As the devil-may-care bravado of Wall Street marches on, history warns that -- in the end -- there will be the devil to pay.
On the heels of the much-anticipated Federal Open Market Committee meeting, I thought it might be worthwhile to take a step back and try to assess the big picture, as I believe we might be idling up to a rather large inflection point, i.e., the beginning of the end of the central bank print-fest-inspired levitation of financial markets.
Beginning of the end justifies the means
By that I mean that if the Fed has lost control of the bond market -- which is my belief, though we can't yet be certain -- interest rates will rise no matter what the Fed does, with very negative ramifications for the stock market and the economy.
If Federal Reserve forecasts point toward full employment and price stability, policymakers at the upcoming FOMC meeting will have a hard time getting Wall Street to reconcile that outlook with a 1% Fed funds rate.
The much-anticipated nonfarm payroll report took center stage upon its Sept. 6 release, with the data considerably weaker than expected. The actual headline number was down only slightly, at 169,000 jobs, versus expectations of 180,000 (the Federal-Reserve-is-going-to-taper-because-the-economy-is-so-great crowd had been mentally penciling in 200,000, maintaining an optimism they have demonstrated for many months). But the revisions were pretty startling: July was revised down by about 60,000 jobs and June was also reduced.
Nonetheless, it would appear that stock bulls still want to believe that the Fed is going to taper, and that action means everything is going to be better because the Fed thinks so. (How anyone can believe that after what we have witnessed the Fed do in the past 20 years is unfathomable to me, but there it is.)
This might be the month of reckoning for failed central bank money-printing policies. Mounting evidence suggests that markets are starting to notice that the Fed is trapped.
It was interesting to see in the most-recent quarterly filing (released a week ago) that Goldman Sachs Group (GS) spent around $500 million in the period to buy 3.7 million shares of SPDR Gold Shares (GLD), making Goldman the exchange-traded fund's seventh-largest shareholder.
After having been a vocal proponent of the view that a much stronger economy (which we haven't seen) would lead to a tougher Federal Reserve (which won't ever happen) and a weaker gold price (which we did experience until June 30), Goldman is perhaps starting to connect the dots.
Putting the 'gold' in Goldman
To be sure, Goldman's negative call on gold received a tremendous amount of fanfare, and it appeared to be at the epicenter of the huge price break we saw in the second quarter. But I haven't seen comments anywhere discussing its quiet, bullish bet. (For all we know, depending on exactly how the company holds the shares, it could be some sort of arbitrage against something else, but I doubt that.)
As the walls close in on central bankers and their inane policies, they seem ready to fight with the only weapon they know how to use: the printing press.
Though it may have largely been lost in the shuffle of Middle East headlines, sales of new homes fell 13.4% in July to 394,000, which was a far cry from the 487,000 forecast by the consensus and the biggest variance from expectations in more than five years. In addition, sales in June were revised down to 455,000 from 497,000.
Those numbers are proof that whatever logic the real estate Pollyannas, who said mortgage rates weren't going to affect demand for new homes, were using is totally false.
Conventional wisdom attributes market indigestion to anticipation of Federal Reserve action, but the evidence indicates investors are finally reacting to what our central bankers have already done.
I'm going to begin on the subject of financial publication headlines, expectations and what might really be behind the recent weakness in stocks and bonds. The Financial Times recently led off with the following above-the-fold headline: "Sell-off as markets expect early Fed move."
The article began: "Expectations of an early move by the U.S. Federal Reserve to slow its support for the U.S. economy firmed (on Aug. 15) after the release of data showing a strengthening labour market and higher inflation." The British newspaper went on to attempt to blame the previous day's stock market decline on jobless claims.
I would be the first to admit that on many days the market does what it does and there really is no proximate cause or logical explanation. But I can guarantee you that the FT's explanation is not what happened, because all the other macro data were weak and there was no new news about potential early tapering.
They're not buying it
In fact, in an article the day before in the same publication -- headlined, "Central banks struggle to convince investors" -- author Ralph Atkins tried to get at the real problem, although he couldn't quite put his finger on it. Atkins noted that central banks have failed to persuade markets on a case for interest rates remaining low, but asserted: “Central bankers are used to having their way.”
Atkins continued, "The U.S. Federal Reserve's large-scale asset purchases, or quantitative easing, delivered the desired market rallies. Mario Draghi, European Central Bank president, crushed eurozone doubters by pledging to backstop government debt markets.
"But the latest actions by the ECB and the Bank of England -- using 'forward guidance' to persuade investors that interest rates will remain firmly at historical lows -- have had, at best, mixed results. Market borrowing costs have actually edged higher and on some gauges investors have brought forward the expected date for hikes in official interest rates. If market scepticism builds, the two central banks may be forced into fresh measures to stimulate growth."
The QE and the damage done
Therein lies the dilemma. If markets don't do what the central banks want, the central planners will do more, thinking that the problem is that they haven't done -- or threatened to do -- enough. However, if the markets know that the central banks will do more if required (i.e., in the event that bond markets don't bring rates back down to where the central banks want them), then why are bond markets declining?
The only logical answer is that they are reacting to what the central banks have already done. That predicament is the one no financial bull wishes to contemplate, but it is at the heart of the problems we are headed toward.
My belief is that bond markets around the world have not backed up because of any serious fear that a massive amount of stimulus is going away, but rather because the deflationary fear trade was way overdone. Now debt markets are declining because there is no real investment demand at these levels. Yes, there are forced buyers, such as pension funds and insurance companies, but investors are not really dying to own them, as yields are absurdly low.
Aug. 20 saw the release of the Fed’s July Federal Open Market Committee meeting minutes, which were eagerly awaited even though they once again revealed nothing new. In the wake of the release, the bond market sold off hard, closing at a yield of 2.89% for the 10-year, a new high. Thus, our Treasury market continues to be weak, in defiance of the Fed's wishes, bolstering my contention that the Fed is no longer able to control that market as it used to.
In short order
On a related note, The Wall Street Journal ran a front-page story on Aug. 20 headlined, "Rising markets batter short sellers." In it, one featured short seller stated: "'It is actually more painful now than it was in '99.'" Though I am very sympathetic to that statement, I would like to disagree with it. There is really no comparison between the lunacy of 1999 and the present day.
The insanity back then was not confined just to dot-com business concepts. Most stocks were ridiculously valued until the very end, when there was a group of mundane securities that weren't too expensive. Nonetheless, the environment was much better because that bubble had not yet spawned the real estate bubble or the misallocations of capital and bad policies that followed in the wake of both.
Thus, prices of stocks were insanely high, but there were not the massive macro problems that exist today. Thus, given the horrible fundamental backdrop, stocks are expensive and risky, but there are only a modest number (perhaps 100) of truly ridiculous valuations.
The same trader was later quoted as saying he believes that his short positions "will be proved right -- eventually," which brings up another point that needs to be made about short selling. Namely, that while research is essential, it alone won't get you very far. Short selling, sadly, is all about tactics, managing risk and the constant need to modulate positions, i.e., when to press and when to take positions off.
Also, anyone who has survived this long on the short side should realize that it is nearly impossible to win when the Fed is doing what it is doing. The amount of money (about two weeks' worth of QE) that blew the top off the stock market in 1999 is literally a rounding error compared with the QE we have seen since 2009. Thus, it will be difficult for the shorts to win until either the bond market reacts more violently or we get closer to the time when bond traders take the printing press away from the Fed. And then they will win big.
More signs suggest that gold has reached a turning point. But putting a fair value on the yellow metal is harder than assessing what a business is worth.
Last week, I received a question from a member of my subscription site who wanted to know about recent action in gold and the miners (which have been showing signs of life), and whether higher prices would give me more confidence that we had seen the lows.
In trying to craft an intelligent and useful answer, I spent a lot of time thinking about the gold market and related ideas I hadn't really discussed in the past.
What follows is my response, which I hope illuminates why it is so difficult to be truly emphatic about the price of gold -- as opposed to the value of a business.
I feel strongly that June 30 was most likely the low for gold and the miners. But the problem with gold is that it is just a price. It isn't like a business, where you can track such things as balance sheet items, sales, margins, channel activity, competitors and suppliers to get a very strong feeling that something important has changed or that the time to act in a big way is now -- long or short.
About the closest thing we have to a timely, nearly unequivocal fundamental fact is that gold has been in backwardation for 30 business days. This should never happen -- and has happened only rarely, briefly in 1999 and 2008 -- because it should just get arbitraged away.
The fact that the market hasn't reverted to contango suggests there isn't enough metal around in New York or London (at current prices) to allow that to happen. A potential conclusion is that there is such huge demand versus supply at current prices that the price should not be able to go lower (and stay there).
If that's true, it would argue in favor of the idea that the lows in June were "it" and that this tightness, combined with the short position and prior liquidation, means that prices are poised to rocket higher at some point soon.
A store of guesswork
The problem is that no one knows for sure. I have talked to several people who are close to the metals trading industry (whom I have known for a long time), and they agree with my analysis. But there could be other technical explanations -- mostly having to do with the fact that interest rates are near zero -- that could mean my thesis is wrong.
We will only know for sure as time goes by and new developments occur. All of the above is also why so many people who have opinions about gold base them solely, and often erroneously, on the chart patterns.
As for the miners, it is even harder to be certain about them, because their whole business revolves around the hard-to-determine future gold price.
The bottom line is it takes melding together lots of clues and charts, as well as fundamental guesswork, to be able to have a correct opinion about the gold price. Obviously, being right about the overall trend, bull market or bear market, is a huge help. I did that pretty well in the bull market but totally missed the shift to the bear market.
I can't believe it, but it took me well over a year to consider the possibility that gold had slipped into a bear market. In any case, I think we are now in the process of restarting the bull market, but I don't know for sure and can't know. Until it is a bull market, it will still be a bear market, with the attendant dangers and different risk management (technique) requirements.
It's who you know
In the investment business we all have periods when we are hot and when we are cold. On that subject, one has to realize in one's own investing there are periods where most everything you think and do is correct, and when that is the case it is possible to be more aggressive.
While it is easy to make money when it seems as though you are getting The Wall Street Journal a week early, the bigger trick is not to get killed when it seems you can do nothing right. When that inevitably happens, you must spend more time sitting on your hands while waiting for your view of how the world should work to coincide with that of the masses, aka the market.
In his most recent Gloom Boom & Doom report, Marc Faber discusses his experience at the tail end of the tech bubble and makes an important and related point. He writes: "I had heavily shorted high-tech stocks in 1998 and subsequently I lost a ton of money. This episode is really a dark spot in my life as an investor and investment advisor. It taught me several lessons that I shall never forget. What I think about markets is completely irrelevant. What matters is what other people think about them. Fundamentally, I was right about the coming collapse of the Nasdaq; however, for as long as the majority of other investors believed in the 'New Economy' theme, high-tech and communication stocks continued to appreciate."
Those of us who understood that the dot-com boom was a bubble were all tortured until the bubble burst. That often happens in markets, where you are exactly right about what you think will happen, but the market doesn't agree with you right away, and until it does you have to manage your positions carefully.
It should be worth the weight
To state the obvious, when the bull market in gold resumes, it will be easier to make money being long, though it will still be tricky. Unfortunately, trading and investing in gold is more difficult than just investing in the stock market. It is more like managing a short position.
I wish that wasn't the case, but it is. I also wish the Federal Reserve wasn't so incompetent, so we could just buy stocks or bonds and didn't have to focus on the variables we do. But we must play the hand we are dealt, and we have been dealt one with central banks pursuing insane policies that force us to deal with a warped economic/financial world where the money is "no good."
I hope this discussion helps readers understand the gold market better and, more importantly, is useful when it comes to managing positions.
The liquidity-fueled rally of the past 9 months is easy to like. But recent history tells us higher prices based on easy money carry extreme dangers, so a violent drop could lie ahead.
There is not much one can say to make sense out of the maniacal rise we have seen in the stock market since last fall, other than to note that the third and fourth rounds of bond buying by our Federal Reserve (aka QE3 and QE4) have boosted stock prices 20 to 25%.
Beneath the surface, however, stocks are a house of cards. Simply because prices are rising as a consequence of the massive liquidity injected by the Fed (and the Bank of Japan) – combined with "professionals" running other people's money who are terrified of not keeping up with the averages – does not mean that participating in the stock market at the moment is something that anyone who is sane ought to do.
The wrong kind of royal flush
Even so, resisting the siren song of apparently easy money is difficult, and most people eventually get sucked in. This is shown by the latest mutual fund statistics, which show that people are taking money out of bond funds and pushing it into stock funds.
While stocks continue their momentum-driven run, the bond market is still the ultimate canary in the coal mine.
The stock market has now weathered the bulk of an earnings season that was OK, on the surface, but not so great prospectively. On that note, I was forwarded a link to an article regarding the second-quarter letter from David Einhorn, Greenlight Capital's founder and president, who made a point that I thought was worth sharing:
"Indeed, in the recent quarter, 70% of companies in the S&P 500 'beat' the official street estimates, while forward estimates fell for roughly the same percentage of companies. At this point in the cycle, lowering the bar seems to be treated as bullish because it increases the likelihood of future earnings beats."
I wasn't aware of that specific percentage of companies that had lowered guidance, but I was obviously aware that it didn't make any difference to the stock prices of the companies involved.
There's no doubt this little game has been successful and is reminiscent of other crazy periods we have seen in the last 15 years. There is also no way to know how long it will last, but it is quite possible to know it is abject silliness, unless of course companies have been wrong to lower their guidance and actually do substantially better than they are currently forecasting. In that case, we would have to conclude that the market figured that out ahead of time.
That is not my expectation, however. Thus, this is a period of wild speculation that will end badly, as such periods always do, though it is impossible to know when.
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ABOUT BILL FLECKENSTEIN
This column is a synopsis of Bill Fleckenstein's daily column on his website, FleckensteinCapital.com, which he's been writing on the Internet since 1996. Click here to find Fleckenstein's most recent articles.
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As the devil-may-care bravado of Wall Street marches on, history warns that -- in the end -- there will be the devil to pay.
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