The trading after Friday’s unemployment number proved to be some of the most interesting market moves we have seen for some time. For the first time in a long while, both stocks and bonds had large moves down together. Over the past couple of years, when we have had a big move lower in stocks, bonds have usually rallied. Or if stocks raced ahead, then bonds were generally a little weak. But what we witnessed on Friday, was something new.
Have a look at a chart of both the S&P 500 future and the US long bond future during the past year and a bit.
Both stocks and bonds have been in a steady uptrend. If there was move lower in one of the asset classes, then the other often made up for it by rallying. They have both risen, but with a little negative correlation to make an investor that was long a mix of stocks and bonds, experience a nice smooth ride upwards.
I have re-created a crude 60/40 stock bond portfolio using the SPY (S&P 500) ETF and TLT (US Long Bond) ETF. I indexed it to $100,000 at the lows of the 2008 credit crisis. I know that it isn’t perfect because I am not accounting for dividends and interest, but given the low rates, it does a pretty good job at tracking the returns of a typical classic simply diversified portfolio.
In 2007, this portfolio got destroyed from a value of $170,000 down to $100,000 in the depths of the crisis. That was a drawdown of over 40% in the space of under twenty four months.
But since then, this portfolio has barely had even a hiccup. It has been a steady easy ride. That $100,000 portfolio in 2008 is now worth $230,000. The rise has been epic. Owning financial assets has been a slam dunk win. With a portfolio of both stocks and bonds, the volatility has been dampened even further. Closing your eyes and investing in the classic 60/40 stock bond portfolio at the height of the panic has proven to be one of the greatest trades of all time.
Yet all great trades eventually come to an end. It has been a fool’s errand to predict this end, but one of the days, the fools will be right.
I have been surprised by the strength of the US stock market during the past few months. I don’t understand the great attraction to this asset class at these elevated levels. In my mind, they are rising solely on the positive price momentum.
This week-end while I was reading a great article at ZeroHedge interviewing Jim Bianco, I came across what I think is the best articulation of the bear argument I have heard in some time.
And here is where the story gets really interesting: Estimates for first quarter earnings are down at negative 4.5%. And even if you exclude the energy sector it is still at 3% which is not very good. The second quarter looks almost identical to this and 2015 is down to around 2% according to Bloomberg. So earnings really are not good and that is reflective in the disappointing growth of the economy.
Wall Street’s favorite metric, the forward P/E ratio, is above 17 right now. This is the highest level in eleven years. Over the last 40 years, only in the bubble period of 2000 the forward P/E ratio was higher. So if you ask a typical fund manager when he would generically sell the stock market he would probably say: «When earnings are declining, interest rates are rising and the economy is slowing.» That is exactly what we have right now. But all of a sudden, no one wants to believe it and no one wants to sell.
I think that Jim is smack on correct. We have a stock market priced for perfection, a bond market that for the first time in a long while is declining, and pressure from the tremendous US dollar strength which will weigh heavily on US companies’ profit margins. The probabilities of a big accident in US markets has not been higher in quite some time.
US markets have had the Fed at their back for six years now. Financial repression from the ZIRP and QE policies have forced investors out the risk curve in both equities and also in fixed income duration and credit risk. The Fed’s behaviour has created a bull market in all financial assets. Although this bull markets started out with decent valuations, it has long past that point and has now begun to feed on itself. Financial assets are not going up because they are good value. They are going up because they are going up. The herd mentality of chasing the best performing asset has sown the seeds of one of the greatest bubbles of all time.
This time the overvaluation is not limited to dotcom stocks like in the 1999 bubble, or real estate in the 2005 boom, or resource plays in China is “going to grow forever” joke. The bubble is in all asset classes due to the Fed’s financial repression. No financial assets have been exempted from the sky high valuations. When you fix the interest rate at zero for 6 years, long term asset prices go up. Too much… Much too much.
Now that we see the writing on the wall for the end of this financial repression, the bubble is starting to unwind. Friday’s good unemployment report was one more nail in the coffin for ZIRP (zero interest rate policy).
I know that it is early, and I know that I might look like an idiot for claiming this… But I think we have likely seen the top in the 60/40 stock bond portfolio.
I have predicted that in the coming bear market, the 60/40 stock bond portfolio will get halved in real terms. I will stick my neck out and make another prediction. As of today, we have seen the highs in this portfolio.
This last push higher during the past few months was the last hurrah.
I have a good buddy that has a real job and doesn’t just stare at blinking numbers on the screen for a living. He sent me an email on Friday because he got a notice from Interactive Brokers that his account had fallen by over 1%. Now, he is a conservative guy with a nicely diversified portfolio. He sent the email with a little tongue and cheek remark about how he had forgotten that his account can actually go down. I realized that many people have forgotten that financial assets can go down. It has been six years of a perfect grind higher.
This sort of perfection eventually causes overvaluations and corrections that catch everyone off guard. The more convinced they are that the corrections are not coming, the more damaging they will eventually be.
Almost no one thinks that both stocks and bonds can go down at the same time. There are some stock market bears, but they think that bonds will rocket higher when the economy collapses. There are some bond market bears, but they are convinced that stocks are tremendous value versus the risk free rate. No one is bearish on both.
Well, both stocks and bonds went up with the Fed at their back, why can’t they both go down with the Fed doing the opposite?
Thanks for reading,