Real Interest Rates
Diversification with a solid strategy
Fed Chair Janet Yellen will deliver her inaugural monetary policy testimony on February 11 and 13. Her prepared remarks will be released at 8:30amET and the testimony will begin at 10amET. Goldman, unlike the market of the last 3 days, believes that Ms. Yellen is likely to "stick to the script" in her first public remarks since taking over from Bernanke but they look for additional color on the following issues: (1) the recent patch of softer data; (2) the Fed's thinking on EM weakness; (3) the hurdle for stopping the taper; (4) the amount of slack in the labor market; and (5) the future of forward guidance.
Because the ultimate outcome of this monetary cycle hinges on how, when, or if the Fed can unwind its unwieldy balance sheet, without further damage to the economy; most likely continuing stagnation or a return to stagflation, or less likely, but possible hyper-inflation or even a deflationary depression, the Bernanke legacy will ultimately depend on a Bernanke-Yellen legacy. But what should be the main lesson of a Greenspan-Bernanke legacy? Clearly, if there was no pre-crisis credit boom, there would have been no large financial crisis and thus no need for Bernanke or other human to have done better during and after. While Austrian analysis has often been criticized, incorrectly, for not having policy recommendations on what to do during the crisis and recovery, it should be noted that if Austrian recommendations for eliminating central banks and allowing banking freedom had been followed, no such devastating crisis would have occurred and no heroic policy response would have been necessary in the resulting free and prosperous commonwealth.
Nine Event Risks for the week ahead: identified, discussed and assessed.
Back in December 2013, as we do after every periodic bout of irrational exuberance by Goldman's chief economist Jan Hatzius et al (who can forget our post from December 2010 "Goldman Jumps Shark, Goes Bullish, Hikes Outlook" in which Hatzius hiked his 2011 GDP forecast from 1.9% to 2.7% only to end the year at 1.8%, and we won't even comment on the longer-term forecasts) designed merely to provide a context for Goldman's equity flow and prop-trading axes, we said it was only a matter of time before Goldman (and the rest of the Goldman-following sellside econo-penguins) is forced to once again trim its economic forecasts. Overnight, two months after our prediction, the FDIC-backed hedge fund did just that, after Goldman's Hatzius announced that "we have taken down our GDP estimates to 2½% in Q1 and 3% in Q2, from 2.7% [ZH: actually 3.0% as of Thursday] and 3½% previously."
Ten days ago, the few carbon-based habitual gamblers left in the market stopped and read Goldman's report which, as we said, may have 'just killed the music' with its slam of the market saying the "S&P500 is now overvalued by almost any measure." Recall: "The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock: (1) The P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales; (4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of (6) inflation; (7) nominal 10-year Treasury yields; and (8) real interest rates. Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of (9) Operating EPS and (10) about 45% overvalued using As Reported earnings." Since then, many of Goldman's client must have been displeased that David Kostin refuses to drink from the punchbowl anymore, and sent in their complaints. However, Goldman has refused to budge and issued a follow up defense to its thesis that stocks are overvalued more than at any other time except the tech bubble with "Valuation fact vs. fiction part 2: Responding to common questions about S&P 500 valuation."
"It's dangerous to be short still, but we might be building toward a moment where the market becomes quite vulnerable," warns Bill Fleckenstein who is finishing up the documentation on a new short fund he is about to start marketing. With the slowing growth of the Fed balance sheet, over 70% of the S&P's gains since 2011 from hope-driven multiple-expansion alone, bond and equity market sentiment at extremes, and (as Goldman warned) valuations anything cheap; it is hardly a surprise that, as Reuters reports, after years of hiding under their desks, short sellers are re-emerging - slowly. Whether outright short or long/short funds, the market-share of this corner of the business bottomed at approximately 25% in 2013, but in the last weeks, several S&P 500 companies have seen large increases in shares borrowed for short bets; and the "tide might be turning."
It was all looking so good. NASDAQ was green for the year (so were Trannies), stocks in general were rising and everyone on TV could proclaim how well the 'market' was handling the taper. Then Dennis Lockhart spoke...
*LOCKHART SEES `GROWING CONFIDENCE' IN 2014 OUTLOOK, U.S. ECONOMY ON `MORE SOLID' FOOTING
*LOCKHART BACKS $10 BLN TAPER AS CONFIDENCE IN 2014 GROWS
That's great news right? Wrong? Stocks didn't like it... and NASDAQ rapidly gave up its gains... Fun-durr-mentals remain in control eh? It shouldn't be a big surprise given what Goldman Sachs warned about over the weekend!
"We downgrade the US equity market to underweight relative to other equity markets over 3 months following strong performance. Our broader asset allocation is unchanged and so are almost all our forecasts. Since our last GOAL report, we have rolled our oil forecast forward in time to lower levels along our longstanding profile of declining prices. We have also lowered the near-term forecast for equities in Asia ex-Japan slightly. Near-term risks have declined as the US fiscal and monetary outlook has become clearer. Over 3 months our conviction in equities is now much lower as the run-up in prices leaves less room for unexpected events.... Our US strategists have also noted the risk of a 10% drawdown in 2014 following a large and low volatility rally in 2013 that may create a more attractive entry point later this year."
S&P 500 valuation is lofty by almost any measure, both for the aggregate market (15.9x) as well as the median stock (16.8x). We believe S&P 500 trades close to fair value and the forward path will depend on profit growth rather than P/E expansion. However, many clients argue that the P/E multiple will continue to rise in 2014 with 17x or 18x often cited, with some investors arguing for 20x. We explore valuation using various approaches. We conclude that further P/E expansion will be difficult to achieve. Of course, it is possible. It is just not probable based on history.
Unstable eurozone states are particularly vulnerable to default because they no longer have their own sovereign currencies, putting them in a similar position as emerging countries that borrowed in U.S. dollars in the 1980s and 1990s.
A look ahead into 2014.
This past week the Federal Reserve began tapering their current large scale asset purchase (LSAP) program, more commonly referred to as Quantitative Easing (QE), by trimming $10 billion in bond purchases from the previous monthly totals. This week's "Things To Ponder" is a diverse set of views on the potential effect of the taper on the financial markets and the impact to investors. Regardless of your personal expectations as to the impact of the reduction of liquidity in the months ahead, it is always a good mental exercise to consider opposing viewpoints to balance your own views by eliminating confirmation bias. Here are 5 disparate views on the effect, and potential outcome, of the Federal Reserve's latest move.
"If secular stagnation concerns are relevant to our current economic situation, there are obviously profound policy implications... Some have suggested that a belief in secular stagnation implies the desirability of bubbles to support demand. This idea confuses prediction with recommendation. It is, of course, better to support demand by supporting productive investment or highly valued consumption than by artificially inflating bubbles. On the other hand, it is only rational to recognize that low interest rates raise asset values and drive investors to take greater risks, making bubbles more likely. So the risk of financial instability provides yet another reason why preempting structural stagnation is so profoundly important."
Those who adhere to the don’t-stop-til-you-get-enough theory of sovereign borrowing, and by extension argue for a scrapping of the debt ceiling, couldn’t be more misguided. In free markets with no Fed money market distortion, interest rates can be a useful guide of the amount of real savings being made available to borrowers. When borrowers want to borrow more, real interest rates will rise, and at some point this crimps the marginal demand for borrowing, acting as a natural “debt ceiling.” But when markets are heavily distorted by central bank money printing and contrived zero-bound rates, interest rates utterly cease to serve this purpose for prolonged periods of time. What takes over is the false signals of the unsustainable business cycle which fools people into thinking there is more savings than there really is. Debt monetization has a proven track record of ending badly. It is after all the implicit admission that no one but your monopoly money printer is willing to lend to you at the margin. The realization that this is unsustainable can take a while to sink in, but when it does, all it takes is an inevitable fat-tail event or crescendo of panic to topple the house of cards. If the market realizes it’s been duped into having too much before the government decides it’s had enough, a debt crisis won’t be far away.