The Market's Pot Odds
Stocks got rocked (-1.6%) and bonds (after starting the day weak) ended with marginal gains. Why is that interesting? Well, after rallying for two days and erasing much of the selloff from Tuesday through Thursday of last week, it sure looked yesterday like another setup in which panicky buyers, afraid of missing the boat, would take the market to new highs.
Another 1.6% decline was really not in the playbook.
The economic data was solid, with ISM coming in at 61.4, slightly above the consensus expectations for 61.0 but probably slightly below the upward revisions that economists made after Chicago PM was strong.
But energy prices rallied again, with Crude futures +3.4% and front Unleaded up a whopping 9.2%. (Yesterday I suggested tongue-in-cheek that the Iraqi refinery outage which happened over the weekend would be traded on Wednesday. I underestimated energy traders as it only took until Tuesday!) The gasoline spike takes the front contract over $3/gallon. It is hard to believe that back in 2008, the peak was only at $3.631 - we have come a long way back! As a reminder, back then the year-on-year rise in headline CPI got to 5.6%, although to be sure that was with housing also contributing 2.5% instead of one-fifth of that.
The weird part of all of this is that today's geopolitical events should only be surprising if you were living in a fantasy world in which only what you saw on TV was reality. But the existence of "reality TV" doesn't imply that everything not on TV is not real, does it? Investors acted with surprise when an Egyptian paper reported that the Saudis were sending tanks to help quell riots in Bahrain. Really? Is it shocking that Bahrain would ask for materiel, or that the Saudis would supply it?
Investors seem surprised that the U.S. and Britain are considering establishing a no-fly zone in Libya to support the anti-government forces. It seems that the market's tacit assumption up until now was that the Middle Eastern turmoil wouldn't directly affect western nations except indirectly through the oil price (and our leaders pooh-poohed the loss of Libyan oil, so what is there to worry about?). Really? It's not exactly a new idea that a wider conflict in that region could draw in western allies. I think the idea is a bit more than 900 years old. I even think Nostradamus suggested obliquely that WW3 would start this way. Speaking of world wars, don't forget that some of WW2 was fought on the sand as well: Rommel's first offensive in 1941 started in Libya. So...I'm not predicting a world war; I'm just observing that it shouldn't be terribly shocking that the First World is being sucked in, since that intersection has been busy for the last millennium or so...
In theory, all of the likely and somewhat-likely events are supposed to be already discounted in the market. Stocks and bonds at these levels should fully discount the fairly high likelihood that conflicts in Tunisia, Egypt, Bahrain, Libya, Yemen, and other countries will not pass away with no impact. Asset prices should incorporate the somewhat-likely possibility that American machines and marines will end up being involved in some way. I'm not sure that these things are in fact being discounted. In fact, I would suggest that they are very likely not being so.
Last June, I wrote what I thought was a very useful piece about how to think about sizing trading bets under crisis situations. Quoting from that piece which said, in the context of the 2008 crisis:
"The relevance here is as follows: when a crisis hits, two things are happening to you as an equity investor. First, you are becoming more confident that the market will reward you for buying when everyone else is selling, because (as noted above) unless the world actuallydoes end you are likely to be getting a good price. Second, though, you need to recognize that the increasing chance of debacle implies a worse payoff. In April of 2008, the chances of losing everything the next day were pretty slim. In mid-September 2008, the chances were appreciable that a bunch of your portfolio might be in trouble. So your edge (confidence in winning, if the bet was repeated a bunch of times) was growing, but your odds (payoff if you win, relative to your loss if you don't) were worsening."
The relevance today is that while your odds are worsening, because the chance of a debacle is growing (by the way, the VIX shot back up to 21 today), your edge has not improved. Your edge improves when prices decline. Taking a shot on buying the market when there is a crisis is defensible and even smart, if the market has fallen enough to improve your edge sufficiently. But buying the market when there is a crisis developing but the market isn't yet providing you good pot odds is not a good play. It is always possible, in other words, to hit an inside straight on the river, but if your payoff is only 2:1 if you make your hand, folding is still the right thing to do. This market is not offering good pot odds on the bet that the Middle Eastern crisis will pass away without impact on our economies.
In all of this I haven't mentioned Chairman Bernanke. A thoughtful comment posted to yesterday's article observed that the market may also be reacting today to the fact that Bernanke in his seminannual testimony gave no hint about a possible QE3. That's a good point, but again it makes me scratch my head and ask "is that a surprise to investors?" The Fed right now thinks they've won, and their biggest problem (they think) is no longer deflation but the question of how to unwind the portfolio cleanly. Many Fed officials have been openly questioning the need to fully implement QE2 (make no mistake, however, they will finish QE2), and Ron Paul is going to make any consideration of QE3 extremely painful for the Fed. So should it be a surprise that QE3 is not likely in train unless something really bad happens?
Maybe the reason I find all of this hard to figure out is that I don't watch CNBC. Maybe they've been downplaying the significance of having all of the bad population-pyramid countries bursting into flames in unison. I don't mean to blame CNBC. They're not paid to see around corners, to anticipate problems and to assess the likelihood of improbable events. They're paid to provide entertainment. It's we investors who are paid to evaluate investment returns and risks. And if we're doing it badly, it can't be CNBC's fault. (Well, not entirely their fault).
Tomorrow brings another uptick in the tempo of economic data as the ADP report (Consensus: 180k from 187k) is released at 8:15ET. Remember that the Fed has made quite an issue of the weakness in employment as a reason for continuing to add so much liquidity. In my mind, this makes it somewhat hard to figure out whether a higher-than-expected number from ADP is bullish for equities or not. On the one hand, it (perhaps) indicates a stronger economy; on the other, it may lessen the monetary support for the asset markets. I can make a plausible argument to fade equity strength following any upside ADP surprise.
Bernanke also repeats, tomorrow, his semiannual testimony - this time to the House Financial Services Committee. Ordinarily, the second round is much less interesting than the first round in the other chamber (since the text of the speech is the same), but in this case it is the Republicans' first crack at Bernanke's semiannual talk since they took over the Committee. I predict there will be some entertaining Q&A.
Ten-year Treasuries at 3.40% are right back in the prior consolidation zone. The roundtrip from 3.40% to 3.75% to 3.40% took almost exactly one month. At this level, the market ought to be fairly balanced, and a neutral outlook is appropriate. On the bullish side are the geopolitical developments; on the bearish side is the fact that the end of the Fed's buying program is one day nearer every day, and the economic data is strengthening (albeit slowly). I suspect rates will resolve higher, but there is no urgent time-frame for them to do so.