One of the biggest mistakes that investors make is falling prey to cognitive biases that obfuscate rising investment risks. Here are 5 counter-points to the main memes in the market currently...
While the Bank of England's chief economist, Andrew Haldane, admitted that reviving investors’ appetite for risk was one of the forgotten goals of central banks, he notes there are concerns that risk is not being "removed" but changing shape and migrating to more liquid markets but that should not be a problem as "monetary policy can on occasions have a role to play in ensuring against these financial stability risks..." i.e. the market put. His biggest concern is the aggregation of derivatives clearing which could be a "problem from hell" but he notes the future will not be the same as the past as "volatility in financial-market asset prices will be somewhat greater," and that interest rates will not 'normalize' to the levels of the past.
Pending home sales surged by 6.1% MoM in May; this is the largest jump since April 2010 (when first-time buyers scrambled to sign contracts before tax credits expired. However, exuberant spike aside, this is the 8th month in a row of a year-over-year drop in home sales. NAR is ever-optimistic suggesting "sales should exceed an annual pace of five million homes," amid low rates, inventory and job creation (goldilocks?). The sales, unsurprisingly, are all high-end: "The flourishing stock market the last few years has propelled sales in the higher price brackets," as lower-cost home sales plunge.
As individuals, it is entirely acceptable to be "optimistic" about the future. However, "optimism" and "pessimism" are emotional biases that tend to obfuscate the critical thinking required to effectively assess the "risks". The current "hope" that Q1 was simply a "weather related" anomaly is also an emotionally driven skew. The underlying data suggests that while "weather" did play a role in the sluggishness of the economy, it was also just a reflection of the continued "boom bust" cycle that has existed since the end of the financial crisis. The current downturn in real final sales suggests that the underlying strength in the economy remains extremely fragile. More importantly, with final sales below levels normally associated with the onset of recessions, it suggests that the current rebound in activity from the sharp decline in Q1 could be transient.
"Why would anyone pay an advisor and reduce their returns when all one had to do was point-and-click their way to wealth." Near each major market peak throughout history, there has been some "new" innovation in the financial markets to take advantage of individual's investment "greed." In 1929, Charles Ponzi created the first "Ponzi" scheme. In the 1600's, it was "Tulip Bulbs." Whenever, and where ever, there has ever been a peak in "investor insanity," there has always been someone there to meet that need. In that past it was railroads, real estate, commodities, or emerging market debt; today it is investment advice. The latest innovation to come to market is what is termed "Robo-Advisors." That is the cycle of innovation in the financial market place. Despite the best of intentions, and advances in innovation, humans will always seek out the comfort of other humans in times of distress. The rising notoriety of Robo-advisors is very likely the symbol of the current late stage "market exuberance."
While Morgan Stanley's lower-than-consensus economic expectations for the US economy splits the difference between an economy where people remain hesitant to take on risk, essentially extending the post-crisis pall, and one where they embrace risk in the manner of a more typical post-WWII cyclical expansion; their alternative scenarios (at either corner of the goldilocks world) make one wonder just what the catalyst will be to release the kraken of better-than-subpar growth...
Over the last few years central banks have had a policy of quantitative easing to try to keep interest rates low – the economy cannot pay high energy prices AND high interest rates so, in effect, the policy has been to try to bring down interest rates as low as possible to counter the stagnation. The severity of the recessions may be variable in different countries because competitive strength in this model goes to those countries where energy is used most efficiently and which can afford to pay somewhat higher prices for energy. Whatever the variability this is still a dead end model and at some point people will see that entirely different ways of thinking about economy and ecology are needed – unless they get drawn into conflicts and wars over energy by psychopathic policy idiots. There is no way out of the Catch 22 within the growth economy model. That’s why de-growth is needed.
Borrowing heavily from Albert Edwards "Ice Age" analogy of our new normal, PIMCO's Bill Gross, after explaining why he does not have a cell phone, discusses the "frigidly low" levels of "The New Neutral" in this week's letter. Confirming Ben Bernanke's "not in my lifetime" promise for low rates and a lack of normalization, Gross explains that the "the new neutral" real policy rate will be close to 0% as opposed to 2-3% (just as in Japan) leaving an increasingly small incremental rise in rates as potentially responsible for popping the bubble. Gross concludes, "if 'The New Neutral' rates stay low, it supports current prices of financial assets. They would appear to be less bubbly," clearly defending the valuation of bonds knowing that he can't expose stocks as 'bubbly' without exposing his firm to more outflows.
During the first internet boom, the business model of South Park's Underpants Gnomes was commonplace, as scores of companies flooded the marketplace, sustained purely by the promise of future profits that would somehow magically appear. As Grant Williams scoffs in his most recent letter, it was the corporate embodiment of George Costanza’s “yada, yada, yada”: “First we build a company... yada, yada, yada... we make billions.” Of course, most of these companies went the way of the dodo; but remarkably, a mere 14 years after the bursting of the original internet bubble, there are signs of what Yogi Berra so beautifully referred to as “déjà vu all over again” - signs which some real heavyweight financial minds have recently highlighted...
These two charts depict the same index over the same time frame, but they reflect two stories and two economies.
Does this look in any way normal to anyone?
Simply put, there are three downside risks for markets - that appear to be off the 'meme of the day' beaten track of any average investor nowadays eyeing the record highs and gloating at any bear left standing:
1) China has shifted from a monetary policy of choice to a monetary policy of necessity.
2) The Narrative of Fed Omnipotence continues to reign supreme, but now in a tightening monetary policy environment.
3) The Hollow Market is cracked open by well-intentioned but destructive regulators.
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What is an underlying explanation that can account for Momentum failing and Value working, but Quality NOT working? When one of my colleagues here at Salient saw these charts he said, “looks to me like the market is trading on a narrative of risk appetites and fear rather than toward some notion of seeking fundamentals or selling overbought growth stocks; otherwise Quality would be working, too.” To which I replied, “Amen, brother!” The notion that this market sell-off is limited to biotech or Internet or some other high-flying sub-sector because the market “realized” that these stocks were too expensive or out of concern with earnings this quarter (both explanations that I’ve seen of late in the WSJ and FT), just doesn’t hold water. These high-beta stocks are being hit hardest because they are at the epicenter of a broad market or beta earthquake. This is what it means to be high-beta…you live by the broad market sword and you die by the broad market sword.