Perspectives

Climbing a Wall of Worry

It is more like a climbing stairs than a wall.

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The worry is the height of the stairs and lack of support.  In Party Like Its 1929 we talked about how the SP500 Price/Revenue (median) is now at an extreme. But we also know the party does not end based on valuations. The current party resumed on 11 February 2016 and continues to rally US equity funds while the rest of the world wonders if they will get a turn.

The TSP S small cap fund rallied the most during the last year simply because it lost the most in the two draw-downs. It took the two US equity funds  18 months to surpass the lowly TSP G fund plodding along like a turtle (the TSP C fund combined with the S fund track the total US stock market).

The TSP F fund (tracks Barclay’s US aggregate bond index) pulled ahead of the TSP G fund on capital gains as the central banks pushed global interest rates to a 5000 year low (negative rates) in 2016.  Then gave its relative gains back with capital losses as interest rates bounced off those manufactured lows.

tsp-since-2015-peak

The current rally in equities will end when US speculators become averse to holding risk once again.  This would happen quite rapidly if the global central banks ever decide to stop buying everything not tied down. In the meantime, our global credit bubble continues to float higher in search of a pin.

Traditional analysis is struggling with this market

I believe the economic sphere and financial sphere need to be analysed separately.  I do not think America’s economy is “a great big mess”, it is just stuck in slow growth. If we have another financial crisis, then we could see “a great big mess”.  The economy needs trade tweaks, not trade wars.  The unrepentant financial sphere is the real risk to the global economy.

So how does one invest when sitting on top of a global credit bubble?  Carefully. Defensively.  How does one analyse such a market?  Mindfully.

Mindful that bubbles do not act like bull or bear markets and can surge higher on positive narratives until they take back all the gains on short order – regardless of economic and profit growth.  Mindful that bubbles can continue to inflate much longer than a rational investor would imagine.

So we mindfully ask what was it that propelled the US stock market to new highs while US corporate profits are sitting close to where they were in the 2011 – 2012 time frame?  And why have the European and Japan declined since their 2015 market peaks while the US stock market has surged yet again?

 

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We know part of the answer.  The Bank of International Settlements (BIS) confirmed the obvious in yet another study that “Cast doubt on the ‘Ultimate Effectiveness’ of QE” by finding:

…unconventional monetary policy post-crisis is found to have no statistically significant real impact (on the economy), despite having a sizeable negative effect on the term premium (higher prices on financial assets). 

Lucky for the financial markets all that money creation had “no statistically significant” transmission to economy or growth in future US economic production. Or typical recovery job creation which would have risked actual wage price inflation sooner. And thus more pressure on interest rates and less justification of the Fed’s balance sheet repair operations (financial asset inflation).

Yes, it seems much of the great global money-creation-relay-race since the financial crisis found its way into US financial assets.  Having the world’s reserve currency helps no doubt.  Do you see the hand-offs between the ECB and US balance sheets sprints?

Chart: Central Bank Balance Sheet (US$)

Bill Gross provided the graph above in his latest outlook where he touches on the “what’s changed” that in my opinion negates so much of the traditional market analysis.

But in order to control volatility, and keep a floor under asset prices, central bankers may be trapped in a QE-forever cycle, (in order to keep the global system functioning). Withdrawal of stimulus, as has happened with the Fed in the past few years, seemingly must be replaced by an increased flow of asset purchases (bonds and stocks) from other central banks, as shown in Chart I. A client asked me recently when the Fed or other central banks would ever be able to sell their assets back into the market. My answer was “NEVER”. A $12 trillion global central bank balance sheet is PERMANENT – and growing at over $1 trillion a year, thanks to the ECB and the BOJ.  -Bill Gross

To be clear, that is $12 trillion dollars worth of money creation so the central banks can prop up the financial markets at high prices by removing the supply of financial assets from the supply & demand equation.  Add to this the removal of US stocks through corporate buyback programs and you have the recipe for “juicing valuations” as pointed out in Bloomberg’s  Supply Is the Technical Factor Behind Global Rally in Markets.

“The decline in equity supply last year created a support for equity markets, largely offsetting the decline in demand by retail investors,” Nikolaos Panigirtzoglou, who leads the U.S. bank’s flow-and liquidity team, wrote in a report published last week. 

Expectations are the growth in equity supplies in 2017 will remain near zero.  So limiting new US stock supply along with an estimated 2 trillion more in money creation by the global central bankers provides a pretty good preventative backstop to free market price discovery.

While the last US QE program ended in late 2014 (and the US stock market started trading sideways), other central banks have been more than happy to double down.  So what happens when the financial markets begin to run out of supply to feed the QE monster?

I ask because Bloomberg recently reported, it is No Laughing Matter for Kuroda With BOJ Near 40% of Bond Market.

 Looking forward, it seems the BOJ can’t stop buying, otherwise it would lose control of yields while its inflation target remains far from 2 percent. Yet it can’t go on buying forever either, thanks to a lack of ready sellers.  

I disagree that it can not go on forever since the solution will be for the governments to spend more and issue more debt and the central banks will go on monetizing the debt by holding it on the balance sheets forever.

We could have fiscal spending through money creation but hidden in complex transactions so the benefits get channeled into wall street first and foremost. Or the treasury departments could just bypass the central banks and create money as they spend, but then wall street would not get their cut.  And clueless politicians would figure out what is really going on.

The problem will come if too much of this monetary largeness actually leaks over into the real economy and consumer or wage inflation sets in.  Then the central bankers will either continue to throttle interest rates in financial repression of savers, or they allow rates to rise and prick the financial asset bubbles.  Fiscal stimulus will simply accelerate the outcome either way.

What is an investor to do

Does all this mean the market cycle is dead thanks to central bank market mopping and propping tools?  No, but the financial markets detachment from fundamentals has and can continue to get extended (that was one nice save in 2016). And become more unstable and requiring ever-larger central bank interventions for each hiccup (4 trillion in 2016 including China).

At some point, the global credit bubble will find its pin or simply not be controllable. Today we read the BOJ is finding it difficult to centrally manage their yield curve – as opposed to allowing the market to determine rates. Good luck with central management of complex systems. Printing money is easy, controlling yield curves should be interesting.

Buy & hold and passive investing wins and wins and wins, until it crushes investors in price then in panic selling. Don’t worry they will say, the market always comes back.

Don’t tell the Japanese about buy and hold, they have been waiting 26 years for their stock market to reach the 1989 levels. And the chart does not take into account the loss of purchasing power due to inflation.  The chart below illustrates why sometimes buy and hold is not the best answer and why maybe he who panics first will have money to invest another day.

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The Bigger Bull

The US has been in a secular bull market in bonds for 35 years.  It is coming to an end since Europe and Japan decided that negative interest rates were not the answer. After his failed experiment with negative interest rates, the BOJ’s Kuroda is now worrying about how low interest rates are sowing the seeds for the next financial crisis – 20 years after setting interest rates to zero he becomes worried?

That is a lot of sowing.


 

TSP Smart Investor is mindfully invested in equities today.  Watching for a shift to risk aversion or the end of the favorable season for equities.  Our goal remains to help investors make more informed decisions.  If interested, you can read about us or take a look at our different levels of service.