November 15, 2013
By Steve Blumenthal
I’m in San Diego this week speaking at the Bloomberg ETF Master Class Conference– an interesting group of advisors seeking further knowledge on trading ETFs. Throughout the conference, I kept thinking about being in the midst of a speculative spike in the equity markets. The Fed is out over the cliff and beginning to lose its effectiveness on the bond market.
Today, QE continues to fuel equities and that makes everything feel pretty good. The problem is that manipulation tends to have a habit of ending badly. It felt good in 1999 (tech bubble) and good again in 2007 (housing bubble) and good again today in 2013 (bond bubble). The signs were evident back then. Do we see them today?
This week, I share the following research:
- On Debt and Deficits – The Fed Now Owns 50% of All Treasuries
- Bridgewater’s Ray Dalio On The Fed’s Dilemma: “We’re Worried That There’s No Gas Left In The QE Tank”
- Paul Singer – Letter to Clients
- Hussman – A Text Book Pre-Crash Bubble
- Trade Signals – Investor Sentiment and Cyclical Trend charts continue to remain favorable though sentiment is far too optimistic today. Note the market’s poor performance when investor sentiment is in the Extreme Optimism zone. Stick to a risk management game plan.
On Debt and Deficits – The Fed Now Owns 50% of All Treasuries
Bernanke is getting out just in time. He is leaving his successor with this to think about:
- “A brief update on the bloated condition of the Federal Reserve’s balance sheet. At present, the Fed holds $3.84 trillion in assets, with capital of just $54.86 billion, putting the Fed at 70-to-1 leverage against its stated capital. Given the relatively long maturity of Fed asset holdings, even a 20 basis point increase in interest rates effectively wipes out the Fed’s capital. With the present 10-year Treasury yield already above the weighted average yield at which the Fed established its holdings, this is not a negligible consideration.” Source: November 5 (King World News) – “Do We need A Dodd-Frank Rule For Central Banks? – Art Cashin Interview
- The Federal Reserve now owns 50% of all treasuries maturing between 10 years and 15 years. Further, there are barely $100 billion of treasuries outstanding for the public to buy. $85 billion per month is a lot of billions.
The Fed has created such a void of paper that pension funds and others that want somewhat longer dated assets need to go elsewhere. They are buying corporate debt. When it gets easy to finance, and rates are low, corporations are happy to issue credit.
- From today’s WSJ, “Corporate bonds are selling at a record pace, topping $1 trillion this year”.
Bridgewater’s Ray Dalio On The Fed’s Dilemma: “We’re Worried That There’s No Gas Left In The QE Tank”
Excerpted from the Bridgewater Daily Observations:
“As shown in the charts below, the marginal effects of wealth increases on economic activity have been declining significantly. The Fed’s dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias. In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness.
The basic issue is that quantitative easing is a much less effective tool when asset prices are high and thus have low expected returns than it is for managing financial crises. That’s because QE stimulates the economy by (1) offsetting a panic by providing cash to the financial system when there’s a need for cash, and (2) by raising asset prices, and driving money from the assets they buy into demand and investment, creating a higher level of future economic activity. So, the policy was particularly wise and most effective (in the sense of impact per dollar) at the height of the financial crisis when there was both a desperate need for cash and when extremely depressed asset prices were heavily weighing on demand and investment.
Now, there is a flood of liquidity and asset prices are high relative to underlying fundamentals. So the impact of additional asset price increases on demand is much less (as high asset prices and low future returns make assets more interchangeable with cash).
Quantitative easing today is driving asset prices to unsustainable levels, without stimulating much additional activity. That leaves a much clearer tradeoff between driving up asset prices today and lowering future returns (the price of which will be paid in the future).
The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.
We think the question around the effectiveness of continued QE (and not the tapering, which gets all the headlines) is the big deal. Given the way the Fed has said it will act, any tapering will be in response to changes in US conditions, and any deterioration that occurs because of the Fed pulling back would just be met by a reacceleration of that stimulation. So the degree and pace of tapering will for the most part be a reflection and not a driver of conditions, and won’t matter that much. What will matter much more is the efficacy of Fed stimulation going forward. (Emphasis mine.)
In other words, we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.”
Here is the full link to the article.
Paul Singer – Letter to Clients
Several selected quotes from famed hedge fund investor, Paul Singer, in a recent letter to his clients:
- “What has been happening with the US federal government in its recent highly-theatrical phase, as contentious and difficult as it has been, is merely a precursor to much bigger events.
We are talking about the underlying structural issues of the federal budget deficit, economic growth, the deeply contentious Affordable Care Act, and the long-term insolvency of the country due to the government having made (and continuing to make) massively unpayable promises for the future. As we have pointed out, the current annual federal deficit, so ballyhooed to be “coming down nicely,” is actually catastrophically out of control. It is not a trillion dollars. The true figure is more like $7 trillion (and growing!) after accounting for unfunded liabilities, which are mounting at a fantastic pace. It is not an exaggeration to say that America is deeply insolvent, and for that matter, so are most of continental Europe, the U.K. and Japan. No combination of achievable growth rates and taxes can pay for the promises that have been made. The numbers are clear and inexorable.” (Emphasis mine.)
- The volatility in fixed income markets earlier this year, occasioned by the Fed’s use of the word “tapering” (meaning a possible gradual reduction in the pace of Fed bond buying), resulted in medium- and long-term interest rates rising back to the levels of the spring of 2009. In other words, $3.8 trillion of bond-buying since 2008 by the Fed has had only a temporary effect on medium- and long-term interest rates. It is impossible to predict the prices of bonds in the event the Fed stops buying, or actually starts to sell off its massive portfolio, although it is a decent bet that prices would be much lower than current levels.
- It is also not clear whether stock prices, which are still on a tear and at all-time nominal highs, are at these levels because of optimistic economic prospects, QE, or the beginnings of a loss of confidence in paper money causing a shifting of capital out of fixed income and into purportedly “real” assets. (Emphasis mine.)
- However, the fragility of capital markets, so reliant on zero percent interest rates (ZIRP) and QE Infinity for their equilibrium, is clearer. The markets’ ability to withstand any adversity is highly questionable, and it appears to us that the Fed is basically paralyzed (though they would probably call it “focused and determined”) and afraid (perhaps they would say “prudently risk-averse”) to reduce, much less eliminate, its bond-buying. In this environment, plain-vanilla ownership of stocks or bonds represents a highly conjectural bet on government-manipulated markets.”
Here is the link to the full piece.
While equity prices most certainly could be manipulated even higher, Hussman shares a more immediate concern.
Hussman– A Text Book Pre-Crash Bubble
“Despite the unusually extended period of speculation as a result of faith in quantitative easing, I continue to believe that normal historical regularities will exert themselves with a vengeance over the completion of this market cycle. Importantly, the market has now re-established the most hostile overvalued, overbought, overbullish syndrome we identify. Outside of 2013, we’ve observed this syndrome at only 6 other points in history: August 1929 (followed by the 85% market decline of the Great Depression), November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a market crash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007 (followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limited to just under 20% as a result of central bank intervention). These concerns are easily ignored since we also observed them at lower levels this year, both in February and in May. Still, the fact is that this syndrome of overvalued, overbought, overbullish, rising-yield conditions has emerged near the most significant market peaks – and preceded the most severe market declines – in history.”
By John P. Hussman, Ph.D. President, Hussman Investment Trust. Here is the link to the full piece.
Trade Signals – Investor Sentiment and Cyclical Trend charts continue to remain favorable though sentiment is far too optimistic today. Note the market’s poor performance when investor sentiment is in the Extreme Optimism zone. Stick to a risk management game plan.
Finally, each Wednesday I post several shorter-term Sentiment Charts to our website in a piece called Trade Signals. In it I share thoughts on investor sentiment, price momentum (current trend) and risk management.
Click here for this week’s sentiment charts and short commentary.
My wife and I enjoyed a two hour walk on the quiet Carlsbad beaches. The surfers were everywhere and the waves looked great. Every once in a while there was that “wow” ride. How do they do that? What a nice way to live life. Of course, you were at your desk calling your clients, thinking about positioning and running your practice. I hope that you are getting away soon. If you are out of gas, then drop what you are doing and jump on a plane. Do something fun for yourself. There is no shortage of stress in our business and there is nothing like a long walk on the beach to slow down, unwind, re-center, and think.
Wishing you a peaceful weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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