Investing, Markets

Mind The Gaps

A version of this post first appeared in The Felder Report PREMIUM.

About a month ago former Fed head, Richard Fisher, came out and confirmed the idea that the FOMC’s quantitative easing policies over the past seven years have pushed prices of risk assets, including stocks, beyond what would otherwise be supported by their fundamentals.

There are a few ways to visualize this. The first comes from Dr. Ed Yardeni who tracks a fundamental indicator shown below. Notice the yawning gap between the S&P 500 Index and the major economic fundamentals.

Screen Shot 2016-02-05 at 9.34.00 AM

We can also just look at the index versus its components’ earnings. Here’s another gap:

And if you prefer to look at forward earnings estimates, you’ll find another massive gap:

Specifically, Fisher said that the Fed had, “front-loaded a tremendous rally.” All this means is that the Fed pulled returns forward from the future to generate larger gains today. Notice in the chart below that returns have recently been significantly better than valuations (using the Buffett indicator) 10 years ago justified. This is exactly what Fisher is referring to.


The last time this happened was in the late 1990’s. From that peak, stocks fell more quickly than forecast in order to play, “catch up,” to the downside. Interestingly, the 3-year forecasts I generate using margin data show the very same gaps in the late 1990’s and today.


And there are other indicators suggesting these gaps could close sooner rather than later. Bond market risk appetites (very similar to spreads in corporate bonds, junk bonds and leveraged loans) have been falling farther and for a longer period of time than stocks. These are normally very highly correlated to stock prices yet here is another major gap.


Another way to visualize this is to compare bond market risk appetites to stock market volatility. While fear in the bond market has soared recently, fear in stocks is relatively subdued. Notice the gap between them in the chart below.


So when Richard Fisher says he, “can see significant downside,” in the stock market right now, he’s probably thinking about these sort of gaps between stocks prices and economic fundamentals. Between stocks and their earnings. Between stocks and the corporate credit markets. Because he helped create them. And, like Dr. Frankenstein and his monster, nobody knows better what they’re capable of.


Are Passive Investors Taking On Far More Risk Than They Realize?

“The average American is from Missouri everywhere and at all times except when he goes to the brokers’ offices and looks at the tape, whether it is in stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile.” -Jesse Livermore

These days, the sort of reckless financial abandon Livermore describes is on prominent display in the rapidly rising popularity of, “passive investing.” I first addressed this issue two years ago in a post titled, “one reason I’m worried about the rise of the robo-adviser,” writing:

…as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk. When you have a growing stream of buyers who are agnostic when it comes to value – meaning they will continue to buy regardless of price – it’s hard not to see problems arising.

Hedge fund manager, Bill Ackman, recently attempted to quantify the growth of this style of investing, writing, “Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago.” Considering the rapid growth in this form of price-insensitive buyers, he comes to a very similar conclusion:

We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on.

In other words, “passive investing” will ultimately become a victim of its own success. The massive shift to index funds over the past 15 years or so drove the valuations of the largest index components to levels which guarantee poor returns going forward. Poor returns, in turn, will guarantee these inflows will turn to outflows and the virtuous cycle becomes a vicious one.

Danielle DiMartino Booth, formerly of the Dallas Fed, takes it another step further suggesting the rise in index investing is, to a great degree, a result of the Fed’s conscious efforts to stoke, “animal spirits,” over the past seven years or so. As such, it is directly in the crosshairs of its consequences:

“…Investors must reckon with the systemic risk that permeates the markets when boom turn to bust. The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the ‘miracle’ of China’s emergence onto the global economic stage that ignited the engine to begin with. Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher’s stone. Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these last few years. Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.” [Emphasis mine.]

Ultimately, it’s very difficult to argue that, in pursuing passive investing strategies to the degree they have recently, investors haven’t, ‘risked half their fortune in the stock market with less reflection than they devote to the selection of a medium-priced automobile.’ And, after witnessing first hand the disastrous consequences of such actions nearly a century ago, Jesse Livermore would be shaking his head right now.


Owning Stocks Today Is Risking Dollars To Make Pennies

Screen Shot 2016-01-15 at 2.42.50 PM

“The Big Short” Is Only Half The Story

On Monday I finally got around to seeing “The Big Short.” I’m no film buff but I really enjoyed it and thought Christian Bale and Steve Carrell both gave amazing performances.

To me, the film did a great job of profiling a few of the guys who really nailed the mortgage crisis and fully understood its implications for the broader financial system way before anyone else even had a clue. I especially appreciated how the movie treated the abject loneliness of being a true contrarian. I’ve gone through it many times in my career. The film does about as good a job as I can imagine of putting you in their shoes as they are ostracized, ridiculed and eventually even victimized to some degree by their peers, clients, the media and the big banks before finally being vindicated.

There is one major component, however, that is glaringly absent from the movie and that is the role of the Fed in laying the groundwork for the crisis in the first place. For a more holistic view, I highly recommend my friend, Jim Bruce’s documentary, “Money For Nothing.”

Ultimately, I believe both films are “must watch” for anyone who truly wants to understand what really went wrong back in 2008 and why. More than that, they can help us understand just how history rhymes, knowledge which may prevent us from making these same, critical mistakes again and again, both as investors and as a society.

Get your copy of “Money For Nothing” at moneyfornothingthemovie.org and follow Jim on Twitter. He may even have a few t-shirts left (pictured above).


Why Recession Is More Likely Than You Think

The debate over the economy has really heated up over the past few weeks since the Fed raised the funds rate. Some believe we are likely headed for recession. Others dismiss the idea out of hand.

Many times, these latter folks point to the yield curve as evidence there is no recession on the horizon.

But it may not be that simple. Certainly, corporate earnings, even outside of the commodity sector are now in recession.

And the corporate credit markets are also suggesting we may be near an important turning point in the cycle.

Other signs of economic activity have also slowed significantly including rail traffic…

…and industrial production.

On an anecdotal level, companies have been saying for months now that we are in an ‘industrial recession’ driven mainly by waning demand.

What’s more, equity markets around the world and here at home are now tipping their hand.

Few understand this dynamic better than George Soros.

But don’t take his word for it. When we look at manufacturing through the lens of the markets it has a 100%-accurate track record in calling recessions.

And as for that whole yield curve thing, it may not be as accurate as the Pollyannas may have you believe.

Why should investors care about the economy? Well, if this is more than your typical “growth scare” it may not turn out to be the greatest of buying opportunities.

In fact, if we are entering recession, risk assets like equities and corporate bonds probably have much farther to fall.

The Game of Life
board game

In The Game of Life, players work their ways around a "3-D" game board that replicates life's journey through adulthood. Fortunes are made and lost; players face success, failure, and revenge. The objective of the game is to be the first to complete the life course. Here the player chooses to retire to Millionaire Acres or gamble at being a millionaire tycoon--the automatic winner of the game. Famed game designer Reuben Klamer designed the game for Milton Bradley. To promote the game, Milton Bradley sought and gained the endorsement of radio and television personalilty Art Linkletter. At least one version of the 1960 game box also featured the slogan "Milton Bradley 100th Anniversary Game."

Manufacturer	Milton Bradley Company
Material	printed cardboard | molded plastic | paper
Origin	Springfield, MA
Object ID	101.492

How Demographic Trends Help Explain Rising Cash Balances And Persistent Outflows In Mutual Funds And Pension Funds

For all of the digital ink spent recently on the two interrelated topics of investment managers raising cash holdings and mutual fund outflows, very, very little of has been spent on why we have seen these new trends develop.

The Wall Street Journal on Sunday ran such a piece and out of 1,162 words, some readers may have been intrigued by the following two sentences:

Many mutual funds are facing rising requests for withdrawals from retiring Americans. About 10,000 baby boomers turn 65 every day.

It’s a shame the article’s authors didn’t see fit to delve into this topic to any greater extent. The balance of the article is spent discussing waning risk appetites, implying rising cash levels are more of a sentiment signal than anything else.

And the topic of demographics and its impact on the markets is consistently being given short shrift. Even in a recent feature on demographics in which they call the latest developments, “dramatic and unprecedented,” the Journal’s focus is squarely on the demographic effects on the economy without even a single mention of its potential effects on the financial markets.

The Fed, in contrast, has made a point to demonstrate the strong link between demographic shifts and equity valuations here in the U.S. Using a ratio of middle-aged to old-aged cohorts, they find price-to-earnings ratios are highly correlated to long-term trends in demographics.

This measure of the population and its most active investors peaked around 2000, along with the dotcom bubble, and has been falling ever since with no bottom in sight for about a decade from now. If the relationship between folks and stocks is to hold up over that time, it suggests the broad stock market could once again become just as cheap as it was during the 1974-1982 period.

Screen Shot 2016-01-11 at 8.32.25 AM

The larger point to be made here, however, is that simply due to the sheer number of baby boomers retiring, outflows from mutual funds and pension funds are likely to be more of a secular trend than a cyclical one. Investment managers are then forced, to some extent, to raise cash levels to meet these persistent redemptions.

Surely, there are cyclical forces at work, too. Investors always pour too much money into risk assets during bull markets and do the opposite during bear markets. But to dismiss the secular, demographic forces at work right now is to miss the big picture. And this could prove costly to those seeing contrarian signals in today’s rising cash levels that could eventually prove illusory.