It’s time to think like a contrarian, warns ConvergEX's Nick Colas. Why? Because capital markets seem as bulletproof as one of those up-armored military personnel carriers you see in war zones. So what could really rattle stock, bond and commodity markets over the next 3-6 months? The go-to answer, steeped in history, is geopolitical crisis, where the logical hedges are precious metals, volatility plays, and possibly crude oil. Look deeper, however, and other answers emerge.
The simplest one is a shallow U.S. recession starting early next year. The causes: slack consumer spending and a slower labor market as corporations take a “Wait and see” attitude into the Federal Reserve’s first rate hikes in eight years. Hedges would include non-cyclical stocks and volatility plays.
Lastly, the most common answer from an ad hoc survey of our peers at ConvergEx: a surprise bout of inflation that forces the Fed’s hand to raise interest rates in a still slow economy. Hedges: volatility plays. But fair warning: it is time to think like a contrarian. But not, perhaps, to invest like one. Yet.
Via ConvergEx's Nick Colas,
Ever see an older man at a nightclub or bar, chatting up much younger women? Or -yes – perhaps, much younger men? He doesn’t have the Russian oligarch vibe – no entourage to order his drinks or hold his cigarettes. And he’s not a friend of the owner, or an A&R guy from a major label, or just one of those super-cool dudes that can just pull it off. No, he is mildly awkward, bordering on creepy. Watching him in action is like a nature show where the aging, toothless lion can no longer hunt for his food. And yet, he persists. Again and again, he (the guy, not the lion) proves impervious to public embarrassment and repeated rejection. But he keeps trying.
After a while, you realize that there is a reason for all this: it worked once, and probably fairly recently. For reason or reasons unknown, that aging Romeo found his Juliet and for one day in late fall it felt like summer. At least to him. And because it worked once, he tries again. Just hang around long enough and you will see it happen.
Take away the awkward desperation, and this paradigm broadly fits the price action of risk assets like global stocks and derivative markets at the moment. Today was a good example. Take one part mini-banking crisis in Portugal, add some weak European economic data, and mix with a twitchy U.S. market and you should have had a day-long sell off. Instead, the open was the low. Equity buyers stepped in, using exchange traded funds, and the U.S. stock market lifted most of the day. Why would investors step in, especially with news that would have sent them running just a few years ago? Because every single pullback for over 5 years has been a buying opportunity in U.S. large cap stocks. Every. Single. One. Equity markets have trained investors to keep buying, so while the bull market is +5 years old, it still thinks it “Has it…”
So what could be the shock that ends this persistent pattern? I got asked that question on television today, and I punted. The truth is that any really bearish case is hard to describe without sounding like you are stepping into the realm of fantasy. But the reality is that an ever-up trending market is the actual fantasy. With all that in mind, here are three events that would finally cause that elusive 10% correction and enough actual stock market volatility to get the CBOE VIX closer to 20 than 10.
Geopolitical risk. This is the most common answer to the question “What could hurt stocks?” At the same time, the devil is in the details. Israel’s relationship with the Palestinians is tragic for both sides, but neither side is a major oil producer. So however bad that problem gets, it is unlikely to force oil prices higher. Also, keep in mind that Israel has been in hot and cold conflicts with its neighbors since its founding in 1948. None of the headlines we see about the latest problems are new. Sad, yes. Novel. No.
To really inject fear into capital markets, you need to disrupt oil supplies with a short sharp shock. Think the Saudi embargo in 1973, or the Iranian Revolution of 1979. Then there is Saddam Hussein’s invasion of Kuwait in 1990, and the post-9/11 Gulf War II. Four major events in the last 40 years. That pace makes an oil shock something more than a bolt out of the blue, but less than a persistent threat. If you want to include the short period in 2008 when Crude went to $140/barrel, that would be a fifth. Whether that liquidity-driven bubble would have created a recession even without the Financial Crisis, we’ll never know. But make no mistake – a quick move up for oil prices always pushes equities lower. Always.
Recession. Yes, I said it. What if the yield on the 10-year Treasury at =/- 2.50% is right? One way to explain this parlous payout is that fixed income markets forecast a long period of slow growth and modest recessions, eliminating the threat of inflation. At +5 years of ‘Expansion’, we are due for a recession just based on historical averages. Just consider how quickly expectations for a robust 2014 collapsed under the weight of a few feet of snow this winter. Or the way economists gave up on a robust Q2 2014? The smart money seems to be on a 2% run rate for the second half, and that seems reasonable enough.
But what happens in early 2015? Will companies continue to hire as the Federal Reserve embarks on its first rate increases in 8 years? And will consumer spending finally accelerate? Anyone who lived through the 1994 rate cycle - a violent rotation of both capital and sentiment – knows not to diminish the impact of a rising rate environment. For proof, a quick quiz. What were Fed Funds on Christmas 2007? Answer: 4.25%. Pretty normal times, those. Now how long do you think it will be before the Fed gets to a 4.25% Fed Funds rate now? And can the economy continue to expand as we get there?
The old guy at the club gets kicked out. As I canvassed ConvergEx staffers about their most-likely downside scenario, their most common answer was a rising rate of inflation. This would force the Federal Reserve to raise interest rates Volcker-style, threatening or even causing a recession to dampen rising prices. Certainly, a burst of inflation would challenge the Fed in a way not reflected in equity prices. The fact that inflation has remained calm (unless you have a child in college, or a parent in need of medical care, or are inordinately fond of breakfast foods) doesn’t make this concern any less valid. The road to Hell is paved with good intention, after all.
In summary, it is important to keep the worry-wart playbooks close at hand. After all, it wasn’t all that long ago that our aging Lothario looked more like a bear than a bull. It is time to think like a cautious contrarian, even if the current market still rewards the brave. Remember – it works until it doesn’t.