Here we go again, creating another asset bubble for the third time in a decade and a half, is how Monument Securities' Paul Mylchreest begins his latest must-read Thunder Road report. As Eckhard Tolle once wrote, “the primary cause of unhappiness is never the situation but your thoughts about it," and that seems apt right now. After Lehman, policy makers went “all-in” on bailouts/ZIRP/QE etc. This avoided an “all-out” collapse and bought time in which a self-sustaining recovery could materialise. The Fed’s tapering threat showed that, five years on from Lehman, the recovery was still not self-sustaining. Mylchreest's study of long-wave (Kondratieff) cycles, however, leaves us concerned as to whether it ever will be. More commentators are having doubts; and the problem looming into view is that we might need a new "plan." The (rhetorical) question then is "Have we really got to the point where it's just about more and more QE, corralling more and more flow into the equity market until it becomes (unsustainably) 'top-heavy'?"
Policy makers are pushing monetary systems and experimental policies to their limit, so shouldn’t we consider the possibility of correspondingly extreme outcomes in financial markets in due course... cause and effect?
No Plan B?
After Lehman, policy makers went “all-in” on bailouts/ZIRP/QE etc. This avoided an “all-out” collapse and bought time in which a self-sustaining recovery could materialise. The Fed’s tapering threat showed that, five years on from Lehman, the recovery was still not self-sustaining. Our study of long-wave (Kondratieff) cycles, however, leaves us concerned as to whether it ever will be. More commentators are having doubts, e.g. Andrew Law of Caxton in the recent FT interview. The problem looming into view is that we might need a new “plan.”
Does the incoming Fed Chairwoman have a new plan and, more importantly, one which could work? We have our doubts, the default strategy being continued reliance on liquidity-driven asset bubbles, while hoping for the best in terms of traction with the real economy. Our colleague, Andy Ash, commented last week.
“The biggest impact of QE1 was on metals and EM (emerging markets) indicating that the result of QE was predicted to be growth. The three lowest beneficiaries of QE3 have been Gold , Metals and EM, all SIZEABLY NEGATIVE IN RETURNS. So QE3’s effect unlike QE1’s has been nothing to do with global growth. The biggest return on QE3 was/is Western equities.”
If the US is locked into low growth for the foreseeable future, should the S&P 500 be trading on a 12-month forward earnings multiple of 16.2x, slightly higher than the 15.5x long-term average? Let’s not forget that Europe appears to be stuck in an even lower growth scenario and China’s growth rate is moderating. Moreover, corporate margins are close to an all-time high and earnings forecasts are being progressively downgraded.
So higher and higher valuations for more distant, and (arguably) increasingly uncertain, cash flows.
With the temporary deal agreed in Washington, QE looks set to continue running at US$85bn until March 2014, maybe longer. We’ve written about the QE/repo linkage a lot in recent months and it’s our opinion that the collateralisation of excess deposits created by QE has positively impacted equities via shadow banking conduits, e.g. repos.
Even the US Treasury (Treasury Borrowing Advisory Committee report for Q2 2013) noted the correlation between weeks when QE exceeded US$5bn and strength in the S&P 500.
Have we really got to the point where it’s just about more and more QE, corralling more and more flow into the equity market until it becomes (unsustainably) “top-heavy”?
Trying to Make Sense of Bubbles
If we are in a centrally-planned bubble (and it feels like it to us), we are reliant on second guessing policymakers, trying to gauge flows (positive for equities right now) and utilising any indicators which seem to be showing good correlations. An example of the latter is the Summation Index. This is a measure of market breadth, being a running total of Advance minus Decline values of the McClellan Oscillator. A pattern of declining peaks had formed since the correction in late-May, but this reversed with the recent upward move.
We are still in the biggest debt crisis in history and the banking sector will remain at the centre of its ebbs and flows. The divergence of the sector’s performance from the broader market pre-empted the Lehman collapse in 2008. In the US, we are keeping a close eye on the breakdown in the BKX.
In such extreme circumstances, we should also keep an idea of “crash patterns” in the back of our minds in case. These often play out as a peak followed by a failure to make a new high and a subsequent break of support. Here are some notable examples.
A final word on equity market indicators. In our reports since May, we’ve been “road-testing” a model for the US equity market (using the DJIA which has a longer history). It is based on cycles, not economic indicators, but cycles in time. It is created from the interaction of 18 cycles in US equities. These vary in length from just under 3 months to more than 30 years. Most of these cycles were discovered by the Foundation for the Study of Cycles (FSC), which has published a vast body of work during the last 70 years. We’d like to make contact with any readers who’ve also looked into this type of work, as trying to incorporate it into our research is very much work in progress.
While in its very early days, the model has been a reasonably good predictor of market direction since the beginning of 2009 (having also picked out most of the market peaks and troughs since 1905). We are slightly alarmed because it’s predicting that the Dow should be rolling over now into the first part of 2014.
Buying time in a brought forward world
Manipulating the Time Horizon
We’ve been reflecting on the idea that using unconventional monetary policies, i.e. QE at the long end of the yield curve, central banks have “bought time” in a profound sense by manipulating the time horizon. This leads to longer-term cash flows associated with financial assets being discounted at artificially low rates. It has been crossing our minds as to how much equity investors have really considered this issue, even if (like us) they are believers in equities overcoming bonds in the inflationary endgame (see “Inflationary Deflation” report from December 2012?
Fixed income investors are acutely aware that QE has forced them to extend duration. That comes with the scary knowledge that they might all rush for the exit at the same time. While many financial assets have long duration, equities have very long “duration,” often reflecting theoretical cash flows to infinity. Equity investors typically make detailed estimates for corporate cash flows, e.g. for 7-10 years. Beyond that, cash flows to infinity are capitalised (using long-term growth rate assumptions, ROIC fades, etc) in the form of terminal values...or until analysts predict that the deposit/reservoir will be depleted in the case of mining/energy stocks. QE obviously keeps rates lower than they would otherwise be and increases the value of these capitalised cash flows - especially more distant ones.
When we think about long-term economic cycles, one of (if not) the biggest single driver is the growth in debt (and, problematically, its eventual reduction at the end of the cycle). If we consider the US economy, the huge increase in debt has brought forward consumption over an extended period of several decades. That process has become increasingly “long in the tooth”, so it’s hardly surprising that credit and consumption growth is currently subdued.
When so much consumption has already been “brought forward”, it might seem counter-intuitive that the valuation of distant cash flows is being inflated via PEs above their historic average AND artificially suppressed interest rates. When you also consider that corporate margins are close to a historic peak, the market takes on the appearance of an athlete that is expected to continue performing at peak level almost indefinitely.
Hmmm, as Grant (“Things That Make You Go Hmmm”) Williams might say.
It Should Work Both Ways
In a world of US$85bn per month QE, the corollary of the discussion above should be that the valuation of long duration financial assets should be unusually sensitive on the downside to anything that threatens this current “buying time” and “brought forward” model for long-term financial assets. The obvious candidates are:
- A rise in interest rates; and/or
- An event which leads to a significant contraction in the time horizon for investors, such as a sudden deterioration in the macro outlook, or a geo-political shock.
The market turmoil induced by Bernanke and his colleagues with the taper threat (quickly watered down and subsequently canned) seems entirely fitting in this light. The consequence is that the Fed’s ability to taper looks ever more serious with regard to asset prices. This is the two-way version of the “Stockholm syndrome” between the Fed and markets we’ve highlighted before.
Full Thunder Road Report below: