Submitted by Pater Tenebrarum via Acting-Man blog
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Distorted Markets
We have always liked Eclectica fund manager Hugh Hendry for his
sound views and outspoken manner. Below is a somewhat dated video
compilation showing several moments in which he stunned his
opponents in television debates by voicing uncomfortable and
politically incorrect truths. Included in the video is a defense of
speculators, entrepreneurs and other risk takers in the marketplace
against statist interventionists and “champagne socialists”, which
we wholeheartedly agree with. Speculators have a bad name, mainly
because they always serve as a convenient scapegoat for politicians
(in fact, speculators and merchants have served as scapegoats
whenever economic policy failures became apparent since
at leastthe time of the Roman empire). However, they
fulfill an extremely important function, as Mr. Hendry points out
to his debate opponents.
A few excerpts from televised
debates with Hugh Hendry
Mr. Hendry runs the Eclectica Fund and in recent quarters
has frequently stressed that being contrarian has been a losing bet
over the past few years (there are a few notable exceptions to
this, see further below), while investors and fund managers relying
blindly on the “money illusion” provided by central bank
interventions have done quite well.
This is undeniably true.A prime example of what
absurdities have become possible is shown below. The chart shows
the 10-year JGB yield; Japan’s monthly annualized CPI rate of
change over the past year is also shown, as an inset in the chart.
The red rectangle outlines the time period over which these CPI
readings were reported. At no point over the past year was Japan’s
CPI not
at least more than twice as highas the 10-year JGB yield.
Even if one disregards the fact that CPI has been boosted due to a
sales tax hike in April, current JGB yields make no sense. Prior to
the sales tax hike, CPI fluctuated between 1.4% to 1.6% annualized,
or 1.5% on average. This would still be almost five times the
current 10-year yield of 0.31%.
In past “reflation” attempts by the BoJ, investors tended to
drive up JGB yields concurrently with stock prices. Reported CPI
figures also happened to increase slightly on these occasions.
Investors consequently demanded higher yields. However, nowadays
the BoJ has “become the JGB market”. It is such a big buyer, that
no-one dares to oppose it anymore. After all, it has theoretically
unlimited amounts of money at its disposal, since it creates them
with the push of a button. Trading volume in the JGB market has
completely dried up. Shorting JGBs is still the “widow-maker trade”
– for now, anyway.
10 year JGB yields since 2006 and
Japan’s CPI rate of change over the past year (the period
corresponding to the red rectangle) , click to enlarge.
We are mentioning all this not to pick specifically on Japan’s
policy makers (most others are by no means better), but mainly to
confirm that Hugh Hendry does have a point. The prices of financial
assets have been and continue to be massively distorted by loose
monetary policy, and fighting these trends, no matter how absurd
they appeared, has hitherto been a losing game.
The Fund Manager Conundrum
As we recall, Hugh Hendry mentioned in one of the Eclectica
Fund’s previous reports that he has not only fully embraced the
trends set into motion by central bank policy, but that he has also
altered his short term tactics, by becoming more tolerant of short
term losses. This was done because in recent years, every short
term decline in the stock market was immediately recouped, so that
“stop loss” strategies resulted in selling of long positions at
exactly the wrong moment.
Zerohedge has recently reportedon Mr. Hendry’s
commentary accompanying the fund’s most recent results. These
results were quite good, confirming that the current strategy works
well, or at least that it has worked well in the most recent
reporting period. Here are a few selected excerpts:
“There are times when an investor has no choice but to behave
as though he believes in things that don’t necessarily
exist. For us, that means being willing to be long risk assets
in the full knowledge of two things: that those assets may
have no qualitative support; and second, that this is all going to
end painfully.
The good news is that mankind clearly has the ability to
suspend rational judgment long and often.
[…]
However since Draghi spoke,
the role of market Disneyland has increasingly been taken on by
the equity and fixed income markets.
So the S&P has massively outperformed what has
proven to be a tepid recovery in nominal GDP and a global real
economy that is beset by deflation; just this month, European swaps
contracts began to price in near term deflation. Yet equity
markets are ignoring that reality in favor of the idea that the
deflationary fallout from the collapse in the oil price will almost
certainly mean even more monetary accommodation.
The worse the reality of the economy becomes, the more we take
on the reflexive belief in further and dramatic monetary expansion
and the more attractive the stock market looks.
What is one to do with such a situation? In my view there are
really only two responses. On one hand we have today’s bears.
Remember the film The Matrix? Morpheus offered Neo the choice
of two pills – blue, to forget about the Matrix and continue to
live in the world of illusion, or red, to live in the painful world
of reality. They, as the “enlightened”, chose red, and so are
convinced that they understand everything which has become illusory
about today’s markets. Their truth is Austrian economics. They know
that today’s central bankers are spinning a falsehood of recovery;
they steadfastly refuse to be suckered in by the euphoria of a
monetary boom; and they are convinced that they will therefore be
spared the consequences of the inevitable crash.
Everyone else, currently drugged by the virtual simulation
of prosperity and its acolyte QE, will be destroyed, leaving them
alone, to re-invest when markets finally get cheap. They will once
again be masters of the universe.
This sounds good. Really good. I have long thought of myself as
one of the enlightened. My much thumbed copy of Kindelberger’s
Manias, Panics and Crashes aided and abetted my thinking as I
correctly anticipated and monetised profits from the crisis of 2008
for example. But it isn’t always good. Kindelberger has been
absolutely detrimental to my investment performance for the last
six years and as a result I have changed.
I still believe that the attempt by central bankers to prevent
the private sector from deleveraging via a non-stop parade of asset
price bubbles will end in tears. But I no longer think that
anyone can say when. Look back on the last five years and I
think that it is indisputable that mass injections of loose
monetary policy have both fueled asset prices and staved off
further crisis.
I am also absolutely persuaded that the global economy remains
so fragile that modern monetary interventions are likely to
persist, if not accelerate. They will therefore continue to
overwhelm all qualitative factors in determining the course for
stock prices in the year ahead.
So I have come to embrace the French philosopher Baudrillard’s
insight. “Truth is what we should rid ourselves of as fast as
possible and pass it on to somebody else,” he wrote. “As with
illness, it’s the only way to be cured of it. He who hangs on to
truth has lost.”
The economic truth of today no longer offers me much solace; I
am taking the blue pills now. In the long run we will come to rue
the central bank actions of today. But today there is no serious
stimulus programme that our Disney markets will not consider to be
successful. Markets can be no more long term than politics and
we have no recourse but to put up with the environment that gives
us; the modern market is effectively Keynesian with an
Austrian tail.
(emphasis added)
We would agree that Mr. Hendry describes the
currentfinancial market reality quite well.At
present, bad news seem to promise more monetary stimulus, hence
they don’t represent a reason to sell. We would however add to this
that
good news have also not been seen as a reason to sellover
the past year. One could therefore be tempted to conclude that
there is actually
nothingthat could prompt a sell-off in risk assets. It
seems possible that there is a catch.
As to the “Austrian” position, Mr. Hendry is correctly
characterizing it in that Austrians are no doubt convinced that the
artificial boom cannot last. Monetary pumping has distorted
relative prices in the economy, which has far-reaching
consequences. Since these distortions falsify economic calculation,
many of the earnings reported by companies in recent years will
later turn out to have been hiding capital consumption.
Interventionism inspired by Keynesian (and monetarist) tenets has
set the boom into motion, but the false reality and distortions
this has created will eventually be unmasked. Insofar, the image of
a “Keynesian boom with an Austrian tail” is not incorrect. However,
it should be noted that the focus of Austrian business cycle theory
is really on the boom, its chief causes and effects, and the fact
that instead of increasing prosperity, it will lead to
impoverishment in the long run.
Mr. Hendry’s brief characterization of Austrian
investment philosophystrikes us as far too narrow though.
The major difference between someone simply taking the blue pill
and an “Austrian” investor in the current situation is probably
that the latter attempts to incorporate all possible outcomes in
his strategy, instead of trusting that central bank interventionism
will continue to “work” for investors. It may well work for a while
yet, but as Mr. Hendry himself points out: “
I still believe that the attempt by central bankers to prevent
the private sector from deleveraging via a non-stop parade of asset
price bubbles will end in tears. But I no longer think that
anyone can say when.”
If no-one can say when, then the “blue pill” strategy has a
major weakness. It means that things could just as easily go
haywire next week as next year.Monetary pumping is not
operating in a vacuum. The higher asset prices go, and the bigger
the distortions in the underlying real economy become, the more
likely it becomes that a continuation of the asset price bubble
will require
acceleratingmonetary inflation. However, US monetary
inflation has been slowing for some time, and continues to do so.
The y/y growth rate of the broad money supply measure TMS-2 stands
at a still brisk 7.57%, but this is actually one of the lowest
readings of the past 6 ½ years:
Money TMS-2, y/y growth rate, click
to enlarge.
This growth rate could accelerate again if private banks were to
step up their lending, but if they fail to do so, then the end of
“QE” implies that the slowdown will continue. In that case, the air
could rapidly get quite thin for currently still extant asset price
bubbles. We will definitely concede though that there is nothing
that can tell us with absolute
certaintythat recent trends won’t continue for a while
yet. However, numerous technical warning signs have piled up as
well in the course of the past year (most notably, market internals
have deteriorated and trend uniformity has decreased) and sentiment
has become extremely lopsided.
We understand the conundrum faced by Mr. Hendry. Being
contrarian hasn’t paid, and he is running a fund that must report
results every month. If he doesn’t deliver a certain level of
performance, his fund will suffer redemptions; moreover, the fund’s
earnings are tied directly to its performance. Mr. Hendry is
essentially saying: “I don’t get paid for being right and not
making any money”, which is fair enough.
We would however be remiss not to point out that investment
funds run by dedicated “Austrians” such as Mark Spitznagel’s
Universa fund and the still young Incrementum Fund run by Ronald
Stoeferle and Mark Valek (which has just won the
FERI Euro Rating Award for “most innovative new
fund”) have had a quite successful year as well.It is
definitely
notthe case that “Austrians” don’t know how to make money
in distorted markets. Even though these fund managers are well
aware of the dangers associated with the boom and are frequently
warning about them, they are still delivering great returns for
their investors.
Contrarianism and the Danger of Taking the Blue
Pill
We believe that there is a grave danger associated with
simply “taking the blue pill”.First of all, in the context
of “risk assets”, having faith in central bank magic is most
definitely
nota contrarian position anymore – less so than at any
other time in the past six years. Contrarian views have actually
worked very well in treasury bonds and crude oil in 2014, so it
would also be quite wrong to state that “contrarianism no longer
works” as a general proposition. The majority is of course always
right during a strong trend. However, there inevitably comes a time
when a trend has lasted long enough and gone far enough that the
ranks of doubters have been thoroughly thinned out and the majority
ceases to be correct.
We perceive a “greater tolerance for short term drawdowns”
as quite dangerous in connection with risk assets at this
juncture.In asset bubbles there are usually a number of
short term breakdowns that are immediately followed by prices
moving to new highs, a fact that greatly cements the confidence of
market participants – usually to the point where it becomes fateful
overconfidence. The main problem with this “tolerant” approach is
that one simply cannot differentiate a run-of-the-mill short term
correction from a short term downturn that ends up heralding
something far worse. Initially, all corrections look similar.
To see how dangerous overvalued and extremely stretched markets
can be, one only needs to study how prices have behaved following
previous major historic peaks. The initial downturn is never seen
as a cause for alarm. Sometimes this can however be followed by a
decline so swift that having a tolerance for drawdowns can end up
leaving one with very big losses in a very short time period.
Such sudden reassessments of market valuation can rarely be tied
to specific fundamental developments. Rather,
anythingthat is reported is all of a sudden interpreted
negatively and becomes a trigger for more selling, even though
similar news would have been shrugged off a few days or weeks
earlier. After all, nearly every economic news item
canbe interpreted in a number of different ways, so that
even superficially good news can become a problem (in the current
situation they could e.g. create fears of a faster tightening of
monetary policy).
Below is an update of Rydex assets and Rydex ratios. As can be
seen, although the stock market is actually not very far above the
peak it attained prior to the October correction, there has been a
major rush by Rydex traders out of bearish and into bullish
positions:
Rydex bear fund assets have ended the year right at an all time
low, while the bull-bear asset ratio has continued to soared in
blow-off like fashion. Remarkably, the ratio has moved from a level
just below 12 at the low of the October correction to a high of
nearly 30, in spite of the market not making a great deal of
headway above its September peak, click to enlarge.
We were recently asked whether Rydex ratios are still meaningful
nowadays. Although the assets invested in these funds are very
small relative to the market’s size, we believe the data are akin
to those gathered in e.g. political polls: the replies of a few
thousand people can deliver statistically quite meaningful results
applicable to the population at large. Similarly, the positioning
of Rydex traders does tell us something meaningful about general
market sentiment.
The most recent development strikes us as actually as especially
meaningful. Bullish positioning has taken off like a rocket in the
last quarter from an already high level (bull and sector assets
rose by nearly 40%), while battered bear assets have plunged nearly
by another 40% in just the final ten weeks of the year. The last
quarter is especially noteworthy, as a massive surge in the
bull-bear ratio occurred while the SPX gained only 70 points
relative to its September peak. Comparing the two data points
peak-to-peak, the SPX rose from about 2,020 at the September peak
to 2,090 at the December peak (a gain of 70 points or 3.47%) while
the Rydex asset ratio rose from approximately 18 points to 29,81
points over the same stretch (a gain of 11.81 points, or 65.6%).
From its October low the ratio notched a gain of nearly 153%. In
short, there is quite a big divergence between the actual gains
delivered by the market at year end and the extent of conviction
regarding further gains expressed by the positioning of Rydex
traders.
Conclusion
We will readily admit that one cannot know with certainty
whether the bubble in risk assets will become bigger. However,
it seems to us that avoiding a big drawdown may actually be
more important than gunning for whatever gains remain. One
can of course endeavor to do both, but that inevitably limits short
term returns due to the cost of insuring against a potential
calamity.
We don’t know what, if any, insurance the Eclectica fund has in
place, or whether Hugh Hendry’s trader instincts will help him to
sidestep the eventual denouement; we are certainly hoping so and
are wishing him all the best.
However, we don’t think it is a good idea to simply “take
the blue pill” and rely on the idea that the effects of the money
illusion will last a lot longer.It is possible, but it
becomes less and less likely the higher asset prices go and the
more money supply growth slows down.
Lastly, the crude oil market strikes us as quite a pertinent
example in this context, because everything that is these days
mentioned as a cause of its enormous decline (such as the economic
slowdown in China and Europe and the greater supply due to
fracking) was already known many months before the sell-off
started. The only thing that actually changed were market
perceptions.
No market is magically immune against such a change in
perceptions.