Market Fundamentalists Beware: Fed To Blame For Volatility
I apologize in advance if this week’s commentary is a little shorter than normal. I was at a client dinner in Palm Desert last Wednesday night when my wife called to say our daughter had broken her arm in a fall at the park. I rushed back to Newport and two hospitals later, an ambulance ride, a surgery, and 36 hours in CHOC, and we are now home. I actually had a lot of time in the hospital to read but the full writing project of the week didn’t quite enjoy it’s normal focus and time. The important thing is Sadie is okay, home resting, and the doctor is adamant that she will heal nicely. It was a really bad break, and there is just nothing in the world as awful as seeing your daughter in pain, but we are grateful to be home and through it. With all of that said, let’s get into this week’s commentary, for surely there is much to comment on regarding the market environment in which we find ourselves.
- The market rallied in a big way last Monday, Wednesday, and Friday coming off of big sell-offs the week before as the market felt that the Federal Reserve was pointing to an extended period of zero interest rates
- Timing this market volatility is going to crush people
- Alternatives should be in a portfolio to help diversify equity beta risk, not to add to it. Same for fixed income.
- In the short term, markets are popularity contests. In the long run, they are weighing machines (and what they weigh is earnings)
- There is one way to prudently manage money – and that is with the long view
Before you talk about specific days this week, what is the general explanation of the overall market volatility we see day by day and week by week right now?
Some market participants may find this something to cheer about (I am not one of them), but there is one reason for the violent up and down movements of the last two weeks, and that is the Fed. On days where the market feels continued Fed assistance is here (Mon, Wed, and Fri of last week, for example), risk assets rally and treasury yields drop. On days where the dollar is rallying and Fed tightening is expected, the opposite happens. NEITHER of these catalysts have staying power – they are not fundamental, and they are not indicative of a lasting or real economic or earnings paradigm. But in this current landscape, markets are obsessed with (a) what the Fed will do, and (b) what other market participants think the Fed will do, and (c) how market participants will react to what those market participants think the Fed will do. You did read that correctly – the market is jumping around based on how people think the market will jump around. It is the worst possible environment to be a fundamentalist in, and I am a fundamentalist.
Were you surprised at the posture the Fed took this week and the language/mood indicating a much longer period of easy monetary policy ahead?
I challenge anyone who has read this commentary to claim I was surprised. =) My forecast (heavily reiterated just last week) is that the sell-offs we see based on fear of the Fed getting tight and normalized have been the silliest, shortest-lived sell-offs in recent memory. We have had a lot of them over the last five years, and we have had a lot over the last three months. I am well aware of the fact that the Fed will, at some point, stop bluffing, but I believe they will begin tightening and implementing monetary logic when they are FORCED to, and not a minute sooner.
What was behind the big rally last Monday?
I think at this point it is not worth it to question what causes a given day’s big move up or a given day’s big move down, because the volatility levels are so elevated that we are having these one after another. In a broader and more meaningful sense, the elevated volatility centers around macro uncertainty and a reality check around the Fed potentially pulling some of the backstop markets have grown accustomed to. But on a certain day’s particular action any number of things may be the specific catalyst. Monday of last week I believe it was technical buyers coming into the market after the sell-offs a few weeks ago, and it was the Chinese premier promising “more government support for the economy” (whatever that means). Some head fake towards fiscal or monetary propping whether it be in China, Japan, Europe, or the United States are all loved by markets everywhere (short term).
What about last Wednesday and Friday?
Pure direct Fed language. The implicit wink and nod from the Fed that they will remain patient (regardless of language) was all that was needed to sell off the dollar and rally stocks. The Fed’s forecast of slower than expected GDP growth, lower than expected core inflation forecasts, and a macro economy that is “moderating” (where before they said “expanding”) told the market exactly what the Fed thinks: This economy needs more morphine and we’re not about to unplug the patient.
Do you find this current volatility to be opportunistic?
Really I do not. I have worked very hard and been very disciplined to get client portfolios positioned the way I want them to be. To try and trade around day by day volatility once I am in a position of target allocation is very risky, almost always futile, and generally quite tax-inefficient. In fact, because most of the things affecting markets right now are inherently non-fundamental I am actually far more committed to that unimprovable conviction from the late, great Benjamin Graham: “In the short term the market is a voting machine; in the long term it is a weighing machine.”
What is the warning you would offer to investors pursuing diversification with both bonds and alternatives?
The S&P 500 has a negative correlation with Treasury bonds and a negative correlation with the aggregate bond index. But it has a positive correlation (a highly positive one) with High Yield bonds as well as with most “nontraditional” bonds (think of unconstrained or flexible bond categories). The equity market traditionally has a negative correlation with managed futures but can have a highly positive one with such categories as Long/Short equity. I highly recommend that if the objective of the various fixed income (bond) and alternative strategies you implement into a portfolio is to create lower correlation with broad stock markets, that the nature of the bond and alternative strategy you are using be understood in this regard.
Is the only reason to use alternatives to find low correlation with equities?
Not necessarily. Sometimes the broad correlation may be high but the execution or specific source of risk may be quite different. It just takes thoughtful intentionality within the portfolio construction process. This is something we take very seriously at The Bahnsen Group.
What are you seeing as the effects of Japan’s massive currency depreciation so far on their economy?
One of the major objectives in weakening one’s own currency is to theoretically improve the country’s competitive standing by making their exports more attractive. Of course, this depends on the health of your BUYERS as well, and with 18% of Japanese exports going to a slowing China and 10% going to a morose Europe much of this desired effect is being offset. The other issue is that Japan is a net importer of energy, right at the time energy costs are making new lows. This is not helping their trade deficit. I believe their real objective (primarily) is exporting deflation, and they are doing that, but to the extent they accomplish that without structural reform I think it will gain them absolutely nothing.
Are you considering an increase into European equities?
I maintain a focus on the risk/reward proposition which I believe is unfavorable to European equities, whether or not they go higher in price from these present levels. The trade-off is not attractive to me. With that said, as a dividend-growth investor I am bottom-up meaning if the right companies are growing a sustainable and attractive yield I will go anywhere to buy that.
The single number one thing holding the price of U.S. Treasuries up and yields down?
Foreign demand, period. There is unfathomably high increase in foreign purchase of Treasury supply which has pushed prices higher and yields lower.
Are you in the camp that improving U.S. jobs data reflects a strengthening U.S. economy?
I am not. Here is what I know: Industrial production underwhelmed, factory orders are down, manufacturing production fell, and durable goods production was weak. Capacity utilization rates are falling which of course is not good for Capex. The only production we see increasing is in the utilities space. Will all this mean a Q1 GDP number that disappoints? I suspect so, but regardless, it won’t be a GDP number that lifts markets (in my opinion).
What most stuck out to you from the Fed report last Wednesday?
I have been speculating for six months that the strength of the dollar would turn into an excuse for the Fed to delay normalizing interest rates. This week, for the very first time I can remember (ever), the Fed talked about “weakening export growth”. The Fed has always said they are “data dependent” around prices and jobs; this week, that sure looks to me to be inclusive of dollar strength.
What is the Fed’s desire for the Dollar at this time?
My analysis would indicate that they feel this stronger dollar has done a lot of their job for them. The spread between our treasury yields and European/Japanese yields is sure to keep the dollar “strong enough”, and a perpetually easy Fed monetary policy is sure to keep it from getting “too strong”. They seem to me to be trying to thread a needle.
It looks like your call on Dollar/Euro parity may happen a lot sooner than expected?
Indeed. I would now imagine we will see a Euro much below the dollar in the next 24 months. Unhedged European equity investors would be shocked to see their returns are throughout the European equity rally (because there are none). +10 in stock prices and -10 in currency equals a zero return (illustrative numbers only). European equity investing has its own pros and cons, but doing so without hedging the currency may be particularly unwise.
Can you elaborate as to what you mean when you refer to The Bahnsen Group’s commitment to “the long view”?
The long view is the only view for one looking to deliver stellar results over a full cycle which are matched to a client’s goals. We think about the ramifications of all decisions we make in terms of years and decades, not merely months or quarters. A commitment to managing for risk, managing for volatility, and managing beyond a mere news cycle means being willing to look wrong in certain periods of time; it means being committed to the lessons of history and the realities of the future; and most of all, it means being informed by principles and fundamentals, and not emotions or behavioral gyrations.
“Easy monetary policy”
Attempts to ADD liquidity in the economic system – printing more money, lowering interest rates, etc. – are considered “easy” or “loose”. Attempts to take money out of the system – raising reserve requirements, raising interest rates, selling bonds – are considered “tight”.
QUOTE OF THE WEEK
“Success is a lousy teacher. It seduces smart people into thinking they can’t lose.”
— Bill Gates
So while I am not out in my desert respite enjoying college basketball this weekend, I am home with the people I love most in the world: My family. We have had several clients pass this year, and we have several who are quite ill right now. All of us know the pain and loss of a family member or loved one. This weekend, dealing with the loss of clients whom I have known and loved for years, and having seen my baby girl in such pain, I just want to say that Fed action and inaction notwithstanding, it is family and loved ones that drive all we do. Enjoy the weekend with that family and those loved ones.