Monday, June 17, 2013

Visibility And The Clearer Trade?

Michael Gayed, chief investment strategist and co-portfolio manager at Pension Partners, wrote a comment over the weekend, Visibility And The Clearer Trade:
The S&P 500 (SPY) fell last week as markets gyrated between gains and losses following unimpressive industrial production, concerns over Japan, the direction of bond yields, and ultimately what the Fed will say next week. On CNBC Thursday, I argued that the big concern is that we are in a period of falling bonds and falling stocks - something which is an infrequent occurrence given the historical inverse relationship between longer duration Treasuries and equities. However, just as everyone is seemingly getting nervous about a rising interest rate environment, it does seem entirely plausible that the exact opposite occurs and we re-enter a period of falling bond yields and recovering cyclicals.

I am not convinced a correction is yet here for stocks. SuperBen and the League of Extraordinary Bankers will not risk their precious wealth effect by attempting to end quantitative easing too early. In fact, I suspect they may talk up the possibility that they will only do more given that global growth is faltering. Recent downgrades of economic activity span across multiple countries, making it hard for any central bank to do anything other than push more money into their respective economies. Schizophrenia over an end to QE will soon be replaced by the very real concerns over deflation given that, as has been the case all year, the reflation story simply is not materializing.
The irony over the last few weeks of the Fed's "confuse and conquer" strategy to tame equity markets is that the threat of QE tapering domestically in the U.S. has most hit emerging markets (EEM), with those currencies (CEW) getting hurt, and equity markets entering correction/bear market territory. Any kind of reversal in rhetoric, then, likely reverses the oversold nature of anything outside U.S. borders. With globalization, the Fed needs to be wary of their words and their actions on not just America, but everything else connected to us and the types of ripple effects and feedback loops that result.
Our ATAC models used for managing our mutual fund and separate accounts rotated, favoring bonds over stocks in the near-term. Historically, such moves have preceded corrective environments, but I'm not so sure if that is the case now. Bonds may simply be a more clear long trade than stocks are either long or short. Much clearly will depend on the tone the Federal Reserve takes, and how that impacts expectations and intermarket trends. I suspect that emerging market currencies will likely bounce rather strongly, alongside sovereign debt. In the U.S., momentum favors shorter-duration Treasuries for now, but perhaps for only a fleeting moment. Any kind of realization that the yield curve steepened too far, too fast likely means the long-duration bond trade (TLT) returns (click inage below).
I agree with Michael and wrote my thoughts last week on why I think fears of Fed tapering are overblown. I mentioned the factors below:
  • Inflation in the US is at a 50-year low, which concerns doves on the FOMC who are worried about deflation. Fiscal austerity and now sequestration are driving inflation expectations lower.
  • Euro zone is flirting with deflation and the ECB is reluctant to crank up its quantitative easing or lower rates. The Fed can't ignore Europe and will step in to fill the void.
  • Emerging markets have experienced a sharp selloff in recent weeks and remain on shaky grounds. Again, the Fed can't ignore what is going on in emerging markets because a crisis there would intensify global deflationary headwinds, which is exactly what the Fed doesn't want.
In recent weeks, hedge funds have been deleveraging and we have seen violent moves in emerging markets and sectors related to them. My lump of coal for Christmas got obliterated last week. Coal exports plunged in April and the sector remains in awful shape (for several reasons, over-supply, demand weakening, competition from nat gas).


And it's not just coal. The broad slump in commodities might be a harbinger of things to come. One thing that strikes me is how dividend stocks have become the new nifty fifty. A year ago, TIME Magazine asked whether dividend stocks are the next bubble and sure enough, they have been rising steadily as investors clamor for yield in an ultra low interest rate environment. 

But  investors dipping their toes back into the market may be in for a rude awakening when the bottom drops out of consumer staples stocks and other high dividend sectors. Chasing yield is risky in this environment. Witness the recent selloff in the mortgage real estate investment trust sector.

The same goes for the high yield bond market (HYG) where history appears to be repeating itself:
At this stage of the game, speculative-grade securities appear to be nearing an extreme. According to economic research firm Bank Credit Analyst, the average price of a bond in the high-yield index is well above par, at $105.92. "It will be difficult for prices to rise much further given that roughly 70% of public market high-yield bonds include some type of call option to the benefit of the issuer," BCA notes. "Thus, total return investors who have become accustomed to equity-like returns from high-yield bonds are liable to be disappointed buying at these prices."

In other words, there are no more seats to be added to the game of musical chairs being played out in the debt markets.

There is a possibility that high-yield securities as a whole have further to run though. Monetary authorities have vowed to maintain an aggressive policy stance in support of economic recovery, which will continue to support corporate cash flows, keep default rates from rising and perpetuate the ongoing credit-agnostic search for income in a yield-starved investment climate.
The extreme valuation in the high yield market is yet another reason for the Fed to keep humming along and not taper any time soon.

Nevertheless, regardless of what happens at the Fed meeting later this week, there are plenty of reasons to be concerned. The world cannot afford higher interest rates but as the bubble in dividend stocks, high-yield bonds, leveraged loans and structured products keeps growing, so do concerns that the fallout will be much graver when interest rates do start rising again.

Having said this, I'm not worried about a rise in interest rates any time soon. I'm more worried about deflation/ deleveraging which will hit all assets hard (except long bonds). Riskier assets will fall hardest but others will follow if deflation rears its ugly head.

Central banks know this and will keep pumping massive liquidity into the financial system, even if that means sowing the seeds of the next crisis. The question now is how will markets react later this week and in the near-term? Michael Gayed wrote me: "...the question is if stocks will react favorably, or begin to question Fed efficacy aggressively at this point and sell-off. We'll find out soon enough."

We sure will but I don't like the volatility I'm seeing in stocks right now and think that Michael is right that the yield curve steepened too far in recent weeks. If a summer swoon develops, or worse still a crisis, the long duration bond trade (TLT) will return with a vengeance. If you don't like stocks or bonds here, start raising your cash levels and wait for better visibility before taking on more risk. 

Below, discussing how rising interest rates are impacting the economy, with Michael Gayed, Pension Partners; Warren Meyers, DME Securities; Hank Smith, Haverford Investments; and CNBC's Rick Santelli.