Observations On The Psychology Of A False Market Rebound
A recent note out of permabullish ward of the state BofAMLCFC (makes sense why they would be permabulls: after all nobody asks why CNBC is a non-stop propaganda mouthpiece for pro-market, pro-GE, pro-stimulus policies... everyone makes fun of it, everyone cracks up at Kudlow and company, but nobody questions it - it does, after all, make complete sense when one considers their agenda is to have all their ever diminishing viewers purchase however many shares of their soon to be former employer GE, even if it means said viewers financial ruin in a month or a year) shares some interesting perspectives on what would happen if a market that is priced for absolute perfection does not end up occurring (or, scarier, does). The note below out of Sadiq Currimbhoy, Merrill's Hong Kong strategist should be kept in mind any time readers enjoy the rosy propaganda from Merrill's David Bianco, which has the form, consistency and texture of two-ply Charmin'.
We thought we would break [down how markets trade after traumatic events] into 3 stages.
Stage 1: The bounce from the low
After what appears to be a monumental collapse, it is met with monumental policy response. With different stimulus and rescue packages plus extremely easy monetary environment, and almost certainly market overshoot, there is a strong recovery rally.
Stage 2: The data improves
Stage 2 is where we think we are now, as the economic data initially surprises on the upside and then the data continues to show incremental improvements. In the coming months, we will see just how much export growth will be following the near -50% base effect. This we think will grind equities higher. Our global team is very bullish global equities and thinks there will be a “bond/cash to equity” switch. [Again, nobody is surprised... Just gigglish]
Stage 3: “Its sustainable” – but of course, it is not
Stage 3 is when investors think that the rally is sustainable and there is a new paradigm of recovering growth. This is of course rarely the case. Policy makers’ typical objectives are not to set a new stage of progress but rather to prevent a collapse of the previous one. Everything is done to keep the old system as much in place as possible to avoid a much larger economic collapse. Eventually reforms have to be put in place.
“You can’t fight a debt problem with more debt”
In this cycle, we do think the key issue preventing a sustainable upswing is that you cannot fight a debt problem with more debt. Japan did try that and unfortunately has yet to show any signs of success. Furthermore, there is greater political pressure to create a different regulatory environment to correct what has been a massive moral hazard created. There is still no sense that this is getting any way near being resolved.
One factor that could bring forward any top or indeed drag out the rally is how inflation expectations are moving. We do think given the levels of unemployment and output gaps, controlling inflation expectations is almost more important than inflation. These expectations are, given where we are in the cycle, we think elevated. We look at US 5year5year forward breakevens (calculated from the TIPS markets) and these remain stubbornly high despite the higher unemployment rate and output gaps (see the chart to the left). In the last recession 10 years ago, these breakevens were 80-100bps lower. We think that this represents some concerns over the Fed’s credibility. The good news is that they remain somewhat below the 2.5% level. However if we are right and the economy continues to recover, then the Fed may have to respond by raising rates sooner than investors might think. All of these suggest to us that the outlook in the coming quarters is that policy risk remains very high and the outlook remains murky.
So there you have it: when even the permabulls at the successors of a bankrupt Merrill Lynch say be careful what Kool Aid you drink, the bottom line is that every day's market move is the same as flipping a coin. The truth is that nobody knows what is happen one day down the line, let alone one year. Which is why as less and less people trade with a market increasingly disjointed with fundamentals and inflation expectations, the only ones who profit from equities, are the intraday momentum traders, whose market impact is felt ever more strongly, now that traditional market players are solidly out. The complete lack of direction is the only reason why the market keeps melting up on ever lower volume: it has worked in the past, so why screw with it. And every time there is even a hint of a correction, the volume spikes to the downside, unitil the same small volume momentum manipulators can step in after hours courtesy of leveraging futures positions break any increasing volume reverse momentum and reposition the market for the same old low volume creep ever higher. And this is precisely the environment in which both good and bad economic news get translated into exclusively good market news. The problem is, of course, all the gains on the ever decreasing margin, are paper. And when the conviction of the true direction of the economy (ironically better would be worse for equities) is uncovered, watch out below as one after another every "dumb" money manager hits the sell button.