Investor sentiment comes full circle since 2009

Something is really bugging me. Especially after reading NY Fed Chief Bill Dudley’s speech:

The Bank of Japan (BoJ) responded by reducing overnight interest rates from a peak of more than 8 percent in early 1991 to ½ a percent by the fall of 1995. Most studies of this period suggest that policy was generally appropriate given economic forecasts at the time, but too tight relative to the actual outcomes. Economic forecasts for Japan ­both by the official community and by private sector agents ­were consistently more optimistic than the actual outturns. It is noteworthy that as late as January 1995–­on the eve of deflation–­10-year Japanese Government Bond (JGB) yields were still at 4.7 percent.
With the benefit of hindsight, we now understand that the disinflationary consequences of the asset price bust and financial stress where vastly more powerful than was widely realized at the time.

It’s all so Captain Hindsight, but note the black hole of demographic headwinds and potential unintended consequences of declining interest rates itself are totally discounted.

Glass half full, or overflowing?

My, what a long way we’ve come in March 2009 when we nailed the bottom. Where do we stand now in terms of sentiment?

Example of a Simple Sentiment Cycle
Example of a Simple Sentiment Cycle

Let’s take a look at three stories from the past 24 hours.
1. Blackstone co-founder Steve Schwarzman says liquidity is overrated. Easy for him to say when he gets a cut of $250 BILLION assets under management no matter what happens.

2. Daytrading, the game, is here. And this guy is a young guy, so a new generation of pikers has arrived.

3. Penny pumper Tim Sykes is in PR overdrive and even managed to suck CNN into making a “story” out of a press release about a statistical artifact that will drive sales for his courses for the next few years.
Trader turns $1,500 to $1 million in 3 years
Trader turns $1,500 to $1 million in 3 years

Out of the tens of thousands of gamblers taking Tim’s Challenge, there are bound to be many lucky ones. I should know. I did it by myself in 1996:

Or he may be lucky. The “random walk” theory posits that if a large number of monkeys pick stocks by throwing darts at stock tables, half will do better than the average stock picker and half will do worse. If the winning monkeys then repeat the exercise once each year for ten years in a row, one out of 1,024 will beat the average every year, merely on the basis of probabilities. A stock picker who beats the S& P 500 ten years running will almost surely be lionized as having a special genius —and some may—but others will do so merely as a matter of chance. Robert Rubin, In an Uncertain World: Tough Choices from Wall Street to Washington

There’s lots more. We’ve already noted the sea change in perception. With only the usual permabears left doing their perpetual “this is the top” raindance, the rest of the pundits are now firmly in the “pullback” camp.

CNBC December 10, 2013
CNBC December 10, 2013

CNBC December 9, 2013
CNBC December 9, 2013

Headlines like these could have never happened couple of years ago. What do they tell us about where we might be in the investor sentiment cycle?

  1. Why traditional diversification is ‘downright dangerous’
    The question now—as the number of asset classes and strategies available cheaply to investors proliferates, and the risk of holding U.S. bonds rises—is whether the classic 60/40 portfolio split has outlived its investment usefulness and, if so, what should replace it?
  2. Lower-Quality U.S. Stocks May Excel in January (January effect already?)
    Shares of companies with the worst track records on earnings and dividends are well positioned to beat their highest-rated peers next month, according to Savita Subramanian, head of U.S. equity strategy at Bank of America Corp.’s Merrill Lynch unit.
  3. Looking to play the rental market? Blackstone wants you
    Blackstone is originating loans of $500,000 to $50 million to small and midsize investors buying a minimum of five single-family rental properties.
  4. Why the economy might finally take off
    The economy may finally have a clear runway for takeoff in 2014.
  5. Guess what? DC could deliver a merry Christmas
    The budget deal, if it materializes, would follow another month of strong job creation that saw the jobless rate hit a five-year low with the size of the labor force increasing, indicating that Americans are growing more hopeful about their job prospects.
  6. Gartman’s ‘old man’ reasoning on why rally will continue
    “Write this down: ‘It will continue to go up until it stops,’ ” he said. “I’ve only been at this 40 years, but I’m constantly amused by attempts to discern where the top shall be, or conversely, where the bottom shall be. Stocks stop going down when they stop. Stocks stop going up when they stop. That’s the best you can do.”
  7. The survey says: ‘Santa Claus rally’
    On CNBC’s “Halftime Report,” Sherrod said it was the second-most bullish reading in its 4-year-old IMX survey of retail investors.
  8. Now where do stocks go? Here’s a hint: Ho ho ho
    Stocks should be buoyant in the week ahead, helped by year-end seasonality—or maybe Santa. The “Stock Trader’s Almanac” says the official “Santa rally” takes place in the several days after Christmas, but traders expect to see a fairly merry market clear on through December now that the November jobs report is out of the way.
  9. Charles Schwab says Dow 20,000
    Renowned investor Charles Schwab said Tuesday the stock market is not a bubble but supported by a “very strong economy,” with the Dow Jones Industrial Average poised to soar to 20,000 within the next year few years.
  10. Even Mischa Barton looks “happy and healthy”
    A couple of months ago, she opened up about her ‘full-on breakdown.’ And since revealing her struggles, Mischa Barton has been putting her health first. Her new focus seems to be paying off, with the actress looking happy and healthy as she ran errands in Silverlake, California, on Saturday.
  11. Bill Miller to start fund with son under the family name
    During the 2008 credit crisis, the Value Trust lost 55% by betting on financial stocks, prompting a wave of withdrawals. In April 2012, Mr. Miller left the value trust, which currently has about $2.5 billion in net assets.

The most egregious case is Blackstone’s Byron “Why I’ve become bullish on the market” Wien. CNBC reports that “Wien said the market would sink in 2013. But that prediction didn’t pan out, and now he’s changing his tune.” Stop and reverse is rarely a good trading strategy.

Walk the Walk

You might say, “T, these are just a collection of anecdotal comments.” Sure, and that’s why I didn’t write this piece until now. Late last week, I came across the allocations for the Ivy League endowments.
First up, Harvard. This is their Policy Portfolio Asset Allocation with 11% in fixed income:
What about Yale? The Yale Endowment earned 12.5% return for the year ending June 30, 2013, but the asset allocation left me gasping:

Yale continues to maintain a well-diversified, equity-oriented portfolio, with the following asset allocation targets for fiscal 2014:
Private Equity: 31%
Absolute Return: 20%
Real Estate: 19%
Foreign Equity: 11%
Natural Resources: 8%
Domestic Equity: 6%
Bonds and Cash: 5%

5% to bonds and cash. OMG.
Why is this a big deal, you might ask. Haven’t I heard the news that the bond bull since 1980 is over? If Bill Gross says it, it must be true. David “The Turncoat” Rosenberg said in a recent WealthTrack interview that there is a “seismic investment shift” to inflation. Cliff Asness wrote bonds off, but threw in a small disclaimer that one should own a little, for diversification sake.

The purpose of bonds

David Swensen is Yale’s Chief Investment Officer. He wrote the book on asset allocation:

When inflationary expectations fail to match actual experience, bonds tend to behave differently from other financial assets. Unanticipated inflation crushes bonds, while ultimately benefiting equities. Unanticipated deflation boosts bonds, while undermining stocks. Bonds provide the greatest diversification relative to equities in cases where actual inflation differs dramatically from expected levels.
. . .
U.S. Treasury bonds provide a unique form of portfolio diversification, serving as a hedge against financial accidents and unanticipated deflation . No other asset type comes close to matching the diversifying power created by long-term, noncallable, default-free, full-faith-and-credit obligations of the U.S. government. Investors pay a price for the diversifying power of Treasury bonds. The ironclad security of Treasury debt causes investors to expect (and deserve) low returns relative to those expected from riskier assets. While holders of long-term Treasury bonds stand to benefit from declining price inflation, in an environment of unanticipated inflation Treasury bondholders lose. Treasury bonds’ modest expected returns and adverse reaction to inflation argue for modest allocations to the asset class by long-term investors.Swensen, David F. (2009-01-06). Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment

What does it say to us when Yale now holds FIVE PERCENT in bonds and cash? Maybe they think U.S. government bonds no longer offer the diversifying power that saved Yale during past market crashes. Maybe they believe there is no upside left to bonds, even in a flight-to-safety event. We have no particular insight, but the fact is that most of their holdings — 31% Private Equity, 19% Real Estate, 11% Foreign Equity, 8% Natural Resources, and 8% Domestic Equity — will go in the same direction as it did in 2009 if the market crashes again in the future. The only hope they would have is the 20% in Absolute Return actually gets an absolute return.

Money talks

Yale is basically investing as if there will not be any more financial accidents and unanticipated deflation. With respect to “liquidity is overrated”, let’s not forget that the Harvard “endowment distributions for operations represented 35 percent of the University’s income,” in 2012 while “spending from the endowment for Yale’s 2014 fiscal year is budgeted at $1.05 billion, representing approximately 35% of the university’s net revenues.”
Their asset allocation is especially bizarre considering the universal sentiment that the economy is so “weak.” IF the economy is so weak, THEN it would take only a small shock to send the economy into negative growth. With inflation barely holding the Fed’s target, it wouldn’t take much for “it” to happen here.
1. Right now, the velocity of money is still on the floor, so by the quantity of money theory, inflation is dead:
2. The David Rosenbergs of the world still have a ways to go before the quits rate [PDF] returns to 2007 levels.
3. There is still the matter of the debt ceiling standoff for 2014, which is also tied into a phenomenon nobody ever talks about anymore, the Presidential Cycle:

presidential-cycleLarry Allen, The Global Economic System since 1945 (RB-Contemporary Worlds)

For more, see John “I earn $60 million a year writing essays” Hussman, The Curse of the Six-Year Itch, and Recessions and the presidents who inherited them.
4. The yield curve is not much different than it was during Armageddon 2009.
5. And perhaps most interesting of all is the US Economic and Financial Outlook featured in the December 6, 2013 piece from Goldman Sachs written as a rebuttal to “… former Treasury Secretary Lawrence Summers [who] argued that the economic weakness over the past 10-15 years may have much more deep-seated causes than commonly recognized. Summers suggested that the economy may be in a “secular stagnation,” a situation where the equilibrium real interest rate is sharply negative on a sustained basis.”
Goldman’s pro forma real GDP for 2014, 2015 and 2016 average 3 percent, making this “weak” economy one that is not expected to have a recession in the foreseeable future.
And of course, there is a strange barbell type of prediction at CNBC, Here’s what could push Treasury yields to 2% in 2014.

The point is this

Right now, maybe it’s difficult to quantify the cumulative effects of millions of retired people whose pensions will be slashed, of millions more retiring with less income and more healthcare costs, of more people earning less, of more people more leveraged than before, etc. But there are telltale signs and potential headwinds:

  1. How ‘on-call’ hours are hurting part-time workers
  2. S&P downgrades US growth forecast
  3. Producer prices slip in November, hinting at lack of inflation
  4. More borrowers will struggle to pay off home equity loans
  5. Americans no longer want to drink these 9 beers while Craft brew craze creates black market for coveted beers; some sold for hundreds of dollars
  6. Americans say “Bah! humbug!” to diet colas and beer
  7. Wealthy Go Frugal This Holiday Amid Uneven U.S. Recovery
  8. Middle class buying luxury again—but at a bargain

Maybe all the Fed cares about and fights against are the “disinflationary consequences of the asset price bust and financial stress” AKA Irving Fisher’s debt deflation because there is nothing they can do about the challenges from demographics.
Until QE came about, the only tool the Fed had available was interest rates which has been lowered repeatedly since 1987 in response to every financial crisis. What if THIS reaction actually launched a vicious cycle that dovetailed with demographics to i.) sow the seeds for the next crisis (by allowing accumulation of more debt to hold up asset prices), and ii.) weakened the economy by depriving millions of interest income and therefore spending?
The “stress” is now gone from institutions while asset prices are back up, but the economy is still weak for most participants. Doesn’t this add up to Larry Summers’ secular stagnation?
In that case, is it possible that the American economy is in the same place as Japan’s in January 1995? I think I’ll keep my bond allocation, however unfashionable it may be, just in case the music stops.