U.S. After all, our economy has regained and surpassed its pre-2008 size, while Europe’s economy remains smaller than it was before Lehman Brothers collapsed. Yet a remarkable thing has been happening in Europe’s bond markets: yields have plummeted to common currency-era lows. As the chart below shows, the benchmark 10-year Eurozone yield has fallen below 1% in recent days, even as the Euro has also continued a sharp downward trend.
We have noted in other commentaries that low bond yields in other developed economic regions like the Eurozone and Japan have been a driving factor in keeping U.S. yields down. The 10-year Treasury yield currently sits around 2.4%. That is much lower than most market observers expected at the beginning of this year, but it’s fairly attractive when compared to the sub-1% levels elsewhere. Riskier assets normally trade at a positive spread to the risk-free rate, but in the Wonderland that is today’s credit markets that seemingly impregnable financial axiom stands on its head. And the Euro’s decline adds the variable of lower purchasing power to the mix. All this raises the question: why are Eurozone rates so low, and who is crazy enough to be buying?
Mario and the Banks
Much of the answer to that question has to do with the policy measures Draghi and the ECB have focused on up to now. The centerpiece of this policy is the ungainly acronym TLTRO, for “targeted long term refinancing operations”. Basically, these are series of ultra-cheap loans provided by the ECB to European banks, for the purpose of encouraging banks make their own loans, in turn, to European businesses.
But in reality, not much in the way of TLTRO funds have found their way into commercial lending markets. Rather, the banks have used the cheap loans to invest in European sovereign debt. Why is the Spanish 10-year benchmark yield virtually the same as the U.S. Treasury yield? Because Spanish banks have loaded up their balance sheets with Spanish government debt, locking in as pure profit the difference between the cheap TLTRO paper they borrow and the sovereign yields they purchase.
Time for QE, Euro Style?
This practice directly challenges the original logic of the TLTRO program. If European sovereign yields are unsustainable from a fundamental valuation perspective, and if most of this paper is concentrated on the balance sheets of European banks, a painful unwinding could follow. The betting among investors currently is that the ECB will take pre-emptive actions to forestall this outcome by implementing its own version of quantitative easing – buying bonds in the open market in the manner of the U.S. Fed, the Bank of England and the Bank of Japan.
A massive QE effort – and there is no guarantee that even Super Mario could jawbone this policy through the EU bureaucracy – would likely add to downward pressure on yields, at least in the near term. But the policy may not work. First, as already noted, rates are already low, and much lower than justified by the fundamentals. There may not be much tangible benefit to squeeze out of whatever additional bond buying can accomplish.
Second, European businesses do not rely on the bond market for their financing anywhere nearly as much as U.S. corporations do. QE has been a boon to U.S. enterprises, enabling them to raise money through bond issues at extremely low rates. In Europe, businesses borrow more from banks than from the bond market – and as we noted above, the banks have not been enthusiastic lenders since 2008.
There are fears in some corners that if European asset markets falter the contagion could spread elsewhere. That is possible, but in our opinion a more likely outcome in the near term would be the continued relative appeal of other markets, including the U.S. and perhaps the recently surging emerging markets. Investors need only look to Japan – the Nikkei 225 is still less than 40% of its peak value 25 years ago – to see what a prolonged freeze can do to portfolios. Mario Draghi, arguably more than anyone else at Jackson Hole, has his work cut out for him.
The S&P 500 recovered ground this week, climbing from last week’s low of 1909.57 to high of 1953.45 at the time of writing this piece. It seems the market has continued to move onward and upwards, repeatedly shrugging off geopolitical worries as it has for the greater part of this year. While this is seemingly good news for investors, it is important to keep abreast of some of the troubles which are brewing abroad and may bring further volatility in days to come – namely a region which has continually kept investors’ anxiety on edge since the Great Recession, the Eurozone.
Rise up and hear the Bells: Troubling Numbers from Abroad
This week, economic reports from Europe showed that trouble still lingers for many of the countries within the region. Surprisingly, even the stronger economic powerhouses of the continent, such as Germany and France, are beginning to show signs of trouble. Germany’s economy has failed to show positive growth; in recent economic releases German GDP shrank by 0.2% - the first time that the country has shown a negative outlook in over a year – and France’s economy hasn’t shown any growth for the second consecutive quarter year to date. Other countries such as Italy and Spain, who are no strangers to negative economic data, continue in the same fashion with the prospect of steady growth still far off in the horizon.
Draghi: For You They Call
The European Central Bank (ECB) has had their work cut out for them since Draghi’s proclamation of “whatever it takes.” While the Fed continues to tighten the quantitative easing pedal here domestically, abroad it seems the ECB cannot do the same. The ECB, like the Fed, has taken measures to keep low interest rates, encouraging cheap bank loans and purchasing securities to beef up Europe’s respective economies; but it seems the ECB, unlike the Fed, may have to ramp up their efforts in the near future.
Draghi seems to be resistant to this idea however, voicing scrutiny directed towards the leadership of different nations, highlighting that reforms and policies must be enacted within the different Eurozone nations to become more competitive.
The Ship is Anchor’d – Safe and Sound?
So, all this data begs the question: what does this mean for capital markets around the world? The answer is yet to be determined. The US domestic picture continues to be strong; it remains the biggest engine of growth in today’s capital markets. How asset prices begin to reflect the lagging of the Eurozone depends on whether investors will continue to focus on positive US data or if the economies of countries abroad will become too heavy of an anchor for positive overall momentum.
Our outlook remains generally positive; however we will keep a watchful eye on markets abroad from Europe to China and everywhere in between. This year’s markets have been a story without much volatility, but for investors to fall asleep at the wheel now could prove dangerous.
It’s summertime, but the living has been anything but easy for the past couple weeks. A news cycle full of geopolitical flare-ups, health crises and dissension at the Fed has brought volatility and wild intraday price swings back onto center stage. Yet there appears to be less to the daily drama than meets the eye. For all the lead stories spilling out of the world’s trouble spots, the real force driving volatility is the low levels of activity typical of summer. Since the beginning of July, daily volume on the S&P 500 has been below its 200 day moving average 82% of the time. Low volume amplifies price swings. We think this environment is less about news, more about noise.
Geopolitics Priced In (For Now)
Of all the current flashpoints, arguably the escalating tension between Russia and the West is cause for greatest concern. This tension certainly has not helped Europe, which depends on Russia for the majority of its energy imports. Shares in broad Eurozone market indices are down nearly 10% from where they were at the beginning of July. But Russia’s role in the global economy is less impactful than China’s or Brazil’s. Even if economic sanctions between Russia and its main trading partners worsen, the effect is likely to more localized to companies with significant interests in Russia (major international energy companies come to mind) than widespread.
Events in the Middle East are likewise unsettling, but contained in terms of practical economic impact. Crude oil prices – often a barometer for tensions in the Gulf – are at their lowest levels for the year to date. Questions remain about the level of U.S. engagement as the crisis in Iraq creeps towards the oil-rich Kurdish state, but for now any potential use of ground troops is fully off the table.
Support, Resistance and Round Numbers
There is nothing particularly magical about round numbers or 100 day moving averages, but in the capital markets perception creates its own reality. The S&P 500 broke through the 1900 resistance level back in May, and was closing in on 2000 before gravity kicked in late last month. The Dow Jones Industrial Average topped 17,000 before the latest tumble. On the other side, though, the major indexes are all finding support around intermediate-term moving averages: the S&P 500 is currently trading right around the 100-day average.
Bear in mind that over 60% of the daily trading volume on U.S. equity exchanges is machine-driven, reacting to algorithms rather than human decision makers. Many of these algorithms are programmed to react specifically to things like round numbers and moving averages, and that is why they figure so prominently in observed trading patterns. Given the pace of the rally that started in mid-May, it is scarcely surprising that we see a brief pullback and perhaps an extended period of trading in a narrow support-resistance corridor. Whether it turns into something more remains to be seen, but for now the noise factor appears to predominate.
Major U.S. equities indexes gave up all their July gains and more on Thursday, the final trading day of the month. The Dow Jones Industrial Average, which has lagged the S&P 500 and the Nasdaq Composite for many months, finished the day in negative territory for the year to date. Tellingly the pullback was sandwiched in between two events: the Fed Open Market Committee deliberations which ended Wednesday, and the July jobs numbers, released earlier this morning. Was this 2% reversal a brief event, a virtual particle popping into and out of existence within the blink of an eye? Or does it portend a double portion of toil and trouble in the weeks ahead?
One has to feel sympathy for Fed Chairwoman Janet Yellen as she and her Fed colleagues deal with a full complement of X-factors, good and bad, bubbling up in their policy cauldron. It is an unusually eventful summer. In addition to trying to sort out the U.S. macroeconomic picture and communicate clear forward guidance on interest rates to the market, there are the crises in Ukraine, Gaza and Iraq trading places as any given day’s front page headline. Europe’s economy is stuck in the doldrums and sits in the shadow of Russia, its principal energy supplier.
On the other hand, China seems to be back on track after concerns earlier this year about the sustainability of its growth trajectory in tandem with a major economic rebalancing. India’s outlook appears somewhat more promising in the wake of May’s elections bringing Narendra Modi and his business-oriented BJP to power. There are reasons for caution and reasons for optimism. That makes it difficult for the Fed to maintain tight consensus. We saw some cracks in the consensus with the holdout vote Wednesday of Philadelphia Fed president Charles Plosser. Tension over rate policy is likely to continue, and likely helped stoke the flames for Thursday’s pullback.
Good News, Bad News
The economic data continue to accumulate more in the good news column. GDP grew at an annualized rate of 4% in the second quarter. Inflation is over the Fed’s 2% threshold. But in the looking glass world of capital markets, good news for Main Street is often bad news for Wall Street. More jobs and higher wages mean tighter capacity, upward pressure on prices and, eventually, rate hikes. Breaking the six year zero-rate addiction will be hard.
Yellen caught a bit of a break with today’s job numbers, though. Nonfarm monthly payrolls came in over 200,000 but below consensus expectations, and the unemployment rate ticked up slightly. In other words: good enough but not too good. Equity futures rallied on the jobs news, though they have pulled back into negative territory (as of this writing) as yesterday’s selloff gets a second wind. It would certainly not be unheard of for a pullback of 5% or more to materialize. But at some point good news may just be good news, even on Wall Street. We’d be fine with a 10% correction if it were followed by a sustained, genuinely organic economic growth story.