Okay, I have to admit it. Lots of posts about economic theory lately, but no sex in my blog! In economics, sex is money. And making money is undoubtedly sexy. But I stand for safe sex. ¿Is that financially viable now, without subscribing to the “common knowledge game” (and its implied risks) ?
I’m starved for sex, but don’t want to risk my capital. Return “of my money” versus “return on my money”, comes to me as a priority nowadays, and that’s not a constructive starting point. Courtesy of the large central banks (via ZIRP and NIRP), there is no safe sex available any more. And the way things are going, sex won´t be free either. In a couple of years, “one way or another”, as Blondie would say, capital controls are coming. Spain is tentatively introducing some back door regulations in this area.
For now, sex is free, but risky. We live an investment era where making money implies risking capital big time, even if that risk has not materialized until now (due to the global central bank “put”). I’m fed up with the situation. Macroeconomic musing is nice, but it’s not a real substitute for the hard core thing. I’m not going to fix the global economy, whatever I write, so I might as well engage in the sexier task of money making. If, and that’s a big if, I can.
True enough, I only started this blog in May, and we’ve made money with our euro bearish call last June. But I have to concede that my presumed financial intuition has been helped by the fact that the ECB has been proactive in support of this trade. And, to make it worse, these subtle gains come on the back of heavy losses in this trade throughout 2013.
Good news any case. Be it via the ECB POMO desk, or any other POMO center, it’s unlikely we are going to make big money betting against one of the big central banks, until or unless the “common knowledge game” fails. I learnt that the hard way. There’s not that many trades available, that make economic sense (after QEternity has distorted pricing to unbelievable limits), and have a central bank supporting them. The ECB is likely to persist in euro weakening mode in the foreseeable future. This is as good as it gets. We can be short with a fundamental support for the trade, and have one big central bank helping us remain “in the money”. On top of that, the Fed has reconfirmed explicitly it wants out of the money printing business for now, and plans to exit by October. We shall hold on to those leveraged euro shorts, keeping an eye on Janet and Mario to see if this environment remains unchanged.
We have a problem though. We can’t put all our money in one bet, or else we will end up as casino players. You know what I mean: engaging in red or black, plain, brainless, bets. So I´m pressed to find additional sexy ideas. But the situation is dire. Financial markets are rich in valuations, and poor in return perspectives, on a global basis. That makes real old style investing (safe financial sex) as tough as I have seen it in a life time. I am talking about stock and bond portfolios, not just currency strategic positioning. That used to be complementary to the real issue: what stock, or what bond to hold.
¿How can we build a safe, traditional, portfolio? No way you can do that right now. In times like this only cowards survive, and heroes are the first to die. If survival is a mandate for the human race, today, you have to be a coward. Let’s look at the actual equity environment. I will come back on global bonds next post.
1. First of all, the general price level of stocks has been distorted upwards. Because of the XXXL money printing that has taken place over the last years, most of that money has not found its way into the real economy, and is parked in stocks and bonds. Corporates and individuals do not want to commit to spending or investing in the supply infrastructure, and ZIRP precludes investing in money market assets (particularly after we are talking about putting some gates in them). Actual pricing in bond and equity markets is totally unreliable. Not that it has ever been something to trust (save for Fama and acolytes). But mispricing wasn’t normally this bad.
2. Manipulation is evident. Another issue complicating the plot. With markets intervened “all the time” (James Bullard), little is as it seems in financial markets. As always, perception trumps reality in financial markets (hat tip Todd Harrison). Central Banks know that. And there is a strategy behind that manipulation that goes way further than just altering the general level of market prices as collateral damage from money printing. Ben Hunt (Epsilon Theory) explains this in succinct style.
“… in the Golden Age of the Central Banker it is impossible to distinguish fundamental economic reasons for asset class price movements from politically-driven strategic reasons. Are European sovereign bonds so strong over the past few months because growth remains pathetically weak, or because Draghi is promising his own version of QE?”
…We (are) wired to watch stocks go up and down and think about fundamental economic explanations for market outcomes no matter how many signals exist that non-economic game-players are really calling the shots. Government actors, from the Fed to the ECB to the White House to the Chinese Politburo, understand how we are wired, and strategically use that understanding to further political goals such as market stability (US) and trade regime change (China).
… you (should) start thinking about what’s happening in markets and the world as an inextricable weave of fundamental events and political efforts to shape our interpretation of those events to achieve a political end”
Prices are not only distorted, they are deceptive. They are deliberately moved intraday, with a segmented approach to different asset classes, in order to generate specific behavioral conduct by the economically ignorant participants. Not everybody is ignorant, but those who aren’t, are mostly working for the securities industry. They have to keep their mouths shut if they need next year’s bonus (or job!).
3. Demand is being turbocharged. Not only money printing is taking place. Rampant speculation induced by ZIRP, and the Yellen “put” (common knowledge game), have allowed leverage and gearing to be back “en vogue”, helping demand further. So much for chastised investors, who became afraid of debt in 2008. The extreme brevity of financial memory always surprises me (even expecting it). Margin buying is as high as it has ever been, and well above the 2007 highs. And it is more institutional than private! Risk taking and ignorance are spreading faster than Ebola these days. Or maybe it’s just that career risk has never been higher: lots of managers are chasing the markets to every new top.
4. Compounding the excess demand effects, stock supply is clearly not keeping up. Stocks are being permanently bid by their own issuers in order to reduce the number of shares outstanding and increase earnings per share, leveraging sales growth where available. Just take a close look at IBM. They are buying back equity in size, against debt, in a context of stagnant or decreasing sales! But it’s not only IBM. Most of the issuers are trying to use ZIRP and leverage to increase “eps”.
By the way, ZIRP is actually weakening balance sheets. Net corporate debt is now higher globally than it was in 2007. Balance sheets have more cash, but total debt has grown more than cash. Freshly printed money is being used to increase gearing in corporate balance sheets.
Mergers and acquisitions are on a roll, and further decrease the amount of investment available free float. Jeremy Grantham thinks they might help finance the jump to a two sigma price deviation from fair value for the S&P500. His target for the bubble, if nothing changes the actual environment, is 2250, based on increased M&A activity.
Central banks are a third institutional factor also helping decrease the investment available free float. They have decided to increase equity allocation in their permanent reserve scheme. The SNB holds 15% of assets in equities (in a currency peg bloated balance sheet). The Chinese Central Bank, with 3.9 trillion in investments, is reportedly buying buying minority equity stakes in European listed companies. Not to forget some ultrarich sovereigns, such as the emblematic Norwegian example. The NBIM is ¡60%! invested in equities. According to David Marsh (marketwatch), this is equivalent to an average of 2,5% of the market cap of every European listed company.
Printed money increases balance sheets, increases that are then used to buy equities or bonds. ¡The SNB is one of the main players in the European sovereign bond markets! The Japanese public mega pension fund is changing its investment strategy (a once in a blue moon event) with a substantial increase in equity weightings.
5. Stock pricing has helped balance supply and demand, and at current valuations market cap is high as a percentage of GDP, particularly in the United States. That absorbs a proportionally higher amount of cash that wants to be held in stocks.
Optimists beware: the market cap increase, only absorbs fresh money with the new listings. Previous listed companies are worth more, but their valuation increase has generated more money in the process. So we got a bonus “wealth effect” in this. Awesome!
Of course, you can imagine there is a cost to be paid: a substantial overvaluation. Warren Buffet used to say that market cap as a percentage of GDP is one of the most reliable valuation gauges for the market. He has kept this observation at a distance lately, but then, he owns a huge portfolio. He is a part time salesman for equities. His valuation criteria have become suspiciously biased.
To conclude. Equity investing is far from safe today. You are going to be able to find some alpha if you do your homework properly. But when selecting your names, make sure they have also got a low beta. As low as possible. The macro environment is shaky at best.
Best theoretical strategy is clearly to go long high alpha low beta stocks, and short the indexes. In practice this is outstandingly difficult. You need the best team, and the best technology for that. And, even if you end up generating some value, you may have to endure substantial periods “out of the money”. Careerwise, it is not advisable. Facts support this statement. The hedge fund industry is under severe stress these days, and they are the best at this kind of sophisticated strategies.
Volatility plays are dangerous. POMOs want low volatility, but “uncommon sense” says you should buy volatility today, not sell it. Maybe that’s the reason out of the money strikes volatility is remarkably higher than normal when compared with at the money volatility. All in all, it is again a difficult play.
If you have the timing technique, and the emotional resilience, to withstand the pressure, the definite trade is shorting the next market top. When? At what price level?
The global economy is slowing. US growth is the cleanest dirty shirt (Gross), but no relevant, sustainable growth, is at hand. China has delayed the day of reckoning again, but for how long? Growth has to falter if a top is to be found. You don´t want to be too early in a super bull. Keep an eye on objective real data like the Baltic Dry Index. And wait for a PMI confirmation around the globe.
To time the top you need a second component. M2 growth has to stall. This is a very, very important timing tool. Money growth inflated the bubble, and it will not stop until M2 growth slumps. What is the minimum M2 growth level to sustain multiple expansion? Great post on this at Actingman.com. Chart is from the FRED (data base of federal reserve of Saint Louis).
Not precise enough? Sorry, no further details possible at this time, or else I would’t be typing right now. No safe sex available. Take ZIRP or risk. High risk. What I do say, is: timing the top with a short is less risky than playing the “buy and hold”, plain vanilla, strategy.