What lurks be­neath

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Last week saw the con­vic­tion of both bulls and bears tested. Job cre­ation in the US ex­ceeded ex­pec­ta­tions in June and in­vestors bid the S&P 500 to yet an­other high. Bulls prob­a­bly took suc­cor from Janet Yellen’s mid-week prom­ise not to use the blunt in­stru­ment of in­ter­est rate rises to prick any ir­ra­tional ex­u­ber­ance. Yet, ear­lier in the week, bears must have looked ap­prov­ingly at a Bank for In­ter­na­tional Set­tle­ments re­port which in­toned gravely against the risk from “eu­phoric cap­i­tal mar­kets” and made a call for tighter mon­e­tary pol­icy.

Let us ad­dress the key is­sues for in­vestors raised in the BIS re­port.

1) Are fi­nan­cial mar­kets ex­pen­sive? At the very least, they are not cheap. Those as­sets for which we have a work­ing model tend to be slightly above their aver­age val­u­a­tion level. Look­ing across the spec­trum, mar­kets vary be­tween be­ing on their fair value mean to be­ing one stan­dard de­vi­a­tion over­val­ued. The only as­set which is “cheap” is the US dol­lar.

2) Do bear mar­kets al­ways start from an over­val­ued level? Not at all. The last two bear mar­kets (de­fined as a de­cline of more than 10% over a six month pe­riod) which started in 2007 and 2010 oc­curred when prices were be­low an aver­age val­u­a­tion level. This is not un­com­mon.

So, our first re­ac­tion to the BIS com­ments is that we could have a bear mar­ket, but it will not arise be­cause of ex­treme val­u­a­tions as was the case in 1962, 1987 and 2000.

The big­ger is­sue raised by the BIS was whether cen­tral banks’ con­stant ma­nip­u­la­tion of in­ter­est rates cre­ates false sense of se­cu­rity among mar­ket par­tic­i­pants. Here, we are in full agree­ment. One prob­lem is that more and more money is man­aged via in­dex­a­tion, which is just a form of mo­men­tum buy­ing. And since in­dex money is not al­lo­cated on the ba­sis of the mar­ginal re­turn on in­vested cap­i­tal but rather ac­cord­ing to mar­ket cap, the re­sult is large-scale cap­i­tal mis­al­lo­ca­tion. As such, it is a form of so­cial­ism, and we all know how ef­fec­tive this sys­tem is at al­lo­cat­ing cap­i­tal.

Adding fuel to fire has been the Federal Re­serve’s zero in­ter­est rate pol­icy. Back in 2011, we ar­gued that sus­tained low rates would re­sult not in growth, but cap­i­tal mis­al­lo­ca­tion. We wrote that ZIRP would cause a rise in as­set prices, but not an in­crease in the na­tional in­ven­tory of cap­i­tal. And the re­sult would be a struc­tural de­cline in pro­duc­tiv­ity and a huge rise in the Gini co­ef­fi­cient (the rich get­ting richer, the poor get­ting poorer).

The point was that while high in­ter­est rates im­pede growth, low rates achieve ex­actly the same. What is needed is a mar­ket de­ter­mined cost of cap­i­tal which is el­e­men­tal to cap­i­tal­ism.

Mar­kets are now en­gaged is a mo­men­tum game with in­vestors con­vinced that cen­tral banks in the US and Europe can avert big as­set price de­clines. That was not such a dan­ger­ous propo­si­tion for in­vestors back in 2011 and 2012 when shares were cheap. Back then, we ad­vised in­vestors to be 100% in­vested in eq­ui­ties even though we hated the poli­cies. The prob­lem is that in­vestors are now skat­ing on much thin­ner ice, which is why since 2013 we have ad­vised an eq­uity po­si­tion hedged by a long dated zero coupon bond. Such a bal­anced port­fo­lio has strongly out­per­formed so far this year, and we rec­om­mend to stick with it.

What is wor­ry­ing is that bonds have out­per­formed both eq­ui­ties and a bal­anced port­fo­lio for six months and no one seems to care.

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