Wounded Worrier

By: Michael Ashton | Thu, Jul 7, 2011
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The stock market continues to power ahead, with the S&P up another 1.1% today and about 7% over the last 8 trading sessions. For those keeping track that's roughly a 220% annualized growth rate, but the bulls don't seem to care about such trifles. And, indeed, the optimists clearly have the upper hand as the indices power to a seemingly unavoidable rendezvous with the destiny of the year's highs. Today, the market was launched higher following a rate hike in Europe (and hints that more, incredibly, are yet to come) and a slightly stronger number from a second-tier jobs report, and sustained their gains in the face of a 4.1% rise in gasoline prices.

You can call this a "risk-on" trade if you like; commodities broadly were up 1.5% and Treasury yields rose to 3.14%. But you could also term it a "growth" trade. A recovery that is about to gain steam suddenly would leave the same market footprint: higher commodities prices, especially energy commodities, rising interest rates, and rising stocks.

I personally am short stocks, but fortunately through the medium of options. Having bought options at low vol, I am losing on delta but not losing doubly by watching vols drop further. Indeed, it is somewhat incongruous but implied volatilities have not been declining over the last few sessions despite much higher equity prices.

However, a worrier doesn't have to look very far to find worries (and a bull doesn't have to look very far to find a wall to climb). Rate hikes into a sovereign debt crisis would be a good place to start, although at the same time the ECB suspended its minimum credit-rating requirements for Portugal so it is strangely being both tight and loose at the same time.

The general loss of ECB credibility could be a worry, although to me the whole institutionalized crazy routine makes me think more of the scene in Blazing Saddles where the sheriff pretends to be taken hostage by his own split personality, in order to manipulate the crowd. I don't think the manipulation routine in this case is working very well, but I just prefer to believe that over the alternative that Trichet has simply gone mad. Today he insisted that the Irish government, which recently has threatened to force senior bondholders in the country's banks to take losses as a way of 'sharing the burden,' should instead respect prior agreements. "All the plan, nothing but the plan including all what has been said at the time of the approval of the plan," quoth Trichet expansively, apparently numb to the dramatic irony of demanding utter fidelity to precedent on one hand while rewriting collateral guidelines with the other hand.

The growth camp got a mild boost from the ADP figure, which was stronger-than-expected at 157k (versus 70k expected). That got people excited, or perhaps I might even say overwrought with joy, about tomorrow's Employment data. Initial Claims came down to 418k, which is still high although down from 432k last week. It seems weird, though, to get very excited about beating expectations when that happened mainly because the expectations were stupid. The ADP number was actually right on the regression line (see Chart below) - it was last month's number that appears to be the aberration. Economists were just too morose. Oh joy!

Economists shouldn't have been so surprised by ADP,
which was right where it should have been given Claims.

The ADP figure suggests Payrolls should be around 162k on the coarse regression I use, but even though expectations for that number rose today, they're still well below that number (Bloomberg reports 105k but that includes people who didn't change their numbers on the new information). There is a good chance of a high-side surprise in Employment tomorrow, although it shouldn't be a surprise especially after today's data. A 150k jobs gain is no reason to set off fireworks, folks, and the stock market is already priced as if it is known that job growth will shortly triple from that level. But if (probably when) we get that surprise, the market will leap higher, especially if the Unemployment Rate falls from 9.1% - it is expected to be unchanged. Personally, I will use that opportunity to add to my put position, although I will not do so if stocks blast through the year's highs.


There was again news today about the notion of changing the cost-of-living adjustment in Social Security so that it uses chained CPI rather than the current "standard" CPI. Note this is not a change to CPI, and will not affect TIPS (which were unchanged today versus a declining nominal market), but rather is a change to the index to which Social Security will be statutorily indexed to.

There is a lot of debate about whether or not this is a "tax increase" or a "benefit cut," but that misses the point. If you want to call this a tax increase on the old, to keep the young from having to pay back in the future the money that we have to borrow today to pay those benefits, then fine - although calling it a "tax" just makes the political deal-making that much more difficult, the description I just used at least captures the notion of what is really happening: this is a question of a transfer more than a tax.

And, as someone who doesn't yet receive Social Security, doesn't ever expect to, and yet will be paying for it throughout my entire life, I would say - isn't it about time? The transfers have run the other direction for decades: young people have pledged trillions of dollars far into the future to pay the Medicare and Social Security entitlements. When there was some chance those young people might eventually receive similar future entitlements, that arrangement was arguably fair - an intergenerational transfer that could be thought of as a low-interest savings program. I am paying extra money now so that my future-self can receive money. But because it was never built as an actual savings program, that intergenerational transfer turned into a Fountain of Youth that politicians could bathe in by pledging more benefits to politically-active retirees. Now that those programs are clearly not viable - Medicare especially: in principle Social Security could be made temporarily viable with changes to entitlement age etc - the time is probably right to ask, "why shouldn't there be an intergenerational transfer back to the young from the old?" The answer, of course, is that no one will ask that question in the right way, and explaining it won't fit in a sound bite. I fear for my country, and this is one reason why.


One additional worry just cropped up today with the release of the weekly money supply numbers. There was a very large increase in the latest week, which brings the annualized 13-week growth rate to 11.1% (highest since March 2009), the 26-week growth rate to 7.0% (highest since June 2009), and the 52-week growth rate to 6.1% (highest since November 2009) - see Chart.

I start this graph in 2009 so the crazy spikes from 2008 don't distract us.
M2 is jumping.

While I am trying not to get alarmed yet, it is interesting to reflect on this chart in conjunction with the resurgence in equities and the sudden (and largely unexpected) recovery in commodities. Commercial bank credit, which has been contracting on a year-on-year basis since early 2009, is essentially flat (-0.1%) over the last 52 weeks (see Chart).

Bank credit is still technically contracting year-over-year, but only by a hair.

So, perhaps the stock market has it right, and the ECB is right to begin tightening. I am skeptical about that possibility, especially since the European crisis is far from over. And yet, that set of facts is consistent with the dollar being stronger than one would expect given 11% dollar M2 growth and an ECB tightening, and with the U.S. 10-year rate being at 3.14% instead of at 5%.

It is a set of facts and hypotheticals that I am not comfortable with, and indeed I think this optimism will prove to have been premature. Moreover, the stock market has already priced in the money-stimulated recovery - that's what the rally from last August was theoretically about (or so we were told) - and I am always reluctant to pay for the same item twice. But there is certainly a chance that the market is right this time.



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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