Over the past few weeks we have been busy at work on our algo strategies, and we think we have come up with the optimum formula:
Can’t have it both ways
As stocks continue their relentless march higher, market participants are becoming more emboldened. But are they thinking through their expanding bullishness?
Although stocks have almost tripled off the 2009 panic lows, stocks have merely mirrored the Fed’s massive balance sheet expansion. If you measure the Fed’s Total Balance Sheet versus the price of stocks, this ratio has been strangely level over the last half dozen years.
Ratio of S&P 500 to Fed’s Balance Sheet</a> </div>
Are the bulls expecting the Fed to continue expanding their balance sheet forever? Do they expect the Fed to continue to fuel stock market gains at this rate in perpetuity?
Fed’s Total Balance Sheet (white line) vs S&P 500 (yellow line)</a> </div>
So far, all of the stock market expansion has come on the back of an increase in the Fed’s balance sheet. Over the last few years, the moment the Fed has tried to stop the expansion, stocks have immediately sagged.
Do all the raging bulls know something about the Fed that I don’t know? I am fairly confident that the Fed is not going to be expanding the balance sheet anytime soon. They are in the process of winding down their third QE program, and given the increasing ineffectiveness of QE in regard to affecting the real economy, I don’t think they are going to be reinstating it anytime soon.
Therefore if you are getting bullish at the stock market up here, aren’t you betting that the ratio of the level of stocks versus the Fed’s balance sheet is about to break out?
Now I am fine with making that bet, but I would argue that for that to happen, the economy would have to be expanding naturally. Most of the stock market bulls seem to be ignoring the fact that if they are correct about the level of economic activity needed to justify these elevated stock market prices, then interest rates are way too low.
You can’t have it both ways. The Fed is no longer going to be expanding the balance sheet, so stock market appreciation is only going to happen with economic expansion and this is going to cause interest rates to be massively revalued upwards.
In fact, I would argue that given the bulls’ enthusiasm has resulted in stocks being priced at levels where even with economic expansion, the increase in interest rates is going to lower the P/E ratio more than the E can rally.
I just don’t get how the stock market bulls can be bullish on stocks, all the while understanding that the Fed is no longer going to be expanding, yet also be sanguine about economic growth.
The Fed’s balance sheet expansion is no longer going to be a tailwind at the back of the stock market. You better be bullish on the economy if you are buying stocks up here. And then if you are indeed that bullish on future economic growth, you better hope that bonds don’t shit the bed. It all seems rather precariously balanced to me.
Speaking of economic expectations
It is interesting that although market participants are all bulled up about stocks, their expectations for economic growth are rather muted. This probably has something to do with the fact that during the period of 2011–13, each hopeful economic recovery seemed to inexplicably sag at inopportune moments. Have a look at this chart of the Bloomberg Economic Surprise Index.
Bloomberg Economic Surprise Index</a> </div>
This index measures the performance of the economy versus economists’ expectations. So when the index is rising, the economy is outperforming the economists’ expectations. Starting in 2011 and for the next few years, the economy seemed to roar out of the gate to start the new year. But then in March, the momentum faded.
In 2014 the economists wised up to this tendency. They stayed muted in their growth expectations.
But have they gotten too bearish? Are they underestimating the economy’s potential?
I would argue that they are. This repeated lack of ignition has convinced everyone that the engine is no longer capable of starting. Which is all the more surprising given the increased bullishness on stocks.
I think the surprise is going to be that the economy outperforms expectations, but nonetheless stocks and other financial assets actually go down on the news… Buy the rumour, sell the news…
Bid wanted on Iraqi 5.8s of 28
The situation in Iraq continues to deteriorate. It is disconcerting to realize that the bad guys have captured US equipment and have pimped them up with their own flags and undercar LED lighting.
I am not sure how liquid these bonds are, but there is an Iraqi 5.8s of 2028 bond. As expected, it has had a tough week:
Iraq 5.8s of 2028 bond</a> </div>
$96 down to $89 seems like a fairly large move for a bond. But if you step back and look at the longer term chart, this is actually another case of the market assuming a level of optimism that seems wholly misplaced.
Same Iraq bond – longer term chart</a> </div>
In 2012 these bonds were $75. And that was before you had these guys, who were kicked out of al-Qaeda for being too much of a bunch of assholes, taking over wide swaths of Iraq. Once again, the market is blind to the real risks… I guess buying an Iraqi bond yielding 7.3% makes sense to some leveraged up hedge fund, but I would argue that the yield pickup probably doesn’t justify the risk…