Reasons To Be Nervous

I’m teetering on the brink of going very short of this market. I’ll still keep a few tactical longs, but as the days go by and the indices sit in a tight trading range, I’m getting less and less convinced that we can keep going up. I just don’t see the appetite for more risk, and once traders start to book profits, we could easily drop back another 10 - 15%, or worse. OK, so it might just be the famous ‘wall of worry‘ that all bull markets have, but I’m particularly worried and I think we might just be about to hit the wall.

This is a more convoluted blog than usual, so you might need to take a deep breath, a cup of coffee, or something stronger, before attempting to digest it. As I’m an amateur economist, I may have got some of this wrong, so feel free to correct me in the comments!

Let’s look at the main arguments.

The Bull Case Says:

There is momentum behind the move that we’ve had since March. The bottom is in. There’s a search on for yield - return on investment - so where should you put your cash? In cash savings accounts or bonds that yield tiny percentages? Or in stocks which have growth potential, which pay out decent dividends, and which have been trading at multi-year lows? There’s been rebalancing of portfolios, and a lot of the big long-only funds are now putting their toes back into the market, as have retail investors, especially those looking for more bang for their buck. And if you bought in early March there are plenty of stocks that have doubled, tripled, quadrupled even. That means that there’s some real impetus. Over a longer timeframe this might be a great buying opportunity.

Tax breaks and lower borrowing costs are putting more cash into the pockets of households and companies. With a lot of money still on the sidelines, we could yet see further highs, particularly if the economic newsflow continues to get ‘less worse’ and the market prices in a recovery later this year or next year. And that means commodity prices will push up, so it’s good to get long of oil, gas etc. And if inflation is coming, then equities, property and commodities are a better place to have your money than cash. So even if we get a sell-off, there’s enough spare investment cash that people will ‘buy on the dips’, anticipating better earnings in 9 - 15 months time.

The long risk currency trades - GBP and the ‘commodity exporter’ currencies - AUD, CAD, NZD - have all perked up over the last week. Oil is back firmly into the mid $60’s. The public investment in infrastructure, healthcare and low carbon technologies will feed through, and people still need to eat, clothe and house themselves - so large cap names like McDonalds and Wal-Mart will continue to outperform, along with utilities, healthcare and some tech and energy stocks, so long as they have low debt. And there are plenty of under-rated ‘value’ stocks that still have lots of juice in them.

The Bear Case Says:

No-one’s really got any spare cash

Even with unprecedented amounts of cash being pumped into the system, a lot of cogs in the machine are barely moving. Lending levels are nowhere near where they were. Even if banks want to lend money (which is doubtful, ‘cos they need it to pay down their debts and pay back the government bailout money), the only people that really want to borrow are the people they don’t want to lend to - the riskier, highly indebted consumers and companies. There is more money in the system - the acute phase of the credit crunch is over - but there’s a black hole called deleveraging - paying down debt - that’s sucking in what spare cash there is. And even with low base rates, those investors/banks that are willing to lend are demanding a higher risk premium (i.e. higher interest rates on loans) - because there are so many uncertainties about the ability of individuals and companies - even countries - to service their debts.

There’s no let up in foreclosures; and unemployment will have a real dragging effect on the economy, taking purchasing power away from households. There’s no evidence that disposable income is rising - quite the reverse. There have been tax breaks, but moving forward the government is going to have to tax more, to pay back all the money it’s borrowed. So people rein in their spending (especially wealthier folks who are near retirement), build up their savings, and sell off assets to raise cash - deleveraging. Trouble is, demand is still anaemic, no-one wants to buy, so prices keep falling. Think Japan in the 1990s.

There’s a second negative feedback loop. There’s pressure on companies to reduce prices because of reduced demand, but raw material (input) costs are now increasing again. Look at the price action in copper, oil, gold, wheat etc. Up 70%+ since December. Now that’s dangerous. So profit margins are getting squeezed. Overheads aren’t reducing fast enough, and the cost of borrowing is still high. That means company earnings get squeezed, which could make equities begin to look rather overpriced.

So businesses keep on cost cutting. Unemployment keeps rising. And with the prospect of a government of ‘austerity’ in the UK, we’re looking at big cuts in public spending - more jobs on the chopping block. (You might argue that it’s the size of the UK’s public sector that has stopped the economy from slumping into all-out depression).

The cost of borrowing isn’t going down fast enough

Now, even more ominously, the action in Treasury bonds over the last few days is pushing up the long term cost of borrowing money, despite the billions that central banks have already pumped into the system to make money cheaper. That in turn will push up mortgage rates, as banks act to protect their margins. Banks borrow money on the wholesale market, and lend it out at a mark-up. The difference between the price they can borrow at and the price they can lend at, is how they make their cash. Any increase in the cost hurts borrowers.

But default rates on loans aren’t going down. The value of the assets underlying the loans - i.e. property prices, business valuations - on the banks’ loan books isn’t really showing any signs of stabilising. There’s still trillions of toxic junk sitting on the banks’ books, which unless asset prices recover, might just leave them bankrupt.

If the US or the UK decide to print even more money to buy up the junk and keep the cost of borrowing down, there’s a chance that the currency markets will let them have it with both barrels, although it’s hard to know what to buy against the dollar in this environment. That goes some way towards explaining the relative strength of gold. If the dollar weakens, then commodity prices tend to rise to compensate. The flip side of that equation is that there needs to be real demand for the rise in commodity prices to be sustained. There’s a second inflationary risk - of scarcity of supply - ‘cost-push’ inflation, where production of commodities and goods is so muted that prices go up because of shortages. Combine that with a weak currency and you’ve got a recipe for hyperinflation. But we’re not anywhere near there yet, in my opinion.

The acceleration in the price of oil over the last few weeks is probably more down to dollar weakness, geopolitical jitters, and anticipation of a recovery, than with fundamental problems of supply and demand. And this has led a few commentators to point to an armageddon scenario of a weakened dollar, high commodity prices and high unemployment. Stagflation.

That’s Why I’m Nervous

So, toe in the water,I’ve closed out my AUD/JPY long trade, and I’ve got a short FTSE (^FTSE) position from 4400, which is currently in the red. If they look like working I’ll add to the shorts, and go short of EUR/JPY into the bargain. I’m also considering shorting crude oil, especially if the dollar strengthens and equities sell off. I’d like to short gold, because I think it looks overbought, but with all the uncertainty about the future trajectory of the dollar, I’m not making that trade quite yet.

But - a certain amount of inflation could be useful. Why? Because it pushes up prices and makes it easier to service debts. So you could argue that it’s precisely an expectation of inflation that is needed to push the market onwards and upwards. But I have a nasty feeling that what we’re seeing is a toxic combination of deflation and, wierdly, currency debasement. We’re caught between the weakening purchasing power of currencies because of quantitative easing - which is inflationary - and the black hole of deleveraging, both of which are destroying capital much faster than it can be created. And when the deflationary penny drops, so too will the commodity prices, and, in all likelihood, equities, especially resources stocks and cyclicals, because the earnings just aren’t going to be there. At the moment the market seems to be rising on the hope of future earnings rather than any solid information.

And what can the Fed do to combat the inflationary effects of currency debasement? Raise interest rates or reduce the money supply - perhaps sooner than we think - which will put the brakes on even more, and blow a hole in their plan to raise money for government spending by issuing billions-worth of bonds at relatively low cost.

And what this morning’s markets seem to be saying is that everyone’s jumping on the reinflation bandwagon - the commodity exporting, high yielding currencies are pushing up, gold is up, equities are up, oil is up. So it looks like a recovery, but it might not be at all what it seems.

Tricky, isn’t it? Prepare for a rough ride.

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