Investing, Markets, Weekly Reports

On The Stock/Bond Conundrum

Professional investors typically look at the stock market as playing Curly to the bond market’s Moe. (I don’t know who Larry is… Currencies? Commodities?) Behavioral finance teaches us that neither of them are very rational over the short run and can, at times, get pretty zany. But the bond market is typically a bit wiser than the stock market and at times it likes to slap the stock market around when it gets wise. Maybe it’s because the bond market has things like “vigilantes” (or used to) that keep it a bit more honest. Who really knows?

Right now traders can’t stop talking about the divergence between the two. Bonds are saying the economy looks punk (as the yield curve continues to flatten) and stocks are saying everything looks hunky dory (as they surge to new highs). So who’s right? Is Moe about to do the eye poke on Curly or will Curly get the block in along with the last laugh.

I’ll just say that I don’t know; I’m not an economist and I wouldn’t trust those guys to know either. But I do have at least a clue.

First quarter GDP would suggest that the bond market has it right but, as we all know, markets are forward-looking, discounting mechanisms. So the continued weakness in yields would suggest that bonds see the Q1 contraction as more then just a blip while stocks are saying, “it’s not so bad.

And we’ve recently heard from a couple of market watchers I do trust who have come down on the side of the bond market. Stephanie Pomboy gave a terrific interview to Barron’s over the weekend:

The No. 1 thing is that investors generally have underestimated the impact that QE [quantitative easing] has had on the economy and the degree to which it has supported growth. As a consequence, they have underestimated the cost the tapering [of monthly Treasury bond purchases by the Fed] would have, and that is starting to come into focus. People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing…. I expect to see Treasury yields trading in a range from 2% to 3%, basically how it’s been for the past several years. You want to sell at 2% and buy at 3%. I wouldn’t be surprised to see rates fall below 2%, as investor perceptions about the economy meet with reality and they realize that the Fed still has a lot of work to do.

Is it just a coincidence that the Fed began to taper in January and the economy began to contract at the very same time? Maybe. But it’s worth making a note of especially due to the fact that each time QE has ended in the past it’s led to problems that have forced the Fed into a new round of QE. Different this time?

Jeff Gundlach, another whose work I greatly admire, seems to agree with Stephanie. A couple of weeks ago he predicted we would see “one of the biggest short covering scrambles of all time” in the bond market that would send the 10-year yield below 2% and perhaps even below the 1.5% level tagged back in 2012. The recent economic slowing would have to at least continue if not accelerate for something like this to occur.

To be sure, this is THE contrarian call right now. A recent poll of 72 economists found none of them see a contraction in our future. To me, this is the sort of consensus that Bob Dylan sang about:

“Half of the people can be part right all of the time
Some of the people can be all right part of the time
But all of the people can’t be all right all of the time” [emphasis mine]
I think Abraham Lincoln said that
“I’ll let you be in my dreams if I can be in yours”
I said that.

And I wouldn’t be surprised to see Curly get slapped upside the head yet again.

Investing, Markets

The Calm Before The Storm

It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you’re not supposed to short a dull market but…

When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now. Bianco research recently noted that over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007. This marked the beginning of a volatility pick up that ultimately peaked manifold higher during the height of the financial crisis.

Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this it does suggest that investors are usually in for some sort of ‘surprise’ that sends volatility higher. And there’s a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.

It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security or confidence that stocks just don’t go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the “great moderation” line of bullshit. This causes them to become overconfident and over-commit to stocks. When a pullback greater than just a few percent finally happens these investors are surprised by the ‘extreme volatility’ (which is really just normal volatility that has been dormant) and they reduce the undue exposure they put on when they believed volatility was dead. Add this to the normal selling that occurs during and you get a greater than average sell off. Multiply all of these effects (to account for record low vol) from the beginning and that’s how you get a crash like we saw subsequent to the record low vol mid-2007.

Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations and that’s not about to happen again. But history does look like it could be rhyming in some ways right now.

Any major dude will tell you” about not just the record low vol but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double digit decline once this happened. And @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.

I know: Correlation ≠ causation. Still, it makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.

And we’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs.

As for the latter, @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “RUT [Russell 2000] recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead.” That level lies >5% below its current number but there’s a good chance stocks could fall at least twice that much. Again @ukarlewitz:

At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.

No. This doesn’t mean stocks are about to fall 20%+. But with record low vol over this span how many investors are prepared for such a scenario?

There are also divergences galore. Toddo, calls our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since… you guessed it. Yep, 2007.

Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well. So what to junk bond investors see that equity investors don’t?

Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.

Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.

Maybe it’s the bursting of the bubble in profit margins.

Maybe it’s the bursting of the housing bubble in China.

Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction. Who knows?

In any case, I’d argue that the record low vol shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible. But people love to believe things even when they know they’re not true. And you know what? According to the Fed, this is the very definition of a bubble.

It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today. And it’s increasingly likely this is just the calm before the storm.


Riddle: What’s The Difference Between The Fed And LTCM?

Long-Term Capital Management used massive leverage to generate profits in government bonds (before blowing up and nearly bringing the world’s financial markets with it). Is this not exactly what quantitative easing is?

Josh Brown wrote a piece for The Daily Beast today on “The Insanely Profitable Federal Reserve.” They sent nearly $80 billion to the Treasury last year which is truly a massive number. However, if the Fed were to report unrealized losses on the assets in their portfolio I’m certain this entire profit would be wiped out and then some.

The Fed started 2013 with $1.6 trillion of long-term treasuries and $900 billion of mortgage-backed securities. During the year the 10-year Treasury bond lost roughly 7.5% of its value and MBS lost roughly 2%.  This means they lost about $150 billion on these positions.


But the Fed also bought $85 billion per month more of these securities during the course of the year. MBS rallied some to finish the year but the 10-Year Treasury (I’m using this as a proxy for their average duration) closed the year on its lows, meaning every purchase they made during 2013 was underwater. In all, they probably lost more than $150 billion, or roughly twice what they remitted to the Treasury.

They will say, ‘don’t worry, we intend to hold all these securities to maturity when we’ll recover all of our principal.’ It’s not that simple. The Fed now owns over 40% of the long-term Treasury market as well as over 40% of the entire MBS market. This is why they simply MUST taper or the Fed will eventually own both markets entirely. It also makes it nearly impossible for the Fed to sell without crushing those markets, sending rates soaring and undoing all the work QE did in the first place.

Still, as Richard Fisher posits today, the Fed may be forced to sell and at a loss. Unlike LTCM, though, this wouldn’t force them into insolvency because the Fed can print money. That’s the difference. Still, I’m not convinced there wouldn’t be consequences… and neither is Fisher, which is why he is voting to end QE ASAP.

Charts, Investing, Markets, Trading

Leverage Works Both Ways

A couple of weeks ago I took note of the following tweet:

It looks as if traders in Rydex Funds have recently become more bullish on stocks than they have ever been. The charts shows that money that has been poured into leveraged “bull” funds now outweighs the money in “bear” funds by a ratio of 8-to-1. In the past, 4-to-1 has been pretty extreme and we’re now double that level.

Not only is this a pretty good contrarian indicator it also raises questions regarding systemic risk to the stock market. If Rydex traders are this bullish it’s probably safe to assume that traders in leveraged ETFs are similarly bullish. Just a few months ago the Fed warned about the risks that these kinds of funds pose to the broader stock market and even went so far as to compare them to the “portfolio insurance” strategies that have been blamed for the crash of 1987.

Ultimately, the large amounts of cash committed to leveraged bullish funds have acted like financial steroids, powering the indexes higher than they would have been able to climb without these performance-enhancing funds. Should the market reverse trend it could fall victim to its own success as the unwinding of these trades magnify the downside in a bear market. Add a record amount of margin debt to the equation and you could be looking at the raw fuel for a pretty brutal selloff.

Chart of the Day:

Speaking of the 1987 crash, it’s interesting to note that a 13-year cycle (and 6.5 year cycle) lines right up with that stock market peak, the 2000 peak and today.


Charts, Economy, Investing, Markets

The Four Pillars Holding Up The Stock Market Are Crumbling

Earlier this week I wrote, “why I’m bearish,” focusing more on why I am willing and able to take a contrarian stance than on the real reasons for taking it in the first place. So here I’m going to make the case for being bearish right now.

pillarsThe stock market is held up by four pillars: fundamentals, technicals, sentiment and macro (see Todd Harrison’s “The Four Pillars of Trading“). All of these must work in concert, to some degree, for stocks to go either higher or lower. Right now I believe they are conspiring to send prices lower.


The most fundamental part of investing is knowing that ‘the price you pay for a stock determines your rate of return.’ If a stock is worth $100 and you pay $50 you will make 100% when/if the market recognizes its true value. However, if you pay $150 for the same stock you stand to lose 33% so price, and more importantly valuation, is absolutely critical in the investment process.

valuationsRight now stocks are very expensive. Based on four different valuation metrics, courtesy of Doug Short, stocks are currently overvalued somewhere in the range of 42%-70%. In other words, if stocks were to immediately return to their average historical valuations tomorrow they would have to fall 30%-40%. This is why James Montier and Jeremy Grantham have calculated that the probable return for the stock market over the next seven years is roughly 0% (earnings should grow but valuations should decline leading to zero return).

It’s important to note, as well , that there are only two other times in the past 100 years when stocks were prices as high: the 1929 bubble and the 2000 bubble.

profit marginsFundamentally then, the only way this “pillar” becomes bullish for stock is if corporate earnings grow very rapidly over the next few quarters. The problem with this idea is that corporate profit margins are already historically stretched AND earnings growth has slowed nearly to a stop as companies revise their forward guidance downward faster than ever.


spxStocks are up nicely this year but there are signs that momentum has begun to wane. As the S&P 500 has made new highs RSI and MACD have failed to confirm them. In addition, the index has now formed a clear “ending diagonal” or “wedge” reversal pattern.

Turning to the Nasdaq, it has also formed a similar pattern. What’s more, on Tuesday it completed a 9-13-9 DeMark Sequential sell signal on the monthly chart. At the same time it has now retraced 61.8% of its decline since the internet bubble burst. This is a key Fibonacci level that traders follow because it regularly marks changes in trend. Notice that the 2007 top was formed very near the 38.2% level (the inverse of 61.8%). The triple threat of the ending diagonal, DeMark sell signal and key resistance significantly increases the probability of an imminent reversal on this long-term time frame.



We can look at all the surveys there are to gauge sentiment but I prefer to look at what investors and traders are actually doing with their money. There are two in particular we should pay close attention to.

The first is short selling; there’s no better way to determine how many bears there are out there than to take a look at short selling levels. According to this measure, bears just hit an all-time record low. Markit recently revealed to CNBC that a mere 2.4% of S&P 500 companies’ shares have been borrowed to sell short, a record low. Clearly, rising stock prices have forced bears into hibernation.

margin debtOn the flip side, the bulls are out in force. Margin debt levels have recently risen higher than any other time since the internet bubble. Not only are most investors heavily long stocks, they are leveraging their exposure with a massive amount of margin debt.

The bottom line is we currently have a record low in the number of bears while bulls numbers near record highs. Contrarians rarely see sentiment so extremely skewed.


SPYFedTopsBottoms-1024x695Here’s an area I’ve been writing about for months. This stock market is essentially ‘all Fed, all the time.’ And if you doubt the impact the Fed has had on the bull run stocks have made over the past few years, take a look at the chart to the right, courtesy of TheArmoTrader.

The Fed has made it clear it sees the need to “taper” its bond buying programs. And in the words of one of the most successful investors of all time:

If you didn’t believe before that the exit was gonna be tough, the mere hint that maybe in 3 months, if the economy’s good, we might go from 85 billion a month to buying 65 billion a month caused that kind of havoc and risk around the world how in the world does anybody think that when the actual exit actually happens prices are not gonna respond? It’s silly. -Stan Druckenmiller

Make no mistake, the stock market has benefited greatly from the Fed’s money printing; the end is near and stocks will suffer when it comes. The only question that remains is ‘will investors try to get ahead of the actual announcement?’ because it seems the “smart money” is already doing so.

scInvestors in the bond market have certainly gotten ahead of any tapering that may be on the horizon. Interest rates have shot up over the past few months, a development that is neither good for the economy nor for other asset classes. Take a look stocks reacted at prior times interest rates surged to this degree. Two out of the past three occurrences coincided with major stock market tops.


All in all, each of the four pillars presents a challenge for stocks at present. In fact, we haven’t seen this combination of extreme valuations, waning momentum, rampant bullishness and macro threats since just before the financial crisis. Now I’m not calling for another stock market crash but the risk-reward equation seems heavily skewed to the risk side with very little possibility of reward. That’s a game I have no desire to play so go ahead and color me “bearish.”