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!