According to much of Wall Street, the thing to do now is buy – so that is what many on Wall Street are doing.
As Jeremy Grantham of GMO advisors observes, “Fund managers are simply not prepared to take the career risk of being wrong for a little while and losing business.” Mark Lapolla of Sixth Man Research further argues that “the incentive [for equity mutual fund managers] is to not lose ground rather than gain it.” In practice this means hugging the benchmarks as tightly as possible – and buying more of the popular names as they go higher.
Grantham’s “career risk” factor feeds a sort of built-in market inertia, as the large mutual funds try hard to imitate each other rather than risk being out of step. To grasp the dynamic, picture a mobile herd of elephants with no pachyderm truly taking the lead. Instead, the elephants at the outside edges of the herd are constantly trying to jostle their way back into the middle.
There is no decision-making onus in the middle, and the view (nothing but fellow elephants on all sides) is consistently familiar. For many, the middle of the herd is irresistibly comfortable. It feels safe, and there is no need for independent thought in such a place.
On the whole, though, this type of aimless milling about is a recipe for disaster. The leader-free herd has no trouble running itself into a box canyon, up against a flooded river, or even right over a cliff. (Markets do the equivalent of this when they bubble up to unsustainable levels, then retreat violently or crash.)
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Quiet Trouble Brewing
Chart analysis, i.e. technical analysis, is meant to track the footprints of these rumbling elephants. There are varying degrees of fanciness and complexity in the TA methods used. For reasons not worth delving into here, your humble editor is a skeptical minimalist when it comes to this kind of thing. He prefers his charts clean and clear, free from the clutter of bells and whistles. Price, volume and moving averages are generally enough to get the job done.
Going by the charts of the three major U.S. indexes – the Dow, S&P and Nasdaq – there does not appear to be a whole lot to worry about. All three have been making successively higher highs and higher lows. The 20-, 50- and 100-day EMAs (exponential moving averages) have been gently sloping higher.
Yet below the surface, all is not as calm as it may seem. The following charts tell a darker bedtime story than the major indexes. In a way these charts are “bellwethers” – pressure barometers that could be worth keeping an eye on as the storm clouds roll in.
First we have crude oil, which has been trading in strong correlation to stocks for much of the year. As equities went up, crude did too, with positive sentiment on the global economy driving both.
But in recent days, crude oil has taken a different path than the stock market. After months of more or less shrugging off poor fundamentals, an overhang of supply in the face of flat-to-weak demand has begun to weigh on crude. If the price of oil continues to fall, it could suggest that speculative appetites are waning.
Another bellwether to keep tabs on is China...
When Beijing hinted at the possibility of tightening bank lending standards in August, the Shanghai A-shares market went into dramatic free-fall and has since not recovered. The U.S.-based China-tracking ETFs like FXI and PGJ, however, managed to bounce right back as optimistic investors outside China poured in fresh capital.
The Xinhua China 25 ETF (FXI:NYSE) in particular is heavy on Chinese financial institutions. As such, FXI looks due to get walloped when the bumper crop of non-performing Chinese bank loans, or NPLs, finally sprouts from the seeds of reckless lending practices sown earlier this year.
If FXI confirms what looks like a double top and continues to head lower, that would argue that the “Chinese miracle” theme as a justification for buying stocks has breathed its last.
Next up we have copper, also known as “the metal with a Ph.D. in economics.”
The red metal has earned its reputation as a bellwether by way of sheer usefulness. In relation to the gadgets and machines that enable the middle-class lifestyle, copper can be found most everywhere. Cars, hair dryers, air conditioners, washing machines, home electrical wiring – the list is endless.
As a highly useful base metal, copper was also one of the “hard assets” being aggressively stockpiled by China this summer. Given copper’s extensive use in fast-growing emerging markets, a rollover on the chart could be a warning sign for global sentiment too.
But perhaps the most troubling bellwether of all is the strong performance of long bonds, as represented in the chart above by TLT, the 20+-year Treasury bond ETF.
Given Mr. Market’s rose-colored glasses, it is fairly bizarre to see long bonds breaking out to the upside here. Why? Because when long bonds move higher, long-term interest rates move lower. (The price of bonds moves inversely to the level of interest rates.) And why would long-term interest rates be heading lower as a healthy recovery gets under way?
We know Uncle Sam is piling on record amounts – truly frightening amounts – of debt. This in itself is ample reason to sell long bonds. We also know that interest rates are at historically low levels, and that any genuine recovery will create at least some amount of inflation (maybe a LOT of inflation) in the future, as the price of goods and services starts to rise again. This is further reason to sell bonds. What’s more, we know that if investors and global central bankers are truly confident in the future, there are plenty of things they can buy here that look far more attractive than U.S. Treasuries. That is yet more reason to sell bonds.
And yet bonds are going higher, not lower. They are breaking out to the upside, not the downside. If one buys into the global recovery scenario, for long bonds to be rising against such a rosy backdrop just doesn’t make sense.
Unless, of course, the much-vaunted optimism is a ruse, and in reality Mr. Market is a lot more nervous than he is letting on... if confidence is actually evaporating, then the move in bonds looks logical. In a sense, the long-bond market is now calling the stock market’s bluff.
If investors and global central banks are stepping up their long bond purchases, that suggests they are still more worried than not, and thus looking for “safe haven” places to put their cash. (Recall how U.S. Treasuries were just about the only asset class to soar, along with the value of the U.S. dollar, in the aftermath of the 2008 crash.)
It also suggests that Mr. Market still sees deflation as a real concern. Why? Because you don’t sign up for a trend of lower long-term interest rates unless you also see the possibility of continued falling prices. Hardly a fit with the message of the major U.S. equity indexes... which is why your humble editor suspects the mutual fund elephants could soon find themselves stampeding in the other direction.
Warm Regards,
JL
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