|When’s a bubble not a bubble?|
Published on: January 22, 2020 • Duration: 17 minutes
This week we examine the lack of emotional attachment suggesting that equities could still be some way short of a euphoric top. The market chatter sees a buying opportunity for the British Pound in the recent weak UK data, which largely pre-dates the election. And the whisper looks at a couple of market hedges that try to keep down the carry costs that are killing us.
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[00:00:05] The S&P 500 has just cleared 3300 for the first time, while the German DAX is within a whisker of the all time highs. Valuations are rampant and many assets are extremely extended, but our assets are actually in bubble territory. That is the big conversation.
[00:00:27] It seems to be obvious that we are in bubble territory across a great many assets and that these bubbles are still being fuelled by central bank excesses across the world. But bubbles are the result of euphoric human emotion and bubbles are usually relative, with investors piling into one asset over and above all others. And classic bubbles of the past include Japan of the 1980s, the Nasdaq of the 1990s, the chart of which we just saw, property in the noughties and more recently, bitcoin. When the Japanese Nikkei was in its ascendancy 30 years ago, the country was seen as a genuine threat to US business interests and Japanese practices were being adopted worldwide. In fact, Japan sentiment was all pervading. But today, the Nikkei 225 remains below that 1989 peak. So can everything today truly be in bubble territory, or is it merely a reflection of those central bank balance sheets which continue to expand? Japan's balance sheet expansion has never really stopped, although it has slowed in recent months. The ECB reignited its own expansion towards the end of 2019, and Draghi, the former president, has exhorted his successor and the leaders of euro's nation states to spend and spend and spend. And the Fed, albeit on a short term basis due to issues in the repo market, has expanded its balance sheet at the fastest pace since 2009. And of all the key central banks, it's only really China that has remained in a sort of neutral mode. But that's largely out of necessity because of the diminishing returns of its excessive credit creation, which has become very, very hard to ignore. But with three of the big four still recommitting to balance sheet expansion in the last few months alone, asset prices have remained elevated, despite the general distrust for many investors and observers. So have central banks, and in particular, the Fed actually created bubbles? Or do we still have further to go before they can be classed as truly first rate bubbles like the Japan of 1989 and the dot com era 2000? Well, firstly, if we look at M1 money growth in the US, we can see the dramatic shift in U.S. policy during 2019 with M1 supply accelerating in the second half of that year, even as the Fed shifted towards a neutral stance. The move in money aggregates of M2 is even more dramatic, suggesting that there was an outsized impact on credit expansion, which followed the usual path seen over the last decade by finding its way into asset prices rather than into out and out inflation, though as discussed before, few believe the headline inflation numbers actually reflect reality. But if we look at the US stock market, while it has raced to new all time highs in recent weeks, the move looks far less dramatic when viewed on a long term logarithmic chart. And we know that the median valuation i.e. that of the bog standard stock in the S&P 500 is at an all time high, even at the absolute S&P valuation is not. The key question is who is buying those stocks? It's not me. It's not you. And it's not really other active managers. It's obviously corporates and passive funds……the corporates do the buybacks. And in many ways, they don't care about valuation. They're more concerned with the availability of cheap capital and hopefully abundant capital, especially in the case of the corporate buyback. And remember, all bubbles from Dutch tulips via the South Sea to Japan were driven by the euphoria and the rationalization of irrationality with individuals piling money in whilst observing that this time was truly different, when obviously it never was. What is different today is that this market rally is widely reviled with an extremely high level of scepticism amongst human participants, and that fear of missing out has not yet swept through Main Street. The last few years have been dominated by mutual fund outflows. And another relative argument is that the extremely low levels of interest rates and yields support higher prices anyway. Now, clearly, many would argue that its bonds themselves that are stretched. And it's not just sovereign bonds with their negative yields, but also huge swathes of lower quality investment grade and most of the junk bond corporate market also looking excessive. But as we've discussed before, until that framework is broken, then overpriced bonds will continue to drive overpriced equities with both being extreme. But arguably neither of them in bubble territory. And so the bizarro world of buying bonds for capital gains and buying equities for income can continue, while the central bank framework is intact. But what about real estate prices? In 2006 to 2008 there was a property bubble in the US and a good number of other countries. Home prices have now exceeded those extremes, so surely property must again be in a bubble? But if we take those U.S. property prices relative to GDP, as you can see, that they've lagged despite the anaemic growth that the US and much of the world has experienced in the 12 years since that bust. And again, as mentioned previously, if bubbles are relative, then US house prices have significantly lagged the equity market. So property on this metric actually looks cheap and it might even be sensible to switch some resources from one to the other. In Europe, house prices, at least those of the eurozone, have moved further ahead of their 2008 peak, although maybe that's understandable given that rates in the eurozone have been in negative territory. Some mortgages in Denmark, which, although it's outside the eurozone, it’s still tied to the bloc's policies, are actually paying borrowers of capital. But just like in the US, we can see that when adjusted for GDP growth, even European house prices under these extraordinary conditions have failed to beat the 2008 peaks. And that's despite the eurozone debt crisis weighing on GDP growth during the intervening years. Eurozone M2 growth has been somewhat lacklustre versus eurozone M1 growth. And that's suggesting that the ECB policies have not been sparking the same animal spirits as they have in the US. So it's true that the everything bubble has pushed prices and even valuations to an extreme in many locations. It's hard to say that it's created a true bubble in animal spirits. Capital has been spread across many geographies and many assets. So these emotions have also been spread too thinly so that no single asset has taken a significant lead and shifted into another gear, although perhaps the U.S. equity market is exhibiting some of those credentials. But the drivers have been the dispassionate demand of the passive funds and the ongoing shenanigans of the corporate buyback. So whilst markets are clearly stretched and well overdue, particularly in the US, a 5 to 10 percent correction, that should be considered a normal and healthy pullback. The first full week of 2020 did see the Fed contract its balance sheet, but that was quickly followed by a rebound last week and an even healthier move in the S&P 500 to the upside. So what is the Fed's tolerance for weakness in the equity market versus the recent comments showing concern that their efforts to backstop the funding market has distorted prices and in particular, equities? Well, the Fed should now be taking their foot off the pedal, and that should feed through to a low trajectory for the S&P 500. And dare I say, even a down week on the index. We currently have prices that are clearly extended, but it would be very hard to say the public's emotional involvement with asset prices is so extreme that could lead to the sort of populist mass exit the results in extended losses in the equity space.
There's a lot of chatter about the alleged headwinds that the U.K. economy still faces. 2019 was a particularly tricky for the U.K. because of fears, Brexit and then the election uncertainty. Accountants Ernst and Young reported that the number of UK companies that fell short of profit forecasts last year was the highest since 2015. In 313, British firms issued profit warnings. The number of listed companies that warned was the highest in 18 years, even above the number of 2008, the year of the great financial crash. Last week saw some pretty weak macro data out of Britain. Bank of England Governor Mark CARNEY had already indicated that the next rate move could be a cut and markets very quickly pushed the expectation for a cut at the next Bank of England meeting on January the 30th to 70 per cent.
[00:09:09] And the British pound pretty much immediately fell back to the 1.30 mark. But perhaps this is actually a buying opportunity for Sterling? Firstly, what were those data series and why were they of particular note? Well, industrial production for November came in at -1.2% month on month versus 0 percent expected. Whilst manufacturing came in at -1.7% month on month versus 0.2% expected.
[00:09:35] However, none of this should be much of a surprise. The market manufacturing PMI has been below 50 i.e. in contraction territory for much of the last year, and we've documented the slowdown in global manufacturing in many previous episodes of The Big Conversation. But anyway, the UK is a service economy, although the November index of services was also weak at -0.3% month on month versus zero expected, reflected by a similar decline in the monthly GDP reading, which also fell r -0.3% versus no change expected. But by now, hopefully you will have spotted these data releases for the UK are all from November and this is therefore pre-election. Indeed, the election uncertainty probably persisted into the early part of December - the election was on the 12th of that month and because the polls had started to narrow, maybe people's concerns had picked up. But as we all know now, the Conservatives won a landslide. Therefore, not only is the data reflecting pre-election uncertainty, in many ways it reflects a completely different UK to the one that has emerged post-election. We can perhaps already see the potential pick up. Last month's final reading for the Markit Services PMI for December saw a healthy rebound from the initial reading 49.1 to end the month, with the final reading of 50 suggesting that optimism had already rebounded after the election. And even before the election, the November construction data had already started to rebound, with construction output registering a rise of 1.9% on month versus 0.6%, suggesting that this key sector for UK sentiment was already on the turn, after a torrid time for much of the last 12 months when viewed by the construction PMI. So although there remains significant geopolitical uncertainty and a lot of execution risk of the Brexit strategy, the ruling conservatives have a very powerful working majority in parliament. So the British pound, therefore is probably a buy at these levels. Now, cable, i.e. the pound versus the dollar may be subject to the ebb and flow of ongoing global trade negotiations. So it may be preferable to play Sterling - that's another name for British pound - against the euro. Eurozone inflation targets remain a distant dream, and unless we have a surge in coordinated global growth, the prospects for the euro will remain relatively subdued. We do have to be a bit mindful of the key short term support for the pound versus both the dollar and the euro. For instance, there is a gap from 1.28 to 1.26 versus the dollar. But short term, with FX volatility having dropped back, maybe optionality looks attractive, though the cost of buying one month calls versus one month puts on cable are back towards the top of the range. And for corporate UK in general, the easing of domestic political tension plus a focus on fiscal expenditure should allow many of those companies that missed forecasts last year to bounce back healthily in 2020.
As noted in the opening section, markets are stretched, but playing for a reversal has been proving extremely difficult. Buying protection on the equity market in particular, the S&P 500 has been something of a mug's game. Basically you pay your premium, the market marches higher and you have to start again, bleeding away your option premium and making it very costly to carry protection strategies. And even if the market does correct, you will often be from a level that is much, much higher, meaning that the strikes of the put options that have been bought are now much further out of the money when the correction comes. Furthermore, the structural shift that took place in 2012, when asset managers switched from buying tail hedges to selling options for yield enhancement, means the spikes in volatility are quickly suppressed, such that the window to monetize protection is very short.
[00:13:23] So what sort of strategies can we use? Well, firstly, there's a myriad of caveats.
[00:13:28] Every investor has a different time horizon, a different portfolio and a different risk profile and risk tolerance. Therefore, there can never be one strategy that fits all. And in many ways, it's not just about the winning strategies, but also the ones that lose the least whilst also keeping some skin in the game. One area that might be of interest is actually outside equities altogether. FX volatility, currency volatility has returned to the 20 year lows. The last time that the CVIX, which is a bit like the VIX for FX, was at 5 was in 2014 and that was the only time it reached those levels since 2000. Most though, not all equity periods of volatility, we have also seen a rise in FX volatility, though the magnitude of the moves on FX volatility tend to be smaller. Nonetheless, FX volatility is at historically lower levels today than equity volatility. Though not everyone will be able to buy pure FX volatility. In the equity space, a key question is how much faith do you have in the US equity market during the next downturn? Historically, Europe has tended to have a higher down-beta than the US and I'm talking about the S&P 500 for the US. What that means is that Europe falls normally more than the US during a major pullback. Now today many think that the US is a greater risk and obviously this is also a US election year. But that's a big but with, again, lots of caveats. If you think of the historical pattern of Europe declining by a greater amount than the US during a major correction still holds true, then you could buy, for instance, a Eurostoxx March 20th, 2020 95% put and sell the S&P 500 equivalent for around about zero cost and maybe even a small credit. Now, clearly this does not hedge your portfolio, but there haven't been too many occasions over the last decade when you could have put this trade on for free. If the market continues to rally, well, the position has not cost anything apart from your commissions. If it sells off and the historical precedents hold true, then Europe should fall more than the S&P. And you could also do this by selling a FTSE100 put rather than the S&P to fund the position. But this would incur a small cost because FTSE volatility is currently one of the world's lowest. But remember, with this position you are short an option here. So there is leg risk and therefore that's not going to be for everyone. The third trade and one that's been quite popular over the last 12 months has been buying a 100 strike call on the euro dollar futures. That's the interest rate contract and not the currency pair. The thinking here is that if the markets or the economy have a serious wobble, then the Fed will furiously cut rates again towards zero. If the market starts pricing negative interest rates in the US, as many think they will, then that 100 strike comes into play. The Dec 2021, that's December 2021, 100 strike and also the 99.75 strike, they already have a reasonable amount of open interest, so quite a lot of people have bought these contracts already. So it's clear that these Eurodollar trades have already been popular expressions to hedge a real slowdown over the next two years.