If A Tree Doesn't Fall In The Forest

By: Michael Ashton | Mon, Aug 22, 2011
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The question du jour is, what if a tree doesn't fall in the forest, but everyone was waiting around to hear it? Does it still make a sound?

The answer du jour is, of course, no.

The relevance this week is obvious, as investors count the hours, minutes and seconds until Chairman Bernanke speaks at Jackson Hole and (most of them believe) hints at QE3. The problem is that that is very unlikely to happen. The case for QE2 was plausible. QE1 had worked, at least after a fashion, and with core inflation continuing to decline it gave cover to the Fed to pursue an outright inflationary policy. (Many observers didn't realize, and most others conveniently forget, that even by the time of the Jackson Hole conference last year we knew that core inflation would bottom in QE4 simply because of base effects).

The situation is starkly different this time in some very important ways. I have mentioned them before: inflation is heading up. The evidence is that QE2 was ineffective at the stated goal, which was increasing growth, because the money never entered the transactional money supply; it may have been effective at the unstated goal which was to forcibly increase the reserve cushion at banks. I have also pointed out that this has a depressing effect on earnings, but again this was a fact that many people didn't think about and many others ignored - as you can tell from the valuation multiples that banks reached earlier this year. The Despite the fact that the NASDAQ Bank index is now 22% below its early-July highs, and despite the fact that Bloomberg omits negative earnings from the denominator of the P/E multiple, the index (CBNK on Bloomberg) still sports a 31.75 multiple.

The re-learned lesson of these last two facts - the obvious impotence of QE and the obvious overvaluation of bank stocks in an environment of awesome headwinds - is that the evidence of one's own eyes is the only evidence that many investors will accept these days.

But blest are ye who have not lost money and yet believe.

If the Chairman does not announce QE3, this is going to be one disappointed market. Because right now, that's all the bulls have to look forward to. I saw today that Credit Suisse today made a mild adjustment to their year-end S&P target, just a week or two after there was much celebration about how the targets had remained high despite the selloff. On August 5th, CS dropped its target from 1450 to 1350. Somewhere in the last couple of weeks, they adjusted it to 1275 from 1350. And today, they moved it to 1100 from 1275. At least they're flexible! But many analyst targets remain high. There is lots of room still for disappointment (although some pundits are making points similar to the ones I make above - the belief in QE3 is not as widespread as the belief in QE2 was).[1]

Some strategists are heartened by the fact that the dividend yield on the S&P 500 (currently 2.29% according to Bloomberg; I calculate 2.20% using data from S&P) is higher than the 10-year Treasury yield. This is the first time this has happened since the first quarter of 2009. "And you know what happened next!" is the subtext to that observation.

Dividend yields of course were once always above bond yields, because stocks were considered to be riskier (who knew?) and therefore required more compensation to own. (It was later that corporate titans discovered that if they just earned the money, they didn't need to pay it out and investors didn't seem to care if they instead built empires with the money, and frequently blew it.) Dividend yields are now above bond yields not because dividend yields are so high, but because bond yields are so low. As a reason to sell bonds, it's a good argument; as a reason to buy stocks...not so much. Also dampening the power of this argument is the Japan Rejoinder. In Japan, dividend yields have been above sovereign bond yields - in a country with incredibly low bond yields - for some time (see Chart). So the precedents are not wholly encouraging.

Japanese Yields
Japanese dividend yields have been above bond yields for several years. So what?

Now that I've doused the bulls thoroughly, I will also note that for at least a day or two stocks have failed to fall back through 1120. That level, which doesn't look particularly important to me, has nevertheless supported the market four times since August 9th. I am very confident that equities will eventually trade below that level, and probably substantially so. I am becoming less confident that this will happen shortly.

At least, while the bulls are able to sustain faith in His Liquidness.

Speaking of liquid, it is interesting to me that NYMEX Crude Oil rallied as Gaddafi appears to be finally losing his grip on his regime (Brent Crude was close to unchanged, however). I would have thought that oil would decline, since a significant amount of Libyan capacity is idled and a resolution in that country would suggest that capacity could come back on-line. On the other hand, for all his legion faults Gaddafi was good at carrying the mail (in a petroleum sense), and so (and I think this is the thought process) the resolution of the conflict in favor of the rebels means we don't really know much about when production can be restored. If Gaddafi had won decisively, production would have begun fairly rapidly; in the current case, it is not clear.

Of course, I remain a bull on commodities. I am not sure whether it is soothing that I am starting to have a lot of company from fast money, as this story from Bloomberg ("Hedge Funds Buy Corn to Silver to Soy as Commodities Tumble") demonstrates.

Precious Metals continue to rally, joined today by Crude, Grains, and Livestock. Bonds sagged a bit, but at 2.11% the 10-year is no bargain. Ten-year real yields remain at zero (actually +0.02%). These are eventually good sales, but it's hard to pick a place to sell especially with September - a great seasonal month for bonds - hard upon us. I would buy puts but vols are too high. I will try to probe from the short side from time to time and try not lose too much in the updrafts.

Tomorrow, the only data is New Home Sales, which will be abysmal even if the most-optimistic forecasts are accurate. Anything related to housing these days is abysmal. 310k is the forecast; wake me when it gets over 400k.


[1] Personally, I keep an eye on Abby Cohen at Goldman Sachs. She recently stressed on CNBC the importance of taking a longer-term view of "months and quarters, if not longer." I don't know what her current forecast is - I don't think she's allowed to make one any more - but I do know that in December 1999 she was predicting 1525 for year-end 2000 and 1650 for year-end 2001. So she knows a thing or two about 'longer-term views.' The S&P never even sniffed the latter level. Cohen is part of a cohort of perma-bull strategists that believe stocks should go up unless something bad is happening, right this second.



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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