Don’t Fight Central Banks, But Be Afraid

Janet-YellenChris Ciovacco:  There May Be Gains To Capture In Stocks In The Coming Years, But Risk Management May Be Very Important Down The Road.

While pondering the recent shift in market sentiment/hard data, along with the possible ramifications for investors, we ran across the quotes below in an October 26 Bloomberg article:

“Central banks are playing catch up with what the market has known for some time – that global growth is slowing,” said Jason Daw, head of Asia currency strategy at Societe Generale SA in Singapore.

“While inflation is this low at a global level, central banks will step on the gas again and elevate asset prices for the foreseeable future,” Deutsche Bank AG strategist Jim Reid said in a note to clients on Monday. “This leaves a huge gap risk lower for financial markets, but that’s more of a problem for when central banks are unable or unwilling to act.”

The key takeaways from the quotes above:

  1. Central banks may inflate asset prices (again).
  2. Every time they inflate asset prices to a new level, risks get higher and higher.

Central Banks Are Not Going Away

Every once in a while someone summarizes the big picture in a simple way. Bill Gross, formally with PIMCO, noted the following in his December 2013 investment outlook:

Don’t fight central banks, but be afraid.

Why is this statement so relevant? The market’s pricing mechanism is driven by both fundamental and speculative forces. Speculators are not evil; in fact, they provide much needed liquidity for efficient pricing. A healthy market has a relatively even mix between fundamental forces and speculative forces.

Markets that have “excess liquidity” compliments of central banks become skewed toward the speculative end of the spectrum.

Speculative Markets Can Rise For Years

Many will say “I do not want to participate in speculative markets”, which seems logical. However, if we told you the stock market was going to rise for two more years, would you want to participate? The logical answer is yes if there is money to be made. Those who lived through the dot-com and housing bubbles can attest to the accuracy of the statement “speculative markets can continue to rise much longer than rational people believe.”

2015: The Evidence For A Sustained Rally Has Been Piling Up

Bill’s Gross’ don’t fight, but be afraid comments were published in December 2013, just before the 18% pop in stocks. Are we saying the S&P 500 is about to rally an additional 18%? No, we are saying “they are getting ready to inflate” conditions today are similar to the tone in December 2013. This week’s video walks through the evidence that has accrued since the October 2 intraday “key reversal” in stocks, along with an examination of the major shift that helped spark the rally.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.Video

We Must Play The Hand We Have Been Dealt

The following statements are reasonable to those who are experienced in the financial markets:

  1. Central banks have skewed the market, which means stocks carry higher speculative risk.
  2. Markets with a speculative bent can continue to rise for years.
  3. All speculative bull markets end with painful bear markets (20% to 50% losses).

Bull Market Could End Tomorrow Or In Two Years

If we know the statements above are true, then it seems logical that we need to account for the following:

  1. We have no idea when the current bull market will end.
  2. Stocks could rise for two or three more years.
  3. When the bear market finally arrives, investors could lose 50%.

Therefore, we need a way to:

  1. Monitor the health and sustainability of the bull market.
  2. Identify when the odds have shifted to the bearish camp.
  3. Migrate from a risk-on to risk-off portfolio as the odds shift.

Monitor and Migrate

Our market model is designed to address needs 1-3 above. When markets peak, it is logical to assume that investor demand for stocks begins to drop relative to (a) more conservative assets, such as bonds, or (b) risk-off assets, such as inverse stock ETFs (aka shorts).

In a world where central banks have skewed the bond market, a fair argument is “stock vs. bond charts won’t work this time”. While we all know “it is different this time” is a dangerous expression in the markets, let’s assume the stock vs. bond charts will not be helpful this time around. The “it’s different this time” argument does not hold water when we look at the relative performance of going long stocks vs. shorting stocks. It is mathematically impossible for a long vs. short ratio to “miss a bear market”, regardless of what central banks have done.

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