Thursday, August 21, 2014

Breaking the Banks & Finding Gold

Since finding a low in the first week of August, the S&P 500 hasn't wasted much time, closing positive in seven sessions out of nine and narrowing the gap from its 27th record close this year - way back on July 24th. With Yellen flying into Jackson Hole this week to enjoy some good old fashion Rooseveltian eco-tourism, the point spreads have come in considerably for those betting on number 28. Data mining the mountain some more, over the past seven years with the inspiring majesty of the Tetons in the background, stocks have rallied on what the Fed Chair has to say. 

That being said, we remain skeptical that the equity markets can maintain their historic streak and continue to see strains developing in the leading financial sector, which appears to be butting up against the harsh realities of a flattened yield curve and the narrowing margins of net interest income. As we had commented on leading through the decline at the start of the month, the S&P 500 was breaking down along similar folds with the retracement decline this past January. Taking a shallower fall this time around the block - and despite the perceived bid that that Yellen may extend, we do expect a divergent outcome with the sustained recovery that the equity markets had enjoyed earlier in the year. Apparent in the followup study below with the financial sector, the banks relative to the broader market have been making their way down the stairs with 10-year yields. This is in stark contrast to how the banks had led the broader market higher since the fourth quarter lows in 2011.   
As one door closes another cracks open, and we continue to favor the precious metals sector - led by their respective and misfit miners. The common denominator - or hinge, being 10-year yields. As gold and silver relative to yields complete what has become a very broad and symmetrical base from the relative extreme punctuated at the end of last year, the likelihood of an asymmetric return is echoed in the preceding pattern of the financials and similarities in the magnitude of the miners decline over the past few years relative to their denominating spot prices.   

Consistent with our divergent expectations in the equity markets previous retracement patterns, tensions are building up in the precious metals sector to breakout above overhead resistance of their respective interim highs. 

Saturday, August 16, 2014

A Scheduled Departure in Yields

Although we would never dispute that markets often pivot on external catalysts, as we noted recently (see Here) - they often are just instigators of larger forces at play. For every time that a market perceives to be largely driven by breaking news or geopolitical events, we could reference fifty other occasions in which a similar development had no material influence. 

From our perspective, yesterday was a perfect example in which an exogenous event in Ukraine, motivated pre-existing conditions in the Treasury markets. Based on our comparative analysis of 10-year yields developed months before (see Here), the current breakdown truly comes as no surprise. In fact - it arrived right on schedule.  
A similar research approach has been prescient with tangential trends, as depicted below with our work with the TIPS bond fund the past January (see Here), which highlighted both the pivot and proportional recovery path the asset has followed. 
Headed into next week, the asset class relationship that we have favored over the course of this year, namely, long-term Treasuries relative to equities (TLT:SPX) - is at a potential breakout point. As shown below in a similar dynamic that developed after the markets began to normalize to structural and psychological conditions in the wake of QEII, the current set-up is feathering the hinge line of the retracement highs from this past May. Back then, it was the instigating factors of Europe's sovereign debt crisis and our own issues at home, emanating from a contentious Congress that led to a debt downgrade from Standard & Poor's that August.  

Should yields continue to breakdown further with equities next week, we can guess the nature of what the headlines might read. That being said, we continue to believe there are larger forces at play, just as there were in 2011 as the Fed first attempted to wind down QE - and in the mid 1940's when the Fed ended their extraordinary support of the Treasury markets.   

Thursday, August 14, 2014

Past Performance Does Not Guarantee Future Results

We've all read the distilled disclaimer above a thousand times before. And yet, with full frontal cognizance of its universal truth, we ignore the warning for the sake of the still waters of current market conditions and our behavioral predisposition to follow. Follow leaders, trends - follow performance. It's a hardwired survival trait built into all of us, and generally speaking - exposes our achilles heel at times, when it comes to bends in the road and future expectations.

Speaking of which, we see that another large investment bank recently chimed in with long-term forecasts out to 2018 of divergent returns between equities and bonds. Seeing a 6 percent annualized total return in the S&P 500 compared to a 1% annualized gain for the benchmark 10-year Treasury note, the forecast assumes the Fed begins raising rates as soon as the middle of next year - with a 4 percent ceiling by 2018. Citing the same rate increase playbook referenced ad nauseam (94', 99' and 04' cycles) this year, we think it would behoove their expectations to heed the standard disclaimer mentioned above, as well as a wider breadth of market history that rhymes much closer with the current mix of market conditions present in equities, bonds and commodities - against the backdrop of extraordinary monetary policies extended over the past five years  (cough, cough - the 1940's). Taking this into account, the dynamic of divergent returns would vanish as we would cut their forecast for the total return in the S&P 500 in half and more than double the annualized gain noted for the benchmark 10-year Treasury note. 

Befitting of the paradox of both our capacity to collectively follow and ignore, participants appear to receive an almost daily dose of insight and reason from our Madam Chairwoman, who continuously reminds us that rates will stay lower - looonger. Besides the fact that long-term yields continue to move against  a more contemporary conventional wisdom, what does Yellen consider that the rest of the Street choses to ignore? Hint - recent past performance does not guarantee future results? We think so, and expect that as these benevolent market conditions come to pass, the Street will change their tone and karaoke tune as well. 

Although the economic data through the balance of year may run antithetic of the Fed's mandate on inflation, we view that risk - as we believe Yellen does, in shades of gray. The reality in the economy is that a strong pulse of inflation would eventually self-correct trajectory under its own weight - and without further tightening in Fed policy. This isn't the 1970's, where the Fed chased inflation with yields that had been rising for over two decades and where the saplings of globalization began to grow exponentially in the stand. No, we currently reside in the old growth trough of the long-term yield cycle, where generally speaking - the threat of perennial inflation is limited by more than 30 years of inertia on the downside of the cycle. Frankly, we are a bit surprised that this fundamental difference isn't considered more often and that the extremes of the 1970's are contrast for concern, instead of where yields currently sit and the extensive historical record which depicts that the trough - like Yellen, is lower for longer. Will there be spikes of inflation as pressures builds up from time to time under varying conditions. Certainly, but in the recent past and the parallels we noted in the 1940's - they all were ephemeral conditions.

Coming into the home stretch of the year we expect the current pulse of inflation to continue higher as the Fed walks away and foresee the chirping hawk choir grow louder and more emboldened with each reassurance by Yellen that she'll stand pat longer with lower. From our perspective, the double edge sword that Yellen needs to gingerly step between is a damned if she does and damned if she doesn't mentality with tightening, since the risk becomes that rising inflation could hit the brakes in the economy for her, reinforcing the belief that the Fed was foolishly behind the curve. At the same time, if they raise rates too soon the scenario laid out below could have the same outcome - but perhaps even sooner.  
- The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession. - Reuters 8/12/14
All things considered, we tend to agree with Pimco's Paul McCulley that believes "behind the curve" is precisely where the Fed wants to be - for now. Trading more time for inflation risk - that we would argue poses a less long-term threat than many of the hawks continue to posture as severe. With that said and as pragmatic participants, this dynamic should bolster a rising interest in the precious metals sector and commodities - that should benefit from inflationary tendencies and a broad distrust of the Fed as they navigate another difficult policy chapter. 

1994, 1999 - 2004. What do they all have in common besides rate tightening cycles ? A broad respect and lionization by participants of Fed policy and their Maestro that conducted the show. Does that sound like today? While we do find great utility in thoughtful comparative reasoning when it comes to market cycles - the fact remains that past performance never guarantees future results. Especially, when the comparisons are so far off the mark. 

Sunday, August 10, 2014

These Go To Eleven

With geopolitical tensions continuing to escalate, there's a tendency by participants and pundits alike to fit the headlines to the tape. 


While these events have certainly not hurt demand, the respective trends in both Treasuries and gold have been in place all year and under what we believe are more endogenous and cyclical motivations - than event driven reflexes at the whim of Putin, Hamas or Israel. From our perspective, the same holds true with the recent cracks in the US equity markets, which we view as an obvious - but latent reaction, to the
Fed slowly ending their extraordinary policy support this fall. As we see things, the markets will continue to adjust to the visible hand of the Fed, whom to the shock and distrust of most ran an open and heavily subsidized kitchen over the past five years and has been equally public and transparent about shutting it down. As obvious as that may be, ignoring the significance of their influence at these pivotal points in time, would be overlooking the performance in the US markets over the past five years and believing with 20/20 hindsight that the Fed's quite visible hand didn't play the commanding role. 

Tangent to the markets adjustments to transparency on both sides of the field is the realization that the Fed has conducted policy over the past five years from the mystical plane beyond ZIRP. At its basest level, we have argued (see Here) quantitative easing is about instilling expectations in the market, both from a structural and psychological perspective - beyond where conventional policy tools could apply. When the Fed began their fireside taper-talks last May, they tightened in effect through a pivot in expectations. On the Spinal Tap policy continuum that goes beyond the norm - they took the bold step and turned the volume down. Considering the move in 10-year yields that followed, this was largely confirmed by the market - and why we have contrasted the trend in yields throughout this year with the arc of the unexpected rate tightening cycle in 1994 and 1995 that capsized the bond market and reset expectations.  
Generally speaking, we've approached the broader macro picture in the US equity markets from the top down bearings of the long-term 10-year yield cycle and the proportional trends of Shiller's P/E ratio - which we have described in previous notes (see Here) as sharing close parallels with the cyclical peak in equities in 1946. Although the trend in equities did extend further than we anticipated at the start of the year, similar market and policy conditions still exist that hold strong congruencies with this historic time period. This perspective remains supported by:
  • The long-term yield backdrop - which we would argue primarily drives the boat from a valuation and asset cycle point of view and is similar to the range in yields witnessed in the mid 1940's. Yields currently reside on the mirrored return of the 80 year cycle - which would extends the range (~1.5-3.0%) of this extremely low yield environment further out than is currently considered.  
  • The current disposition of Shiller's P/E - which our trend analysis would indicate has a low probability of exceeding the proximate and previous cyclical peak in 2007.
  • Similarities in extraordinary measures in monetary policy between today and the 1940's - which saw the Fed purchase and hold all available short-term U.S. Treasuries and virtually all long-term U.S. Treasuries. We expect a similar outcome in the markets to the normalization of current monetary policy, which from our perspective would likely push an actual rate tightening cycle further out than is currently considered.
  • Similarities in equity market performance since the Fed started visibly supporting the markets at the previous cycle lows in 1942 and 2009. Although the composite duration in policy support extended from the Fed has been longer today, it was intermittently halted on two occasions over the past five years. Taking into account these pauses between QE salvos, comparisons between the two equity market cycles are commensurate.   
  • The pivot higher in the commodity markets this year, which was also dramatically evident when the Fed pivoted from its outright purchase of securities in the market at the end of 45' and extended the commodity cycle to its cyclical high in 51'. Generally speaking, we view the bid in the precious metals sector this year as the leading edge for the broader commodity space and find efficacy in the Fed's policy pivot - which signaled to the markets a trend change in inflation expectations.
Just as the policy shifts by the Fed in the mid 1940's sparked the unique conditions in which long-term yields declined with a rejuvenation in commodities and inflation (see Here), a similar dynamic has developed since last December in precious metals, commodities and those reflationary assets closely associated with their respective performance trends. 

While there are parallels to the wind down of QEII in how long-term Treasuries relative to equities have performed this year, the biggest difference in our opinion - and one we cite as indication of effective demand with policy, is the fact that gold and the broader commodity complex based and pivoted out of a cyclical low last December when the Fed moved to taper. This was largely contrarian to what most participants believed would occur as the Fed walks away. From our perspective and as we had noted last year before the initial taper, these developments ring true if policy accommodations were being withdrawn a final time - and if underlying conditions were in place to sustain reflationary forces.  

These set-ups are greatly divergent from what was present in 2011 as the Fed ramped - then wound down QEII. Back then, the commodity sector - led by silver and gold, had surged higher on the misplaced notion that inflation would rue the day because monetary policy was far too accommodative.  The harsh reality was soon proctored by the markets which saw those assets closely tied to inflation expectations peak in the wake of QEII and begin a long disinflationary downturn and wide underperformance to the S&P 500.

Today, as the markets work through the structural and psychological frictions of a normalization with monetary policy, demand for long-term Treasuries should remain supported - as well as reflationary trends in precious metals, commodities, emerging markets and Chinese equities. With that said and as noted throughout the year, there has been a lagged sequence out of these assets cyclical pivots and respective interim highs and lows. 

In our opinion, the biggest development recently - besides the cracks developing in the equity markets, is the further breakdown in 10-year yields, which should release the next leg higher in gold and draw the broader commodity complex out of an interim low. At the same time, a declining yield environment should present a strong headwind for the financial sector - that up until this spring had led the broader market higher.  All said, ramifications by a zealous audience to a Fed willing to turn the music down. It's still loud out there - but it's not 11. 

Thursday, August 7, 2014

At the Break Zone in Yields

Despite indications of short-term momentum and sentiment extremes, 10-year yields continue to follow the arc of the 1994/1995 rate tightening cycle and are currently hovering around the break-zone of the May 28th lows. 

Broadly speaking, the current dynamic has maintained pressures on the equity markets, specifically the critical financial sector - which exhibits a positive correlation with 10-year yields over the long-term. Conversely, gold and the precious metals space should continue to benefit from the unwind in long-term yields that were stretched at a relative historic extreme coming into the year.   

Wednesday, August 6, 2014

Deflation's Door Shuts in Spain & Opens in Japan

Satisfaction 10/5/2011
The 1987 Nikkei projection that we've followed throughout the year is completing the less mentioned, but more important - long-term patterned outcome the momentum comparative always implied.That market inertias would be quickly restored to the upside, once the retracement decline was completed.  
As mentioned in previous notes, this same pattern was replicated in the S&P as it navigated and was rejected by the Meridian in 1987, 1994 and in 2011. On each occasion, the low offered investors an excellent buying opportunity. Similar to the patterned reversal in the SPX in the fall of 2011, investors are getting one more chance to buy Japanese equities on sale before we expect Japan to overcome the pernicious tentacles of deflation, that has rejected their equity markets at long-term resistance over the past three decades. 
Alexander Graham Bell once shrewdly remarked, "As one door closes another one opens." Fulfilling that leading sentiment, while we are encouraged by the set-ups in Japan, the shutters of deflation appear to be closing in Spain where our long-term deflationary comparative has pointed towards. While the projection implies a short-term low, we offer another pearl of wisdom from Bell that epitomizes our proactive research methodology with markets. - "Before anything else, preparation is the key to success."