Well That Was Quick… And Confusing

Well that was quick—volatility has retraced two-thirds of its early-February spike and stocks have retaken half of their 10% peak-to-trough decline.  After two weeks of heightened fears about rising inflation and higher rates, investors seemed largely to ignore the much-anticipated CPI release on Wednesday.  The inflation data were ahead of expectations, at 2.1%, driven by an unexpected strength in core goods.  Despite the strong print, risk markets unexpectedly rallied even though rates (believed to be the catalyst for the recent rout), continued to sell off.  Some believe this reaction was due to worse-than-expected retail sales, which brought the economy’s strength into question.  While one would expect this to be negative, it seemed to ease fears that the Fed might be more aggressive with monetary policy.  Others believe the steep drop in the USD provided the most relief for US equities.  Others cite a reflation trade.  Nonetheless, it is certainly confusing how, within less than two weeks, investors can go from calling for the onset of a bear market to equities rallying back to within 6% of all-time highs.

Leading up to this point, there have been many technical vs. fundamental debates to explain the multi-sigma market downturn two weeks ago.  Many of the technical arguments largely blame the turbulence on the VIX shock (following the surprise in wages), interest rate volatility and risk parity/trend-following strategies.  One fundamentals-based explanation suggests that there has been a repricing that reflects a progressive shift from a ‘strong growth and earnings upgrade’ narrative to one in which inflation risks are interrupting the conversation.  The first, subtle inflation warning came in mid-January when US core CPI surprised minimally (1.8% actual vs. 1.7% expected).  The second came three Fridays ago (Feb 2nd) when wages delivered a chunkier overshoot (2.9% vs. 2.6%).  The third is coming via Congress, which is easing fiscal policy for the second time in three months by lifting spending caps.  If higher inflation is a precondition for restrictive Fed policy in 2019, then it seems responsible for markets to price a risk premium for overheating due to a possible policy mistake.  As a result, the S&P 500 fell by 10% for the first time in 500 days.  However, if this is the case, then why did stocks quickly rally to within 6% of their all-time highs after even stronger CPI and PPI numbers this week?  A plethora of reasons have surfaced to explain this rebound, including: weak retail sales, a weaker USD, investor positioning/FOMO, etc.  I’m not really sure to be honest.  Good explanations are rarely binary because multiple forces conspire.

The explanation that makes the most sense to me is centered on a sort of reflation trade—buying stocks and selling bonds in response to rising inflation and strong growth.  We are in a strong global growth environment, and US inflation has printed stronger than expected on almost every measure over the past month (average earnings, CPI, and PPI).  Even though the market has been expecting labor costs and broader price gauges to firm this year as slack diminished further and transitory factors faded, it did not expect so many beats so soon.  This is why the ongoing bond bear market is delivering more volatility across rates, equities and currencies than is typical for a rising rate environment, and consequently why stocks are rising and credit spreads tightening less than they typically do when Treasuries sell off.  However, there will always be skeptics of any price upturn given structural disinflationary forces (i.e. Amazon effect and globalization).   So one might take this as a clear green light to buy equities and short bonds, right?  I personally would be more cautious.

A point made by investor Adam Robinson seems applicable to these severe responses to recent data points.   Many investors have been conditioned to believe that the better they understand the world, the better their investment results will be.  This makes sense—the more information we accumulate, the better informed we become and the better our decisions.  However, in the counterintuitive world of investing, too much information can actually hurt results.

In 1973, acclaimed psychologist, Paul Slovic, decided to evaluate the effect of information on decision-making.  He gathered eight professional horserace handicappers for a test that would consist of predicting 40 horse races in four consecutive rounds.  In the first round, each gambler would be given the five pieces of information he wanted on each horse, which would vary from handicapper to handicapper.  One handicapper might want the jockey’s years of experience as one of his top five variables, while another might want the fastest speed any given horse had achieved in the past year.  Then, Slovic asked each handicapper to state his level of confidence in his prediction.  As it turns out, there was an average of ten horses in each race, so we would expect that by random guessing, each handicapper would be right 10% of the time, and that their confidence in their blind guess would be 10%.

So in round one, with just five pieces of information, the handicappers were 17% accurate, which is pretty good (70% better than the 10% chance they started with when given zero pieces of information).  And interestingly, their confidence was 19%–almost exactly as confident as they should’ve been.  In round two, they were given ten pieces of information.  In round three, 20 pieces of information.  And in the fourth and final round 40 pieces of information.  Surprisingly, their accuracy had flatlined at 17% in each round as they were no more accurate with the additional 35 pieces of information.  Unfortunately, their average confidence level nearly doubled—to 34%!  So the additional information made them no more accurate but a whole lot more confident, which presumably would have led them to increase the size of their bets.

Beyond a certain minimum amount, additional information only feeds—leaving aside the considerable cost of and delay occasioned in acquiring it—what psychologists call “confirmation bias.”  The information we gain that conflicts with our original assessment or conclusion, we conveniently ignore or dismiss, while the information that confirms our original decision makes us increasingly certain that our conclusion was correct.

So, to return to investing, the problem with trying to understand the world is that it is simply far too complex to grasp, and the more dogged our attempts to understand the world, the more we earnestly want to “explain” events and trends in it, the more we become attached to our resulting beliefs—which are always more or less mistaken—blinding us to the financial trends that are actually unfolding.  Worse, we think we understand the world, giving us as investors a false sense of confidence, when in fact we always more or less misunderstand it.  You hear it all the time from even the most seasoned investors and financial “experts” that this trend or that “doesn’t make sense.” “It doesn’t make sense that the dollar keeps going lower” or “it makes no sense that stocks keep going higher.”  But what’s really going on when investors say that something makes no sense is that they have a dozen reasons why the trend should be moving in the opposite direction… yet it keeps moving in the current direction.  So, they believe the trend makes no sense.  But what makes no sense is their model of the world.  The world always makes sense.

So, looking forward to next week and beyond—yes global and US growth are good; yes stocks should outperform bonds in periods of inflation; yes investors need income; and yes the return on cash is zero.  However, I would argue for caution as there’s no shortage of risks in today’s investing landscape.  First of all, rates have risen really fast.  The yield on the 10-year Treasury has risen from 2.40% at the end of 2017 to 2.87% this Friday.  Further, global yields are rising much faster than U.S. yields.  The back up in Treasury yields is nothing compared to Bund yields which have more than doubled in two months, rising from 0.31% on December 14th to 0.71% on Friday.

Historically, copper divided by gold has been the single best predictor of interest rates bar none.  Copper is durable, highly conductive, and resistant to bacteria growth, which gives it a long list of industrial uses (i.e. wires, motors, plumbing, etc.).  Gold has a handful of industrial applications, but its relative rarity makes it useful chiefly as jewelry and money—bricks, ingots, and coins meant to store value.  Copper’s rise tends to mean economic activity is improving, or that investors expect it to.  Gold can be more idiosyncratic, but it sometimes rises when investors fear turmoil.  A surge in the copper/gold ratio, then bodes well for growth, which can nudge inflation and lead central bankers to raise interest rates, which tends to damp bond prices and boost yields.  Right now, copper vs. gold is near 4-month lows (albeit way higher than the lows of 2016).  This means that metals traders are positioning for slightly lower interest rates from here.  However, even if that ends up being the case, it’s difficult to be sure that valuations have already digested these higher rates (rising rates are bad for all long-duration asset classes).

Another point to keep in mind, is that when you go back and look at declines that were roughly the same size as the one we experience two weeks ago into Thursday’s low of ~7% below the highs (2015, 2011, 2008, 2002, 2001, 1998, and 1987), each time, equities retested those lows sometime 5-8 weeks after the initial decline.  I’m not predicting that equities will retest the lows of two Thursdays ago, but it’s important to keep in mind that every time we’ve been right here in the last 50 years, we have retested the lows.

Central bank communications will also be in focus next week with the January FOMC meeting minutes on Wednesday and accounts of the ECB meeting on Thursday.  For the ECB, focus will be on their degree of comfort with increased expectations for rate hikes in 2019, timeline for reviewing forward guidance, and the extent of their concerns around the impact of Euro appreciation on the inflation outlook. The January FOMC minutes will likely suggest that the Fed continues to expect a gradual pace of rate hikes remains appropriate as confidence in their inflation outlook improves.  What will likely matter more for the FOMC outlook is the unprecedented late-cycle fiscal stimulus.  Fiscal easing ($1 trillion+ federal deficit or 5.2% of GDP in 2019) at full employment runs the risk of significantly overheating the economy, which would force the Fed to tighten more aggressively.  The rising risk of a hard landing should probably be the key focus going forward as signs of overheating in the growth and labor market data likely pose more risk than a few inflation beats.  Also, propped up global growth (via trade) as a byproduct of US stimulus may be indirect support for initial steps by the ECB and BoJ to begin policy normalization later this year.

Lastly, I’d also be cautious with respect to the potential effects of wage growth and inflation on US corporate profits.  If wages rise, corporations’ costs will increase, but will they be able to pass along price increases to the US consumer in a hyper-competitive, Amazon-dominated world?  I’m not sure.

Overall, I’m positive on equities going forward and negative on bonds.  Stock valuations aren’t super high at 17.5x forward earnings (they aren’t necessarily cheap either!), and global growth looks good.  However, I’d skew more to the cautious-side as we get later in the cycle and wouldn’t be aggressively long stocks with a ~70% stocks and ~30% cash portfolio seeming about fine for me, personally.

My Top 10 Reads of the Week:

  1. The Economist: The Falcon Heavy’s Creator is Trying to Change More Worlds than One 
  2. WSJ: U.S. Consumer Prices Rose 0.5% in January, Up 2.1% On Year
  3. Ray Dalio: It’s All Classic: The Main Questions are About Timing and What the Next Downturn Will be Like
  4. The Economist: America’s Extraordinary Economic Gamble
  5. Bill and Melinda Gates: The 10 Toughest Questions We Get
  6. Wired: Scientists Know How You’ll Respond to Nuclear War – And They Have a Plan
  7. WSJ: Regulator Looks Into Alleged Manipulation of VIX, Wall Street’s ‘Fear Index’
  8. MIT Technology Review: 2017 Was the Year Consumer DNA Testing Blew Up
  9. Wired: Watch Boston Dynamics’ SpotMini Robot Open a Door
  10. Wired: Lab-Grown Meat is Coming Whether You Like It or Not 

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