It’s the risk premium, stupid!


Author Cam Hui

Posted: 9 July 2013

In the past few weeks, I have seen various analysts and commentators stating that either the Fed has fumbled the delivery of its message, or that even if it tapers, the effects will be minor. Here is one example from Comstock Partners:

Last week we wrote that Bernanke could not be happy with the way long bond rates reacted to his press conference answer that the Fed could begin lessening its rate of bond purchases in the next few months, and that he would attempt to sooth the market in yesterday’s press conference following the FOMC meeting. Well, he tried, but ended up making things worse, at least in the perception of the markets.

The Chairman attempted to allay fears by setting specific dates and economic parameters for reducing and eventually eliminating the latest bond purchase program that, until recently, was assumed by the market to be open-ended. He further took pains to assure the markets that just reducing the amount of purchases was not the same as tightening and that the fed funds rate would not likely be increased before early in 2015. He also assured one and all that the decisions would still be data-dependent, and subject to adjustment.

Investors, however, took what Bernanke apparently thought was increased clarity to mean greater hawkishness, and, as a result, bond yields soared as stocks tanked. In addition the markets gave far greater importance to the potential reduction of bond purchases, whereas the Fed attached greater significance to the continuing expansion of their balance sheet.

A history lesson: We want you to take risk
To the contrary, I believe that the Bernanke Fed knows exactly what it is doing with its communications policy. Remember what the intent of the various quantitative easing programs were designed to do. The intent of QE is to lower interest rates, lower the cost of capital and lower the risk premium. In the wake of the Lehman Crisis of 2008, the Fed stepped in with QE1. It followed with QE2 and QE3, otherwise known as QE-Infinity. The Fed first lowered short rates, told the market that it was holding short rates down for a very long, long time. It then followed up with purchases of Treasuries further out on the yield curve and later started to buy Agencies as well in order.

The message from the Fed was: “We want you take take more risk.” Greater risk taking meant that businesses would expand, buy more equipment, hire workers, etc. It hoped to spark a virtuous cycle of more sales, more consumer spending and to revive the moribund real estate market. Moreover, banks could repair their balance sheets with the cheap capital.

Imagine that you are a bank. The Fed tells you that it is lowering short rates and holding them low for a long time. That is, in essence, a signal to borrow short and lend long. In the summer of 2009, T-Bills were yielding roughly 0.5% and 10-year Treasuries were roughly 3.5%. If the bank were to borrow short and lend long with Treasury securities (no credit risk), it could get a spread of roughly 3%. Lever that trade up a “conservative” 10 times and you get a 30% return. 20 times leverages gets you 60% return. Pretty soon, you’ve made a ton of money to repair your balance sheet.

The banks weren’t the only ones playing this game. The hedge funds piled into this trade. Pretty soon, you saw the whole world reaching for yield. The game was to borrow short and lend either long or to lower credits. Carry trades of various flavors exploded. There were currency carry trades, some went into junk bonds, others started buying emerging market paper. You get the idea.

The net effect was that not only interest rates fell, Risk premiums fell across the board. The equity risk premium compressed and the stock market soared. Credit risk premiums narrowed and the price of lower credit bonds boomed.

Managing the exit
During these successive rounds of quantitative easing, analysts started to wonder how the Fed manages to exit from its QE program and ZIRP. We all knew that the day would have to come sooner or later. So on May 22, 2013, Ben Bernanke stated publicly that the Fed was considering scaling back its QE purchases, but such a decision was data dependent.

In other words, it communicated and warned the markets! Consider this 2004 paper by Bernanke, Reinhardt and Sack called Monetary Policy Altnernatives at the Zero Bound: An Empircal Assessment in which the authors discuss the tools that the Fed has available when interest rates are zero or near zero [emphasis added]:

Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve’s monetary policy decisions have two distinct effects on asset prices. These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank “talk” affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero.

The market misses the point
From my read of market commentaries, I believe that analysts are focusing too much on the timing and mechanics of “tapering” and not on the meta-message from the Fed. If quantitative easing is meant to lower interest rates and lower the risk premium, then a withdrawal of QE reverses that process.

In effect, the Fed threw several giant parties. Now it is telling the guests, “If things go as we expect, Last Call will be some time late this year.”

Imagine that you are the bank in the earlier example which bought risk by borrowing short and lending long, or lending to lower credits in order to repair your balance sheet. When the Fed Chair tells you, “Last Call late this year”, do you stick around for Last Call in order to make the last penny? No! The prudent course of action is to unwind your risk-on positions now. We are seeing the start of a new market regime as risk gets re-priced.

That’s the message many analysts missed. The Fed is signaling that risk premiums are not going to get compressed any further. It will now be up to the markets to find the right level for risk premiums.  Watch for Ben Bernanke to elaborate on those issues on Wednesday*. In the July 4 edition of Breakfast with Dave, David Rosenberg wrote the following about the Fed’s communication policy:

I actually give Bernanke full credit for giving the markets a chance to start to price that in ahead of the event, and to re-introduce the notion to the investment class that markets are a two-way bet, not a straight line up. Volatility notwithstanding, I give Berananke an A+ for shaking off the market complacency that came to dominate the market thought process of the first four months of the year (to the point where the bubbleheads on bubblevision were counting consecutive Tuesdays for Dow rallies). Ben’s communication skills may be better than you think – underestimating him may be as wise as underestimating Detective Columbo, who also seems “awkward” but was far from it.

Bernanke knows exactly what he is doing when he hints about tapering in his public remarks. It’s the risk premium, stupid! And it’s going up.

Earnings to do heavy lifting
With this shift in tone, don’t expect the Fed to push yields down anymore. The Fed won’t be pushing you to take as much risk. Consider what this means for stocks. If the economy does truly take off and earnings grow, then stock prices can rise. However, don’t expect stock prices to rise because P/Es are going to go up because the Fed is pushing the market to take more risk. In fact, P/Es are more likely to fall and it will be up the the E component of that ratio, namely earnings, to do the heavy lifting.

As we approach Earnings Season, the task may be more difficult. Thomson-Reuters reports that negative guidance is high compared to recent history:

As the beginning of the second-quarter earnings season approaches, the negative guidance sentiment is weighing on analyst estimates. So far, S+P 500 companies have issued 97 negative earnings preannouncements and only 15 positive ones, for a negative to positive ratio of 6.5. The guidance has contributed to the downward slide in second quarter growth estimates, with EPS currently estimated to grow 3.0%, down from the 8.4% estimate at the beginning of the year.

Analysts have an even bleaker outlook for the top line. After a first quarter when S+P 500 companies reported an aggregate revenue growth rate of 0.0%, the consensus currently calls for 1.8% growth in the second quarter. With revenue growth holding back earnings for the past several quarters, we did an evaluation of company management teams’ outlooks for their revenues. Over the time period evaluated, Q1 2008–present, revenue preannouncements were more balanced than were EPS preannouncements. On average, there were 1.7 negative revenue preannouncements for each positive one. This compares with an N/P ratio of 2.4 for EPS over the same period.

The stock market is facing headwinds. This is a regime shift. Markets generally don’t react well to regime shifts and inflection points like these. Expect volatility and an intensee focus on headlines. The path of least resistance for stock prices, notwithstanding a robust economic recovery, is down.

* Ben Bernanke is expected to take questions after his speech. If anyone who is reading this happens to be there, please ask the following for me: “Mr. Chairman, it appears that the latest round of quantitative easing where the Fed bought Agencies instead of Treasuries was inteneded to narrow the risk premium between the two asset clases. Would it fair to conclude that when the Fed starts to wind down its QE program, risk premiums are expected to widen their natural market determined levels?”

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned. 

Beware the Wall Street Pom-pom Gang


Author Larry Berman

Posted: 24 May 2012 re-posted from etfcm

The S&P 500 had a key inflection day yesterday and held above 1290. This remains an important inflection point as a break would clearly lead to a much more significant downside correction. To be sure, the US is in “less bad” shape than the rest of the world, but it is not immune to the systemic risk by any stretch of the “Wall Street” pom-pom gang. The group of cheerleaders call strategists remain optimistic about earnings and talk of valuation and clean balance sheets, but few if any understand that the markets work more on mass psychology than anything else. So “Bring it On” like you collectively did at the end of 2007 when AJC said all was good and the S&P 500 would earn $110 in 2008.

The world debt levels are toxic and de-leveraging will most certainly lead to another crisis in the US as well. As the political season heats up, Main Street will become aware once again that the US (Washington) is bankrupt both morally and fiscally. We cannot do much about the 20% that are simply lazy and living off the rest of us, but the other 79% that cares is “Fed” up! Bigger government is not the solution, but more QE…?

 

Potential for a Retracement Bounce Followed By Lower Lows


Author Larry Berman

Posted: 22 May 2012 re-posted from etfcm

Support for the S&P 500 has held the initial test of the 1290 area we had been targeting in recent weeks. There should be scope for a retracement “bounce” to something less than the recent highs. If we are correct, there is more European debt inspired weakness in the coming months, compounded by a weakening US economy and more anxiety later in the year over the Presidential elections, and ultimately the US debt ceiling in early 2013.

Japan, the third largest economy in the world and the most indebted (where QE has been little more than a periodic adrenaline boost), was downgraded again overnight. Anyone who thinks it is not different this time just does not get it. To be a successful investor in this environment you have to take money off the table when the birds are chirping and have to get it back to work when all are despondent. We would hardly call last week’s selling a bout of despondency, so there are probably lower lows coming after a bounce.

Resistance between 1342 and 1372 is the zone to sell into in our current view, but that could change if the ECB cuts a check or the Fed cranks up the press in June.

 

S&P 500 Tests Key Support


Author Larry Berman

Posted: 10 May 2012 re-posted from etfcm

The 1340-1357 zone once again was tested by the S&P 500 and provided a cushion for the market. It was key support on the past few declines in March and April and now again. A close below 1340 points to a move down to about 1290 from several technical measurements, we expect to see that lower support tested in the coming weeks to months. We cannot be sure exactly when, but odds are we see the test lower, perhaps even as low as 1257 (unched on the past year or two).

There is no predicting systemic (black swan) risk and market panic anxiety. For now, the euro risk is on the front burner, but both the euro and many commodities linked to it are oversold. Crude oil seems to be finding some footing below $96 and could rebound to $101-102 before dropping back to fair value around $85, if our broader market call is correct.

The highs for the year might be in with a break below 1340 confirming that notion. The complicating factor is the strong seasonal pattern in democratic Presidential cycles through the summer months. We covered our short and will look to sell again on a bounce above 1380.

 

Gold Breaks a Multi-Year Trendline


Author Larry Berman

Posted: 10 May 2012 re-posted from etfcm

The TSX showed its first evidence of a higher volume (27.5% above the 3 month average) capitulation yesterday from an oversold level (RSI <30 at day’s low). But the grey clouds over Europe, the euro and by extension commodity prices linked to the dollar are an ongoing issue. Specifically, gold broke a multi-year trendline and is now in a recognition trade when trend followers are selling. The gold sector is looking to shake out the resolve of the bulls and this could keep pressure on the TSX despite the oversold condition.

WTI is finding some support below $96 for now, but probably has a date with $85 or so closer to the summer low period. Bounces should be limited in the coming months to the declining trendline off the 2012 highs and range trade is the best bet at this point. If the S&P 500 breaks 1340 support, then the Canadian financials should have their bottoms slapped a bit more too. For now, expect the TSX to hold around Nov-Dec lows 11,421-11,469.

Canadian Banks and Stress of the Housing Sector


Author Larry Berman

Posted: 28 Feb 2012 reposted from etfcm

Bank earnings start off with a slightly better than expected result, but there does seem to be at least some concern about the forward outlook. There appear to be notable stresses developing in Canada’s housing sector that are bound to have an impact on the banks in the coming years. The CMHC is about full on their loan books, and housing is simply becoming unaffordable for a conventional type mortgage. How many young couples have $100K or more needed for a down payment?

More important today and tomorrow is what the S&P 500 does at its 2011 high of 1371. There is obviously some hope that the ECB delivers another monster tranche of LTRO (QE), so there is room for some disappointing ‘sell the news’ type event as well.

Gold and silver look poised for a breakout type trade and all will know how badly gold and silver stocks have lagged their bullions. There are lots of potentially offsetting factors for the TSX, which should limit the upside in the coming weeks and months. We still see 13,000 as a reasonable target to take money off the table.

Breakout or consolidation?


Author Cam Hui

Posted: 19 Feb 2012

On Friday, the Dow Jones Industrials Average staged an upside breakout to a new recovery high. The move was confirmed by the large cap OEX, but not by many other averages.

The S+P 500, for example, is still struggling with resistance. The intermediate term trend, however, appears bullish as it is in a well-defined uptrend and there are signs of global healing from stock indices around the world. In my mind, there is no question that the bulls are in control of this market in the intermediate term. The more relevant question is whether they have exhausted themselves in the short-term. Can the S+P 500 clear resistance or are we due for a period of consolidation?

More disturbing for the bulls is the narrowing leadership of this rally as it has been led by the large cap stocks. Small caps have not been as strong, which is a bearish negative divergence. As shown below, the small cap Russell 2000 is barely approaching its resistance zone, though it is in a similar well-defined uptrend.

Cylicals say consolidation
To discern the future direction of equities, I turn to the answer from three place. I analyzed the chart patterns of the cyclicals, as well as the other two sources of macro risk, Europe and China. Consider the Morgan Stanley Cyclicals Index. These stocks staged an upside breakout in mid-January, but have started to consolidate as they moved sideways through the uptrend line.

Other cyclically sensitive indices and currencies, such as the Australian Dollar, the Australian All-Ords, the Canadian Dollar and the TSX Index all show a pattern of breakout and consolidation.

Commodity prices, on other hand, have lagged this rally. They broke out of a downtrend in mid-January and they appear to be consolidating. I am watching to see if the sideways pattern continues or if they can stage an upside breakout through resistance.

Are fundamentals improving?
Josh Brown puts the bull and bear debate into perspective this way:

I’m convinced that the single most important decision facing asset allocators right now is whether or not to join The Big Shift or to ignore it and ride it out. Guys like me need to decide if we’re going to dance with the sinners in the high-beta, risk-on sectors that have been leading this market or stick with the saints – the defensive, income-heavy non-cyclicals that saved our lives when things got dicey last year.

He went on to say that equity prices may have gotten ahead of fundamental [emphasis added]:

The trouble with this is that while we may yet be able to avoid another recession scare this year, the data simply does not confirm (just yet) what the homebuilders, banks, casinos, REITs and materials stocks would have us believe. Instead, I think we’re witnessing a major rotation, one of the biggest I’ve ever seen, and that it cannot get much further until the data on housing and jobs improves markedly and materially.

Have the fundamentals improved? Well, sort of. On the earnings side, things are improving as reporting season progresses. Thomson-Reuters reports that the “beat rate” for companies have been steadily getting better.

Corporate guidance, while negative, has been improving as well [emphasis added]:

Looking ahead to the next earnings season, in which companies will give investors a glimpse of how they are faring in the early months of 2012, the number of companies offering downbeat guidance continues to exceed those steering analysts’ forecasts higher. So far, 52 companies in the S+P 500 have issued negative earning guidance compared to 20 that have issued positive earnings guidance for the first quarter of 2012; the resulting ratio of negative to positive preannouncements is 2.6. While that’s still not telling investors that corporate executives are bullish, it’s a significantly more positive reading than the N/P ration of 3.6 observed as recently as last week.

Watch overseas markets
The other important “tell” of market direction are Europe and China, which are the two big sources of macro risk. I am watching closely the action of the Euro STOXX 50, which has staged an upside breakout, but it isn’t clear whether the breakout will hold. (With the ECB about to unleash LTRO2 that is expected unleash over €600b of liquidity to the eurozone banking system, does anyone want to bet against a breakout?)

Moving east, I pointed out last week that the Shanghai Composite had rallied through a downtrend line. That development had alleviated my concerns of China as a source of tail risk and signaled that a hard landing is less likely. Indeed, China has cut bank reserves another 50 basis points as it followed suit on a trend of global monetary easing by the BoJ and BoE.

Next door in Hong Kong, the Hang Seng Index has rallied to fill a downside gap and is encountering overhead resistance. I am watching carefully to see if the bulls can stage a rally to overcome resistance.

Where to next?
Is this a period of breakout or consolidation? My inner investor tells me to stay with the bull trend in equities as they are in a well-defined uptrend. Moreover, a glance at the 30-year Treasury yield shows that it is forming a saucer bottom pattern, indicating that the risk-off trade is on its last legs.

My inner trader, on the other hand, is more agnostic on the question of breakout or consolidation. On one hand, he is aware that the combination of under-invested equity investors and bullish sentiment can  lead to  a series of “good overbought” conditions that result in higher prices. On the other hand, the markets are overbought and they are ripe for a pullback and he is watching market conditions carefully next week for signs which way the markets break.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Bullish sentiment can be bullish, not bearish


Author Cam Hui

Posted: 11 Feb 2012

On Friday, US stocks had their worst day of 2012 as the S+P 500 fell by -0.69%. With market conditions overbought and sentiment surveys showing high levels of bullishness, does this mark an intermediate term top?

I don’t think so. Let’s get back to first principles on sentiment models. When investors are overly bullish, the market declines because there is no one else left to buy. Read that last sentence carefully, especially the last part. Is there anyone else left to buy?

Doug Kass thinks so, because many investors are under-invested in equities:

Today’s dominant investor classes — individual investors, hedge funds and pension funds — have de-risked and are relatively uncommitted to equities.

A re-allocation into stocks (and out of bonds) represents an underappreciated and potentially massive (and latent) demand that could easily be the catalyst for a move to all-time highs in the S+P 500 in 2012.

Mebane Faber showed this chart of AAII asset allocation on January 27, 2012 showing individual investors were under-weight equities versus their historical average. (The figures have since been updated by AAII and individuals are only at their average weight.) These readings indicate that equity weightings have much farther to run.

Last week, Barry Ritholz spoke with one technician who said that she didn’t know anyone who is bearish and even Roubini has become a bull. Ritholz then rhetorically asked, “Where are the bears?” Here is one key comment in response to his post indicating that individual investors are not excessively bullish in their portfolios [emphasis added]:

This is of interest. Helene Meisler, a technical analyst at theStreet.com, conducted a non-scientific survey which I’d guess probably got a majority of responses from the retail folks about how what they were expecting in the near future. Less than 1 in 5 reported they were positioned for further gains, with rest split between people expecting a pullback of less than 5% and a smaller number expecting a larger decline.

I find this interesting because the last I heard the “smart money” was slightly bearish and the “dumb money” was significantly, though not exuberantly, bullish. So either sentiment has changed, I was wrong and her responses drew from the “smart money” crowd, or else her survey sample was distorted in some way.

A series of “good overbought conditions”
The good news for the bulls is that tcombination of high bullishness and a market underweight is a recipe for a buying stampede.
Don’t forget that this is a central bank liquidity fueled rally. The BoE, the Federal Reserve and the ECB (through LTRO) are committed to quantitative easing. The best analogue is the QE2 rally seen in the latter half of 2010. The market experienced a series of “good overbought conditions” as it advanced.

So am I overly concerned that stocks encountered resistance for the first time and experienced its “worst” one-day decline of 2012?

No. This is a time to be buying the dips.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.  

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