Global Macro Notes: Sizing Up The Bull

April 14, 2011
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On Monday April 11th, the following commentary was posted in the Mercenary Live Feed:

Some will argue any oil decline is a “buy the dip” opportunity before flare-up rages further. This may be true, but it is not a lock by any means.

As the speculative vanguard, small caps are a tell that this decline is about more than just oil. It may be a weakening of risk appetite and a shift towards broad stock market correction. That would be fitting given two potentially “priced in” factors — April being the best month of the year for stocks, and corporate profits hitting new records as cost cuts and rising sales combine.

The trouble is that investors may have anticipated both. This has become enough of a gamed market for the “April effect” to have been pulled forward, and equity levels are certainly rich enough to reflect record earnings.

Put this together and what you get is a classic “buy the rumor, sell the news” type environment. This is why we remain open to long-side setups — in case oil or gold go nuts for example — but maintain an instinctive bias to the short side. The bulls have had the run of the place since September 2010. More than 7 months on, the end of the [QE2] psychology boost and priced-in corporate profits pop are coinciding.

After Alcoa’s miserable kick-off to earnings season, we have seen further evidence of  a “sell the news” mentality in J.P. Morgan’s tepid reaction to strong results.

The old trading wisdom says that “the less observed, the better the trade.” As Bruce Kovner pointed out in Market Wizards, market moves born of speculator activity have lower odds of being the real deal.

This makes for an exceedingly strange environment, as the psychological power of QE2 and the “Bernanke Put” (successor to the Greenspan Put) have made for one of the most gamed markets ever

One can see the degree of gaming via the below eye-opening CRB correlation chart, which has made the rounds from Bloomberg to Minyanville to The Big Picture:

On top of Fed accommodations and improving economic conditions, Mr. Market seemed to don an invincibility cloak after shrugging off the Japan earthquake and Fukushima.

As George Soros has observed, positive feedback loops in markets tend to undergo a series of tests. When a hard test is successfully passed, crowd conviction reinforces itself yet further.

So here is a very rough summation of driving factors thus far:

  • Steadily increasing corporate profits, courtesy of a bought-and-paid for recovery cycle (via huge amounts of stimulus).
  • Deep cost-cuts and improving sales leading to exceptional profit margins for public companies.
  • A QE2-fueled sense of speculative euphoria putting a persistent bid under markets, thus creating the expression JBTFD, or “Just Buy The [Expletive] Dip.”
  • A sense that “bad news is good news” in respect to the 70 / 30 split between consumer haves and have nots. While roughly 70% of U.S. consumers are struggling (food stamps, high unemployment etc.), the top 30% are spending as usual, giving Wall Street the best of both worlds (justification for stimulus plus high-end spending power).
  • A “crisis contained” mentality as all potential top down derailments — European sovereign debt crisis, Japan meltdown, U.S. middle class erosion, China implosion, E.M. slowdown, housing double dip — are written off as manageable or safely at a distance.

In addition to the above, a “wall of worry” was created by the many hesitators and doubters, allowing markets to climb and climb. Then, as noted, the Japan disaster acted as a sort of horrific strength test.

The ability of markets to (mostly) brush off Fukushima like a blip may help explain the rather insane move in emerging markets some weeks back. So many emerging market vehicles went vertical in that rush, India is as good an example as any.

We caught India long (via INP) on the late March wedge breakout, and remain partially long (after booking profits) as of this writing. But the near vertical nature of INP’s move (and many others) felt surprisingly unnatural from the start.

The sudden fevered frenzy for E.M. assets, in other words, seemed not so much a logical reassessment of the global economic outlook, but instead a sort of thoughtless violent spasm comprised of short covering, a damn-the-torpedoes attitude to inflationary pressures and policy risks, and a table-pounding sense of “get me in no matter what.”

The below chart of MSCI Brazil (EWZ), an ag-themed favorite, shows what that kind of “fools rush in” mentality all too often leads to.

At the very least, widespread bullishness on food, energy and emerging markets all at the same time seems a massive contradiction in terms.

The “ambrosia of cheap capital” (to use a Fed president’s term) that helps push grains and oil to new heights also makes life hell for various E.M. central bankers, who one by one give in to necessary tightening measures at risk of economic slowdown.

Meanwhile, the dollar’s managed decline — there is too much collateral damage risk to let it crash — reduces America’s appetite for imports, puts pressure on export-based E.M. economic models as local currencies rise, and places greater pressure on the bottom 70% of U.S. consumers (still being ignored).

Explanations for investor optimism thus provide an overview of “how we got here.” But they doen’t explain how we are going to get much farther, because all these pro-bullish phenomena have built-in self destruct mechanisms:

  • Stimulus cannot go on forever without turning on itself. The long-term costs are too great. Funding a recovery with stimulus is the equivalent of a “buy now, pay later” program. The “pay later” component eventually becomes more than creditors will accept.
  • The psychological aspect of stimulus is time-limited. QE2 was like magic pixie dust for hard asset speculation. At some point the magic dust wears off, the side effects become too toxic to ignore, or both.
  • As mentioned earlier, to be permanently bullish on both hard assets (primarily food and energy) and global economic growth is a contradiction in terms. If the price of everything keeps rising, interest rates must rise and monetary policy must tighten until the growth path stalls.
  • As Jeremy Grantham observes, corporate profit margins are one of the most mean reverting phenomena in all of finance. Profits attract competition. If margins did not wax and wane, capitalism would be broken.

To imagine the bull train rolling merrily along, then, one has to have comfortable answers to the following questions:

What happens when QE2 comes to an end?

What happens to the price of oil in the event of QE3 — and how much more speculation can we handle? Oil $120? Oil $150?

At what point does inflation kill profits, if more “non-core” inflation is what we get?

How long can America’s “have nots” (the bottom 70% pincered by stagflationary forces) be ignored?

Can China really be expected to pull off a soft landing? If they fail, how deflationary is that?

What about Spain — Europe’s true test — where massive real estate losses are yet to be acknowledged?

Whither investor expectations? And where do corporate profit margins go from here?

JS


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