Commentary

Latest Post: June 6th, 2013

Harvey Dent’s Market

The current stock market is fit for Harvey Dent of the popular Batman comics. On certain days, positive fundamental data is cheered and on others it is booed. Harvey Dent was nicknamed Two-Face and it is precisely that reason why I am labeling it Harvey Dent’s Market. Two-Face based outcomes off a coin flip using a rigged coin (it had heads on both sides). He had the foresight of knowing what the outcome would be before the coin came to rest. Similarly, retail investors are often blind to the outcome of economic reports and trade activity. A look into the action from Friday and Monday shows my point fairly well.

FRIDAY

Good News is Good

Graph-1

Chicago PMI came in much higher than expected which lifted the S&P 500 marginally. Incoming tangent! Bear with me for a minute here. There is no unfair advantage or information leakage in the markets, right? Think again. High frequency traders (“HFT”) and institutions gain early access to certain economic reports and have the ability to trade on the information with incredible speed. Premium subscribers can see the PMI release at 9:42 ET while the rest of the world has to wait until 9:45 ET. Take a look at the below video, courtesy of Nanex, which depicts the first 100 milliseconds of trading after the early release. It is truly mind boggling.

http://youtu.be/a9JBm51Zj3U

Good News is Bad (or maybe it does not matter)

Graph-2

I think everyone forgot what month it was until the afternoon session. Equities sold off hard into close, marking a late revival in the “Sell in May and Go Away” motto. Maybe a great Chicago PMI number is not good? Maybe it was end of month selling or the realization of how terrible the ISM-Milwaukee number was in the face of Chicago PMI or the perception the PMI release may push the Fed towards reigning in its bond purchases. Either way, any good news was swept aside and replaced with shouts of “Sell! Sell! Sell!” a la Jim Cramer.

MONDAY

Bad News is Bad

Graph-3

After the release of the ISM Manufacturing report, we saw S&P 500 futures trade down to session lows as bad news was seen as bad. Both indices fell well under expectations and into contraction territory.

Speaking of information leakage, it appears the ISM release either leaked early or someone flipped a coin just prior to the release (See the following link for more details from Nanex on how trades began 15 milliseconds before the official release time: http://www.nanex.net/aqck2/4306.html)

Bad News is Good

Graph-4

You could almost see the wheels turning a few minutes after the release. “ISM Manufacturing prints at the worst level since the summer of 2009? Sounds bad which means the economy is not doing so well which means the Fed has to continue QE3!” Anything which can be spun to keep the QE-addicted market pumped full of liquidity will be and has been.

Bad News is Bad

Graph-5

It did not take long before people started to remember what Bernanke said recently about reducing or stopping bond purchases. Suddenly, bad news becomes bad again. If the Fed takes off the training wheels and the economy is still struggling, there will be pain in the markets.

Wait…maybe Bad News is Good!

Graph-6

The short sellers had a short selling window (no pun intended) because before long, traders remembered Chicago PMI printed at 58.7 on Friday and bad ISM means QE stays! Ever see the new Wheat Thins commercials featuring the tag line “Must have Wheat Thins?” If equities had a commercial on Monday, the tag line might have been “Must trade higher!”

You might be asking yourself what all of my rambling means for you. Quite simply, it boils down to the fact the economy is stuck in first gear and the Federal Reserve has created a situation where it is forced to sit on the fence. The risk-to-reward ratio of staying long in the market has tilted to the side of more risk than reward. We are participants in a sentiment focused market. Every whisper from Merkel, Abe, Draghi, Bernanke, etc. could mean riches or doom for your portfolio. In this environment, tactical strategists drool over the uncertainty because it is in these periods where we tend to shine. The flexibility of a tactical portfolio allows us to maneuver away from risk and into favorable opportunities.

Will the S&P 500 close higher or lower than today’s level at the end of the year? Flip Harvey Dent’s coin. I call heads. The detachment of fundamentals from stock market movement makes the forecast difficult. As I stated in my last post below, the Federal Reserve faces the challenge of deciding when to end its current accommodative policy. If the chatter becomes action, watch out! We will be in for a wild ride either way.

– Brian Durbin


May 30th, 2013

The Problem with Buying is You Have to Sell at Some Point

Buy Low, Sell High is the mantra of the investment world. The Federal Reserve’s motto seems to be Buy More, Sell Never. First we had QE. When QE failed to stoke growth, the Fed extended the program into what is now known as QE2. When QE2 gave similar results, Big Ben initiated QE3 (or QE-to-Infinity) a $40 billion/month bond purchasing program with no definite end date. The Fed now sits at the critical crossroads of increasing QE again or tapering it down. Maybe it is just me, but I believed QE3 was the bottom of the Fed’s toolbox and there were no tools left. An indefinite program certainly gives the impression of grasping at straws. Each of these two main options involves a question of magnitude (e.g. Do you cut off the bond buying completely? Lower the amount? Unwind the purchases?). Each of the options has several potential outcomes. These scenarios warrant a discussion.

Increasing QE

On a base level, there are logical reasons (in theory) for increasing QE. The economy has yet to move out of the sluggish growth range of the last 4 years. The labor market, while “improving” in the sense of lower unemployment, is barely adding enough jobs to keep up with population growth. Manufacturing has tailed off in recent months, both domestically and globally. Inflation remains below target as recent price declines are starting to tip the scale of discussion to deflation. Now what could happen if QE was bumped up?

• Talk of asset bubbles forming has escalated in recent weeks as the U.S. stock market approaches 20% gains on the year. Even Bill Gross chimed in, tweeting “#Yen carry trade driving all asset prices higher. Bubbles getting more bubbly. Will #QEs produce growth?” If additional QE fails to materialize in economic growth, it will only serve to further any asset bubbles forming. One may argue higher asset prices will stimulate the economy as individuals become wealthier and thus have more confidence/money to spend. A recent study by Pew Research Center shows though, only the rich tend to get richer in strong equity markets. The wealthiest 7% of the population saw their net worth increase from 2009-2011 while the remaining 93% saw a decline, most likely a factor of where wealth is held. A May Gallup poll showed the lowest percentage of stock ownership by households in the survey history since 1998 with only 52%. The lower income brackets tend to have their net worth tied up in their home while the upper brackets hold investments like stocks. Households earning $75,000 and over had 81% ownership while those under $30,000 came in at 21%.

• An increase in QE could finally ramp the economy up enough to break through the ceiling it is trapped under currently (see Figure 1). However, until the increase in money supply starts flowing THROUGH the economy (i.e. velocity of money), it will only stand to push up asset prices.

Graph-1

Ultimately, an increase in QE only stands to delay the inevitable: the day the spigot gets turned off. Speaking of…

Tapering QE

Right now the Fed has an unrealized gain on its books. The unrealized gain is the improvement in the economy from the recession trough in 2009. At some point it has to close its positions. The Fed faces two outcomes if it begins to sell the bonds purchased through its QE program: economy performs worse or economy holds steady and continues to improve. Unwinding purchases too early may cause growth to stall or fall just as selling a stock without enough bid support will cause it to tumble. Most expectations are for further guidance on a plan to cut back on QE to come about in Q4. The Fed will need to see a few more months of economic data to judge whether the economy has legs it can stand on freely and if there are indeed asset bubbles forming.

Conclusion

In my opinion, the Fed needs to decide one way or another and soon. A chart of Wednesday’s price action proves we cannot have Bernanke talking out of both sides of his mouth. Futures moved higher on his initial comments, which appeared to indicate further QE, only to come off highs moments later when he hinted at paring back QE. The release of the FOMC meeting minutes later in the afternoon caused equities to pull back further. Staying in the middle ground will only push uncertainty into risk asset markets and business decisions, especially if comments continue to flow from both sides of the coin.

Graph-2

The minutes displayed more signs of the growing dissent between members on policy action as well as concerns about possible negative outcomes of continuing the current accommodative stance. Included in the minutes were the following statements:

• A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth;

• At this meeting, a few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant, pointing to the elevated issuance of bonds by lower-credit-quality firms or of bonds with fewer restrictions on collateral and payment terms (so called covenant-lite bonds)

Although Fed officials have individually made comments about risk asset prices in relation to QE, the release of these minutes was the first time we have seen it directly from the FOMC. Additionally, the first statement above has finally put a date to what I’ll refer as QE0. Prior meetings were marked by singular members expressing the need to start closing the valve while these minutes appear to show more members have joined in the chorus.

After getting the label of being the training wheels of the economic bicycle early on in the program, QE has become known in certain circles as the “only wheels.” (See Peter Schiff’s comments from May 26, 2011) Will the bicycle crash if QE is stopped or will it continue down the road (albeit probably wobbly and nervous)?

– Brian Durbin


May 24th, 2013

Watching Risk-Reward Ratios: Economic Data Still Positive – But Rate is Slowing

Risk-reward ratios are on our radar screen these days as we review the most recent economic data against the backdrop of recent market movement. This is not to say that we are in any way suggesting a top, a bear market, or even that a correction is on the horizon, even taking into account this past week’s movement and volatility—although each of these scenarios remains a possibility. At this point, though, we do have some minor concerns about risk-reward in the markets going forward, suggesting that a slight adjustment in beta or equity exposure from current levels is prudent.

Our investment philosophy is to adjust equity exposure based on the velocity of economic fundamental data, combined with analysis of correlations between assets. Our objective is to adjust asset exposures to create the most efficient portfolio.

To be clear economic data is still positive, but the rate of increase in the positive data has not been accelerating with the market—and in some segments is slowing. For example the three-month trend of employment growth as measured by the jobs report has gone from 208,000/month at yearend, to 209,000/month as of April, which includes a large outlier of 332,000 in February, over half the total.

The ISM Manufacturing Index measured 50.7 in April, up very slightly from the 50.2 at yearend. The four-quarter average GDP growth rate was 1.85% as of Q1 2013, down from the 2.6% at the end of Q3 2012.

Much of the emerging market economic activity data is below expansion levels, and indices in many countries are down for the year. At the same time the U.S. broad market averages are up nearly 24% from the low in November. Simply stated, the last six months appear somewhat out of step with fundamentals.

Many economists forecast that 2013 would be back-loaded. However, I am concerned that it might be front-loaded.

As we have discussed previously, we have gone from uncertainty to visible risk; as a result, investment dollars have flowed into U.S. equities. To be sure, some of the visible risk is uncomfortable and even unpalatable at times, but financial destruction appears to be off the table. Accommodative global central bank activity has gone a long way to alleviate many of those structural concerns for now, while also making financial risk assets look more attractive. Recent outlooks from Fed Chairman Bernanke and members of the FOMC have varied in terms of continued duration and level of QE, but the Fed has nonetheless provided investors transparency into their views, and thus the ability to make calculations to the risk of exiting QE.

Hopefully, we’re just in for some garden-variety economic hiccups that can be managed with only a little indigestion for investors. However, if the data softens from here, and things get really distasteful or start to look queasy, we’ll get more defensive. And, if the Fed alters course and the loose negative-rate environment changes, we will also adjust fixed-income holdings accordingly.

For now, as always, we’ve got a close eye on the economy to see how things are shaping up.

For more insight into Astor’s philosophy, my latest publication, the 2013 edition of “Finding the Bull Inside the Bear” is available. To request a free copy, please email info@astorllc.com.

– Rob Stein


May 15th, 2013

WANTED: Growth… and Inflation

The first quarter of 2013 defied many prognostications as growth tracked faster than most had expected. We noted in our outlook report that the sanguine Q4 GDP number would most likely produce a bounce back effect as we transitioned from uncertainty to an “identifiable risk” environment. However, in the face of ongoing concerns and the prospects of national austerity measures, this year surged at a rate faster than many anticipated. National output measures and employment reports buoyed hopes of a strengthening economy. Although Q1 GDP posted at 2.5%, below revised estimates of 3%. We should not forget we were not even close to 2.5% as the year began.

As steady as the data was, the vast majority of reports after March 20th and into April began to express a different tone than the recent trend. ISM Manufacturing took a dive to 51 from a previous 55, followed by other regional output gauges with similar declines. The Chicago Purchasing Managers Index reported its first reading under 50 since late 2009. Non-farm payrolls for March played out the recent move higher in weekly jobless claims. The aggregated job adds, including previous month revisions, was in the 150k area. Job creation was consistent with totals over the past 6-9 months but not in the ballpark of expectations after February’s 236K report. Given the surrounding environment, it’s excusable to have held off on buying into this market given its recent history to disappoint at this time of the year.

In reality, the most rational way to view the current period is we are still in a low growth range and experiencing a temporary patch of weakness. We simply got a little excited in Q1.

With that being said, there are some dichotomies in the financial markets right now that may foreshadow deeper rooted issues. Around mid-February, when the financial markets experienced their first bout of volatility of 2013, a divergence among international and U.S. markets seemed to appear. As you can see in the chart below, international equities are well behind domestic equities this year with emerging markets actually down for the year. The renewed stress on the European financial system and a weak recovery has put pressure on those markets. Commodity prices have fallen, led by base metals, as concerns about China’s growth have risen. The above factors pressured commodity producing nations and hampered returns for emerging markets.

Graph-1b

Graph-3

Everyone is focused on when the Fed will exit its QE program as the economy moves forward. Maybe Mr. Bernanke was placating us by alluding to the exit, knowing full well the economy is not ready. Either way, recent economic reports have us moderately concerned about growth again.

So the question is why are all of these economically sensitive commodities (gold, copper, oil) seeing price declines if the global economy is evolving into a self-sustained expansion? Are rates signaling something as seen by 10 Year yield staying pressed below 2%?? Against the back drop of surging stock prices, this is curious. Combined with the recent announcement from the Bank of Japan on their U.S. look-alike QE program and it makes the interest rate AND precious metals price movement even more surprising on the surface. Throw in the continued weakness in Europe and a considerably benign inflation picture and you have a recipe for continued stimuli, not less.

The currency base has increased substantially, specifically MZM, or Money with Zero Maturity. However, if you look at velocity of money chart (shown by M2), you can see the rate of decline has been consistent for almost 5 years now. We are not creating the Fed induced monetary bubble that many think.

Graph-4

Money is just not out there chasing goods, the definition of monetary inflation. Consumers have been deleveraging for the last five years, banks are not lending a great deal and corporations are still reluctant to release the purse strings on capital investments with their record levels of cash. Commodity prices have been fading all year, another indication of slack end demand. To be sure about this sentiment, we also looked at other price and demand related gauges for further indication. Recent trends in PPI, CPI and Import Prices have all moved to multi-year lows and in some case post-recession lows. The Personal Consumption and Expenditure Core and Deflator indexes reported at month end also posted their weakest year-over-year readings post-recession. Lower commodity prices/input costs are helping keep cost down for producers, but the aggregate demand curve is proving a bit inelastic in the current environment.

Graph-5

How to read this:

What we’ve learned in recent weeks is the Fed is most likely to maintain its programs to support the economy. Recent FOMC minutes detailed that the Fed is willing to move that lever wither way as needed. With the labor market recovery pausing last month, their peg to the UE rate seems to support continuation for now. Recent national output reports from ISM Manufacturing and Chicago PMI, which measured a sub-50 reading for the first time since 2009, are supporting this recent soft patch. While concern may be building over the eventual exit of QE, recent data had provided support for at least the maintenance of the program for the near term.

The domestic inflation readings are confounding Fed policy. There is one way to look at this. Supply is currently outstripping demand and global growth is below expectations. Import price, PCE deflator, CPI, et al, have all been declining. This movement supports the Fed and other central banks in their continued supportive monetary stances, but it means the excess liquidity is only solving one half of the equation. It is not sparking a demand recovery, yet.

SUMMARY

Broad markets in the U.S. have posted strong gains to start 2013. While the U.S. has fiscal issues to navigate, the European environment is much more unpleasant. A great credit shock seems less likely now as preparation and awareness is the antidote for surprise, but the recovery appears arduous and uneven. Logistics in the U.S., while not ideal, are more manageable at this point and the corporate sector is in good shape. Thus far, Q1 top line revenue growth and guidance have disappointed on the balance: a potentially ominous sign.

The economy has impressed early this year with its “plow along, steady as she goes” pace. However, more recent data has been less encouraging. If the current shift turns out to be a new pattern, we would become concerned and reduce exposure.

The lack of inflationary pressures in the market and economy are of some concern as they could be signaling a weakening demand picture or even a worst case scenario of a deflationary spiral if growth cannot pick up. The first half of 2013 was supposed to be on the weaker side. The second half of this year was supposed to be where we got back on track for good, remember? We may have gotten further ahead of ourselves recently, with our perspective suffering by default. Remember we have some non-standard issues in type and magnitude we are still reconciling, and they may take time.

We are not of the camp that the trend is back down at this point, but the length and breadth of the soft patch is expanding. This deserves our attention and some thought to risk. Lastly, as stated in our outlook report, we do not expect this to be the year the bond bubble (if there is even a bubble) bursts. Rates appear to be a bit jumpy but range bound. The persistent strong demand for fixed income assets is keeping a lid on rates. The transparency of the Fed has created a great environment for our Active Income strategy, which is a component of most of our other portfolios as well.

– Bryan Novak


May 1st, 2013

Risk: A Four-Letter Word. That’s Good for the Market.

The stock market has posted a solid start to the year, with the S&P 500 up some 6.5% in January and February. The reason (at least in part) is—risk.

That four-letter word is good news for a market that, since the financial crisis, has been beleaguered by “complete uncertainty”—which left many investors with the sinking feeling that the proverbial shoe was always ready to drop. To counter the undercurrent of impending doom (real or imagined), the Fed, the Treasury, and central banks around the world essentially propped up the market.

When risk is visible, it can be measured, evaluated, mitigated, managed, and hedged (at least to some degree). And where there is risk of the visible variety, there is also the potential for reward.

Let’s take a simplified example. Say you have $20,000 to invest. If, based on visible risk, you determine that the most you stand to lose is 10% or even 20%—whatever the potential downside might be—then you can make an investment decision accordingly. You might decide to invest all of it and risk $2,000 or $4,000 (depending upon the magnitude of risk that you foresee), or you may decide to invest a portion—say, $10,000 and risk a potential loss based on your analysis of $1,000 or $2,000. (Hopefully, the potential on the upside more than offsets that risk, of course.)

The point is, with a better handle on the potential downside, and being able to tie actual reason to what’s behind potential risk, investors have been committing more to the market, as we’ve seen with the Dow hovering at all-time highs over the 14,000-mark.

The one caveat on visible risk is that it is—well, risk. Without the Fed-administered training wheels to guide the market through the bumps, now when risks are detected the market will react—for real. Therefore, should there be a significant change in the economic picture, there could potentially be a 20-25% correction lasting two to four quarters. This is not a prediction—just a potentiality.

With visible risk, we also expect the market to be more responsive to economic fundamentals than it has in recent years when intervention basically clipped the tails. This is a far healthier environment, at least from a fundamental, tactical asset management approach.

The dominant reality for 2013 is all about whether we will see a pickup in demand. Since the financial crisis, demand has been crimped as consumers dealt with hangovers caused by pre-crisis overindulgence. The good news, we believe, is that there is pentup demand, particularly for capital spending. A revision in Q4 2012 GDP brought the reading to +0.1% from -0.1%. The ISM’s manufacturing purchasing managers’ index increased to 54.2 in February from 53.1 in January. Thus far, sequestration has had less impact on the market than many people thought because of drama fatigue. In housing, some improvements point to potential good buying opportunities on corrections in the right sectors. At the same time, investors should be cautious when it comes to oil and other commodities.

Not all the economic data, however, has been promising. The Philadelphia Fed Business Index worsened and fell into contraction territory in January, while construction spending posted an unexpected decline in January. The point being we’re not pushing the envelope on growth right now. Whatever occurs—an accelerating economy or a sudden contraction—the market will react accordingly, based on visible risk. (Beware that just because the return of visible risk was hailed by a market that moved higher, don’t expect that to always be the case.)

Risk is back, with its potential to move the market in either direction. After the past few years of complete uncertainty and market intervention, this is a welcome sign, indeed.

– Rob Stein