Diary of a Financier

Bull v. Bear

In Capital Markets, Dissertation, Economics on Thu 9 Jan 2014 at 12:56

I’ve spent considerable time synthesizing all of the information I’ve consumed over the past month(s) and rendering a timely, cogent market opinion.  Particularly interesting at the outset of a new year, the following signals-through-the-noise attempt to substantiate an objective narrative that can guide me through the equity market over the coming days, weeks, months, and quarters…

Bull

  1. Economic strength (PUSH)– GDP growth should be strong, perhaps starting the year as high as 4% & settling into a 3% FY clip
    • Counterpoint: Don’t confound the economy with capital markets; the latter is a discounting mechanism that handicaps the future of the present-day economy, which is very much a psychological exercise performed by imperfect, procyclical agents; the GDP outlook above is now the Street’s base case expectation–echoed by the Fed–and therefore priced-in
  2. Continued Fed easing (+)– Accommodative monetary policy will remain, with ZIRP likely for the longer-term (explicitly extended to 2016)–even after a QE taper has reduced LSAPs to nil.  In accordance with Janet Yellen’s “Optimal Control Policy,” December’s most recent Fed minutes show willingness to lower the unemployment target to 6% and tolerate above trend inflation en route to fulfilling the central bank’s dual mandate.
  3. Strategists’ sentiment (PUSH)– BAML’s sell side consensus indicatorBAML sell side consensus indicator (2013.12.31) is the only remaining, bullish gauge of psychology left–barely hanging-on to a contrarianbuy signal at 53.3 vs. 54.5% threshold
    • Counterpoint- This indicator measures strategists’ sentiment, and per the historical data, strategists tend to be more conservative than analysts, who have been exceedingly bullish since 2012

Bear

  1. Retail sentiment ()Bull/bear ratio at alltime highs; dumb money’s stock allocations Sentiment survey (bulls/bears); Allocation survey (stocks/bonds/cash); Real gross margin debtat 2006 highs with cash & bonds near alltime lows; margin levels at alltime highs (nominal gross, real gross & net balances)
  2. Technicals ()– The base case bear outcome is developing exactly as envisioned, with a daily/15min bull flag devolving into a complex fulcrum top
  3. Fundamentals ()– Amidst the rising rate regime associated with the QE taper, earnings yields SPX earnings yield vs Baa bond yieldshould rise with the risk free rate.  At best, a risk-on environment should see a compression in the historicarb spread between theSPX E/P ratio (6.5%) and Baa bond yields (5.3%) as bond yields catch-up to earnings yields and eliminate risk’s relative value advantage; at worst, stocks willrevalue, given the razor-thin equity risk premium (ERP).
    • Counterpoint: Secular bull markets never end at fair value; SPX multiple analysis (FY14 ao 2013.01.08)they always ride momentum’s wave and overshoot… but that doesn’t mean a correction (>10% drawdown) can’t occur, as supported by my 2014 multiple analysis
  4. 1994 analogue ()– Similar to the “Fundamentals” vein, 1994’s bond massacre saw SPX sources of total return (multiples/earnings/dividends, y/y)significant multiple contraction (ttm PE from 17.57 to 14.67) in a broad revaluation per rising base rates.  In 1994, SPX ended Q1 down 4% after a 10% drawdown, managing to end the full year down only 2%.
  5. Mean reversion ()– Despite a lot of debate citing overfitted data, SPX typically mean reverts after big years like 2013. After >25% CY performance, SPX’s subsequent mean return is only 5.47 vs 11.5% historical average. 1946 (-11%) may be the best analogue for 2014, given the pattern of preceding annual returns (through 1945), the ending war, and the demographic trough.
  6. Credit spreads ()– High Yield ($HYG) and High Grade ($LQD) spreads HY credit spreads- absolute (blue), relative (red), SPX-adjusted (green)have been whittled down to almost nothing: HY absolute spreads at 387bps are sliding lower to new postcrisis records in the 2004-07 & late-1990s range (low ~250bps), but more importantly, relative spreads sit right there at alltime lows.  IG absolute are down to 68bps–a postcrisis low in the 2004-07 range–Sources of fixed income returns (risk free rate/credit spread/coupon, FY13)and relative remain just off alltime lows after setting a record in 1q13. Emblematic of this dynamic, a tightening of credit spreads contributed +9.4% to junk bonds’ performance in 2013 (+3.0% for IG/$LQD).
  7. Durable goods/Capital goods (PUSH)– I still fear aggregate oversupply, with orders far exceeding shipments and inventories accumulating, which all worsened in November’s most recent report.
    • Counterpoint- This is a rather low-frequency indicator that’s pretty noisy; the real test is to see whether or not shipments pickup in coming months–a signal that CapEx is improving due to the QE taper

~~~~

I count 1 positive (+), 6 negatives (), and 2 pushes (PUSH)–quantitatively a bearish slant.

In full acknowledgement that my default setting should be bullish optimism 90% of the time, I think today’s market falls under that bearish 10% balance.  Throughout this Diary’s last 4+ months, I’ve remained bullish while preparing for this precipice.  At first, the event horizon lay “in the long term”; then it was “the intermediate term”; and now “the short term” has arrived.

Regarding that event horizon, I’m not sure of the magnitude.  I’m still inclined to expect a base case garden-variety correction; worst case bear market.  My confidence in the base case is rooted in a number of findings.  A counterpoint mentioned above is chief among them: secular bull markets never end at fair value.

As I mentioned yesterday, we’re returning our allocation from overweight risk back down to benchmark-weight.  We are not going to overreact right now (i.e. go underweight) for two reasons, including the probability that our correction call is poorly timed given the market’s momentum, and the fact that a 10% SPX drawdown (~5% for a diversified 60/40 allocation) is peanuts within the big picture context of a bull market.

That said, part of that derisking involves a reallocation of our fixed income sleeve, with High Yield/Floating Rate positions getting swapped for Municipal Bonds and eventually some deep discount Closed-end bond funds (CEFs)/Mortgage REITs (mREITS).

We’re doing this for a couple reasons.  First, munis still trade near historically Taxable Equivalent Muni yields (TEY) vs 10y Treasury yield ($TNX)wide spreads over Treasuries on a taxable equivalent yield (TEY) basis, so there’s value there.  Second, while lending to the real economy (C&I loans) has Fund flows- High Yield Bonds & Leveraged Loansbeen satisfiably tepid, it’s been displaced by junk credit issuance.  While I’d call this a Grey Swan that regulators are consciously addressing, the demand for high yielding paper has been insatiable enough that it needs a correction to remind investors of the risks. At this point in the greater market cycle, these spread corrections are merely the undulations of a short term debt cycle, not systemic defaults associated with larger credit booms.

We’re also pursuing better equity values internationally (e.g. some Japan, Europe & now Canada) and considering increasing our allocation to commodities.

–Romeo

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