We were on the road in Switzerland this week, and as we travelled along the northern shores of Lake Geneva, the view across to the French Alps is simply stunning. Many market commentators will describe markets via analogies such as “we’re in the 8th inning” and our view of the mountains has inspired this week’s analogy on markets.
According to Wikipedia (emphasis is ours);
“The death zone is the name used by mountain climbers for high altitude where there is not enough oxygen for humans to breathe. This is usually above 8,000 metres (26,247 feet). Most of the 200+ climbers who have died on Mount Everest have died in the death zone. Due to the inverse relationship of air pressure to altitude, at the top of Mount Everest the average person takes in about 30% of the oxygen in the air that they would take in at sea level; a human used to breathing air at sea level could only be there for a few minutes before they became unconscious. Most climbers have to carry oxygen bottles to be able to reach the top. Visitors become weak and have inability to think straight and struggle making decisions, especially under stress.”
So the Death Zone is extremely dangerous, humans struggle to survive there unaided for more than a very short period and have an inability to think straight.
Chart 1 (courtesy of Bank of America Merrill Lynch) shows an old favourite metric for measuring the value of US equities. We say old favourite, as this was the metric that Warren Buffet remarked in 2001 “is probably the best single measure of where valuations stand at any given moment”. As can be seen, the US equity market, by this measure, is at the second highest (most expensive) level back to 1970 (actually in history, but the chart only goes back to 1970).
Chart 1 – US Equity Market Cap relative to GDP
The guys at Merrills have kindly pointed out that this metric will hit a new all-time high if the S&P 500 can trade to 2620 points which is about 7% above current levels. Quite frankly, we are amazed (and appalled) that the market is as close to the all-time bubble high valuation and significantly above the 2007 valuation level. Having invested through both prior periods, we struggle to rationalise how investors can sit here today have anything but the minimum exposure. How did we get here? The main reason is of course the trillions in liquidity that central banks have injected into the system along with zero or even negative interest rates.
In mountaineering terms, we are at 8000+ metres altitude and entering the death zone. We know it is extremely dangerous to our health if we try and reach the summit, and unaided, we would probably only survive a few minutes. As in late 1999, we know that final move higher to the peak must be done as quickly as possible and we also know that the greatest number of fatalities have occurred in this zone. At the moment, we do have some help in the form of central bank largesse, however, this help is being slowly withdrawn.
We suspect that many investors are not receiving enough oxygen, and they are displaying signs of being unable to think straight and make sensible decisions, especially under stress. That stress is either the fear of missing out or so-called career risk, which encourages investors to maintain exposure to equities as being in cash could lead to underperformance, and potentially the end of careers. Of course, many believe that central banks will provide an unlimited supply of oxygen, and that risks (despite all the historical evidence) can be managed quite safely. We have to point out that, after markets peaked in early 2000 and late 2007, the S&P 500 declined by over 50% on both occasions. The use of the word peak is very appropriate; markets simply do not hang around at these sorts of valuations for long. Just like mountaineers trying to scale Everest, the move to the peak and back down again is done as quickly as possible.
Regardless of whether central banks are removing policy accommodation, the US equity market is at extremely dangerous levels. We were clearly wrong in holding a bearish view in the last few weeks, but we limited our risk to a very small amount of our capital, and we fight to live another day. And with the major central banks meeting in the next two weeks, we will be able to get a sense of how much help to the system they are removing.
Last week’s US employment report was a rather messy report. Although the unemployment rate fell again to 4.3%, indicating extreme tightness in the labour market, the number of jobs (especially full time) was disappointing and the labour force participation rate fell again as more workers dropped out of the labour force. Overall, we thought it was a poor report, although not bad enough to stop the Fed from raising rates on 14th June. The real news will be their guidance in terms of further rate rises and plans to reduce their balance sheet. We still believe that the Fed is intent on tightening in a steady fashion, and will likely keep going until something breaks.
Before the Fed meets, we have the ECB meeting this coming Thursday. Our view remains that Mario Draghi does not want to make any decision on tapering or interest rates at this time. Yes, he has to update us before the year end and we know that there are some of the ECB council who are more eager to remove accommodation than Draghi is. However, in recent speeches Draghi has sounded quite dovish. But this is all rather nuanced. Currently, the ECB still has an easing bias on interest rates, and so perhaps this is removed and any decision on tapering and rates is deferred to September. Draghi may not even want to discuss policy removal at this meeting but, if they do, we suspect the market will take this as the signal that the normalisation process has started for sure.
What is interesting is that we are getting mixed messages from the markets. With bond yields in core Europe slipping again in recent weeks, is that a sign that bond investors are less than sure that the ECB is close to signalling the normalisation process, or is it a natural reaction to the softer than expected inflation data? FX traders on the other hand seem to be wagering that the ECB will pull the trigger next week. We, on the other hand are not so sure, but the situation is not clear. Let’s start by thinking big picture, and look at a chart we used a couple of weeks ago in our bond market comments.
Chart 2 – US and German 5 year yields
As can be clearly seen in the lower panel, the difference between the US 5 year yield and the German 5 year yield is very close to historic highs. If you buy the US 5 year bond you will receive an annualised yield of 1.72% and if you sell the German 5 year bond you will also receive an annualised yield of 0.45% (as the German 5 year bond has a negative yield). So, assuming no yield changes over time, this long short trade will pay 2.16%.
It is our expectation over time that the yield difference over time will narrow, and so the return on that long short strategy we hope will be much higher than 2.16% annualised. We should be indifferent as to how the yield difference narrows, however, it is likely to occur in one of two ways. In a benign environment, the ECB will taper their bond purchases and lift the deposit rate out of negative territory, and it would be likely that German yields move some way back above zero. The alternative is likely less than benign in that the US suffers a recession (due to the Fed tightening until something breaks?) and cuts interest rates back to zero and prints more money.
As noted, for the trade to work, we should be ambivalent, but it is noticeable how the bond markets have completely given up on the Trump reflation narrative and that yields (especially at the long end – thereby causing yield curves to flatten) have been falling again. If we are right that the yield differential does narrow, this should be very important to FX traders. Chart 3 below shows the 5 year yield differential alongside the EUR/USD FX rate. Although the fit is by no means perfect, the two move together reasonably well over time. Currently, there is a bit of a divergence and the Euro is looking a bit rich compared to interest rate differentials.
Chart 3 – EU/US 5 year yield differential and EUR/USD FX rate
Chart 4 below shows the EUR/USD FX rate alongside the speculative positioning on the IMM data. Although the IMM data only captures a small per cent of the FX community, over time, it is not a bad representation of overall market positioning. As can be seen, net positioning has moved from a sizeable short Euro position at the time of the US election to the biggest net long position in the last five years, and in fact, the second biggest net long position since the financial crisis.
Chart 4 – EUR/USD FX rate and speculative position on the IMM
So we have a challenge at the moment. Although we can see why the Euro should be stronger against the Dollar over the longer term (as the interest rate differential narrows), we think that the Euro is overbought in the short term, and we worry that the long Euro trade has become too popular with the fast money crowd. We would also note that one of our sentiment indicators has moved from only 15% bullish on the Euro at the recent low in early March to 81% as of last week, also indicating a short term crowded long Euro position amongst small traders.
To try and wrap things up here, ahead of the ECB, we think that the FX market has become a bit too optimistic on the Euro and we would not be buying it up here. Of course, if Draghi lays out an explicit path to ending QE and raising the deposit rate, then we have to expect the Euro will move higher. However, Draghi has been reasonably dovish in his recent public statements, and with the recent decline in core inflation, we just don’t think he is ready to pull the trigger on normalisation at this meeting. We will be looking to buy Euros on a pullback to the 1.08/10 area given our bigger picture view, depending on what Draghi does say on Thursday.
As for our broken record message on US equities, we can only watch with growing incredulity as the market scales bull market heights that have only ever been seen once before in history. The air up here is very thin indeed, and unhealthy for us mere mortals. Yes, progress is being made with the help of central bank oxygen, but this help may not last as the market embarks on the last leg up to the summit. In any event, we know the last two times that markets were scaling such valuation heights, after the peak had been scaled, the way back down was fast and furious ending with two 50%+ bear markets. For our part, we have chosen to not even try and scale the summit; we don’t think the central bank oxygen supply ever really got into our oxygen tank and in the big picture, we think the potential downside is much greater than the upside.
Stewart Richardson
RMG Wealth Management
