Virtuous Cycle of Optimism

By: Michael Ashton | Mon, Feb 28, 2011
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One thing seems reasonably clear: in the absence of news, equity markets want to rally.

Heading into Friday, stocks ripped higher, and then ended up with a healthy gain on the day. Bloomberg attributed the rally to the revision in the February Michigan Confidence number to 77.5 from the initial estimate of 75.1 ("Stocks Gain as U.S. Consumer Confidence Exceeds Forecasts") This is patently ridiculous - few people follow Michigan closely, and almost no one pays attention to the revision, and the revision was only a couple of points. That became the headline because no one had a better explanation. I didn't write a comment on Friday, because I didn't have a better explanation either.

Stocks ripped higher overnight again last night, heading into Monday. Again, there was no news. Bloomberg this time attributes the gains to Warren Buffett's potential purchase of...something: ("Stocks Gain As Buffett Goes Shopping"). Again, that's a crazy reason to explain a $50-100bln rise in the market's total capitalization. He can't buy everything, and it isn't clear anyway how much value should be added to the market from one company buying another company (at least notionally, that's a zero-sum game, so while I believe Buffett is attentive to synergies it's hard to imagine $50bln of synergies). And what's he buying? Telecom companies were up the most, followed by utilities, basic materials, and health care. There is not a lot of commonality there.

The same article also attributes the 1% decline in Crude Oil prices to the Saudis' offer to make up for lost Libyan production, even though that was Thursday's news (man, oil traders are slow!). No mention was made of the attack this weekend by insurgents in Iraq on an oil refinery north of Baghdad that took about 150,000 bbl/day from the market, but presumably that news will be traded on Wednesday!

What's really going on is that volumes on Friday and today were much lighter than the three "news days" prior to them (although after I wrote that line, in the last 5 minutes of Monday's session some 400 million shares changed hands, a third of the whole day's volume and much more than is normal at the end of the session). There is clearly a wellspring of optimism right now that is difficult to divert and anything short of a steady drumbeat of bad news will fail to keep the market down.

There is plenty of bad news to be concerned about. Atop the Libya news - which is thinly reported because Gadaffi has done a fine job of keeping the media silent - and the explosion of the Iraq refinery, the results of the Irish election on Friday seems to put the new government on a collision course with the EU. On Thursday, the European Commission had made very clear that the bailout deal was with Ireland and not with "any particular government." This is a very proper theory - governments should respect the agreements entered into by prior governments, or international relations becomes very challenging - but also not very realistic when the government entered into an agreement that is clearly (and was clearly, at the time) against the wishes of the electorate. The agreements of a rogue government certainly ought to be subject to reasonably timely ratification by the people, and in this case it appears that the people have not ratified the deal. I expect that the Irish citizenry will win this debate, since the EU is unlikely to roll tanks into Dublin to enforce the deal and the Irish can be excused for thinking that the long-term health of their economy is more important to them than the notion of European unity. In any event, it's a source of uncertainty.

So there's no shortage of bad news, but the news cycle is clearly on "optimistic spin." I have never been able to figure out if optimism causes optimistic news coverage or if optimistic news coverage causes optimism, but there clearly is a virtuous cycle of good-feeling at the moment.

And I suppose that's the issue. Is this momentary? The underpinnings of the optimism seem ephemeral - lots of liquidity, solid momentum, and economic data consistently surprising on the high side. The Citi USD Economic Surprise index last week moved above where it had stood in early-September 2008. The current peak was last exceeded in August 2007, and before that in December 2003. Right there, you see the debate. Does the current skein of positive surprises represent the early stages of economic expansion, as it did in 2003, or the overreaching of euphoria as it did in 2007?

Perhaps it is a little bit of both. There is no doubt that the economy is in better shape now than it was a year ago, and better still than it was two years ago. But on the other hand, there are many more unpriced risks now than there were two years ago (when although the economic situation was more uncertain, investors were being reasonably compensated for many risks). My calculation of the Shiller "Cyclically-Adjusted P/E" (CAPE) as of today's close on the S&P is 23.7. My estimate of the ten-year expected real return to equities (reflecting a current dividend yield on the S&P of 1.7%, assuming 2.25% annual real growth, and incorporating a reversion of the CAPE two-thirds of the way back to the historical average of 16) is a mere 1.55% per annum.

So are 10y TIPS at 1.01% cheap, or are stocks expensive? I'm inclined to believe that they are both expensive, but TIPS somewhat less so. I don't see very much room for disappointment, and while I have no idea what kind of disappointment will break the virtuous cycle of optimism there is one thing I am sure of: there will be disappointment in the future. There always is.

It doesn't seem likely that Tuesday will see the beginning of that disappointment. The consensus for the ISM report is 61.0 versus 60.8 last month, but economists have been raising their estimates (not reported on Bloomberg, though) on the basis of the stronger-than-expected reports out of Chicago PM and other less-important regional surveys. However, at the very moment that report is released Chairman Bernanke will be starting his Monetary Policy Report to the Congress (neé Humphrey-Hawkins). It is a pretty decent bet that he will not be terribly downbeat, since the Fed's entire gamble is that the economy will suddenly ignite with enough strength that the central bank can then drain the liquidity without any ill effects. It seems a bad bet, and one that is apt to meet with disappointment...but probably not on Tuesday.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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