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Fear vs Greed: Greed Is Winning

Here in South Florida we have a saying. If you don’t like the weather, just wait ten minutes – it will change. During rainy season when the weather person says there is a 50% chance of rain, that means it will rain on half the city for half the day. Like the weather in South Florida, if you don’t like the market climate, just be patient, it’ll change soon. Back in late spring, when everyone thought the demise of the Euro was imminent and QE3 was but a twinkle in traders’ eyes, the mood for stocks was sour and bonds were running. Being the contrarian I am, I was looking for the silver lining and our portfolios were about as fully invested as they’ve been over the last few years. And that worked out pretty well. Stocks are up 15% since the bottom in June.

Now, however, the mood is downright ebullient after seemingly every central bank on the planet cranked up the printing presses again. Long term bonds have been falling, inflation expectations are rising and stocks are at their highest point of the year. Me? Well, I’m back to wondering why everyone is so optimistic. We’ve raised cash and hedged our portfolios and my commentaries have turned so dour that a commenter last week accused me of calling for multiple crashes in the hope I’d get it right some day. I actually don’t remember calling for a crash anytime recently although I did point out that a Fed rooting for a falling dollar did remind me of 1987. If I did and just can’t remember, well it wouldn’t be the first time I was wrong and it definitely won’t be the last. But when sentiment gets this bullish I’ve learned to watch my step.

What has me so worried again?

  • The options market: Back in late May we were seeing about 1.25 puts being bought for every call in the equity options market. Now traders are loading up on calls with only 0.6 puts being bought for every call. The market for index options is not as frothy with a put/call ratio of about 1.1. However, since index options are where most go to hedge it is normal to have a put/call ratio over 1. Anything near 1 is a warning while anything over 2 is usually an all clear sign to buy.
  • Momentum: The S&P 500 is about 4% above the 50 day MA and 8% above the 200 day MA. That is about as large a spread as we’ve seen since the cyclical bull market started back in 2009. The good news is that both moving averages are rising so we might be able to close the gap by just going sideways for a while. But that isn’t what has happened the other times we’ve been here recently.
  • Junk bonds: The spread between junk bond yields and Treasuries is less than 3% which is as narrow as I can ever remember. In addition, we’re seeing B rated companies issuing debt under 6%. That is unprecedented. Obviously, Ben Bernanke’s wish that everyone go out and take some risk is being realized. A couple of years ago Warren Buffet, quoting Ray Davoe, said, “More money has been lost reaching for yield than at the point of a gun.” This time won’t be different.
  • Stock/Bond performance: Stocks have outperformed bonds by almost 400 basis points in just the last month. Investors, despite an iffy economic environment, are leaving the safe haven of the bond market to chase higher returns in the stock market based solely on the hope that QE3 will be successful in accomplishing what versions 1 and 2 failed at miserably – raising growth.
  • Volatility Index: The VIX is trading at the lowest level since the crash of 2009. While we have seen sustained periods of lower volatility, that was during the housing boom years. And no matter how much housing has improved, this isn’t a boom period for anything.
  • Sentiment polls: Investors Intelligence, a measure of financial advisers sentiment, shows 54.2% bulls, 24.5% bears. Over 50% bulls and less than 30% bears has marked turning points in the past. The American Association of Individual Investors poll has 37.5% bulls, 33.8% bears and 28.7% neutral. That isn’t an extreme reading but their August asset allocation survey showed cash at the lowest level in 15 months. The Consensus Index has bullish sentiment at 73%. Market Vane is at 69%. These are extreme readings.
  • ETF inflows: The S&P 500 SPDR (SPY) has seen assets rise by 11% in just the last month. Emerging market and gold ETFs are also seeing big inflows while bonds are bleeding cash. Investors appear to be chasing performance again and in the past that has worked just about as well as reaching for yield.

Some of these, such as the option market, are short term indicators and some are longer term worries (junk bonds) but the evidence shows that the consensus right now is bullish on stocks and growth. Combine that with future expected stock returns in the mid single digits (based on a variety of methods) and it is hard to justify a fully invested position right now. Meanwhile, implied volatility of the long term Treasury ETF (TLT) is higher than for the S&P 500 and about 80% more puts are being bought than calls. The bears have shifted their attention to bonds.

There are good reasons to believe that stocks will outperform bonds in the coming years. The 10 year Treasury yields 1.8% right now so while you might get some capital appreciation in the short term, the 10 year return is known and low. I see little prospect that inflation will be that low so Treasuries at these prices are probably a sure loser in real terms. Depending on what model you use for the stock market’s future return (Shiller P/E, dividend growth, etc.) the 10 year expected return comes out to somewhere between 0 and about 6%. So stocks will probably outperform bonds and provide a real return over the next decade. It should be noted however that achieving that return involves considerable risks and probably a lot of volatility.

The short term, however, can and likely will vary significantly from the expected long term return. Short term movements in stocks, bonds and commodities are based on the changing expectations about an unknowable future. As we’ve seen over the last few years, those expectations can change rapidly and right now they’ve been ramped up to what I believe are unrealistic proportions. There is no evidence that QE3 will make any positive difference in the performance of the economy. In fact, if past is prologue, the current expectations are bound to be disappointed. QE1 and 2 temporarily raised inflation expectations and with it commodity prices, particularly oil prices. They also raised nominal bond yields and the combination offset any perceived gain from higher stock prices. We’ve had multiple rounds of QE and growth is still struggling to maintain a 2% rate while unemployment remains stuck above 8%. With that inspiring track record one wonders why sentiment has turned so bullish.

I would also note that lower real yields reduce the incentive for banks to lend so if the Fed is expecting this round of QE to spur borrowing, they will likely be sorely disappointed. Borrowers are not particularly interested in borrowing and banks are not particularly interested in lending. Lowering the potential reward for lending would seem an odd way to get banks to lend and not surprisingly, it hasn’t worked. The problems with our economy are not ones that can be fixed by monetary policy. Even if Bernanke gets what he wants I suspect it will only mean higher inflation rather than more real growth. Real growth will come from a change in policies that affect real growth such as tax and regulatory reform. In short, there is no reason to believe that QE infinity will work any better than its predecessors. If that is true, investors are too optimistic and a correction is likely. How big is anyone’s guess.

Markets in the short term, as Warren Buffet has pointed out, are voting machines and right now traders/investors are voting for greed. In the long term though markets are weighing machines and I fear this economy will come up light. By the way, when I started writing this it was sunny outside and I was looking forward to hitting the driving range later this afternoon. Unfortunately, it’s now raining and practicing my golf swing will have to wait. At least the market climate doesn’t change that quickly.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or  786-249-3773.

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