Tuesday, December 16, 2014

the Crude Reality in Oil

Just as we've found the more contemporary comparisons of previous rate tightening cycles misleading with today (e.g. ZIRP), we find a similar fallacy in gleaning a positive context of the relative health of the US equity markets after a significant decline in commodities. Point being, with the bottom falling out of oil over the past few weeks, some analysts have pointed to periods in the 1980's and 1990's where equities continued to outperform, subsequent to major corrections in oil. While we would agree that the recent decline in oil is less a statement on the health of the US economy and primarily a market driven consequence of a zero sum game, we do view the extreme nature of the move as another hallmark of exhaustion in the broader downtrend in commodities - than one of continuation that many participants appear to gravitate towards. 

This isn't surprising given the dominance of trend in the equity markets over the past four years, where participants have been shaken out of their initial intuitions of more inflationary driven investment theses, into a concerted reach for yield in the equity markets. That said, we believe there is a valuation ceiling - either rational or not, that the equity markets have been pushing up against over the past year and which we expect is limited by the markets disposition in the trough of the long-term yield cycle (see below). While the Fed has succeeded in raising the valuation ceiling in equities far above where almost everyone had anticipated six years ago, participants would be exceedingly optimistic to expect that the markets and the economy could carry a significant and sustained rise in yields that would accompany a move out of the long-term yield cycle's trough - and away from the cyclical nature in the markets we still believe exists between equities and commodities today.
Although the economic data has continued to come up roses, just as the housing market quickly took a significant hit when yields surged in 2013, we think the collective knock-on effects to the economy can not be overstated when considering a rising yield environment. Historically speaking, this is why the trough of the cycle is so long and shallow, as the markets and the economy slowly transition - to be capable of carrying the heavier yield weight of the next growth phase. When we look at the size of downtrend in yields over the past four decades and the benevolence it imparted to assets such as equities, it seems reasonable to expect that the trough of this cycle would at least be commensurate with the scope of the previous (1940's) - with the real possibility of greater asymmetries extending the low yield environment even longer than its mirror. For market participants, this is akin to working in geologic time and one we expect could unfurl with similarities to the mirror of the cycle in the 1940's - as equities and commodities rotate between cyclical moves across the trough with more or less a sustained bid in the Treasury market. 
Over the past week the talk of the Street has been whether the Fed would remove "considerable time" from its policy statement at this weeks meeting. The general consensus appears split between leaving the language as is or amending the statement to reflect a modest shift to an increasingly data dependent posture. All things considered, we believe either outcome is a moot point over the next several months, as the inflation data will likely be weak as the lagged effect from the strong dollar and commodity slump makes its way through the system - further easing expectations of more imminent rate hikes by the Fed next year. We think the best case scenario would eventually reflect an excessively modest and gradual rise in the fed funds rate, as we know the 1937 rate hike from the trough looms large within the Fed as well as the broader collateral impact to world markets. Either way, we find the FOMC members own dot plot projections, wildly optimistic of where the funds rate will be at the end of next year and thereafter. For now, this expectation gap should provide further downside in yields as the market continues to pan Treasuries with expectations of a rising rate environment in the back half of 2015.

While we expect the inflation data over the next few months to reflect the significant move in the dollar since this summer, the reversal in gold in November may be a leading indication that the dollar - like the equity markets, are butting up against the limits of their respective trends. 
Historically speaking, the same leading nature in gold has been present in the past with upside reversals in oil.
As measured by its weekly RSI, oil is the most oversold it has been in over thirty years. The other two RSI extremes were in 2008 and in 1986. 
To illustrate and contrast these three comparative declines, we created two studies. The first was normalized to momentum and performance and the later to duration and performance.  The broad brush takeaways would indicate that in the two previous occasions where the market expressed its most oversold condition, oil subsequently stabilized with a retracement rally - before completing the downtrend. In both previous occasions, the moves were approximately 90 percent complete with respect to downside performance and approximately 85 percent complete for the duration of the decline. 
Although we've been following throughout the year the relative symmetry in the pattern of the SPX:Oil ratio, we did not anticipate another decline to develop in oil along the lines of the mirrored shoulder that was formed in late 1985 into 1986. Hindsight 20/20, this appears as a rather daft read - but par for the course of play this year as nasty curveballs were once again thrown in commodities and currencies in the back half of the year. 
What's interesting to note, is that assuming the decline in oil is close to exhaustion, when we look at the pinnacle of the ratio with the major low set at the end of 1998 in oil - the pattern symmetry, structure, seasonality and performance are quite similar with that periods capitulation decline. 

Friday, December 12, 2014

Turning Up the Heat in Europe

One of our better pairs strategies this year was playing the breakout in Japan from its nearly 25 year trading range and the turn down in Europe that materialized at the end of Q2. While we were guided by a comparative roadmap through the retracement decline in the Nikkei in the first half of the year (see Here), the bigger picture narrative of the strategy was outlined in a note at the end of April (see Here), that weighed the two major perennial asset unwinds that took place over the past century and the gathering deflationary conditions swirling across Europe, focusing specifically on Spain's IBEX index for comparison. 
In relation to these two previous examples, the loss of momentum this year in Europe arrived around where both markets made a cyclical high from their secular peaks. Pulling a page from the freshly printed third edition of the Fed's handbook on reflating your way out of a liquidity trap, it comes as no surprise of where the ECB left their passive stance and began easing and posturing a major policy shift towards QE. 
Here's a snippet from a note in June framing that development as Spain's IBEX rounded the corner of the comparative cyclical high:
With Japan languishing in the back eddies of deflation over the past 25 years,  it comes as no surprise of what the ECB is attempting to avoid. In a brave new world where central banks are active not just in the throes of a crisis - but in the midst of momentum, it's easy to get swept up in the hope of avoiding such fate. Our general take, however, is it's also easy to conflate causation with policy - as the efficacy of such correlations ebb and flow with a market's given structure, sentiment and positioning. The long and short of which would indicate that time is the great revelator, and although the ECB's actions are received better late than never, the reality is the markets - like water, will gravitate to the path of least resistance in the face of an incoming deflationary tide. - 25 Years to Life
The bottom line remains, that if the Eurozone has any chance of avoiding or lessening the same pernicious conditions that held both the US and Japan for a quarter century, respectively; the higher beta equity markets in Europe - such as Spain's IBEX, will need to reboot with whatever-it-takes abandon, to mitigate the hazardous debt-to-equity ratios that become compounded with a cyclical decline in their equity markets. Our best guess is that it will be attempted from lower levels and only after the German's feet are held closer to the fire. Considering the cyclical comparative with Japan - circa 1997, that fire may soon get a bit hotter.

Tuesday, December 9, 2014

Following a "Deflated" 2008 Redux in Commodities

While the respective moves are roughly half 2008's magnitude - led by a corresponding seasonal pivot in the US dollar and euro, commodities have loosely followed the glide path of the 2008 sector decline this year. Should the comparative prove prescient, a similar dynamic will continue to develop as precious metals have found a foothold - before the broader sector and currency markets turn

Thursday, December 4, 2014

the Delta blues - Side I

With consumer confidence at its highest level since before the Great Recession and with unemployment below 6% for the first time since 2008, you might expect a more ebullient characterization of the economy and outlook for the future. And yet the prevailing sentiment remains that the current recovery stinks. 


Predominately, because it has taken so long for us to get here. Most economists would agree that the recovery has been slow and uneven with wide swaths of the workforce encountering varying economic conditions. Although the unemployment rate has fallen swiftly over the past two years, it still remains at a relatively elevated level. Whereas, the average jobless rate for the decade before the Great Recession hit in December 2007 was 4.9%, the current recovery for this decade has been significantly higher around 8.1%. From our perspective - and like most things in life, the crux of our collective frustrations and disappointment extends from a lack of understanding what the realistic expectations of where we are situated. Simply put, you're not 18 anymore - and either is the economy.

With the jobs report on deck tomorrow, we though we would share a simple visualization of how we view the economy and this recovery. Generally speaking, we approach the markets from a top down perspective that starts with a characterization of the long-term yield cycle and progresses with shorter asset appraisals that are affected by its bearings.

The long-term yield cycle is a massive period that extends for decades from trough to trough - the current cycle in its eighth decade since the previous secular low was made in 1941. Comparatively speaking, the current cycle is roughly twice as long as the previous cycle in the first half of the 20th century. As we conveyed in previous notes, we expect the current trough for the cycle to extend into the next decade before yields make a sustained secular move higher.

One way to look at the current disposition of yields and the economy is through the prism of a river systems channel morphology. For this analogy, assume that the secular peak in yields in September 1981 served as the headwaters for the great economic expansion of the 1980's and 90's and the lackluster conditions we remain mired in today. Back in 1981, the downslope gradient in yields was steep and the velocity of the recovery swift. Similar to the erosion in a river bed that is affected proportionally by the speed of the water in the channel, the subsequent sub-cycles have all exhibited progressively longer recoveries - as the gradient of the cycle lessens and lengthens as it makes its way towards the terminus of the delta. 
The broader takeaway, is that while we would all welcome the robust GDP prints from the 1980's and 90's or income growth above 5%, the economy - like the river channel, is limited and affected by its downstream situational bearings within the yield cycle. While the Fed can build creative engineering controls and levees to buttress sections of the economy and certain markets - they can't make the entire river system run upgrade. And like we witnessed in the financial crisis, sometimes those systems fail - and fail with spectacular consequences. 

Nevertheless, it is what it is and we like to remind ourselves as reminiscence of economies and market conditions of yesteryear are brought up for comparison with today. Point being, although we expect the jobs report tomorrow to remain upbeat, we continue to find the bullish conventional wisdom directed towards the US and US dollar exceedingly optimistic, especially when participants and pundits cite current market conditions in relation to the two previous occasions when the dollar broke materially above its perennial downtrend. In many ways, anticipating that the dollar will continue higher from here as it did in the early 80's and late 90's, would be akin to expecting similar economic conditions to materialize in the economy today. While we have come a long way from the delta blues of the financial crisis, bear in mind where we sit in the broader cycle. Similar to our structural expectations with yields, the dollar should follow its lead and trough-out as the balance of the worlds major economies take the torch we have carried and maintained over the past several years, as we collectively make our way across the broad transitional divide to the next era of growth. 

Wednesday, November 26, 2014

The World is Flat - at the Transitional Divide

One of the side effects of the financial crisis was that growth cycles across the world that had converged leading up to 2008, became untethered in the ensuing aftermath. We recall listening to an economist in the summer of 2006 wax poetic about how the 66 largest economies in the world were enjoying a historic and synchronized expansion. Naturally, his takeaway was broadly bullish - implying a sturdy and broad foundation was extended beneath the markets. While that was exceedingly true at that time, his observation of the cycle resonated for us in a very different way. If everyone was expanding on the same growth wave, the inevitable contraction would be greatly magnified. We found the statement so poignant, it remained written across the top of a whiteboard in our office for several years.

These same wave principals are taught in your high school physics class as a phenomenon known as constructive interference. When two waves of identical wavelength are in phase, they form a new wave with an amplitude equal to the sum of their individual amplitudes. Conversely, when two waves of identical wavelength are out of phase, they cancel each other out completely. Often, it's a combination of varying degrees of both destructive and constructive interference that determines the composite structure of the new wave - or in this case, the aggregate cycle of the largest economies in the world that had become highly synchronized. Needless to say, our greatest fears in the market were realized just two years later as momentum was translated and magnified sharply lower during the financial crisis. 

Back in the spring of 2011, we created a video around this concept (see Here) - that also played on the interventive policies that the financial system were increasingly reliant on. For us, Constructive Interference took on new meaning - which was summed up with three progressive assumptions at the end of the video.
  • The current financial system requires Constructive Interference by the worlds major central banks - the Federal Reserve acting as the principal director of policy and practice. 
  • Consolidation within the financial sector (i.e. Too Big to Fail) in the last 30 years has enabled central banks with the infrastructure to administer reflationary policies efficiently and with greater efficacy during illiquid periods of contraction.
  • The cumulative effects of Constructive Interference within the financial system has led to increased speculation, frequent financial bubbles and confidence within the monetary system to react (i.e. moral hazard).
It should be noted that from the cheap seats of the peanut gallery, we certainly would not have chosen or advocated the TBTF system and policy path that was taken over the past three decades. However, from a pragmatic perspective - it is the framework the system funneled towards and which greatly governs conditions in the markets today. Example being, while it's a step in the right direction requiring banks to significantly expand their capital cushions - for better and worse, we don't expect these enormous institutions to be dismantled any time soon. The dirty little secret: when it comes to administrating monetary policy - the bigger the better, i.e. easier. Subjugating that reality with counterfactual arguments has practically become a rite of passage for many journalists (e.g. Matt Taibbi) and pundits - and painful in the purse for those participants that have carried a strong bias with expectations of an even greater crisis in the future. Ever superior to ones opinion, it simply is what it is. 

While the crisis exposed the catastrophic dangers of the TBTF model, the massive pipes that were built through consolidation, did help quickly flood the system during and subsequent to the crisis. Would a dendritic banking system have been safer or failed with less collateral damages as the new paradigm? Certainly. Growth would have been constricted, more moderate, less synchronized - and therefore less amplified on both sides of this cycle. However, in many ways it's an anthropologic chicken-or-the-egg debate on markets and capitalism, that we suspect was as inevitable as it was predictable. Free will be damned, we cynically arrive at our collective and predetermined destination.

Although the TBTF system has only grown larger since the crisis, the varying policy responses by the four largest economies (US, Europe, China & Japan) has dispersed the correlation extreme in growth tracks that were present in 2006. Moreover, this has steadily eased the tight correlations across world markets that peaked in 2011. That said, for investors it's certainly no cornucopia - considering many economies now sit in the trough of their respective long-term yield/growth cycles. One way of looking at the bigger picture and where we may be headed, is that economies and markets became highly in phase leading into the composite yield/growth trough, which culminated with the financial crisis. Post crisis, varying policy responses have further dispersed growth tracks as the major global economies bounce in and along the yield trough with much greater destructive than constructive interference. Some might call it secular stagnation, or as the man who coined the phrase some 75 years before, aptly posited; 
"...passing, so to speak, over a divide which separates the great era of growth and expansion of the nineteenth century from an era which no man, unwilling to embark on pure conjecture, can yet characterize with clarity or precision." - Alvin Hansen, Economic Progress and Declining Population Growth, 1939
Works for us - and once again on this side of the cycle's trough, we can only speculate as to what the catalyst for the next era of growth will be and when to realistically expect it. Our best guesstimate, however, is that Hansen's transitional divide will extend much longer than most participants expect, as we bounce along the bottom of the trough. We speculated going into this year, the structure and performance extremes that were quickly translated at both the top (12/13') and bottom (7/12') in 10-year yields, might be implying a long-term range was being established as the great inertias of the secular trend in Treasuries entered the trough of the cycle.
As conveyed in our last note, this point of view remains supported by our research of historical trends that implies yields are not headed materially higher anytime soon. Last week we came across an interesting chart posted by Michael McDonough of Bloomberg, that resonated with this perspective and the significant expectation gap that still exists in the market today. We inverted 
Michael's chart - which shows that the trends in 10-year yields and the number of months in the fed fund futures market to reach the implied rate of 0.5%, were quite correlated going into 2014. Similar to the trend gap that now exists between 5 and 10-year yields, the shorter more impressionable end of the market continues to err on the side of sooner rather than later, when it comes to rate hike expectations over the next year. As framed in the Bloomberg chart and illustrated in the roadmap of the last transitional divide (see Here), we believe long-term yields are pointing the way when it comes to rate hikes over the next several years. All things considered, we still like long-term Treasuries - especially relative to the US equity markets.

In the equity markets, we suspect it will increasingly becoming a market-pickers market between the four different food groups (US, Europe, China & Japan), with sub-varieties tangent to choice. As mentioned in previous notes, despite instigating the catalyst for the crisis, the US had a head start of working and digging the fire lines, that eventually brought the economic disaster under control first. Relative to what the balance of the worlds major central banks were willing and capable of extending - and with the Fed acting as the policy lead, the differential of capital flows has disproportionally supported our equity markets and the dollar since the crisis spread in the summer of 2008. Are the US markets in a bubble today? In our opinion it's a semantic debate, but one we do believe has greater contrast than comparison between the two previous equity bubbles and their respective downturns. 

Nevertheless, we still expect that with Europe, China and Japan now hitting the accelerator as the
US coasts away from QE, the shear stresses that engendered a broad based positive skew in the US equity markets and dollar, should diminish over time. Although it's a short window to measure, from a relative performance perspective, we have already seen as much since QE wrapped up in the US last month. 

For everyone in the States and traveling this weekend, have a happy and safe Thanksgiving.

Monday, November 17, 2014

The Commodity Supercycle Ain't Over - Yet

As surprising as it might sound today, we believe the secular trend for commodities has higher elevations to travel, before eventually running its course - possibly as far out as early into the next decade. While in 2011 we became adamant that the thesis trade in commodities - specifically in its leading sector of precious metals, had become crowded and overhyped, those excesses have been wrung out of the markets over the past three and a half years and offer what we perceive to be extremely compelling long-term valuations going forward. 

This idea remains supported by our research that implies yields are not headed materially higher anytime soon - despite the anxieties surrounding the Fed raising interest rates over the next few years. Moreover, we expect that real yields (nominal - inflation) will remain suppressed and eventually retrace the rise that began in the back half of 2011. When the real yield cycle finds its zero bound and breaks below, commodities tend to outperform in the market over an extended period of time. All things considered, the death knell spike in real yields that has historically punctuated the end of major commodity booms in the past - has yet to appear for us on the horizon. 
Over the years we have shown a long-term Hawking view of the nominal yield cosmos, which depicts an antithetic and gradual troughing, versus the violent and exhaustive secular peak in yields the markets experienced in the early 1980's. While 10-year yields this year have retraced back to the mid point of our expected range (1.5%-3.0%), taking into account the symmetrical structure and mirrored return of the long-term yield cycle,  an estimated secular pivot higher would not take place until early in the next decade. 
When it comes to a roadmap for short-term yields going forward, we looked back at the last time 3 month Treasury yields broke below 0.5% in 1934 and troughed over the next 13 years until 1947. Notwithstanding the failed rate hike regime by the Fed in 1937, the current market has closely followed the historic comparative performance trajectory of that time. Interestingly, by normalizing a duration study to that period (see below), the estimated run below 0.5% would also extend early into the next decade. 

From our perspective, the broader cycle takeaways are:
  • Although the Fed may tweak short-term yields gradually higher at some point in the future, the expectations by participants of a one - and certainly two or three handle, in front of the fed funds rate - appear wildly optimistic over the next few years.
  • We believe the extended and gradual basing structure of the historic cycle reflects more realistic expectations for yields and the natural equilibrium that the Fed will ultimately be guided and constrained by - just as they were across the trough of the cycle last time around. 
As shown in our first chart that depicts both the long-term nominal and real yield cycles, commodities have outperformed along runs leading up to the nominal peak in yields and through the nominal trough of the cycle. From a comparative perspective, the 1970's commodity boom that ran commensurate with the yield peak was roughly half the duration of the commodity boom that ran through the trough in the 1930's and into the early 1950's. This makes logical sense to us, considering what we know of the nominal yield cycles structure - i.e. shorter exhaustive highs versus long drawn out troughs.

When comparing the performance of the CRB index between the 1970's supercycle and today, you might come to the initial conclusion that the current cycle hasn't been that super after all. In fact, the current cycle (as expressed by the CRB) would roughly fit within the performance envelope of the first leg of the 1970's market (71'-78') - despite being more than twice as long. Complicating the tea leaves of the current market was the major currency dislocations in the financial crisis, which caused an overshot on both the top and bottom sides of the performance ranges. 
That said, when we extrapolate a normalized comparative study - balanced by momentum (RSI and stochastics) signatures across the complete run of the 1971-1980 boom, we find an estimated comparative leg higher up to the early part of the next decade. Fittingly, this would roughly match the duration of the previous commodity boom that extended for ~20 years along the mirrored trough of the long-term yield cycle in the early 1930's and 1950's.

While the recent prognostications of $700/ounce gold and $50/barrel oil make for great hyperbole by the bears and in the punditsphere, we view them as the typical overshots that are thrown around during the final throes of capitulation. In as much as markets tend to overshoot significant moves, expectations soon follow - always in the same direction of where a market has been trending. With commodities remaining under pressure since Q2 2011, recency biases have entrenched towards further downside in the future. For gold to reach $700/ounce or oil $50/barrel, real yields would be pushed significantly higher - essentially repeating the performance declines for both assets that began in 2011. From what our anticipated range implies for nominal yields over the next few years and how eroded inflation expectations have become today, both targets appear grossly unrealistic. Contrary to conventional wisdom in the market today, we still believe hard commodities such as gold and oil will once again outperform - greatly supported by the tangential performance trends in catalysts such as China and emerging markets. 

You'll find that for many of the commodity cycle bears today, their theses hinge on a continued catalytic decline in China. This is predominantly because China had played such a pivotal role through the first boom of the commodity cycle in the massive demand created by significant investments in infrastructure and urban development. While the excesses in China have been well described and rigorously debated for the better part of this decade, the just how bad the crash will be expectations by the policy bears have so far been largely unfounded. 

Quite the contrary, although these concerns remain at the forefront of debate as growth in China has slowed, the leading edge in their equity markets have surprised (finally) many this year - and broken out from a 5 year consolidating range. 

As much as their arguments are well founded with cogent logic, the reality becomes that  increased capital flows and resurrected confidence in Chinese markets will have a mitigating effect on the immanent credit conditions that academics and strategists such as Paul Krugman and Michael Pettis have been greatly concerned with over the past several years - and whom largely expected significant pressures to remain on the commodity markets as China would be forced into a long and painful economic rebalancing. 

While it remains to be seen weather China has its comparative 82' awakening (see above) or its much anticipated bust, we do believe the recent positive developments in their capital markets will provide a constructive rather than destructive environment for the commodity sector over the next year. All things considered, we'll still take that bet and doubt we will ever see $700 gold or $50 oil again in our lifetime. From our perspective, $1400 and $100 appear more likely in 2015 - and by 2022... who knows - the super may have shown up again in this cycle.   

Wednesday, November 12, 2014

Marination Station

We've been preoccupied this week with another side project, but thought we could offer up a few charts for consideration. Food for thought.  

- Click to enlarge images -