As I have been putting together pieces of data since QE3 to better understand whether the market has indeed priced in QE3 or whether we need to reset charts and look at things with a new perspective, I have highlighted several issues regarding QE3 that I think are important to address. These ideas may not be correct, but ignoring them and simply accepting the conventional wisdom of trading during Quantitative Easing is not giving you anything more than a ridiculous mantra such as, "buy the dip".
Those who bought this dip probably weren't too happy with the results.
The Result?
The market becomes very dangerous when traders are conditioned to mottos, expecting nothing has changed or will change.
While I'm open to wherever the data leads, there have been several themes that are unique to QE3 that I have tried to illustrate, they seemed to be very common sense ideas to me, yet I hadn't heard too many people espouse the same until recently.
In the interest of brevity, I'll bring you these comments that sum up a couple of thoughts I've had about the complexities of the market that we shouldn't take for granted, I don't think anyone would argue against the statement, "The market is dynamic".
David Rosenberg- You can find out more about David here at Gluskin Sheff under the heading, Investment Management/David Rosenberg. His resume is impressive, I'll just take one snippet...
"Ranked most accurate forecaster of 2011 by MSNBC"
Much of what I have been talking about recently is covered by David, in some cases near verbatim even though this piece was just published today, take a look at some of the themes that make this time different.
While we share many of the same thoughts (it would be a long post if I listed all of them, but you can read them at the link above), I'll just cut to the last paragraph:
"What makes QE3 different and maybe even less potent than its predecessors is that the trend in global economic activity is still down. In the prior QEs, activity was already reviving and actually this may have played a more significant role in stimulating investor 'animal spirits' than the actual liquidity boost. Let's not also forget that earnings, both operating and reported, are now contracting sequentially. And the ISM is in a multi-month sub-50 pattern. This was not the case during these other QE episodes and serves up a greater hurdle for market performance this time around."
Furthermore, if we go back to my post, "The History of QE" from September 14th, I provided all of the previous LSAPs from QE1 to the extension of Twist, what you will notice is the market was at depressed prices when QE was announced except QE2, but that was only because it was telegraphed by Bernie at Jackson Hole a few months before it started, at depressed prices.
I also noted the dividend yield for at least QE1 and pretty close on 2 was 4%, now 2% and the Price to Earnings ratio was 10 as opposed to 14.9 now, which means stocks are much more expensive with less income not to mention the fundamental global economic trends which David covers most I have brought up.
Several other differences I have noted off the top of my head include the divergence between transports (really we are talking about manufacturing here) this time vs all other times, the difference in the Economic Surprise Index vs the SPX this time vs all other times (both charts are posted here from yesterday) , many posts addressing the inflation problem for consumers and manufacturers and how QE is inflationary and how it can and likely will create a negative feedback loop which is completely at odds with the stated goal of fostering employment and the "conditionality" phrase of the QE program "Within the context of stable inflation" which you may recall received a bad reaction from the market when Bernie was asked about this during the press conference, that exact minute was the high of the day and prices dropped from there as the market seemed to recognize that while buying expensive stocks, at any moment inflation could cause a pause or change to QE creating uncertainty.
I certainly am not the only one who has talked about the possibility or even probability given the exceptionally weak macro economic data, that QE had already been priced in to the market by the time it was announced. However today for the first time, a member pointed out something I hadn't considered with regard to the 92% of Hedge Funds underperforming the SPX which is ridiculously high. At first it seemed, "Maybe smart money isn't so smart" until this member email today put things in a different light worthy of consideration....
"Hi Brandt,
3c explains why hedge funds have been doing so bad lately, if 3c is accurate then they have been dumping their holdings and shorting into this move higher right before the QE announcement."
Said another way, Hedge Funds may be using the pricing in of QE3 to dump positions, essentially selling into the news. Maybe 92% aren't the dumb ones, their year isn't over and the SKEW Index (Black Swan Index) may indeed be pointing to a rather sudden and nasty event.
I first pointed out the bothersome Rate of Change in the Skew Index on August 31st while SKEW seemed subdued at 119, only 4 points above the historical average, but the Rate of Change is what was bothersome (again ROC is one of the most valuable, least appreciated indicators out there, apply it to almost any other indicator and see that indicator's signals become more valuable).
Sure enough, as pointed out in last night's post, the SKEW as of Friday's close had moved in the direction ROC was pointing out while few others would have noticed this as ROC is not a new, fancy indicator.
Now for the second point released by Morgan Stanley today is a theme I have covered extensively as each week we see worse and worse global manufacturing data, today we saw even more in the Chicago F_E_D National Activity Index , where as usual, the devil is in the details.
Taking just an excerpt from Morgan Stanley's QE3 analysis...
"It would appear from this final chart that a great deal of the current market is pricing in Fed action - as more than a year of rolling returns are now negative if it were not for the actions of Bernanke...
What Might Be Different This Time?
One big potential difference between today and prior periods of unconventional policy is the price of oil. Will QE3 drive further commodity price inflation? And, if so, will there be negative feedback into the economy and equity markets? We suspect so given the fragility fo global growth."
In capping off this post, I'll just remind you of how many EU policy initiatives we have picked apart the day they were released based simply on common sense:
1) The Ultra-leveraging of the EU's EFSF bailout fund as the EU came under pressure to find a solution before the upcoming G-20 meeting. The EU decided to leverage the EFSF to over a trillion Euros!
Result: They assumed China would provide the funds, they did not and went looking for opportunities in Africa instead and now in Afghanistan. One of the first auctions of EFSF bonds to leverage up the fund was a mere $3 billion Euros, the auction was a technical failure and they couldn't even cover the $3 bn issuance, much less the Trillion.
2) The Greek Bond Holder Haircut that would allow Greece breathing room and return to the debt markets in a few years...
Result: Greece is already in need of another bailout, the bond holder haircuts scared bond traders and yields soared in countries that weren't in immediate danger lie Spain and to a lesser extent, Italy. If they could force 50+% losses on the holders o Greek debt, why couldn't they do it to any other sovereign nation?
3) The Spanish Banking Bailout Bazooka! Spain at the time may have needed about $65 billion Euros to bailout their insolvent banks, over a weekend conference call the EU decided they'd shock the market in to relief by offering up $100 bn Euros.
Result: We immediately recognized the problem, the ESM bailout facility was to be used (which by the way still isn't ratified or active) and by doing so, all debt including sovereign debt (bonds) would be subordinated and hold junior status to the ESM's loan. That day I said that the solution would likely take Spain from a banking sector bailout to a full blown sovereign bailout. Immediately as bond traders realized that they'd be last to be paid debt payments/interest while the ESM would be first, yields crossed the 7.5% mark, effectively locking Spain out of the debt markets.
4) Draghi's OMT bond purchasing program. The ECB had been supporting bonds of various countries whose yields were rising to unsustainable levels by buying debt in the secondary market, they shut down this bond buying for several months and came back with the new OMT program which promised virtually unlimited support for sovereign debt, thereby holding the Euro-zone together.
Result: As predicted, the North (countries like Germany with Aaa ratings and money) were even more deeply divided in what I have called the "North/South Divide" as the Southern countries, also known as the PIIGS had the votes, but not the money so of course they voted the OMT through, in the process causing a divide between the ECB and Germany/Bundesbank where all the money essentially comes from. Draghi attached "conditionality" to any purchases which meant any country needing support would have to request it and then be subject to the austerity and other conditions the ECB decides to impose, if they fail to do so, their bonds will be sold right back in to the market. Spain had already made clear that they would not accept any aide with conditions tied to it, Spain being the last domino to fall before the Euro-Zone collapses is now in a position in which politically it is VERY difficult for them to request aid, making it likely that Spain will have to be destroyed in the bond market before aid is requested at which point it is too late. Furthermore, the southern countries and the ECB did nothing but tick off the Germans whose contributions to the ECB and bailout mechanisms are by far the largest, making it more likely that at some point Germany simply decides the costs outweigh the benefits and walks away from the grand experiment that is the EU.
These are but a few examples of Central and political planning causing unforeseen collateral damage, but I'm no economist or expert by any means, if you just have a basic knowledge of what is going on you can see the flaws as clear as daylight and given enough time the flaws become real damage.
The point simply being, either there are large flaws in the thought process of QE3 or perhaps as former F_E_D governor Kevin Warsh said, the F_E_D panicked in a time in which we aren't in a panic, unless they know something the rest of us don't? As QE has never been proven to be effective in lowering unemployment, the fact employment was used as the cover seems odd. I'd like to think the F_E_D is smarter than the ECB/EU and I believe they are, the question that is scary is, "Do they indeed know something we don't?"
To sum up the circular and downward spiraling logic of QE to stabilize unemployment, I'll just repost the idea from last night's post.
"If the F_E_D's goal is to lower unemployment with QE3 (and recall that the goal was stated as "lowering unemployment within the context of price stability") which is half of their mandate, the other being price stability, it makes no sense whatsoever to introduce QE3 that is not sterilized (meaning that doesn't create more money out of thing air, rather than sterilized in which the money supply remains constant). Manufacturers the world over are seeing a decline in orders, they have stock on their shelves and as a result they aren't using their manufacturing capacity and are letting employees go; in addition their input costs are rising due to inflation. Debasing the dollar makes purchases more expensive, savings are worth less, prices for every day consumer goods like gas and food are higher. Manufacturers need consumer demand, but consumers are already feeling the pinch of food/gas inflation and QE would only make that worse, it would also make input costs for manufacturers worse. How does this lead to a rebound in manufacturing and thereby an increase in employment? The only way would be to make US goods (exports) cheaper, but as we already saw in Japan as a response to QE, other countries Central banks will fight back so their currency doesn't rise killing their own manufacturing/exports."
4) Draghi's OMT bond purchasing program. The ECB had been supporting bonds of various countries whose yields were rising to unsustainable levels by buying debt in the secondary market, they shut down this bond buying for several months and came back with the new OMT program which promised virtually unlimited support for sovereign debt, thereby holding the Euro-zone together.
Result: As predicted, the North (countries like Germany with Aaa ratings and money) were even more deeply divided in what I have called the "North/South Divide" as the Southern countries, also known as the PIIGS had the votes, but not the money so of course they voted the OMT through, in the process causing a divide between the ECB and Germany/Bundesbank where all the money essentially comes from. Draghi attached "conditionality" to any purchases which meant any country needing support would have to request it and then be subject to the austerity and other conditions the ECB decides to impose, if they fail to do so, their bonds will be sold right back in to the market. Spain had already made clear that they would not accept any aide with conditions tied to it, Spain being the last domino to fall before the Euro-Zone collapses is now in a position in which politically it is VERY difficult for them to request aid, making it likely that Spain will have to be destroyed in the bond market before aid is requested at which point it is too late. Furthermore, the southern countries and the ECB did nothing but tick off the Germans whose contributions to the ECB and bailout mechanisms are by far the largest, making it more likely that at some point Germany simply decides the costs outweigh the benefits and walks away from the grand experiment that is the EU.
These are but a few examples of Central and political planning causing unforeseen collateral damage, but I'm no economist or expert by any means, if you just have a basic knowledge of what is going on you can see the flaws as clear as daylight and given enough time the flaws become real damage.
The point simply being, either there are large flaws in the thought process of QE3 or perhaps as former F_E_D governor Kevin Warsh said, the F_E_D panicked in a time in which we aren't in a panic, unless they know something the rest of us don't? As QE has never been proven to be effective in lowering unemployment, the fact employment was used as the cover seems odd. I'd like to think the F_E_D is smarter than the ECB/EU and I believe they are, the question that is scary is, "Do they indeed know something we don't?"
To sum up the circular and downward spiraling logic of QE to stabilize unemployment, I'll just repost the idea from last night's post.
"If the F_E_D's goal is to lower unemployment with QE3 (and recall that the goal was stated as "lowering unemployment within the context of price stability") which is half of their mandate, the other being price stability, it makes no sense whatsoever to introduce QE3 that is not sterilized (meaning that doesn't create more money out of thing air, rather than sterilized in which the money supply remains constant). Manufacturers the world over are seeing a decline in orders, they have stock on their shelves and as a result they aren't using their manufacturing capacity and are letting employees go; in addition their input costs are rising due to inflation. Debasing the dollar makes purchases more expensive, savings are worth less, prices for every day consumer goods like gas and food are higher. Manufacturers need consumer demand, but consumers are already feeling the pinch of food/gas inflation and QE would only make that worse, it would also make input costs for manufacturers worse. How does this lead to a rebound in manufacturing and thereby an increase in employment? The only way would be to make US goods (exports) cheaper, but as we already saw in Japan as a response to QE, other countries Central banks will fight back so their currency doesn't rise killing their own manufacturing/exports."
In no way am I going to write-off QE as this post would seem to suggest, I understand the power the F_E_D has wielded and the effect it has had on the market which is ultimately our goal, to understand the probabilities and opportunities in the market. I'm simply pointing out the glaringly obvious dichotomies that exist and pointing to others much smarter than myself who are arriving at the same conclusions (although I'd be more content to call my analysis of QE, ideas and not conclusions). We will still look for the hard evidence that suggests the path of highest probabilities, whether that be a total risk on environment, total risk off or as I have noticed recently, a bifurcated market in which some assets seem to be ok and others are on less stable ground.
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