The Great Rotation

Since Donald Trump was elected president, US 10 year treasury bonds have sold-off drastically, pushing yields from 1.7-1.8% to currently 2.5-2.6%. Is this finally the start of “The Great Rotation” from bonds to equities? It almost feels like the boy who cried wolf here, given that people have been clamouring about the end of the bond market for, well, forever!

While I’ve certainly been on the bear camp for U.S. treasuries for far too long, the evidence here of an inflection point seems to be strong. And while many right now sing a song about how the market fears Trump’s fiscal policies will be inflationary, evidence seems to point another way for the true source of this inflection point: China.

From this USA Today article, Japan has overtaken China as the biggest owner of U.S. government bonds where at the end of October 2016 held $1.13 tn US government debt, above China’s $1.12 tn. China has been selling U.S. treasuries (on the record is ~1/3 of their $3.1 tn foreign FX reserves) in order to prevent a massive devaluation in their currency. Since October 2015, China has sold $139 bn of US government debt, or more than 10% of their holdings.

And the trend of China selling U.S. treasuries will undoubtedly continue. In the latest December Economic Work conference meeting, they emphasised the need to stabilise the Chinese Yuan (CNY). The most obvious method is liquidating their U.S. Treasury holdings and buying CNY.

But this trend in itself sets up a remarkable conundrum: as treasuries get sold, yields go up, the USD goes up, and the pressure increases for the CNY to depreciate even further. I can’t see how this doesn’t become an economic shock to the world, and potentially the start of the next crisis. If anyone can come up with an argument on how this gets resolved peacefully and without a crisis in China, I am sure the Chinese leaders would love to hear it.

The bond bears have growled and called wolf for many years (including myself!) and the evidence is increasingly compelling that they are going to see the big bad wolf show itself soon enough. 

Final Innings

                Over the last few years, candidates for being the harbinger to the end of this bull market have come and go. We’ve had the Grexit crisis, China collapse, tech 2.0 bubble, property bubble, and much more that have growled, only for the market to yawn and keep rallying. But over the last month, a more interesting candidate has surfaced, which has been overshadowed by the scare about a China collapse: high yield bonds, formerly known as junk bonds.

In mid-December, 2 high yield funds halted redemptions to avoid liquidating assets in a fire sale: Third Avenue’s $3bn Focused Credit Fund and Stone Lion’s high yield fund. In other words, there simply is not enough liquidity in the high yield space to meet any type of selling. Illiquidity in the bond market has been well flagged this year; if even the IMF warns about this (in Sep 2015), you can be sure everyone knows. While the market has more or less shrugged this incident off, it’s a warning shot to risk assets. There’s no need to panic just yet, but it’s become clear where the risk is.

The underlying cause for all of this undoubtedly is low interest rates and leverage. The risk curve shifted down and money went to all types of yield seeking assets, including property, dividend stocks, higher yielding currencies (ie emerging markets), and of course high yield bonds. Other examples of an outcome of ultra-low interest rates are unprofitable ‘unicorns’ as well as companies issuing debt for share buybacks. Simple reversal means money flows the opposite way. For assets which are leveraged, like REITs, high yield bonds, problems become magnified. Today one of the issues is energy prices collapsing from >$100 to <$40 in over 1 year, dragging down the high yield market where it is ~14% of the market. While energy high yield bonds itself may not bring down the entire market, increasing rates over the next year or two will undoubtedly cause problems for the high yield market.

While pundits continue to worry about the slowdown in growth in the USA, they really don’t need to with unemployment close to NAIRU and wage growth picking up. Walmart is a key example where they have raised minimum wage to $9 and then will further raise to $10 by February 2016. They didn’t necessarily want to, but they needed to with labor market competition increasing. While costs will rise for companies, ‘main street’ will benefit and start spending their excess savings. Add that onto savings from lower gasoline prices, the USA will be doing just fine. For now, they are dragged lower by big oil cutting spending, but in the longer run the rest of the economy will benefit, starting from the consumer.

Which brings me to my final topic of discussion, the Fed’s pace of tightening. For the next year, the dot plot projects 4 rate hikes, which is exactly what the overall market is currently factoring in. Last I checked 10 year treasuries are trading at ~2%, which means market isn’t factoring in much of inflation at all. This is a huge risk for the market with labor markets tightening and wage inflation creeping up, as it could imply rate hikes quicker than market expects. You can be sure the market will not like that.

For the near future though, the market continues to choose to ignore these warning signs and misplaces their fears. The market is nervous, but not about the structural issues such as an overinflated high yield market and higher inflation. They’re still worried about things like China, ISIS, OPEC, crude oil, things that make the headlines but not the ones that will bring down the market. The market will continue to climb the wall of worry, until it finally faces the problem children of zero interest rates - and you can be sure high yield bonds will be one of them.  

Rally On, Bull

As soon as the Fed tapering talks died down a U.S. government shutdown comes. This year has definitely not been short of excitement! 

The confusion in the markets is quite surreal - the equity markets rallied and treasuries sold-off post-government shutdown, which is initially counter-intuitive, because, shouldn't people be scared of a world where Americans can't visit their national parks and see pandas live on the internet? Some are arguing that the cause of the equity market rally is that this shutdown will prolong easy money from the Fed, helping the markets extend their rally:

"We do not know how long this impasse in the U.S. will last. If it persists, there is a chance it will hurt economic growth and affect chances of Fed tapering," said Daragh Maher, strategist at HSBC. Source: Reuters 

I have to biased-ly agree on this (see my previous post on delayed Fed tapering). This is definitely going to hurt the economy, and the damage will extend beyond the humorous shut down of the panda live cam. Easy money will continue.

In terms of implications for the markets, this turn of events is extremely confusing and even more ambiguous. On the one hand you have expansionary monetary policy with the Fed continuing QE3 and low interest rates, and on the other hand you have a contractionary fiscal 'policy' (or rather, 'failure'!) where the two parties are jockeying for political position at the expense of the citizens' livelihoods. So in the end the status quo continues: easy money in the market, higher equity valuations, but an economy that continues to stumble along. At some point these two trajectories will change directions and that's when I foresee a turn in the equity markets. Below is a simple picture of how I imagine this will all end up in the next 2 years.

At the point where the two lines intersect is the situation where the equity markets will have far outrun the growth in the economy, and become irrational just as easy money gets taken out of the money by the Fed. The most likely scenario at that point will be a market crash.

In the near term, I think easy money will prevail and it's most likely that the equity markets will continue on their upward trajectory this year. Some kind of market pullback is warranted as the economy remains tepid due to the fiscal budget while market valuations have run since last year. However, judging from all that I read I just don't feel that we are at the euphoric phase of the bull stock market just quite yet; the Fed has continued to distort and fuel the markets. Get ready for the next bull leg of the markets, it may just be the last one!

To Taper or Not To Taper That is The Question

I'm re-focusing today's topic on something I only talked about briefly last post, the US Fed's next move. The market consensus today is that the Fed will start tapering (i.e. slow down QE3 / long dated bond purchases) in September. This has been the case shaping since May of this year when Bernanke did a fumble and made the mistake of saying out loud that tapering could happen as soon as September. He quickly tried to make a U-turn subsequently by going to media to say that no, they were only going to taper if the economic data showed significant improvement.

The market has not cared about Bernanke's frail attempt to calm market fears. As shown in the chart below, US 10 year treasuries have sold off quite drastically relative to the stock market (shown as the S&P 500). This is a normalized chart and not a very typical chart to show, but I thought it neatly showed the relative underperformance of US Treasuries.

Source: Bloomberg














People have been pulling money out of bond funds relentlessly. It's pretty easy to guess where most bond funds have been allocating their money based on how quickly the US treasuries have sold off.

The question going into September is definitely if the Fed will start tapering or not in September. Most people have already factored in at least a $10bn reduction in QE3.

I really don't know why they think this!

In the last FOMC statement in July they revised down their vague Fed language on US economic growth from "moderate" to "modest", the first time in a few years. Only one person dissented from this statement and this was long time dissident Esther George. Everyone agreed on continuing the $85bn in monthly QE3. First quarter GDP growth was revised down from 2.4% to 1.8%. People have all of a sudden forgotten about sequestration (the word we all just learned in 2012) and the negative effect on people's income and employment. For example, an indication of this is Walmart earnings and their negative outlook for the 2nd half of the year. The market gets fixated over every little economic data and the accelerated sell-off in US treasuries is irrational. Why would the Fed pull-back so drastically? They are not stupid. They know a spike in mortgage rates will hinder the housing recovery. They know a spike in borrowing costs will hinder the economic recovery.

Now don't get me wrong: I too am a long term bear on US treasuries as I've said in my previous posts. But let's not get ahead of ourselves please.

The End of "Always Buy, Never Sell Property"?

Let me start off this post with a paragraph reflecting on the latest chatter before I lead into the main subject of this post. The year so far hasn't deviated too far from how I thought it would end up. The USA has been talked up to recover faster than the expectations of lots of people and the EU is still around. Where I've been wrong is the underperformance of emerging markets. I had thought that a recovery in the USA would pull along the rest of the global economy in tandem. That however, has not occurred as China remains soft, pulling lower commodity prices, and together pulling lower other emerging markets so dependent on commodities like Brazil, Indonesia, South Africa. In addition, the latest volatility in the market has arisen due to the sudden spike in treasury yields due to just a few words from Bernanke in reference to the end of QE3.

I've been wary of the end of low interest rates for as long as 2-3 years ago (I have so many posts on this) so this speech was of no surprise to me. What did surprise me was the reaction of emerging markets. For example, the Philippines, Thailand, Turkey and China have all been in free-fall. China itself is a bit of a domestic issue due to its financial markets still being largely closed, while Turkey is due to some domesetic unrest. However, I didn't foresee the interest rates being the real killer for the other emerging markets. I didn't realize some punters have been borrowing on low-US interest rates and investing in these booming emerging markets. In a sense it's a carry trade of some sorts and an idea that just slipped my mind in analyzing some of these smaller emerging markets.

This has really lead me to think even further on this issue of interest rates which are so critical. Asia property has risen to new and newer heights on the back of low interest rates (see my post on HK property in 2009). When I compare property in Asia to such established places like London and New York, the alarming closeness in prices is, well, alarming! Fundamentally speaking Asia property shouldn't be per square feet as expensive since GDP/capita really isn't quite there yet. You can certainly debate all day with me on this. Nonetheless, this relative overvalue of Asian property actually isn't what I really want to talk about in this post.

Rather, it's that property as an entire asset class should fall or stall over the next decade. My attack is on the conventional wisdom of "Always Buy, Never Sell Property". And it's entirely predicated on the contents and trends of this chart below:

Source: Yahoo! Finance

This is the chart of the 10 year treasury yield over the last 50 years. The thing to take from this chart is that it's been on a downward trend for the last 30 years. Most of the people alive today  giving you the advice to "buy and never sell property" have been living in a generation where the interest rates have continued to fall. With expectations that interest rates will keep dropping steadily it makes complete sense to buy property. Easier credit = easier to borrow money to buy property = higher housing prices = more inflation. This cycle more or less continues as interest rates continue to fall. I guess some places like Japan (prior to Abe-nomics) refute this logic, but for the most part it's generally true.

And then if the reverse happens, as the market is now slowly starting to expect (i.e. tougher credit coming in the form of higher interest rates), property prices should have a tough time climbing. The path of least resistance for property prices would be on the downside in that circumstance. I was surprised at the market's volatility and reaction of late to Bernanke's comments - I thought everyone knew that interest rates would come up. The enormous positions entwined in the low interest rate environment is certainly deep. Housing as an asset class is one of them.

This idea that real estate prices could have a persistent bear market is a challenge to conventional wisdom and there are certainly plentiful of counterarguments to this challenge. For example, reasons why real estate markets will always rise are usually due to people always needing to live somewhere, people continue to urbanize, etc.

My take against the  conventional wisdom is that credit markets are so key to all of this. Low interest rates lead to a lot more people participating in borrowing money to buy property. The reverse would lead to the exit of these buyers unable to buy with cash, which is in fact a lot of people in the world, and especially in emerging markets. In a world with no credit, housing prices should go to a level where cash buyers can afford to buy. And looking at today's Asian property prices, they are a long, long, long way from a level where cash buyers can afford to buy. The implications for the Asian markets are far and wide as most of Asian wealth created over the last decade has come from property.

Lately the treasury yields have spiked and people are rushing to the exits already of all easy-money related trades. I'm sold on the idea that yields will come up over the longer term. However, I actually don't think in the short term they should come up all that much so fast because the Fed is still pumping money into the system. The American recovery has been a bit over hyped (I believed in it too but at this point I think the media has exaggerated it too much). Fundamentally I do believe that this is a preview to the start of an eventual upward trend of treasury yields. The implication to global markets are far reaching and highly impactful. Buyers beware!

Almost All of Wall Street Got 2012 Market Calls Wrong…And Will Likely Again in 2013

With a new year ahead of us and plenty of opinions out there on what will happen this year, let’s first take a look back and see how accurate forecasters were one year ago. According to this Bloomberg article it turns out most of them were inaccurate:

From John Paulson’s call for a collapse in Europe to Morgan Stanley (MS)’s warning that U.S. stocks would decline, Wall Street got little right in its prognosis for the year just ended.

Paulson, who manages $19 billion in hedge funds, said the euro would fall apart and bet against the region’s debt. Morgan Stanley predicted the Standard & Poor’s 500 Index would lose 7 percent and Credit Suisse Group AG (CSGN) foresaw wider swings in equity prices. All of them proved wrong last year and investors would have done better listening to Goldman Sachs Group Inc. (GS) Chief Executive Officer Lloyd C. Blankfein, who said the real risk was being too pessimistic.

The ill-timed advice shows that even the largest banks and most-successful investors failed to anticipate how government actions would influence markets. Unprecedented central bank stimulus in the U.S. and Europe sparked a 16 percent gain in the S&P 500 including dividends, led to a 23 percent drop in the Chicago Board Options Exchange Volatility Index, paid investors in Greek debt 78 percent and gave Treasuries a 2.2 percent return even after Warren Buffett called bonds “dangerous.”

link to article

Government actions were an “X” factor this year that most of these forecasters failed to foresee. Brought down by pessimism from a late drop in 2011 many drew a straight line downwards for the stock market. Additionally, Wall Street (sell-side) never really likes to be bold; after all, if they step out too much and are wrong, they will likely lose their jobs!

If they had just taken a step backwards and looked at pure fundamentals, they would’ve seen the discounts equities were trading at (all types of valuation metrics, e.g. P/E, P/B), and should have been even more bullish if they had simply compared the earnings yield versus what a treasury bond yields!

Likewise at the beginning of 2013, the earnings yield for the S&P 500 (inverse of the forward P/E), despite its run up, stands at 6-7% while a 10-yr treasury bond yields roughly just under 2%. If you look at Europe where some government bonds trade at negative yields and many large cap stocks trade at ~10x forward P/E, the absolute spread between the bond yield and earnings yield for some of these markets is even greater. Any rational person would buy equities instead of piling into the bond market. Well, of course, as the title of my blog says it, the market does get euphoric/irrational at times.

For 2013 I see most analysts/forecasters expect a +10-20% increase in the S&P 500 and for many markets. They fret about the Fed pulling back QE3, the fiscal cliff, Europe breaking up, and overcapacity in China. Once again I get the sense they are just drawing a straight line from the end of 2012 and have a lack of conviction on the market. I also get the sense that retail investors are still not buying the stock market yet and are still parked in bonds. Combining these two observations of people still doubting the market uptrend (and thus not displaying euphoria, a sign of the market peak) with the fundamental positive spread between the index earnings yield and bonds, equities still have room to run a bullish course for 2013. To all those pundits who claim the “Death of Equities”, I say, not quite yet!

The forecasters might just get 2013 wrong again. This time though, it’s not the direction of the market they’re likely to get wrong, but the amount the market will move up!

Is Europe in a Depression?!

The other day I read in the Business Times an interview with 4 quite notable investment managers. Kenneth Courtis, a former vice-chairman of Goldman Sachs and co-founder of Themes Investment Management, gave a quite striking remark on the situation in Europe:

“Large swathes of the eurozone are already in recession now, and its southern tier – Greece, Spain, Portugal, as well as Ireland – are in outright depressions”
Link to the article

My instant reaction was: holy cow! I’ve been following the situation in Europe as you can see in my previous posts, but never even thought about it as drastic as a depression. I’ve always thought about depressions as a thing of the past, like a pre-WW II kind of event that would never happen in my lifetime (I don’t expect to live that long). At first, I thought he was just being airy and bold, after all, this was an interview and these guys will use the interview as a marketing tool.

But as I thought about it more and more, I realized that there was no way that Europe would NOT enter a depression.

When a country goes into a recession, it usually has two ways to dig itself out of the hole: fiscal tightening or monetary easing/devaluation of their currency. The former is in fact the more responsible way to do it, but is also both politically and socially tough. So most countries will choose the latter since it’s just easier to explain to the people that they’ll get to keep their jobs rather than cutting the budget. Even though monetary easing will end up hurting people’s pockets all the same through inflation, it’s a delayed process that’s easier on people – biggest example is what’s going on in the USA right now.

In the case of Europe, the countries can’t exercise independent monetary policy, so they have no choice but to go the route of fiscal tightening. Thus you see the high unemployment rates, budget cuts, etc in Europe (eg >20% unemployment in Spain), whereas in the USA you see unemployment rates easing downwards and a much more optimistic view of the economy.

If the Europeans choose to keep the Euro and the European Union intact which they seem quite intent on doing, many of the problematic countries will undoubtedly slip into not just recession, but depression. The EU may get saved, but the people will suffer for it. 

Don’t Call The Bottom

It’s been a while since I’ve written a post just about trading and where I feel the stock markets are heading. Well, actually I almost always write about it indirectly, like my previous post on June 17 on the “Unease” in the market that was a prelude to the market drop. But I digress.

A lot of people around me have seen the market drastically drop in 2 weeks and subsequently have begun to believe that the market is a “buying opportunity”. This has caused me to become concerned enough to write a post about it. Simply because the market has dropped significantly does not mean it won’t drop more. Certainly that statement goes both ways, but I would like to pose a question – what will drive the market back up? QE3? “Better” than expected economic news? Economic unity in the Europe? “Low” valuations as pundits claim? Yes, all these things might trigger a short term rally, but the downside is all there and I can’t think of many positive things that could surprise on the upside. The market follows the path of least resistance, and it’s clear to me that the path of least resistance is downwards. There’s not a whole lot right now that could drive this market upwards other than short-term swings in the market.

The major problem for me in terms of seeing a clear bottom right now is the lack of conviction in the market. Today I read an associated press article titled:

“AP survey: No recession but weakness will endure—Economists doubt another recession within 12 months but see weakness into 2012”

http://finance.yahoo.com/news/AP-survey-No-recession-but-apf-523688622.html?x=0&sec=topStories&pos=8&asset=&ccode=

Just what kind of prediction is that? Shoot, I'm pretty sure I don’t need a PhD to make that kind of prediction.

I decided to not go too fancy with this drawing; not even drawing support and resistance, ascending triangles or things like that. The point is that the upward swing has been broken, rather violently as witnessed by the previous few weeks’ market action.

What, then you ask, will signal the bottom? When the “market” has conviction. A sign of the top is when everyone is bullish, the bears have been beaten down and are back in their caves. A sign of the bottom is when everyone is bearish, the bulls are screaming and driven up the trees. In recent memory - March 2009 was when everyone thought the world was going to end. Before this summer everyone thought the recession was over.

Point is, until everyone is bearish, I wouldn’t call this the bottom. Or at least not until an European Union country defaults and gets the boot.

Technorati Tags: bear case,euro,market outlook,global macro

Predictions for a New World Economy

http://marketblog.files.wordpress.com

Due to complications from starting work in finance, I will have to stop blogging on my finance blog. Thus, since I can’t blog for a while, I’m going to write my predictions for events in the next year. It’s going to be fun looking back at what I write here, either because of how wrong or right I was.

So first of all, what’s that picture up there? Not only is it a picture I borrowed from another website, it also shows the market mind/emotion in different stages of a bull and bear market. And if I were to guess where we are right now, it’s at optimism. According to the media pundits, the job loss situation is “stabilizing” and activity is “picking up”.

All words of optimism. And I don’t doubt this optimism. With interest rates so low, something’s going to happen. The problem is, nobody knows if this “stabilizing” and “picking up” is moving towards growth or simply more stabilizing, or as some would call it, stagnation. As some of you who read my blog know, I’ve been quite pessimistic this past year. I’m not so much anymore. I believe in monetary policy and when interest rates are low, economic growth is going to return. Additionally, I was previously quite pessimistic due to the dire situation of the financial sector. However, the engines of the US, the financial sector, is becoming more profitable (in part due to the steep yield curve), and as lending picks up, economic activity is going to pick up.

On the chart up there, optimism becomes enthusiasm, then exhilaration, before peaking at euphoria. We are just at the start – optimism. Yet I’m not completely optimistic about this upcoming up cycle. I think it’s going to reach euphoria much quicker than historical bull runs.

Why? Because inflation’s going to hit the economy really quickly as activity picks up. Money velocity is going to shoot and blow the roof off the top of this house. And interest rates are going to have to go up, up, and up, and the economy will once again slow down.

But I digress – I’m supposed to be looking at the upcoming year, which looks pretty good economy wise. It’s all about the low interest rates - which are not only propping up the economy, but also the equity markets.

Lastly, I must mention the potential risk from sovereign debt defaults. There’s been a lot of conversations and fears about Greece, Ireland, Spain, etc, including my post on Nov 26, 2009 about the Dubai request for a standstill. The big questions for me are: Will the EU survive? Will these countries break off from the EU? What are the consequences from a default from Greece, Ireland, Spain or another EU country? I think there’s a good chance that a EU country is going to default. They simply over levered themselves during the good times. But will the EU disband if that happens? I actually think not – they might just kick out that country. Will the world stock markets be shocked? I think there’s a fair size of risk to this economic and market rebound coming from potential sovereign debt defaults.

In conclusion, this is going to be a good year for the economy and stock markets – if a sovereign debt default doesn’t kill the rally.

Muscling With The Markets

"The market wasn't agreeing with my view. But rather than listening and being patient, I tried to muscle it. It was a classic case of thinking I knew more than the market...I was so badly hurt that all I could do was lick my wounds and get the hell out of there. Not only did I lose a lot of money, I missed a great opportunity."

- Yra Harris, Praxis Trading, from Inside the House of Money, Steven Drobny

I've had some down time recently and have been reading Inside the House of Money, put together by Steven Drobny. It interviews hedge fund managers/traders who have the style of investing known as Global Macro, which is essentially investing in everything, from stocks to bonds to commodities to trees. You get the point, they invest in anything! (Pretty badass, if you ask me)

So I read an interview with Yra Harris, a veteran trader on the Chicago Mercantile Exchange, and came across the quote above, and it got me thinking.

Is it possible that right now, with the stock markets rallying roughly 50-60% from its March '09 lows, that my continued pessimism is like "muscling" with the markets? Is this the classic case of thinking that I knew more than the market? Am I missing something?

After reading a lot today, I find that the most prevalent bullish case in finance media and blogs is nonetheless still that the "global governments are pumping lots of money into the system" and that monetary policy drives the markets. As I argued in my previous two posts, this pumping of money into the system is neither effective due to the reduced risk taking of the financial sector nor will it be healthy for the economy since it increases risks of high inflation. If there are other stronger bullish arguments, somebody tell me please!

After some evaluation, I believe that while my fundamental argument is still intact, my timing is off. I don't think I'm still a bear simply because I'm arrogant or too proud or anything like that. I sure wouldn't mind a happy-go-lucky bullish market.

I'll need to continue honing my entry points into the market as I gain experience in trading.