Please note, this commentary was written prior to the Fed's announcement.
With age comes wisdom, as the saying goes. This is not always the case but there are a few successful investors who time and time again seem to be one step ahead of the crowd. Thus, when they speak, the investing crowd listens. Two of these men are Bill Gross from PIMCO and Jeremy Grantham from GMO. Both men have impressive track records and successful businesses to show for it. Bill Gross, aka “The Bond King,” who manages the world’s largest bond fund often moves the markets when making comments. Jeremy Grantham (who created the nice graphic above) is a famous value investor who successfully spotted all of the last three bubbles: the tech bubble of the 1990s, the stock bubble of the 2000s, and the most recent housing bubble. Therefore, it is of no surprise that his comments are highly valued given his incredible foresight in investing. Both men are known for their big-picture thinking and provide excellent market commentary, with both recently weighing in on the expected Fed quantitative easing round two that is anticipated to be announced on November 3rd, the next Federal Open Market Committee (FOMC) meeting. While both men have been known to be outspoken with bold comments in the past, their recent commentary is a bit more strong than normal and we couldn’t agree more with what they had to say. Highlights from both will be provided in this commentary which helps explain my own view of the market and economy.
In Jeremy Grantham’s recent quarterly report he spent a considerable amount of time commenting on the presidential cycle and the outcome of monetary policy on financial assets and the economy. While we believe the economy is deteriorating and will continue to do so into 2011, it is this very development that is prompting the Fed to take further action to stimulate economic growth. When the Fed creates money there are two sinks for it to flow into: financial assets and the economy. Often the greatest impact is felt by financial assets rather than the economy. This is what we can likely expect from the Fed’s next quantitative easing program, which just happens to coincide with a very bullish historical backdrop, the third year of the presidential cycle, both of which are what Mr. Grantham highlights below (emphasis added).
GMO, “Night of the Living Fed” (10/2010)
The Effect of Subsidized Rates and the Economy on Financial Markets
But subsidized debt – debt at manipulated rates – in contrast to normal debt at market clearing prices, has a large, profound, and dangerously distorting effect on market prices. The Presidential Cycle, which I have often talked about, shows most clearly how hard it is to move the real economy with low rates and moral hazard, and how easy it is to influence speculation and market prices…
Exhibit 3 reminds us of the substantial Fed effect all around the world. Never fight the Fed about market prices or underestimate its global reach. The U.K. stock market has been more responsive to the U.S.’s Year 3 stimulus than the U.S. market has itself. It shows Britain in its true colors: half a hedge fund and half the 51st state. How humiliating!
Here the plot thickens, for I suspect that Greenspan and Bernanke know this: that their only decent tool to help the economy is to move the market. They know, as we have also deduced, that the market is far more sensitive to monetary factors than is the real economy. “Monetary policy works for the most part by influencing the prices and yields of financial assets, which in turn affect economic decisions and thus the evolution of the economy” (Bernanke, May 2004, American Economic Review). If you believe this, then goosing the market deliberately is a useful short-term tool for getting traction in difficult economic times, such as those following a severe financial crash or even a normal cyclical contraction.
Source: GMO, “Night of the Living Fed” (10/2010)
The reason why there is a presidential cycle is that presidents who want to be reelected to a second term try to stimulate the economy prior to the next election and often do so with fiscal policy and then push for monetary policy in the third year of the presidential term. Financial assets respond more quickly than the economy and receive a big boost in the same year (third year) while the effects of increased financial wealth on economic growth trickle over into the fourth year right before the next presidential election. This trend is shown in the GMO table above in which the stock markets average return compared to its historical annual return is 17.6% in year three and real GDP growth is actually below trend by -0.3%. Subsequently, the next year stocks do not perform as well after a large run up and rise by 1.7% in the fourth year but the economic effects are more dramatic compared to the third year as the unemployment rate drops, consumption rises, and real GDP rises 0.6% above trend. The following chart from Contrary Investor illustrates the presidential cycle and the stock market, in which a significant low occurs near the end of year two and a large rally occurs in year three.
Source: ContraryInvestor.com, “QE Canaries In The Coal Mine?” (09/16/2010)
Currently, we find ourselves in year two of a presidential cycle, which is also following quite closely the above historical trend. Typically, during this second year, there is a significant peak in the spring (April this year) followed by a correction that leads to a significant low in the fall (July this time around) followed by a strong year-end rally that carries over into the next year. Throw in another round of quantitative easing by the Fed and there is certainly the potential to have asset reflation next year with, unfortunately, minimal economic growth to show for it. Monetary and fiscal policy have a much greater and quicker affect on financial assets than on the economy, and this time around is likely to be no different.
If we are to have significant asset reflation next year based on the presidential cycle and quantitative easing, it would be worthwhile to look at what sectors and asset classes do well in both cases and then position one's account accordingly. We know that significant reflation by monetary authorities has the greatest impact on high-beta cyclical sectors and commodities, while bonds and defensive non-cyclical sectors of the stock market tend to underperform. This was exactly the case with the first round of QE by Bernanke in March of last year and will likely be the case again. However, a second round appears to be already priced in as the cyclical sectors and commodities have been on fire since August when the Fed first made mention of it.
Interestingly, these same sector trends are the exact ones seen in the third year of the presidential cycle in which cyclical sectors and commodities are the strongest performers within the S&P 500. Again, take the normal reflationary trend that supports high beta cyclical stock sectors and commodities and tack on the normal third year presidential cycle trend and there is a very strong argument to be made for overweighting the cyclical and commodity sectors while shunning the defensive sectors.
Source: Bloomberg
In terms of asset classes, stocks and commodities do well while the USD and bonds perform poorly in the third year of the presidential cycle, implying that stocks, foreign currencies, and commodities may perform well next year.
Source: Bespoke Investment Group
There is also another potentially powerful force that could drive the stock market higher, which is the end of the secular bull market in bonds that began in the early 1980s and likely peaked in 2008 with a final transition to a secular bear market this year. When the biggest bond investor in the world, Bill Gross, AKA “The Bond King,” says the secular bull market in bonds is over, I take notice. If in fact the secular bull market in bonds is over, investors will be net sellers of bonds going forward and will look toward other asset classes for higher returns; I believe they will turn to the stock market and commodities, as they have in the past. So, the great tide of retail money that flowed into bonds may do an “about face” and slowly trickle back into the stock market, particularly if reflationary efforts by the Fed are effective at boosting the stock market. Investors will see these returns compared to the losses in a potential bond bear market and act accordingly. There were some very key points made by Bill Gross who was exceptionally outspoken about the Fed, calling the US deficit and the US Treasury bond market a big Ponzi scheme. Snippets from his recent monthly commentary are provided below.
PIMCO Investment Outlook: “Run Turkey, Run” (11/2010)
Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic…
The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen? There has not. This one is so unique that it requires a new name. I call it a Sammy scheme, in honor of Uncle Sam and the politicians (as well as its citizens) who have brought us to this critical moment in time. It is not a Bernanke scheme, because this is his only alternative and he shares no responsibility for its origin. It is a Sammy scheme – you and I, and the politicians that we elect every two years – deserve all the blame.
The Fed wants to buy, so come on, Ben Bernanke, show us your best and perhaps last moves on Wednesday next. You are doing what you have to do, and it may or may not work. But either way it will likely signify the end of a great 30-year bull market in bonds and the necessity for bond managers and, yes, equity managers to adjust to a new environment.
There are of course no guarantees in investing, and while stocks have tended to have a great year in the third year of the presidential cycle and perform well under very accommodative Fed policy, there is no guarantee that they will do so into year end and next year. However, there is a very strong track record for outperformance under these two environments and investing is a game of probabilities, not certainties, and there is a high probability environment for a good year in 2011 in which high beta cyclical stock sectors and commodities and foreign currencies outperform non-cyclical sectors, bonds, and the USD.
Market Tops are a Process, Not an Event Revisited
That said, the proof is in the pudding and the stock market needs to head higher if the reflation and presidential cycle trends are to play out. Back in January I made the case in an article (Market Tops are a Process, Not an Event) that the stock market was not topping as market breadth (participation) was broad-based, contrary to what is seen at market peaks, noting the following:
However, emotions and opinions aside, the technical and economic breadth measures are collectively indicating that it may be premature to call for an outright stock market peak. The stock market is currently overbought and ripe for a correction, but given the collective message of technical and economic breadth measures any correction is likely to be a dip in the primary trend, which is presently bullish.
We did end up correcting shortly after the article was written but again, given the economic and technical breadth remained strong the correction proved temporary and the markets headed higher. I did not feel the April peak was “THE” peak for this cyclical bull market for the same reason I didn’t feel the January top was “THE” top, which is that technical breadth measures remained very strong and didn’t show the deterioration seen at market peaks. Market peaks are a process, not an event. Like the changing of summer to fall where leaves fall from trees one by one to indicate the change in seasons, market peaks are similar in that stocks individualy roll over into their own bear markets and when enough stocks begin to roll over the overall market indices eventually roll over and a top is formed.
After we began to rally off the July lows I was very interested to see if the new 52-week highs on the NYSE and NASDAQ would match or exceed the levels seen at the April peak. If they did not then we would have a similar situation to 2007 in which the November peak in the markets showed significantly weaker breadth than at the Juy 2007 peak. Well, as we are knocking at the April highs a quick look at new 52-week highs/lows is in order.
While more time is needed to make any big determinations, so far the data is not looking promising. At the April peak roughly 20% of NYSE tradable issues were hitting 52-week highs while stocks hitting new 52-week lows was 0.2%, not the stuff of market peaks. On the NASDAQ 15% of tradable issues were hitting new 52-week highs while 0.3% were hitting new 52-week lows. Again, not the stuff of market tops.
Now the plot thickens. While breadth was strong at the April peak breadth has deteriorated since then given we are at roughly the same levels and yet new 52-week highs are much lower, not unlike the 2007 top. In 2007 the percentage of NYSE issues hitting new 52-week highs peaked in April and progressively weakened throughout the year. However, the percentage hitting new 52-week lows jumped substantially in which its spike to nearly 20% in August was larger than any 52-week high spike as new lows dominated new highs for most of the remaining year.
On the NASDQ, while new 52-week highs were not showing a large bearish divergence with price like the NYSE, new 52-week lows spiked over 10% in the July correction and November correction and dominated new 52-week highs, not the makings of a strong market.
Back to the current situation. While the NYSE is not quite back up to its April 2010 highs, new 52-week highs are considerably below the roughly 20% level reach in April. It’s too soon to make any judgments, particularly since new 52-week lows are non-existent, but the divergence definitely warrants a close watch. If the NYSE reaches or exceeds its April highs and new 52-week highs do not confirm, that would be a red flag.
While the NYSE is not yet back to its April highs, the NASDAQ is, however, and the percentage of issues hitting new 52-week highs is considerably lower than what was seen in April. Also, new 52-week lows spiked north of 5% in the summer correction, a pick-up from prior corrections. The breadth on the NASDAQ is clearly not as healthy as the NYSE and both exchanges show 52-week highs not confirming price presently, yet another watch point.
So, while a Fed hell-bent on reflating and a favorable presidential cycle ahead of us suggests an overweight position towards cyclicals and commodities, it's always about price and not theory. If the markets fail to head higher then it would indicate Fed reflation attempts are failing and the presidential cycle may not play out as strongly as it has in the past. Again, its market action not theory that matters to money management and if price is not confirming the theory of asset reflation and the presidential cycle then throw out the theory and put on the risk management cap. Again, while new 52-week high data for the NASDAQ and the NYSE are not encouraging, the jury is still out and I’ll be watching these data series closely for ultimate resolution.
