This white paper addresses the extreme opacity of the current
macro backdrop caused by monetary and fiscal policy, and how it
obscures market sentiment and traditional measures of valuation. It
is necessary to look at the real economy beyond monetary policy,
and at my firm we propose that the cleanest and simplest of market
measures are likely the most effective given the complexity of the
underlying macro conditions. Such measures include structural
fundamentals of the market, the current inter-market relationship
between equity and debt markets, and technicals. By comparing these
findings to historical precedents,
our conclusion is that there is an impending bear market in
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Flawed Market Sentiment
The Federal Reserve Bank has been printing one way or another since
2008. The generally accepted Wall Street view is that the United
States has turned into Japan through its own Quantitative Easing
(QE) programs and therefore equities are "safe" from a bear market
as this Fed-controlled game will go on forever (QE Infinity). We
believe this corollary is wrong when compared with historical
- Japanese stocks NEVER rallied. If we are indeed "just like
Japan", then our equities market will act like just like Japan's
and mean revert to the reality of the situation by selling off. A
much lower stock market would more likely validate the "US has
turned into Japan" premise.
Valuation: Impossible to Properly Measure
- Another generally accepted view is that the Fed's QE programs
cannot "allow" stocks to sell off (Bernanke put). Wall Street
seems to have a short memory when it comes to the Flash Crash in
May 2010 and the bear market of summer 2011, both of which were
examples of aggressive mean reversion in action.
While market sentiment and valuation are separate constructs, they
are both affected by the Fed's monetary policy. Continuing to use
traditional Wall Street axioms on valuation without considering the
current environment is inane. It is impossible to see clearly by
looking at the
(INDEXSP:.INX) through the lens of Price to Earnings without
factoring in the Fed buying of
a month in debt. We are not saying that stocks are expensive or
cheap. Rather, we are saying that traditional valuation analysis
has been rendered impossible by the Fed.
Furthermore, we believe the ferocious buying back of shares by
companies from issuing cheap debt is the
low valuation story. However, it is a story that is anchored on a
historically unprecedented and unsustainable catalyst of Fed bond
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The Real Economy: Housing and Payroll Tax
Housing is in the same camp as valuation. If the Fed
buying $85 billion a month in debt, where would rates, and thus the
structured credit markets, and thus housing, be? The answer is
. This opacity is
bullish, contrary to every loud economist and pundit talking on TV.
The payroll tax of 2% will put consumers into a recession this
year. The consumer continues to be highly levered while wages have
been falling. We feel very confident that the street is working off
of a higher base number for consumer discretionary budgets than is
truly the case in reality. Therefore, the 2% that comes off the top
is a much more impactful amount to the consumer than the street
Market Structure Fundamentals
In this muddled macro environment, it's important to study the
underlying structure of the market to determine vulnerabilities.
While volatility has been low, we believe that this is the product
of the Fed's policy of intentionally compressing volatility by
commandeering interest rates and therefore commandeering control of
equity market prices to the upside.
- Cash levels of domestic equity mutual funds are under 4% and
rivaling all-time lows. The US equity market has had four major
sell-offs (in 1973, 1976, 2000, and 2007) when cash levels were
- NYSE margin debt rose to $364 billion in January, which
nearly matches the July 2007 peak of $381 billion. Furthermore,
net free credits have plunged to negative $77 million. This shows
that the market is extremely leveraged.
Debt: Connection with Equity Markets and Divergence from
- By all generally accepted measures, short interest in
equities is at an all time low. The S&P 1500 short interest
is now at 5.9%. This is below the level during the market highs
of 2007 and down more than 50% from the market lows in 2009. We
view short interest plummeting to an extreme low percentage as a
direct effect of the Fed's volatility compression policy, and
extremely unhealthy for the market. High short interest embeds
natural liquidity in a downturn and acts as insulation to the
system, cushioning the market from future shocks. The lack of
such insulation is downright scary.
It is also important to look at the market structure issues within
the debt markets. Corporate issuance had its busiest January ever
with $412.3 billion vs. the all-time high January issuance of
$407.2 billion in January of 2009. The obvious difference is the
massive narrowing of spreads from historically wide levels in 2009
to all-time lows today. We believe the Fed's QE programs have
turned equity markets into expressions of "bond yield complacency"
and therefore the two markets are inextricably linked. This link
manifests itself in the capital market phenomenon of Profit and
Loss (PnL). For any market participant, whether institutional like
a pension or hedge fund, or an individual, it's the loss of
principal that causes aggressive net selling.
The real risk here is the global margin call that can occur from
simply too much long leverage chasing artificially low yields. The
bloat in the system on the long side in bonds is now associated
with long bloat on the equity side. Margin calls and selling in
junk bonds and down bond funds will bleed over into equity funds
and vice versa. The Fed would have zero control over a global PnL
margin call on bond principal scenario.
Despite the highest corporate issuance of all time in January of
2013, global bond markets had their first selloff in 14 months.
Even in a month with issuance buoyed off the FED's $85 billion a
month buying program to artificially suppress rates, the fact that
corporate bonds could go lower in price proves that markets can't
be controlled by the FED forever.
We believe equities are further away on the risk curve and
therefore more susceptible to true market forces over time.
Equities and higher yielding debt such as long dated treasuries,
high yield and corporate high grades CAN diverge from each other,
contrary to current market perception. We believe this dangerous
long leverage is not present in certain bond markets such as
shorter duration treasuries.
Technicals represent the market forces that, over time, will no
longer be under the FED's control. The transports have made
parabolic moves on the weekly and daily charts. Bull markets don't
start with old economy indexes such as the transports going
parabolic to all time new highs. Instead, that's how they end.
The Nasdaq-100 tracking ETF (
)) has formed the start of major Head and Shoulders (H&S)
pattern on a weekly chart (See Appendix).
iShares iBoxx $ High Yid Corp Bond ETF
SPDR Barclays Capital High Yield Bond ETF
iShares IBoxx $ Invest Grade Corp Bond Fund
(NYSEARCA:LQD), all of which are
that track junk debt and corporate debt, have also been forming
H&S on daily charts (See Appendix). These patterns are
extremely bearish. We do not view H&S patterns, if confirmed,
to be associated with merely "corrections." We would view the
selloff with the current incredibly low short interest environment
to be much more severe.
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A Matter of Time
History invariably repeats through each market cycle, even if
expressed in different ways as society evolves. This bull market
will end, like all bull markets eventually do. By looking at the
cleanest and simplest of market measures, we've found
vulnerabilities and a foreshadowing of a bear market. The dearth of
short interest and extreme long leverage in both stocks and bonds
is not only scary, but was exacerbated by the Fed's policies.
The notion that stocks must sell off because of any of the things
we have mentioned from a macro perspective is a matter of time, not
a matter of timing. Like all bull market endings, it's impossible
to time on a macro level. This one is even harder to time due to
the Fed's artificial manipulation. However, the technical signals
now in the market, along with the small but obvious divergence of
bond prices and bond issuance, works as a whole as a timing
mechanism for US equities entering a bear market. History says
watch your charts first; connect the future obvious macro catalyst
The Head and Shoulders pattern is one of the most reliable and
powerful trend-reversal patterns in technical analysis. The drawn
neckline of the pattern represents an important support level, and
the H&S pattern is confirmed when the neckline is broken.
QQQ Weekly (Aug '07 - Present)
Click to enlarge
HYG Daily (Apr '11 - Present)
Click to enlarge
About the author:
founded Macro Trading Consultants (MTC), a macroeconomic and
quantitative investment strategy & consulting firm
in 2008, and continues to serve as CEO and Chief Strategist.
After graduating from the University at Albany SUNY in 2000, he
went through the trading desk training program and was a junior
trader at Goldman Sachs. Subsequent to leaving Goldman, Scott was
head trader at various hedge fun
ds and broker dealers including the Abernathy Group,
Diamondback Capital, and Keel Capital, before establishing
, Director of Research & Development and Managing Editor at
MTC, also contributed to this story. Wong is a Bayesian
statistician and received his master's degree in Statistics from
Harvard University after graduating from Tufts University with a
triple major in Math, Quantitative Economics, and Psychology. Prior
to joining MTC, Henry worked as a proprietary equities trader and
China-focused quantitative analyst.
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