By Lance Roberts, STA Wealth
This past week I wrote two articles discussing Shiller’s CAPE ratio (see here and here) and why valuations are still an important metric when it comes to making long term investments. However, during the research process of writing that article I could not help but notice the extreme amount of optimism about the financial markets. Despite weak economic data and geopolitical intrigue the complacency and “bullishness” are at extreme levels.
My Californian money manager friend sent me the following note yesterday from Wolf Richter:
“And so we have a series of geniuses: Greenspan who said that the very concept of a national housing bubble in the US was impossible just as the national housing bubble was inflating to monstrous proportions; Bernanke who said that the consequences of sub-prime lending were ‘contained’ just as the consequences of subprime lending were eating up the banks from the inside out; and Yellen who now told us that complacency is nothing to worry about.
So we sally deeper into the Yellen era, which is the same as the Bernanke era, in that the Fed – and other central banks, for that matter – is the only thing worth looking at. Central banks rule. Practically nothing else matters. Metrics and ratios are just for decoration. Markets as a means of price discovery no longer exist.”
Wolf is correct, the markets have now come to believe that the Federal Reserve is the omnipotent controller of the financial markets. Such beliefs have always ended badly. This is why I discussed one of the biggest traps that investors fall into during times like these, “Confirmation Bias:”
“As human beings, we hate being told that we are wrong, so we tend to seek out sources that tell us we are ‘right.'”
This week’s “Things To Ponder” is dedicated to things that “market bulls” should consider to keep from falling prey to the psychological biases that lead to poor investment returns over time.
1) Who Is Selling Stocks? by Sigmund via SigmundHolmes.com
“According to Reuters, 1st quarter share weighted earnings amounted to $258.8 billion. So companies in the S&P 500 spent 93% of their earnings on buybacks and dividends. It’s been all the rage in this cycle to look at “shareholder yield” which is a combination of buybacks and dividends, something I find too clever by half considering the past track record of management led buybacks. But if you think that is a useful metric, you have to ask yourself, is a 93% payout ratio sustainable? I guess we do have the answer to one question though. We know why capital spending has been so punk.”
2) BuyBacks Grow 50% YoY – Near Pre-Recession Highs via FactSet
“Aggregate share buybacks for the S&P 500 grew 50% in Q1 to $154.2 billion, and amounted to the third largest quarterly total since 2005. The biggest contributor to the Q1 total was Apple’s record $18.6 billion in repurchases, but IBM also had an uncharacteristically active quarter with $8.3 billion in buybacks. In addition, five of the top ten companies by dollar-value buybacks in Q1 are traditionally not big spenders, and each spent more money on buybacks in Q1 than in any quarter in at least ten years.”
“But the increase in buybacks has outpaced cash inflows for the highest growth sectors. The Materials sector spent 195.5% of adjusted free cash flows on share repurchases in the trailing twelve months ending Q1. This compares to a median of 82.9%. In addition, the Information Technology and Industrials sectors are also significantly above their median (83.7% versus 68.7%, and 104.6% versus 79.4%).”
3) Volatility Is Disconnected From Fundamentals by JP Morgan via ZeroHedge
To further understand the current low volatility levels and compare it to the 2004-2007 time period, we looked at levels of market activity and structural drivers of volatility. Firstly, there is much less trading activity now as compared to the 2004-2007 time period. [The data] shows a nearly 50% decline of equity share volumes since 2007. Volume and volatility are highly correlated. Volatility and volumes are linked by a positive feedback loop (lower volumes lead to lower volatility and vice versa).
In summary, we see the current market environment as different from 2004-2007. Volatility appears to be too low and disconnected from fundamentals.However, the low yield environment and support from central banks is currently keeping volatility low not just in equities but across asset classes.
Additionally, equity volatility has been held down by low trading activity and option hedging pressure. As we will discuss below, some of the option-related pressure on volatility will abate after the June expiry, which could result in higher realized volatility.
READ ALSO: It’s Not The VIX That’s Vexing The Market by Michael Kahn via Barron’s
“I won’t debate whether indicators measuring investor sentiment are different from those measuring professional sentiment. But from what I see in many sentiment gauges, the weight of the evidence leans toward the market being too sanguine for its own good right now.
Jason Goepfert, who runs the SentimenTrader.com Website, offered a third view, saying that the low levels of volatility expectations across asset classes have forced traders to make bolder bets.
It is the same concept. Traders and investors are taking risks without worrying about the consequences. That should be a warning for everyone.”
4) Food Stamp Usage Is Cratering by Cullen Roche via Pragmatic Capitalist
The rate of participation in the food stamps program has now declined on a year over year basis for six straight months. And the cost of benefits has declined at a near double-digit pace for each of the last 5 months. After reaching peak participation of 47.6 million last August the number of participants has declined to 46.1 million.
This might seem like good news, but it’s more likely a sign of a late cycle recovery trend. You see, food stamps are a countercyclical event. They’re part of what economists refer to as ‘automatic stabilizers’. That is, when corporations fire employees they often sign up for government benefits so they can try to make ends meet while they look for work. And those benefits are most in demand when the economy is at its worst. So programs like food stamps ‘automatically’ kick into high gear when the economy goes into recession. You can see this clearly in the following chart:”
“The fact that this trend is now sharply improving means that the economy is on the mend. But it also means that the economy is late in the cycle of expansion. And so what looks like a positive trend could actually be a sign of something negative developing.”
5) Does The Fed Really Know What Time It Is? by Vince Foster via MinyanVille
“Fed officials keep talking about when they will raise rates, and media focus is on whether it will be sooner than the market expects. More significant questions are not being discussed.
JPMorgan CFO Marianne Lake outlined the exit process the bank was preparing for, raising some risk management hurdles…
‘In terms of sequencing, what we expect is that the Fed will seize asset purchases by the end of this year. The likely next step would be to drain liquidity from the systems, potentially as much as $1 trillion or so using the reverse repo facility with non-banks. This is likely to happen over a short period of time, maybe a quarter or two and probably in the second or maybe in the second-half of 2015. After which the Fed funds rate will start to raise and lastly reinvestment in order to shrink the remaining balance sheet, but over time.
The second important assumption we’re making is that as rates continue to normalize over time, we’re all likely to also see a migration of stickier high quality retail deposits in favor of more attractive rates in money funds. We think ultimately those deposits will likely find their way back to bank balance sheet in the form of wholesale deposits, which of course is very important particularly in light of regulatory liquidity standards, when notably, if you take a retail deposit that has a low outflow assumptions and ultimately replaced with a wholesale deposit that has a high outflow assumption, it could substantially reduce your liquidity…”
Think about that last bit for a minute. The Federal Reserve will drain liquidity from the system at the same time they begin to raise the overnight lending rateswhile looking for rates “normalize” at higher levels. Considering that the markets have been primarily advancing on the back of continued flows of liquidity from the Federal Reserve combined with artificially suppressed interest rates; what do you think the impact on the financial markets will be? The chart below shows the history of the Fed’s ability to control the economy.
“Success breeds complacency. Complacency breeds failure. Only the paranoid survive.” – Andy Grove