Over the past week, I’ve collected my thoughts, looked at the world in a few different ways and am becoming more convinced that being short is the right trade, and for long only accounts, a time to reduce risk not add risk. There are lots of moving parts out there, but I think the bull arguments are far weaker than they appear on the surface, and that the long trade is extremely crowded, especially given how little liquidity there is.
Fight The Fed
The Fed first cut the target rate from 5.25% to 4.75% on September 18, 2007. Remember when 50 bps was a big cut and not twice the target rate? The S&P 500 was 1,477 the day before the cut. It popped 43 points that day to close at 1,520. It got as high as 1,565 in October and has never been above there since. So in a 5 year period where the Fed has been more aggressive than any other central bank known to mankind, the Fed is still losing. Before going further, think about what the Fed has done since that first rate cut and where stocks are now.
I am not looking to go toe to toe with the Fed for 10 rounds of a bare knuckle brawl, but “don’t fight the fed” as an effective investment strategy has a lot of flaws.
Also contrary to the universally accepted wisdom that QE ensures good stock performance, we show QE isn’t a cure all for stocks and then many other things, including powerful earnings growth (which we neglected to mention) helped power stocks. On an even more basic level, the initial QE1, didn’t turn stocks around immediately, and stocks in fact sold off for months and hit record lows after QE was announced.
Europe “Gets It”
I thought they did, but they don’t. They need to ask for the money, get the money, and spend it. It really is that simple, yet here they are talking about leveraging ESM in an effort to avoid spending money and scaring the market into submission. As we wrote about in manana manana manana Europe continues to miss the opportunity to fix the economies and banks and seem determined on forcing yet another crisis before taking definitive action.
Underperforming Funds and Cash on the Sidelines
The concept that underperforming funds will plow into stocks resonates well with people but is likely wrong. It is appealing because the underperformers will now chase up your good ideas. You benefit even further from the mistakes they made in the past. Human nature loves that sort of thing.
The reality is much of this has already gone on and we won’t get much more. The dilemma facing an underperforming fund is far more complex than that. In my opinion, the die-hard bears would rather explain how they missed some of the rally, than risk getting long, just as the market sells off. That stubbornness is also a trait many of us have.
In any case, the math just doesn’t justify the trade idea. Without using leverage, the underperformers will never catch up. The underperformers this year, were cautious or bearish, so the likelihood of them abandoning their style en masse and leveraging up the highest beta sectors seems a stretch. It isn’t like people are running around saying how cheap stocks are, or how good earnings look, it is all about central bank intervention. I don’t see the performance chase happening anymore than it already has, and there are few weaker longs, than a bear who got long in a desperate move to save their year.
Which brings us to the “cash on the sidelines” arguments. From what I can tell, mutual funds are actually running quite low cash levels. There isn’t a great deal of cash at the long only funds, so this alleged stockpile of cash is at hedge funds.
It makes me wonder if any of these analysts have ever looked at what a hedge fund does, or if they understand the concept of margin, futures, long/short, OTC derivatives. Any of those strategies/tools, used by funds, require cash to sit on the hedge fund balance sheet. They need the cash for margin calls, or if they use futures, they have so much leverage at their disposal, they would never tie up their cash. Hedge fund cash balances are not a particularly useful way to judge how exposed funds are or aren’t to the market.
Historical Relationship to Treasuries
There is another wave of recent research showing how cheap stocks are compared to treasuries. You cannot ignore that. Many historical relationships between stocks and bonds have broken down, and offer some compelling arguments to get long, but they all ignore one key premise. The Fed now owns almost 40% of 10 year treasuries and that may explain changing relationships as much as anything. As we wrote about in Oranges in the USSR we have to question some long held assumptions. What has the Fed done to the market. Ignoring the potential impact the Fed is having is convenient, because it is simple, but may be the critical reason why these long term relationships have broken down.
I was not concerned about VIX back in August because if anything, too many people were talking about it. There were lots of reasons to ignore VIX back then, many of them are still in place, yet I can’t shake this feeling that now, low VIX is a more serious sign of complacency.
I don’t see a trigger event, but what happens if all the “offer lifting push it higher” algos that hope to sell to momo’s and shorts moments later, find that the money making is to “smack bids” and catch a puker later? High Frequency, Algorithmic trading, or at least some subset of it, seems to feed on current direction. If that direction of choice becomes negative, I am extremely concerned about well the market can respond. Are there many humans on the bid side?
Even in the corporate bond world, which everyone still is in love with, I detail some risk of Negative Feedback Loops that could turn a mild correction in a strong market, to an overbought, mark to market and arb driven sell-off.
Every iPhone 5 announcement seemed to add $1 billion to Apple’s market cap. To generate $1 billion of profit, Apple needs to sell about 5 million iPhone 5’s. Somehow the relationship between market cap and sales seems to be getting out of whack. Also, in spite of the hype, I found phones available at 2 different locations. I also am intrigued by the fact that even at the Apple stores, most of the phones are being sold on 2 year plans. Consumers have adopted a conditioned response to phone buying. They wait til the end of their service contract so they can buy a new, subsidized phone. Depending on how many contracts are expiring, the marginal improvement of the new phone, and the subsidy rate, the consumers may change behavior. To me, this behavior doesn’t attract the attention that is warranted. Yes, the new phone is great, but would anyone pay full retail for it? What would opening week sales have been if it wasn’t planned for so long and enabled by carrier subsidies? I own Apple products, like some of them more than others, but see more and more signs of a bubble mentality in Apple share prices. Without Apple leadership, the US markets will struggle.
Given how bearish my comments sound, I’m not at extreme levels of bearishness. I’m saving room because we may see some positives out of Europe, the QE announcement may draw in more money, so I’m not max bearish. That time may come, but for me at least, it’s not yet that time.