Friday, January 26, 2018

The Danger of Irrational Complacency?

Jeff Cox of CNBC reports, An indicator with a perfect track record just sent a 'powerful' sell signal:
The relentless gush of cash into the stock market is sending a powerful "sell" signal, according to a Bank of America Merrill Lynch gauge that has been a reliable indicator in the past.

Investors poured $33.2 billion into stock-based funds through the week ended Wednesday, BofAML said in a report. That's a record both for total flows and as well as for active funds, which alone pulled in $12.2 billion.

By comparison, equity funds across all classes took in a net $278 billion for all of 2017, according to Morningstar, meaning that last week alone equated to 12 percent of flows for the entire previous year.

The week continued a trend that has seen money rush into stocks as major averages climb to new records. The Dow Jones industrial average is up 7 percent year to date.

While the inflows have helped push the market higher, they also can be seen as a contrary indicator when they flash signs of excess. BofAML uses a proprietary "Bull & Bear" indicator that gauges when inflows or outflows point to investors moving too far to either side.

The current reading on the indicator of 7.9 is the most bullish since a reading above 8 in March 2013 — a sell signal. Michael Hartnett, BofAML's chief investment strategist, said the Bull & Bear indicator has shown 11 previous sell signals since the firm started tracking it in 2002 and has been correct each time.

In the near term, around February and March, that suggests a technical pullback for the S&P 500 to 2,686, which would represent a drop of close to 6 percent, Hartnett said.

The enthusiasm has not been unique to the U.S., whose equity markets brought in $7 billion of fresh cash.

Emerging markets attracted $8.1 billion in new flows, Europe brought in $4.6 billion and Japan saw $3.4 billion. That comes as 98 percent of global markets are trading above their 50- and 200-day moving averages, both classic signs of overbought markets.

Stock-based funds overall have brought in just shy of $77 billion in 2018, with the lion's share of $59.2 billion going to passively focused exchange-traded funds.

However, investors continue to hedge, giving about $32 billion to bonds, while last week's $1.5 billion flow into gold funds was the highest in 50 weeks.
Zero Hedge provides charts from this Bank of America report here. Below, you can view the main ones (click on images):





So what should we conclude from this report? Honestly, not much, it just confirms what I warned of back in November, namely, euphoria is creeping into markets (no thanks to central banks actively buying equities) which is why the masses are chasing stocks higher and higher, plowing money into active equity funds and passive ETFs as stocks keep making record highs.

Go back to carefully read my last comment on Ray Dalio's macro outlook where I went over important macro concepts before stating the following:
The conspiracy theorist in me says the US Treasury Secretary is doing his part in talking down the US dollar to raise inflation expectations and prevent global deflation from reaching the US. [Update: Mnuchin clarified his comments on Friday, stating a strong dollar is in the best interests of the US.]

Will it work? In the short run, yes, but longer term it might create an even bigger problem. Why? Quite simply, the depreciation in the US dollar means the appreciation of the euro and yen, and exacerbates deflationary pressures in these regions. If deflation rears its ugly head back in Europe, Japan and elsewhere, it then heightens the risks that deflation will be exported to the US.

Right now, nobody sees this. "Global synchronized growth" rules the day, everyone is excited about the great market melt-up of 2008, and companies like Caterpillar (CAT) and Boeing (BA) leveraged to global growth are seeing their shares rise to record levels, lifting the Dow to record levels.

Good times!! Just buy more stocks! Nothing can stop this bull market! Even Ray Dalio says there's a market surge ahead and "if you're holding cash, you're going to feel pretty stupid.”

He might be right on stocks, after all, just look at this 5-year weekly chart below of the S&P 500 (SPY) and tell me who in their right mind wouldn’t want to buy more stocks (click on image):


As you can see, the S&P 500 broke out in the fall of 2017 on the weekly chart and hasn't fallen below its 10-week moving average. If this isn't momentum trading at its finest, I don't know what is.

And here we are talking about an index of 500 large companies, not a high-flier stock like Intuitive Surgical (ISRG) which keeps making new highs (click on image):


I'm astounded at people who come on television and keep repeating the mantra, buy stocks, sell bonds, stocks are overbought but they will melt up to the moon!!

I'm not saying this melt-up can't continue, it most certainly can, but as stocks keep making record highs, downside risks are rising even faster.

Earlier this week, Yves Martin, a former colleague of mine from the Caisse who ran his own commodity fund, gave me this update on the market melt-up (he was quoting someone):
"The largest melt-up occurred in 1929 when the Dow rallied 29.9% in 94 days. The current rally - which I believe is in a melt-up - has lasted 95 days and is up 21%."
Of course, history doesn't repeat itself, it's possible that this QE/ central bank engineered melt-up lasts longer, but people tend to get way ahead of themselves when they see stocks making record highs and many extrapolate recent good performance well into the future.

On the flip side, bonds are bad! Who in their right mind would want to buy US long bonds (TLT) when the Dow (DIA), S&P 500 (SPY) and Nasdaq (QQQ) keep making record highs?

Even Ray Dalio appeared on Bloomberg yesterday stating bonds face their biggest bear market in 40 years, echoing what Jeffrey Gundlach and Bill Gross have been warning of.

As you are well aware by reading my comments, I don't buy this nonsense on the 2018 Treasury bond bear market and neither should you.

I've had market disagreements with Ray Dalio privately when we met back in 2004. I don't care if he manages the world's largest, most successful hedge fund, I'm firmly in the camp that believes there is no bond bear market, only a temporary backup in yields due to a temporary rise in US inflation.

Importantly, I can't tell you whether the yield on the 10-year Treasury note will hit 3% in the next three months but if my Outlook 2018 is right, the yield will be below 2% by yearend, which is why I've been telling investors to buy US long bonds (TLT) as yields back up and prices fall (click on image):


Remember, bonds aren't going to make you rich but they're going to save your portfolio from a serious drawdown when risk assets get clobbered.
I still fundamentally believe that in this environment, US long bonds remain the ultimate diversifier and investors chasing stocks would be wise to hedge for increasing downside risks.

I understand, every day you open your screen, the Dow is up another 100+ points, making fresh record highs, and the same goes for the S&P 500 and the Nasdaq, they too are on fire, soaring to record highs. Why bother with bonds when momentum is clearly in stocks?

There is no easy answer to this question except nobody can predict the future and if something goes wrong, you don't want to be caught like the proverbial deer staring at headlights.

I personally would like to see the S&P 500 pull back to its 50-week moving average. Guess what? The market doesn't care about what I'd like to see or what Ray Dalio, George Soros or anyone else wants or thinks.

Are markets overbought and over-extended? Yes but we're not living in normal times. Importantly, unlike 1929, global central banks are actively backstopping equities which makes all historical comparisons useless.

But it also creates an atmosphere of irrational complacency which is why Alberto Gallo, portfolio manager and partner at the London-based asset manager Algebris Investments, doubts that central banks can normalize their policy without causing a correction:
Mr. Gallo, the world economy is expanding synchronously and volatility is at record lows. Are financial markets poised for another strong year?
Investors are very complacent, but I think it’s an irrational complacency. The market is pricing in that earnings will keep rising, volatility will stay low and central banks continue to support growth without generating inflation. The party can go on for while, but there are more and more reasons to be cautious.

What are the main reasons to be cautious, and what has changed in the last months?
Central banks are moving closer to the point where they will have to normalize interest rates. And rates might rise faster than the market is pricing in. This and next year some of the ECB board member will leave. And the new board will definitely not be as dovish as the current one.

Inflation is still very low. Doesn’t this mean that monetary policy can remain accommodative?
Inflation has been elusive 2017 but could actually re-appear this year. There are several forces that could push inflation higher. Fiscal policy in the US and in Europe is loosening with Trump’s tax programme and a probable great coalition in Germany which could result in higher government spending. And China, the big engine of global disinflation from 2012 to 2016, is now exporting inflation as prices continue to increase and the renminbi is strengthening. Last but not least, there is inflationary pressure coming from rising commodity prices.

But why should we worry? The Fed has raised rates five times and nothing happened.
This kind of complacency is actually another reason to be cautious. There is the belief that central banks will manage the transition without bumps. Over the last two years, stocks went up and credit spreads shrunk when interest rates and government bond yields rose. But this correlation is not stable. The risk is that central banks lose control over the markets. Think of the taper tantrum back in 2013 when the Fed mentioned a possible reduction of its QE-pogramme and markets were freaking out.

Haven’t the central banks learned from that experience?
There is this widespread belief that they have and that they are a lot more cautious in communicating today. It’s a dangerous assumption and it’s a reason why there has been more risk taking in the market.

Where is this risk-taking most visible?
People are selling volatility and basically betting that tomorrow will be as calm as today. We estimate that there are over $2 trillion in these kinds of short volatility strategies.

Why is this problematic?
We have to put this number into context. At the bottom, you have $20 trillion in central bank balance sheets. Then you have $8 trillion worth of negative yielding bonds and $5 to $6 trillion non-investment grade bonds that trade at a yield of close to 2%. And then you have the $2 trillion in short volatility strategies. These strategies are just the top of the pyramid.

Is this the likely source of the next financial crisis?
I am not forecasting a financial crisis but the risks are increasing. The risks have shifted from the banks to the capital markets and the nature of leverage has changed. Back in 2007 investors were highly leveraged in credit products. Now they are leveraged to short volatility.

What about investor sentiment?
Investors are very bullish and become even more bullish with every day. For example, a year ago, there was still a lot of skepticism about the recovery in the eurozone, but now more people are positive, even on weaker economies such as Italy and Greece. That’s positive for these markets, but overall it’s another reason to be more cautious.

Why?
When everybody is positive and the market is going up in a straight line you do not even need a catalyst to cause a correction.

A market correction is one thing to be prepared for. But what about the risk of an economic downturn or a recession?
In the near term, I am worried about the high valuations and the belief that central banks will manage to gradually scale back without bumps. This makes a major correction very likely. A recession, however, is not in the cards over the next 12 months.

What are the medium and long-term risks?
The recent policies, such as Trump’s tax programme, increase the degree of inequality and that can cause the political system to polarize further – and populism to rise. The Brexit vote and the election of Donald Trump were just the beginning. With rising inequality there will be more anti-capitalist, protectionist and anti-free market policies.

Is the situation in the US and the UK worse than in continental Europe?

In the US and in the UK, the polarization has already intensified not least because inequality has risen faster. The UK is probably the most divided country where we are invested in. In the eurozone, the populists are not yet very strong and we have relative stability. But we are worried that in the next downturn the political landscape will get more polarized and populism will be on the rise if reforms are not implemented.

Italy is going to have general elections this year. What outcome do you expect?
For the financial markets, the Italian election is a non-event, luckily, but unluckily for the Italian people. Because the most probable outcome is a fragmented government and that would mean a lack of reforms on a three-year-horizon and no solution to the problem of low productivity growth.

What does all this mean for the positioning in your portfolios?
We are more cautious than a year ago. We hold more cash and have reduced our overall credit risk. We see more upside in equities than in credit, but overall we have reduced risks in our portfolios.

How painful are rising rates for the bond market?
The normalization of the central bank policies is going to hurt most fixed income assets except subordinated bank debt, Greece and Italy, which need higher inflation to pay their debt. That’s why we see more upside in equities.

Which equity markets do you prefer?
Within equities, we like emerging markets as we expect a weaker dollar. The most interesting sectors are energy and financials.

Where do you see opportunities in fixed income?

The overall market offers less value than a year ago. We like Europe but are underweight the US. American high yield bonds for example will particularly suffer when the tide of central bank liquidity turns. In Europe, we are two years behind in the credit cycle compared to the US and now the balance sheets of corporates are becoming healthier. We also see value in some sovereign bond issuers that are still perceived as too risky, like for example Greece.
Greek bonds?!? Believe it or not, Greek bond yields hit record lows this week:
Short-dated Greek bond yields hit record lows in Tuesday’s trading.

Two and five-year bonds yields in Greece, which received its first ratings upgrade from Standard & Poor’s in two years on Friday, hit record lows at 1.21 percent and 2.73 percent respectively.

“Concerns about Italy have died down, we’ve had the Spain upgrade, good news on Greece as well as a quite good economic environment, which is something that benefits the periphery,” said DZ Bank strategist Daniel Lenz.

Eurozone finance ministers welcomed Greek progress in delivering reforms but said on Monday they would only disburse the next tranche of loans once all agreed actions are complete.
All this good news out of the eurozone has driven the euro to a three-year high versus the US dollar:


Now, if I told you a year ago to go long the euro following the Brexit vote knowing all the political and economic problems in the periphery, you'd think I'm nuts.

What's even more impressive? Despite the significant appreciation in the euro, European shares have been on fire since bottoming in November 2016. Have a look at the 5-year weekly chart of the Vanguard FTSE Europe ETF (VGK):


So, getting back to irrational complacency and Mr. Gallo's comments, I find it hard for him to say on one hand he's worried about central banks normalizing rates quickly, especially if the ECB elects a more hawkish board, and then recommending emerging market (EEM) and European (VGK) shares.

In fact, the appreciation of emerging market currencies and the euro relative to the US dollar tell me there's trouble ahead for risk assets in these regions, so it's best to maintain a US bias in equities.

I found Gallo's comments interesting but confusing and lacking coherence:
  • He rightly notes there is a lot of complacency in the markets as witnessed by the ongoing silence of the VIX and silence of the bears
  • He then notes inflation might rear its ugly head in 2018, failing to explain this is cyclical (short-term) inflation due to the weaker US dollar pushing up commodity prices, not structural (long-term) inflation due to sustainable wage gains. He alludes to rising commodity prices, Trump's tax cuts and adds: "China, the big engine of global disinflation from 2012 to 2016, is now exporting inflation as prices continue to increase and the renminbi is strengthening." Really? This is news to me. How can the renmibi have appreciated if it's pegged to the US dollar which is declining? Also, I agree with those who say China is not booming, pointing to the slowdown in fixed asset investment. The mere thought of China "exporting inflation" is preposterous, I worry that this time next year, China's deflation demons will come back to haunt the global economy. Then again, Chen Zhao and the folks at Alpine Global are bullish on China, commodities and commodity currencies, stating the 2018 consensus is wrong (read their latest weekly comment on "What Would Charles Kindleberger Say?").
  • As far as the Fed and central banks normalizing too fast, and the market not pricing this in, this is the same argument Ray Dalio made this week. Admittedly, it is a fear of mine too as central banks might erroneously overreact to cyclical inflation pressures (due to a declining US dollar) but I had an interesting discussion with a currency trader earlier today who told me the Fed and other central banks have become a lot more forward-looking in the last few years, telegraphing their every move as to not catch markets off-guard. According to him, the risk of the Fed or other central banks hiking rates by a lot more than what is priced in is way overdone. Also, he told me: "Central banks won't backstop currencies but they are actively backstopping equities and will react swiftly if stocks start plunging."
  • Gallo does strike a cautious tone, in line with my Outlook 2018: Return to Stability, but he repeats the mistakes of bond bears who believe the Treasury bond bear market is just beginning and recommends energy (XLE), financials (XLF), emerging market (EEM) and European (VGK) shares. I would take profits and underweight all these sectors as global PMIs turn south in the first half of the year.
Interestingly, in my discussion with the currency trader earlier today, he told me that repatriation of US foreign profits (which will get a boost now from the weak US dollar) "will lead to more share buybacks and fixed investment and once the Trump administration announces the trillion dollar (or more) infrastructure program, it will boost the economy for another couple of years". He added: "US workers are going to receive an extra $1000 on average from tax cuts but they're going to blow it or pay down their debt."

He doesn't see rates going up too high (another 100 basis points max on the Fed funds and the 10-year Treasury yield between 3-3.5%) but worries that after the 2020 US elections, "we're going to be in for a long tough slug ahead because there will be a lot more debt and a lot less stimulus."

As far as stocks, he only holds ETFs like the S&P 500 (SPY) and the S&P/ TSX 60 (XIU.TO) as he's Canadian and he personally doesn't like picking stocks. However, he agreed with me that Starbucks (SBUX) is a great company and one stock he might buy and own for the long run given its recent weakness (click on image):


[Note: I'm not recommending individual stocks but you can follow me on Stocktwits. Importantly, do your own due diligence and most of you should be buying stock and bond ETFs and sleeping well at night without the stress of picking the right stock. If you're looking for a low-volatility ETF with low fees, do some research on the Vanguard Global Minimum Volatility ETF (VVO.TO). It's not very liquid but it's worth looking into.]

I'll leave you with some more food for thought. First, a tweet from David Rosenberg that caught my attention earlier today:



Also, as far as the US tax cuts, I agree with the folks at the Economic Cycle Research Institute (ECRI), Trump's Tax Cuts Won't Offset the Impending Slowdown:
Market-oriented economies such as the U.S. are inherently cyclical, and there are warnings of a cyclical slowdown in 2018. Yet this view is at odds with the increasingly optimistic consensus that economic momentum, turbocharged by President Donald Trump's tax cuts, will sustain the upswing throughout the year.

The notion that momentum propels economic expansion -- and is therefore a good way to forecast growth -- is often valid away from cycle turning points. This is why extrapolating recent trends is a popular basis for forecasting growth. The exception, by definition, is at cyclical turning points, when momentum reverses. This is when gross domestic product consensus forecasts systematically exhibit their largest errors.


Good leading indexes are designed to signal when the risk of a turning point is high, or when some of the biggest GDP forecast errors are likely. Lately, growth in the Economic Cycle Research Institute's U.S. Short Leading Index, which we recently highlighted, has been "pointing to a U.S. growth rate cycle downturn." Prospects for a slowdown have not changed despite an even more upbeat consensus. In turn, this optimism has supported a record-breaking rise in stock prices to start the year.

The cheerful sentiment is driven by expectations the tax cuts will provide a lift not only to profits, but also to economic growth. But business investment growth in the year after tax cuts has actually been shrinking since the 1960s; President George W. Bush’s tax cut was followed by less growth than occurred after President Ronald Reagan's tax cut, and even less than after those signed into law by President Lyndon Johnson. In any case, most estimates of the boost to overall growth from the Trump tax cuts in 2018 are in the range of some fraction of 1 percent of GDP.

Nevertheless, virtually everyone, including ECRI, agrees that the tax cuts will provide at least some economic boost, following the cyclical upturn during which year-over-year GDP growth probably doubled by the end of 2017 from the three-year low of 1.25 percent in mid-2016. The question is if tax cuts can offset the cyclical slowdown that is likely to follow.

Since the last recession, the U.S. has had three cyclical slowdowns, in 2010-11, 2012-13, and 2015-16. As the chart shows, those downturns typically reduced year-over-year GDP growth by a couple of percentage points.


The point is that such slowdowns tend to cut GDP growth by quite a bit more than the expected gain from the tax cut.

Looking elsewhere, could the synchronized upturn in global growth help sustain U.S. growth momentum? In theory, yes, but ECRI's international leading indicators also point to slowing growth ahead.

In fact, the growth rate of ECRI's international long leading index -- which, a year ago, correctly proclaimed the "brightest global growth outlook since 2010" -- has turned down, delivering a clear message. Cyclical forces are in no position to sustain the synchronized global growth upturn that has gone on for more than a year.

Not that global growth has been providing a major tailwind for U.S. growth. Even with synchronized global growth in full swing in 2017, U.S. net imports of non-petroleum goods over the past 12 months were larger than ever.

Despite hopes that economic growth momentum from 2017 can be sustained through 2018, a slowdown is likely to take hold this year. Perhaps this is part of the message from bond market yield spreads. And even as tax cuts support growth, they will, at best, mitigate that slowdown -- a far cry from current expectations.
Now, I like the folks at ECRI but a lot of the material posted above I've already read a few months ago by reading François Trahan's comments at Cornerstone Macro. In fact, I'm pretty sure I saw that first chart in his research or something very similar.

Regardless, the point is the same. US tax cuts won't stop the impending slowdown and those of you who want to position your portfolio accordingly should take the time to read my Outlook 2018: Return to Stability to understand why Risk Off markets will dominate the second half of the year, the shift will be from growth to profitability, and you're better off underweighting cyclical sectors like energy (XLE), financials (XLF), and industrials (XLI) and overweight less cyclical sectors like healthcare (XLV), consumer staples (XLP) and utilities (XLU).

More importantly, the downturn in global PMIs augurs well for US long bonds (TLT) and the US dollar (UUP) so take advantage of the recent backup in US long bond yields (decline in prices) to add more Treasuries to your asset mix.

Hope you enjoyed reading this comment. As always, please remember to kindly donate or subscribe to this blog on the top right-hand side, under my picture and show your support for the work that goes into these comments. My job is to make you think and always ask questions. I thank all of you who value my efforts and support my blog through a monetary contribution.

Below, Davide Serra, chief executive officer and founder at Algebris Investments (where Mr. Gallo works), discusses various markets and his thoughts on investing. He joins Bloomberg's Erik Schatzker on "Bloomberg Markets" at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

Second, Mark Machin, president and chief executive officer of Canada Pension Plan Investment Board, discusses asset-price returns, inflation and emerging markets. He speaks with Bloomberg's Erik Schatzker at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

Third, Michael Sabia, chief executive officer of Caisse de Depot et Placement du Quebec, discusses the outlook for markets, the impact of politics and importance of trade. He joins Bloomberg's Erik Schatzker on "Bloomberg Markets" at the World Economic Forum's annual meeting in Davos, Switzerland. Watch the interview here if it doesn't load below.

Lastly, André Bourbonnais, president and CEO of PSP Investments, was in Davos this week. Below, he discusses why "it's very hard to find value" in any of the asset classes. I wish they posted the extended version online but this gives you a sense at what the big institutions are worried about. Watch the interview here if it doesn't load below.

These are all great interviews. As you can see, the CEOs of Canada's largest pension funds aren't suffering from irrational complacency and they're already thinking ahead to the next downturn and how they will weather the storm given that they are investors with a long investment horizon that are continuously invested across public and private markets all over the world.




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