Thursday, 17 September 2015

Good. That's out of the way.

Opinion is split over the Fed decision though I would suggest the split is not even.

 My first thoughts were -

- If the Fed were FIFA there’d probably be an investigation going on right now into emerging market bribes.
- It's paradoxical that the market moans that the Fed is influenced by the market and then the market moans that the Fed hasn't done what they want.
- Fed cut volatility.
- Perhaps instead of weening the market off low rates the Fed is trying to ween markets off Fed credibility to make it's own damn decisions via the rest of the curve.
- As with China and Greece, 'Fed risk' has to be moved from the acute ward to the chronic ward.

An event risk has just passed and the immediacy of imminent doom slips back and any belief you have as to the long term outcome has to be moved out in a smear across weeks rather than days of future ‘maybes’. The risk may be ahead but it is no longer today. The bears will be arguing that the end of the world may not have occurred today but it damn well will soon and the bulls will be breathing a sigh of relief for now.

Yes OK, but I think we can squeeze in a quick holiday before we have to sell the cat. 

But what for positions?  As mentioned in Tuesday’s post,  the most likely outcome is a fall in volatility and we have seen it coming off pretty hard over the last 2 days. But to expand on that, a fall in volatility normally invokes a period of 'carry creep' where if nothing is going to go wrong right now, yield starts to dominate as the cost of carry erodes shorts on yielding assets. In other words risk assets grind higher and, with the bear call so dominant, a grind higher will be accompanied by wails of pain and disbelief,

Watching the price action in that uber-benchmark of SP500 has been fascinating since the announcement. Up, down, up, down and as with all roller coasters each oscillation is accompanied by  whoops from those on the ride, but the ride ends where it started. So far SPX is within a gnat's crotchet of where it closed yesterday. Interesting to note that the extrapolationists are having a ruler snapping time trying to call the next move with the intraday movements being so wild, but a low close sees the majority calling it lower. Because it closed lower. I am also aware, having been reminded by @NicTrades,  that 'a red market on Fed day usually means follow through the next day'

Technically speaking the 1980-2000 SPX area has encompassed a myriad of important levels and to see the blow to 2020 can lead us to assume that many stops where taken out leaving us room for a resumed fall.

But there is a piece of the jigsaw that needs to play out first and that will be Asian markets overnight. Lower for longer US rates ‘should’ be of assistance to all those Emerging Market countries that have been listed as being most damaged by a Fed rate rise (most of them). With Asia woes having been a major driver of sentiment recently it makes tonight's moves all the more important.

Nothing is easy re markets,  but the Fed is back in the box for a month though I note that Octobers have a tendency to provide market and hence confidence jitters that could give the Fed another reason to delay.

 For now I am going to sit back and brace myself for the deluge of articles telling me why the Fed was wrong. On that note if someone comes across one praising them can they send it to me?

Update 18/9 11am BST - Looking at this morning's price action I think we have stumbled upon a new market's circle of life.

Fed steady -> EUR/USD up -> Dax Down -> DM eq down -> OMG -> Fed steady


Booger said...

I think with EM, the underlying issue remains capital outflow from China. There is a central contradiction that will have to be reconciled: 1) they were until very recently liberalizing their capital markets in terms of allowing capital more freely flowing in and out b) the economy is still based on economic repression of the consumer, poor treatment of capital and returns are poor. The average Chinese person I anticipate will want to move their capital out of China. The Yuan devaluation turned a slow burn problem into a problem that will likely be a major issue in the next year. Another more significant devaluation is very likely and everyone knows it.

The S&P does seem to be behaving as if the top is in. The question to be pondered is, does one increase shorts at 1950 or stay pat ?

Short S&P is my favored position at the moment. Higher probability than EM short from current levels. EM needs a break before falling apart and oil could well rally to the low 50's before another leg down.

Booger said...

Well, after a limited period of bearishness, lasting the better part of 2 days, I pulled in the S&P short and am thinking perhaps a bit of chop could be due soon. It is very hard to have clarity about anything at the moment.

I think I will spend a bit of time gazing my navel.

I am growing partial to the idea of nibbling on aud.cad short at current levels and shorting aud.usd if it gets to 0.74

Eddie said...


you said a couple of times that you think equities are good value at these levels because dividend yields are comparable to bonds or higher. I think you make some implicit assumptions that might hold or not. But maybe I got you wrong.

You assume that a) rates stay at currrent levels and either that b1) equities stay at current levels or at least don't move a lot or b2) equities move but you don't have to sell in the meanwhile. Now Polemic has balls of steel and no risk manager breathing down his neck so b2) probably holds. But most traders would have to assume b1) imho. Since profits are the main driver in the long run (I deliberately ignore multiple expansions here, PEs should hover around an appropriate level since rates and stuff are factored in already) corporate profits should remain at current levels. Which are rather high in absolute terms and relative to GDP. Mean reversion of profits is the hallmark of capitalism (at least on average, Buffet made a fortune finding the outliers) so I think this is a rather tall order. But lower profits would mean higher implied PEs and so on, you know that better than me.

Now how long have rates to stay low ? For stocks to outperform treasuries I would say at least a couple of years, for sure not just one or two. If I factor in some price risk for equities this period becomes even longer (to account for the loss due to lower future PEs). Call me a skeptic but I have a hard time getting my head around this notion.

Happy to hear your thoughts.

Polemic said...

Eddie, I ve had a tough day and your comment is making my head spin with concentration. I'll have to come back to you on that.

Eddie said...

Take your time, sir. I've read your statements a couple of time and always had that nagging feeling that somehow it doesn't fit to my model of the world. Finally I found a way to express that, however clumsy it may be.

Polemic said...

Eddie.. Not clumsy at all.
With ZIRP PEs can rise dramatically and still outperform zero as far as yield goes. The chicken and egg will be why rates rise. If its due to inflation then we need to know where that inflation is coming from. If final prices are foing up I assume its cos passing on cost to maintain profits and margins. If the Fed really is behind the curve then pass through (inflation) will occur faster that rate rises giving corps another window of relative outperformance. If it is due to wage rises then I assume their is more money to be spent by employees. Both better news.

If rates just go up, because of historic anchoring beliefs of where they should be, before inflation is seen then yes it would be worse than the now. But expectations in the market are preety dire at the moment so I still think the risk is against consensus.

To be fair you shouldn't take much of what I say with any confidence as so far I am being proven wrong by price in a lot of what I think!

Booger said...

Pol, one problem with your argument as I see it is that it justifies infinitely priced equities in the positive feedback loop of lower prices and lower discount rate.

But equity prices are determined by the discount rate and also the terminal growth rate. If the 30 year risk free rate goes to zero then the long term GDP growth rate one would presume would also approach zero (or even negative at this point) and also the terminal earnings growth rate for the S&P.

In any care, I am not sure that PE expansion could be indefinite even in a ZIRP world. Logically, PE should be then the inverse of the equity risk premium even if the 30 year rate is zero and the potential for the PE to increase is not to infinity, even with zero long term rates. The discount rate cannot go to zero unless the equity risk premium goes to zero and rationally, it should not under any circumstance approach zero.

I suspect that we are in the twilight zone, where rates are low and earnings have not peaked but if they do, there is real potential for PE compression again, whether long term rates are zero, close to zero or 1% above zero.

Eddie said...

Ok, I think I see where you are coming from... finally.

I think John Hussman addressed that point much better than I can but let me give it a try.

Let's assume the "normal" short term rate is 4% (insert any figure you like, it doesn't make one hell of a difference as long as it is greater than 0) and assume equities are fairly priced given this rate (the infinite wisdom of the crowd got the correct growth rates). Now assume that the short term rate jumps to 0%. Under the usual DCF model you would be willing to pay 4% more than before, everything else being equal (ignoring discounting effects for the moment). If rates stay at 0% for 2 years you would pay 8% more and so on. At some point my „ignore discounting effects“ assumption comes back to haunt me since convergence will set in but I agree that in principle PEs might go to infinity if rates stay at 0% until the world ends. But still you have these pesky price movements Booger mentioned. Not everyone acts fully rational and a bunch of people may act quite irrational on average. Which brings me back to the second part of my argument that you have to stand any MtM movements… whatever it takes as Mario D. would say.

So even if we agree that rates stay at 0% until eternity (something I don't believe but that's my personal view) you probably would want some premium for the risk that you have to stand the volatility between now and eternity. Which caps your PE at some level. And all the time you have to assume that profts stay where they are… namely pretty high given the historical context.