Thursday, January 31, 2013
What determines the level of the 10 year note yield (top chart)? I'd say that this yield depends on investor expectations about two things: the real rate of growth in the economy and the rate of inflation over the next 10 years. We can simplify this idea even further by saying that the level of 10 year note yields should roughly equal investor forecasts of the average annual rate of growth in NOMINAL (no inflation adjustment) gross domestic product over the next 10 years.
As you can see in the chart investors are expecting nominal GDP to grow at about a 2% annual rate for the next 10 years. Since people expect inflation rates of at least 2% as far as the eye can see, this level of interest rates suggests that investors think that the real economy will not grow at all during the next 10 years!
You can get another read on this expectation by looking at the yield on the 10 year TIPS (inflation protected treasury notes) which were auctioned at a rate of a NEGATVE 0.63% a few days ago. People who bought these notes are paying the US treasury to take their money and spend it!!! From a purely mechanical point of view the difference between the yields on the 10 year note and the 10 year tips represents investor's expectation of the rate of inflation over the next 10 years. In this case the difference is 2.60%. Put another way, the 10 year TIPS yield suggests that investors think the real economy will shrink by 0.60% per year over the next 10 years while inflation averages 2.00% per year! Of course there is probably a fairly big risk premium built into the negative TIPS yield so the forecast is not really as pessimistic as this. Even so I still think this is an incredible forecast for the US economy.
Is this forecast likely to be close to the mark? I don't think so. I think people are grossly underestimating the likely effects of the Fed's quantitative easing policy and the Fed's commitment to pursue that policy at least until the US unemployment rate drops below 6.5% (it is currently 7.8%). The Fed's policy is having an effect on the Euro which is steadily rising against the dollar (middle chart). The Euro is above it rising 200 day moving average as well as above its rising 50 day moving average, a bullish configuration if there ever was one. The market is pricing in not just the survival of the Euro currency but also the fact that the Fed's monetary policy is relatively loose compare with that of the European Central Bank. Liquidity in the US is increasing relative to Europe's. This will inevitably lead to a pick up in US economic activity relative to that of the EU and a further advance in the Euro against the dollar.
The market thinks that the Fed will also be getting help from the Japanese central bank in pushing upward world economic activity. The bottom chart shows the yen priced in dollars. This bear market in the yen is a forecast of a big expansion in yen liquidity relative to dollar liquidity (which of course is itself increasing). This would be an enormous change in policy by the Bank of Japan (if it occurs) and will have very positive effects on the Japanese and the world economies.
All in all I think the market forecast of only 2% annual growth in nominal US GDP over the next 10 years is plain silly. My own guess is that this number will come in closer to 5% or even higher. If I am right 10 year note yields are in the early stages of an advance which will last several years. You can see that the 50 day moving average of this yield has finally climbed above the 200 day moving average, the first time this has happened in years. This I think is a harbinger of a long term bear market in bond prices.
Sunday, January 27, 2013
I want to point out one change to which we contrarians will have to adjust. The print media, the mainstay of my approach to identifying information cascades, are rapidly declining in significance relative to electronic sources of information. This is going to make it harder to identify information cascades, especially the bearish ones which typically come and go quickly. As a concrete instance of this trend one can point to the demise of Newsweek's print edition. Time magazine is evolving into a tabloid and so I think its usefullness is diminishing too.
A big part of the art of investing, and particularly of contrarian investing, is the ability to adjust to changing circumstances and market environments. So going forward I will be trying to incorporate more electronic sources of information as indicators of market sentiment to supplement my readings of newpaper headlines and magazine covers.
My last post on this blog was in December 2011. In it I said that pessimism about the US and European stock markets was thick and that this meant that higher prices were ahead. A few days after that post long term contrarian traders were confronted with a mechanical sell signal on December 20 in the S&P 500 when its 200 day moving average dropped 2% from its high point reached earlier in 2011 (chart is above this post). I personally ignored this signal as a matter of contrarian logic - if pessimism dominated the markets at the time then this sell signal would turn out to be wrong (and it was).
There were other technical reasons to doubt the signal. First, the Dow industrials never got even close to generating a similar sell signal. Secondly, when the S&P's 200 day moving average achieved its 2% decline on December 20 the S&P was actually above its rising 50 day moving average (wavy green line on the chart above). At the very least this would have been reason to delay acting on the mechanical sell signal. The next time the S&P traded below its 50 day moving average was in mid-2012 after the 200 day moving average had resumed its strong up trend.
Aggressive contrarians had abandoned long positions in late August 2011 near 1200 in the S&P. Needless to say I repurchased my own aggressive contrarian long position on the one day dip right after Christmas of 2011 at about the 1255 level. It has remained undisturbed since then.
At the top of this post is an image of the January 26 front page of the New York Times. For the first time in a very long while there is a headline about bullish stock market performance pointing out that the S&P has closed above the 1500 level for the first time in five years.
Is this a sign of a bullish information cascade? I am doubtful about this possibility. I think the man on the street is still pretty much out of the stock market and pessimistic about the US economy.
Nonetheless, one must recognize that S&P average has been moving generally upward for 46 months, an unusually long time for a market advance. And the average is approaching the levels of two big tops at 1553 in 2000 and 1576 in 2007. There was a lot of pessimism around at the time of the 2007 top. This fooled me then into thinking that the worst that was likely on the downside then would be a 20% or so drop.But things got a lot worse than I imagined they could. I don't plan to make this same mistake again. This is another reason for contrarians to take the headline above this post as an early warning of a possible storm ahead.
I think that both conservative and aggressive contrarians should now be looking for reasons to reduce the size of their long positions. Personally I think the advance from the November 2012 low point has further to go. I am looking for a move up to 1546 in the S&P. Once the market gets there, or if other bearish signs develop in the interim, I think it will be appropriate for aggressive contrarians to cut way back on their long postitions.
Conservative contrarians dodged a bullet in December 2011 when the S&P generated a mechanical sell signal which I ignored. I think it will be appropriate to take advantage of this fortunate circumstance to sell long positions at the same time that aggressive contrarians do even though this would violate the mechanical guidelines for conservative contrarians whichI set down in my book.
I will keep you posted on my thinking about these possibilities going forward.