Posts tagged Market Anomalies
An up and down week on Wall Street may end on a slightly positive note, if the sentiment we are seeing on this Friday morning makes it through the afternoon. Don’t mistake this for some kind of definitive trend, though – what’s been happening this week is much more about technical buy and sell triggers that send much of the market’s intraday volume hither and yon. At one point earlier this week the S&P 500 actually closed below its 200-day moving average for the first time since early 2016. There’s nothing magical about moving averages, of course, except that lots and lots of trading strategies are programmed to react to them. Perception is reality in the world of short term trading.
In any event, while indexes bounce up and down in search of a driving theme to provide direction for the rest of the year (which we think has a better chance of being up but a not immaterial chance of being down) we want to dig into some of the X-factors contributing to the current frisson of unease. In this week’s commentary we feature the Italian debt market. Spreads between Italian benchmark bonds and German Bunds (the go-to safe haven for EU fixed income) are at their widest levels in four years.
Return of Eurozone Mal de Mer
The above chart shows that Italy-Bund spreads are a useful indicator of unrest in the Eurozone. After ECB chief Mario Draghi assured the world that the Eurozone would stay intact with his “whatever it takes” speech in 2012, the spread tightened from the wide gulf of the crisis years to a more typical risk premium that lasted for most of the past four years. That all changed with the national elections in March 2018, which ended with a populist government sworn in two months later, in May. The coalition government of the Five Star Movement (FSM) and the League, representing different flavors of anti-establishment populism, set out some ambitious plans to deliver on its campaign promises of stimulus measures for growth and jobs. Eventually, these plans found their way into a budget the country is required to submit to EU officials in Brussels, to ensure that the terms are in keeping with EU standards and constraints. Brussels, to put it mildly, was not amused.
EU economics officials routinely issue rebukes to member country policies which they see as deviating from rules – particularly the rules developed during the crisis years earlier this decade. But the language in this Thursday’s communique from Brussels to Italian finance minister Giovanni Tria was – well, practically Trumpian in its histrionic flavor. “Unprecedented in the history” of EU budget rules! – said the stern technocrats. One would think nothing of such a seismic nature had rocked the continent since Charlemagne crushed the Merovingians.
The odd thing is that Brussels’ main sticking point with the budget is its assumption of running a 2.4 percent fiscal deficit. While not inconsiderable, that is a lower fiscal deficit than those run by EU members France and Spain, and it is also lower than what the new Italian government initially planned after the coalition came together in May. The real underlying problem is that few observers believe a fiscal deficit of this size is sustainable for a country challenged by slow economic growth and a cost of debt that is already rising. The bond investors who have been selling off Italian bonds this week anticipate further downgrades to Italian debt from S&P and Moody’s later this month, and expect further headwinds to buffet the fragile condition of large Italian banks.
The bigger contextual picture, of course, goes beyond Italian sovereign debt to the overall health of the EU. There has been little in the way of good news from Europe this year. The Brexit negotiations are an ongoing fiasco painting nobody in a good light. On the eastern periphery Hungary and Poland can fairly be called ex-democracies as their authoritarian governments consolidate one party rule. Italy and Austria are ruled by populists. Establishment darling Emmanuel Macron’s approval ratings in France are an abysmal 33 percent (that’s lower than Trump has ever fallen here back home!). And Germany is also teetering on the dividing edge between populists and technocrats. Witness this past weekend’s regional elections in Bavaria where the long-dominant CSU (the regional partner of Chancellor Merkel’s ruling CDU) suffered its biggest loss of seats in the party’s postwar history.
In this fraught landscape, the notion of a fiscal crisis or banking system collapse in Italy has the potential to inflict more damage than the original Greek economic crisis that led to the dolorous years of 2011-12. Back then those three magic words uttered by ECB chair Draghi – whatever it takes – were enough. We may see proof in the coming weeks, one way or another, whether indeed it is enough.
Investors who like nice, clean narratives keep getting flummoxed by the global economy’s refusal to serve up steady sequences of consistent data points. This was a week, after all, when bond markets around the world took a Super Mario-sized beating in the wake of the ECB chairman’s musings about recovery and reflation in the Eurozone. The bond carnage even spilled into the seemingly Teflon stock market on Thursday. And yet, where did it all end? In the US, the latest reading on personal consumption expenditures (PCE), the Fed’s go-to inflation gauge, posted a weaker than expected year-on-year growth rate of 1.4 percent (both headline and ex-food & energy) on Friday. That same day the latest Eurozone flash CPI showed a 1.3 percent year on year gain, in line with expectations but down from the previous month. Reflation? Or could the bond market just possibly have jumped the gun a tad?
Phillips Curve to Nowhere
The May inflation numbers are, of course, representative of just one month. But there is very little in the longer term trend to suggest that this mythic reflation is anywhere on the horizon. The chart below shows the headline and core (ex-food & energy) PCE along with the US unemployment rate trend for the past five years.
The Fed pays closest attention to the core PCE rate (the green solid line) because it excludes the volatile categories of food and energy, and thus presents a steadier picture of underlying trends. As the chart shows, core PCE has fallen over the past five years from a high of 1.9 percent to the current level of 1.4 percent. Not once during this period has this rate surpassed the Fed’s desired target of 2.0 percent (the headline number was briefly above 2 percent, almost entirely on account of a commensurate rise in oil prices).
While prices have largely gone nowhere over this period, the complexion of the labor market has changed considerably. The unemployment rate (red dotted line) was over 8 percent in June 2012, and currently resides at 4.3 percent. Private nonfarm payrolls have made gains every single month over this period, the longest streak since the Bureau of Labor Statistics started recording this data shortly after the end of the Second World War. Normally, economists would expect this brisk pace of labor market growth to put upward pressure on wages and consumer prices. The Phillips Curve, bane of every Econ 101 student, came into existence to quantify this relationship, but its explanatory powers would appear to have diminished to the point of irrelevance.
Low Growth, Lowflation
When the “reflation trade” theme became the dominant market sentiment at the end of last year we expended a considerable number of words musing about just where all this growth was supposed to come from. Even the most wildly optimistic assumptions about a new bout of pro-growth fiscal policies from Washington, in our opinion, was not likely to change the basic growth equation: declining population growth, a smaller percentage of the population in the labor force and chronically low productivity together comprise a speed limit on how fast the economy can grow. If and when productivity were to return, it would quite plausibly come at the expense of jobs, as nonlinear advances in artificial intelligence and deep machine learning make real inroads into companies’ business operations. Why should we expect to see a major bout of reflation if this is the case?
This week’s bond market activity was significant. We are far from convinced that it marked the start of a paradigm shift away from the low rate environment of the past few years. The Fed may well raise rates again this year – it really, really wants to, and absent a major deviation from headline macro trends it could probably do so without too much risk of collateral damage. But unless some catalyst that we don’t see today shows up to push prices significantly higher, the urgency for the Fed to act again (or the ECB to start tapering) just won’t be there. And we are always just one unexpected market crisis away from the Greenspan-Bernanke-Yellen put coming out of the desk drawer and back into action.
Remember the Flash Crash of 1962? Of course you don’t. Neither do we. But it happened. On May 28th, 1962 the S&P 500 plunged 6.7 percent in a single day, seemingly out of the blue. Concerned investors noted immediately that this was the biggest single day retreat in the stock market since 1933, with more shares changing hands than since those panicky October days of the Great Crash of 1929. No shortage of commentators at the time wrote about the near inevitability of a sustained period of panic selling.
Pretenders to the Bear
That chronic downturn never happened, of course. The Flash Crash of ’62 came and went. A few weeks later saw the end of the ephemeral bear market that spanned December 1961 – June 1962 and the resumption of a long-running macro bull environment. That “bear” had no material impact on the economy and no lasting effect on anyone’s memory save small clusters of Wall Street vets swapping yarns about the olden days over Old Fashions at Harry’s Bar. It was, in our lexicon, a pretend bear.
So why are we taking the trouble to write about the 1962 event today, 54 years later? Our theme this week takes direct aim at the incessant chatter in today’s environment about the “length” of the current bull market and whether investors should be worried that the bull has run its course. We use the example of the Flash Crash of ’62, along with a handful of other pretend bears and near-misses, to argue that the entire technical construct of a bear market is arbitrary and has nothing to do with where the stock market is in the context of a long term macro environment.
In other words, there may be plenty of things about which to worry in regard to the current market. The rate of economic growth, the limits of central bank monetary policy and the prospects for corporate earnings are all legitimate causes for concern. The fact that – at seven years, five months and counting – this is one of the longest “bull markets” on record is not a legitimate cause for concern.
A Macro Framework
Since the end of the Second World War there have been four macro environments for US equities. There was the Great Postwar Boom of 1949 – 1968, followed by the Stagnation Bear of 1968 – 1982. Then we had the Great Moderation of 1982 – 2000, which finally ushered in the Time of Troubles that ran from 2000 to at least 2009 and possibly longer. Hold that thought, as we will come back to it at the end of this piece.
This framework is key to how we at MVF Research think about markets. It is our frame of reference for growth and non-growth (gap) environments much more than is the arbitrary construct of a 20 percent pullback from the previous high, which is the conventional industry definition of a “bear” market. Consider that postwar boom environment of 1949-68. There were three conventional bear markets over that span of time: a 21.5 percent pullback from August ’56 to October ’57, then the aforementioned six month retreat of 28 percent from December ’61 to June ’62 that included the Flash Crash, and finally another 22.2 percent drop from February to October, 1966. Of those three bear markets only one – the fourteen month stretch over 1956-57 – coincided with an actual recession.
That last point is important. What we can learn from the past is that the worst sustained market environments – the ones where investors really do benefit from added downside protection – tend to coincide with genuine problems in the broader economy. In 1962 there were few signs of economic stress, while in 1966 you had the first slight signs of the overheating that would lead to massive inflation a few years later. Investors who stayed put during this period came out fine; the S&P 500 gained a cumulative 178 percent from the 1957 market bottom to the 1968 peak.
Perhaps no example serves better as an admonishment against pretend bears, though, than October 1987.
The Roaring Eighties
The Great Moderation ran from August 1982 to March 2000. Over this time period the S&P 500 returned a staggering and unprecedented 1,391 percent in cumulative price accumulation (which does not even include the return from dividends paid over the period). But this span of 17 years and 8 months does not technically qualify as the “longest bull market on record.” It was broken up once in 1987 by a technical (read: pretend) bear, and experienced two near-misses with a 19.9 percent pullback in 1990-91 and another of 19.3 percent in 1998. In fact, if you were to use intraday highs and lows rather than closing prices, then both the 1990 and the 1998 events counted as bears.
The 1987 event, of course, was driven by the one-day freak crash of October 19. This was of an even bigger magnitude than that of May 28, 1962; major indexes closed down more than 20 percent from where they opened. All told, the S&P 500 would lose 33.5 percent from peak to trough. But it was all over less than four months after it started. And – like the instances of 1962 and 1966 – there was little in the way of macroeconomic data to suggest a sea change from the generally favorable growth conditions that prevailed at the time. In fact the next recession would not happen for another three years (and it turned out to be mild one).
The Benefit of Hindsight
Now we come back to the present environment. When we look at past market environments we can comfortably put start and end dates around them; the passage of time affords us that opportunity. For example, we know today that the difference between 1966 and 1968 was that only the latter pullback was accompanied by a real change in the economy that precipitated more than a decade of stagnation and a real, as opposed to pretend, bear market. We know that the 1929 market crash had an immediate effect on the economic decisions of businesses and consumers, with industrial production falling by double digits within a matter of weeks, while the 1987 crash barely registered in the real economy.
We know that because of where we stand today relative to those events. An investor in October 1987 or October 1929 (or May 1962 for that matter) had no such luxury, of course, and neither do we as we ponder where markets go from August 2016. We can’t even define where we are today relative to that framework for macro environments we described earlier. Are we in the beginning stages of a new third macro growth environment, a successor to the Postwar Boom and the Great Moderation? Or are we still in the Time of Troubles, with the other shoe yet to drop when the world’s central banks run out of ammunition? We do not yet have the luxury of hindsight with which to offer up a definitive answer to that question. There were plenty of false dawns during the 14 year Stagnation Bear and another interregnum during the 2003-07 phase of the Time of Troubles.
What we do know, though, is that while the world economy is in a slow-growth phase it is still, by and large, growing. We do not see evidence for the US heading into recession, or for the Eurozone to get sucked into a deflationary spiral. We are in a much more managed economic environment than that of the liberalizing 1980s and 1990s, but so far, at least, managed monetary policy has managed to keep potential crises at bay.
We know that pullbacks are a regular part of the market landscape, and sometimes these pullbacks can push over that arbitrary 20 percent threshold into technical bear territory. In the absence of compelling evidence to the contrary, though, we will have a general tendency to see such pullbacks more likely than not as pretend bears. The fact that the current bull has run since March 2009 means essentially nothing to us as any kind of a signal. Our job is the hard work of piecing together disparate data into a composite view of where we may be in the larger macro context. Real bear markets happen rarely. We do not yet see the data telling us we are entering another one.
It’s just a natural continuation of conventional monetary policy, say the central bankers who have unleashed the hounds of negative interest rate policy – NIRP – into the capital markets. The Swedish Rijksbank is the latest to join the club, setting the key bank overnight repo rate at minus 0.5 percent. Even stranger than the rate itself was the accompanying announcement, part of which read thus: “Growth in the Swedish economy is high and unemployment is falling, which suggests that inflation will rise in the period ahead”.
Got that? Sweden’s economy, in fact, is growing at a clip of around 3.5 percent, or more than twice that of the Eurozone. If US GDP were growing by anything close to that rate it’s a pretty sure bet that Janet Yellen & Co. would be hiking rates with nary a second thought. What possible reason could there be for Sweden, then, to send rates below zero? “Global uncertainty” was the phrase the Rijksbank deployed in that same press release, along with a vague reference to recent inflationary weakness. “Everybody else is doing it” seems to be the underlying context, though, and that has the makings of a potentially dangerous trend.
Wonderland Not So Wonderful
We took note in this column a couple weeks back of the Bank of Japan’s joining Club NIRP. Now, as with any easy money policy, two key motivating incentives for negative rates are a weaker currency (to improve trade conditions) and higher domestic asset prices. How’s that working out for Japan so far? Consider the chart below, showing recent trend performance in the Japanese yen and the Nikkei 225.
In fact, the currency and the stock market have both done exactly the opposite of what the BoJ would have hoped. The Nikkei 225 has fallen by more than sixteen percent since the beginning of February, while the yen has strengthened by 8 percent against the dollar. Oops. The point to make here is simply this: NIRP is not, as claimed, simply an extension of the conventional easy money continuum. It is a whole new territory, an unknown land where the normal rules of finance do not necessarily apply. That NIRP is going viral around the globe is, in our opinion, cause for considerable concern.
Here Be Dragons
There are many facets to our concern about the NIRP contagion. A central one is its impact on the financial sector. The fruits of this impact are already visible in the form of a global bear market for the shares of financial institutions. Banks have to hold a certain fraction of their liquid assets in the form of central bank reserves. When the cost of holding these reserves goes up they need to make up the difference elsewhere, either in raising lending rates (counterproductive to growth) or in venturing into riskier lending areas (counterproductive to risk-adjusted capital adequacy). Again – a key objective of any easy money policy is to funnel money back into the economy via bank lending and accelerate its velocity. All the quantitative easing of the last six years has failed to accomplish this objective. It seems a great stretch to imagine that, suddenly, credit demand is going to materialize out of nowhere in response to negative rates. The banks, meanwhile, will have to figure out how to adjust their business models to remain profitable.
The reasoning behind NIRP is also flawed in terms of its capital markets objectives. Negative interest rates have spread into a widening swath of fixed income instruments, primarily (though not exclusively) government bonds. Five year German Bunds currently trade at negative yields, as does the Swiss ten year note. That’s right – if you buy a Swiss government bond and hold it to maturity you are guaranteed to lose money. What NIRP does, then, is to take low-risk assets and make them riskier – a complete perversion of standard capital market theory.
No Country for the Prudent Investor
Bear in mind that institutional investors like pension funds and insurance companies are required by their investment policy statements to hold sizable percentages of low-risk assets in their portfolios. Part of the NIRP objective is to make safer assets less attractive to stimulate purchases of riskier assets like stocks. But a prudently managed pension fund cannot simply take itself out of short term bonds and dump the money into small cap stocks. In this way, again, NIRP is counterproductive.
Finally, NIRP could potentially achieve the opposite of what it wants in terms of guiding inflation back up to those elusive 2 percent central bank targets. Think again about that ten year Swiss government bond we discussed a couple paragraphs above. Nominal bond yields are comprised of two sections: an expected real return (i.e. what the investor expects to earn from the investment after inflation); and inflationary expectations. Say for example that a certain ten year bond yields five percent and that inflation is expected to run at two percent for the next ten years. So that bond’s real return would be three percent and the inflation expectations component would be two percent. Easy math.
In light of that example, what does a yield of negative 30 basis points (about where the Swiss ten year is today) tell us about investor expectations? Only that for a rational investor to hold that security, the investor would have to believe that the most likely price trend for the next ten years would be deflation. If the average price of goods and services in the economy were to fall by one percent annually for the next ten years then it would make sense to invest in a bond, the slight negative return of which would still preserve purchasing power. Of course, deflation is exactly what financial policymakers want to avoid.
Expectations matter in explaining economic behavior and outcomes. The advanced-math models central bankers use in arriving at policy decisions have been shown to be demonstratively poor in accounting for the expectations factor. Want proof? Go back to that chart showing what the yen and the Nikkei 225 did in the aftermath of the BoJ’s NIRP decision. Expectations matter, and central banks ignore them at their – and our – peril.
The Efficient Market Hypothesis (EMH) is a theory about asset prices and information. At the heart of this theory is the assertion that capital markets are fully efficient. According to the EMH, asset prices always reflect every single piece of information that could reasonably impact the asset’s value. As new information becomes known it is instantaneously baked into the price. Anyone operating at a speed slower than Planck time could not possibly take advantage of such new information to trade profitably. Price always equals value, the market is always rational, and bubbles don’t exist, say the efficient market proponents.
Theater of the Irrational
The problem with believing in the Efficient Market Hypothesis is that every fiscal quarter delivers a compelling piece of evidence to the contrary, otherwise known as corporate earnings season. The quirky rituals of earnings season refute two key EMH tenets. First, the idea that an asset’s price is always equal to its value is very hard to square with the fact that prices can lurch up or down in double digits before, during and after earnings announcements. Second, the way that prices move in reaction to the actual information released tend to be anything but rational. Consider the following chart, which shows the price movements of two companies – Intuitive Surgical and Qualcomm – in the period leading up to and immediately after their respective second quarter earnings announcements:
What could possibly have happened to make Intuitive Surgical a more valuable company by 17.7% in just one day? Did the net present value of Qualcomm’s future free cash flows suddenly drop by 7%? Of course not. Large publicly traded companies like ISRG and QCOM continually issue guidance on their projected sales, earnings and other key data. Analysts use this forward guidance, as it is called, to model their valuation estimates. Going into earnings season there are consensus estimates for just about every company in the S&P 500. When the actual numbers are released they are compared to the earlier estimates. If the actual figures are higher than the estimates then we have a “positive surprise” or “beat”, in analyst-speak. Lower than expected results, by comparison, are “misses”. High-profile companies can generate considerable drama around their earnings announcements, and the drama often leads to these erratic – and very un-EMH – price movements.
The Fool’s Errand
But the EMH does get one thing right: attempting to profit from a company’s earnings announcement is a fool’s errand indeed. Consider again the two companies in the above chart. You would think that Intuitive Surgical had a blockbuster quarter, and that something awful must have happened to Qualcomm, right? Wrong on both counts. ISRG’s earnings were actually 3.5% lower than the consensus estimate based on the company’s earlier guidance. Qualcomm, on the other hand, delivered earnings 18.6% higher than the estimate. The ensuing price movements are basically the opposite of what a rational investor may have expected.
Markets defy rational expectations every day. Those who come into the capital markets with rigid ideological views about how assets ought to behave should expect to be disabused of their dogma in very short order. Smart investing requires an openness to all ideas and all possibilities, while knowing that no one single view or theory works in all markets at all times.