Thursday, February 4, 2016

Legends of the Fall

A man will sometimes devote all his life to the development of one part of his body - the wishbone.  -Robert Frost

It wasn't that long ago that anyone could walk into their local community bank and purchase a one-year certificate of deposit with a risk free return of around 5 percent. In the late 1980's that same CD would have yielded more than 9 percent. Less than a decade before in 1981 - nearly 18 percent! For equity market investors today, the thought of an 18 percent return for the year would certainly turn heads, regardless of its risk profile. But wishful thinking is one thing - reality is another. 

Just as pensioners and savers have been led ignorant to these historical downtrends and hence gripe in disbelief as yields have fallen into the trough of the long-term yield cycle, the Fed has promulgated an expectation of eventually raising rates to levels of yesteryear like Lazarus from the dead. 
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The only problem, however, is while they’ve expressed a clear capacity for intervention and a knack for plotting dots, it's the divine influence they sorely lack in the face of market history. In absence of the second coming, we unfortunately don't expect yields on CD's to return much more than they have over the past several years, as global economies and markets work across the transitional divide of the long-term yield trough and markets come to grip with the next phase of lower for longer.
Over the past several years we've noted the mirrored symmetry of yields retracement return from their 1981 secular peak, with the abstract idea that the return would be roughly commensurate with the rise - a move that spanned 40 years from the trough low in long-term yields in 1941. This perspective has implied a lower for longer environment, perhaps much longer than most participants suspect.
The relative symmetry represented in the current yield cycle is not unusual and looking back several hundred years, quite characteristic. The previous cycle (from trough to trough) spanned 40 years to the month (1901-1941), a period in which yields rose for 20 years followed by a 20-year decline. Unlike the current downtrend in yields that has trended to the trough with acuminating symmetry with the mirrored rise from 1941 to 1981, the previous cycle exhibited an asymmetric return below the 1901 lows, as economies pushed up against the limits and unbalances exposed and magnified during the great depression - and markets stumbled their way across the transitional divide to the next long-term growth cycle.

From our perspective, the yield trough that markets currently reside in and which constitutes the divide between these overarching growth and debt cycles, will eventually reflect a largely proportional transition with the broader cycle itself. Meaning, the massive relative symmetry in yields expressed over the past 75 years (much more when considering previous cycles), would imply a greater probability that today’s historically low range could extend well into the next decade. 

Why is this so important for future expectations in the US dollar?

While the Fed's dot plot projections continue to trend lower, in relation to either current economic conditions; the retracement symmetry of the long-term cycle's trough or the comparative path from the last time short-term yields fell to the lower bound of the transitional divide - their estimates are still exceedingly unrealistic. Although we agree that from a signal point of view to the markets the Fed acted accordingly in modestly coming off of its crisis stance of ZIRP, their quarterly updates of forward guidance through wishful dot plot projections, caused significant tightening to US and global markets - predominantly through the broad sword of the US dollar. 
David Beckworth had a nice chart this week (see above and read, Here) that showed how the move in the dollar coincided with the rise in fed-funds future rate expectations in Q2 2014. As mentioned in previous notes (most recently, Here), we know in past cycles – and characteristic of markets forward discounting dynamics, the dollar strengthens during the expectation phase of tightening (buy the rumor) and typically begins to weaken as markets become confident that the Fed will move (sell the news). For the dollar in this cycle, we’ve referred to it as - buy the hype/sell the bluff. The bluff being: the posture and expectations shaped from comparisons to more conventional tightening cycles would ultimately have stronger influence within the markets, than the actual structural significance of a fractional hike. Moreover, the ambiguous and prolonged nature of this cycle’s expectation phase - in the face of multiple large easing initiatives around the world, allowed participants an abnormally large and fertile window to build assumptions and positions in the US dollar; regardless, that the Fed would likely never achieve the same reach as they have in more recent tightenings. 
This is one of the main reasons we’ve carried a bearish long-term outlook towards the dollar, as we’ve viewed the rally as predominantly built around misplaced expectations from Fed posturing, rather than more underlying structural support - such as a secular move higher in yields or growth that would also likely sustain a more lasting move in the dollar as well. It is also why we have viewed the large reflex and retracement in yields in response to the taper in 2013 as the leading move for the dollar, as the Fed advanced into the next phase of normalizing policy from an extraordinary position. 
Our best guess over the past year has been that the dollar would ultimately crack upon the weight of the move itself (on the markets) or the Fed calling its own bluff when it came to future rate hikes. And while the old market adage certainly comes to mind that markets can remain irrational longer than you (and companies - i.e. commodity producers) can remain solvent, the dollar appears to be finally breaking down; in part from recent and pragmatic Fed-speak - as well as the knock-on effects from the relative performance extreme of the dollar on economies and markets over the past two years.

While we expect it will be a tougher slog for fixed income and most developed equity markets over the next phase, for commodity investors that have been hurt by the strong US dollar, a cyclical upturn appears to be unfolding - led by the move higher in gold that coincided directly after the rate hike in December.

Thursday, January 28, 2016

A Meridian Market Update

With trading for January coming to a close this week, US equities remain skittish - after breaking through intermediate support last Wednesday around 1860 on the SPX and quickly testing long-term support just above the Meridian at 1808. Although the subsequent rally was sharp and recaptured intermediate support, considering the proximity and significance of the Meridian - the bounce isn't all that surprising or telling just yet.
That said, the SPX did fulfill the basic technical condition of testing the Meridian, that our more bullish (but less probable) equity scenarios (see Here) from a few weeks back were looking for. With sentiment eroded from January's steep decline, elevated pessimism likely sparked the sharp short-covering move. Nevertheless, the buoyancy quickly dissipated yesterday as the Fed statement largely upset, in part, by not unequivocally ruling out another rate hike at their next meeting in March. Although we find that outcome extremely unlikely and misread, the volatile breakdown in equities does speak to the fragile nature they continue to demonstrate.

As a cautious reminder heading into next week and February, we wanted to again stress that equities technically remain precariously situated, with intermediate support just below and with the Meridian rising to ~1817 next month. Naturally, with the market so close to pivotal support, the longer it remains in limbo, the more likely a more significant breakdown becomes. Moreover, the break and recapture dynamic seen over the past week was quite similar to another reaction period with the Meridian: the broader breakdown pattern in the SPX in early August 2011, directly before the markets took another leg lower (see Here). 
While expressed on a longer timeframe with a much larger move, the potential top in the SPX has mimicked the same market reflexes of the 2011 breakdown following the end of QE2. Although we don’t foresee a market decline proportional to the full retracement of QE2 in 2011, the broader technical structure, as well as the underlying policy mechanisms that helped drive and prick the rally – are alike. All things considered, the bulls need to gain breathing room and quickly, by replicating another large short-covering rally that manifests into a larger move.   
From a big picture perspective - and as described in our previous equity note (see Here), we hold as our base-case scenario that a cyclical decline is underway. Of course how pronounced a potential downturn becomes is largely an educated guesstimate, but we'd argue it's chiefly dependent on how well the Fed and markets handle and react to this atypical period of policy normalization, as well as the underlying health of the US and global economy.  

Domestically, although we certainly see a clear causal connection in equities from the extraordinary measures taken by the Fed to support the markets - and believe an extended period of recalibrating expectations and valuations is warranted; we also recognize the significant deleveraging that's been accomplished during this period for US households, who still very much drive the economy through their respective consumption habits. Fundamentally, this is one reason to suspect a milder bear is in store, rather than the two most recent cyclical downturns that were effectively borne-out of pronounced excesses in the economy in 2000 and 2007.

A key difference and one that frames our broader outlook, is that we view the economy slowly catching up with extended - but receding valuations, rather than valuations sinking with the economy. For worst or for better, it is this distinction that has largely kept us out of the more bearish deflationary camps; as we view these dynamics as primarily massive market displacements greatly steered and volleyed by the worlds largest central banks - rather than the more pernicious symptoms of underlying economic decay that some participants may try to conflate. 

This doesn't imply that we believe the effects from these policies are benign or without significant impact to the US or global economy - they certainly are not. We simply recognize them as our market reality in the wake of the financial crisis and within the trough of the long-term yield cycle, where central banks extraordinary actions largely diverged markets from the fundamental underpinnings that investors had relied on to navigate and appraise economic conditions. Consequently, the playbook and experiences that many money managers had followed and passed down over the course of their careers have gradually stopped working. 

For example, while we certainly have experienced significant disinflationary conditions over the past several years, we primarily view it as a consequence of the currency markets, rather than symptoms of underlying economic malaise that could manifest into investors worse fears of deflation. Generally speaking, the US dollar has exerted the most influence worldwide, not from endogenous deflationary pressures, but primarily from reflexive market behavior reacting to the world’s largest and most influential central banks. From our perspective, the danger for participants is viewing and conflating the market effects - such as the collapse in the price of oil, as primarily a consequence of diminishing demand or an economic downturn. The same is true for the equity markets, where participants and pundits would typically expect a recession to follow a market decline, or conversely, that an exuberant market indicates a strong economy. It's a different paradigm completely, but we've been here before

Wednesday, January 20, 2016

A Foothold for Gold

Gold continues to trade out of its post rate hike low – akin to the taper low in December 2014. Our view has been while they both represent similar market reactions, the broader reflection that's played out in the currency markets over the past two years – presents a significant catalyst for gold going forward. Specifically, we expect a much weaker US dollar this year. 

Unlike gold's Q1 2014 rally that coincided as the US dollar was basing and exhausted as the dollar broke out; gold has been stepping higher since the December rate hike with what we perceive as precarious underlying support for the US currency – that remains stretched at a relative performance extreme. From a longer-term perspective, the inverse correlation between gold and the US dollar index has been strengthening over the past two years, with precious metals leading the downside move in commodities as the US dollar rallied appreciably. 

We know in past cycles – and characteristic of markets forward discounting dynamics, the dollar strengthens during the expectation phase of tightening and typically begins to weaken as markets become confident that the Fed will move. Commonly understood by traders as buy the rumor/sell the news, we've suggested its become – buy the hype/sell the bluff with the dollar. The bluff being: the posture and expectations shaped from comparisons to more conventional tightening cycles would ultimately have stronger influence within the markets, than the actual structural significance of a fractional hike. Granted, this is par for course with the Fed and monetary policy over the past 7 years, where the behavioral reflex inferred was arguably as or more important than the structural transmission mechanisms themselves. Nevertheless, the dollar has walked a similar line going into the rate hike in December, regardless of whether the Fed's bark-plots eventually measure up with the reach of previous tightening cycles.  

With an expectation phase for this cycle commensurate with the extraordinary span of ZIRP, the window for participants to build assumptions in towards the dollar has been historic. Consequently, the move in the dollar over the past two years has been extreme; arguably, from a relative performance perspective – as its secular blow off top was in 1985.

As equity markets stumble and expectations of further rate hikes diminish, broad support for the dollar should modulate lower. Increased pressure from the yen, which is attempting to break out and from euro strength – as it became a major funding currency for the markets over the past two years, is leading the move for now. Going forward, we expect the breadth of outperformance versus the dollar to become more widespread as the Fed walks back their own expectations that should eventually support a rebound in a broader basket of assets closely tied to the value of the dollar. 

As a parting thought/jab, we’re reminded of an old quote that aptly sums up the hype and expectations towards the dollar over the past year.

A man is like a fraction whose numerator is what he is and whose denominator is what he thinks of himself. The larger the denominator, the smaller the fraction. - Leo Tolstoy

Wednesday, January 13, 2016

Equity Market Musings

Despite last weeks historic travails, there has been no rest for the weary - as equity markets remain volatile and under pressure through most of this weeks early sessions. Finding a late day bid on Monday deep around 1900 on the S&P 500, the index quickly recovered 20 points and closed just over flat. Working off Monday's pattern, the bulls quickly spilled early gains on Tuesday, before recovering sharply in a late day push. With less than two hours remaining in todays session, the S&P 500 has followed this weeks intraday pattern and is revisiting the lows from Monday. 

Although traders may take some solace over the recent stick-save reversals, it pays to mention that the index is flirting with a major support zone just below, established in the fall of 2014 when the Fed terminated its active QE3 program at the end of October. Since then, the index has traded between modest gains and loses, with a cycle high put in last May. Moreover, the index is now trading close to where major long-term support comes in around 1810 on the SPX. From our perspective, if the SPX breaks below it's intermediate support zone around 1860, we suspect that longer-term support will be broken at the Meridian just a few percent away. 

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Figure 1
Our general outlook towards US equities has been that a cyclical top was in play and have viewed the 1946 cycle as the closest market parallel. This view was based primarily on our reads of 1) the long-term yield cycle and equity market valuations (i.e. CAPE ceiling from 07' cycle) that are greatly derivative from their bearing within the cycle; and 2) the monetary policy backdrop that echoes the long normalization phase in the late 1940's from the extraordinary measures taken by the Fed and Treasury to support the markets after the Great Depression and through World War II. 

For equity market investors today, the major takeaways from this period are two-fold:

  • Equities that had been buttressed and supported by extraordinary measures had diverged from the underlying economy. The recession in 1945 was one of the only periods in history where the stock market overlooked economic conditions, gaining more than 20 percent even through the downturn. It was only after these measures ended in 1946 that valuations "normalized" with the economy and policy. 
  • Although the initial correction was swift and significant (~26 percent), the economy did not fall into participants greatest fear of another depression, but muddled through and was range-bound over the next three years (Figure 10) as the economy traversed the yield trough to its next major growth cycle. 
Figure 2
Overall, while the current cycle has its own inherent variables and unique catalysts, we continue to find merit with the big picture congruences with the 1940's. This implies that valuations in equities should modulate lower as policy further normalizes from the crisis stance it held over the past seven years and yields work their way across the shallow trough of the transitional divide. 

Although we expect a modest rebound in long-term yields as the Fed moves further away from ZIRP, a secular move higher as last seen in 1950 is still likely years away. As such, we suspect that the sea change in yields we noted last year between the 10-year and S&P 500 will continue to diverge as equities cyclically turn down and yields flag through the trough. 

Technically, there are two broad-brush outcomes for US equities over the next year, which we guesstimated subset probabilities for each. 
  • Bullish scenario A (30 percent probability) - The S&P 500 finds long term support at the Meridian and trades higher in a 20 percent range up to ~2200.
  • Bullish scenario B, (10 percent probability) - The S&P 500 finds long term support at the Meridian and trades higher in a continuation of a secular bull market.
  • Bearish scenario A, (55 percent probability) - Intermediate-term support fails for the SPX ~ 1860, causing equities to swiftly break through the Meridian and into the air pocket between the previous cycle high (10/07). A target of ~1576 would be a roughly 26 percent decline from the cycle high last May to the previous cycle high in October 2007. This is also within 1 percent of the 38.2% retracement level of the entire bull market rally that began in March 2009.
  • Bearish scenario B, (5 percent probability) - Intermediate-term support fails for the SPX ~ 1860, causing equities to break through the Meridian and begin a third major bear market (~50% decline) since 2000.

Figure 3
As much as the 1929 and 1937 market declines scare up the most headlines, from a historical perspective, the less severe bearish scenario A would correspond with the cyclical downturn that began in 1946. And while the Fed's extended duration of QE this time around pushed valuations up to the ceiling of the previous cycle (07' CAPE - Figure 2), the three peaks of that period (1929, 1937 and 1946) have mimicked how the current pattern in CAPE has unfurled - and naturally the disposition of yields within the long-term cycle. 

Getting back to current market conditions, the SPX is within a few percent of intermediate-term support, extended from the closing exhaustion low in October 2014. This level was also tested during the initial market decline last summer. Although we had used the 2011 low and retracement rally as a prospective guide in December, the recent leg down has broken that pattern (Figure 9). That said, when you view the broader structure over the past two years, it is also a fractal replication of the 2011 market top, which coincided with the end of QE2. The current market, which followed a much longer QE program and a much larger equity rally, has all of the same structural components of the 2011 top (Figure 5), just extended along a much longer timeframe. 

Figure 4
Figure 5
These examples, both the 2011 low and retracement rally - as well as the broader structure of both QE programs, are representations of a markets scale invariance. We incorporate fractal and analog studies within our work not as an act of clairvoyance, but to gain greater perspective. This extends primarily from a belief that market behavior - especially at volatile transitions - reflects persistent patterns, that can provide participants an enhanced outlook. This methodology is based on the notion that participants behavior throughout market history has remained constant and depicted along an emotional continuum that encompasses both rational (i.e. linear) and irrational (i.e. nonlinear) market psychology. It is the self-similarity in price structure that reflects the inherent emotionalities or DNA that can replicate at many different scales, as illustrated in these two examples.

Like most research approaches, fractal analysis is just a framework that ultimately should be incorporated in a more expansive evaluation of market conditions. From our point-of-view, although we do not expect a market decline proportional to the full retracement of QE2 in 2011, the broader technical structure that remains under pressure - as well as the underlying policy mechanism that helped drive the rally (Figure 3), impressions us to believe that bearish scenario A is the most probable outcome. 
Figure 6
Figure 7
Figure 8
Figure 9
Figure 10
Figure 11

Tuesday, January 5, 2016

Connecting the Dots - 1/5/16

As trading commenced for the new year, Santa's fine offerings were shamelessly returned, as if to imply that cash was the preferred fairing - or at least sorely sought. With renewed collective resolution to panic at the whiff of uncertainties in China and a freshly opened wound in the Middle East, the S&P 500 opened down approximately 45 points Monday, eventually completing a full retracement intraday of the Santa rally that began in mid December. 

Stepping back, while we certainly take heed from the obvious concussion to world markets this week, we don't believe an all or nothing outcome awaits participants this year. Conversely, we expect a broadening dispersion of performance in equities worldwide, building on last year's underperformance by US stocks; spearheaded by the Nikkei's outperformance and the surprising truth that - gasp - the Shanghai Composite bested them all. 

To a much greater extent, it's the nuance that shapes the big picture these days, which is an ongoing challenge for investors to read or foresee in the policy doldrums where a cockpit instrument panel is more than occasionally forsaken for a glance out an opaque window. That said, we maintain our convictions that the US dollar is poised to decline from the relative performance extreme it revisited again at the end of last year, which we'd speculate would only help widen the breadth of relative outperformance to US equities by global markets that have yet to turn the proverbial corner. Namely, in emerging markets that took the brunt from the collapse in the commodity markets and the strength of the US dollar over the past four to five years. 

Taking its cue from the Fed last month and guiding our outlook for hard commodities, precious metals have another window to work higher over the first quarter. Similar to the early stages of normalizing QE, gold set a low the day after the Fed's initial taper in December 2013. Although precious metals and commodities did eventually succumb to another disinflationary front encouraged by the respective blowoff legs in the currency markets that began in the second quarter of 2014, the currency backdrop these days frames a much different picture. 

The dollar index, which gold has increasingly tracked over the past year is once again stretched and listing with popularity as the trade du jour for 2016. With net speculative positions back near all-time highs, conditions are once again ripe for disappointment. In previous notes we've compared the current set-up in the dollar as analogous with the consensus expectation of rising yields going into 2014, which was propelled by a strong sell the rumor (i.e. taper tantrum) and eventual buy the news reaction (inverse dynamic in Treasuries) that played out during the Fed's first phase of normalizing policy through posture than gradual practice. With the exceedingly modest pace and reach of potential rate hikes by the Fed over the foreseeable future, we speculate the strength in the dollar built and buttressed over the past 18 months will bleed lower in 2016.

The yen, which we have appreciated as an increasingly asymmetric hedge to equity positions - specifically in Japan, is beginning to move out of the broad base it carved over the past year. As described in previous notes, the yen and Nikkei are working away from the negative correlation extreme that has been in place over the past three years since Abenomics was first floated in the fall of 2012. We are looking for the correlation extreme between the Nikkei and yen to continue to thaw, in a manner similar to the reversal in Q2 2009. The difference of course being, that the trends today between these assets are inverse to that time.  Mimicking the dynamics in 2009, they should continue to mirror performance moves, while also gradually trending higher. 

Both gold and the yen have trended closely together since the equity markets peaked in October 2007 and the financial crisis unfolded over the next two years. While gold set its closing high eight weeks before the yen in 2011, it has followed the downside breaks in the yen over the past 4 years with varying lags of several weeks - the most recent breakdown in the yen last May occurring 8 weeks before gold. 

Mirroring the leading downside move in the fall of 2012, the yen has recently begun to break out of the base it had built over the past year. As such, we will be looking for gold to follow suit, which dovetails to our suspicions that the miners have a window to break the replicating downside pattern they have been stuck in over the past several years.