WHY THERE IS A SIZABLE AIR POCKET BENEATH RISK ASSETS CURRENTLY

October 18, 2010

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Excellent article on exactly why Pragcap is seeing excessive risk in this market. – Ilene

WHY THERE IS A SIZABLE AIR POCKET BENEATH RISK ASSETS CURRENTLY

I wanted to pass along some thoughts on the current macro environment as I believe we are at a potential turning point. After turning very pessimistic in August markets have once again swung to an excessively optimistic position on hopes that the economic recovery is intact and that the Fed will sweep the lingering economic problems under the rug via QE. I think the market has greatly misinterpreted the current environment and therefore sits at a potentially risky position. I believe the three events that the market has rallied in anticipation of are largely priced in and largely misinterpreted. Those three events are the following:

1) QE2

2) Earnings season

3) November elections

Regular readers are well aware of my position on QE. I believe it is the “great monetary non-event” (see here for more). Although the Fed can temporarily alter asset prices, or as the NY Fed President likes to say: keep “asset prices higher than they otherwise would be” (an astronomically irresponsible comment in my opinion), they cannot increase wages, increase jobs, or increase economic output via QE. QE adds no net new financial assets to the private sector. It merely shifts deckchairs around on the Titanic while the orchestra plays a happy tune and the passengers get herded along as if everything will be fine. The current equivalent is obviously an attempt to herd investors into risk assets by lowering interest rates which will hopefully create a wealth effect which will result in more spending of paper profits even though the underlying fundamentals are not going to support said asset price increases. It’s ponzi finance and a very dangerous and desperate road for Mr. Bernanke to venture down. It failed the first time around, it failed in Japan and it will fail the second time here in the USA.

This earnings season is another fine example of irrationality at work. The market has rallied in front of each of the last few earnings seasons in anticipation of the “better than expected” figures we see every single quarter. Unfortunately, this is not a case of stellar corporate earnings. It is merely a case of analysts being behind the curve or reducing estimates. Although the margin driven earnings recovery has been impressive it has proven that the profits recovery has not been organic by any means. As I previously showed revenue per share remains meager at best. The heavy lifting is still being done by the cost cutting. Nonetheless, investors have happily front-run earnings reports in anticipation of companies “beating Wall Street’s estimates”. Every quarter companies sangbag the estimates and play the analysts for fools and then are rewarded with stock price increases after the world is “shocked” by their “better than expected earnings”.

There is probably no better example of this market irrationality than in shares of Apple. Apple consistently sandbags analyst estimates every quarter. Then they report a huge blowout, the stock surges, and everyone ignores their guidance because everyone knows it’s sandbagged. So, what we’ve seen in the last few weeks is a case of Apple surging 30% in just 6 weeks (ADDING 68 BILLION TO ITS MARKET CAP!!!) on anticipation of an earnings report that will certainly be well above analysts estimates and will “shock” every investor on the planet. The problem here is, you have to living under a rock to not know that Apple has sold an iPad to every bankrupt American under the sun and has once again performed stupendously this quarter. The idea that the shares are not priced to near perfection at the moment confounds me. But Apple is not the only company this is happening to. It will happen to roughly 70% of the companies in the S&P 500 this quarter and the financial media will tell you to buy stocks because earnings are “better than expected”. The smart money in these shares will be looking for the next “greater fool”.

The November elections are the third theme that investors are currently front running. Many view the potential gridlock on Wall Street as a positive, however, this is misguided in the current balance sheet recession (see here). A shift in power means a shift towards austerity and a shift towards austerity means many of the market trends (such as stimulative government action) of the last few years become headwinds. You can agree or disagree with the government intervention of the last few years, but one thing is undeniable – government intervention has helped the markets a great deal. Removing government from the equation via gridlock removes a strong tailwind.

Currently, I view the market as excessively risky from the long side (which is why I am net short for the first time since before the flash crash earlier this year). Aside from several exogenous risks (the foreclosure mess, a strong Euro sparking sovereign debt fears in Europe, currency war, etc) there is also the risk that all three of the themes above disappoint investors in the coming weeks as a massive “sell the news event unfolds” in the final weeks of October and in early November.

On a slightly different note – I ran some numbers over the weekend and pulled up a few factoids that readers might find interesting with regards to the indicator I use called “quantified disequilibrium”. As I’ve previously mentioned, this program quantifies what I call the disequilibrium in the market – it quantifies hundreds of inputs to output a real-time measurable risk level. Using this algorithm without leverage in a long/short 100% equity strategy has generated a 25.67% annualized return since inception (January 2006) with a Sharpe ratio of 2.29 and a max monthly drawdown of -5.22% in one of the most challenging market environments ever. The risk component has only been at current levels (or higher) twice in the last 5 years. The first instance was September 24th, 2007 at S&P 1526. Just shy of the all-time high and prior to a multi-month decline of almost 20%. The second instance was January 5th, 2009 at S&P 890. We had rallied 11% off the October 2008 lows and we all know what happened next. The market took a nose dive down to the March 2009 lows for an epic two month collapse of 25%.

From all of the evidence above it’s clear (in my opinion) that we’ve moved into an extreme disequilibrium in the market. Market trends are very bullish, analysts are excessively optimistic, sentiment is nearing highs, news flow is very positive, positive catalysts are ending and investors are misinterpreting all news as good news. QE2, earnings, the election – it’s all clear sailing and it looks like nothing can derail the bull and all of its very bullish catalysts, right? Of course, the market is likely to fool most of the people most of the time – even those David Teppers of the world who believe no one can lose by buying stocks in the current environment. None of this means that markets can’t become more risky in the near-term, however, based on my work 3 month returns have proven to be poor from a risk adjusted level when entering the market on the long side given the current set of circumstances.

It’s a most interesting time to be a macro theorist and investor. If my theories prove correct it is likely that the dollar is well oversold and equities have become overextended on false hopes of a Fed driven economic recovery. This means the market is excessively concerned about inflation and we are likely to move closer towards our economic reality of disinflation with a higher risk of deflation than high inflation. If this is correct it means there is a fairly sizable air pocket beneath risk assets currently. Warren Buffett once said it is better to be greedy when others are fearful and fearful when others are greedy. I am currently fearful.