Hilary Kramer has 30 years of experience on Wall Street; she was an analyst and investment banker at...
Solving the puzzle of the current stock market
06/04/2013 8:30 am EST
And, of course, where you have to solve that puzzle with significantly different time horizons depending on which of the three drivers of global financial markets—the United States, Japan, and China—is gathering attention at the moment.
That makes this market very difficult to read, very volatile, and rather scary.
Here’s my guide to what’s going on, what to pay attention to, and what to ignore in the next few weeks.
Consider Friday’s market action as a good example of what we can expect in June and probably into July.
In the morning of May 31 a medium-term view held the court. A strong report on Midwest manufacturing activity led traders and investors to focus on the possibility that the U.S. Federal Reserve would start to reduce its $85 billion a month in purchases of Treasuries and mortgage-backed assets sooner rather than later and perhaps as early as this summer or September. That led bond prices to retreat and the yield on a 10-year Treasury climbed 0.15 percentage points to 2.21%. One month ago the yield on the 10-year Treasury was just 1.65%.
In the afternoon the temporal perspective shifted back to the short-term. Bond prices had fallen so far so fast on the day (and yields on the 10-year bond were now above the 2.08% yield on the Standard & Poor’s 500 stock index) that short-term traders were willing to bet that bond prices would stage a modest rally. Their willingness to take that bet was increased by the coming weekend. It’s typical for traders to take profits and square positions before the weekend. Taking the end of a trade predicated on rising bond prices and falling yields had a good risk/reward ratio in the short-term. And traders on that end of the trade did make a good profit as bond prices rose and yields fell back to 2.13% at the market close.
And what about stock prices? They moved in exactly the opposite direction to bonds, rallying in the morning and then falling sharply in the afternoon largely, I think, in reaction to the move in bonds rather than to any significant news for equities themselves.
In the background for all this sits the long-term view. The consensus there is that the Federal Reserve will have to taper off (the medium-term view) and then end (the long-term view) its program of buying Treasuries and mortgage-backed assets. At best the end to the Fed’s buying program will push interest rates higher. In an even longer long-term view interest rates will rise as the Federal Reserve sells Treasuries to reduce the size of its balance sheet.
A lot of this consensus view is speculative. No one knows if the Federal Reserve will actually sell Treasuries—Fed chairman Ben Bernanke has hinted that the Fed will simply hold to maturity and reduce its balance sheet very gradually. No one even knows if the Fed will start to taper off its buying program in the fall. The Fed has said that its actions will depend on the data and no one yet knows what the economic data will look like in, say, September.
But 1) this consensus view seems logical and 2) this consensus view is the consensus and that gives it influence over the U.S. financial markets even if it ultimately turns out to be wrong. Until we get data that says the Federal Reserve will stay on the sidelines, or growth numbers so strong that investors are willing to buy stocks anyway no matter what the Federal Reserve may be planning to do, or some statement from the Federal Reserve that recasts Federal Reserve policy, then I think the long-term consensus view will provide a bearish cast to the short- and medium-term views of the market.
But remember that this relatively long-term negative view doesn’t have the stage to itself. Just as on Friday, May 31, the bond market was able to rally because the short-term view said there were profits to be made by reversing the morning’s slide lower, so too could a sufficient drop in U.S. stocks lead to a calculation that concluded that, in the short-term, reversing any drop would be profitable to traders who had gone long. In other words, if U.S. stocks drop far enough--5% to 10% would certainly be enough in my estimation (the S&P 500 was down 2.3% from its My 21 high at the close on May 31)—I think we’ll see short-term buying pick up no matter the pessimistic long-term view.
I know this is complicated so let me try to boil it down.
I think the trend in the U.S. financial markets is downward right now because of the long-term consensus view that the Federal Reserve will begin tapering off its monthly purchases of Treasuries and mortgage-backed assets by September or October—and perhaps even earlier. We could get a temporary bounce out of a disappointing jobs report on Friday—the consensus among economists is for a weak 165,000 net new jobs—but I think it will be hard for any disappointment to shake the consensus. I think the downward trend could easily produce another bad month for Treasuries like the 1.8% drop in the Bank of America Merrill Lynch index in May. In stocks I think the decline—which may be quite gradual—persists until buying for a short-term bounce starts to look attractive on a risk/reward basis. That might require as little as a 5% drop or as much as 10%.
From the perspective of current risk and reward, I think this argues for raising cash in U.S. stocks to lower risk in portfolios and to increase money available for buying after any potential bigger decline. I think there is a good likelihood that the market is over-reacting to the downside in its long-term view of Federal Reserve policy, but for the moment at least, I don’t think it matters much if the consensus view is actually correct. It will drive the market until proven wrong (or confirmed.)
So far I’ve been treating the U.S. financial markets as if they exist in a vacuum. They don’t, of course. At the moment I think U.S. and global investors need to take moves in the Chinese and Japanese markets into consideration too.
Of those two markets, I’d say China is the least important right now.
Before everyone jumps all over me let me emphasize that “right now.”
Two factors limit the influence of Chinese stock market moves on the global financial markets in general and on U.S. financial markets in particular.
First, the long-term consensus here too has a negative cast. The consensus view of China at the moment is that growth in China is in more danger of slowing than revving upward. The June 1 release of the official May Purchasing Managers Index from the National Bureau of Statistics does not seem to have dented that consensus even though at 50.8 it was higher than April’s 50.6 and higher than the consensus of 50 among economists surveyed by Bloomberg. (In this index any reading above 50 signals that the economy is growing.) The reaction to that good news—certainly good news after the flash version of the index released last week showed the economy slowing—was muted with Hong Kong’s Hang Seng index climbing less than half a percentage point in Monday trading.
Second, the uncertainty and volatility in the U.S. and Japanese markets has thrown global markets back into risk off mode. With fear running relatively high, traders and investors are likely to follow past pattern and sell emerging market stocks and bonds even if the cause of the fear is in the United States and Japan. Not logical or fair, but that is how the markets have worked for2012 and 2013.
Japan is quite frankly the most unpredictable part of this entire puzzle. It’s hard to tell at the moment if the 11.9% drop in the Nikkei 225 index from the May 22 high to the close on May 31—with the index turning in another 3.7% drop Monday—is just a correction, sized large to match the 80% gain in the index from its November 2012 low, or something more. What would something more be? A vote of no confidence by the financial markets in the Abe government and the Kuroda team at the Bank of Japan is a possibility that comes to mind. Financial markets—and especially the big jump in yields for Japanese government bonds—could be saying that they think the Bank of Japan has lost control of bond prices and yields.
That’s certainly possible—but I think unlikely because it would be such a fast jump to judgment in a country that doesn’t jump, usually, to conclusions so quickly. And it’s especially unlikely given the way that Japan’s financial institutions and the Bank of Japan are accustomed to working together.
I think we’re likely to know what’s up in Japan in relatively quick order. Until the correction that started on May 23, Prime Minister Shinzo Abe looked certain to lead his Liberal Democratic to victory in the July 21 elections for Japan’s Upper House of Parliament. Abe is shooting for not just a majority in the chamber his party doesn’t control but for a two-thirds majority that would guarantee the passage of his government’s potentially controversial plans for changes to Japan’s university system and its agricultural policies. I fully expect Abe to bring out all his guns to restore market calm—at a minimum—before the start of July. If the financial markets—and the yen—don’t respond, it won’t be because the Abe government and the Bank of Japan haven’t tried everything they can think of, but because they have really lost the confidence of Japan’s financial markets. I’d bet that Abe’s efforts will succeed in the short-term.
And unlike in the U.S. financial markets where the long-term consensus sets the market direction currently, I think it’s the short-term that counts in Japan.
Japan’s short-term volatility has unnerved U.S. and other financial markets. A return to order—if not 80% gains in less than seven months—would go a long way to stabilizing global markets. That might not be enough to stem a downward trend in U.S. markets this summer, but it certainly would lower the risk that the downtrend would be more than just a 5% to 10% correction.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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