A suitable follow up to our earlier post on domestic equity fund flows (which have been negative year to date), and our conclusion that Primary Dealers are merely taking advantage of the ZIRP carry trade, is Rosie's observation that the only entities doing any relevant trading are the prop desks of the Big Five TBTFs. If that is indeed the case, the market, which Rosenberg concludes optimistically is 25% overvalued will certainly face a Black Monday-type correction as soon as the elusive "unpredictable" occurs and the Prop desks as always scurry for cover, with no volume consolidation to the upside. It would be such a wonderful time to truly implement the Volcker Rule as the bank's prop desks, if David is correct, are about to cause some major damage to the market... Of course, it is these very prop desks that are the staunchest opposition to the Volcker Rule and its negative implication on prop trading.
From David Rosenberg and Gluskin-Sheff:
Well, well, the theory that the stock market has turned in a double top may not have gone the way of the Dodo after all, following the reversals we saw in the last two trading days of last week. Negative reversals and distribution days in three of the last six sessions is something to be concerned about if you are long this market — and volume remains tepid at best.
The market is now overvalued by over 25% but is also extremely overbought having gone 24 sessions without a decline of 1% or more, and 89% of the stocks in the S&P 500 are now trading above their 50-day moving averages (see page M3 of Barron’s). The Dow has advanced in 17 of the past 21 days. I mean, even if you are bullish on the outlook, one would have to admit that such a parabolic move is vulnerable to at least a modest pullback… or more. I know what a broken record sounds like and this has been a confounding and confusing market — for both the bears and many (though not all) of the bulls.
Looking at the fund flows, there is only one conclusion that can be reached: This market is being driven by pig farmers. Retail inflows may have picked up of late, but only fractionally. The focus on the part of the individual investor remains on the fixed-income market, for better or for worse (better from our standpoint, worse from the standpoint of my friend and fellow debater Jim Grant).
Institutional portfolio manager cash ratios are back to the rock bottom levels of around 3½% — where they were back at the market peak in October 2007. The shorts have all but been covered. Foreign investors have been few and far between, based on the latest TICS data. The lack of volume speaks volumes — there are no sellers. Investors of all types have been content to just sit and watch their equity position expand via the price appreciation, but there is scant evidence of any follow-through this year in terms of volume buying.
So, that leaves me with a suspicion that the entities doing the buying are the pig farmers. Who are they pray tell? They are the prop desks at the five large banks. They buy and sell securities, with leverage ... to each other! And, these transactions often occur late in the day or in the futures pit after the market closes. There is no sign of any other buyer out there, including the Fed who has been too busy choking on mortgage backed securities and Maiden Lane assets. To repeat, that is why the volumes have been so low.
What we should be aware of about the pig farmers is that they could, at any time, flick the switch in the other direction. What the “trapped longs” may be forced to do — the ones that have been sitting on their hands and have been waiting for the bear market rally to take their portfolio back to where it was at the peaks — at that point is start to sell. That is when the volume picks up ... and accelerates the downside pressure.
Of course, it is always difficult to predict the future, but so many investors are caught in the moment and are being told “not to fight the tape” and simply play the momentum game. They do not see that the current rebound in the economy is a statistical mirage orchestrated by record amounts of monetary and fiscal stimulus that are simply unsustainable and actually risk precipitating a very unstable financial and economic backdrop in coming years.
From our lens, the rally of the last 12 months smacks of the 1930 snapback, and if memory serves us correctly, the S&P 500 went on to hit new lows in subsequent years and the next secular bull market did not start until 1954. I am sure that all the bullish pundits and ‘tape watchers’ were ridiculing the cautious folks back then — just go and have a look at the Diary of Benjamin Roth and you will see how much giddiness there was over the bear market rally and that the worst was over back then. Meanwhile, the lows were still more than a year away to everyone’s surprise — except those who kept their eyes on the forest, not the trees.
Deleveraging cycles take years to play out, even with massive doses of government intervention.
In today’s context, once again few, if any, will know when we reach the peak since there is no perfect market-timer out there that we know of. But the pattern of the past 12 years, when Alan Greenspan embarked on the bailout path with LTCM back in 1998, and the roller-coaster ride that ensued since, it has been just as prudent to take profits after a 70% bounce as it would have been to start adding to equity positions after a 50% decline.
It is clear from the volumes of emails I receive daily that there is frustration among those who think they have somehow missed something important by not being overweight cyclical stocks over the past year. The tone of the responses to my daily musings is eerily similar to the complaints I saw frequently back in 2006 and 2007 — and the advice not to “fight the tape” or to “fight the Fed”. These are just glib after-the-fact excuses for going long the market when nobody really has a good idea on why we should be bullish in the first place.
We hate to break it to the bulls but even with the pleasant rally in risk assets over the past year, there really is nothing to be bullish about when it comes to how the economy is performing now or in the future as all the monetary and fiscal largesse is unwound. Have a look at States Look to Tax Services, From Head to Toe on the front page of the Sunday NYT, as well as Moves to Tax Banks to Pay for Bailouts Gain Steam on page C1 of today’s WSJ.
What we have to constantly remind ourselves is that we are still in a secular bear market, that the S&P 500, through all the numerous peaks and valleys, is still in the hole to the tune of 25% over the past decade, that we are in the classic Bob Farrell stage 2 of the long cycle, which is the “reflexive rebound” phase, and that frankly, there is really no reason to add undue risk to the portfolio except perhaps for the most ardent day-trader.
It’s remarkable how so many people still refuse to accept what history has taught us about post-bubble credit collapses — they do indeed require ongoing government support, but even then we endure five to seven years of economic stagnation. And, that flat line will involve periods of growth followed by periods of contraction but the lasting theme is one of volatility.
For a long while, I have recommended that investors have a read of “The Great Depression: A Diary.” It is the story of Benjamin Roth (a Youngstown lawyer) — the only detailed personal account of the 1930s that has been published. On July 31, 1931, he entered this into his journal: “Magazines and newspapers are full of articles telling people to buy stocks, real estate etc. at bargain prices.” Of course, this was right during the “reflexive rebound” and the market still had 35% to go on the downside before the triple waterfall bear market was complete.
On March 6, 1933, he lamented that “When I started in 1930 to jot down the happenings during the depression I had no idea it would last as long and I did not think I would require more than one small notebook. Now after 3½ years of the worst depression has even seen, the end is not in sight.”
It is very important not to get caught up in the euphoria in the business media and the mania in the financial markets. The most dangerous thing anyone can do right now is extrapolate the stimulus-led bounce of the past year into the future. As Mr. Roth’s diary shows, these post-bubble bouts of giddiness were not sustained, even with the New Deal.
As was the case back then, the investors who end up succeeding are not the ones who are able to play the flashy bear market rallies but the ones who opt for strategies that minimize volatility and optimize risk-adjusted returns. Income, whether it be from paper assets (bonds, dividends) or hard assets (oil and gas royalties, REITs), is going to emerge as king in an environment where the primary trend is one of deflation, which is indeed the case as private sector credit contracts.
The U.S. dollar has been strengthening, gold is sputtering, rents are declining, wages decelerating, core consumer prices flattening and now money supply growth is vanishing. It may take the equity market time to absorb all of this, but for those who believe that at some point the economic fundamentals will come to dominate the landscape, it may pay to gaze at the charts below that depict the current economic cycle relative to the average of its predecessors. These charts show everything from real GDP, to real final sales, to employment, to industrial production, to retail sales, to housing and it is plain to see that this goes down as the weakest post-recession recovery on record despite the fact that it is being underpinned by the most intense level of government support on record. That indeed is cause for pause. [charts attached]
Full analysis courtesy of Gluskin-Sheff