Last week we wrote about “taperphobia” in the wake of the Fed’s decision to back off from plans to start reducing the size of its QE3 monetary stimulus program. After that announcement on September 18, the S&P 500 jumped 1.2%, and then gave back all those gains and more over the course of the next five trading days. Yet the pullback has been relatively gentle as pullbacks go, at least so far. More interesting still is what we call the “volatility gap”. This gap is a measure of the relationship between stock market prices and risk, with the latter being represented by the CBOE VIX index. The larger the gap, the calmer the markets. Here’s how the volatility gap looks as of this writing (afternoon on Thursday 9/26):
The green vertical line indicates that the volatility gap is about as wide as it has been any time this year. Curiously, this comes at a time when a handful of uncertainties loom. In addition to ongoing confusion over the Fed’s non-decision last week, we have the specter of a possible government shutdown come Tuesday next week, and more brinksmanship over the debt ceiling to follow almost immediately thereafter. Is this collective yawn by investors a clever calling of the government’s bluff, or are we in for a nasty October?
Been There, Seen That
There is clearly a rational case to make for calling Washington’s bluff. When the debt ceiling theatrics bubbled up in the summer of 2011, it marked the first time that a normally routine decision involving the legislative and executive branches became an acrimonious political football. For a while it seemed genuinely, stunningly possible that the United States would default on its outstanding obligations. But now these dismal sideshows are a permanent part of the landscape. Sequestrations, fiscal cliffs and budget impasses haunt us at regular intervals. Each time some quick fix is applied so that the worst case scenario does not prevail. Viewed in this context, perhaps the volatility gap is not so curious after all. Investors expect that, regardless of how many Senators posture their way through the midnight hours on an oratory soapbox, and regardless of the slings and arrows of partisan vitriol, life and markets will go along more or less as normal.
Corporate Earnings: Trick or Treat?
If we do manage to jump through the hoops of Washington dysfunction, we still have to contend with the onset of corporate earnings season. Consensus 3Q earnings estimates for the S&P 500 are currently at 3.5%. That’s quite a bit lower than they were at the end of the first quarter. The 3Q consensus as of March 31 was 9.5%, reflecting a gradual souring of analysts’ views of the sales & profits landscape across most industry sectors over the ensuing time. It will be important to see early signs of companies at least able to meet, if not surpass, these lowered expectations.
Follow the Signals
The volatility gap is an important market signal. Continued tameness in this metric would indicate to us that a handful of present trends – including outperformance by cyclical industry sectors over defensives and non-US stocks over US names – may supply a tailwind to take us into year-end. However, as the above chart shows, the volatility gap can also reverse course very quickly. Our outlook remains oriented towards the optimistic. However there are enough potential tricks along the path to keep our attention fully engaged.
Sapiens est, qui omnia pacata mente tueri potest
(Wise is the person who can regard all things with a calm and tempered mind)
With apologies to Lucretius for the slight paraphrasing of his great insight from “The Nature of Things”, it would be nice if there were more calm and tempered minds out there observing markets and making policy decisions. Unfortunately we got the opposite of calm and tempered this week, with the Fed announcing that it would not begin to taper back from the $85 billion of monthly asset purchases that form the core of its monetary stimulus program. More than ever, QE3 really does live up to its nickname of QE4ever. What happened this week is significant and deserves much more than the brief commentary we can provide in this week’s Market Flash. So this is the first of a series exploring what is behind “taperphobia” and how it may impact investment markets in the weeks and months ahead.
Since late May of this year the Fed has appeared to be guiding us towards the first baby steps away from dependence on quantitative easing for risk asset performance. Up until this past Wednesday the guidance seemed to be working. Yes, the S&P 500 experienced a 5.7% pullback for a month in late May and June. Yes, the 10-year Treasury yield went on a rampage from 1.5% to just under 3% — a run-up almost entirely unjustified by the fundamentals. And yes, the economy continues to grow only sluggishly – but it does continue to grow. We have not drawn close to the precipice of another recession. Corporate earnings are still close to or at record levels. Yet at the last minute Bernanke blinked. Out the window went all that careful guidance from the last four months. Investors and professional market commentators around the world are scratching their heads – and the confusion is nearly universal – and trying to figure out exactly what spooked the Fed.
One issue to which Bernanke made explicit reference in his remarks on Wednesday was the next installment of Washington dysfunction. A possible government shutdown looms at the end of this month, and another fight over the debt ceiling limit is on deck shortly after that. The battle lines are drawn and appear to be more partisan and irreconcilable than ever, if such a thing is possible. So one view is that the Fed felt the need to keep the money spigot open to ease the pain if Republicans and Democrats take this one to the mat. That said, it’s a bit hard to understand how the decision to keep buying $85 billion in bonds versus $70 or $75 billion (the expectation was for a taper of $10-15 billion) would offset the effect of the government ceasing its daily functioning or the US not paying its debt obligations for the first time in the history of the Republic.
Let Markets Be Markets
In the immediate wake of taperphobia stock markets soared. The S&P 500 and other major market indexes leaped to new record highs. Now let’s be serious – as managers of mostly long-only portfolios of diverse risk assets we generally like it when the market goes up. Our clients win, Americans across the country with 401(k) plans win, and that’s a good thing. But Wednesday’s record closings did not feel good to us – in fact we were left with a rather queasy feeling, more like the feeling we have after a day of big losses.
We feel this way because we believe that, to the extent possible, markets need to be allowed to…well, be markets. “Being a market” means to continually price in new information and adjust to that new information, up or down. Do markets overreact? Of course. As we noted earlier, there was no basic economic reason for the 10-year yield to soar to 3%. But we also don’t think that the economy will collapse into itself with the 10-year at 3%. At the beginning of 2011 that rate was over 3.25%. The historical average of the 10-year yield since the end of the Second World War is a bit over 6.1%. A 3% yield, in our opinion, is not sufficient cause to panic and reach for the next morphine injection.
Getting Off the Drug
We have our concerns about the economy, about government dysfunction, about the upcoming earnings season – all the things that keep our minds focused each and every day. But those concerns are magnified, not mitigated, when we get signals from policymakers reflecting a lack of faith in the integrity of market mechanisms to work on their own. Right now markets are addicted to easy money. Addiction in any form is hard to break, and the longer it goes on the harder it gets. We are optimists by nature and we believe growth will return – but we need to start letting the system find its own legs.
By the end of the business day next Wednesday we will know more than we know today about what specific course of action the Fed plans to take – if any – to begin the process of weaning markets off the QE drug to which they have been hooked up for the past several years. While there is much debate about whether QE has made any difference to the lives of working Americans, or to business capital formation or bank lending activity, in one metric there is precious little doubt. QE has lifted risk asset markets and been the primary tailwind behind the bull market that began in 2009 and technically became – at least for now – a macro growth market when the S&P 500 sailed first past its 2000 and then 2007 high back in March of this year. The foremost question among market observers now is whether the smooth sailing can continue once the training wheels come off. So far, at least, key indexes are tacking into next week’s decision with a steady hand.
What’s At Stake
Two things are not going to happen next week. Interest rates won’t go up, and QE won’t come to an abrupt end. The Fed has put out clear metrics in this regard: QE should not wind up completely while the unemployment rate is still above 7% (currently it is 7.3%) and overnight rates should not go up for any reason until it falls at least to 6.5%. That’s probably still quite a ways off. So what’s at stake next week is simply whether the Fed will announce that it plans to reduce by some amount the $85 billion of fixed income securities (government and mortgage backed issues) it purchases every month, what that “some amount” might be, and whether or not that will be evenly split between govvies and MBS.
Some observers would appear to see the current firmness in risk asset prices as illusory. According to a recent Wall Street Journal survey of 47 economists, 66% believe that the Fed will start tapering in September, but 40% also believe that the market hasn’t fully priced in the effect of tapering. In other words there is a possibility that if, for example, the Fed announces that it will immediately start cutting back QE by $15 billion per month (which is the average amount the WSJ economists surveyed expect) the market could be surprised and react sharply. That’s rather unusual given how much the topic of QE tapering has dominated the financial conversation in the past couple months.
Never Say Never
On the other hand, even a definite tapering move doesn’t necessarily start nailing the QE coffin shut. Bernanke has made it clear that the Fed remains ready to do anything and everything necessary to bring about the desired economic improvement. If something comes along – a government shutdown or another debt ceiling fiasco that roils markets – it’s not hard to see the Fed reversing course and buying up more bonds. The age of moral hazard is probably with us for some time still to come, and the steady course markets are maintaining this week seems to indicate that most participants don’t see the “Fed put” disappearing anytime as far ahead as the eye can see.
Investors and market pundits call it “Jobs Friday” – the first Friday of every month when the Labor Department releases a batch of data about the previous month’s employment trends. The one number that gains the most chatter is the headline unemployment number, but that is just one piece of the puzzle and a sometimes misleading one. Well, today is Jobs Friday for September, and the last Jobs Friday before the Fed’s upcoming QE deliberations on September 17-18. What can we expect?
Fewer Unemployed, Fewer Looking for Work
That headline number fell to 7.3%, which is the lowest it’s been since the dark days of December 2008. It’s the latest in a downward trend from a peak of 10% in October 2009. Good news, right? Not entirely. The unemployment rate shows the number of people in the workforce who don’t have a job, as a percentage of the total number of people in the workforce. The key phrase here is “in the workforce”. That’s the number of people who want to work – they either have a job or are actively looking for a job. But there are also working-age adults who look and look and finally give up looking. They are subtracted from the “in the workforce” population, and mathematically that can reduce the unemployment rate.
Jobs, Payrolls and the Workforce
That “in the workforce” definition is important in the context of this month’s reading because the number of working-age American adults considered to be in the workforce is 63.2% – the lowest number since 1978. That is supported by another data point that comes out on Jobs Friday – the total non-farm payroll numbers for the month. The 169,000 jobs added in August was slightly below consensus expectations and below the 200,000 level that many economists see as a benchmark threshold for the economy to be able to sustain a long-term growth rate of more than 2.5%.
What Is a Job, Anyway?
Payrolls reflect the number of people with what we would consider to be conventional jobs – i.e. a job where you get a W-2 form, are eligible for benefits and paid vacation and the like. It’s fairly clear from looking at payroll trends since the turn of the millennium that they are in structural decline. People who freelance or work on a 1099 contract basis also don’t show up on the payrolls – and these historically unorthodox means of earning a living are steadily becoming more of the norm.
Meanwhile, Back at the Fed
The Fed has tied its stimulus programs to the health of the economy as measured by jobs, saying that unemployment should not be any higher than 7% when quantitative easing comes to an end, and around or below 6.5% before anyone starts thinking about raising interest rates. Of course the Fed knows that context matters, and the mixed picture provided by September Jobs Friday will figure into the discussions. We think it is still likelier than not that tapering will go ahead this month as expected. But it’s not yet a slam dunk, and not the time for large bets either way.
April may be the cruelest month for those cutting a mid-month check to Uncle Sam, but for investors it’s another 30-day month – September – that comes around every year to spread misery. Right? So say many of the market pundits spouting their wisdom on CNBC. We say: Not so fast. Context matters.
A look at the last 20 calendar years shows that the September price return of the S&P 500 was worse than the average monthly return for that calendar year on eight occasions. That means, of course, that on twelve occasions the performance during back-to-school month was better than that year’s monthly average. Interestingly, four of those Septembers correspond to the four worst-performing years of that 20 year stretch – 2000, 2001, 2002 and 2008. Two other years for bad Septembers – 1994 and 2011 – also aligned with generally unfriendly equity market environments.
Traders of a Feather
That is perhaps not surprising: autumn tends to be a time when traders and money managers tack their portfolios towards end of year performance, and that can magnify the year’s trend to date one way or the other. Once the kids are back in school and the bags with Halloween decorations are coming out of garage cupboards, traders’ thoughts turn to their calendar year performance. Being creatures of a herd sensibility they will be very attuned to breakaway trends one way or the other. Small wonder that September and October tend to, historically speaking, bear the brunt of that.
On Tap For This Year
So what does that mean for this year? Well, no doubt there are a couple potential headwinds, as we have pointed out in previous Market Flashes. The big one is the mid-September FOMC meeting that will send the first clear message as to whether QE tapering is an imminent reality or not. With a strong GDP revision and continuing firmness in employment leading the macro picture the consensus appears to expect tapering to begin next month. Then we have the anticipated budget and debt ceiling battles, the ongoing volatility of emerging market currencies, geopolitical flashpoints in the Middle East and much else to keep our eyes on. It will be a month that calls for laser-like focus, to be sure.
But there is a fairly strong undercurrent that may take us through the headwinds without much damage. Steady, if somewhat modest, growth with improving employment and low inflation; moderately positive corporate earnings; and gradual improvement in Europe’s economy remain positive factors. And it’s not like we’re cruising into September on the back of a hot rally: the S&P 500 is down around 3% for the month of August to date. We think it more likely than not that most of whatever the S&P 500 earns for this year is reflected in the current price. But in the absence of a sharp reversal there may be room for a bit more as money managers dress up their portfolios before Christmas.