Posts published in November 2015
It has become something of a tradition for us here at MV Financial, on one occasion during the year, to do something a little different for our weekly commentary. In the days leading up to Thanksgiving, as we prepare to gather with friends and loved ones, we briefly turn our attention away from the incessant craziness of the global capital markets and reflect on the many reasons we have to be thankful. With this reflection, of course, comes a sober mindfulness. For far too many people on the planet, the onset of the holiday season brings no respite from suffering, from hardship and from loss. Our reflection this year, in particular, is acutely shaped by the tragic events that have unfolded around the world in the past several weeks. From Paris to Mali, from Beirut to Sharm el Sheikh, brutal acts of terror have once again seized the world’s attention. Our deepest sympathies and condolences go out to all those who grieve for loved ones lost to those terrible, violent events. Nous sommes avec vous.
Financial markets have been eerily quiet in the immediate aftermath of these events, almost as if geopolitics has ceased to matter to the performance of stocks, or crude oil, or foreign currencies. On the Monday morning following the Paris attacks the French CAC Quarante index retreated by close to one percent, but had largely recovered its losses in full by midday. The S&P 500 went on to have its best calendar week of the year, gaining 3.3 percent in the five days through November 20. In the Middle East itself, the potential vulnerability of the region’s vast oilfields to violent attack has been an imperceptible factor this year in the price of crude oil, which remains mired in the depressed constraints of a global supply-demand imbalance.
Perhaps we should add “stable financial markets” to the things for which we are thankful. Having experienced a jarring stock market correction this past August, in which certain risk measures signaled an environment far worse than what actually played out, we would just as soon see out the rest of this year with minimal drama. We are not so complacent, though, as to take the current relative stability as an article of faith. Geopolitics does have real economic consequences, and we very much expect it to be a variable at play as 2016 gets underway. Europe’s ability to deal with its refugee crisis in a way that balances humanitarian aid and practical security concerns will be one flashpoint of concern. So will Russia’s expanding role in the Middle East – Saudi Arabia’s finance minister was in Moscow this week for policy discussions between these two oil powers. Not least, of course, will be the global geopolitical overhang influencing the contours of debate in next year’s US presidential election.
We live in a time of massive change, a time when events and trends seem to be moving faster than humanly possible. Young people coming of age worry about where the jobs are going to be. In the past, seismic technology paradigm shifts mostly resulted in net job creation, as demand for new skill sets more than compensated for those rendered obsolete. That may not be the case this time; consider that, in their heyday, the giants of the emerging disruptive technologies of the early 20th century employed hundreds of thousands of people to design, build and sell their products. Today’s Silicon Valley disrupters often sport multi-billion dollar market caps on work forces less than 100 strong. This raises questions about jobs, not in some distant future, but in the immediate future.
And yet, we are thankful. Thankful for the innovative drive of the human spirit to meet and overcome the most daunting of challenges, thankful for the love of family, community and environment that more often than not impels us towards doing the right thing. Thankful that we have been here before and not only survived, but prospered. The America of the 1890s, at the zenith of the Second Industrial Revolution, would have been utterly unfathomable to a time-traveling observer from the pastoral 1820s. The America of seventy years hence may prove to be just as unfathomable to anything we could conceive today. If we were to make a prediction, though, we would predict that prosperity will prevail over any and all challenges thrown up by change.
To all our clients and friends we wish the very happiest of Thanksgivings.
“The Gross National Product measures everything, in short, except that which makes life worthwhile” – Robert F. Kennedy in a campaign speech at the University of Kansas, March 1968.
Stock markets rise and fall, interest rate policies are set and reset, people feel good or not so good about their material fortunes depending on how much this number – Gross Domestic Product (GDP), successor to the slightly differently-calculated Gross National Product (GNP) in favor at the time of Kennedy’s speech – manages to grow or decline every three months. Most of the time we here at MVF go along with the rest of the world and obsess over the data when the Bureau of Economic Analysis releases its quarterly reading. It is important, after all, as an input into the models with which we fashion portfolio policy.
Rumour Has It
Every now and then, though, we come across something that calls to mind the critique RFK and many others before and after him have made of the self-styled World’s Most Important Number. Today that something – or someone, to be more precise, is Adele, the music superstar whose latest album is due for release today. “25”, her first album in nearly five years, is virtually guaranteed to sell like hotcakes (and rightfully so, for we are Adele fans in addition to being research analysts). What it won’t be doing (as rumor has it) is reaching the millions of waiting fans via the primary way most of us now listen to music – streaming services like Spotify or Apple Music. Adele is part of a small coterie of megastars, including Taylor Swift and Beyoncé, with the clout to treat the powerful streaming services as she sees fit. More power to her. But the part of all this that gets our analyst radar going is how Spotify and so many other services that account for a rapidly growing slice of our economic decision-making actually show up (or don’t show up) in our headline economic calculations.
Don’t You Remember
As with most issues of economics, the answer varies depending on how you look at the question (despite the efforts of so many economists to prove otherwise, economics is not a hard science like physics, and there is never one right answer). One way for us to think about the relationship between streaming music and GDP is to remember how we used to do these things. Back in the day there were vinyl LPs, which morphed into cassette tapes, which in turn became compact discs. What all these had in common was that one purchased them in a straightforward way that made a direct contribution to GDP. The $8.99 that one shelled out for “Surrealistic Pillow” or “Dark Side of the Moon” was recorded and valued as economic output, each and every time one went to the record store (remember those?) and purchased a new piece of music. Oh, sure, we made mix tapes and burned CDs. But there was a much more linear relationship between songs and sales.
Those of us who shell out $9.99 per month for Spotify or other streaming services (which of course does not include those on the free side of the “freemium” proposition) assume that these payments also figure into GDP. But that more direct relationship between utility and cost is gone – more specifically, the economic constraint is gone. Most of us would never have gone out and dropped upwards of $2,000 per month on LPs back in the day, no matter how much we liked Carly Simon or the B-52s. But a typical Spotify account can easily reflect that theoretical value, if one were to impute the cost of an actual album to all the music captured and saved in one’s account. How, then, do we better express the utility equation, not just for streaming music but for everything else that affords a demonstrably great amount of value relative to the economic constraint involved in utilizing that value? Economist have tried modeling some ways of measuring the relationship between price, utility and physical or virtual output in these newer segments of the economy, but they have yet to make it into a headline number to which analysts can readily turn for a usable periodic data point.
Like many other numbers that continue to dominate macroeconomic headlines today, GDP first came of age in the 1930s. The unprecedented severity of the Great Depression convinced policymakers and the business community that better tools for understanding economic behavior were necessary. But while today’s economy bears very little resemblance to that of the 1930s, the methods of calculation have changed very little. By giving these numbers the status of revealed truths, we are effectively making decisions worth billions of dollars every day based on a tired, outmoded view of economic reality. Robert Kennedy may have overstated the point when he said that gross output measures everything except that which is worthwhile. But economics IS about understanding what a society deems worthwhile – be that Adele songs or dog-sitting services or crowd-sourced reviews of the Thai place down the street – and measuring those things. As the aggregate definition of “worthwhile” changes, the measurement standards must change too. To paraphrase Adele, we’ll be waiting.
Since its inception in 1990 the CBOE VIX index – the so-called “fear gauge” – has shown itself to be a fairly good barometer of market risk. The index’s mean reversion tendency is particularly useful; the long term average value of 20 (shown as the dotted green line in the chart below) fairly neatly separates lower risk and higher risk environments. A value of 20 or higher signals a relatively high perception of risk, while extended periods below that threshold generally suggest benign conditions for equities. In view of the recent market correction and (partial) recovery, what can the VIX tell us about where we may be headed as 2016 approaches?
Let’s start with the most dramatic – and most often misused – feature of the VIX, namely those periodic Andean peaks spiking into the stratosphere. A VIX peak over 20 will typically be accompanied by a stock market pullback of several percent or more. More often than not, though, the risk reflected in that pullback is short-term and event-driven, rather than a signal of a more sustained bear market environment. Consider October 2014. The VIX had been sleepy for most of the summer and early fall, hovering in the low-mid teens as October got under way. A confluence of several events – among them falling oil prices, a weird “flash crash” in Treasury yields and an inchoate panic over reports of an Ebola outbreak in Sierra Leone – managed to rouse the trading bot armies into sell mode. The VIX spiked to 26 and the S&P 500 gave up close to eight percent. Then, as quickly as it appeared, the risk vanished, leaving a great many hedge strategies much the worse for wear.
In analyzing the VIX we care more about the baseline trend than the peaks. The above chart shows three distinct, sustained periods of relatively low volatility to which we refer as “valleys”: mid-decade in the 1990s and 2000s, and the better part of the past four years. Not surprisingly, all three valleys have coincided with favorable tailwinds for stocks. However, the baseline in the most recent valley is somewhat higher than that for the previous two. The average VIX level from 2012 to the present is about 15.6, compared to 13.7 for the 2004-06 period and 13.8 from 1993-96. While part of this difference is explained by a handful of higher peaks (notably those associated with the pullbacks of 2014 and 2015), there have also been – as clearly seen in the chart – fewer “tween” days (where the VIX closed between 10 and 12). This has been a somewhat jittery recovery despite the strong gains.
This brings us to the VIX characteristic we regard as most instructive: the mesa formations. On the above chart these are the two examples of the VIX maintaining a baseline level of 20 or higher for a sustained period of time. The two mesa environments since 1990 have both coincided with bear markets, but the more salient fact is that both mesas formed well before the bear took shape. During the 1990s bull market, the VIX was setting regular baseline closes above 20 from the middle of 1997 on. Practically the entire final phase of that great bull took place in an elevated risk environment. In a somewhat similar vein, the VIX was already in a mesa formation by the time the S&P 500 set its final pre-crash record high in October 2007.
A VIX mesa is not by itself a sell signal. Clearly, it would have been a poor strategy to sell out of the market between 1997 and 1999. Any technical signal needs to be considered in the context of other signals, and only when enough of them are flashing does it make sense to execute a defensive position. We do not see a sufficient number of flashing signals today to suggest putting up the ramparts. But we are watching the VIX trend. A mesa formation is a plausible scenario for 2016, even if the bear is (as we imagine) still some ways away. It would be consistent with both a narrow rally led by a few high quality performers, which is our base case scenario, as well as a “melt-up” reminiscent of 1999. Time will tell.
Stocks threw a mini-tantrum earlier in the week after Fed Chairwoman Janet Yellen made it pretty clear that she really, really wants to get that first rate hike on the board in December. Today’s jobs release from the Bureau of Labor Statistics goes a very long way to help make the Chairwoman’s wish come true. While the headline number of 271,000 new jobs is impressive enough, given expectations for just 180,000, it is the wage number that should really move the dial very close to rate hike certainty. As the chart below illustrates, year on year wage growth is stronger than it has been since the beginning of 2010, and the first real upside breakout over this time period.
To be clear, this is just one month’s worth of data. But the 2.5 percent year-on-year growth in wages finally seems to square with much of the anecdotal evidence dribbling in from corporate earnings calls this quarter, from the likes of Wal-Mart among others. Wages do seem to be gaining traction. The unemployment rate, at 5.0 percent, is half its level at the height of the jobless trend and just ten basis points above the 4.9 percent level often cited as the full employment threshold. This recovery has been decidedly low-wage up to now, and even at 2.5 percent it remains below pre-recession norms. But some degree of normal cause-and-effect still prevails in this economy. With higher wages should come higher prices, sooner or later. In her recent comments Yellen has conveyed a line of sight to that elusive 2 percent inflation target. That target is finally starting to come into our sight range as well.
So the stars seem to be aligned. Yes, a truly miserable November jobs report – and we would imagine the misery threshold to be somewhere around 50,000 or fewer payroll gains – could put plans back on ice. Another stock market meltdown could do the same. But with the default scenario now fully pricing in a rate hike, our attention floats across the pond to Europe. ECB Chairman Draghi appears ready to expand the current quantitative easing program if need be, probably by extending the planned September 2016 end date. Heading further east, the Bank of Japan passed on further easing in its deliberations last week. But the consensus opinion among observers is that, barring some unexpected stimulatory impact from one of Abenomics’ fiscal arrows, monetary action will once again need to ride to the rescue there. All this would appear to point to the very real possibility of policy divergence among the world’s principal developed regions. That has never happened, so we will be headed into uncharted waters as we transition into 2016.
Growth Trumps Rates
Yes, we have used the “Growth Trumps Rates” headline in previous commentaries, but it is a useful reminder for us that we would rather live in a world of rising interest rates and economic growth than zero-bound rates and stagnation. We do not think growth here at home should necessarily be stymied by monetary policy divergence, should that come to pass. The Eurozone economy has managed to slightly outperform what were admittedly fairly low expectations at the beginning of the year. If Chairman Draghi believes an extra shot of QE will move it further back from the deflation cliff, then so be it. A continued headwind for US exports, to be sure, but we would expect the impact on GDP to be largely offset by brisker consumer spending at home, helped along by improving wages.
This scenario in turn feeds into the “quality rally” thesis we have set out in recent weekly commentaries. This thesis sees companies able to demonstrate competitive advantage – evidenced for example by double-digit top line growth despite FX headwinds, emerging markets softness and other challenges – as likely to outperform their peers. To some extent this trend is already underway. A December rate hike should provide confirmation for this new phase of the bull market. The training wheels are coming off, and future price gains should be more about the good old metrics of free cash flow generation and strategic execution than about QE and zero percent rates.