Fear and Longing

By: Michael Ashton | Sun, Aug 7, 2011
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Stocks avoided diving further on Friday - but at the same time, there was no overnight bounce to speak of going into the day. That was pretty chilling after the waterfall decline on Thursday, and really speaks to how much fear is growing. Ordinarily, after such a decline the "bargain hunters" will swoop in and push prices up at least a little bit, but there wasn't much of that going on.

The Employment number helped a little (or at least it didn't throw fuel on the fire). Payrolls came in ahead of expectations, which I thought would happen. The number was 117k new jobs with upward revisions of 56k to the prior two months, which means we essentially had double the jobs that were expected. The Unemployment Rate dropped to 9.1%, which I didn't expect, but that happened because the jobless continue to leave the labor force. The Labor Force Participation Rate fell 0.2% to 63.9% (see Chart), easily the most-depressing part of the whole report. One economist calculated that if the participation rate hadn't declined, the Unemployment Rate would have risen to 9.3% even with the upward surprise in the Payrolls number.

US Labor Force Participation Rate
I'm sorry to run this chart every month,
but it's an amazingly negative secular trend...as well as being somewhat hypnotic.

On the other hand, average hourly earnings rose more briskly, at +0.4% compared to expectations of +0.2%. Since wages don't push inflation, this is better thought of as an increase in real income (although there will be plenty of people who worry more about inflation because of this figure. There are reasons to worry about inflation; I just don't think this is one of them). It is only one month's worth of data, though, and it's hard to get that excited about it.

The data surprisingly didn't do much to bonds, which were already somewhat weak, but helped equities. Stocks bounced higher on the open, for about five minutes before the rout was on again. I had thought that people would sell into the bounce, and indeed they did. Until noon, the prospects for the market were looking ugly. By lunchtime the Dow was down another 200 points and looking somewhat sickly. Bonds, surprisingly, were not rallying on the further equity decline.

And then, finally, there was a pulse. In fact, the market came all the way back and actually traded higher until, with both buyers and sellers exhausted, stocks closed basically unchanged. Bonds, however, never recovered from the beating they took in the morning and upon the stock market's rebound. The 10y yield rose 14bps to 2.55% with the 10y TIPS yield +11bps to 0.31%.

I say there was fear, rather than panic. While the blood pressures were certainly rising when stocks were skidding (this is one of the only reasons I'll turn on financial news networks during the day: to assess how stressed the reporters and guests are), no one was pleading for calm. Instead, they were admonishing investors to buy. That's very different. In a crash, you will hear authorities telling people to relax but you will never hear them telling people to plunge into the market. Instead, there were people like Barton Biggs, who calling into CNBC said "I can't get bearish here." He pointed out that a collapse of the global economy is unlikely, about which point I agree. But he errs when he supposes that the alternative is a bull market. Stocks are priced for strong growth at record margins, and if we merely get weak growth or margin compression, they are overpriced.

This is an error that many analysts are making right now. When you hear people say that stocks are cheap, they are typically using some form of the Fed model, or an understanding of market pricing based on similar philosophy. The Fed model basically says this: because stocks are more or less perpetual bonds with small coupons (dividends) that rise over time, when interest rates are low it implies a higher fair value for stocks just like low interest rates imply higher bond prices.

As far as it goes, that is true. Low interest rates are explanatory for the level of the stock market. But as Cliff Asness pointed out a long time ago (and so did I, but I wasn't running tens of billions of dollars for AQR), explaining the current level of the stock market and saying it is fair relative to interest rates is not the same as forecasting an average future return to equities.

Stocks, in fact, work much like bonds in this respect. When interest rates are very low, are bonds overvalued or undervalued relative to interest rates? Well, by definition (since the price of a bond is merely the known future coupons discounted at the yield to maturity), bonds are always "fair" relative to interest rates. But that's trivial! The question is, when are bonds likely to have a higher future return - when interest rates are at 10%, or when interest rates are at 2%? Obviously, it is when interest rates are high, partly because the income stream is larger but also partly because when interest rates are high, it is more likely that they will fall than when interest rates are low already.

And so it is with equities. When interest rates are low, then naïvely you can say "they're valued fairly." But that's answering the wrong question. We don't really want to know how stocks are going to perform relative to bonds, but whether stocks are going to perform well outright. And it turns out that the answer is very clear: when interest rates and inflation are low, stocks tend to have higher valuations (as the Fed model suggests they should). But this also means that the expected future returns to equities are very poor when the starting point is a period of low interest rates.

Are stocks fair with interest rates at 2.5%? Well, maybe; they might even be cheap to where stocks typically are given those interest rates. So as long as interest rates stay very low, stocks might be fair or cheap. But if interest rates move to 4.5%, they are expensive, and quite so. And frankly, without another credit crisis I think it is far more likely that interest rates move to 4.5% or higher than that they will stay this low.

Now, technically speaking it isn't a huge win that the stock market finished unchanged, because volume was extremely heavy. More than 2.1 billion shares changed hands on the NYSE, and even though the S&P was unchanged the declining stocks outnumbered advancing stocks by a 2:1 margin. You want to see selling pressure ebb if you think we are reaching an extreme, but building volume at this level implies price acceptance - that is, both buyers and sellers are content with this price, and that suggests a big rebound is not soon in the cards. On the other hand, the VIX didn't decline at all despite the fact that the Employment data is now past, so there is still plenty of fear. It's just not panic.

It seems clear that we have now entered a new phase of the crisis, although if you like you can call this a new crisis. To me, the sovereign debt crisis has its seeds in the stresses of 2007-09, but it's an academic point. One way that this new crisis is less-threatening than the last is that there is less leverage in the system now than there was. To be sure, there isn't dramatically less leverage, because the Federal Reserve worked very hard to keep leverage from declining markedly in the financial markets and households haven't had the wherewithal to reduce leverage. But there is somewhat less leverage and probably significantly less that is off-balance-sheet.

On the other hand, one way that this new crisis is more threatening is that trigger fingers are faster this time. In 2008, it took a long drumbeat of bad news before institutions went into their shells and the real panic part of the crisis began. But the 2008 crisis started, after all, in 2007 when the mortgage market began to fall apart. It claimed a major firm in March of 2008. But it wasn't in full-fledged panic mode until the summer of 2008 - no one really believed that such a thing was possible, and no one had seen it. But now, bank risk managers are much more likely to take cataclysmic outcomes into consideration, and that will affect risk budgets...and, in turn, market liquidity. That liquidity could vanish far more quickly this time. (On the third hand, regulators are much more attuned to that possibility and I am sure are working the phones much more diligently this time around to head off any market seize-up).

But make no mistake, we have entered a new phase of this crisis, and one which could claim a major bank and has a fair chance of sundering the Euro before it is all over. Traders have suddenly come to grips with the possibility that nominal interest rates are starting to become negative (as Wells Fargo is now charging interest to hold deposits), and the trade du jour on Friday was 100,000 June Eurodollar 100.00 strike calls. Those options will only be in the money if Libor on the settlement date is negative. After buying 100k of these calls (that's $100bln of notional), the buyer bid for another 500,000 but ended up pulling the bid when he found no interest. I am not at all amazed that someone was willing to buy these calls. I am amazed that someone would sell them. The upside for the seller is ¼ of 1 basis point, or $625,000 for the entire hundred-billion-dollar notional. What's the downside? 25bps? 50bps? Who knows where rates could go once they start to trade negative. That's a dumb risk to take.

Friday's trading also saw the dollar index trade back 1% or so, and commodities slide -0.7%. Gasoline actually rallied 2.4%, but industrial metals fell -3.7% and precious metals were off -1.1% as well. As the crisis spreads, I would not be surprised to see commodities fall further but I will be a buyer on weakness...eventually!

But the best was yet to come when we went home on Friday. The good people at S&P chose to announce their downgrade of the United States' long-term credit rating (to AA+ from AAA: a single notch) at around 8pm on Friday. That is borderline criminal - to make such a huge announcement when market participants cannot react to it is likely to make the initial reaction worse. I still don't think the downgrade is particularly important, and shouldn't change the function of the Treasury market at all. But it was clearly released in a manner designed to get the most attention from the weekend news cycle.

Ironically, if the market doesn't overreact to the news, it may give some investors a reason to hope and a little more courage to buy. This was clearly a Sword of Damocles over the market's head, and it is now released. If investors act like grownups who understand the significance of the downgrade (essentially, none), then it might help the market slide sideways to higher over coming days. However, it is hard to declare that we've seen the worst from the market when there has not yet been a panicky washout. In my view, the best approach here is to husband one's resources. There is no reason to worry about "missing the rally back." It's more important to try to miss the schuss lower.



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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