With Greek elections resulting in a fairly benign outcome that promises to hold the euro together in the near-term, the market may enjoy some amount of relief. The extent and duration of that relief will be informative. Based on broader factors, we don't expect that relief to survive very long, but we are willing to respond more constructively if our own return/risk measures become more favorable.
Our estimate of the prospective return/risk tradeoff in the stock market remains in the most negative 0.5% of historical instances. That said - and this is important - if market internals improve meaningfully over the next few weeks (measured across individual stocks, industries, sectors and security types), our estimate of the market's prospective return/risk profile would improve, despite what we view as rich valuations and a new recession. Very roughly speaking, this would require a solid rebound in market internals over a period of 2 or 3 weeks. That sort of outcome might accompany a Fed easing or other event, but our focus is on the measurable condition of market internals, not on Fed policy or other news per se. A positive shift in our measures of market action would likely be enough to ease back from our tightly hedged investment stance to a slightly constructive position. For now, we don't have the evidence to take anything but a very defensive stance, but we'll take changes in the evidence as they arrive.
It's fair to say that we don't foresee any development that would encourage us to remove a major portion of our hedges at present, and my personal expectation is that conditions are likely to deteriorate sharply rather than improve, but as always, I want shareholders to know where my attention is focused. Our measures of market action - and any meaningful improvement over the next few weeks - will be important in determining the whether we maintain a tightly defensive stance or shift to a slightly constructive one.
Investors have a large number of trees to occupy their focus - Greek austerity, Spanish banks, Italian yields, U.S. economic data, Fed policy, earnings preannouncements (just ahead) and so forth. On a day-to-day basis, developments on any one of these fronts may bring fresh concern or relief. The larger issue is that we suspect that the forest has already caught fire.
The global economy remains in a deleveraging phase - the difficult portion of what is known as the "financial cycle" - in the aftermath of a long period of excessive debt expansion and credit growth. Meanwhile, by our analysis, the U.S. has also now entered a recession in the business cycle (particularly based on what we infer from unobserved components methods, and also evidenced by observable factors such as weak growth in consumption and income, a dropoff in new orders and industrial production, an acceleration of negative surprises on short-leading indicators such as Fed surveys, and now even softness in short-lagging data such as new unemployment claims).
As researchers at the Bank for International Settlements have pointed out (h/t Cam Hui), "the financial cycle is much longer than the traditional business cycle. Business cycle recessions are much deeper when they coincide with the contraction phase of the financial cycle. We also draw attention to the 'unfinished recession' phenomenon: policy responses that fail to take into account the length of the financial cycle may help contain recessions in the short run but at the expense of larger recessions down the road."
To a large extent, the repeated monetary interventions of the past two years have been an attempt to contain the unfinished effect of the 2008-2009 downturn. Since we never restructured debt burdens, we never saw a sustained resumption of demand, so aside from short-lived bursts of activity on the heels of QE2, the Twist, and LTRO interventions, important leading economic indicators have hovered close to territory traditionally associated with recessions. Bill Hester notes that if we cluster broad economic data into two bell curves, one for recessions and one for expansions, the data of the past two years has generally resided in the very left tail of the expansion bell, and in the overlapping right tail of recession data. The softness in mid-2011 - and even more in late-2012 - fit the profile of an economy transitioning from expansion to recession, but large interventions pulled the economy from the brink. At present, the joint deterioration in the economic data is significantly worse than either of those instances. I doubt that a fresh Fed intervention will be sufficient to pull the economy from the brink this time, but we'll take our evidence as it comes.
With regard to the Federal Reserve, we do expect further monetary interventions, but doubt that further intervention will substantially stabilize, much less reverse, the Goat Rodeo of challenges that the economy faces. Specific options, in order of likelihood, are a) re-opening dollar swap lines to increase the ability of European banks to access liquidity in the form of U.S. dollars; b) extending the length of the "Twist" program (whereby the Fed has sold much of its short duration holdings and replaced them with longer maturity Treasuries) by 3-6 months; c) "sterilized" QE3, whereby the Fed would purchase long-term Treasury securities, but require the proceeds to be held as reserve balances on deposit with the Fed. At close to 18 cents of base money per dollar of nominal GDP, and core inflation still running well above 2%, there is not much likelihood of massive, unsterilized quantitative easing. But I doubt that anything short of that will be satisfying to investors.
The upshot is that we continue to view market conditions as being among the most negative 0.5% of historical instances. Our analysis suggests that the U.S. has entered a new recession. Still, there is a significant prospect of further monetary interventions, and while we don't expect much of durable benefit from that, our focus is squarely on our own measures of market action. To the extent that we see material improvements in those measures, we would be inclined to ease our presently defensive position. My impression is that further Fed easing will be relatively weak and surprisingly poorly received by the market, but in the event our own metrics improve materially, we would respond with a more constructive stance. For now, we remain tightly defensive, and believe that the headwinds remain unusually strong.
