posted on 09 October 2016
by Lance Roberts, Clarity Financial
It's actually quite amazing. In March of this year, I wrote a missive entitled "Fed Levitation" discussing the Fed's ability to detach asset prices from the underlying fundamentals.
Despite the "Brexit," weakening economic growth, declining profitability, terror attacks, Presidential election antics, and Deutsche Bank, the markets continue to cling to its bullish trend. Investors, like "Pavlov's dogs," have now been trained the Fed will always be there to bail out the markets. But then again, why shouldn't they? The chart below shows this most clearly.
Okay...maybe not clearly...but you get the idea.
Over the past several months the markets have consistently drifted from one Fed or Central Bank meeting to the next. Yet, with each meeting, the questions of stronger economic growth, rate hikes, and financial stability are passed off until the next meeting. So, we wait.
The chart below shows the very strange price behavior over the last three trading days. Early morning sell-offs are quickly recovered back to levels above the running bullish trend and then goes flat-line.
However, it's not just the last three days, but rather the last couple of months where this levitation of asset prices and defense of critical support is apparent. Despite the news, good or bad, asset prices react very mildly. This "strange" price consolidation behavior will end, and historically speaking, the resolution of such consolidations tend to be rather significant.
As I wrote this past Tuesday:
For now, however, the markets remain stuck.
If The Economy Is So Good, Why Are Bankruptcies On The Rise?
As I have discussed many times in the past, economic cycles, while they can be extended through monetary interventions, can not be repealed.
While there are many currently suggesting that the current economic cycle still has years to potentially run due to low interest rates and continued accommodative policy. However, there is mounting evidence this current cycle may be nearer its end than most believe. I discussed one such piece of evidence last week with respect to auto sales. To wit:
Given the consumer is roughly 70% of the economic equation through their spending (the demand side of the equation), things like auto sales, restaurant trends, retail sales, etc. are good measures for tracking consumer health. However, it is "demand" that pushes the "supply" side of the equation as well. When demand is strong, commercial and industrial businesses tend to borrow money to increase production and employment to meet increases in demand. As Wolf Richter noted this past week, there are early signs of economic stress here as well.
There are two important points being made here. The first is that if loan demand has peaked that is also suggestive economic activity, and ultimately employment, have likely peaked as well.
Secondly, and very importantly to those betting on a resurgence in oil and energy prices, a big chunk of the gains in the Energy sector came from massive loan demand to expand drilling activity, particularly in the "shale" fields. As the chart shows below, there is a direct correlation between the increases in the Fed's balance sheet and oil prices.
Of course, the increase in oil production WAS NOT due to investments in oil drilling by banks, but rather by the loans given to oil companies to expand their drilling and production.
With the Fed's liquidity being drained from the system, it is not surprising to see loans from banks beginning to slow. This is particularly the case given the rise in bankruptcy filings as of late. As Wolf notes:
Recessions & Markets - Who Really Leads?
So, why are rising bankruptcies important? Elena Holodny recently penned the following note from a UBS team led by strategist Julian Emanuel:
Unfortunately, that not exactly an accurate statement. As I noted previously in "Think Like A Bear, Invest Like A Bull":
It is during the latter stages of the economic cycle when "growth and value" investing gives way to pure momentum and speculation. As investor "greed" and "exuberance" rises, the time-tested principals of "value" investing become a relic of the past.
It is ONLY during the last stage of an investment cycle that "fundamentals appear not to matter" as typically the fundamentally worst stocks lead the markets higher.
In other words, it is during these late stages we hear discussions of why "This Time Is Different (TTID)" and "There Is No Alternative (TINA)."
This cycle does end, and the reversion process back to value has historically been a painful one. Unfortunately, after it is far too late, investors begin to change from TTID and TINA to FUBAR (F***ed Up Beyond All Recognition)"
Understand It, But Don't Fear It
Currently, there is little doubt that we are in both the late stages of an economic cycle and a momentum driven market.Therefore, investment focus must be adjusted to current market dynamics that requires a focus on relative strength and momentum as opposed to valuation-based strategies.
There have been many studies published that have shown that relative strength momentum strategies, in which as assets' performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton's Law Of Inertia, that states "an object in motion tends to remain in motion unless acted upon by an unbalanced force."
In other words, when markets begin strongly trending in one direction, that direction will continue until an "unbalanced" force stops it. Momentum strategies, which are trend following strategies by nature, have been proven to work well across extreme market environments, multiple asset classes and over historical time frames.
While there is substantial evidence that market valuations and fundamentals are not supportive of asset prices at current levels, investor psychology has likewise reached extremes. In such an environment, it is also beneficial for investors to shift focus to momentum based strategies as trend-following strategies reflect the behavioral factors such as anchoring, herding, and the disposition effect.
Let me explain.
Fundamentally based investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late cycle stages.
The other inherent problem of primarily data-based investors is the "herding" effect. As prices move higher, valuation arguments lose relevance. However, the need to produce investment performance in a rising market, leads to "justifications" to explain over-valued holdings. In other words, buying begets more buying.
Lastly, as the markets turn, the "disposition" effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. The end effect is not a pretty one.
By applying momentum strategies to fundamentally derived investment portfolios it allows the portfolio to remain allocated during rising markets while managing the inherent risk of behavioral dynamics.
As I discussed last week, despite the fact that I write like a "bear," the portfolio model has remained allocated to equities during the market's advance. The point is simple, our job as investors is to make money when markets are rising as well as avoid potentially catastrophic losses when trends change.
As stated above, there is ample evidence mounting this current bull market and economic cycle are very "long in the tooth." However, for now, the market has not violated its bullish trend and the economy is still "struggling through."
This will change. The timing of WHEN is always the critical question. As BofAML recently wrote:
Importantly, it is correct when people say there is NO SIGN OF RECESSION currently. However, what they get consistently wrong is accounting for the future negative revisions to past data which reveals the start of recessions in hindsight. Unfortunately, you just can't invest that way.
Of course, by the time you figure it out, you will have also figured out "you are the pigeon at the poker table."
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