The best show on the internet is back!
The best show on the internet is back!
I don’t have much to write about this weekend as we are basically waiting on the Fed’s “taper” decision next week and watching the Syria diplomatic debate as we creep closer and closer to the debt ceiling. I will direct your attention, however, to a few other posts I’ve written over the past couple of weeks that may have flown under your radar:
Have a great weekend.
Now that stocks have finally started to pull back from record highs investors are probably asking themselves, ‘is this a standard correction or something more than that?’ I believe we are in the process of forming a major top and here’s why:
My advice? In the words of Yogi Berra, “you can observe a lot just by watching.” Investors would do well to take some risk off and simply watch how this unfolds.
I was dead wrong when I recently wrote “how I stopped worrying about interest rates and learned to love the long bond.” Since that time long bonds have dropped almost 10% in response to the Fed disclosing it wishes to “taper” is $85 billion per month in bond purchases. In fact, my timing could hardly have been worse. I will say I’m glad I took my losses quickly and avoided the majority of the decline over the past couple of months.
Still, I’m watching the bond market like a hawk these days. Since Bernanke started the “taper” talk the surge in interest rates has been dramatic and it has all sorts of implications for other asset classes.
Let’s put it into context. The rate on the 10-year Treasury bond has risen from 1.65% at the end of April to 2.9% today. This may not seem like much but when you consider that this rise amounts to a 75% increase in our government’s cost of capital over a period of three months you start to understand how significant it really is.
In addition to the government, it’s also been significant to investors. Income-based investment classes that have appealed to more conservative investors like REITs, preferred stocks and utility stocks have all been negatively affected by the surge in rates handing these investors losses they probably didn’t imagine were possible.
There are hints that Asian markets may be affected, as well. After surging through the first few months of the year Japan’s Nikkei now looks vulnerable to a significant decline and emerging Asian markets like Indonesia (fell nearly 10% this week) have already begun to show serious signs of distress. I can’t say for sure that these are related to the interest rate surge but it’s very possible that it’s more than coincidence. We are a world economy and you know what they say about a “butterfly flapping it’s wings in the Treasury bond market….”
What I find most fascinating is that beginning soon after the “taper” talk the Fed became much more dovish in its communications and rates STILL continued to climb. On Wednesday, for example, the Fed minutes included this statement: “Almost all committee members agreed that a change in the purchase programme was not yet appropriate” making it fairly clear the committee doesn’t intend to taper its bond purchases. STILL rates surged on the announcement.
This market action suggests to me that “Bernanke’s Grand Confidence Game” may be coming to an abrupt end. Over the past few years it’s very clear the Fed’s bond buying programs gave investors the confidence to push all sorts of risk assets to record highs. It’s very possible, however, that these same investors are now losing confidence in the Fed’s willingness, and perhaps its ability, to backstop them. In fact, it looks to me like they now have decided to front run the Fed’s unwinding of its bond buying programs and this is a very dangerous game.
I recently wrote, ‘should stocks and bonds begin to fall in tandem I’ll begin to worry that the marginal demand for risk assets that has been inspired by the Fed’s actions could evaporate very quickly.’ This is exactly what’s begun to happen over the past couple of weeks. Stocks have peaked as bonds have been slaughtered and I have indeed begun to worry that the end game is near.
Stocks have recently run to new highs, surpassing the levels they first set back in 2007. However, we have a 9-13-9 DeMark sell signal on the S&P 500 monthly chart:
Investors have also become very complacent recently. I’m not referring to sentiment surveys here; we’re talking what investors are really doing with their money. And they’re not buying any put protection right now. In the past, this sort of complacency has signaled a short-term top was near.
I’m also keeping a very close eye on the bond market for clues to where we are headed. The stock market strength over the past month has seriously diverged from bond weakness. Either bonds should rally or stocks sell off for this disparity to be rectified.
Much of this is left to the discretion of the Fed. Their views towards maintaining or reducing “quantitative easing” will drive the action over the near term. A lot can be learned from paying attention to a very similar experiment going on in Japan where they are much farther down an even more aggressive path of central bank easing.
I’m watching the Nikkei to see how investors are reacting to the Bank of Japan’s uber-aggressive policies. After starting the year on fire the Nikkei has struggled to keep its momentum and risks forming an awkward head and shoulders top.
As for the Nikkei, it’s been trading largely on what the Yen is doing. A strong Yen means investors don’t believe the Bank of Japan has the power to stimulate enough to make a real difference. Either that or they are not aggressive enough relative to the Fed. And the Yen looks to be forming a fairly rounded bottom here.
Regular readers know I’m not bullish on the stock market’s current prospects. Obviously, I don’t know what the future holds but these charts will tell the story as it unfolds.
See all of my public charts at StockCharts.com
According to a variety of valuation metrics stocks have only been more expensive than they are today on two occasions: the 1929 stock market bubble and the 1999 stock market bubble. Relative to history then I think it’s safe to say that stocks are “very expensive” (aka, very risky) at current levels.
But this is not what Wall Street would have you believe. Wall Street only makes money when you, the retail investor, are a buyer so to keep you buying they play a shell game with both earnings and valuations to keep you hitting the buy button. One way they do this is to focus your attention on stock prices relative to “forward earnings” – a fancy term for analysts’ predictions for what companies will earn in the future.
Below is chart of the S&P 500 compared to “forward earnings” (via Crossing Wall Street). I’ve seen charts like this popping up everywhere lately.
The problem is that this chart looked just like this at the 2000 and 2007 stock market tops just before stocks fell roughly 50%. So what gives?
Well, near market peaks investors tend to forget that everything, including the economy and the stock market, works in cycles and, in the words of the Federal Reserve, they, “extrapolate recent price action [or economic action] far into the future.” (This quote comes from a study the Fed did to determine how bubbles are formed.)
What analysts know and should prevent them from ‘extrapolating the recent earnings growth far into the future’ is that outside of financial companies, earnings growth actually turned negative last quarter. What’s more the strength in financial companies’ earnings is based on bogus accounting (reduced loan loss reserves are not real earnings and portfolio losses from rising interest rates are no longer reported). To my mind this makes these “forward earnings” numbers nothing more than hope… and you know what they say about hope as an investment strategy.
Professional investors understand this and I believe it’s the reason they’ve taken the opportunity over the past four weeks to dump a massive amount of equity exposure onto retail investors who are suddenly eager to buy both the Wall Street fairy tale of “forward earnings” and the stocks they are selling in the telling.