Was last week’s rally—you remember Wednesday and Thursday, right?—on the surprise “no taper” decision from the Federal Reserve a sign that stocks are headed even higher from here or an indication of an increasingly nervous and volatile market?
I’d vote for the latter.
Think about this indicator: A decision to put off a cut of what was probably no more than $10 billion to $15 billion a month in Fed purchases of Treasuries and mortgage backed securities was enough to drive the Standard & Poor’s 500 stock index to a new all time high.
That’s clearly an over-reaction unless global financial markets see the Fed’s decision on when to taper its purchases as a marker for the end of cheap money. I think the logic goes something like this: As long as the Fed doesn’t taper at all, the moment when the central bank decides to start to raise short-term rates is postponed. When the Fed does start to taper, even if rising short-term rates aren’t on the immediate agenda, they do go on the calendar.
In other words, the big rally last week was a relief rally and global markets are starting to make a transition from certainty that U.S. short-term interest rates will remain at 0% to 0.25% to a period of worry about exactly when interest rates will start to climb.
If this isn’t the end game for cheap money, we’ve moved closer to that end game and that means more volatility and more exaggerated market moves.
Globally, money is still cheap. Short-term benchmark rates are effectively 0% in the United States and Japan. It pays to borrow at low rates and put the money to work. It doesn’t pay to keep money on the sidelines since cash and cash alternatives pay almost nothing. Traders and investors who look down the road into 2014 or 2015 can see this environment coming to an end: The Fed has said it will keep short-term rates at their current extraordinarily low level until 2015, but doubts are starting to creep into the collective mind we call the market. There’s not an endless amount of time to waste if you want to play the cheap money game. You don’t think its coincidence, do you, that Verizon (VZ) just sold $49 billion in bonds, beating the largest previous biggest bond deal (Apple’s $17 billion offering by Apple (AAPL) by a mere $32 billion? Verizon sold $15 billion just in 30-year bonds.
This remains a global financial market driven by the availability of cheap cash. And the single biggest worry is that the world’s most influential central bank can’t be all that far away from taking away the punchbowl
If your goal is keeping money at work, it pays to look past negative data or the lack of data for as long as you can. The U.S. markets did that immediately after the Federal Reserve decided last Wednesday not to begin taper off its program of buying $85 billion a month in Treasuries and mortgage-backed securities. The S&P 500 rallied on that news to a new all-time high—even though the Fed’s decision to keep pumping the full $85 billion a month into the global economy (and global financial markets) was predicated on persistent under-performance in the real economy.
As markets get closer and closer to what they feel to be the end of the ball with its cheap cash punchbowl, you can expect to see more volatility. The trend may still be upwards—after all the cheap money is still available—but market volatility will increase as everyone edges closer to the door.
If I’m right, what we should be seeing now is a greater use of derivatives and trading strategies designed to protect against downside moves. We know from past market “events” that these trading strategies, unfortunately, can have the effect of actually increasing market volatility. For example, if everyone’s computer program trades are set to sell when the S&P 500 drops to a certain level, then at that point, rather than stabilizing the market, this trading strategy will produce a rush of selling.
If I’m right, what we’ll see is relatively big short-term shifts among markets and assets as traders try to keep cheap money at work but seek to limit risks and maximize rewards. The huge move in gold at the end of last week is an example—the big move up on Wednesday and Thursday, largely fueled by buying by traders who had been short betting on a further decline in gold, turned into a rout in gold and gold mining shares on Friday.
Any conviction here? Any sense that gold or gold mining fundamentals had changed? Nah. But certainly a big rush to take advantage of a temporary move in prices.
For equity investors I’d suggest watching the moves in and out of U.S. and European stocks. The story of the moment on Wall Street is that European equities are cheap in comparison to U.S. stocks and in the last week or so I’ve seen significant moves up in European stocks. To this way of thinking it doesn’t really matter that European growth continues to lag U.S. growth. A move into European stocks and out of U.S stocks is a short-term effort to take advantage of a perceived differential in asset prices.
Similarly watch out for some of the money that flowed out of emerging markets to continue to flow back into emerging markets simply because traders are looking for a short-term rebound after a big sell off. There’s enough “good” news to fuel the flows—for example, China’s manufacturing index climbed to a six-month high in September, the Chinese government announced over the weekend—but the real driver here is a sense that assets are due for a bounce.
The problem in all of this, of course, is that since there’s not much in the way of fundamentals underpinning these moves, it’s very hard to predict how long any move in one direction or the other will last. It’s something to watch, for example, that the good news on Chinese manufacturing didn’t produce a big move up on Monday in Chinese or Asian stocks. Maybe that’s just an issue of timing and we’ll see that move up later in the week. But maybe it’s an indication that after a rally of 20% in some Chinese markets, traders are treating this as a sell on the good news moment.
The danger here for investors is that they’ll get swept up in these moves and interpret a slosh of global money as an indication of something more fundamental and lasting. You don’t want to overpay for a stock because a sudden move higher in the market flavor of the week leads you to believe that the fundamentals of the stock, market, or economy have changed. In the same way you don’t want to be frightened into selling just because the money has sloshed away from that stock, market or economy.
On the other hand, the opportunity for investors from this volatility is that some stocks with great fundamentals will suddenly become cheap because global cash flows head elsewhere. Then, thanks to short-term volatility you’ll have a chance to find bargains where you never thought to find bargains.
My advice in this market for most of us who aren’t day-to-day traders is to know what you want to own and to know what you want to pay. Keep your list of stocks that you want to add to your portfolio at hand and know what price would be attractive to you. Same with stocks that you already own. Try to calculate a fundamental value that isn’t dependent on the whims of the moment.
Not so long ago, I put together a list of stocks to buy when the price is right. I’m going to update that for a new post in the next week or so.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/