Market Perspective for 9/12/16
Last Friday (9/6/16), the market experienced one of the “reddest” days I have ever seen. The advance-decline ratio on the NYSE was 152 to 2929, which is approximately 19 to 1. The cause of the decline appears to be the idea that interest rates have put in their lows, and therefore bond prices have made their highs. Of course, the market has had this fear many times and has always been wrong. We won’t know for several months at least whether the post-Brexit vote interest rate plunge in early July marked the interest rate bottom or not, just as it took until July of this year to establish that the U.S. equity market hadn’t peaked in June 2015. Still, for a market that had been experiencing near record levels of intraday stability, a day where practically everything declines in both the stock AND bond markets is probably significant.
World central banks have been providing an extremely benign investment environment by expanding liquidity in the banking system and buying bonds outright in order to drive bond prices up and interest rates (borrowing costs) lower. It became extremely profitable to play the “carry trade”, or in other words, to borrow money denominated in a low interest rate currency (like the Japanese yen) and invest that money in a currency where yields are much higher (say the U.S. dollar or the Malaysian ringgit). If you were interested in a dollar based investment, you could pick a safer security such as a treasury note and add multiples of leverage to the trade, or you could opt for a higher yielding but less leverage-able corporate bond. You can see how this would fuel a surge in riskier fixed income securities, but it also fueled a surge in equity prices as well. Many investment strategists calculate the value of the stock market as a function of a given risk premium over bond yields, as bonds are in theory a competing investment. To them, lower bond yields justify a higher P/E multiple.
Therefore, on 9/8 when Mario Draghi said that the ECB had done enough and he wanted to wait before doing more, he was echoing Japanese Prime Minister Shinzo Abe’s recent ambivalence about the benefits of reducing rates when they are already below 0%. Asset prices (stocks, bonds, and to a large extent commodities) are priced to reflect the idea that policymakers are committed to stimulating the economy through interest rates and that this commitment is not bound by 0%. The notion that this might not be entirely true, therefore, potentially impacts all asset prices and is negative for almost any of them you can think of (including gold). On September 8th Jeffrey Gundlach of Doubleline made that point during a webinar. He predicted that going forward economic weakness will not be met by lower interest rates but instead by fiscal stimulus (government borrowing). If he is correct, bonds will underperform, as will interest rate sensitive equities.
Keep in mind that one bad day does not end a bull market. Today’s down market may prove to be a “shot across the bow”, or in other words a warning of what may eventually happen. It is by no means a guarantee that the market is topping and asset prices are heading lower. In my opinion, the most vulnerable securities right now are longer duration bonds and interest rate sensitive equities, because they benefitted the most from the “lower interest rates for a longer period of time narrative”. I would make an exception for the very longest Treasuries, which will have a natural buyer in pension funds that need safe, higher yield assets. I would feel less worried about assets that would stand to gain from a higher level of economic activity, such as natural resources. Higher interest rates would likely bring about a stronger dollar, which would not be favorable for gold.