Show me an investment manager with strong convictions and I’ll show you a manager with spotty returns. Flexibility is a key attribute if we’re seeking to avoid major downdrafts because markets are continually evolving. Even using highly effective quantitative systems we know that there is always the chance that markets will do something unexpected or never seen before.
Many of my quant friends are extremely rigid in their methods. Its their belief that human judgement is best avoided altogether even if you have 10,20 or 30 or more years of experience and have seen many bear markets come and go. But experience tells us that just when you think you’ve mastered the markets, be prepared to get whacked…..and hard. Hence my reluctance to rely solely on historical data when our current economic foundation has elements that have never existed before. What good is a system that worked in 2000 or 2007 when Quantitative Easing was an unknown term, when we’ve never had an economy so reliant on 0% interest rates?
As you can probably tell I do believe there is a place for experienced human judgement and when properly applied it can enhance the performance of purely mechanical systems.
A case in point is whats happening now in the stock and bond markets: Both the stock and bond markets are acting as if we’re entering a recession and that a new bear market is emerging. But the classic signs of impending recessions are not visible yet. Our long lead indicators are telling us that a recession is not likely within the next 9 months nor have we seen the peak in the business cycle. Treasury bond yields have not inverted…..yet. Regardless the stock and bond markets are sending a very strong message right now and that message is its likely we’re entering into a bear market.
I’ll let the talking heads and my quant associates debate whether raising interest rates from 0% to 1.5% is considered tightening or not. All I’m concerned about is how the markets are processing this news. Simply put: Markets are behaving just as we’d expect them to react during a period of Fed rate hikes where their motivation is to dampen economic growth which in turn devolves into a recession.
What we are looking at now
The economy is slowing.
Present data shows no recession in sight but we do have slowing. Slowing does not mean a recession is imminent but recent data suggests tops in Auto Sales, Home Prices, Consumer Confidence. RecessionAlert.com is flagging Corporate Profits Growth Index, Private Residential Fixed Investment, Housing Long Lead Growth Index approaching or near recession levels. RA’s probability of a recession starting in 12-18 months is 4.54%* The caveat with these recession odds is that no one is quite sure how the economy will react when the 0% interest rate policy ends.
Quantitative Easing or 0% interest rates are ending. The Federal Reserve will let the economy sink or swim without the aid of QE. This is especially important since market performance and the size of the Fed Balance Sheet have been tightly correlated since 2009.
* The with the major indices down 7% or more the drum beat for an extension of QE is starting. The Fed’s Williams says QE may be needed if economy falters. Translation: If the markets make another steep leg down look for another round of QE and time go all-in once again.
Small Cap stocks are lagging badly, the disparity between large and small caps is dangerously wide.
Charts courtesy of Jason Geopfert of Sentimentrader.com
Jason Goepfert of SentimentTrader.com has published a very telling chart that shows how rare and the potential result when the small stock Russell 2000 closes at a 200 day low while the large stock S&P 500 closes within 30 days of a 200-day high. Normally, these two indices tend to move hand in hand and the disparity is both rare and troublesome. It makes some sense that the best way (relatively speaking) to solve this disparity is to bring all sectors of the stock market down hard and then begin a new cycle. We think this is a real possibility here and now.
Europe is heading to a recession and the European Central Bank in moving at glacial speed. Whoops, sorry…..slower than Glacial Speed.
What was once a tight correlation has delinked as the S&P 500 has rallied hard based on the Fed’s QE intervention. Whereas the European Central Banks has been………quiet.
Stock market volatility is increasing – this is frequently a harbinger of market direction change.
What concerns me about the rise is volatility as you can see from the chart below is the time duration for the bear markets to evolve, years. While 2011 does fall into this category we need to add that the Fed started a new round of easing right after the decline in 2011. I don’t think we’ll have that luxury this time around.
Investor Sentiment has been stubborn and excessively complacent for far too long.
The lack of investor worry and concern is very troubling and unsustainable. Sentiment can swing swiftly and sharply as the herd can migrate in extremes of exuberance to panic. Markets are manic / depressive and with the Fed taking away QE this can be like Carrie Mathison not taking her Lithium.
Long dated Treasury Bonds are rallying hard and threaten to invert the yield curve.
Indicative of a slowing economy and the end of QE is the strength in Treasury Bonds. There is no reason for Treasury prices to rally in a normal healthy economic expansion as demand for loans and use of capital would add pressure on bond prices. But short term rates have been rising in the US in anticipation of the Fed raising rates next year. The rise is bond prices is likely due to the weakness in Europe and a reaction to a sharp decline in yields in Europe. Weakened US and Euro economies and the Taper (the end of QE) are bullish for Treasury bonds. Does this foretell a new recession? I don’t know and its too early to tell, but it is ominous.
Long TMF