It's fun to try and distill the zeitgeist. This essay was first published by CFA Institute's Enterprising Investor.
The subject of this essay is simple: Just look at the title.
That cake, of course, refers to a recovering global economy. The hope goes that low interest rates will persist long enough that investors can have a levered feast on discounted (and appreciating) securities.
And with Fed Funds futures implying just a 5% chance that this week’s statement from the Federal Open Market Committee (FOMC) meeting of the US Federal Reserve will contain news of a rate hike, it would be crazy not to expect the leverage component of the feast to stick around for a while.
But will the food be any good? There is a camp of thoughtful people who have never bought the “bull” market. Many of them haven’t turned in great performance numbers over the past few years, but it’s not like the criticisms they offer have withered on the vine. True growth is hard to come by. Financial engineering is everywhere.
And we’re still in emergency mode. Weird stuff happens when tools meant for emergencies — like a fire extinguisher or that credit card you gave your kid — are used constantly for seven years.
Of course, this all means that not much is new. Let’s unpack the data to see whether the party is likely to continue. But before I offer any analysis, it’s time for a disclaimer: There is a narrative here, but it’s mine. You need to build yours. Be critical, question my assumptions, and let me know what you think in the comments below.
Let’s Get Started:
Chart (BAML): More investors view the current global economy as being in the "late" phase of the cycle - pic.twitter.com/ArQ2krleja— SoberLook.com (@SoberLook) October 20, 2015
I began one of these in March by asking if I was the only one starting to feel like it’s pretty darn late in the business cycle. Markets were higher then, and nobody wrote in to make me feel less lonely.
Today it looks like four out of 10 professional investors would agree. This could be interpreted to mean that the fight between bull and bear is about to get a lot fairer, but take care and look at how wrong those investors were back in 2011 and 2012 before getting too confident either way.
Actually this is pretty amazing. $4.5tn worth of buybacks since 2004 vs. $158bn of cumulative flows into US funds: pic.twitter.com/QPcXClwQF2— Tracy Alloway (@tracyalloway) October 19, 2015
There’s good reason to be pessimistic though. People talk about how the market is financially engineered, but it can be tough to tell if we’re talking about the amount of engineering necessary to build a paper airplane or a Boeing 777. Turns out it’s the latter.
Companies have spent 2,848% more money buying their own stocks than investors have moved into the stock market since 2004.
I guess this means that each dollar that did flow in received a significantly greater participation in the market, but it strains credulity to call something with that characteristic a robust bull market.
Chart: On a "harmonized" basis US is in deflation; price declines worse than in the Eurozone - pic.twitter.com/5uOcwPmDYO— SoberLook.com (@SoberLook) October 20, 2015
Or this characteristic. I spent some time at a Euromoney Inflation-Linked Productsconference at the tail end of last month, and I met a number of very sharp portfolio managers who have had a tough go of things in the last few years. At the beginning of this stimulus cycle, it seemed obvious to many that inflation was going to take off and protecting your earnings against it was imperative.
Now it seems many believe that inflation protection is about as useful as cloud insurance. I don’t agree — look for a great article from Dave Allison, CFA, CIPM, in the next week or so explaining why in some detail — but this does fall firmly into the camp of things that aren’t good news.
You have to dig a little to see why. These “harmonized” indices come from the European Central Bank (ECB), and they’re designed for comparisons across countries. This has some differences from the US CPI, perhaps most notably in that it incorporates prices from rural areas.
Whatever the methodological differences are, you have to take it seriously when an apples-to-apples comparison from a reputable statistical agency shows the United States’ deflationary spiral is worse than Europe’s. Perhaps our rural areas are an economic drag similar to Europe’s southern countries?
Shelter inflation continues to lead the way, accelerated to new cycle high of +3.2% yoy in September pic.twitter.com/m49WVOHgbx— Matthew B (@boes_) October 15, 2015
This is actually the point in this essay where I start to get more upbeat though. Bear with me.
Remember that time we built way too many homes and tons of people bought too many of them and it almost ruined everything? Remember NINJA (no income, no job, no assets) loans and this character? It turns out all that might leave a scar. Multi-family housing starts (often built by investors) are back around pre-crisis levels, but single-family housing starts are a country mile away.
And setting 15% of your income on fire to rent a house every year gets tiresome after a while.
Contributions to world growth, via DB. pic.twitter.com/V6po8fo1fY— George Pearkes (@pearkes) October 17, 2015
Especially if you have a job finally and are ready to get your act together.
light vehicle sales / NFP.— Guillermo :( (@groditi) October 17, 2015
The anomally is how low auto spending was, not how high it is. pic.twitter.com/HOwYjPHn3a
And consumers are no longer shying away from the big ticket purchases they’ve been avoiding for years.
So as they say, something’s got to give. The traditional way of thinking has long been that as slack dissipates from the economy, it translates into inflation. But so far translating anything into inflation has been about as easy as translating the Financial Analysts Journal into Akkadian. Good luck if you want to give it a try, you know?
With that said, there is important optimistic logic here. It goes like this:
- People with jobs mostly choose to live indoors.
- It would be cheaper for many of them to own than to rent.
- Some of those people will buy houses.
- Big ticket purchases!
- You need furniture and stuff for a house.
- Consumer spending!
At least that’s the theory. This logic is really just okay, since it’s not drawn from a diversity of premises. But it is intuitive that after many years of renting and unemployment, recently much more employed American consumers are ready to treat themselves. And, of course, in economics we call the subset of this logic that relates inflation and unemployment the Phillips Curve.
For the past few years, the Phillips Curve has been something of an enigma. Nobody has seen it in a while — like interest rates. But it does make sense that incremental tightening in the labor markets will eventually flow through to higher spending and eventually inflation. At least that’s the hope.
Now shifting gears to China, I can remember way back to a time (this summer) when financial news channels sounded an awful lot like that three-minute montage of Donald Trump saying “China”.
Now it appears that trend has abated, at least in terms of news flow.
But maybe it should be accelerating. $500 billion has left China so far this year. You can call it “hot money” or whatever else you want, but it stings.
ZH chart showing that China is selling large amounts of US Treasuries via Belgium... pic.twitter.com/lyNzfdjRxs— Ron Rimkus, CFA (@RonRimkus) October 20, 2015
And is almost certainly related to some of the stealthy selling of Treasuries my colleague Ron Rimkus, CFA, noted on our pipeline call recently (and tweeted about later). The money to defend your currency has to come from somewhere, after all.
So Where Does That Leave Us?
Depending on what you took into this article — your mental models, biases, and research — you might be thinking that the economy is about to heat up. Or you might still be thinking about that flows vs. buybacks chart and getting ready to short the market. Don’t. Yet.
Look how wrong the average dopey economists has been last 6yrs on prediction where 10yr would be in 12mos pic.twitter.com/86eEngXd5t— Dividend Master (@DividendMaster) October 14, 2015
Before you think you know anything, take a second to think about how bad we are at forecasting the 10-year Treasury.
via HSBC pic.twitter.com/rc8LrY1gtD— Sam Ro (@bySamRo) October 14, 2015
And the Riksbank rate.
DB's Slok: Rates markets have been pricing a hike since 2009 pic.twitter.com/JlGtXQ7h2p— Brattle St. Capital (@BrattleStCap) October 14, 2015
And the Fed Funds rate. And pretty much everything else.
When markets could either plummet or redefine the term “rally” (which is pretty much always), the worst thing you can do is seek to be correct at the expense of being robust. So as much as you focus on coming up with a good forecast, make sure you also prepare for those times when your model is wildly off. After all, the financial reward for being right “eventually” only comes if you’re able to stick around till whenever that is. So plan for whatever could happen, not just what you think will happen.
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