Diary of a Financier

From the comments section: The wall of worry

In Capital Markets, Economics, Idiosyncrasy, Politics on Wed 28 May 2014 at 17:09

I get a few comments and emails every week.  Some are argumentative and some agreeable.  That’s just what makes a market — we all buy our assets from sellers, and we sell to buyers.  Fact of life that somebody will always be on the other side of your trade.

Now, as I say in my “About” page:

“Recognize that I write for myself, but I do welcome the eyes of the public. I implore your contention. That’s why I have not adorned this Diary with a lock. Petrified in these pages, my entries forever carry the weight of scrutiny. For that, I am better.”

Scrutiny is more valuable to me than affirmation.  Sometimes I get reader feedback that intrigues me for that very reason: it makes me pause, re-evaluate my hypotheses, and challenge my beliefs.

Recently, I received just such a comment.  Ignoring its frail jabs, I think it characterizes the prevailing (perma)bear argument — the everpresent “Wall of Worry” the market’s always climbing.  It also has me consolidate a lot of my hypotheses and opinions regarding capital markets, investment, portfolio management, macroeconomic theory, secular trends, and psychology.

I’ve reproduced the digital conversation below…

~~~~

A reader made an… interesting comment here on the blog two weeks ago, verbatim:

Joeallen Gibson:

Your listing of pros and cons of various aspects of the market condition is just about the most ludicrous example of financial analysis I’ve ever come across. This type of evaluation works fine in picking out a toaster but the financial markets are a complex set of interdependent data sets. You just throw out the data you dislike with an explanation, it’s a data point not subject to being dismissed. It’s not a pro or con they are facts.

  1. lowest bear level in years,
  2. VIX very low (almost no fear in the market), margin debt through the roof, highest in 20 years (no money on the sidelines),
  3. RUT just formally met the criteria for a correction down 10%,
  4. QE has levitated the market for past three years,
  5. one misstep from war,
  6. US dollar status as “World Reserve Currency” under threat,
  7. banking stocks down trend and heading to correction range (while using 0% money), it goes on and on,
  8. SPX trading at 26.5 and 26.7 PE when using current earning or the better current earnings with the companies weighted for capitalization within the index, not using future earnings. At what PE is the market to high priced for your taste?

I can point out many more data points that are Bear indicators but you have an answer for them all, which I appreciate. Your type of guidance is what causes stampede selling when you don’t even tell your clients things are dicey and that they should at least raise cash and hedge up a bit. So I thank you I’ll cash the check as your clients stampede out in the coming months.

Here is my response, verbatim:

Romeo:

Not sure to which “analysis” you’re referring, but isn’t this an example of factual data with heed to “complex set of interdependent data sets”:
https://thebuttonwoodtree.wordpress.com/2014/05/15/bull-v-bear-11/

As for much of the data you present, I would suggest you to evaluate those points within a larger, historical context. For example:

  1. Lowest bear level in years– This is a high frequency (weekly) indicator, so it’s susceptible to noisy reads. While bears are at lows, bulls are lowly too, so the bull/bear ratio is far below its norm due to a lot of “neutral” respondents. (https://thebuttonwoodtree.wordpress.com/2014/05/11/top-newsstuffs-may-5-11/)
  2. VIX low & margin debt high– I agree. Persistently low VIX signals complacency, but it’s a poor timing-mechanism for calling a market top (i.e. exuberance). On the other hand, in April & May I did say margin debt was the “single variable [that] could cause the market’s first correction since 2011.” (https://thebuttonwoodtree.wordpress.com/2014/04/06/top-newsstuffs-march-31-april-6/ & https://thebuttonwoodtree.wordpress.com/2014/05/04/top-newsstuffs-april-28-may-1/)
  3. $RUT correction– I covered that in a balanced fashion here, concluding that it was in fact a negative short term signal. (See “Size Divergence” https://thebuttonwoodtree.wordpress.com/2014/05/15/bull-v-bear-11/)
  4. QE levitation– I’ve covered QE ad nauseam. 3 quotes characterize my stance:
    i. “The deficit is the only thing really stimulating the economy. Deficit spending is the closest thing to money ‘printing’–as so many people habitually mischaracterize QE… QE tapering will trigger a proportionate de-risking only if the economy stalls. Then, capital would reverse its flow back down the pyramid towards risk-free assets.” (https://thebuttonwoodtree.wordpress.com/2013/06/17/tapering-reactions-whats-really-happend-so-far-what-will-happen-in-the-future/)
    ii. “the US is dealing with issues from a dearth of secular innovation, sustainable growth rates & demographics… monetary policy is a zero-sum game, a bridge over troubled water, and real growth requires natural resources, demographics, or innovation.” (https://thebuttonwoodtree.wordpress.com/2013/04/19/the-problem-with-mmtmr-and-all-your-other-economic-theories/)
    iii. “The short term [read: shotgun] solution of QE/ZIRP should’ve been succeeded or complemented by fiscal stimulus. No, not the Bush stimulus (tax rebates) that mailed checks to everyone; yes, long term investments in things like our alternative/renewable energy infrastructure, R&D, etc. [ARRA funds were not fully spent]… Now, 5 years later, were we to have implemented a combination of short term stopgap measures and long term kickstarters, I don’t think QE would’ve had to have been scaled-up the way it has, as employment & economic expansion associated with those investments would be yielding gains.” (https://thebuttonwoodtree.wordpress.com/2013/10/24/the-qe-counterfactuals-counterfactual/)
  5. One step from war– Geopolitics, especially war, would’ve kept you out of this market for the best days, weeks & months of the post-crisis bull run. Even were war to beset us, the history of such geopolitical shocks are ephemeral. (https://thebuttonwoodtree.wordpress.com/2014/03/09/top-newsstuffs-march-3-9/)
  6. USD threatened– I’ve mentioned the analogue between WWI Britain & modern USA many times. The “reserve currency status” threat is real, and an Asian/Chinese currency bloc may be the most likely successor, but that’s decades away, low probability, and even then the outcome is pure speculation. (https://thebuttonwoodtree.wordpress.com/2011/03/31/more-on-inflationdeflation-qe3/)
  7. Bank stocks ineffective– They’re (deservingly) paying billions in fines for crisis-era misdeeds, and the regulatory cycle has swung back a la Pecora Era, so their cash flows are being redistributed elsewhere in the economy as opposed to shareholders; spreads historically tight to benefit households & real economy; this is what happens to ground zero sectors after a crisis, but the broad market & economy move on
  8. SPX PE– PE ttm is 17.28. (https://www.spdrs.com/product/fund.seam?ticker=spy) What’re you looking at? Shiller CAPE? That has no merit as a timing mechanism within 24 months’ latency. Market becomes too highly priced for my taste when some combination of the following occur, with consideration to other variables:
    i. A combo of PE/PS/PCF/PEG far exceed historic averages, since “secular bull markets never end at fair value.” (https://thebuttonwoodtree.wordpress.com/2014/05/15/bull-v-bear-11/)
    ii. My valuation analysis, which controls for habitually overestimating analyst consensus (forward EPS), says investors have discounted-forward an unrealistic growth extrapolation (i.e. “price compression”)
    iii. Earnings yields drop back beneath IG bond yields (Baa)

For every datapoint, there is a permutation or a counterpoint. I take each of my hypotheses and try to disprove them with such a null hypothesis. I end up with a multifactor, multidisciplined output that effectively controls for my cognitive biases — behavioral influences we all bring to the table.

As for my clients, we’re a multifamily office, so I manage the majority of their assets with discretion.

We do hedge when necessary, but our only hedges right now are junk credit spread wideners. No equity hedges today because this is the most dangerous part of the market cycle to hedge (i.e. the blowoff phase after fair value has been reached).

I prefer to use cash as an equity counterbalance here, so you might notice that we have 8% cash right now, since I post our core portfolio’s positioning in real time. (https://thebuttonwoodtree.wordpress.com/2014/05/15/bull-v-bear-11/)

Further, our Beta is benchmark-weight (0.76 for a 60/40 portfolio).

Your thoughts?

Really, anyone out there, what are your thoughts?

–Romeo

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  1. A half-a-generation-long secular bear market in equities, involving two traumatising market crashes, conditioned investors to never fully relax, and always be waiting for the other shoe to drop. That mindset is not wholly appropriate to the secular bull that has emerged, but it’s a mindset that will take an age to be fully abandoned. Indeed, its abandonment will mark the final phase of this secular bull, when everyone is projecting better things to come for ever. That’s likely a decade (or even two) away, with a cyclical bear (or two) perhaps en-route to that destination, so unlikely to be of concern today. In the meantime, I find your holistic analysis, based as it is on chart facts, an open mind and a willingness to equally consider +ve & -ve in order to counter cognitive biases, to be fascinating and instructive. Safe Journey!

  2. […] extreme 30-55%     2011-14: avg <5% range; extreme 10% [Previously: Bubble indicators, Vol is not a timing mechanism, How the stock market resembles the heartbeat of a dying patient, From mediocristan to […]

  3. […] at the market right now.  Most of it is of the garden variety, those constant fixtures in the everpresent wall-of-worry.  Euroskeptics are perhaps the loudest of the lot right now.  This ilk is framing a much […]

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