Via ConvergEx's Nick Colas,
The current set of dominant market narratives are so well known as to be cliché. Invest where central banks are pumping liquidity, and short the currency of those countries or regions. Look for growth, and pay any valuation multiple that seems half way reasonable in today’s market. Expect any spike in volatility to wilt like cut flowers in the hot sun, and the Fed to care intensely about stock prices. And maybe that will continue to work in this last month of the first quarter… But it always pays to question the foundations of market assumptions, and today we do just that.
“51 Loaded Firearms and a Chihuahua” isn’t an invitation to a wild party; it is the headline for the U.S. Transportation Security Administration’s blog post this week. In the seven days ending March 6th, 2015 the TSA found all those guns and the one dog in various flyers’ carry on and checked luggage. The dog was evidently taking a nap when its owner zipped up her bag. Security at LaGuardia found the dog and reunited pooch and owner.
Now, let’s talk about the guns. Since the beginning of 2015, the TSA has found 365 loaded firearms in the carry-on luggage of U.S. travellers – an average of 6/day. Some other odds and ends from this week’s TSA haul: 4 other guns (unloaded), 13 stun guns, and 2 large hooked machetes measuring 10 inches apiece. Yes, all in baggage that the owner fully expected to pass through security.
A few other fun facts about what the TSA has discovered passing through their x-ray machines:
- In 2014, the TSA found a total of 2,212 guns in carry-on luggage across 224 domestic airports. The vast majority (83%) were loaded, many with a round in the firing chamber. By comparison, consider that in 2006/2007 the average annual TSA haul of loaded guns found in carry-ons was 812. Yes, in the last 7 years the number of guns found has increased by 170%.
- Top airports for gun finds: Dallas/Ft. Worth (120), Atlanta International (109), Phoenix International (78), Houston (77), and Denver International (70).
- Other notable finds in 2014: 140 inert/replica hand grenades, a knife hidden in a computer hard drive, and a checked bag with 33 pounds of marijuana, 2 disassembled handguns, 350 rounds of ammunition, and some kitty litter (presumable to mask the smell from drug sniffing dogs). The owner was, needless to say, arrested on the spot.
So what’s going on here? The most obvious observation is that Americans own a lot of guns. Data from the FBI shows that last year the Bureau performed 21 million instant background checks on prospective and current gun owners/buyers. That number a decade ago was less than half that level. The fact that the top airports for gun finds are in states where concealed carry is more popular supports the notion that gun ownership is increasing throughout America. So does the growth rate for year-over-year TSA finds of those weapons.
Psychologically, the problem is complacency and inertia. The TSA data shows that many people simply forget that their handgun is in their bag. They know they cannot bring it on an airplane. Like the TV ad says, “Everybody knows that”. But they are so used to carrying their firearm that they don’t even check for it, let alone leave it safely at home.
I think the current set of dominant market narratives are much like a loaded gun passing through an airport x-ray machine. We know better. We know that investing is all about clear-minded foresight rather than assuming today is the same as yesterday. But inertia has taken hold of many capital markets, and money flows resemble a piece of driftwood simply moving with the tide.
Take, for example, volatility – both actual and projected. The last time the CBOE VIX index was over 25 was 5 months ago. For readings over 30 you have to time-travel back to 2011. Yes, Friday’s sell off on the back of the jobs number was dramatic, but the VIX ended the day at 15.2. The long run average is 20, and we are a long way from that. Fading any VIX rally over the past 5 years has been some of the easiest money on offer in any derivative market globally.
The foundation of this complacency in U.S. stock markets is easy to find; it is central bank policy. The Federal Reserve set out, in large part, to create a wealth effect with ultra-low interest rates and capital injections into the financial system. From that perspective, quantitative easing was a singular success. But now we see that the market will struggle with any change in that fundamental construct. Make no mistake – the Fed really should increase interest rates if only to signal that American economic growth is truly self-sustaining. It just won’t be an easy pill for U.S. equity investors to swallow.
Have no fear, however, for the European Central Bank is picking up where the Fed ends. Its quantitative easing program is just leaving the gate, and investors are putting even money on Europe being the winning trade du jour. Consider that of the $32 billion of fresh money invested in U.S. listed exchange traded funds, $10 billion has gone to just two products – HEDJ and DBEF – both of which are currency-hedged Europe or EAFE (Europe, Asia Far East developed economy) equity funds.
Those flows suggest a high degree of certainty in the notion that quantitative easing in Europe and Japan will deliver higher asset prices along with weaker currencies. Risks to that assumption remain. Japan is a country with uniquely challenging demographics and parts of Europe are not far behind. Policymakers have kicked the Greek amphora down the road a few months, but the existential problems remain. Bottom line: money might not buy happiness or a true self-sustaining economic recovery. So how long can it buy higher asset prices?
And then there is the problem of asset price valuations in the U.S. capital markets. At 17x earnings for the S&P 500 and 19x on the NASDAQ, no one can say equities are cheap. The problem for the bears is simple – investors have to put their money somewhere. I know that sounds like a lame explanation, but it is true. The NASDAQ has the same yield as a German 30 year sovereign bond. The S&P 500 yield of 1.8% isn’t far off the U.S. 10 year’s of 2.2%. Which would you rather own for a decade or two or three, even considering risk? With rates so low, stocks could grow more expensive before they finally reach peak valuations.
In the end, I don’t have a problem with high equity prices or even lazy thinking; at issue is the balance of volatility against these factors. Since the market lows 6 years ago, investors have built up a set of beliefs about how markets work. Follow the central bank money. Use the valuation measures of the day rather than assuming any long-term reversion to the mean. Sell any spike in volatility. And, in general, this worked.
But just as with our forgetful gun-toting traveler, investors need to understand that not every day is the same as the last. So check your bags for anything that shouldn’t be there before you leave home. There just might be a Chihuahua in there.
