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Investors Are Still Not Impressed With The Long Bond

Everyone’s talking about how the stock market has recently broken out to new highs. I’ve heard no mention, however, of the breakout in the long bond. In fact, this might be the most hated breakout I can remember.

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What I find most fascinating is that even with this recent pullback, the long bond has absolutely crushed the stock market in terms of performance over the past year or so and it continues to be scorned while stocks continue to be loved!

We regularly see panicky headlines like this:

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…and this:

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The latest survey from BAML shows fund managers are still way overweight equities and way underweight bonds.

Screen Shot 2015-02-19 at 5.09.26 PMChart via Fat Pitch

Retail investors are also very bearish. Take a look at the top bond ETFs by assets and you’ll see that the two most popular funds are bearish funds. Between the two of them they have more assets than the top ten bullish funds combined.

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On a shorter sentiment time frame, DSI shows an incredible surge in bearish opinion of the long bond right now.

Do bull markets like this one ever end in this sort of fear and skepticism? Where’s the euphoria that typically marks the end of a bull market? Until we see it I’m still under the impression that if there’s an asset class that’s going to “blow off” it’s more likely to be bonds than stocks.

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“The Wisdom Of Insecurity” In The Stock Market

Over the past few years, the idea of “passive investing” has increasingly resonated with the general public. Money has rushed out of actively-managed mutual funds and into index funds at a rapid rate. Most recently, the passive investing ethos has grown so strong it now reminds me of some hard-core religions that take an unwaveringly literal interpretation of their founding texts.

In the case of passive investing, these founding texts are the “efficient-market hypothesis” (EMH) and “modern portfolio theory” (MPT). Created and developed by ingenious men with noble intentions, these theories put forth wonderful arguments for the wisdom of the crowd and the incredible value of diversification, among others.

Like most religious texts, however, the main problems arise in their interpretation and implementation. As Alan W. Watts explains in The Wisdom Of Insecurity, “the common error of ordinary religious practice is to mistake the symbol for reality, to look at the finger pointing the way and then to suck it for comfort rather than follow it.” Investors, too, must think critically about the effectiveness of these theories when it comes to practical application rather than take them literally on blind faith.

It pays to remember that blind faith in these sorts of mathematical models leads even nobel prize winners to disastrous results. As my friend Todd Harrison likes to say, “respect the price action but never defer to it.” Clearly, there is value in understanding and incorporating the ideals of these theories. There is also danger in simply deferring to them because the costs of their shortcomings can, at times, overwhelm the benefits of their wisdom. Like the Long-Term Capital boys learned, as soon as you really need to lean on them they vanish like a cheap magic trick.

Where these theories go wrong in their practical application is that they both assume there are only rational participants in the markets. While the crowd may be right most of the time, there are clearly times when the crowd is not rational (note the preponderance of manias throughout the history of finance). In fact, the proprietors of these models have acknowledged this Achilles’ heel themselves.

The most successful professional investors like Warren Buffett, Paul Tudor Jones, John Templeton, George Soros and Jim Rogers, know this well. Their methodologies are even built upon the idea that an intelligent investor can get ahead by taking advantage of those times the crowd becomes irrational, the antithesis of the EMH and MPT.

So saying you believe in passive investing is fine and, in fact, I’ll grant it’s better than most of the alternatives. It will work great most of the time. But know that, just like some fanatics deny evidence that disproves the idea that cavemen and dinosaurs coexisted, you are denying the overwhelming evidence that suggests its foundations are simply not to be relied upon during those rare times when market participants abandon rational thought for panic or euphoria.

Make no mistake, those selling this idea of passive investing are selling a very good product. I firmly believe it’s a large step above most of the alternatives out there, more so in the case of those selling it at a minimal cost. But I fear investors are also being sold a false sense of security today.

I believe investors passively buying equities today are doing so under one of two false assumptions. They either believe that future returns will look something like they have over the past 40 years or that because the market is totally efficient it’s currently priced to deliver risk-adjusted returns that are acceptable given the current low-yield environment.

The first assumption is something I have called the “single greatest mistake investors make” and it’s a trap even the Federal Reserve admits it regularly falls into. The second assumption runs into the problem of the evidence which suggests there is a very good likelihood returns from current prices will be sub-par, if not sub-zero over the next decade.

And the reason returns are likely to be poor going forward is investors have pushed prices to levels that nearly guarantee it. In my view, passive investors have irrationally relied upon the idea that the market is rational, and therefore attractively priced, in pouring money into equity index funds, sending equity values to heights never before seen (on median valuations) virtually guaranteeing themselves they’ll be disappointed.

Just because the future of the stock market is bleak doesn’t mean investors should ignore these facts or have them withheld from them. Ignorance may be bliss but it is not a valid investment methodology. Those with a religious sort of belief in passive investing and its main tenets need not abandon it to acknowledge its limitations. In fact, a little insecurity would go a long way for the growing hoard of passive investors in today’s market.

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Why Today’s Ultra-Low Interest Rates Are Actually Bearish For Stocks

There are plenty of pundits out there arguing that today’s record-high valuations in the stock market are validated by ultra-low interest rates (see Fed Model). The problem with this idea is it really only tells us how we got here. What investors should really care about is where we’re going and ultra-low interest rates are not at all bullish for future returns in the stock market.

In some respects, the idea that low rates should mean higher equity valuations makes perfect sense. If the 10-year treasury bond only pays 1.7% and the dividend yield on the S&P 500 is closer to 1.9% why wouldn’t I be more inclined to buy stocks? Good question! And this is probably why investors bid stocks up to astronomical valuations in the first place.

The major problem with this line of thinking is that it is backward-looking and it is no justification for valuations to remain high going forward. I’ll let Cliff Asness explain:

It is true that all-else-equal a falling discount rate raises the current price. All is not equal, though. If when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates.

In fact, over time corporate earnings growth tracks very closely to the rate of inflation. This is why so many people like to say stocks are a good inflation hedge because they can typically raise prices to combat rising costs in an inflationary environment. But if that’s true then they also make a very poor deflation hedge as their earnings also must also fall when the rate of inflation does. And right now the bond market is pricing in the lowest levels of inflation since the financial crisis:

fredgraphChart via FRED

This would suggest that earnings growth going forward should also be very weak. In fact, we are already seeing this reflected in companies’ fourth quarter earnings reports and in the forward guidance they are now giving. Goldman Sachs reports that guidance is now the worst ever recorded. Forward earnings estimates are beginning to reflect this as they have been falling for almost as long as long-term interest rates have been:

Screen Shot 2015-02-02 at 1.02.58 PMChart via Humble Student

From this perspective, it’s very hard to make the case that low-interest rates are a valid reason to be bullish on equities. It may be true that low rates encourage increasing risk taking when investors compare alternatives to the “risk-free rate” of the 10-year treasury bond. This is where the Fed’s interest rate lever and quantitative easing have obviously been successful. But at some point, plunging interest rates like we have seen over the past year, are a sign that earnings growth could be rapidly slowing if not turning negative, a development not at all supportive of risk assets.

Historically, this may be represented by the fact that low interest rates have led to the worst forward returns for stocks. The chart below separates the market into five distinct buckets ranked by the level of interest rates. Bucket 1 reflects the lowest month-end 10-year treasury rates on record during the 1965-2001 period. It’s clear that the 10 year periods leading up to those low-rate environments were fantastic for stocks. The subsequent 10 years were not nearly so kind, as investors suffered losses after adjusting for inflation.

Screen Shot 2015-02-02 at 11.36.14 AMChart via Fight The Fed Model

There is also recent evidence in other countries that the idea of low interest rates supporting stock prices is faulty. Just take a look at Switzerland. This Swiss 10-year bond yield is now negative. Based on the idea that low rates justify higher valuations, one could make the case that an infinite price-to-earnings multiple for stocks would not be unreasonable in comparison. But what did the Swiss stock market do while their long bond yield recently plunged? It also plunged!

tumblr_nialaheKOR1smq3o4o1_1280Chart via JLFMI

The point is investors like to use low rates as justification for higher equity valuations. At some point, however, really low rates go from being benign to malignant for risk assets. No doubt low rates have supported risk assets in our markets for the past five years or longer. But the rapid decline over the past few months is now being reflected in company earnings. And investors may soon begin to question whether it still makes sense to pay record-high valuations in light of this.

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Respect The Trends In These “Widowmaker” Trades

“Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” -Sir John Templeton

There are a couple of trends out there in the markets right now that are becoming so-called “widowmakers.” Specifically, I’m referring to oil and long bonds.

Oil has been crashing while long bonds have been soaring. Oil is way oversold and long bonds are way overbought. They should both probably retrace a bit of their recent moves simply because they’re both so overextended right now.

However…

See the massive inflows into the oil ETF in the chart above? That is not the sort of “pessimism” that forms a major bottom.

Conversely, in bonds…

Investors have been drastically underweight and heavily short bonds for over a year now. This is why I’ve been writing for some time that bonds may be more likely than stocks to see a “blow off” sort of move.

Now traders are clearly trying to anticipate a trend change in both of these asset classes. They are getting heavily long oil and they remain heavily short long bonds. Now, to be clear, I think they may revert a bit if only to work off their overextendedness (if that’s even a word).

But the big problem with these trades is that the trend is plain as day and traders shouldn’t forget, “the trend is your friend!” Oil is nowhere close to breaking out of its downtrend and long bonds are nowhere close to breaking down out of their uptrend.

Trying to anticipate these trend changes must have been inordinately painful for these traders over the past few months. And the odds are neither of these trends will actually change until we see some real despair in oil and some true euphoria in long bonds, as witnessed in ETF flows or some other similar indicator. At least, that’s what I imagine the brilliant Sir John would have told us.

Follow me on Twitter: @jessefelder

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The Skyscraper Index Is Flashing Another Sell Signal

STOP! Before you flood my inbox telling me I’m an idiot to put any faith in such a stupid concept, know that this is just for fun. This is not anything to be relied on for any reason, unless you’re just curious about these things, as I am.

Now that I’ve gotten that out of the way, I find it fascinating that at this point in the business cycle we are once again witnessing a race to build a record-breaking skyscraper. The “Skyscraper Index” is a concept that suggests, “the world’s tallest buildings have risen on the eve of economic downturns.” Statistically speaking it may not be entirely accurate but I find the theme to be very intriguing nonetheless.

Although the index was only created in 1999, this concept dates back to time immemorial. In fact, the tower of babel should probably be the first instance catalogued by the index. In short, humans built a tower to the sky to celebrate their god-like powers (of uniting humanity under one language) and were soundly smote in response. This story can be found in many religions, actually. And ever since there have been many great monuments built during times of economic euphoria as a testament to our greatness. Only shortly thereafter do we realize it was not so much greatness as hubris.

Construction of record-breakers like the Singer Building and the MetLife Building coincided with the panic of 1907. The Empire State Building, the Chrysler Building and 40 Wall Street, were all built or launched just prior to the 1929 stock market crash and subsequent Great Depression. The World Trade Center and the Sears Tower opened just prior to the 1973-74 bear market. Today, we have two New York developers racing to build the tallest residential building in the Northern Hemisphere.

So where are we in the business cycle? I have no idea. Over the course of modern history, however, our economy has suffered a recession every five years or so. The last recession ended June of 2009, just over five years ago. (In and of itself, this does not suggest we are necessarily due for a recession but global growth is clearly slowing and I doubt the US will be entirely immune.) The longest expansions in American history lasted about ten years. It may be fair to say, then, that we are probably closer to the end than the beginning of this particular expansion. And regular readers should know where I believe we are in the financial market cycle.

Late in the economic cycle, then, in the financial capitol of the world, which has benefitted mightily from the greatest money-printing experiment in the history of the world, we have two real estate developers in a heated battle to build a greater testament to their own greatness than the next guy. To my mind, it is the height of financial hubris and a clear example of economic euphoria. And it’s all happening just as luxury apartment sales in New York are starting to slow. All in all, I wouldn’t be surprised to see this index correlate with yet another economic and financial market peak.

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