Tempestuous Times

By: Michael Ashton | Mon, Aug 27, 2012
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At last, we are in the home stretch of August. This month has been excruciating by any measure - even by the measure of normal Augusts. Heck, even by the standard of normal Decembers; right now, New York exchange volume is on pace to be 15% less in August than on the slowest December in the last decade-plus.

That's remarkable, but I remain unsure of the significance of this lull. We are plainly in the midst of a secular decline in trading volumes, and at least some of that is healthy since there was probably too much of the frenetic, momentum-type trading that adds to swing amplitudes. The flip side, though, is that some of the decline in volumes reflects a decline in market-making activities, which are typically 'speculative' in that they are short-term in nature but nonetheless add liquidity and decrease swing amplitudes. Again, I don't have a clear answer to this.

It is tempting to say that it represents part of what Bill Gross means when he says "the cult of equity is dying." Maybe it does, but I don't see a lot of evidence that the cult of equity is dying. The average pension fund today has maybe 50% stocks rather than 60% stocks, most 401(k) accounts don't offer commodity funds or inflation-linked bond funds but instead 12 flavors of equity funds, and Jim Cramer is still on the air.

Still, faith in "the system" is indeed at an ebb that hasn't been seen since my lifetime, anyway. Perhaps in the 1970s the counterculture lost faith in America, but the majority still believed that working hard resulted in a person getting ahead, and that one's children were likely to enjoy a higher standard of living than one's self. Most of us would still like to believe this, but at least one party believes strongly that these days you can't get ahead without a hand up, and members of both parties (and every sentient being) knows that the entitlements currently promised virtually assure that our young are being yoked to the Medicare plow. And yet, stocks trade above a 20 Shiller multiple and 30-year bonds sport a 2.80% yield!

Tempestuous times tend to produce momentous change.

We remain in tempestuous times, although we heard nary a peep from Europe this month. The global economic system is creaking again. On Friday, Durable Goods was much weaker than expected, with core durable orders -0.4% and revised downward by -1.1% to the prior month (from -1.1% to -2.2%). That produces the lowest year/year growth in core Durables since early 2010. As the Fed pointed out in their minutes, the U.S. economy is not ready to take another punch, and another punch may well be coming from Europe in the next few months.

It is therefore not surprising that presumptive Republican nominee Mitt Romney says that if he is elected, he would not re-appoint Ben Bernanke to be Fed Chairman when his term ends in a year and a half (January 31, 2014). In good times, candidates want to bestow laurels on the Fed Chairman (such as when Arizona senator McCain in a 1999 debate said that if Chairman Greenspan were to die in office, 'I would do like they did in the movie Weekend at Bernie's. I'd prop him up and put a pair of dark glasses on him and keep him as long as I could'), whatever his merits.

It is also not surprising, in times like this, that a political party (again, the Republicans) would consider a platform plank calling for a full audit of the Federal Reserve as well as one calling for a commission to study a return to the gold standard. These are momentous proposals! Change is a good thing, but in times like these we must always be careful of deploying change for change's sake. I don't think any of those proposals would threaten the republic, but going back to a gold standard would be too much in my opinion.

I don't think a commodity or gold standard is necessary, if the central bank is run correctly, and in fact such a linkage could create rigidities that prevent some of the automatic stabilizers in the macroeconomy from working correctly. But it comes down to a question of whether central bankers can be trusted to do what they can, and to understand what they cannot do, and to eschew what they can, but should not do. Organizationally, I am not sure any groupthink body can manage something as complex as the U.S. macroeconomy, to say nothing of the world economy.

So what's the alternative? 'Ending the Fed' and returning to a gold standard is one solution, but it sort of throws the baby out with the bathwater. Paul Ryan's proposal in 2008 to limit the Fed's mandate to only inflation, rather than the impossible dual mandate, would be significant progress (and is unlikely to happen). Failing that tweak, I still think the Federal Reserve can be more effective than it has been through the last two Chairmanships. The middle road between a gold standard and a continuation of business-as-usual - which would have, incidentally, completely opposite implications for inflation - is to appoint a better Chairman. A person who has a steady hand, a healthy respect for the difference between data and facts (data are just estimates of facts, not the same thing), and a healthy respect for the difficulty of certainty. A person who (as I say in my book) recognizes that the person running the Fed is in a short-options position, and therefore should focus on doing only the things which clearly must be done. A person who won't tinker.

Now, we're unlikely to get such a thing, because the prevailing wisdom is that the central banks should do everything they can. They should be in continuous motion, balancing and re-balancing, optimizing and re-optimizing. Choosing between that on one hand, or a gold standard on the other, is a much harder choice.


Speaking of commodities, the market seems to believe that we're more likely to keep our activist central banks than to get a gold standard, and hence more likely to get inflationary rather than disinflationary/deflationary outcomes. The chart below shows the current technical condition of the DJ-UBS commodity index. As regular readers know, I don't spend a lot of time looking at technical analysis; I do, however, think it can be useful in testing hypotheses and in 'taking the temperature' of the investing public.

The DJ-UBS chart shows a break higher from a base on the last day of June, followed by a consolidation in early July that produced a second breakout and a longer consolidation band. This second plateau, covering late July through mid-August, seems to be resolving higher as well although without the sharpness of the prior thrusts. But the crucial test is whether the index can remain above 145 here and extend higher.

The evolution of Tropical Storm Isaac may help. While so far all the storm has done has been to cancel one day of the Republican convention, it is moving into the Gulf of Mexico and generating the possibility of disrupting gas and oil production there. It is not expected to strengthen above Category 2, so this isn't going to have the monstrous effect of Katrina, but it won't hurt the technical situation of the commodity indices any.

So what do these tempestuous times and momentous changes mean for markets? At the moment, they mean little, because the momentous changes are unlikely to happen if the current Administration wins a second term. But for the first time in a very long time, the two parties are offering very different views of America and very different plans; and that means that for the first time in a while, it actually may matter to the markets which party actually rules once the votes are counted. At present, polls have the Presidential race very tight, but with the Republicans favored to pick up some seats in the Senate and to retain control of the House. There is a chance, although still odds-off, that the Republicans gain control of both houses of the legislature and the executive branch as well. The difference in the policy portfolio in that circumstance, compared to the status quo or one in which the Democrats seize control of the House of Representatives as part of a general electoral landslide (this is much less likely than the reverse, since the House is the body that is most skewed at the moment - towards Republicans), is huge.

Is a Republican sweep good for bonds, since the fiscally conservative credentials (if taken at face value) would imply lower future debt issuance, or bad for bonds, because a President Romney would make QE3 less likely? This isn't entirely clear to me, but more volatility and consequently more volume seem likely, as more focus turns to these polls over the next month or two. This election will matter to markets.



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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