The increased use of computerized algorithms in the markets is not only leading to a false sense of volume but also an increased risk of cyber attacks on our financial system. As we have discussed before, we continue to be concerned about the underlying risks of HFT algorithms. HFT themselves cause us worry about another flah crash until they are regulated but add in the risk of a cyber attack on our financial system and the magnitude of an event like that is unimaginable.
While this has likely already been priced in for now, it says a lot about where Pimco thinks rates will be going over time. Also, it takes one of the largest domestic buyers out of the market. That can only cause bond prices to fall over time, both leading to higher rates.
The Middle Eastern turmoil that began in Tunisia and Egypt spread to Yemen, Bahrain, and Libya in February, driving oil prices to $100 per barrel. At the same time, bond spreads in Greece, Ireland and Portugal continued to widen (albeit under the radar) as investors demand a higher premium to embrace the risk of these sovereign issuers. In fact, as I write this, the Greek 10-year yield has surged to 12.76% while the Portuguese 10-Year moved to 7.66%. The tumult drove gold prices up by nearly 6% in February, closing the month at $1, 411 per ounce. In February, the US Government racked up its largest monthly deficit in history — $233 billion. To put this into some kind of perspective, February’s deficit was larger than deficit for the entire year of 2007.
February brought with it, however, some encouraging news. People seeking unemployment benefits fell to the lowest level in nearly three years during the last week of the month. Both retailers and the service sectors have posted positive reports, and the unemployment rate dropped below 9% — ending February at 8.9%. Manufacturing activity (as defined by the ISM report) rose to its highest level in nearly 7 years; marking the 19th consecutive month of expansion for the economy as a whole.
Against the backdrop of these conflicting ominous and encouraging indicators, and a nearly 2% stock market decline during the last week of the month, the S&P 500 managed to add 3.4% to its already massive (+28%) gain since the Fed’s Jackson Hole meeting last August. For yet another month, Quantitative Easing coupled with pockets of good news pushed investors into risk assets with little regard for macro-environmental risk.
Our position has been (and remains to be) that the forces driving the economic recovery are not particularly solid and based almost exclusively on massive amounts of liquidity. Further, we continue to contend that the global financial issues that were exposed during the crisis remain largely unresolved, and for the most part, politicians and policymakers have merely attempted to push the problem into the future rather than structurally repairing it today.
To quote Citigroup’s Steven Englander, “It’s hard to argue with this line of analysis except that it has been dead wrong in market terms.”
Englander also made an observation that is dead-on with what we have observed in this uni-directional market: Investors have grown tired of being told to hedge against risks that have not emerged. In fact, he opines, the downward trend in volatility (as the stock market continues to melt up) may reflect that too much capital was dedicated to hedging risks that didn’t happen and that capital is now being deployed back into the market.
Since 2007, we have taken the position that the probability of a high magnitude, negative event (or a series of such events), remains higher than normal. We were rewarded for that observation in 2008 and penalized for it in the succeeding years. Like Mr. Englander, we have increasingly heard from more clients and prospects that either resist or reject the notion that such events may occur in the near- or intermediate-term. Basically, the line of reasoning is that they have heard this song many, many times since 2009, while the markets for all things risky have marched onward and upward.
If you subscribe to the theory that the ending of the financial crisis of 2008 and the subsequent recovery in risk asset prices is almost exclusively the result of trillions of dollars of money creation, it begs the question as to what policy tools remain to address a future crisis. Do countries simply print more and more money? Do they draft new, more restrictive and cumbersome legislation? Do they try to find new and creative ways of deferring the painful solutions to yet a later date?
I am not confident that policy-makers possess the tools required to address another significant crisis; and as a result, the absolute magnitude of a negative event has risen while the probabilities have, at best, remained the same. At worst, the probabilities have increased as well.
I will not go into itemizing the specific risks we see in the present environment. Those who have read our monthly letters or listened in on our prior calls should be acutely aware of the factors we view as problematic. Rather, I’ll conclude my prepared remarks with another quote from Mr. Englander: “When we see volatility so cheap in a world that appears to be so risky and in which policymakers do not hold a terribly strong hand, it makes a strong case for hedging tail risk, even if price action is apparently indicating otherwise.
While we don’t think the probablility is high, the magnitude if this were to happen is mind boggling.
The liquidity-fed rally in domestic stocks continued in January with the S&P 500 gaining 2.3%. Smaller stocks, however, did not fare as well; with the Russell 2000 actually falling by 1.1%. Internationally, monthly returns were a mixed bag, with the UK, Brazil and China falling (-0.3%, -3.2%, and -3.5%) France and Japan were the strongest regions with their indexes rising 5.5% and 0.1% respectively.
January was characterized by increasing macro risks, juxtaposed against a demonstrably improving US economy. On one hand, turmoil in the Middle East, continued European bond downgrades, and runaway pricing on agriculture commodities provided ample worries for the near-term future of global growth. On the other hand, solid earnings from US corporations, coupled with upgraded GDP projections for 2011 (3.2%) counterbalanced the scales nicely. The factor that tipped the scales in favor of the equity bulls, in my opinion, was the continuing Open Market Operations by the Fed. As the Fed continues to dump billions of new dollars into the markets, risk assets like stocks will have a tailwind in the form of the “Bernanke Put”.
That said, it is hard (if not impossible) to predict how long this US stock rally will continue. QE2 is set to end this summer, but if unemployment continues to persist, might we see QE3? Conversely, if QE2 is allowed to expire, how does the Fed begin mopping up all this excess liquidity without causing a dislocation in the bond markets and precipitating a spike in the US Dollar? Finally, how much of our exported inflation (prices in cotton, corn, wheat, oats and soybeans) can the developing world tolerate before social unrest becomes even more widespread? While I don’t pretend to know the answers to these questions, we keep our portfolio positioned to shield our assets against these uncertainties while looking to gather gains in a prudent way.
I’ve spent a good deal of time during the month of January insuring that, as a firm, we are not falling victim to “confirmation bias” – that is, the tendency to favor information that confirms your preconceptions or hypotheses regardless of whether the information is true. Confirmation bias is more difficult than ever to avoid, given that, if you have any idea you can likely find information to support it on the Internet. Confirmation bias is one of the primary factors we investigate when deciding to terminate a manager from our Fund-of-Funds. To quote Wikipedia, “Confirmation biases contribute to overconfidence in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Hence they can lead to disastrous decisions, especially in organizational, military, political and social contexts.”
Our investment hypotheses have been presented openly in numerous past letters and monthly calls, but they basically boil down to this kernel: The various macro risks confronting the stock market, while having only modest probability of occurring, are embedded with such high magnitude negative outcomes that the risks outweigh the potential rewards.
If this were a ballgame that began at the March 2009 stock market lows, the score would emphatically indicate that our hypotheses were wrong. That said, I can easily provide mountains of evidence from reputable sources reinforcing why our hypotheses are correct and why the market is behaving temporarily irrational. But, that would be the very definition of confirmation bias! I believe my time would be better used trying to gather data regarding the source and timing of the market’s divergence from where we believe it should be.
I began by investigating the “where” and the “how much” relating to the cash flows that are driving the markets upward at nearly a 45 degree angle. Looking at the Investment Company Institute’s data of weekly net flows into or out of US stock funds, we found that over a 36 week period ending in January, 35 of those months’ showed net outflows amounting to nearly $110 billion. Recently, this trend has changed, with net inflows of $6.7 billion. So, all-told, $100 billion or so has left the stock mutual fund complex. Just since August, retail investors have taken out $38 billion more than they have added. So I think it’s safe to say that the retail investor has not been the driver of market gains. (As an aside, the recent re-entry of the retail investor could be viewed as an indicator that this rally may be getting “long in the tooth.”)
At the same time, the Federal Reserve has “created” nearly $400 billion of new base money within the financial institutions of this country. It stands to reason that these institutions are (much to the Fed’s pleasure) fueling the upward bias. To quote Chris Martenson, “the stock market has become a liquidity gauge first and a discounting machine second.” The liquidity explanation for the market’s performance helps to clarify our recent relative underperformance, but it does not provide much evidence of “staying power”.
Another impact from all this “new money” is a major decline in the US Dollar. Since its peak in June, the US Dollar Index has declined 12.8%. Partially as a result of this decline, and partially due to demand changes, agricultural commodities have soared. In the past 12 months, cotton is up over 150%, corn +85%, oats +73%, and soybeans +57%. Gold was up a mere 21%. The global social impact of these price hikes is beyond the scope of this writing, except to say it may be exacerbating the unrest bubbling in the Middle East and elsewhere. What is relevant is the impact on the share values of commodity-based stocks. Here are a few examples of performance over the past twelve months: Gold Miners ETF (GDX) + 31%, Agribusiness ETF (MOO) +42%, Base Metal Company ETF (XME) +55%. Even the financial sector is posting record profits on the back of free-money spreads. These profits are reflected, for example, in the 23% 12-month gain in the Financial Sector ETF (XLF).
So, what are our conclusions from this exercise? First, the Fed has thus far accomplished what it wanted by elevating asset prices, setting the stage for improved corporate profitability, and generating positive GDP. Second, corporations have enough excess capital to continue improving productivity, thereby increasing margins, and ultimately profits. Third, our decision to avoid making a bet on the height and duration of a liquidity-based market rally has muted our performance.
Circling back to confirmation bias… Spending a month focusing primarily on research that refutes our position has been an interesting exercise. Sometimes it was downright uncomfortable. But, in the end, I find our position to be largely unchanged.
Structurally, we continue to believe that the stock market is damaged. Few lessons were learned from the Flash Crash and fewer actions were taken to prevent it (or even a more severe version) from recurring. From a macro perspective, we continue to believe that inflation is a global problem as evidenced in commodity prices. Geo-politically, we are in the midst of happenings that history may well consider being watershed events. We also think that when the Fed ultimately is forced to remove liquidity, the impact on stock prices and bond yields will be dramatic – and not in a good way. To analogize, the broad picture is akin to a rubber band being stretched: Solid US profits, growth, and share prices being tugged upon by inflation, structural flaws, and geo-political strife. Since people who invest with us seek consistent returns and vigilant dedication to preserving capital, this is a tug-of-war on which I choose not to bet.
I’ll conclude by sharing an anecdote about the Egypt ETF (EGPT). On January 28, during the height of unrest, money began flooding into this ETF – an ETF with an average volume of about 51, 000 shares. The money flow was apparently buying, driving the ETF up 14% while volume spiked to over 1 million shares. Be mindful, during this time the Egyptian stock market remained closed, causing the fund to trade, at its peak, at 14% over its Net Asset Value. This is indicative of how free capital presently views risk. It’s also evidence of why we choose to look elsewhere for investment returns.
Legendary value investor Benjamin Graham observed, “Speculators often prosper through ignorance; it is a cliché that in a roaring bull market knowledge is superfluous and experience is a handicap. But the typical experience of the speculator is one of temporary profit and ultimate loss.”