The Countdown to Year-End
December 6, 2013
With about three weeks to go until year-end, things are turning more interesting.
December 6 – Bloomberg (Saijel Kishan and Kelly Bit): “The $2.5 trillion hedge-fund industry, whose money managers are among the finance world’s highest paid, is headed for its worst annual performance relative to U.S. stocks since at least 2005. The funds returned 7.1% in 2013 through November… That’s 22 percentage points less than the 29.1% return of the Standard & Poor’s 500 Index, with reinvested dividends, as markets rallied to records. ‘It has been difficult for hedge funds on the short side,’ said Nick Markola, head of research at Fieldpoint Private, a $3.5 billion… private bank and wealth-advisory firm… Hedge funds, which stand to earn about $50 billion in management fees this year based on industrywide assets, are underperforming the benchmark U.S. index for the fifth year in a row … Billionaire Stan Druckenmiller, who produced annual returns averaging 30% for more than two decades, last month called the industry’s results a ‘tragedy’ and questioned why investors pay hedge-fund fees for annual gains closer to 8%.”
Let’s talk the markets. There are now only about three weeks to go to wrap up an extraordinary 2013. One wouldn’t think the calendar should be much of an issue for the markets. Yet market closing prices on Tuesday, December 31st, will determine the compensation for thousands of hedge funds that control Trillions of positions (not to mention year-end bonuses for tens of thousands of market professionals worldwide).
The traditional standard has been that hedge fund operators take 20% of a fund’s return for the year. Often it’s a case of receiving a cash payment for “paper” (unrealized) portfolio gains. For a decent number of funds, market performance over the coming three weeks will significantly impact 2013 returns. A major move in the markets might prove a case of life or death for struggling firms. For the fortunate ones, a big year ensures financial security for years to come. 2013 market gains will add to the already inflated number of global billionaires.
As noted in the Bloomberg article above, hedge fund industry returns have struggled again this year. Shorting stocks has been a nightmare. Long exposure in precious metals and commodities has been a nightmare. Playing the emerging markets (EM) has been dashing through minefields. In general, global fixed income has been tough. It’s not that much of an exaggeration to say equities have been the only game in town. Yet the yen short and yen “carry trades” (borrow/short yen and use proceeds to buy higher-yielding securities) have been huge winners. European periphery debt has also provided strong returns. But, basically, there’s just way too much (and growing) “money” chasing securities markets and mucking up the traditional game of market speculation.
Within the hedge fund community, there’s an unusually wide dispersion of performance. Some of the big “global macro” funds hit home runs with the central bank liquidity trade – short the yen and go long equities. At the same time, a notable percentage of funds have posted only modestly positive returns for the year. And, I’ll presume, there are an unusually large number of fund managers that have been pulled into the long European debt and global equities trades with a sense of trepidation. To be sure, it’s been a year where trend-following and performance-chasing dynamics attained unstoppable momentum.
Friday’s trading bolstered the consensus view that equities are poised for a strong year-end mark up. I have posited that the backdrop creates the potential for the emergence of a lot of weak-handed traders in the event of an unexpected market reversal. Fortunate managers might want to lock in their big years, while many others could be forced to impose aggressive risk management to safeguard evaporating 2013 gains.
Over recent weeks, market dynamics have unfolded that seemed to increase the probability of an unexpected bout of “risk-off” trading. In a replay of the May/June Dynamic, global yields have been on the rise. After declining to a low of 2.50% in late-October, 10-year Treasury yields ended Thursday at 2.85% - not far from the 3.0% level from early-September.
This week saw the MSCI Asian Pacific equities index drop 1.8%, the biggest decline since August. Australia’s main equities index was hit for 2.5% and New Zealand stocks were down 1.7%. Australian 10-year bond yields jumped 21 bps this week to a 25-month high 4.44%. Singapore stocks fell 2.0%, and South Korea’s Kospi sank 3.2%. Turkey’s major equities index fell 3.1% this week. Argentina’s Merval stock index was hammered for 6.77%.
EM instability has returned – in some cases with a vengeance. Brazilian (real) yields closed Wednesday at a multi-year high 13.27%, up 190 bps from early September lows. Other EM problem children also saw bond yields spike higher. Indonesian 10-year yields ended the week at 8.64%, up from the October low of 7.0% and not far from September highs (8.93%). Indonesian yields began the year at 5.19%. The Ukraine has become another EM worry. Ukraine’s dollar yields jumped from 9.40% on November 25th to 10.38% on December 3rd (after trading at 6.86% in early-March). After ending October at 7.16%, Russian (ruble) yields jumped this week above 7.90%. After trading down to 8.20% in late-October, Turkey’s 10-year sovereign yields this week returned to 9.60%. South Africa saw 10-year yields jump from October lows of 7.30% to above 8.10% this week. Almost across the board, EM yields have risen over recent weeks.
This quietly emerging “risk off” backdrop took an interesting turn this week in Europe. Curiously, French 10-year yields surged 29 bps to 2.44%, the highest level since September. French debt has been a speculator community darling. Perhaps there is a large yen “carry trade” component in the French bond market. Shorting German bunds to lever in higher-yielding French debt has definitely been a huge winning trade – although less so after spreads widened a notable 14 bps this week. Italian and Spanish debt have also been 2013 winners, although these gains were also under pressure this week. Friday’s bond rally reduced what were mounting early-week losses in periphery European bond markets.
However, Friday’s equities rally didn’t make much headway on notable losses in European equities. Italian stocks were slammed for 4.7% this week, taking back about 30% of Borsa Italiana’s 2013 gain (11.4%) in only five sessions. Spanish stocks’ 4.4% drop cut year-to-date gains to 15.1%. The French CAC40 sank 3.9% (up 13.4% y-t-d), and Germany’s DAX fell 2.5% (up 20.5%). It’s worth noting that Financials led European stocks lower this week. And Friday from Bloomberg:
“Corporate Bonds Suffer Biggest Weekly Loss Since June in Europe.”
ECB President Mario Draghi made an interesting comment during his post-meeting press conference: “If we are to do an operation similar to the LTRO (“long-term refinancing operations” - the ECB’s preferred liquidity-bolstering measure) we want to be sure it’s being used for the economy and that it’s not going to be used to subsidize capital formation for the banking system through carry trades.”
The “Draghi Plan” has proved a huge boon for speculators in periphery (particularly Greek, Portuguese, Italian and Spanish) bonds. Perhaps Draghi’s comment this week suggests the ECB is increasingly concerned about mounting speculative excess. A downside of the ECB backstopping European debt has been the huge speculative inflows that have boosted the euro currency at the expense of struggling periphery economies. The ECB is now in a difficult spot. It would prefer a weaker currency, but dovish talk at this point only feeds a speculative Bubble.
Here at home, the Fed as well confronts dysfunctional speculative dynamics. QE has fueled a year-to-date 29.1% total return in the S&P 500, with the small cap Russell 2000 and the S&P400 Midcaps returning 34.8% and 30.0%. Yet Treasury and MBS yields have marched higher in the face of the Fed’s Trillion dollar bond market liquidity injection operation. In spite of the Fed and Bank of Japan’s combined $160bn (or so) of monthly liquidity injections, global yields for the most part have jumped higher.
Thus far, cracks in the “periphery” of the global Bubble have only worked to bolster excess at the “core” – a destabilizing dynamic fueled by central bank liquidity injections, guarantees and backstops. The global leveraged speculating community has been right in the thick of this dynamic, as they flee underperforming markets to jump aboard inflating speculative Bubbles. U.S. equities and corporate debt, along with European stocks and bonds, reside today at the heart of increasingly unwieldy global Bubble Dynamics.
Friday’s stronger-than-expected U.S. non-farm payroll data add an exclamation point to what has been a batch of strong data. With surging stock prices, inflating home prices and about the loosest corporate Credit conditions imaginable, it would be surprising if the economy weren’t picking up some momentum. As such, our central bank is bringing new meaning to “behind the curve.” The case for further delays in tapering gets only weaker by the week.
If the Fed doesn’t begin articulating its tapering strategy on December 18th, it surely will by January 29. This would suggest ongoing “risk off” for the troubled periphery – especially the “periphery of the periphery” of troubled emerging markets. And after the way equities responded to the Fed’s retreat from September tapering, I expect Fed officials will be more hesitant to pamper a speculative marketplace next time around.
How will the global leveraged speculators game this? Play for further “how crazy do things get” speculative excess at the “core”? Push the melt-up dynamic in U.S equities for all it’s worth – squeezing the shorts and hedgers at each and every opportunity? Or does the unfolding “risk off” dynamic continue to expand, as was the case for much of this week? Are we in the early stages of a problematic de-leveraging throughout global fixed income, a predicament exacerbated by ongoing Bubbles in “core” equities and corporate debt?
As the marginal source of buying and selling pressure in many global markets, the now $2.5 Trillion hedge fund industry will undoubtedly set the tone. If the hedge funds get through year-end, they will then have January to contend with. They surely would like to avoid having to de-risk into a June-like backdrop of heavy mutual fund and ETF outflows. The current backdrop would seem to imply the return of unstable markets for some weeks to come.
All of this has taken place without the help of especially strong earnings or declining interest rates. The U.S. economy has struggled to grow at 2%, and the much-anticipated year-end acceleration has failed to materialize. The individual investor has become less enchanted with bonds and has been buying stocks, but it has not yet become a tumultuous shift. Corporations have been purchasing their own stock back, but nothing much beyond normal levels. Washington continues to be dysfunctional, so nothing has happened there to increase confidence. Geopolitical issues have improved, but we are not yet at a point where we can feel comfortable about the Middle East, Europe or the South China Sea.
I continue to believe that the monetary expansion of the Federal Reserve was a major factor in the appreciation of equities this year. In my view, about three-quarters of the $85 billion a month of the bond-buying program flows into financial assets rather than the real economy, so the program is a very inefficient form of economic stimulation. The main effect of the expansion is to move stock prices higher and keep interest rates low. If you assume that of the $85 billion, 75% goes into financial assets, that's about $63 billion. If 75% of that goes into equities that's $47 billion. The average daily dollar volume for the New York Stock Exchange and the Nasdaq is about $34 billion.
Assuming 22 trading days a month that's $748 billion. The $47 billion seems like a minor factor influencing the stock market, so it must be the confidence the monetary easing engenders that propels the market higher. We saw a hint of that when Ben Bernanke said he was thinking of tapering and confidence declined.
Renewed confidence has been reflected in mutual-fund flows. Up until this year investors have been more favorable toward bond funds, but the strong performance of equities in 2012 and so far this year has changed the mood. As a result, through October flows into U.S.-oriented equity mutual funds have been $20.2 billion and international equity funds have gotten $113 billion, while bond funds have experienced withdrawals of $39 billion. Institutional investors also have been more willing to take the cash they have had in reserves and put it into equities. The prevailing view seems to be that as long as monetary policy is accommodative, stocks will keep rising. In the view of most investors, valuation is not yet a problem. The S&P 500 is selling at less than sixteen times earnings, a long way from the excessive multiple levels of 2007 and 1999. Fifteen times is the long-term average.
There is fear that the good times will end when the Federal Reserve trims back its easing. To me that does not seem likely to happen soon. December will be Bernanke's last Federal Open Market Committee meeting and I do not think he plans a policy shift as his parting gesture. Similarly, it is not likely that Janet Yellen changes the policy at her first meeting. What happens when is dependent on how the economy is doing. Unemployment is still above 7%; real GDP growth probably will not exceed 2.5% soon. The economy still needs the modest amount of stimulus the Fed is providing, so a change of policy will not take place before the spring, in my opinion.
This is because the typical bear market is caused by a tightening of monetary policy to control inflation resulting in rising interest rates. As interest rates fall to combat the recession, price earnings ratios rise. But that didn't happen this time. The bear market of 2008-9 was caused by the sub-prime mortgage crisis and the recession it produced.
Interest rates were low when the decline started and they stayed low throughout the rise in the market. In this cycle, which has lasted 56 months, the S&P 500 has risen 166% with 106 points coming from earnings improvement and only 59 points from multiple expansion.
Based on history, the current bull market is already aging, and with most observers expecting interest rates to rise, there is not much chance for further multiple expansion. These factors would argue for limited upside.
There is some better news on the earnings front. While the U.S. economy has continued to plod along at a growth rate of 2%, and earnings and revenues for the S&P 500 had been increasing at 2% and 2.5%, respectively, there has been some improvement since October.
Earnings and revenues are now increasing at 5% and 4%, respectively. While this does not yet confirm the acceleration that many were expecting for the second half, it does reflect a more positive business environment.
Earnings for the S&P 500 for 2013 are running at a rate of about $105. The consensus estimate for 2014 is about $120. I have been skeptical about an increase of that magnitude with profit margins at a high and revenues increasing modestly, but if the present favorable trend continues, earnings may turn out to be stronger than I had thought.
I was originally planning to write about the emerging markets this month. Equities for these countries have been doing better since the summer, but overall, the performance in 2013 has been disappointing. The economies are still growing, but their rate of growth has slowed down substantially and this has cooled off investor enthusiasm. Their GDP is expanding faster than their developed country counterparts.
China is expected to grow at 7.4% in 2014, India at 4.5%, Brazil at 2.3% and Mexico at 3.5%. Emerging markets are 45% of world GDP, however, and, in my view, they are going to increase their importance going forward. The standard of living in these countries is rising in contrast to the developed world and that should provide numerous investment opportunities in the future. It is just hard to know when these markets will start to perform again.
There is reason to think important changes are taking place in China. The November Third Plenum proposed a number of reforms. The country is shifting toward market-driven pricing for fuel and pharmaceuticals rather than state control. Eventually even the currency could float. The one-child policy will be relaxed over time. The hukou system, which deprived migrant workers of the ability to transfer social welfare benefits from their home town to their new place of employment, is in the process of change. State-owned enterprises will set aside 30% of their profits for programs like social security and healthcare. The result of these initiatives will be a shift in the balance of the economy from an export orientation to internal consumption. Instead of providing favorably priced goods to the United States and buying our Treasury securities, China may become the most important customer for our manufactured products. Xi Jinping, China's President, has the power and political base to make this happen. Let's see how long it takes.
After an initial surge of enthusiasm about the effects of Shinzo Abe's first two "arrows" of fiscal and monetary stimulus, investors have become skeptical about the third arrow which is a growth strategy based on deregulation, increased competitiveness and innovation. The major impediment to the success of the growth plan is Japan's aging population and declining workforce. Japanese real growth has averaged .8% for the past decade and the goal is to raise it to 2% in the future. That may be hard to do based on Japan's traditional slowness in implementing reforms. Right now according to the Japanese National Institute of Population and Social Security Research, Japan's working age population is set to fall from 82 million in 2010 (when the total population was 129 million) to 73 million in 2020 (when the total population will be 100 million).
It is hard to see how growth can increase with that demographic background. Abe has already accomplished more than his critics thought he could, so perhaps further favorable surprises are ahead.
Similarly, most investors believe that Iran is serious about its willingness to curtail its nuclear weapons development program. There is reason to think that view is correct since the sanctions imposed on the country were clearly holding back economic development and depriving the population of a better quality of life. But Benjamin Netanyahu believes the deal is an "historic mistake" and Iran is deceiving naïve Westerners. It is probably wrong to be complacent about the potential success of the Iran agreement, but it is better than the threatening situation that existed before and worth a six-month try. The main criticism of the Iran deal is that the sanctions were working well and Western leaders should have settled for nothing short of a total suspension of the Iranian nuclear program. By letting the Iranians continue to enrich uranium, albeit not to the weapons grade level, they will be in a position to produce a bomb within a short period if the limits on their efforts are ever suspended for any reason. If Iran had a nuclear weapon the entire region would be destabilized.
Back at home we have the unfortunate rollout of the Affordable Care Act. There is no question that it was a serious failure and its lasting implications depend on how rapidly it can be fixed. I continue to believe that the major problem with the Act will be its cost to both the individual participant and the Federal government. It is unrealistic to assume that you can insure more than 40 million people without Washington providing significant financial support. The success or failure of this program is clearly going to be a key issue in the Congressional elections in 2014.
As an aside, I traveled to Myanmar (Burma) during November. It is one of the world's true wonders. The temples and stupas of Bagan are breathtaking and rank with Angkor Wat in Cambodia. Inle Lake with its communities of houses on stilts is something to see. It gives someone in our business perspective to see thousands of people living on several dollars a day. Don't worry about having to get there tomorrow. The major cities like Yangon and Mandalay may change but the principal areas of interest have been that way for hundreds of years and, aside from the hoards of tourists already there, are likely to remain that way for a long time.
We have reached that time in the year where everyone is speculating about the prospects for equities in the year ahead. As usual the consensus is that the market will be up 10% in 2014. I have been an observer of strategists' estimates for half a century and I can tell you that as a group they always think the market will be up 10% in the following year whether stocks were up 20% or down 20% in the previous year. What nobody seems to be talking about is the possibility of a "fat tail." With the uncertainties surrounding Obama's Affordable Care Act, and the risks of the initiatives in Syria and Iran taking a turn for the worse, profit margins peaking and earnings falling short, the downside is certainly not out of the question. As for the positives, the tone of economies around the world is improving, individuals are coming back into the equity market, share buy-backs continue, merger and acquisition activity is picking up, growth in Europe is getting better, the decline in oil prices increasing consumer purchasing power and interest rates are likely to stay low because of a reduction in bond offerings. This could produce another year of strong stock market gains. At this point I don't know which of the "fat tails" is more likely. While investor optimism is approaching extreme levels on the positive side, which is a warning signal, stocks don't appear to be melting up yet. I just have a feeling that 10% appreciation won't be the number at year-end 2014.