ATAC Week in Review: What Can Break Treasuries

“We are near, very near, to an end to the eurozone crisis… The worst – in the sense of the fear of the eurozone breaking up – is over. But the best isn’t there yet.” – Francois Hollande

Stocks rallied as yields nudged higher following the prior week’s break in market internals as tensions “eased” in the Ukraine and markets continued to disregard any kind of warning signs that things could get more challenging. Investors and traders turned their focus on the Fed yet again, with the media reciting Yellen’s Jackson Hole comments. I suspect the word “slack” is going to be this year’s taper in terms of frequency of word use, as the Fed debates when to raise rates with wage reflation still nowhere to be found.

What happens in the U.S. may end up being a side show relative to Europe now. More and more traders and investors are convinced that Quantitative Easing in the Eurozone is inevitable, and that we may see bond buying by the European Central Bank by December. I do not disagree, largely because Germany’s economy is now contracting and there is less reason for pushback on large scale monetary action. Inflation expectations have been cratering in Europe, and it remains to be seen if the ECB can indeed reverse that trend.

I have noted before that I find the notion that QE can reverse deflationary pressure curious, given that QE failed to achieve its objectives in Japan and the US. However, if Draghi initiates QE and inflation expectations rise, then European yields likely rise and that could finally break the Treasury uptrend and high correlation over the last several months between stocks and bonds. This is much needed for alternative strategies like our primary inflation rotation approach. In a world where everything is correlated to the upside, the only way to be uncorrelated is to not participate to the same extent. Every time a central bank has initiated QE, yields rose. If this happens in Europe, it would take US Treasuries down and finally create a marginal rising rate environment so many have been wrong on for so long.

As correlations normalize and the Fed gets out of QE, we fully expect more normalized intermarket relationships to take hold, which from the standpoint of tactical trading across asset classes and sectors is a very positive thing for our strategies. Every day we get closer to that type of environment which can meaningfully alter the signaling power of the inputs that go into our primary risk trigger which causes us to rotate into or out of various investable instruments. I continue to be very excited for that environment to reassert itself as it did in 2012 which was a particularly strong year for our ATAC approach.

The coming week will be another one filled with travel for me. For those in Kansas City, I encourage you to sign up to my CFA presentation on predicting stock market volatility and corrections (http://www.cfasociety.org/kansascity/Lists/Events%20Calendar/DispForm.aspx?ID=99). From the standpoint of asset class choice and sector movement, small-caps may begin to stage a period of near-term outperformance, and energy (from a beta rotation standpoint) could finally begin to strengthen after meaningful weakness.

Sincerely,
Michael A. Gayed, CFA
Chief Investment Strategist
Pension Partners, LLC
Twitter: @pensionpartners
YouTube: www.youtube.com/pensionpartners

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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Seven Years Later: What Does the Fed Know?

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“This is about Bernanke. He has to be on that [Bear Stearns] call. Bernanke needs to open the discount window, that’s how bad things are out there. Bernanke needs to focus on this. Alan Greenspan told everyone to take a teaser rate and then raised the rate seventeen times. And Bernanke is being an academic. It is no time to be an academic. It is time to get on the Bear Stearns call. Listen, open the darn Fed window. He has no idea how bad it is out there. He has no idea! He has no idea! I have talked to the heads of almost every single one of these firms in the last 72 hours, and he has no idea what it’s like out there. None! And Bill Poole has no idea what it’s like out there. My people have been in this game for 25 years and they’re losing their jobs, and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing! I have not seen it like this since I went five bid for a half a million shares of Citigroup and I got hit in 1990. This is a different kind of market, and the Fed is asleep. Bill Poole is a shame. He’s shameful.” – Jim Cramer, August 3, 2007

It’s hard to believe that it’s been seven years since the epic Cramer rant of August 2007. In my view, it was one of the most entertaining and fascinating pieces of financial television that you will ever see (click here for clip). The timing could hardly have been better.

It was Friday, August 3, 2007, two months before the ultimate stock market top. The S&P 500 had just closed below its 200-day moving average for the first time in a year, but was still up over 1% YTD.

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Financials were telling a much different story than the broader market as the start of the housing collapse had already begun. The largest financial firms had significant exposure to securities predicated on the belief, shared by the Fed and chairman Bernanke, that on a nationwide basis “housing prices never go down.” That belief was soon to be tested.

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“As Bad as I’ve Seen it in 22 Years”

Bear Stearns stock was plunging after a conference call was held to address concerns stemming from a rating agency action. Standard and Poor’s had changed its outlook for the firm’s bonds to “negative” from “stable.” Sam Molinaro, Bear Stearns’ CFO, compared the last six weeks in the market to the shocks of 1987, the Asian and Russian debt crises of the 1990’s, and the dot-com collapse. “These times are pretty significant in the fixed-income market,” he said. “It’s as bad as I’ve seen it in 22 years.”

Cramer was not happy with the call, saying: “Memo to Bear Stearns: you gotta adopt a Henry Ford attitude here, which is never explain, never complain. And they didn’t do that. You keep your mouth shut during this period, you don’t say a thing…I don’t want to create fear, I like Bear Stearns very much but I think that at this stage, this is not a good call. They shouldn’t have done it. And they should’ve just said you know what, we’re doing well and don’t say another thing.”

Cramer would go on to say that the Fed knows “nothing” about how bad the market environment was, imploring Bernanke to stop being an “academic” and to open the “Fed window.” He also went after Bill Poole, chairman of the St. Louis Fed, likely in response to Poole’s recent comments on the Fed’s role in the market. Poole had said that the “Fed should respond to market upsets only when it has become clear that they threaten to undermine achievement of fundamental objectives of price stability and high employment or when financial market developments threaten market processes themselves.”

Cramer either disagreed with Poole’s hands-off theory or believed that financial market developments were already threatening “market processes.” In either case, he was adamant in saying that lower rates were necessary.

A month later, the Federal Reserve would comply with Cramer’s request, cutting the Federal Funds Rate from 5.25% to 4.75% on September 18, 2007. The Fed would continue cutting rates until December of 2008 when they moved the Fed Funds Rate down to 0%.

Cramer was prescient in his assessment of how bad things were in August 2007, which was in sharp contrast to the Fed’s still rosy outlook. What he and most other market participants likely did not appreciate was that lowering interest rates could not prevent what was to happen next. For it was not simply a liquidity issue; it was very much a solvency issue. Indeed, the Fed lowered the Funds rate from 5.25% to 0% and the S&P 500 declined 57% during that time period. If cutting rates were a panacea, surely this would not have happened.

Seven Years Later: What Does the Fed Know?

The Fed Funds Rate still stands at 0% today, more than five years into the economic recovery that began in June 2009. Financial conditions have normalized, deflation is no longer a legitimate concern, equity markets are at all-time highs, and yields on risky debt are at all-time lows. Why in the world is the Fed maintaining such an aggressive policy stance in spite of these facts? “They must know something” is the common refrain. With the unprecedented boom in all asset prices, market participants are equating short-term market performance with long-term economic insight.

Indeed, the same organization that missed (and whose policies encouraged) the internet and housing bubbles when they were right before their eyes is now being credited with having unique foresight into the future. I have a slightly different view.

Jim Cramer was correct. The Fed knew nothing about the health of the economy in August 2007 and from all the available evidence I can only conclude they know even less in August 2014. They maintain that quantitative easing and 0% interest rates are for the good of the economy but ignore evidence to the contrary that this has been the slowest economic growth and weakest wage growth recovery in history.

Fed4The Fed’s response is that they simply “need to do more.” Perhaps a fourth round of QE and another year of 0% interest rates will do the trick. But as I questioned in a recent piece, do more at what cost?

The Fed will never admit to it, but what they really do know a lot about at this point is not the economy, employment or real wages. What they know a lot about is how to blow bubbles. Indeed, they have likely already created the third financial bubble in the last fifteen years. They pretend to be totally oblivious to the relationship between 0% interest rates and rampant speculation, but we all should know better by now. Their accommodative policies and the “Greenspan Put” helped inflate the internet bubble. Their solution to its eventual bust was the creation of a housing bubble. And their solution to the housing crash was apparently to create an all-encompassing reach for yield and risk bubble, this time under the guise of a “wealth effect.”

When this bubble eventually bursts, we can expect the Fed to do more of the same: deny any culpability and try to inflate once again. Market participants and bad actors will indeed be counting on the latter part as the moral hazard has been firmly engrained by now. The only question in my mind is whether the majority will once again stand for it all, especially as the wealth gap has only widened during quantitative easing and 0% interest rates. As Stanley Druckenmiller has said, quantitative easing has been the “biggest redistribution of wealth from the middle class and the poor to the rich ever.” Indeed, households in the top 20 percent of U.S. socioeconomic groups saw their incomes grow by an average of $8,358 a year from 2008 to 2012, compared with a $275 annual decline for the lowest 20 percent, according to data from the Bureau of Labor Statistics.

Can this really be good long-term policy? And does a policy focused on the creation of bubbles and crashes really promote the Fed’s “dual mandate” of maximum employment and stable prices? I think we all know the answer to these questions but as we’re mesmerized by rising asset prices, we remain silent. Only after a sharp decline will we start pointing fingers, but again, most will be looking for the Fed to do more, not less at that point. With the end of QE coming at the end of October, the debate may come sooner than most think.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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No Bubble, No Problems?

There’s a recurring theme emanating from nearly every permanently bullish pundit right now. I’m sure you’ve heard it. It goes something like this: “I was around in 1999-2000. You have no idea how crazy it was back then. We are nowhere near that level of mania today. We therefore have much, much further to go.”

On its face, it seems like a reasonable statement. After all, 2000 was the peak of the greatest U.S. stock market bubble we have ever seen. A chart of the CAPE ratio (or Shiller P/E) illustrates just how stretched valuations were back then and how we’re  still far from such levels today.

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The issue, though, is that every Bull Market doesn’t go through a 2000-like bubble before it becomes a problem. Since 1929, there have been twenty Bear Market declines in the S&P 500 (roughly one every 4-5 years). Only one of these was preceded by our collective definition of a bubble.

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Therefore, to argue that stocks are a good buy today and can’t go down because they have not yet reached the extremes of the greatest bubble in history is to argue two things. First, that there is a high probability of a similar bubble occurring, and second, that you have the ability to time your exposure to the bubble to insure that you get out before it inevitably bursts.

Today, many would argue on the first point that the probability of a similar bubble occurring is indeed high. After all, the Federal Reserve seems to want this outcome as they have maintained the loosest monetary policy in history five years into the recovery. If market participants are correct and the Fed does not raise rates until next July, it will be six and half years of zero percent interest rates at that point. Investors tend to do highly irrational things when money is this cheap. Thus, while I would not go as far as to say the odds of another dot-com like bubble are high, we cannot entirely rule it out.

What I would argue strongly against, though, is ability of the majority investors to effectively time their exposure to such a bubble. If history is any guide, most investors will not fare well as they have a strong tendency to buy high and sell low.

As we are approaching the 90th percentile of historical valuations (CAPE above 26), make no mistake about it, investors getting in here with hopes of another 1999-2000 bubble are indeed buying high. No, not as high as 1999-2000, but high enough where they should be expecting significantly below average returns over the next 7-10 years.

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Bottom Line

The permanently bullish camp is correct. It is not 1999-2000.  If that makes you feel better about buying stocks here, great, but it is not an argument based on logic.  As we saw in 2007, just because it is not a once in a hundred years bubble, it doesn’t mean there is no risk of a significant market decline. It also doesn’t mean that valuations are compelling and that investors should be expecting above average long-term returns from here. They should not. Something to think about the next time someone tells you a story about how this mania pales in comparison to the epic dot-com bubble.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

 

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New YorkCharlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers on Intermarket Analysis. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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