Bloomberg: "Equities in Denial"

Bloomberg writer Richard Breslow this morning expressed a rather sanguine assessment of the current equity markets, despite price strength.

Credit Trumps Equities

from Macrostory blog:
Credit markets are truly forward looking. Equity not so much. History clearly shows credit should never be ignored. There have been three large divergences between equity and credit since the late 90′s and each time credit forced the hand of equity.
Here we are once again on the eve of a possible breakout in the entire treasury curve to new all time highs (low yields). History does have a way of repeating when it comes to the capital markets.
Below is a 15 year comparison of the 10 year yield and the SPX. Also note the orange circles outlining that huge head and shoulder’s pattern on the SPX that has taken a decade to form. In the words of the Dos Equis man “stay thirsty my friends.”

But Pollyanna Roars

This is a rather large loss (Dow down about 160) to start the day, but anything can happen! Right now, Wall Street is trying to fix a bottom in the equity markets.

European Debt Disaster Tumbles Equity Markets

Richard Koo on Why Stocks, Commodities Surged During QE2

Great analysis from Zero Hedge by Richard Koo at Nomura:


Over the past several days, quite a few readers have been asking us why we are so confident that QE3 (in some format: it does not and likely will not be in the form of the Large Scale Asset Purchases that defined QE1 and 2 - the Fed could easily disclose that it will henceforth sell Treasury puts, a topic discussed previously, or engage any of the other proposals from Vince Reinhart disclosed in June of 2003, or worse yet, do what the BOJ does and buy ETFs, REITs and other outright equities) will eventually be implemented by the Fed. Luckily, instead of engaging in a lengthy explanation of the logical, Nomura's Richard Koo comes to our rescue with his latest research piece. While we disagree with Koo on various interpretations of his about monetary theory (namely that the Fed is not in effect "printing" money and thus creating inflation - this is semantics and leads to a paradoxical binary outcome, whereby if there Fed was successful in boosting the economy, the economy would indeed be flooded with the nearly $2 trillion in excess reserves held with reserve banks. And good luck trying to contain this surge by changing the IOER - if the Fed indeed pushed the IOER to the required 5%+ level it would immediately destroy money markets, leading to the same liquidity freeze that marked the post-Lehman days, confirming the "Catch 22" nature of Quantitative Easing that we have observed since its beginning) we do agree with his analysis of what would happen to the economy if either stocks or commodities are in a bubble (and judging by the violent opinions out there, most investors believe that either one or the other has indeed reached bubble territory), should QE2 end cold turkey: "Viewed objectively, the central banks are trying to push up asset prices using quantitative easing and the portfolio rebalancing effect. The resultant rise in asset prices based on this effect represented a potential bubble—or at least a liquidity-driven event—from the start. The question is whether the real economy can keep pace with asset prices formed in those liquidity-driven markets. If it cannot, higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more severe than if quantitative easing had never been implemented to begin with." Bingo. "In other words, if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy. an increase in DCF values, either." And there you have it: Bernanke's all in gamble that QE2 would have been sufficient to restore the virtuous circle of the economy has failed with less than 2 months to go under the QE2 regime. As such, and with fiscal stimulus a dead end, the Fed has two choices: watch as the economy collapses in flames to a state far worse than its pre-QE1 outset, or do more of the same. That's all there is. The rest is irrelevant. And since the Fed will choose the latter option, the market would be wise to start pricing in precisely the same reaction as what happened following the Jackson Hole speech...although to the n^th degree.
And some other key observations from Koo:

Government borrowing has supported money supply growth

The question, then, is how to explain the modest growth in the money supply at a time when private-sector credit has steadily contracted. A look at Japan’s experience shows that the answer lies in increased bank lending to the government. As long as the government continues to borrow, banks can continue lending (by buying government bonds) even if the private sector is deleveraging in an attempt to clean up its balance sheet.

If the government spends the proceeds of those debt issues, the people on the receiving end of that spending will deposit money with a bank somewhere, leading to an increase in the money supply.

In effect, the money supplies of both the US and the UK are being supported by government borrowing. If the two governments chose to embark on fiscal consolidation, their money supplies would contract.
Portfolio rebalancing effect was primary objective of QE2

So what are the actual problems inherent in QE2? Mr. Bernanke has stated from the beginning that QE2 would not lead to an increase in the US money supply.

If so, why did the Fed carry out QE2? The simple answer is that it believed QE2 would result in a portfolio rebalancing effect. The portfolio rebalancing effect can be described as follows. When the Fed buys a specific asset (in this case, longer-term Treasury securities), the price of that asset rises. That prompts private investors to re-direct their funds to other assets, which leads to a corresponding increase in the price of those assets.

Private-sector sentiment may improve as asset prices rise, and if that prompts businesses and households to spend more money, the economy may improve. In effect, the Fed hopes that quantitative easing will lift the economy via the wealth effect. Inasmuch as the balance sheet recession was triggered by a drop in asset prices, monetary policy that serves to support asset prices may also help pull the economy out of the balance sheet recession.

Reasons for divergence of liquidity supply and money supply

The decline in private-sector credit in the US and the UK is attributable to both the unwillingness of banks to lend and the unwillingness of the private sector to borrow. The two factors are rooted in balance sheet problems and are indications that both countries remain in balance sheet recessions.

When a bubble collapses, the value of assets drops, leaving only the corresponding liabilities on the balance sheets of businesses and households. To fix their “underwater” balance sheets, companies and individuals do whatever they can to pay down debt and avoid borrowing new money even though interest rates have fallen to zero. Banks, for their part, are not interested in lending to overly indebted companies or individuals, and often have their own balance sheet problems. With no borrowers or lenders, the deposit-growth process described above stops functioning altogether.

US banks now appear slightly more willing to lend money, although that is not the case in the UK. In neither country, however, are there any signs of greater willingness to borrow among businesses and households.

Unable to buy more government bonds or private-sector debt, investors have few places to turn
In the hope of producing a portfolio rebalancing effect, Chairman Bernanke declared that the Fed would purchase $600bn in longer-term Treasury securities between November 2010 and June 2011. This was roughly equivalent to all expected Treasury debt issuance during this period.

From a macroeconomic standpoint, these purchases of government debt meant that—in aggregate—private-sector financial institutions would be unable to increase their purchases of US Treasury securities, because all of the growth in Treasury issuance would be absorbed by the Fed.

The fact that US businesses and households were rushing to repair balance sheets by deleveraging meant that—again, viewed in aggregate—private investors would be unable to increase their purchases of private-sector debt.

With the private sector no longer borrowing and all new issues of government debt being absorbed by the Fed, US institutions found themselves with few investment options.

So funds found their way to equities and commodities
The only remaining destinations for these funds were equities, commodities, and real estate. Real estate had just been through a bubble and remained characterized by heavy uncertainty. In commercial real estate, for example, banks—at the request of US authorities—are engaging in a policy of “pretend and extend” and offering loans to borrowers whose debt they would never roll over under ordinary circumstances. That means that current prices do not accurately reflect true market prices. Housing prices, meanwhile, resumed falling late in 2010.

UK house prices have been falling since mid-2010, and the Halifax House Price Index dropped 1.4% in April 2011 alone (the decline was 3.7% on a y-y basis).

The only remaining options for private-sector investors have been stocks and commodities. That, in my opinion, is why both markets have surged since the announcement of QE2.

And the conclusion:

QE2 was Bernanke’s big gamble

When the situation is viewed in this light, we come to the realization that Mr. Bernanke’s QE2 was in fact a major gamble. It was a gamble in the sense that the Fed tried to raise share prices with QE2. If the wealth effect resulting from those higher prices led to improvements in the economy, the higher asset prices would ultimately be supported by higher real demand, thereby demonstrating that prices were not in a bubble.

However, I cannot help but feel that the portfolio rebalancing argument was putting the cart before the horse, in the sense that it is ordinarily a stronger real economy that leads to higher asset prices, and not the other way around.

It might be possible to sustain the portfolio rebalancing effect for some time if conditions were such that investors were totally oblivious to DCF values. But with market participants paying close attention to DCF values, any delay in the economic recovery will naturally bring about a correction in market prices, thereby causing the portfolio rebalancing effect to disappear.

Treasuries to Rise Counterintuitively

This seems counter-intuitive, but he may be spot on! As equities sink into the end of QE, there is a reflexive run for bonds and treasuries as a measure of safety. I think gold is a better bet than fiat currencies or sovereign debt.

(Reuters) - U.S. Treasuries will perform well following a downgrade by Standard & Poor's on Monday of the rating agency's credit outlook for the United States, DoubleLine Chief Executive Officer Jeffrey Gundlach said on Monday.
Gundlach said Treasuries, whose major holders include foreign investors, will be in high demand as the U.S. economy will "soften subtantially" with no monetary stimulus in the pipeline.
The S&P warning, which cited a risk that policymakers may not reach agreement on a plan to slash the huge federal budget deficit, is "good for Treasuries and bad for the economy and stocks," Gundlach, who oversees $9.8 billion at the Los Angeles-based firm, told Reuters.
Last week on an investor conference call, he said: "By now it's getting relatively close to June 30 and it's about time for the markets to start discounting the end of QE2 and a weaker economy."
Gundlach is referring to the Federal Reserve's end of its purchases of $600 billion in long-term Treasuries until June 30, as part of a second round of quantitative easing.

Doug Kass: Quantitative Wheezing!

Ten days ago, during my guest-hosting stint on CNBC's "Squawk Box," Appaloosa's David Tepper made some very optimistic comments about the U.S. stock market and on the domestic economy. In part, based on those remarks, equities embarked on a sharp run up that began that Friday morning and has continued to date.

Sometimes it's just that easy.... What did the Fed just tell me? What did they say? They want economic growth. And they said, We want economic growth, and we don't even care -- not only do we not care if there's inflation but we want a little more inflation. Have they ever said that before?... They want the market up. So, what am I-I'm gonna say, No, Fed, I disagree with you?... Either the economy is going to get better by itself in the next three months. And what assets are gonna do well? You can guess the assets that are gonna do well. Stocks!... Or the economy's not gonna pick up in the next three months, and the Fed is going to come in with QE. And then what's gonna do well? Everything!... Let's see. So what I got-I got two different situations. One, the economy gets better by itself.... The other situation is the Fed comes in with money.... You gotta love a put.... I gotta buy; I can't take the chance of not being a little bit longer now.... That does not mean that I'm going balls to the walls.... That's how easy it is right now. -- David Tepper, "Squawk Box" comments

Let me begin by make one thing clear: We can admire our icons, but we can question and be in disagreement with them:

• I worshipped at the altar of Tiger Woods' golf game, but he moved down many pegs after the disclosure of his many trysts.
• I worshiped at the chess altar of Bobby Fischer, but his idiosyncratic behavior turned me off to him and to chess.
• I worship at the baseball altar of anything having to do with the New York Yankees, but I disagreed with the manner in which Brian Cashman and George Steinbrenner appeared to treat former manager Joe Torre, when he was asked to take a pay cut following the 2007 season.
• I worship at the altar of Quentin Tarantino's movie productions. While most of his body of work can be viewed as pure genius, I hated Kill Bill (both volumes).
• I worship at the altar of Julia Roberts' acting prowess, but her recent performance in Eat, Pray, Love (more like Sit, Watch, Groan!) was sententious, patronizing and saccharine.
• I worship at the music altar of the Grateful Dead, but I have attended numerous Dead concerts in which Jerry Garcia was so stoned his voice was unrecognizable.
• I worship at the political altar of President Obama, but, at times, I have been critical of his policy and lack of focus regarding the need for a transformative jobs program.
• I worship at the consumer advocacy altar of (my ex boss) Ralph Nader, but he never knew when to get off the stage and cost Vice President Al Gore the Presidency.
• I worship at the investment altar of Warren Buffett, but I shorted Berkshire Hathaway's (BRK.A) shares in early 2008, based on the belief that his portfolio was too skewed toward financials (an industry that that had lost their "moat" feature), and I disagreed with the timeliness of his derivative short of the S&P 500.
• Similarly, I continue to worship at the hedge fund altar of Appaloosa's David Tepper, but this morning I want to question the conclusion he made during his "Squawk Box" appearance that, if the economy fails to recover up to expectations, the Federal Reserve will embark on a successful QE 2 that will dutifully bring a rally in the U.S. stock market.

Shock and Awe (QE 1) to Shucks and Aw (QE 2)?

• interest rates are already low
• absence of global cooperation in reflating
• weak confidence and uncertainty of policy
• bank loan demand and credit extension weak
• bank reserves are already plentiful
• increased suffering by the savers class
• QE 2 fails to address structural unemployment issue
• long-term costs considerable

Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren't even sure if it has any effect on the economy.... The Bank of Japan tried quantitative easing to revive their economy and avert deflation, but it didn't work.... Bernanke knew back in 1988 that quantitative easing doesn't work [Bernanke and Blinder research]. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.
-- Ed Yardeni

The economic signs continue to point to the need for more quantitative easing. (This view is generally agreed to by bulls and bears alike.) What is not agreed to is the likely effect of QE 2, especially when compared to the first round of quantitative easing.
Will David Tepper be accurate, or will the "shock and awe" of QE 1 be replaced by "shucks and aw" in QE 2, having very little incremental benefit? (See Ed Yardeni's comments above.)
Last week, Credit Suisse's Andrew Garthwaite captures the consensus that QE 2 will be implemented in November/December and that it will be successful for the following reasons:

• By driving down real bond yields (which helps government funding arithmetic, lowers the savings ratio and pushes up DCF valuations of assets);
• Through the funds flow effect: it gives asset allocators money, which they partly invest in other assets;
• Via the currency: a weaker dollar forces other central banks to adopt QE (Japan, U.K. and maybe eventually after a stronger euro the ECB). This, of course, will eventually lead to a revaluation of emerging-market currencies (which is what most policy makers in the developed worlds desire) as GEM countries have an inflation backdrop that will not permit them to participate in QE. (They either have to accept an asset bubble or currency revaluation, probably a bit of both);
• Through psychology: the lower the bond yields, the more fiscal tightening is postponed (as we have now seen with the likely renewal of the Bush tax cuts).

I previously chimed in that there is little doubt that QE 2 will have some positive influence but questioned the degree of its impact:

• It will pull the U.S. dollar still lower, serving to improve our exports and slow down our imports and resulting in a more balanced trade deficit.
• The yield curve will likely flatten further -- in theory, serving to encourage banks to lend.
• The consumer will continue to benefit by a further drop in mortgage rates as debt service ratios improve. Refinancing activity will also increase; a pickup in consumer spending could follow.
• Even though housing will continue to be haunted by an unsold shadow inventory, lower mortgage rates raise the odds that the residential real estate markets stabilize sooner and, with less pressure on home prices, that consumer confidence might recover quicker.
• Real interest rates will drop further, so risk assets should theoretically gain in price.

The times, they appear to be a-changin', and the effect of QE 2 -- its ability to move the needle -- despite David Tepper's assurances, remains uncertain. Back then, QE 1 was instituted at a very depressed level of worldwide economic activity, during a period when market participants were fearful of a financial collapse. Balance sheets were unstable, and funding was problematic. There was unanimity of opinion (over here and over there) that our financial institutions needed to be backstopped, and they were by central bankers in a synchronized and coordinated global fashion.
Everyone was "all in."
Today, our financial markets are stabilized, credit and spreads and risk markets are in far better shape, and our stock market is up violently from the March 2009 lows.
We needed (and got) stability two years ago, but today we need growth.
Today we have a broken domestic money multiplier, we suffer from structural unemployment, interest rates are already at zero (and our savers' class continues to suffer from policy), lackluster credit demand is lackluster, our domestic banks hold large excess reserves but are reluctant to extend credit in the face of economic, and regulatory uncertainty and the housing market (price and activity) is losing some of its historical correlation to interest rates (as it is haunted by a large shadow inventory of unsold homes). Also, with the ECB not playing ball with respect to a global coordination reflation program, not everyone is "all in" today for QE 2.
From my perch, it is growing increasingly hard to see QE 2 as a significant needle mover and as a successful/meaningful follow-up to QE 1, but it is easy to see some intermediate-term fallout.
Dr. Bobby Marcin offered a negative and extreme view of QE 2 recently:

[The Fed] has pulled out their one trick pony named All-Ease-All-The-Time. The Fed insists this trick is panacea for the economy.... [The Fed believes that] asset speculation creates wealth and economic prosperity. Bernanke believes currency debasement will create jobs, reflate housing, spike financial assets.... And, it will accomplish this by only gently nudging inflation up to 2%. What a joke.
The next QE performance will create trillions of paper dollars and create no jobs and minimal GDP growth and inflate no home prices. It might goose financial assets a bit temporarily, but that seems to be the ... end game.
QE 2, however, will crush the dollar, hurt pension funds and savers, spike inflation (especially in commodities) and distort market pricing signals. And if it persists, will force investors out on the risk curve and may initiate bubbles in bonds, stocks and commodities. Easy Al has relinquished the circus ring to Bubble Ben.
In an act of suspension of disbelief, the markets wants to applaud this pony trick. How foolish. Printing money and inflating asset prices creates no sustainable wealth or economic activity. It creates the illusion of wealth and fosters major economic imbalances. That's our problem today, yet the clowns running the circus don't understand that sentence.

Bobby's prose might appear inflammatory, but there are kernels of wisdom/truth contained in his rant. Rather than a consensus-like response that QE 2 will be successful economically and market-wise -- currently the U.S. stock market is having a benign response to a weakening dollar (as it did in 1987) but for how long?) -- I would offer some additional questions investors should be asking:

1. What will the costs of QE 2 be?
2. At some point, shouldn't increased monetary intervention by the Fed (and fiscal intervention by the government) cause market participants to lower the market multiple as opposed to increasing it?
3. Isn't QE 2 simply reducing the quality of earnings and, similar to Cash for Clunkers or the Homebuyer's Tax Credit, borrowing from future growth?
4. How does QE 2 resolve the single-most headwind to growth, structural unemployment?
5. At the very least, at what point have the prospects for QE 2 been priced in?

The above issues and the uncertain impact that QE 2 will have on our currency helps to explain the very public debate going on now among the Fed members that we have witnessed over the last week. And it also helps to explain why some of those members are encouraging an incremental policy, not a "shock-and-awe" QE 2 but a "shucks and aw" QE 2. As my idol and icon, Grandma Koufax, used to say to me, "Dougie, I will always love you, but sometimes I don't like some of the things you do."
In a similar vein, with respect to one of my icons/idols, Appaloosa's David Tepper, I must respectfully take some exception to the certainty of a salutary investment and economic consequence of QE 2 that Tepper displayed in his remarks on "Squawk Box" -- namely, that investors will win whether the economy strengthens or weakens and is followed up by QE 2.
Heads investors win, tails investors win?
At current stock prices, that is not a coin toss that I wish to bet on right now.

Setting Up for Bearish Equity Reversal?

Intraday chart shows Dow down 100 points with 90 minutes remaining in the day, but anything can happen in the last hour of trading!

Daily chart looks bearish (both prices, volume)

Investors Continue to Pull Out of Equity Markets

It is beyond a joke now: ICI's latest data discloses that in the week ended September 8, domestic funds saw outflows of $2.2 billion, following last week's massive $7.7 billion. And yes, ETFs experienced outflows as well. So far September has experienced nearly $10 billion in outflows, even as the market has ramped by over 6%. Who is buying this shit? Just ask The New York Fed and Citadel: they may have a few pointers (wink wink). This is the 19th sequential outflow from US stocks, and amounts to $65 billion in redemptions for the year. With the market pretty much unchanged YTD, it means that mutual funds can not resort to capital appreciation as a substitute to outflows, and most are on their last breath (Janus: blink twice if you are still alive please). The kicker: the S&P is at the level it was when the outflows began back during the flash crash. If that doesn't restore all your confidence that Uncle Sam will be so good at managing the market (just like he has done with everything else), nothing else will. Throw in a little HFT, a little subpennying, a little Flash trading, a little DMA trading, a little quote stuffing, a little hedge fund clubbing, a little specialist front running, a little daily flash crash in big caps like Nucor Steel, and you can see why next week we will most certainly have our first inflow in 20 weeks. Or not. It doesn't matter. Nobody that is made of carbon, or who doesn't already have direct access to the Fed for zero cost funding, is trading stocks anymore.
Weekly YTD outflows:

Cumulative YTD outflows:

Societe Generale's Albert Edwards Cuts Lose on Equities

"The current situation reminds me of mid 2007. Investors then were content to stick their heads into very deep sand and ignore the fact that The Great Unwind had clearly begun. But in August and September 2007, even though the wheels were clearly falling off the global economy, the S&P still managed to rally 15%! The recent reaction to data suggests the market is in a similar deluded state of mind. Yet again, equity investors refuse to accept they are now locked in a Vulcan death grip and are about to fall unconscious...

The notion that the equity market predicts anything has always struck me as ludicrous. In the 25 years I have been following the markets it seems clear to me that the equity market reacts to events rather than pre-empting them. We know from the Japanese Ice Age and indeed from the US 1930's experience, that in a post-bubble world the equity market merely follows the economic cycle. So to steal a march on the market, one should follow the leading indicators closely. These are variously pointing either to a hard landing or, at best, a decisive slowdown. In my view we are poised to slide back into another global recession: the data is slowing sharply but, just like Japan in its Ice Age, most still touchingly believe we are soft-landing. But before driving off a cliff to a hard (crash?) landing we might feel reassured when we pass a sign that reads Soft Landing and we can kid ourselves all is well.

I read an interesting article recently noting the equity market typically does not begin to slump until just AFTER analysts begin to cut their 12m forward EPS estimates (for the life of me I can't remember where I read this, otherwise I would reference it). We have not quite reached this point. But with margins so high, any cyclical slowdown will crush productivity growth. Already in Q2, US productivity growth fell 1.8% - the steepest fall since Q3 2006. Hence, inevitably, unit labour costs have begun to rise QoQ. This trend will be exacerbated by recent more buoyant average hourly earnings seen in the last employment report. Whole economy profits are set for a 2007-like squeeze. And a sharp slide in analysts' optimism confirms we are right on the cusp of falling forward earnings (see chart below).

Edwards get downright hostile when discussing recent economic data out of US. We understand - the ever more acute manipulation of data by the BEA drones is getting infuriating. (bold below is Albert's)

August's rebound in the US manufacturing ISM was an even bigger surprise. This is a truly nonsensical piece of datum as it was totally at variance with the regional ISMs that come out in the weeks before. The ISM is made up of leading, coincident and lagging  indicators. The leading indicators - new orders, unfilled orders and vendor deliveries - all fell and point to further severe weakness in the headline measure ahead (see chart above). It was the coincident and lagging indicators such as production, inventories and employment that drove up the headline number. Some of the regional subcomponents (eg Philadelphia Fed workweek) are SCREAMING that recession is imminent (see left hand chart below).

Lastly, Edwards discusses the feasibility of his S&P 450 target in light of a Fed that is resolute in never ever allowing stocks to fall again.

Indeed we know that a central plank of the unhinged policies being pursued by the Fed and other central banks is to use QE to deliberately target higher asset prices. Ben Bernanke in a recent Jackson Hole speech dressed this up as a "portfolio balance channel", but in reality we know from current and previous Fed Governors (most notably Alan Greenspan), that they view boosting equity and property prices as essential for boosting economic activity. Same old Fed with the same old ruinous policies. And by keeping equity and property prices higher, the US and UK Central Banks are still trying to cover up their contribution towards the ruination of American and British middle classes - (see GSW 21 January 2010, Theft! Were the US and UK central banks complicit in robbing the middle classes? - link). The Fed may indeed prevent equity prices from slumping with any QE2 announcement. But this sounds a familiar refrain at this point in the cycle. For is monetary easing in the form of QE that different from interest rate cuts in its ability to boost equity prices? Indeed announced rate cuts in previous downturns often did generate decent technical rallies. But in the absence of any imminent cyclical recovery, equity prices continue to slide lower (see chart below).  The key for me is whether QE2 can revive the economic cycle, not equity prices temporarily.

And here is the kicker for all those expecting a massive stock surge on the imminet QE2 announcement: 

Many of our clients think QE2 might give a temporary flip to the risk assets but that the subsequent failure to produce any cyclical impact will cause an extremely violent reaction as investors lose faith in QE as a policy tool and Central Banks in general.

Forget our suggestion about the Greenspan-Edwards deathmatch (aside from the obvious outcome) - we cede it to the SocGen dude preemptively:

If we plunge back into recession, do not place too much confidence in the Central Banks having control of events. As my colleague, Dylan Grice, said last week "let them keep pressing their buttons." Ultimately they cannot fool all of the investors, all of the time.

Amen.

Citi's Robert Buckland Declares the End of the "Equity Cult"

Citi's Robert Buckland is out with the must read report of the weekend, especially for all the optimists who believe that despite the ongoing depression (and as many have demonstrated, all the talk about a double dip is moot, as America has never left the depression, or as Rosie calls it a period of prolonged economic subpar activity: the latest NFP number merely reinforces the theme of economic deterioration), and despite the 17 weeks in retail equity outflows (which would be a contrarian signal if there was hope that retail would ever feel safe enough to return in stocks. After nearly 5 months of no change in trend, the debate can be put to rest, if at least for 2010) there is still hope. There very well may not be - Citi has just pronounced the "Equity Cult" dead: "It has taken 10 years, and two 50% bear markets, to reverse this cult. European and Japanese equities are already trading on dividend yields above government bond yields. US equities are almost there as well. An immediate reincarnation of the equity cult seems unlikely. Global corporates, especially the mega-caps,  rushed to exploit cheap financing as the equity cult inflated. They have been slow to redeem equity now that the cult has deflated. Equity oversupply remains a drag on share prices." And as more and more companies and investors shift to a de-equitization theme, the trendline in allocation for the US pension assets will soon revert to that seen when the "Equity Cult" began, or roughly 20% of all assets, with bonds taking on an ever greater precedence of asset allocation (incidentally the UK is already back to the equity/debt relative investment levels of the early 1960s). What does this mean for capital flows? "A reduction in equity holdings back to pre-1959 levels (around 20% of total assets) would indicate considerable selling pressure to come. For US private sector pension funds alone, that would imply a further $1900bn reduction in equity weightings. The evidence suggests that there could still be considerable institutional selling to come."
So let's recap what the medium- and long-term trends for the market are:

• $2 trillion in equity sales from pension funds alone as capital flows normalize now that the "Equity Cult" is dead
• A seemingly endless push into fixed income by an aging demographic meaning billions more in ongoing monthly domestic stock mutual fund redemptions
• Hedge funds which are underperforming the market massively, and which will see an explosion in redemption letters as the end of Q3 approaches
• An inevitable change in the tax regime over the next 4-5 months, which as Guggenheim pointed out, will force investors to sell billions in stock to catch a sunsetting beneficial capital gains tax.

And yet what happens - the market surges on a negative NFP number that was negative but better by a factor of noise, compared to whisper expectation, as robotic traders pick up on the positive feedback loops to take the market higher one more time as soon everything collapses.
For all those who believe in 17x forward P/Es (expecting a 20% rise in corprate earnings in 2011 with a flat GDP indicates a serious overdoes on medicinal hopium) - Good luck chasing the bouncing ball.
For all those others, who feel like micturating upon the grave of the "Equity Cult" here are the highlights from the Citi report.
Bond vs Equities - Then and Now (this will be familiar to all those who have read Albert Edwards' recent pieces):

In July, global equities rebounded despite continued falls in government bond yields. This defied the strongly positive relationship between equities and bond yields seen since 2000. Many equity investors worry that this decoupling will be resolved by the bond markets being proven “right”. The implications of this are worrying — the last time US treasury yields were down at these levels, the S&P (currently 1050) was nearer 800.

We have pointed out that equities actually have a decent track record when these decouplings have occurred in the past1. Certainly Citi’s equity and bond market forecasts suggest that this current breakdown in the relationship is more likely to be resolved through rising bond yields than falling equity prices. However, we also understand that many investors think we will be proven wrong.

We can’t help but suspect that this hot debate about the relative attractions of bonds against equities — whether one is pricing in the double dip but the other is not, whether one is pricing in deflation but the other is not — is mere froth on top of a much more profound reassessment of the merits of the two asset classes. In particular, has the “cult of the equity” been replaced by the “cult of the bond”? To answer this we first take a look at the origins of the cult of the equity.

The rise of the cult of the equity is reflected in institutional asset allocations. Figure 3 shows the weighting of US private sector pension funds in equities and fixed income as derived from the Fed’s Flow of Funds data. Back in 1952, US private sector pension funds held just 17% of their assets in equities compared to 67% in fixed interest. Over the next 50 years, these weightings reversed — at the peak in 2006, the same funds held 69% in equities and 18% in fixed interest. Of course, some of the increase in equities will reflect the outperformance over the period.

The picture looks similar in the UK (Figure 4). Back in 1962, ONS data suggest that UK pension funds held more in bonds than equities. That reversed in the 1960s, as equity weightings increased aggressively. At the peak in the early 1990s, UK pension funds held 76% of assets in equities compared to just 12% in bonds. It seems that UK pension funds embraced the cult of the equity more enthusiastically than their US counterparts, perhaps as a result of a desire to buy equities as a hedge against the UK’s more significant inflation problems.

We can also see the rise (and fall) of the equity cult in mutual fund flows. Figure 5 shows US mutual fund equity inflows going back to 1984. These peaked above $300bn in 2000. European fund inflows peaked in the same year at €180bn (Figure 6). US equity inflows recovered as markets rallied in 2003-07. European equity inflows did not.

Why the cult is now dead?

It seems that the cult of the equity began in the late 1950s. Why? Many justifications have been put forward. Most obviously, the 1950s marked the beginning of a welcome period of peace and prosperity following a tumultuous 50 years that included two world wars and a major economic depression.

The rise in equity weightings coincided with Markowitz’s first considerations of modern portfolio theory. This promoted the belief that a well-diversified equity portfolio could achieve superior returns while helping to reduce risk. It was clearly the view of George Ross Goobey, manager of the Imperial Tobacco pension fund who was generally perceived to be the godfather of the cult of the equity in the UK. Ross Goobey liquidated his entire fixed interest portfolio in the 1950s and invested the proceeds in equities. This was highly controversial at the time — he was banned from teaching students at the UK Institute of Actuaries.

Other factors may have helped to promote the cult of the equity. Most pension funds were relatively immature back in the 1950s, so giving them a better ability to absorb short-term equity volatility in search of longer-term returns. Equities were seen as a good match against the wage-driven liabilities of defined benefit pension schemes. Equities offered a decent inflation hedge long before index-linked bonds were ever invented. This characteristic was particularly attractive in the 1970s and 1980s. The list of academic justifications goes on and on.

Performance-chasers

But perhaps most convincing is the argument that the cult of the equity was the product of a period of spectacular  outperformance from the asset class. This became self-fulfilling. Pension funds bought more and more equities because they kept outperforming. Insurance companies (except in the US, where their exposure to equities has been limited by law) and retail  investors couldn’t resist the same trade. Figure 7 shows the annual returns from US equities and government bonds divided into decades since the 1920s. We also show the annual returns for the total period.

Since 1920, even including the dreadful experience of the last decade, US equities have generated a healthy annual return of 10.9% compared to a bond return of 6.1%. The most spectacular equity performance (especially relative to bonds) was not in the roaring 1920s, 1980s or 1990s, but in the 1950s. Perhaps this is what brought investor attention back to equities. It took  many years for the wounds of the 1929 crash to heal — US equities only managed to regain their pre-1929 crash levels in 1954. But from there, a new 40-year love affair with equities began. The 1970s were tricky, but equities did no worse than bonds. Indeed, by the end of the 1990s, the long-term outperformance of equities over bonds looked truly spectacular. $100 invested in US equities in 1950 would have been worth $58,380 at the end of 1999 versus $1,651 in treasuries. Those two numbers probably say more about the cult of the equity than any long academic study.

Why Is There A Cult Switch?

The evidence suggests that the cult of the equity began in the 1950s and peaked in the late 1990s — that’s a 40-year bull market. Since then, it seems that the investor love affair with equities has soured.

Many of arguments associated with the cult of the equity have since come under attack. Inflation seems much less of a problem. Equities have never been particularly good at hedging inflation anyway, and now index-linked bonds can do a much better job. The long duration of the equity asset class becomes less desirable for pension funds as populations mature and retirement dates approach. Defined contribution investors (where the individual takes the risk) may be less willing to tolerate volatile equity returns than the old defined benefit plans (where the employer takes the risk).

But most importantly, it is dreadful returns that are increasingly putting investors off equities. Since the end of 1999, global equities have returned just 4% in total. Not only have equity returns been trivial, but the volatility has been brutal. Having two 50% bear markets in one decade is enough to test the patience of the most determined equity cultist. Just as strong returns helped to build the cult of the equity in the 1950s, so weak returns are tearing it down now.

Investor appetite for global equities is falling. Figure 3 shows that in 2009 US private sector pension funds held 55% of total assets in equities compared to 70% in 2006. Figure 4 suggests that UK pension funds cut their equity weighting to 39% in 2009, down from the 76% high in 1993. The 2009 rebound in equity prices has helped to reverse some of this decline in equity weightings, but most investor intention surveys suggest that the secular reduction in equity weightings is likely to continue.

How much worse will it get?

How far could this go? A reduction in equity holdings back to pre-1959 levels (around 20% of total assets) would indicate considerable selling pressure to come. For US private sector pension funds alone, that would imply a further $1900bn reduction in equity weightings. The story looks similar amongst retail investors. Equity inflows into US mutual funds have not recovered from the 2007-09 bear market (Figure 5). European equity inflows never recovered from the 2000-03 bear market (Figure 6).

The evidence suggests that there could still be considerable institutional selling to come. Developed market pension funds have cut their equity weightings from peaks but there is still a long way before they get back down to pre-cult levels. For a broader global comparison, we look at the 2010 Towers Watson Global Pensions Assets Survey (Figure 8). Given different data samples, this might not correspond with the long-term historical data series that we have already shown for the US and UK, but it is a useful guide to regional variations.

What does Japan teach us?

Japan may be a useful guide to an unwinding equity cult. According to Towers Watson, in 1998 Japanese pension funds held 55% in equities, still remarkably high given the dire performance of the Japanese market through the decade. Japanese pension funds now hold 36% of total assets in equities and that number seems likely to head lower. Bonds have been the key beneficiaries of equity outlflows. Elsewhere in the world, Australian pension funds have a high equity weighting although our local strategists have argued that the compulsory superannuation fund structure has embedded the equity culture more firmly than in other parts of the world. Continental European funds are already firmly tilted away from equities towards bonds, so the scope for further equity outflows might be more limited.

Emerging Markets remain one bright area amidst the gloom. Figure 9 shows annual global equity inflows as measured by EPFR. This confirms the sorry state of developed market inflows, but it also shows that the appetite for Emerging Markets equities has been much more robust.

The cult is dead. Long-live the cult

As the cult of the equity fades, it is being a replaced by a new cult of the bond. It is argued that bonds are more appropriate in a world where deflation, not inflation, is the main threat. Liability Driven Investing (LDI) advocates usually promote the liability-matching benefits of bonds over equities. Ageing populations would seem to favour bonds over equities — most “lifestyle” pension schemes automatically switch equities into bonds as a worker approaches retirement age. Perhaps most importantly, bonds have handsomely outperformed equities in the past decade. Since 2000, global equities have returned 4% (0.3% per year), while global government bonds have returned 103% (6.9% per year). The list of factors favouring bonds is as long as that favouring equities back in the 1990s.

These arguments are reflected in rising pension fund bond weightings (Figure 3 and Figure 4). We can also see that mutual fund inflows now favour bonds, although not yet as consistently and heavily as they favoured equities in the late 1990s (Figure 5 and Figure 6).

But even if there is no bond cult, the stock chasing era is over: Conclusion

Of course we can (and will) carry on arguing about whether bonds or equities will be proven “right” after the recent decoupling. We can (and will) carry on arguing about the likelihood of a double-dip in the global economy. We can (and will) carry on arguing about whether the developed world is heading into a Japan-style deflationary spiral. Each outcome should have meaningful implications for the direction of global equity and bond prices.

However, we can’t help wondering if this misses the point. With the notable exception of Emerging Markets, what is really going on is a long-term shift in investor appetite for equities and bonds. It will take more than the avoidance of a double-dip to turn the equity outflows around. Sure equity prices would probably rise in the short term if that were to happen, but a sustainable rerating could only be achieved if investors were to be attracted back to the asset class. Although likely to be painful in the short run, an inflation-inspired global bond sell-off would probably offer the best chance of that happening. That still seems pretty unlikely for now.

The Citi view on the outlook for the global economy could be best described as “uninspiring, but not disastrous”. But rather than furiously arguing about whether that view is right and if it is already reflected in share prices, perhaps we would be better served by accepting that, from a valuation perspective, it is what it is. For all sorts of reasons, both cyclical and structural, equities are likely to remain “cheap” against bonds for some time yet.

So it is what it is. Investors are unlikely to pile back into global equities any time soon. It looks like they are likely to sell weightings down and move further into bonds. This is convenient for government bond issuers given that they have such vast amounts of bonds to sell. Equity and bond valuations will continue to reflect these flows. Maybe global equities can move higher with rising profits but, outside Emerging Markets, the prospect of a 1980/90s-style rerating still seems a very long way off.

Indeed, it is what it is: you can't fund a trillion dollar bond bubble, and see equity allocations at the same time. There is a reason why Albert Edwards sees the S&P in the 400 range: you can't have an increasingly more frugal investors buying both, and you can't have central banks buying everything without risking a completel collapse in the faith of all currencies. In retrospect, it is really simple. There are those who believe they are immaculate daytraders, and believe they can make money chasing everything dip in stocks. We wish we had their skill. Since we don't we would rather put our bet on where the age old adage of follow the money says stocks willl end up going. And that is much, much lower.
Full must read report.

New Milestone in Equty Fund Outflows!

The latest anticipated weekly outflow from equity mutual funds just hit a one month high of $2.7 billion, as reported by ICI, and with that, YTD redemptions by equity investors have hit over $50 billion. Domestic equity mutual funds have not seen a net positive retail inflow since April 28, yet despite this the market has been substantially rangebound and until last week.

Bank of Montreal Tells Clients to Sell Equities, Move to Cash ASAP

We advocate switching out of equity positions and going to cash. The European sovereign debt crisis appears to be nowhere near over. The global credit environment is worsening. Cost of capital is going up and availability is going down. There are large gaps between where the credit market prices risk and where the equity market is priced. Equity is lagging the deterioration in credit conditions. Moves in currency, equity and commodity markets are mirroring the moves in the credit market. Global growth, in a credit-constrained environment, will slow. Profits will be squeezed by the higher cost of capital.

State of the Market: Credit vs. Commodities & Jobs

The frail state of the markets is now becoming more obvious and as such the audience for our call to cash is growing. The difficulty in getting our message out is that in its raw form (how we normally write), the argument is quite technical:

Client: Why go to cash?
Quant/Technical: Look at the euro-dollar basis swap pricing!
Client: Say what??

Now, however, the market is showing signs that everyone can easily recognize as indicative of economic weakness:

Job growth has stagnated, and
Commodities and inflation expectations are falling.

These new signs are not new information on why things are bad. Rather, they are symptoms, or outward displays of how weak the credit market has become.

Weakening credit conditions are the cause.
Economic fallout is the effect.

Western European Sovereign Debt Crisis = Asian Growth Problem

We observed that the sovereign default risk of Europe was very well connected to the sovereign default risk of Asia.

Then we tracked down the tidbit that European financials have funded Asia to the tune of more than half a trillion dollars.

By observation, we know there is a link and now we have part of the economic rationale for what we are seeing.

We have what we need for our call for extreme caution:

The funding of Asian growth is closely tied to the health of the European financial system.

Further, we know that the North American equity market is fixated on Asian growth.

Our equity market correction starting gun went off the moment Asian currencies, and thus optimism toward Asian growth, started falling.

The close ties between European and Asian credit are showing up in the tick charts only in times of stress, which is why we started picking up the relationship quite recently.

Growing Asian risk is equal to, outward capital flows, and ultimately a slowdown in Asian growth. An Asian economic slowdown in a capital-constrained world will bring forth lower global growth, and lower commodity prices.

European Sovereign Debt: Hard & Soft Asset Bubbles

Greece has started the process to sell private assets to raise capital. Publicly traded Greek stocks in which the government has a stake are falling fast, as investors fear large government sales.

The market is concerned that the German taxpayer will have to fund a Greek debt default spiral. Alternatively, euro holders worry that the German taxpayer will not fund Greece, leading to euro disintegration.

The market is now giving Spain a hard time, with Spanish government 10-year yields now higher than when the bailout package for Greece was announced.

The Spanish problem is also one of easy euro credit, which fed a construction, or hard asset bubble, that has now burst.

At the leading edge of the credit crisis in this case are Spanish regional banks, or cajas.

As the FT described succinctly; “the unlisted cajas – many of them politicised, linked to regional governments and with an opaque ownership structure – seized market share from the banks at the peak of the recent housing boom and now account for about half of outstanding loans in Spain. Several are heavily exposed to bankrupt property developers and homeowners unable to meet mortgage payments.”

Smart Money, Hedge Funds Selling Equities

Bank of America Merrill Lynch is out with the latest iteration of their hedge fund monitor report and we get a glimpse at the latest exposure levels. If you like to follow the smart money, then you should highly consider selling equities because that's exactly what hedge funds are doing. Last week we posted that hedge funds had below average net long exposure and we see this trend continues. Long/short equity funds are now around 25% net long, which is definitely below their historical average of 35-40% net long. Of their long positions overall, hedgies favor small cap and low quality 'junk' stocks. Last week we also touched on how there is a divergence between l/s funds and market neutral funds. This divergence continues as market neutral funds are still net long equities (but they did reduce some beta exposure).

We also see that according to CFTC data, many hedgies have been adding to shorts in S&P futures. Whether they are simply selling longs to lock in some profit or making a market timing call, one thing is clear: hedge funds are definitely cautious in this market. We also got confirmation of this trend from David Einhorn's hedge fund Greenlight Capital. In their latest investor letter, Greenlight discloses that they were 100% long and 70% short, leaving them 30% net long for the first quarter. This is right along the lines of what we've seen across industry-wide data sets.

Turning now to other significant asset class moves from hedgies, we see that they were adding to longs in crude oil and pressing deep shorts in natural gas. Additionally, hedge funds continue to pound the euro short. In interest rates, we learn that for the third consecutive week, hedge funds have very crowded shorts in 10 and 30 year treasuries as they short the long end of the curve. Curve steepeners continue to be hedge fund land's favorite drug.

Lastly, we also get a performance update from BofA regarding their hedge fund generals list. This is a basket comprised of stocks widely owned by hedge funds. It is up 13% year-to-date for 2010 and for 2009, the HF generals index was up 69%. You can compare these figures against individual hedge funds in our first quarter performance numbers post.

Embedded below is Bank of America Merrill Lynch's latest trend report on hedge fund exposure levels:

You can download a .pdf here.

So, the trend remains much of the same across hedge fund land as of late. Hedgies are selling equities, shorting the long end of the yield curve, shorting the euro, and longing crude oil. You can view BofA's previous hedge fund trend report here and make sure to also check out their hedge fund generals list to see what stocks hedge funds love most.

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I've noticed that stock market volume has shown liquidation for the past few weeks.

Dollar Gains On Equity Weakness

Commodities are softer this morning because of the firmer dollar.

Global Equity Weakness

It's an Equity Bull Run -- for the Exits!

There appears to be a real bull run today in equities, but they are headed for the exit signs in a stampede. Other positive news, like the buy-out of Sun by Oracle, is a casualty in the stampede out of financials on the news that credit quality is rapidly degrading in all sectors. Reality has come home!

Commodities, Crude Oil Rise

Commodity prices are rising almost universally today with the stock market. If "the worst is over", then demand for commodities will surge along with global equity markets.

Ever Remember

Stocks look destined to dip lower at the open today, perhaps in memory of the catastrophic events on this date seven years ago. Worry, worry, worry in the equity markets! The daily charts (not shown) appear to be on the verge of a breakout to the downside. Some equity sectors already have! And I thought that after the Fannie/Freddie rescue, the market was supposed to turn higher.

Hadn't we hit bottom? Apparently not! I say this to underscore the absurdity of those who constantly declare that we've hit bottom. Lose your opinion, not your money! Predicting the future is for prophets, not profits! Those who try, lose the latter.

Bond Vigilantes Take the Bull By the Horns

Wow! The bond vigilantes have taken the treasury bull by the horns, and are selling treasuries in force today. Apparently, the treasury market is expecting the Fed to cease easing interest rates soon, but they are driving interest rates higher by selling treasuries. Treasuries reached their high on March 17th, and have been trending lower ever since, forcing interest rates higher despite Fed easing. This 15 minute chart today shows the selling activity, with the commensurate interest rate rise. The US Dollar is also modestly higher overnight.

In some ways, this is a good sign, because equity markets have fully priced in a recession, and equities prices have been slowly edging higher as well. Funds are moving out of safe-have treasury investments and back into stocks, albeit on somewhat weak volume. Even bad news for the U.S. economy (investment bank refunding, poor jobs report) over the past week has caused stocks to rally. This is a good example of a case in which the market moves contrary to what would have been expected. It is also an example of the leading nature of stocks and the almost nutty, optimistic nature of equity markets to hope for -- even expect -- improvement soon.