Sunday, December 9, 2012

Fiscal Cliff Meltdown or Melt-Up?

Michael Gayed, chief investment strategist and co-portfolio manager at Pension Partners, explains why the fiscal cliff is bullish:
I've been noting in my writings and in my various tweets since Monday of last week that intermarket trends have been behaving more positively following the elections.

The post-QE3 corrective period has thus far, with hindsight, looked stunningly similar to the May "mini-correction" which was my base case for how the decline would play out, within the context of the "Fall Catalyst" idea of new all time highs in the Dow by end of year.

Stock market resilience cannot be denied. The S&P 500 is still on track for being the third best year in a decade performance-wise, and the German DAX is bumping up against 25% returns for the year. For all intents and purposes, equities have indeed behaved in a reflationary way.

Our ATAC models used for managing our mutual fund and separate accounts are extremely close to pulling the trigger on an aggressive allocation back into stocks, with a bit more confirmation needed to switch out of bonds.

How could this be when the so-called fiscal cliff is still such a risk? Why would stocks go up in the face of no deal being made yet, and with the world now focused on our government now that Europe has completed a debt deal with Greece?

First, consider that the fiscal cliff and "damage" done by going over it is extremely well publicized, with numerous websites and news programs actually going so far as to create a counter for how many days are left to get a deal done. Say what you will about Republicans or Democrats — in a democracy, you don't get elected through austerity as I said on CNBC recently .

The odds favor that a deal is struck in some way shape or form, lessening the depth of the cliff. However the details are worked out, in theory any kind of compromise would be bond bullish.

If spending cuts are made, the Treasury will end up issuing less debt, causing a reduction in new bond supply issuances presumably. We all know that the Fed plans on buying Treasurys at a constant rate from now until kingdom come. That inherently means bond prices continue to get bid up not because of new demand, but because of shrinking supply.

Would those spending cuts lessen economic growth? Perhaps, but if bond yields continue to hold at panic low levels on those spending cuts, it may be bullish for stocks due specifically to the “Bear Paradox” idea I have referenced on numerous occasions recently.

The Bear Paradox is the idea that with bond yields at such incredibly low levels, any kind of a deep correction and risk-off period would make stocks instantly more attractive as a better income play than fixed income. The more stocks decline, the higher dividend yields go relative to bond yields, which would likely only get closer to zero during such corrective periods.

As the gap of income widens between stocks and bonds (barring a credit event), money buys into stocks to take advantage of comparative higher yield. In an upcoming writing Marc Faber of the Gloom Boom and Doom Report will publish of mine in December, I greatly expand on this concept within the context of what I call the Fed's last hope for the economy.

If we go over some variation of the fiscal cliff then, and that ends up being bond bullish, then the Bear Paradox gets even more accentuated, causing stocks to outperform. Take a look below at the price ratio of the Pimco 7-15 Year U.S. Treasury Index ETF (TENZ) relative to the S&P 500 (SPY). As a reminder, a rising price ratio means the numerator/TENZ is outperforming (up more/down less) the denominator/SPY. For a larger chart, visit here.


Note that the spike up in bonds relative to stocks abruptly reversed, and may now be back in a downtrend. Given the Bear Paradox, this should make sense given that yields are once again at absurdly low levels, making stocks more attractive as money puts a bid into stocks.

If the fiscal cliff keeps yields depressed, the Bear Paradox alone makes stocks an asset class to be bullish on (barring a credit event or massive economic slowdown). This in turn then makes the ratio fall at least to the prior support level of around 0.59, and may result in the Fall Catalyst of new highs happening all in December.

This is an important juncture — price continues to not think the fiscal cliff will either a) happen, or b) happen and not matter for markets. Either way, we may be nearing a point where the odds of another "melt-up" in stocks takes place independent of how the fiscal cliff negotiations play out, which can be very tradable in the near-term for those willing to listen to price.
I wrote about the fiscal cliff Trojan last week and warned my readers to ignore all the hullabaloo on this artificial crisis just like you should have ignored all the nonsense on Grexit, the 'imminent collapse' of eurozone and the hard landing in China. All these are distractions. Focus on what top funds are buying and selling; the rest is noise.

Importantly, my thesis has not changed, the "power elite" will do whatever it takes to reflate risk assets and introduce inflation in the economic system. The real threat to their profits remains debt deflation due to a prolonged deleveraging cycle and that's the only thing keeping them up at night.

Central banks around the world face stiff deflationary headwinds in the form of fiscal austerity, high unemployment, aging populations, which is why they will continue using any means necessary to reflate risk assets and introduce inflation back in the system.

Are there risks attached to these policies? You bet, but not the kind of risks you read about on Zero Hedge which states foolish comments like these asking, What Fed Exit?:
To put it simply, the Fed's QE can not stop as there is no real market, or demand for TSYs expressed in duration terms, a fact the Fed's 4 year meddling in the market has been able to conceal quite effectively. Alas, the Fed knows this. The Fed also knows that in a country which will continue piling up $1 trillion + deficits forever, there will always have to be a backstop funder of the US deficit. Since China is long gone as a buyer of US paper, this only leaves the Fed.

In other words, the simplest reason why the Fed will never exit is because the US will never again run a budget surplus, meaningless discussions over what a token $80 billion a year tax increase (which will fund the US deficit for 2-3 weeks) will do notwithstanding, and the Fed will need to monetize ever more US-sourced paper until Bernanke and his successor after 2014 are the only "market" for bonds left standing. 
Oh my! With such deep and astute insights, President Obama should hire Tyler Turden and the rest of the turds on Zero Edge because they got their pulse on the economy and financial markets. They know better than the Fed what is needed to avoid catastrophe. Just stop quantitative easing, remove all "Keynesian stimulus," raise interest rates by 10%, vote in Ron Paul for president and buy 'gold and ammo' to survive the coming apocalypse.

But before you go off slicing your wrists, you better ignore Tyler and the short-selling trolls / gold bug shills on Zero Edge and realize the world didn't come to an end in 2012 and 2013 won't be an unlucky year either, at least not the first half.

I agree with Michael Gayed, Melt-up begins as ‘dividendsanity’ breaks. Europe, the US and China aren't falling off any cliff. If you follow price action closely, you'll see extreme movers are signalling another global melt-up.

The biggest risk is that all this quantitative easing produces inflation in China which gets exported to rest of world. China's inflation rate rose 2% in November, bouncing off 33-month lows. But inflation is the main long-term risk for China as the economy makes a transition from a planned economy to a market-based one, central bank governor Zhou Xiaochuan said on Saturday:
"There is a general tendency for overheating impulses during China's economic transition process and we should always stress the need to control inflation," Zhou told a financial forum.

"In most occasions, pressures from various sides is to loosen monetary policy to spur growth, but there is less push for preventing economic overheating and inflation," he said.

A main feature of China's economic transition is that many entities, including local governments, are not subject to "soft constraints", which means they tend to spend more and fuel economic overheating, Zhou added.
Unfortunately, China doesn't control its inflation path, the Fed and other central banks do. As they keep on printing, engaging in quantitative easing and devaluing their currencies, it builds up enormous inflation pressures in China which will hit margins of US companies.

But all this liquidity is drowning out the meaning of inflation, stoking new asset bubbles. While I agree with those who think the bond party is over, other bubbles are forming as the hunt for yield pushes funds back into structured credit. Nonetheless, I warn bond bears, the titanic battle over deflation has not killed the bond market, at least not yet.

Below, Michael Gayed,  chief investment strategist and co-portfolio manager at Pension Partners, tells CNBC that dividend plays could bring better returns compared to U.S. Treasuries. True but Michael also appeared on CNBC's Closing Bell earlier this week, noting the following:
"I think you're seeing the top of the dividend trade. I think if anything, what's going to end up happening is a focus back into cyclical sectors for 2013. You want the global trade. you don't want the domestic trade anymore.
I agree on the global trade and remain bullish on US financials (banks and insurers), technology, energy and think coal, copper and steel shares will rally hard in first half of 2013 as the global economic recovery improves (led by China). Stay vigilant, track prices closely, but be prepared for another melt-up.