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ContraryInvestor

ContraryInvestor

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20…

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It Don't Mean A Thing If You Ain't Got That Swing

You've heard the old saying that no two financial market periods are ever exactly alike, but they do "rhyme". Of course this characterizes the fact that human decision making is repetitive over time; hence there are certain rhythmic similarities in historic financial market outcomes. Financial market outcomes that are necessarily dependent on human decision making. One exercise we believe is important in each market cycle is to get a feel for individual cycle rhythm and drivers of that rhythm. As an example, clearly in the current economic and financial market cycle US and global central banker intervention has punctuated directional rhythm of markets throughout. If the following chart does not exemplify this, we don't know what does.

SPX With QE I, II and III

Has the rhythm of the financial market mimicked the rhythm of monetary policy application and withdrawal? Almost like clockwork. We inserted the red bars to make a point. At least so far, each round of US Fed money printing (quantitative easing) has had a very positive impact on stock prices, but with diminishing duration of positive impact at each money printing interval. The latest Fed balance sheet expansion experiment that is the current dollar swap arrangement with the European Central Bank (ECB) is now only two months old. The ECB's balance sheet expansion action that is the LTRO (Long Term Refinancing Operation) is now a month old. How long the recent reflationary actions by the US and European Central Banks will positively impact equities remains to be seen. A potential truncated positive impact on equities in the next few months would strongly suggest these interventions are simply no longer packing the punch originally seen early in this cycle, but we're not there yet so stay tuned. Certainly central bank actions have shaped the rhythm of financial markets. A fingerprint of the current cycle.

But so too have central banker monetary interventions influenced the rhythm of the real economy. The Economic Cycle and Research Institute's weekly leading economic indicator index can be seen below with like markings of central banker application and withdrawal of money printing stimulus. Clear enough as to rhythm?

ECRI WLI

We've heard it said by a pundit or two in this cycle that "there are no more free markets, just interventions". Pretty easy to understand why someone would characterize the prior three years as such, no? In quick summation, undoubtedly one of the key drivers of both financial market and economic rhythm in the current cycle has been global central banker monetary interventions. The message is more than clear and we incorporate this reality into our own decision making.

Personally, we believe another very important rhythmic character point of the current cycle has been the ebb and flow in shorter term investor focus at any point in time between secular (long term and big picture) issues of importance and interim cyclical (shorter term business cycle) acceleration or deceleration in economic statistics and reported corporate earnings. Let us explain.

It's an understatement to suggest that in 2011 financial markets exhibited above average volatility. As you may know, the S&P began 2011 at 1257 and wildly enough ended the year right there at 1257 - neither up nor down even one point for the year. But if one were to look at the total points traveled by the S&P each and every day during 2011 (simply the high price minus the low price), the S&P "traveled" a total of over 5,000 points last year to go....absolutely nowhere! But wait one minute; in 2011 the Fed was printing money, and lots of it. In addition they initiated Operation Twist that was indeed effective in bringing down longer term interest rates. Corporate earnings continued to be strong, ending the year at a record level. Nominal macro economic growth continued, albeit at a slower growth rate than was seen in late 2009 and early 2010. Shorter term cyclical character points were positive last year, but investor decision making over the entirety of the year was dominated by secular issues and concerns. Specifically the secular issues of debt and deleveraging, in 2011 relating largely to Europe.

As always, it's "news" at the margin that most heavily influences near term investor decision making and subsequent market outcomes. After very good equity market performance in 2009 and 2010, investors were fully aware of good corporate earnings and had priced in that very fact. That was not new news in 2011. Investors knew full well that monetary actions helped support equity prices, especially after what they had "learned" in 2009 and 2010. But what was new news at the margin last year was the significant deterioration in European credit markets as well as Euro banking system fundamentals. Secular issues dominated the "new news" investors had to subsume into price, so shorter term cyclical considerations despite being positive took a back seat as a driver of market rhythm.

Fast forward to the here and now current month and what do we find? After a softer tone to macro economic growth and leading economic indicators in the summer and fall of last year, investors are now currently reacting to changed "new news" at the margin - a better near term tone to recent economic stats. The deterioration in Euro credit markets that dominated 2011 headlines is now "old news". (Personally we'd characterize it as "older" news given that the Euro credit market reconciliation drama is still playing out act one.) As we've written about in the past, we think Francois Trahan's recent strategic comments are correct. In a zero bound world (short term interest rates set at zero), it's the short term change in business input costs that drive the very near term rhythm of the economy with a lag. Let us give you a real world example.

One of the key divergences in the current economic cycle relative to historical precedent has been that small businesses have not participated in the recovery. Small business optimism has remained below historic recession lows over the entirety of the current cycle so far. But in recent months we've now seen a few rays of sunlight as small business optimism and sales expectations have increased. Optimism is not yet at new highs for the current cycle, but very close. Have a look at the rhythm of small business optimism set against the rhythm of business input costs characterized by the CRB Index (Commodity Research Bureau Index).

NFIB Optimism Index

The rhythm appears clear. Small business optimism has levitated after a period of declining prices (the blue bars in the chart). In like manner optimism has declined after a period of rising costs has been seen (the red bars). Again, in a zero rate environment, it's the short term rate of change in business input costs that acts as the Fed Funds rate would have acted and influenced the economy in prior cycles.

So it appears we have two rhythmic forces at work here in the current market cycle. First is the rhythm of central bank monetary interventions (money printing) and how these interventions have influenced both financial markets and the real economy. The second "force", if you will, is the ebb and flow of investor focus in decision making between the secular issues of importance (debt and deleveraging) and the cyclical (the short term firming or softening in economic tone). These two forces have necessarily collided at times in the current cycle. Right here and right now we have a bit of a collision in that an incrementally better tone to economic stats is now occurring at the exact time the Fed Dollar Swap program and ECB LTRO program have been implemented that have acted to enhance overall market liquidity. A better tone to economic stats accompanied by central bank monetary expansion characterizes quite the sweet spot of the moment. But by definition sweet spots are temporary. They are short term. We'll enjoy and participate for now, but know that an investor refocus on unfinished secular problems again lies ahead. It don't mean a thing if you ain't got that swing (in focus)? If we can correctly identify the key driver(s) of market rhythm in any cycle, our job is to then anticipate change in those drivers.

As a final comment reflective of trying to anticipate change in key rhythmic drivers of the financial markets, there is very much a circular irony to the relationship between central bank actions, business input costs, and the short term acceleration or deceleration in macro economic tone - all of this influencing investor time frame focus at any point in time. That irony is embodied in the chart below.

CRB

Have US Fed monetary actions of QE I and QE II influenced commodity prices (business input costs)? The above three year history of the current cycle would suggest as much. To the extent that Fed and global central bank monetary easing causes commodity price speculation and investor actions to bid up hard assets such as oil (all in an effort to seek purchasing power protection against currency debasement that is money printing), monetary policy in effect sows the seeds of the next cyclical softening in the economy as businesses and consumers will ultimately react to higher input costs negatively with a bit of lag time. This would be the reverse of the sweet spot in which we currently find ourselves. This is the model of the current macro deleveraging environment under which we are working. It's all about being aware of and incorporating into decision making the ebb and flow of central banker actions set against the rhythmic shorter term swing of investor focus between unresolved secular issues of importance and the ongoing "new news" of acceleration or deceleration in near term cyclical economic fundamentals.

Before ending this discussion, a very quick look at what necessarily is the tension between the secular and the cyclical, all embodied in the fourth quarter GDP report just released. As mentioned, recently investors have been positively reacting to improved new news about the US economy. Investors have been focusing on the near term cyclical "trees" for now as opposed the longer term secular "forest" of issues that remain unreconciled. Ultimately a refocus on the secular will occur, but it's all part of the rhythmic dance of human emotion and decision making. So, for all the recent high fiving about a new upturn in the economy, time for a very quick reminder about the forest. Certainly one dampener to investor expectations was the fact that the inventory build in 4Q was large, accounting for 2/3rd's of the headline GDP growth number. Inventories are not sales, but anticipation of sales, yet they are additive to the GDP calculation. We believe the much more important message about the secular is what you see below.

US Nominal GDP

To the point, the year over year change in nominal GDP for 2011 reported just last week was the lowest annual nominal GDP growth rate seen in almost 65 years during a non-recessionary period for the US. Of course this is coming while we're two and one half years into supposed economic recovery. The secular message of slow growth is glaring. Moreover, since the official economic recovery began, the US economy has not managed to achieve even one quarter of real growth above 3.9%, and this has occurred with the aid of historically unprecedented monetary and fiscal policy. You can see in the chart below that in no economic recovery on record has the economy failed to print 4%+ real growth rates during the up cycle...except this one. The last six quarters have all slowed to real growth rates below 3%.

US GDP Qtr/Qtr

The secular view suggests a very slow growth environment, but for now we've experienced a bit of short term acceleration within that very slow growth environment that has brightened nearer term investor sentiment. For now. Macro deleveraging environments are about healing and time. They are about ebb and flow. They are anything but linear in their reconciliatory journey. So too do we orient our decision making to this ebb and flow rhythm? At least so far in the current cycle, it don't mean a thing if you ain't got that swing. After all, isn't that exactly what the S&P's 5000+ point trip to nowhere last year telling us?

 

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