When Alan Greenspan launched the era of easy money in 1998 with the bailout of hedge fund Long Term Capital Management, no one could have predicted the litany of asset bubbles that would ensue.
The Federal Reserve has been actively trying to manage the cost of money ever since in an attempt to calibrate aggregate demand as it sees fit. However, since it is monitoring lagging economic data in order to adjust monetary policy, which also works with a lag, market participants are not discounting future fundamentals. Investors are merely positioning for what they
think Fed policy will be based on past fundamentals. As a result, the market has experienced massive distortions in pricing leading to 14 years of boom-bust sequences.
This past week Federal Reserve Bank of Dallas President Richard Fisher broke this market phenomenon down in simple terms when he said during a speech
that current interest rates are distorting the price signal.
That’s exactly right. By manipulating the yield curve to generate negative interest rates, Fed policy has taken the discount out of the discount rate and thus removed the ability for markets to correctly price assets. Fed policy has essentially turned all assets into commodities subject not to valuation but simply the supply and demand for the securities.
The by-product of this Fed policy has produced what I have characterized as the wrong playbook bubble.
At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.
If everyone is using the same playbook -- which is wrong -- then there is no alpha, which is why so many hedge funds are underperforming. In the ‘90s the few hedge funds that were around generated alpha by betting against the crowd, but now they are the crowd, and they are all using the same playbook.
If you follow me on Twitter, I often make reference to what Billy Ray Valentine (the character played by Eddie Murphy in Trading Places
) is up to in the markets, or more specifically, the pits in Chicago. This is of course a metaphor for what I believe is today’s equivalent to the invisible hand (the self-regulating nature of the market). Last week I commented that instead of studying for the CFA (accounting certification) you would be better off watching Billy Ray Valentine explain trading to the Duke Brothers.
Recall the scene in Trading Places
where the Dukes were short pork bellies and looking to cover but Valentine, obviously having figured out the game of positioning and sentiment in the commodities market, warned them not to buy too soon (I paraphrase).
BRV: That’s a big mistake, man. You’re going to get reamed on this one.
RD: Tell me just why you think the price of pork bellies is going down, William.
BRV: It's Christmas time, everybody’s uptight....
MD: Could we please buy now, Randolph..
RD: What are you trying to say, William?
BRV: OK. Pork belly prices have been dropping all morning, which means that everybody is sitting in their office waiting for it to hit rock bottom, so they can buy cheap and go long. So the people who own the pork belly contracts are thinking, "Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! OK... And my wife ain't gonna make love to me if I ain’t got no money!" Right, so they're panicking right now, they're screaming "SELL! SELL!" cause they don’t want to loose all their money, right. They're out there panicking right now, I can feel it. They’re panicking, look at em,.
RD: He’s right Mortimer, my God, look at it.
Valentine sets the price, saying, “You’ll have cleared out all the suckers by then.”
In order to trade the wrong playbook bubble you have to understand what is driving market price.
With Ben Bernanke having turned all assets into commodities, market price is not driven by valuation and growth based on models and forecasts, it’s driven by positioning and sentiment based on speculation and fear.
In what I have deemed the inverted risk-on/risk-off trade, I see the market positioning as largely long negative coupon bonds (risk-on) and short relatively cheap equities (risk-off). The sentiment is what I deem as short-sellers' remorse or simply put, the speculative community that largely missed the 2008 crash is constantly looking for the next blow up so they remain net short risk (either outright or via bogeys) regardless of the trend.
I believe this whole rally in equities from the March 2009 low has been one giant clearing out the suckers' trade.
Essentially the market is doing a big back-fill of the credit bubble crash. Those who are using the wrong playbook and have missed the rally are looking at stuff that doesn’t matter like economic data and growth prospects. The market is simply filling the gaps left behind by the crash and potentially using the Lehman and Bear Stearns events as pivots. It has nothing to do with fundamentals and everything to do with consolidating the gaps, repairing sentiment, and thus healing the scars left behind by the financial crisis.
Going into last week I published a chart
with a pivot of 1265 which I expected to get tested and possibly flushed to raise bearish sentiment however the market didn’t quite get there with the low of 1266.74 prior to an explosive 4.6% rally to close Friday near the highs of the week. I had this pivot area not only because it represents last year's double bottom prior to the August crash, but it also represents the low after Bear Stearns imploded in March 2008. If this market truly is just back-filling the gaps left behind by the financial crisis then making this area of support is very bullish and could point to new all time highs going into the fall.
One of the more interesting relationships since the 2009 bottom is that each pullback of higher lows in equities has been met with lower lows in bond yields, with the most recent move to S&P 500
1266 SPX producing an all-time low 10-year Treasury yield at 1.45%. Ordinarily in a normalized market we’d defer to the bond market discount implying massively decelerating growth, however as we said above with the Fed taking the discount out of the discount rate and acting as the single largest source of demand we must look at a different interpretation.
With the Fed scheduled to walk away from the market at the end of June as Operation Twist ends we are going to get a very important litmus test in the stock versus flow debate. The Fed is working under the assumption that it’s the removal of bonds from the system that is keeping yields low. Others including Bill Gross of PIMCO, who owns a few bonds himself, believes it’s the flow that matters.
No doubt Billy Ray Valentine would subscribe to the flow theory as well and after taking the large speculators on a spectacular short squeeze ride since the April price lows and last week’s Committment of Trader
data showing them virtually flat. Now it’s time to see who else will step up to replace the demand when the Fed walks away.
Currently the primary source of demand outside the Fed has been from short hedge funds, retail investors, foreign central banks, and the banking system. The bond market is unique in that it is made up of those who have to buy and those who want to buy. We believe most of this current demand is from those who want to buy. But is that about to change?
The blow off rally to 1.45% yields on the 10-year Treasury and .625% on the 5-year has all but eliminated the carry earned by the financial system. If history is any guide once the carry goes flat to negative the demand from the banking system starts to wane; we don’t see why this time would be any different. In fact Bloomberg reported last week that Operation Twist was causing a glut in the repo market lifting the costs to finance inventory. The same could be said for banks whose cost of capital is now near yields in the belly of the curve for agencies and mortgage-backed securities.
Many believe there is just no demand for money. But, it's equally possible that, with historic low loan/deposit ratios and high concentration of securities, there really no supply of money. However, that could change with the carry going flat which would force banks to make loans.
That leaves foreign central banks (or FCBs) and retail investors. With the dollar rallying of late it implies less excess liquidity being exported out of the US. Which makes sense since the current margin would reduce the demand for US treasuries by FCBs. I don’t see any material decline in demand from FCBs but as long as they don’t increase holdings as a percent of outstanding it would be a net/net negative for price.
That leaves the retail investor -- always the last investor class left holding the bag. According to the Investment Company Institute
fund flow data, since January 2009 equity funds have seen a net outflow of $196.9 billion while fixed income funds have seen a net inflow of $889.7 billion for a net swing of $1.087 trillion implying a massive asset allocation shift has already taken place. With the Fed having bought roughly $1.5 trillion US Treasuries over the same time period -- and the Treasury needing to roll $2-3 trillion more in the next couple of years, not including any increase in borrowing -- grandma and grandpa will really need to step up the pace to keep the curve at negative yields. I'm not saying it can’t happen but that’s a lot to ask of an investor class buying in lots of $1,000.
Last week Bloomberg ran a story
titled, “Treasury Bears Give Up as Low Yields Seen Through Election” that had all sorts of hints of capitulation. “As yields on 10-year notes tumbled, dropping below 1.5% last week for the first time, investors who had sought protection from bond losses retreated, reducing the so-called payer skew in option son interest rate swaps from a near one year high.”
In this weekend’s Wall Street Journal Intelligent Investor blog,
Jason Zweig, wrote an article titled, “Are Bond Rates on a Road to Nowhere?” stating that the bond vigilantes had been run out of town and that demand will continue from “uneconomic” buyers who have to buy regardless of price. He concludes, “Above all, grit your teeth and lower your expectations for higher yields. We might be stuck in the flatlands for a long while.”
We can’t be sure if this bear market in stocks or bull market in bonds is over but one thing we do know: When it is over, no one will own stocks and everyone will own bonds. Currently that is the case and the confirmation bias towards both positions is overwhelming. I don’t want to imply that fundamentals and discount aren’t important but they aren’t the dominating factors driving price in today’s market.
The massive underperformance of the investment community is attributable to a wrong playbook bubble. This market cycle doesn’t care about growth or discount, it cares about positioning and sentiment. As we sit here today, it’s very possible the consensus continues to get long the end of a bull market and short the beginning of a bull market.
I have the feeling this summer while everyone continues to focus on stuff that doesn’t matter, Billy Ray Valentine is about to clear out the suckers, and as Mortimer reminds us, "This isn’t monopoly money we’re playing with."