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Trading The Fiscal Cliff

It was perfectly predictable! As soon as the election was over, all the media coverage would be on the US Fiscal Cliff. Why it wasn't even raised by either party during the election campaigns or dragged into the coverage by the media is another discussion. The same reasons it was put off untill after the election, not discussed during the election, are the same excuses that make how it will be resolved, also perfectly predictable.

Both parties will reach an agreement to effectively "Kick the Can Down the Road". Yes, there will be some compromises to give the impression of serious deliberations, but nothing more than 'headlines' for the media and the semi interested public. The soon to be heralded compromises such as not increasing taxes for the rich and not cutting entitlement programs for the growing masses of Americans dependent on transfer payments will be justified by vague reference to closing tax loop holes, agreeing to bipartisan studies on entitlements and closer cooperation. Translation: Do Nothing!

The problem that most have been carefully distracted from, is why the Fiscal Cliff was crafted in the first place. Some will recall the earlier crisis, that without immediate and dramatic financial actions by congress, the US was about to have its credit rating lowered significantly by the credit rating agencies. The politicos were forced to craft these commitments, to buy time and yet not be responsible for the unpopular actions prior to an election. Lower credit rating have traditionally meant higher cost of government financing. Often the death blow to a bloated deficit ridden economy.

So it actually isn't about the Fiscal Cliff, since we already know the outcome. The issue is an almost guaranteed lowering of the US Credit Rating.

What needs to be fully appreciated is that the US dollar as the world's reserve currency is based on it being considered RISK-FREE. As a matter of standard financial practice, all financial risk is assessed and priced off of the spreads against the risk free US Treasury instruments.

Clearly the US$ and US Treasuries are no longer RISK FREE. The fact that the Fiscal Cliff will be 'kicked down the road' without serious changes to protect investors and the risk free status of US government securities, is an official acknowledgement that the US has no intentions of seriously living up to the both the burden and responsibility and of being the global reserve currency.

What effectively is occurring is the US is becoming a counterfeiter of RISK FREE ASSETS and expecting the rest of the world to accept them and price assets based on them.

What is a Trader To Do?

It is important for traders to appreciate the significance of this. It means that the equity risk premium used for valuations is no longer valid. The long accepted "Fed Valuation Model" has broken down.

The market, as a forward looking entity, has already began to price this into stock prices. PE ratios are now compressing after having been artificially expanded due to the expectations of QE III and further central bank liquidity expansion.

To clearly show what is happening we first need to consider how investment regimes as defined by the PE Ratio have behaved since the mid-1960s. Below is a representative study by UBS.

The Disco Regime (1965-80). During the 70s, inflation was the key driver of stock multiples, given that prices were not only rising sharply, but also in a volatile manner.

In the 1970s, inflation was the primary driver of stock valuations...

Falling inflation since the late '70s has made CPI less important to valuations...

The Great Moderation (1981-99). After Chairman Volker broke inflation, the economy entered an 18-year period of solid, less volatile growth, accompanied by falling interest rates. In this environment, investors could focus on a nominal cost of capital (the Fed model) to value stocks.

During the "Great Moderation", the "Fed Model" explained returns...

Since 2000, the Fed Model has broken down...

The Hangover Regime (2004-09). In the aftermath of the TMT bubble, risk became a much more important driver of multiples, with investors using a full cost of capital to value stocks. During this period, stock multiples were closely tethered to investment grade (Baa) yields.

From 2004-09, P/E's anchored on investment grade (Baa) bond yields... This relationship has come unglued since '09...

Hangover Part II (2010-12). Over the past two years, the key metric for valuing stocks has shifted from investment grade to non-investment grade yields.

Given the fiscal situation in both the U.S. and Europe, this regime will likely persist until structural imbalances are meaningfully addressed by policymakers. Don't hold your breath on that happening without a full blown crisis.

The fact that valuations are now following those of Non-Investment grade credit is a sign of serious problems ahead.

Progression To High Yield (HY)

The following report by Citi sheds further light on what is going on.

Much is made of the 'apparent' bubble in Treasury bonds - a 30-year or so relatively consistent trend in government bonds (through thick and thin) and yet allocations remain minimal compared to our increasingly similar Japanese friends have experienced. It would seem to us, thanks to Bernanke's 'visible' hand that the real bubble is in spread product - as rates are so compressed, investors seemingly oblivious to the word 'risk' (unintended consequence) have flooded into ever-increasing yield/spread products - with high-yield bonds now dominated by these technical inflows (as we noted in the close today). If ever the combination of anchoring bias, 'dance while the music is playing', and herding was evident, it is in corporate credit. To wit, the total disengagement from reality (both real 'micro' earnings and 'macro' economic uncertainty) that a flood of money has created in this increasingly crowded (and increasingly illiquid) market. Managers are well aware that the liquidity tsunami has moved the maturity mountain (as Citi's Matt King notes) but has helped the weeds as well as the roses.

The front-running risk-averse yield-seeking flood of money into corporate bonds has technically crushed spreads...

But it has reached epic proportions of disconnection in recent quarters as 'micro' earnings have missed expectations (inverted on scale below - presented as distance from pre-season

expectations we have had 5 quarters in a row of misses) but spreads continue to compress...

and given the massive (almost unprecedented) levels of 'macro' policy uncertainty, the flow of safe-haven-but-yield-chasing cash has broken the link between the reality of risk and the pricing of risk...

and has therefore removed signaling-effects from this critical market. More importantly, the wall of liquidity that has been squeezed into a relatively small market has lifted all boats and enabled the entire maturity structure of corporate debt to be kicked down the road - unfortunately enabling the dead to live 'unproductively' far longer than they ever should - necessarily dragging mal-investment in at every turn...

So this leaves corporate bond managers 'dancing while the music plays' yet fully aware that the market simply cannot bear the type of exit that will occur should reality ever seep back into the market's pricing (say by a fiscal shock?). As Dory would say "Just keep swimming..." as Bernanke has interfered with nature...

The markets are sending a clear signal to Washington that something of real substance must soon occur as risk is being completely mispriced as easy money flows to anything resembling yield and the unintended consequences of this.

Trailing PE: Shorter Term

Trailing PE versus Forward PE versus CAPE versus Real Inflation Adjusted PE10 versus .....

or when PEs aren't PEs.

Some outright hucksters still use the trick of comparing current P/E's based on "forecast" "operating" earnings with historical average P/E's based on total trailing earnings.

There is an unquestioned hope in central bank liquidity injections boasting the markets. Expectations are that earnings will still be OK and PEs will consequently expand further. The thinking on the street is that though Q3 earnings will likely be minus 1.9%, and Q4 earnings is being brought down from 15% to 10.2%, it still gives a 4.0% growth for 2012. That is higher than real GDP growth and suggests to them, PE's will expand, especially with the 2013 forecast at 11.8%. To some analysts it is a time to remain bullish. Unfortunately all that is priced in, along with a resolution to the year beginning US Fiscal Cliff. What is not priced in is the magnitude of the global slowdown, which simply won't allow for further PE expansion.

The PE Compression Shell Game

PE's are above average but trending lower. This is a sign of a Bear Market.

This Trend has been in place since 2000 when we believe the secular bear market, if viewed in real terms, began.

Secular Bear Markets have Cyclical Bull markets within them which are not only evident by rising stock prices but also by rising PE ratios.

If stock prices rise and earnings lag then the PE signals that stocks are expensive relative to their earning power and other yields.

As simple as this sounds, it isn't! One reason is PE ratios can be calculated MANY different ways to prove any number of inconsistent views of valuations.

When PE's for example are 20, it means the for every dollar a stock earns it costs you 20 dollars to buy those earning capabilities. The yield therefore being 1/20 or 5%

The rule of 20 has been a good rule for stocks because bond yields as a competing asset class have approximated those yields over time. Therefore money would flow from the stock market to the bond market and vice versa.

The Rule of 20

The rule of 20 is based on the old rule of 18-22 that said a fair valuation PE multiple range for the market could be calculated by subtracting the expected inflation rate from 18 and 22 to come up with this PE range. Simplified, the rule of 20 takes the mid value between 18 and 22 (20) and subtracts the yield on the 10 year T-Note. The yield on the 10 year treasury is 2/3 to 3/4 determined by the market's expectations for inflation, making this a historically good proxy for inflation. The resulting plot serves as a valuation floor for the market. Over the last 25+ years, the forward PE on the market has closely tracked this plot and rarely trades below this multiple. Those instances that it has traded very far above this Rule of 20 multiple have proven to be good indications that the market was overvalued.

Fed Model

But what happens when competing yields from the bond market are held artificially low, for protracted periods and are then ASSURED to stay low for a SPECIFIC period of time, by the Federal Reserve?

Things then get interesting. They also get confusing, and with confusion we get mispricing of risk.

Remember, the Federal Reserve in its desperate attempt to restart the economy is trying to ensure asset prices remain elevated, as a fall in collateral values is a dangerous thing when deleveraging and deflation is a prime threat within a secular bear market.

Historically High Earnings: Peak Earnings?

You can only lay off workers for profit for so long!

Historically High PE: Peak PE?

There is little doubt that asset prices have responded to Central Bank promises and actions. Even as bottom-up fundamentals are fading, top-down index 'nominal prices' rise on the back of magical multiple expansion - which is defended from on high by sell-side strategists the world over on the back of 'recovery' is just around the corner. The trouble is there's a limit and it seems - from QE2 and LTRO - that we are rapidly approaching that limit; and with earnings outlooks being revised lower, perhaps we are at peak P/E for this cycle of QE?

Each line is the normalized gain in P/E from the onset of expectations for Central Bank largesse: (QE2 - green; LTRO - red; QEtc. - Orange).

Forcing Investors to Take on 'Mispriced' Risk

Why aren't such strong earnings growth being reflected in the 60/40?


The Monetary Mavens are manipulating markets metrics in such a fashion as to intentionally Misprice, Misrepresent & Hide RISK.

Prior PE reference boundary conditions which reflected risk have decoupled.

Never has the game of forward operating earnings (versus historically trailing earnings) been more inappropriate than presently. Forward PE's can only be of value in rapid revenue and profit growth eras. This is not what we have presently. It is the wrong tool for the wrong job! Unless you are a sell side analyst, then it is exactly the right too for the difficult selling job you have.

We have an era of Peak earnings growth RATES, slowing profit growth RATES, Peak PEs which are reflective of rapidly contracting PE's.

We have a secular bear market in REAL terms but PE's are not contracting at a sufficient enough rate to reflect this. Though PEs in nominal terms net out inflation, they don't reflect the underlying downward trend in real terms.

The equity premium is significantly distorted as in fact the US Treasury is NO LONGER AAA "risk free". In the Macro Analytic section of our web site I discuss the Triffin Paradox specifically.

"To supply the world's risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners, until the risk-free asset that it issues ceases to be risk free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened."

ARTICLE: Gold & Triffin's Dilemma
Joe Yasinksi and Dan Flynn of GBI (October 5, 2012)

Traders Need To Be Aware

Trailing, Cyclically Adjusted PE's Are Headed Lower as they Continue to Trend with Higher Yield (HY) Risk

"Profits are an opinion of the moment; cash is a fact."

~The Wizard

"Nobody ever lost money taking a profit."

~ Bernard Baruch

Chart: Bloomberg


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