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Uncertainty Is Good For The Stock Market

Uncertainty Is Good For The Stock Market

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

Here’s an interesting question: Is the Trump administration’s erratic policy and governing style bullish or bearish for stocks?

Lately, I’ve read a number of analyst notes talking about how the current political uncertainty spells trouble for the stock market. They all include the line “…if there’s one thing markets don’t like, it’s uncertainty about the future.” I think that’s lame thinking.

I would argue that this “uncertainty” is bullish for equities, at least over the short-term.

I say this because this “uncertainty” is feeding into the Fed’s rake hiking decisions. Remember the hawkish tone coming from Fed members back in December? That seems to have been reversed since Trump took office and started significantly shaking things up. Fed members have cited the uncertainty over future fiscal policy as a key reason to err on the side of caution in raising rates.

FOMC member, Neel Kashkari, wrote a post this week explaining his reasoning for voting to keep rates steady at last month’s meeting. The whole post is worth reading (link here). but here’s Kashkari’s concluding remarks:

We are still coming up somewhat short on our inflation mandate, and we may not have yet reached maximum employment. Inflation expectations remain well-anchored. Monetary policy is currently somewhat accommodative. There don’t appear to be urgent financial stability risks at the moment. There is great uncertainty about the fiscal outlook. The global environment seems to have a fairly typical level of risk (though that can change quickly). From a risk management perspective, we have stronger tools to deal with high inflation than low inflation. Looking at all this together led me to vote to keep rates steady.

Fed President James Bullard, also cited fiscal uncertainty in a speech he gave this week saying “It is unlikely that fiscal uncertainty will be meaningfully resolved by the March meeting… We don’t have to move. We have a lot of fiscal uncertainty. Why not wait until that is more clearly resolved?”

So Trump’s unconventional governing style is creating uncertainty over the future which is making the Fed step back from its rate hiking path. This is supportive of equity prices over the short-term. The breakouts this past week in many of the indexes seem to confirm this.

This creates the unusual situation where a more steady governance and a clearer picture of future fiscal policy would likely lead to faster rate hikes and thus be a net-negative for markets.  

The Fed conducts a Senior Loan Officer (SLO) Report every quarter. In this report they survey roughly 60 large commercial banks and up to 24 large foreign banks with branches in the US. The survey is intended to provide a quarterly update on credit availability and demand as well as developments in lending standards. It’s a good barometer of the overall credit market and provides us useful insight into how the credit cycle is developing. Read more

SKEW Index Has Trended Straight Upward

Low Volatility Begets Low Volatility. Here’s Why…

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

The trading community has been yapping away about the VIX trading sub-11 and the extreme number of speculative shorts involved. They’re saying it’s gotta burst higher.

Their proclamations are presented with a chart like the one below which measures net nominal non-commercial positioning.

VIX Future Positioning

But these positioning charts are misleading. They fail to account for the growth in open interest. The VIX futures in particular become heavily distorted because open interest and volumes have increased 10x since they first started trading in 2004.

VIX Future Open Interest

Net nominal numbers therefore mean nothing. Yes, the total amount of net shorts is higher than it’s ever been, but that’s because more people are trading VIX futures than ever before.

It’s easier to see why this is true with a simplified example.

Say they’re 100 open contracts and specs are short 99 contracts. Well obviously that’s a crowded trade. If the specs race to cover, price will squeeze hard. Specs are short 99% of the open interest.

Now let’s say activity grows and there’s 1,000 open contracts. Of these, specs are short 600, or 60% of the open interest. Compared to the prior reading, net short 600 looks a lot bigger than net short 99. But in reality the first situation has a more concentrated spec position. Participants previously were short 99% of open interest instead of 60% of open interest now.

That’s why you need to make sure you’re accounting for open interest.

We know a number of you visit freeCOTdata.com to look at positioning. We emailed the site owner Adam to ask if he was accounting for changes in open interest or not. As of now he is not accounting for them. But he’s rolling out an update soon to reflect the changes. After that update, the charts should give us a better idea of whether or not we’re at a true speculative extreme.

It’s worth noting that even without the update the 5-year percentile in VIX futures is not at an extreme. All the fuss on twitter was for nothing…

Futures Is Not At An Extreme

Given that positioning isn’t at an extreme (money managers are way too afraid to short vol in the Trump era), we’re in agreement with Goldman on what these low VIX readings mean. The data shows that low vol begets low vol, not high vol. Goldman conducted a study going back to 1990 to find out what happens to VIX and the market after VIX crosses below 11. The specifics of the study are shown below: Read more

Why Equities Are NOT Overvalued

Why Equities Are NOT Overvalued: The Relative Risk-Premium Spread

The following is an excerpt from our monthly Macro Intelligence Report (MIR). If you’re interested in learning more about the MIR, click here.

Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one–common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.

How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms. In my view, it is only a matter of time before today’s yield pigs are led to the slaughter house. The shares of good companies and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today’s investment-grade issues will be downgraded to junk status if the economy doesn’t begin to recover soon.

What if you depend on a higher return on your money and can’t live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consume some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss. Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital roofing around for incremental yield that is simply not attainable.

I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the gettin is good. Caution has not been a profitable investment tactic for a long time now. I strongly believe it is about to make a comeback.  

The above is from a Forbes article written by legendary value investor and hedge fund manager Seth Klarman.

In the article, Klarman excoriates common investors for being “yield pigs” blindly piling into common stock. Low yields having driven them into a frenzy for return… as they hoof their way to the slaughterhouse to be ground into some expensive breakfast sausage. Read more

China’s Mundell-Fleming Trilemma

China’s Mundell-Fleming Trilemma

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here.

You’re probably familiar with the story of how Soros and Druckenmiller “broke the Bank of England” in 92’.

The two bet against the pound believing that it couldn’t maintain its peg to the Deutsche Mark in the European Exchange Rate Mechanism (ERM). They were right. The Bank of England was forced to stop defending the peg and the pound plummeted. The Quantum Fund (Soros and Druckenmiller) netted over a billion dollars over the course of a few days. The rest is history.

It was an amazing trade. It had all the markings of a “perfect setup”; the kind that only come around once every decade or so. It was extremely asymmetric in that the risk was clearly defined by the upper-band of the ERM peg. And if the lower bound broke, like they expected, they knew the pound would collapse due to all the investors on the wrong side forced to liquidate.

It was also a fundamentally compelling trade. The thesis was based on an economic law derived from the Mundell-Fleming model. It states that in a world of high capital mobility, a central bank can target the exchange rate or the interest rate but not both. This economic reality is also known as the policy trilemma. Here’s the following explanation from The Economist:

The policy trilemma, also known as the impossible or inconsistent trinity, says a country must choose between free capital mobility, exchange-rate management and monetary autonomy. Only two of the three are possible. A country that wants to fix the value of its currency and have an interest-rate policy that is free from outside influence cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy. And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float.

To understand the trilemma, imagine a country that fixes its exchange rate against the US dollar and is also open to foreign capital. If its central bank sets interest rates above those set by the Federal Reserve, foreign capital in search of higher returns would flood in. These inflows would raise demand for the local currency; eventually the peg with the dollar would break. If interest rates are kept below those in America, capital would leave the country and the currency would fall.  

Where barriers to capital flow are undesirable or futile, the trilemma boils down to a choice: between a floating exchange rate and control of monetary policy; or a fixed exchange rate and monetary bondage.

Read more

Trump And The Dollar

Trump And The Dollar

The following is an excerpt from our weekly Market Brief. If you’re interested in learning more about Market Briefs and the Macro Ops Hub, click here. Read more

Understanding Why Currencies Move

Understanding Why Currencies Move: Vicious and Benign Circles

Let’s talk about currencies. The different types of currencies and the various roles they play in the global financial system.

Because this topic is complex and I don’t want to get lost in the weeds, I’ll be making broad sweeping generalizations while focusing on the key points that matter. My plan is to do this while trying not to bore you to death. Read more

A Dangerous Populist Feedback Loop

A Dangerous Populist Feedback Loop

Most are familiar with the term “pavlovian response”. Here’s a short explanation via Wikipedia: Read more

peak-bonds-interview-with-financial-sense

Peak Bonds Interview With Financial Sense

Last week Tyler linked up with our friend Cris Sheridan at Financial Sense to discuss the peak in the bond market. The last time they talked in July, Tyler explained the asymmetric risks bond investors were facing with yields hitting a lower bound. We saw the result of that asymmetry over the last month as bond markets quickly lost more than $1 trillion after the Trump win. In addition to the top in bonds, they also discussed: Read more

Trump

Regime Shift: What Trump Means for Markets

It’s interesting how quickly the consensus around what a Trump presidency means for markets went from “it’d be an unequivocal disaster” to “his policies will bring forth a new and lasting economic expansion.” Read more