out on a shaky limb

8/14/2019 Out on a Shaky Limb

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Out On a Shaky Limb

Human beings are irrational Human actions drive marketsMarkets are irrational

Perhaps the most insightful statement I read this month is that markets are driven by change in consensus. Once you think about that

and if you accept it, then markets begin making more sensethey start to appear less irrational. So what has been happening with US

Equities that they can have a 62% rally (71% on the Nasdaq) in the face of such economic malaise? Is this just humans and, therefore,markets being irrational?

Since March the key to getting the market right is not the real

economy but the monetary stimulus. Equities have rallied and

Corporate Bond spreads have narrowed across the spectrum,

pointing to the notion that reflationary policies are gaining traction.

But is Uncle Ben just inflating another asset bubble that is bound

end in tears?

Lets just assume for a moment that the economy is terrible and that

it isnt going to get any better for quite a long time. Lets alsoassume that the Fed is trying like mad to soften the blow with near

zero interest rates and pumping money into the banking system.

Uncle Ben is hoping that consumers and businesses will borrow and

spend. Despite ultra-low interest rates consumers & businesses

arent spending money or taking on debt. Perhaps they dont want

to because of an uncertain future. Perhaps they cant because of

relatively tight lending standards. Most likely it is a combination of

this diminished demand and tighter supply. Regardless of why,

private sector credit is still contracting, in spite of the Feds best

efforts to push up demand. And thus we have the analogy of

pushing on the string.

So all this low-interest money is sitting there unuseda truly

massive amount of liquidity. Eventually someone in a bank or

institution with this liquidity available to them got the idea that they

can buy things with that money and so they bought some oil and


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some Chinese stocks, gold, corporate bonds, and eventually some US equities. And consequently the prices on all these things, many

of them so-called risk assets, have gone up for reasons largely unrelated to that obscure concept that investors call fundamentals.

In other words, assets are being inflated because of small improvements in the economy and large increases in liquidity. What about

final demand? Some believe that as long as private credit demand is contracting and unemployment is high, the conditions for a

recovery in final demand are not present. So many analysts (and some central bankers) are watching private credit for confirmation of

a turn, but that is still contracting. (It is worth noting that Barclays said most previous recoveries from financial crisis were strong even

without credit growth. (Barclays))

How long might this last? I believe that equities and other such assets will continue to rise as long as the liquidity spigot is open and

will struggle at the first sign of the spigot being tightened. Given the Feds commentary and the ongoing slack in the economy, it is

clear that they are focused on the downside and so monetary policy remains loose. It is true that they are not adding liquidity, but they

are also not meaningfully removing it. It is also true that the absence of further stimulus is different than removing the existing

stimulus. The latter is the environment in which equities and all risk assets probably struggle. It seems likely that the period between

now and monetary tightening is measured in months not days. Thus, I believe the rally continues for at least a few more months.

So what will be the first sign that music has stopped. I do not know what will ultimately cause the market to focus on fundamentals butit will probably be some very positive economic number or a combination of a few positive numbers. Something that makes most

participants believe that we are out of the woods and that the economy has finally proven that it is safe to invest. The market itself

will also provide important clues. If it inexplicably sells off in conjunction with this type of an economic release, that is probably a

sign to be cautious and that the true top is in. Perhaps it is a solid uptick in consumer credit growth, perhaps a clear improvement in the

employment picture.

Thus, I am saying that equities are a bid as long as the economic numbers point to an uncertain recovery and they will likely struggle

just when it seems that we break out of the malaise. As I have attempted to explain, there is a rationale behind this seemingly irrational

thesis. I think we must consider the idea that the actual emergence of facts supporting a solid economic recovery marks an economicRubicon. It is a point at which our central bank must transition their focus away from encouraging sustainable economic growth and

toward ensuring price stability (i.e. preventing inflation). Essentially, because fundamentals improve, then liquidity must

consequently be drained. And it is that liquidity drain, which will most likely trump the positive impact of an improvement in

fundamentals, causing equities to struggle.
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A few other disjointed thoughts:

Lets just say that I am right. Imagine the market being at or approaching 1,200. Do you cringe or smile?

I have certainly overstayed my welcome in a mindset before and I have no way of knowing if I am doing that now. I have tried

to be as objective as possible.

Bill Gross went from holding 25% (or $44b) of the $177b portfolio to 44%, or $83b. He bought ~$39b of treasuries. Grosslikes to play on the governments team. And he thinks the dollar will continue to weaken (who doesnt). Mr. Gross is a tough

guy to fade and I justify being bullish on equities not because I think he is wrong and I am right but because him positioning

into long-dated treasuries is not necessarily bearish for equities. They are separate bets and can both be right for a while.

As one person eloquently put it, the stage is set for one final rally. Mediocre to negative sentiment and positive earningssurprises could be just the catalyst.

Individual stock picking could be much more important now. Last year was a macro market. Sectors performed differently but within

sectors correlations were high. Perhaps we are moving into a world in which some companies will thrive and others will not. This is

pretty subjective, or fuzzy idea but it could prove to be important. The implications are to focus on the survivors, not the junk. Clear

winners will emerge from the wreckage and they will be stronger and have more earnings power.

A Stock Pickers Market?

And now, the usual charts


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China vs US

If you had to guess which market has performed better since the respective tops in October 2007, what would you say? China or US?

S&P returns vs Shanghai Composite since the US top on 10/11/2007

Dont ask about the five year returns because that is a different story. This is just something to keep in mind.


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Something to consider from Merrill


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Why should the dollar go down? Well, it seems obvious. The US has printed a ton of money and, therefore, it has less value. Additionally, ever

since the Asian financial crisis FX reserves at foreign central banks grew. These reserves were largely held in dollar assets. Now those reserves are

being diversified into other assets (gold, oil, etc.) or financial assets denominated in other currencies and the world has seen a steady supply of

dollars pour into markets.

How could the dollar possibly go up? One thing the dollar bears seem to miss is that its a big world, its ugly everywhere and nobody wants a

strong currency. Remember, a currencys value is relative to another currency or, in the case of the chart below, relative to a basket of currencies.

If deflation and

deleveraging resurfacein force, there will be a

big demand for dollars.

Depending on how

crowded the carry

trade is, the dollar

could fly as investors

rush to unwind.

Tying this all back into

the beginning of this

report (i.e. where is

the consensus?) I think

consensus is with the

dollar bear crowd.

And, assuming this is a

correct assessment, I

am not a contrarian

with the dollar. At

times it is rewarding to

bet against the crowd,but contrarianism for

contrarianisms sake is

no virtue.

I think the most likely scenario is for the supply of dollars to continue to outweigh the demand. But the risks are mounting as the carry trade

becomes more crowded. For some reason the strength of a currency is usually positively correlated to a countrys ego. My belief is that the world

with a weaker dollar accompanied by an orderly diversification of FX dollar reserves is much prettier than a deflationary world and consequently a

flustered flight to quality resulting in a stronger dollar. Hopefully our trips abroad are more expensive, because that probably means the worlds

economic recovery is more sustainable.


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Copper, the metal with a phd in economics, meaning that it leads the economy.


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10 Year Yield minus 2 Year Yield

Its very unlikely that the yield curve gets any steeper. If it stays heregreat.


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What about the inevitable flattening? How do equities perform when the yield curve is flattening? Not bad according to the last two

times we came off of very steep levels. Obviously, this is not a huge sample size, but dont be duped into thinking that a flattening

curve must be bad for equities. However, this is probably not good for financials.

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Recession 10Yr - 2Yr Yield SPX


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Gold Priced in Euros


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US Personal Savings Rate as a % of Disposable Personal Income

Rather erratic and still trending up on the smoothed 12 month moving average (pink line). But the consumer isnt a deer in headlights

any more.


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US Auto Sales

Still hung over from the cash for clunkers party.


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Is the inventory rebuilding cycle played out? In the absence of sustained final demand, inventories will just have to be run down again

next year.

New Orders minus Inventories


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Unemployment is ugly, especially when we consider all of the unemployed including the ones working part time who want to work full

time and the ones who have stopped looking. Thats at 17%!

U-6 Unemployment


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A few random ideas I saw recently I felt were worth repeating:

Improved availability of debt funding at low rates while PEs remain depressed is likely to motivate managers to makeacquisitions or repurchase shares with debt. Improving credit availability should also improve willingness to raise or pay specialdividends before the 15% dividend tax rate expires at 2011 start. Dividends might continue to be treated as capital gainequivalents after 2010 and taxed at the long-term capital gains rate, which is set to rise to 20% from 15% at 2011 start.

Decoupling. Anything that is subject to the largesse of Chinese credit has a free put on it - Brazil, Indonesia, Australia,

resources, etc. Anything US consumer exposed gets hit.

o Credit markets are open to companies and that could be a huge catalyst to start borrowing cheap and buying theirequities. Perhaps this is worth more exploring.

Started: 9/28/2009

Finished: 10/12/2009