The Ides of October – October 6th 2014

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Back in early August we suggested that we might have seen a few chinks in the armour of the markets only to be derided when the powers that be pressed the “buy me now” levers yet again. The central bankers have truly been the markets best friends and Dr Aghi and Kuroda-san have been taking over where Ms Yellen has all but left off, but even they can do little in the face of protest and dissent by various members of the global populace and the continuing stupidity and arrogance of our “democratically” elected representatives.

One area of the market that is returning to its senses is high yield or junk bonds as we affectionately used to call them. The realisation that yields were perhaps a touch on the low side has happened slowly but like bankruptcy it could all too quickly come all at once.

In Europe all bond yields are artificially low courtesy of ECB policy, but, historically, in the high yield sector they have tended to be higher than in the US. Some catching up is on the cards here which will be painful for bond holders. The “Bill Gross” effect will also be putting upward pressure on yields. The King of Bonds has moved to Janus (any similarity to the Roman god is merely a coincidence) and redemptions from his PIMCO funds are likely to continue at significant levels. There will inevitably be some “round-tripping” if the redemptions get reinvested with his new company but some bond investors may take this opportunity to look elsewhere; in fact they should be encouraged to.

Quite when interest rates are going to rise is anyone’s guess and sovereign bond yields could yet follow the Japanese path below 1% – German 10 year Bunds are already there and French OATS, would you believe, are at 1.26%. Did anyone say deflation? This would be the last thing the central bankers would want, but Draghi’s TLRTO initiative and ABS bond buying programme have been abject failures. Under TLRTO banks can theoretically borrow from the ECB at 10 basis points and any loans they make as a result would come at a very attractive rate. The only problem is that no one ex the student loan fraternity and the Top Gear wannabees are interested. The ABS market is tiny and the ECB’s scheme will just encourage the investment banks to dream up more bond erotica for the unsuspecting, which is how we got into this jam in the first place Stanley!

Low bond yields should theoretically support higher equity prices in a normal world where stock valuations are generally driven off the risk free rate, but if that rate is artificially low, which they are courtesy of central bank manipulation, then equity prices are too high are they not? This is nothing new and until very recently markets have been a one way bet driven by money searching for a return – any return – better than cash. This is not a rational way to invest it is speculation pure and simple.

I can do no better than quote from a recent John Hussman newsletter.

“As I did in 2000 and 2007, I feel obligated to state an expectation that only seems like a bizarre assertion because the financial memory is just as short as the popular understanding of valuation is superficial: I view the stock market as likely to lose more than half of its value from its recent high to its ultimate low in this market cycle.”

“At present, however, market conditions couple valuations that are more than double pre-bubble norms (on historically reliable measures) with clear deterioration in market internals and our measures of trend uniformity. None of these factors provide support for the market here. In my view, speculators are dancing without a floor.”

“Dancing on the ceiling” is not an option either…Beware the Ides of October.


Central reservation – September 8th 2014

The key take away from Thursday’s ECB announcement was that nothing has changed. Jaw boning is still the main policy tool and further cuts to interest rates and purchases of asset back securities are further fleas on the back of the EU elephant. A 10bps (0.10% if you like) interest rate cut is hardly going to make the good citizens of Europe rush to their bankers for a loan. Not that those banks would be interested in granting them one if they did!

The interest rate on the deposit facility which banks “earn” when they deposit money with the ECB (because they are reluctant to do anything else with it) will be decreased by 10 basis points to -0.20%. So now if they are thinking of “borrowing” money under the targeted long term financing operation (TLTRO) they will be paying 20bps to park the money while they decide if they want to lend it out – assuming there is demand in the first place, which there isn’t! So the banks won’t be rushing out to use this facility either will they?

The ECB press release included this statement which has been the apparent trigger for upward moves in eurozone equities and the short end of the bond markets – “The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP).” In simple terms they are buying a bunch of repackaged mortgages and private loans.

This theoretically allows the banks to recycle capital so that they can issue more debt which is one of the ways RBS got into so much trouble. The European ABS market is still pretty small so any funds raised this way are not going to be of any great significance and won’t help the countries that need the help the most ie Southern Med. The Germans on the other hand don’t need any help at all!

The most obvious, and necessary, effect as far as the ECB is concerned is to weaken the euro, but by nowhere near enough for Greece, Spain and Italy.

In Japan Abe’s third arrow has failed to gain escape velocity and he is relying on the BoJ to keep printing. Kuroda also spoke at the recent Jackson Hole meeting and confirmed that if need be further QE would be forthcoming. The BoJ not only buy JGBs (they now own more than one third of the entire market) but they also buy Japanese equity ETFs. Just imagine where the S&P 500 would be if the Fed were allowed to do this (assuming they aren’t already…). They are trying desperately hard to get some inflation into the system to generate some scope for companies to start paying higher wages, but with the threat of a further sales tax hike from 8% to 10% it is a difficult target they have set themselves. The sales tax regime was introduced as part of the third arrow economic reform package; might be a good idea to let this one go Abesan.

Janet Yellen spent most of the time talking about labour statistics at Jackson Hole and summarised by saying that economic conditions were perhaps still too fragile to start raising rates soon. Last month’s employment figures have confirmed her view although pundits are using the usual smoke and mirrors about seasonal adjustments et al to make the disappointing numbers seem of little consequence; closing on a new all-time high on Friday, S&P 500 aficionados apparently agreed with this sentiment.

Yellen’s counterpart in London has been keeping a low profile lest he is asked why he hasn’t raised interest rates in the UK yet given the apparently strong numbers emerging from the economy. It has been suggested that Carney won’t intervene before the election next May. Traditionally the Bank has not raised rates in the six month period before the event so that means he has another couple of months to go and could still surprise us.

Trying to follow a sane investment strategy when all the cards are held by the central banks is becoming increasingly difficult. Sovereign debt has surprised so far in 2014, but now, as a safe haven, only the very short end of the curve has any attraction. European ABS have a support level courtesy of the ECB, but do you want to be holding them in weak currency? The BoJ are committed to supporting their equity market too and the S&P can seemingly only travel in one direction. There are some markets still playing catch up; the baton here has been passed to China and the Shanghai A-shares index, which after a decent pause for breath in August, is beginning to get a move on again.

But the game of risk is being gamed ever upwards. Small savers and large institutions alike are being pressured into asset classes to generate a “decent” return that will not afford them any protection when the central bank merry go round stops.

Finally another quote from Dr Aghi. “It’s completely wrong to suggest we want to expropriate savers”; but you have Mario haven’t you?

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“History doesn’t repeat itself, but it often rhymes” – August 3rd 2014

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There is no substantive evidence that the above quote was made by Mark Twain, but he did write a far more eloquent observation in a novel, entitled “The Gilded Age: A Tale of To-Day”, he co-wrote in 1874;

History never repeats itself, but the kaleidoscopic combinations of the pictured present often seem to be constructed out of the broken fragments of antique legends.

Piecing through the ever more complex and voluminous data 140 years on is it still possible to get a hint of the future from fragments of the past; antique or otherwise. In the 21st Century investment cycles seem to come around faster than Lewis Hamilton. In the first 14 years we have had significant market peaks in 2000, 2007 and quite possibly 2014. Prior to that you have to go back firstly to 1987 and then 1974 then 1929. Things are speeding up!

But are we near a peak right now? I am indebted to the Elliot Wave Theorist ( for some of the following clues. We have had something of a selloff in mid and small cap stocks already, both here and in the US. The Russell 2000 index of small cap shares saw its closing high back in March as did the FTSE 250 and Small Cap indices suggesting a meaningful switch from risk on to risk off, a pattern that occurred in 2007.

High yield debt (I still prefer the term “junk bonds”) are starting to pull back from historically low yields. The Junk/Treasury price ratio is down more than 11% since its December 31st 2013 peak. The last time this ratio was down more than 11% while the S&P 500 was at an all-time high was in July 2007 and we know what happened in the bond markets after that…

A move out of riskier mid and small caps and perhaps a realisation that high yield is in fact junk is a warning sign that, at the very least, markets have got ahead of themselves. That this is a contrary opinion is something of an understatement as I am continually reminded! Bullish sentiment is rife. “Fund managers are aggressively positioning for a second half upturn in the global economy,” says Market Watch. Citing the recent 51 day span without a single move of more than 1% one pundit suggested that the S&P is not over extended and may never pull back!

The yield on the Dow (2.09%) is now down to levels last seen in 2007 (2.06%). During the ensuing slump yields climbed to close on 5%. In 1929 the market peaked on a yield of 2.83%. Another valuation measure, Tobin’s Q ratio divides the market value of corporate assets by their replacement costs. It is currently standing at the second highest extreme topped only by the TMT frenzy in 2000.

We also have an example of “tulip bulb mania” in the form of a stock with the appropriate name of CYNK Technology. It had no assets, no earnings, no revenue and a business plan based on the idea that “people should, and will, pay to get in touch with people.” It jumped over 36,000% from a low of 6 cents to a high of $21.95 before crashing back to earth; all during the course of July this year. Tulip bulb mania in the 1630s managed gains of a mere 2880% for the “rare” Switzer varieties.

Previous peaks in 1929, 2000 and 2007 have seen a spike in the number of stories about income and wealth inequality, as markets inexorably rise and the rich get richer…And here in April Thomas Picketty launched his book “Capital in the 21st Century” all about…wealth inequality. Another market peak indicator is the increasing concern about bubble conditions. Janet Yellen at Yellen Capital – the new nickname for the Fed given that its burgeoning holdings of US Treasuries make it the world’s biggest hedge fund – doesn’t believe that the price / equity ratio (she probably meant price / earnings but then she is a theoretical economist…) is high, although she did say that certain biotech and social media stocks were overvalued. One is tempted to ask what she was twittering on about…and it seems that I just have…oh dear.

And finally now that he has moved on former Chairman Bernanke has suggested that “It’s entirely possible that if you look at the world, you have slow growing advanced economies and that the rate of return is just going to be low.” Well you certainly engineered a low rate for savers forcing them into just the kind of riskier assets that are now beginning to peak didn’t you?

Mind out below…

Clive Hale –The View from the Bridge – August 3rd 2014


A puzzling disconnect – July 3rd 2014

To read the latest View from the Bridge click here to view pdf 

Summer is upon us and in the UK we are actually enjoying some sunshine as are equity markets notably in the US. Fixed interest markets too are still sitting close to all time low yields and “shock horror” Spanish ten year rates are now below both UK gilts and US Treasuries. No I don’t know why either but Dr Aghi is sitting comfortably at the ECB having told the markets yet again that the sanctity of the euro is sacrosanct and woe betide anyone who disagrees with him.

Without a doubt the central banks are now running the show which is unfortunate as their track record, particularly in avoiding stock market excesses, is patchy to say the least. Janet Yellen, the latest incumbent chair at the Fed is quoted as saying that she is not at all concerned about valuations on Wall Street

In other words she is complacent about complacency, but no different from her predecessors who couldn’t see a housing bust coming (Greenspan) and thought that the subprime debt market was under control (Bernanke).

The Bank for International Settlements (BIS – the central banks’ central bank whose mission is to serve central banks in their pursuit of monetary and financial stability) agrees with our view,

“Financial markets have been exuberant over the past year, dancing mainly to the tune of central bank decisions. Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks.”

The S&P 500 Index, gained almost 20% in the 12 months to May 2014, whereas expected future earnings grew less than 8% over the same period. The cyclically adjusted price/earnings ratio of the S&P 500 stood at 25 in May 2014, six units higher than its average over the previous 50 years.

It is no different in bond world…”Low corporate bond yields not only reflect expectations of a low likelihood of default and low levels of risk premia, but also contribute to the suppression of actual default rates, in that the availability of cheap credit makes it easier for troubled borrowers to refinance. The sustainability of this process will ultimately be put to the test when interest rates normalize.” In other words how secure are the interest payments on the high yield bond you have just put into your retirement account?

“Once more, communication from the Federal Reserve and the ECB helped support credit and equity markets, with the major stock exchanges reaching record highs in May and June 2014.”

They go on to say that…”It is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally….As history reminds us, there is little appetite for taking the long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end.”  Apart from driving asset prices higher and higher has QE really worked as intended? Answers on a very small postcard…or as the BIS puts it…

“The global economy continues to face serious challenges. Despite a pickup in growth, it has not shaken off its dependence on monetary stimulus. Monetary policy is still struggling to normalize after so many years of extraordinary accommodation.  Despite the euphoria in financial markets, investment remains weak. Instead of adding to productive capacity, large firms prefer to buy back shares or engage in mergers and acquisitions. And despite lackluster long-term growth prospects, debt continues to rise.” As does the ability of the creative accountants to produce “ever” rising earnings growth.

But don’t worry the central banks know what they are doing don’t they? “Market participants seem to have become convinced that monetary conditions will remain very easy for a very long time. But markets may be taking more assurance than central banks wish to give, and they may be considering only a very narrow spectrum of potential outcomes. Such overconfidence is dangerous. It may encourage excessive risk-taking, and may add to the pressure on central banks to postpone policy normalization.”

Their conclusion is based upon much common sense but don’t hold your breath waiting for it to happen.

“There is a common element in all this. In no small measure, the causes of the post-crisis malaise are those of the crisis itself – they lie in a collective failure to get to grips with the financial cycle. Addressing this failure calls for adjustments to policy frameworks – fiscal, monetary and prudential – to ensure a more symmetrical response across booms and busts. And it calls for moving away from debt as the main engine of growth. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy maneuver will run out.”

Might we suggest that the BIS restate their mission which should be to “save” central banks from their pursuit of monetary policy? It would be a much safer world without them.