Post Brexit market is confounded by so many drivers that it is a nightmare for both the professional and retail investors alike. The key players are the Bank of England, European Central Bank, Bank of Japan and the Federal Reserve Bank in the form of interest rates and helicopter money (QE). The investors are looking for the “yield” which isn’t available elsewhere except in the US equity market, “the only game in town” so to speak. The bond yields are negative in Japan and Germany and lower in Europe than it is in the US that causes the “Lemmings Syndrome” of flocking to the only game in town. Federal Reserve’s hands are tied in the sense that while they are contemplating increasing the interest rates, certain key measures of the economy such as GDP, political climate and non-farms payroll are not conducive to interest rate hike. The economic situation was good enough in summer 2015 to tighten monetary policy, and the Fed has probably lost a few precious months which could complicate its task. It won’t be able to act through changes in interest rates because they are already too low, so it will be forced to start a new program of bond buying that has many disadvantages, notably popping up the prices of financial assets. This makes their tone more dovish than hawkish. The investors and traders are dumb-founded and there are as many bears as there are bulls. This has resulted in the market indices, DOW, Nasdaq and S&P500 trading sideways for days on end, actually as many as 34 days in a row trading within a narrow 1% range.
Billionaire investors like George Soros and Carl Icahn and many others, are bearish on the market, with immense short positions held in millions of dollars. They too are confounded!
One after the other, they are lining up their investment strategy for negative stock returns ahead. George Soros, who famously made $1 billion in a day shorting the British Pound, has made a massive short bet in the S&P 500.
Carl Icahn also made a huge bearish shift in his portfolio. According to Barron’s, he was 149% short at the end of the first quarter compared with 25% at the end of 2015 and 4% net-long a year ago.
Now Paul Singer, less well-known than Soros and Icahn, but still an investment powerhouse in his own right, is joining the fray and loading up on gold.
On Monday, August 15, 2016, the S&P 500 set an all-time intraday high of 2,193.81, the latest milestone in what’s been an impressive seven year old bull market. Interestingly, this rally comes as expectations for earnings growth continue to slide downhill. This is counterintuitive for investors since earnings are the most important drivers of stock prices in the long-run.
As the aggregate bottom-up EPS estimate declined during the first month of the quarter, July, the value of the S&P 500 increased during the same time frame, from June 30 through July 28, from 2098.86 to 2170.06, an increase of 3.4%, which doesn’t make any rational sense. But, then stocks haven’t made sense in 10 of past 16 quarters anyway.This is not the first time stock prices and earnings expectations have diverged in recent years.
In other words, the stock market has been doing the exact opposite of what investors would expect 62.5% of the time.
The price-earnings ratio (P/E) is way above its long-term average, which comes with a backdrop of what feels like heightened uncertainty around the world.
Investors should not find equity valuations attractive enough to compensate for the macro, political, earnings and business model risks, but yet what we find is a steady grind of the market upwards. The stock markets should be down massively but investors seem to have been hypnotized that nothing can go wrong.What makes some experts particularly troubled is the lack of volatility or fear — as measured by the VIX — being discounted in to the market.
Will calm prevail? Unlikely. It is believable that a VIX near 13 insufficiently discounts uncertainty in the form of political risk in the US and in Europe that is not likely to dissipate meaningfully prior to the US elections on November 8.
So, given the prospects for a contentious US presidential race where the outcome may not be certain until the day of the vote, November 8 (as a reminder, the pollsters were surprised by the 6/23 UK Referendum outcome) along with uncertainty about the economic future of the UK and the EU persisting, talk of volatility’s demise (VIX 13) may be greatly exaggerated.
A spiking VIX is usually accompanied by selling in the stock market.
“But believe me: This watch is ticking because of high global debt and out-of-date monetary/fiscal policies that hurt rather than heal real economies.” says bond king, Bill Gross.
Germany, Switzerland, France, Spain and Japan are among countries that have negative yields on government-issued debt. Their hope is that cheap, even free, borrowing raises inflation and revives asset prices that can filter through economies; they argue extreme policies have been needed. Gross and others have argued that rates, including those at the Federal Reserve, at near zero or below won’t create sustainable economic growth and actually undermine capitalism.
Gross questions the long-term effects of the world’s unprecedented yield conditions and central banker reluctance to let them go.
“Capitalism, cannot function well at the zero bound or with a minus sign as a yield,” wrote Gross, who manages the Janus Global Unconstrained Bond Fund, up just over 4% year to date. $11 trillion of negative yielding bonds are not assets — they are liabilities.
According to some experts, complacency combined with short volatility exposure could set up the market for a highly volatile and correlated sell off on the next shock. While it is uncertain where the next shock will come from, experts believe there are several possibilities. To name a few: a faster Fed hiking cycle than the market is expecting, US election uncertainty, and turmoil in Italian banks.”
No matter how it happens, it will happen eventually, they say. So, they suggest, “be fearful when others are greedy.”
Divergence with the rest of the world only complicates the debate over when and how aggressively the Fed should dial back accommodative policy. Was that enough to scare off most bond investors? Apparently not. Treasury yields logged their largest daily drop in nearly two months to kick off this week, taking back their Fed-spooked gain from hawkish comments at Jackson Hole. Yields, of course, fall when prices rise, and vice versa. If the outlook for the economic growth remains positive, with the prospect of higher inflation in the near future, bond prices are likely to decline, pushing the yields higher, a situation synonymous with Fed’s hawkish tone and interest rate hike.
It’s not easy being wrong, except when wrong is right! More head scratching ahead!
Courtesy: Yahoo Finance, Trading Advantage Larry’s morning commentary