Kevin Armstrong’s Strategy Thoughts

October 2012

Can all the news be good for the market, whatever it is?

Introduction

The most frequent feedback I have received over the last couple of months has been that markets have continued to rally, much to the frustration of the bears. However, it is worth digging below the surface of this observation. To do this one has to look at the ‘breadth’ of the current global equity market rally and the internal breadth of each market; that is the number of markets and stocks rising versus those falling and what the average stock has done. In this month’s Strategy Thoughts I revisit the ‘San Juan Hill Theory’.

Over the years I have on occasion referred to the ‘San Juan Hill Theory’ and it has been a helpful tool in identifying cyclical peaks within the currently still unfolding, and far from over, secular bear market. I say far from over secular bear market purely from a perspective of valuation, and it is only over secular time periods that valuation is of any use to investors. The current secular bear market may be more than twelve years old but, apart from a handful of very depressed European markets, most major equity markets are a very long way from being historically ‘long term’ cheap. Long term cheapness I have previously illustrated employing Tobin Q valuations, cyclically adjusted P/E ratios and dividend yields and none of these measures have approached the kind of historical extremes found at secular troughs.

In addition to the poor breadth found in most markets, and the disappointing experience the majority of investors would have had despite the headlines focusing on rising indices, there are a number of other issues that should be encouraging a cautious outlook. One is the current obsession that all news somehow is good news, another is the action of commodities (oil in particular), and a third is the recent weakness in transportation stocks and rails in particular. All of these will be explored in this month’s Strategy Thoughts, but first I want to examine the danger of finding comfort in an apparently rational anticipation of future market movements.

It may make sense, but it probably won’t work!

Last month my wife and I were in Melbourne meeting with the publisher of ‘Bulls, Birdies, Bogeys and Bears’, while there a number of former colleagues kindly took us out to dinner and gave me a couple of books they thought I would enjoy. Their choices could not have been better; one was on golf in Australia while, more importantly, the other was on trading and risk taking in markets; ‘The Hour Between Dog and Wolf’. This is an outstanding book that I cannot recommend strongly enough to anyone who is interested in what truly drives markets. Long term readers will know of my fascination with and passion for a behavioural rather than economic approach to markets and investing, well this book goes even further. The author, John Coates, a senior research fellow in neuroscience and finance at Cambridge University and a former trader with Goldman Sachs, explores the effects that biology and neuroscience have upon our decision making, why seemingly sensible and logical approaches can so often fail and what it is that truly successful traders have and do, without conscious effort, which makes them successful.

One section mid way through the book brilliantly highlighted the seemingly sensible and comfortable ‘traps’ that most investors and traders fall into. Chapter four is titled ‘Gut Feelings’ with a section on ‘feeling the market’. Coates wrote;

“While trading on Wall Street, I often conceived trades that I thought were brilliant, identifying some securities that were cheap, others that were expensive. But my boss, habitually sceptical, would always ask, ‘if the trade is so compelling and the money making opportunity so amazing, why hpeople spotted the trade? Why is the price discrepancy just sitting there on the screens for all to see, like a $20 bill lying on the sidewalk?’ These were irritating questions, but in time I recognised their wisdom. For more often than not, trades conceived with obvious lines of reasoning turned out to lose money. It was a troubling discovery. Troubling because these trade ideas were usually arrived at using my best analytical efforts, drawing on my education and a wide reading of economic reports and statistics. I was acting as rational economic man. In time, though, I realised I needed more than these cognitive operations. Often, while looking at a problem face on and coming to some obvious solution I would catch a glimpse with peripheral vision of another possibility, another path into the future. It showed up as a mere blip in my consciousness, a momentary tug on my attention, but it was a flash of insight coupled with a gut feeling that gave it the imprimatur of the highly probable.’

I have always maintained that successful investing is more of an art than a science and that attempting to forecast markets by building an economic outlook is futile. Even if your economic outlook is absolutely correct it is unlikely that the correct investment conclusions will be arrived at. It is also the case that whatever economic outcome appears most likely and even obvious then, as Coates describes, that outcome is already priced into the market. But still most investors and strategists preface their investment view on an economic scenario that they believe is most likely, this approach undoubtedly builds comfort, and the more people that share a similar view the more comfort grows, but unfortunately that comfort is totally misplaced.

Currently there is a worryingly strong consensus as to what any economic outcome might mean. Incredibly it seems that it virtually doesn’t matter what happens, bad economic news and good economic news will both prove positives for investors!

Is bad news really good news?

With markets rallying after the ECB announced a potentially unlimited appetite for distressed countries’ bonds and the US Federal Reserve’s announcement of QE3, or what some have labelled QE infinity it is apparent just what conventional wisdom has become. Good news, and especially surprisingly good news, will cause markets to rise, but so too will bad news, especially really disappointing news, the perverse logic being that such terrible news would cause central banks to do more of ‘whatever it takes’. This ‘logic’ was expanded upon as markets rose on the back of some bad news in early September. Bloomberg reported:

U.S. Stocks Rise Amid Stimulus Bets After Employment Data

By Lu Wang and Rita Nazareth - Sep 8, 2012

The article began:

U.S. stocks rose, sending the Standard & Poor’s 500 Index to its highest level in more than four years, amid bets on central bank stimulus as American payrolls increased less than projected.

It then supported this contention with input from investment managers;

“The market is taking this weak jobs number as a positive because it means that we’re going to get action coming from Bernanke and company,” said Michael Mullaney, who helps manage $9.5 billion as chief investment officer at Fiduciary Trust in Boston. He spoke in a telephone interview, “It’s just this new upside-down world of investing that we’re living in where bad news is good news for assets.”

It certainly would be an ‘upside down world’ where the only thing markets could do was rise, irrespective of what was happening. Whilst it is understandable that such an outcome would be popular it does not mean that it is in anyway a correct or even useful assessment. Rather what it does highlight is that investor attitudes and sentiment have become incredibly one-sided. They may not own up to being so, but when only one outcome appears possible it is likely that a surprise may lie around the corner, that was what occurred the last time that bad news was seen as good news because of the central bank action it would induce.

Almost exactly four years ago the Market Oracle website ran the following headline;

The article began with:

“Since the Fed interest rate cut in September, the stock markets across much of the world took the cue to let rip with strong bullish rallies. The trigger for the rally is a switch in market perceptions from interest rate rises to interest rate cuts. The market is therefore pricing in more interest rate cuts AND lower inflation.”

Obviously the story was slightly different back then, but what those who see any news as good news now must hope is that the outcome is very different.

As can be seen from the headline, the article appeared on the 7^th October 2007, just four days later the great bull market from 2002 ended and the market collapse associated with the GFC began, the worst bear market since the nineteen thirties. Those bullish investors were cruelly and rapidly disabused of any idea that bad news was good news. Interestingly a year and a half later attitudes had gone through a one hundred and eighty degree swing so that then, in March of 2009, bad news was bad news and good news, no matter how good, was not good enough to make anyone think the market could rise!

Not all commentators were so blinkered as to argue that bad is good and good is good. I strongly recommended to readers A Gary Shilling’s ‘The Age of Deleveraging’ last year. It was a hefty tomb but made a very clear case for deflation risk rather than inflation risk and also for incredibly low government bond yields. I have followed Shilling’s writings for more than a decade now, since reading his earlier book simply titled ‘Deflation’, and believe his observations and analysis to be refreshing, different and unlike most economic analysis, useful. Richard Russell in his Dow Theory Letter in mid September, amid all the bad news is good news commentary, quoted Shilling:

"Well, I beg to differ with the ‘It’s so bad, it’s good’ crowd. Conditions are so bad, they’re bad. All the immense monetary and fiscal stimuli here and abroad in the last five years have failed to offset the gigantic deleveraging in global private sectors. And they’re unlikely to do so until global deleveraging is completed in another five to seven years." A Gary Shilling

A similar attitude was adopted by Nouriel Roubini:

Investor euphoria as Federal Reserve launches QE3 risks turning sour

Financial markets that rise on both good and bad news are not stable

Nouriel Roubini The Guardian 14^th September

Roubini wrote:

“So, not only has good – or better than expected – economic news boosted markets, but even bad news has been good news, because it increases the probability that central banking firefighters like US Federal Reserve chairman Ben Bernanke and European Central bank president Mario Draghi will douse the markets with buckets of cash. But markets that rise on both good and bad news are not stable markets.”

The complacency that all news is somehow good continues to be shown in the still very low readings on the CBOE volatility index, the VIX:

Low readings on the VIX, such as those at present, have always eventually been followed by higher, and occasionally much higher readings and the journey from low to high readings have tended to be very uncomfortable for those investors that previously had only expected even higher prices ahead.

Naturally none of this commentary can pin point when a reversal will occur, however, it does highlight that the risks of such a reversal have only continued to increase the more the market has risen.

A lot of the comments above were referencing the US market, which has been making new recovery highs over recent months, however, this US strength, which has captured headlines, has masked what is still only a bear market rally in the majority of markets around the world.

Breadth

Over the years I have occasionally referred to an early warning system for the onset of a bear market that I first read about more than thirteen years ago in ‘The Bear Book’ by John Rothchild. In it he described the ‘San Juan Hill Theory’;

“Hong Kong pundit Marc Faber says stocks reach the top when the generals (large stocks) are charging up the hill while the troops (small stocks) lag behind. It is not uncommon, says Faber, for the generals to plant the flag nine months after the troops have retreated.”

Over the last couple of cyclical bull market peaks I have extended this analogy of the ‘generals’. Rather than just focusing upon the largest companies in an individual market it has also proved of value to study the breadth of the global market. Prior to both the 2007 peak and the peak in 2011 a deterioration in global breadth was apparent, this continues to be the case despite the much heralded recovery highs recorded by the major US indices.

Within the US most indices have recorded higher highs than those seen in 2011; however, the transportation index is still down 10% from its mid 2011 high. Europe as a whole is still 15% below its early 2011 high with Finland and Austria both down about 30%, France and Russia about 20%, Hungary down 25% since its 2010 high, Spain, despite a recent 30% bounce, still down 37% since the beginning of 2010 and Greece, perhaps understandably down nearly 75% from its 2002 high. Within Europe Germany is virtually flat with its 2011 peak and only a handful of markets including Denmark, Norway and Ireland have recorded new recovery highs above their 2011 peaks. Overall the breadth of this rally in Europe continues to more closely resemble a bear market rally rather than an extension of the cyclical bull market that began at the very depressed lows of early 2009.

The same picture is found across the Asian markets. The Chinese market is 40% below its 2010 recovery high, Hong Kong remains 17% below its late 2010 high, Korea is still 11% below its 2011 peak and India, Australia and Singapore are all 7-11% below their 2010 levels, Vietnam is down 39% since late 2009 and Sri Lanka is 25% below its early 2011 levels. Only the Philippines, Pakistan, Thailand, Indonesia, Malaysia and New Zealand have rallied to new recovery highs along with most of the US indices, overall the MSCI Asia index is still 10% below its April 2011 level.

The weakness of this recent rally on a global basis can be seen in the chart below of the Global Dow Index, it also highlights the divergence that has been seen between the US market and the experience of most other markets in the world. The most recent peak was below the peak recorded earlier this year and, more importantly, almost 15% below the peak seen in the first half of 2011. It is also below the two peaks seen in early 2010 when a number of the markets listed above rolled over. It is therefore not surprising that equity markets have been frustrating for  more than two years now, however, just because they have been frustrating is no reason to buy into the ‘hope’ that is now so prevalent.

The ‘hope’ that central banks will do ‘whatever it takes’ to fix the current long term problems is not just evident in equity markets, it has also become clear in credit markets. The cost of protecting against default on the part of European governments has shrunk dramatically over recent months, as equity markets have rallied. In Spain the cost of such protection has fallen back to where it was in the early months of this year, in Italy the same measure is now below that level, both have fallen more than 30%. Other European countries have seen the cost of default protection fall even further, in many cases back to levels not seen since early 2011.

The rally has obviously offered opportunities to successful traders; however, for investors there has clearly been less to get excited about. It is also a concern that there may now be less for anyone to get excited about, let alone build ‘hope’ upon.

Is that all there is?

Back in late July Mario Draghi, President of the European Central Bank, made his now famous speech announcing that they would do ‘whatever it takes’ to save the Euro. On the back of that European markets rallied sharply, the Euro Stoxx 50 index surged almost 10% over the next three days but now , two months further on, has only managed to rise another 8% having faltered over the last few weeks at a lower levels than were seen in March of this year. With the market now knowing that the ECB will do ‘whatever it takes’ it is getting hard to see where the next positive surprise can potentially come from, irrespective of whether or not you believe they can do ‘whatever it takes’.

The same observation can be made about the news that came out of the US Federal Reserve in mid September. It was hoped that another round of quantitative easing would be announced, the so called QEIII, after the prior rounds of QEII and QEI. What was announced was almost a ‘whatever it takes’ and understandably it has become known as QE Infinity! When you have announced a totally open ended round of quantitative easing it is hard to see where the next big positive surprise comes from. As was the experience in Europe there was an initial surge on the back of the news, the Dow jumped 200 points the day of the announcement and another 100 the next day before giving up half of that day’s gains to close only 50 points higher. Over the subsequent three weeks the US market has moved broadly sideways and European markets have slipped a little. Perhaps there are still further positive surprises to further fuel hope in this rally but my concern is that we have indeed seen ‘all there is’ and that the faltering seen since the announcements, and the longer term deterioration in global breadth, are both indicative of an ageing and deteriorating rally in those markets that have eked out modest gains compared to earlier peaks and a resumption of the cyclical bear market, and slide down the ‘slope of hope’ in the rest of the world.    

A secular turn?

Frequently in the past I have questioned the certainty that the majority of economists have displayed in arguing that long term yields in the US had to rise. The more vociferous their cries the more certain I was that the surprises would be on the downside, but then in August attitudes appeared to shift.

In the August edition of Strategy Thoughts I wrote:

For a very long time I have proclaimed the virtues of long dated US treasury bonds, and anticipated that yields would go lower than virtually any economist was forecasting. I also didn’t expect long dated yields to rise until the consensus view had given up on looking for higher rates and accepted low rates for a very long time. In June I wrote;

“Until the fear of deflation and ever lower yields becomes widely embraced and discussed it is likely that further surprises on the downside in yields, not a sudden reversal to the upside, are in prospect.”

At the time ten year treasuries were yielding a little over 1.7%, over the next eight weeks yields plunged, briefly falling below 1.4%. As a result there has been an interesting shift in investor expectations and attitude. Two days ago Bloomberg ran the following story;

Treasury Bears Submit To Fed As Bond Optimism At High

 

Jay Mueller, who manages $3 billion of bonds for Wells Capital Management in Milwaukee, resisted buying Treasuries for four months, anticipating the Federal Reserve would drop its pledge to keep interest rate at a record low through late 2014. No more. With the economy growing at a 1.5 percent annual pace, the odds of a recession have risen to 60 percent, making 1 percent yields on 10-year notes a possibility, he said. Wells Capital’s parent, Wells Fargo & Co., boosted its Treasury holdings 32 percent to $11.5 billion in May alone, according to the latest data compiled by Bloomberg. “We’re in a low-rate environment for a long time, longer than I had thought,” Mueller said in a July 26 interview at Bloomberg headquarters in New York. “I’m finally throwing in the towel.” So are Pioneer Investment Management Inc., Pacific Investment Management Co., Federated Investors Inc., Northern Trust Global Investments and Columbia Management Investment Advisers LLC. They are adding to holdings of Treasuries as economic growth cools. Of the 20 firms that own the most Treasuries, 16 bought more U.S. government debt during their most-recent reporting periods, Bloomberg data show.

If treasury yields continue to rise, as they have over the last three weeks, and spreads start to widen junk bond returns will start to struggle.

Since then the pursuit of yield has continued at a frenetic pace. Towards the end of September the Wall Street Journal reported that yields on US corporate bonds hit a record low;

“Corporate-bond yields fell to another record low as recent moves by central banks continued to drive investors into riskier investments. That pushed down the interest, or yield, bond buyers could demand. The Barclays U.S. investment-grade index fell to 2.82% on Tuesday, down 0.09 percentage point from the start of the month. The record heading into 2012 was 3.36%, in data going back to 1973. Investors have piled into corporate bonds this year, seeking higher rates of return than those available from low-yielding Treasurys, while maintaining the relative safety of fixed-income securities.”

 

Of greater concern has been the flood of money that has poured into junk bond funds. According to the Wall Street Journal in September alone nearly $9 billion was invested in such funds in the pursuit of now record low yields on junk bonds. This brought the total for 2012 flowing into such funds to $64.5 billion, more than twice the previous annual record.

Whilst this chase for yield is understandable it is important to note what has been happening to the yields on longer dated Treasury bonds over the same period. Almost coincident with the attitudinal shift I commented upon two months ago ten year US Treasury bond yields have been gradually moving higher in a three steps up two steps back fashion. All this means that spreads between the yields on junk and Treasurys have continued to narrow, just like those credit default swaps on European Government bonds. If markets are in the process of rolling over then the currently popular junk bonds may deliver a nasty shock to yield hungry investors. But then history has repeatedly shown that whatever sector, or industry, sees the number of funds available and the assets invested surge upwards, a reversal is usually not far away.

I continue to be concerned about the prospects for bond investors chasing yield and believe that the chances of the low, seen in late July in ten year treasury yields, being an important long term secular low as very high.

Railroads

In The May edition of Strategy Thoughts last year I discussed the weakness that had been seen in the previously outperforming railroad stocks. I concluded that section with the following observation:

“from a shorter term perspective it is somewhat worrisome that the previously rampant railroad stocks have faltered over the last four weeks while the broader market averages have continued to rise.”

Thse comments were writen on April 26^th 2011, from that point railroads did recover, and so too did the market, however, that first crack in the railroads heralded a far more severe decline a few months later when the railroad index plunged thirty percent in just three months from early July, as can be seen in the chart below.

The Industrial Average held on for about another two weeks from that high level into late July and then fell close to twenty percent.

More recently the railroads have once again dramatically underperformed while the industrial average has clung on to its recovery highs. Since mid September the railroads have fallen more than ten percent, at the same time the industrial average is virtually unchanged.

This does not mean that, like fifteen months ago, the industrial average will follow the rails down, what it does highlight is the lack of ‘breadth’ in the market, highlighted in the introduction and the ‘San Juan Hill Theory’ should not encourage anyone to chase this ever narrowing rally.

Other thoughts on ‘breadth’, commodities and China

I have mentioned the Baltic Dry Freight Index a number of times in the past. It became one of the most watched indicators as the GFC was running its course, understandably given the absolute collapse that it suffered. What is intriguing now is how it continues to just bounce along at historically incredibly depressed levels. It did bounce back after the ‘Great Recession’ but that rally was short lived, only through to late 2009, early 2010, and then its bear market resumed. In many ways the chart is a remarkable ‘echo’ of the Chinese stock market, whose bear market rally only lasted through to August of 2009. In fact it is similar to many markets, excluding the US and a handful of others, that have failed to make any progress since their immediate post GFC rally.

I have shown the Baltic Dry Index on the top and the Shanghai Composite below. Whilst their peaks were not quite coincident their behaviours since the GFC related collapse have been remarkably similar, and neither show any signs of the ‘rally’ that has supposedly been in force since late June. In fact the cyclical bull market that began in just about everything and all markets in late 2008 to early 2009 barely lasted a year for these two indices. What has been suffered since early 2010 has been another meaningful cyclical bear market.

The final chart below shows the US market as measured by the Dow compared to the price of oil over the last two years. Over that period the oil price has been particularly volatile. It fell by 40% before rallying back close to its old highs, then fell by 30% before another less dramatic rally and then most recently it has suffered another 10% correction. What is most interesting to note is that over that period peaks in the price of oil have been a leading indicator for peaks in the market.

At the end of April last year oil peaked and fell precipitously, that sharp fall was to turn into a five month rout that saw oil prices drop nearly 40%. However, in the early stages of oil’s collapse the equity market totally ignored whatever was troubling oil. Broadly speaking the US equity market moved sideways for another two months before joining oil in its plunge. From mid July through to the October low the US equity market fell 20%, half of oil’s fall but still a meaningful and at the time most worrying decline. Both markets bottomed together in October and from there enjoyed a substantial rally through the end of the year and into 2012, but on the 1^st of March oil once again peaked and began an almost four month decline that saw its price fall by 30%. Again it seemed that equities had little concern over oil’s plunge, at least for a month, but in May equity markets began their worst correction since October of 2011, a 10% correction. More recently, and in another indication of the ‘breadth’ of the overall global rally deteriorating, oil suffered another setback falling, so far, 15% to its recent low. Whether this is the beginning of another significant plunge for oil only time will tell but again it is interesting that US equity markets are grimly hanging on at the same levels they held when oil began its latest fall.

Conclusion

I have commented many times over the last few months about just how frustrating the recent market action has been, and not just for those of a bearish disposition, bulls will have struggled too given the deteriorating global breadth that has been seen. It is also important to put the recent strength into a meaningful perspective and not measure it just from the lows at the end of June but over a longer period.

It does concern me that so many commentators are comfortable rationalising just why markets should continue to rise, particularly when those rationalisations seem to always involve a seemingly sensible interpretation of the ‘economic outlook’. Such approaches do build comfort but rarely deliver long term returns, and invariably the more comfortable an investor is the more concerned he should be.

Now is not the time to be chasing yields or returns. There will be some remarkable opportunities in the months and years ahead and it will be important to have preserved ones buying power ahead of such opportunities. However, it is also important to remember that when those opportunities do arrive they will not feel like opportunities. In fact it will take great discipline and intestinal fortitude to even consider looking at them let alone seize them, there will certainly not be any headlines proclaiming their virtues and no one will be producing seemingly sensibly rationalisations as to why the only way for anything is up.

Recommendation

I have now been dragged into the twenty first century and, over the last few weeks, have become somewhat addicted to listening to podcasts on my daily jog, I have now even learnt how to download them myself! This learning curve began when I heard a small part of Professor Niall Ferguson’s BBC Reith lectures; http://www.bbc.co.uk/podcasts/series/reith

This series of lectures provides a refreshing and different perspective upon what we have all been through over the last five years and provides some uncomfortable suggestions as to what should be done in the future.

Finally, for those of you interested in my book ‘Bulls, Birdies, Bogeys and Bears’, the text is complete and is now undergoing editing. From there design work begins and it is now looking like it will be released early next year. I will keep you posted.

Kevin Armstrong

5^th October 2012

Disclaimer

The information presented in Kevin Armstrong’s Strategy Thoughts is provided for informational purposes only and is not to be considered as an offer or a solicitation to buy or sell particular securities. Information should not be interpreted as investment or personal investment advice or as an endorsement of individual securities. Always consult a financial adviser before making any investment decisions. The research herein does not have regard to specific investment objectives, financial situation and the particular needs of any specific individual who may read Kevin Armstrong’s Strategy Thoughts. The information is believed to be-but not guaranteed-to be accurate. Past performance is never a guarantee of future performance. Kevin Armstrong’s Strategy Thoughts nor its author accepts no responsibility for any losses or damages resulting from decisions made from or because of information within this publication. Investing and trading securities is always risky so you should do your own research before buying or selling securities.