The Ides of October – October 6th 2014

To read the “View” in pdf format click here

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.