Sage Weekly Letter

• Posted by Robert Sinn
• on January 28th, 2012

Last week I pointed out that markets were positioned for additional Fed easing without which there was a strong risk that markets would be disappointed. Just as it has done at every critical juncture during the last few years the Federal Reserve delivered the goods that markets sought: a continued promise that interest rates will remain near zero for a long time to come and a new policy of inflation targeting which I will delve into a bit later. Market participants’ reaction to the $FED announcement was swift and decisive:

$GC_F 1/25/2012

$SI_F 1/25/2012

US Dollar Index 1/25/2012-1/27/2012 ($DX_F $UUP)

I often find it useful to think back to key market turning points in order to remember what the mood of the moment was – During the last few weeks of 2011 I was in Europe, the overall mood was decidedly somber and most investors whom I spoke with spoke of the US dollar with a sort of surreal reverence. The dollar had become a bastion of stability and a store of value as a result of Europe’s intractable turmoil. Moreover, virtually every money manager entered the new year repeating the same conventional wisdom of “stay dollar denominated” or “take your US asset allocation to the maximum and reduce European allocation to the bare minimum”.

Less than one month into 2012 it already appears as though the euro ($EURUSD $FXE) has made a significant bottom and the dollar has made a significant top (January effect). Simply put, markets have an uncanny knack for laying bare conventional wisdom and punishing crowded trades – this time appears to be no different for the euro and the dollar.

Markets cheered the Fed announcement and Chairman Bernanke’s press conference but it was a speech which was delivered on Friday by NY Fed President William Dudley that may have spelled out the Fed’s line of thinking even more clearly. On January 6th Dudley stated:

“because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not……Monetary policy and housing policy are much more complements than substitutes.”

Yesterday Dudley cited a series of “impediments” to achieving a robust recovery and finished it off by clearly expressing an impending disinflationary risk:

“Despite some improvements, the economy continues to operate with significant excess slack. Less than 59 percent of the U.S. working-age population has a job. This is unacceptably low—just about the same share as in late 2009 and well below the levels in 2006 and 2007.”

“Once again, this large amount of slack is putting downward pressure on trend inflation. After a brief run-up during the second quarter of 2011—reflecting the pass-through from higher commodity prices and supply-chain disruptions—inflation has retreated and may be headed down further. “

The Fed views disinflation as a major threat to the economic recovery and has essentially stated that it will stop at nothing in order to prevent inflation from being too low. Bruce Krasting wrote an excellent post (“Bernanke Goes All In”) in which he makes the point that Bernanke has now painted himself into a corner by becoming dependent on a single statistic (core PCE):

“I think there is enough monetary juice in the global system for there to be a risk of inflation north of 2%. We shall see. I think Bernanke is going to get his balls squeezed. He deserves that fate, he put them in a vise. As of today, he no longer has choices. He’s made himself a slave to a single dopey statistic.”

I believe that Wednesday’s FOMC decision was an attempt at engaging in QE without actually initiating QE. Let me explain, by committing to zero rates for another year or so and by explicitly stating a 2% inflation target the Fed is forcing investors further out on the yield curve into longer duration and riskier assets if they do not want to receive a guaranteed negative real rate of return. I will give Chairman Bernanke the benefit of the doubt as he has been right on inflation many times over the past several years in the face of widespread skepticism. However, the consequences of incessant central bank intervention are unknown at best and potentially disastrous at worst (think US dollar loses reserve currency status) – it is difficult to imagine when Fed monetary policy will ever be “normalized”; perhaps we are experiencing the new normal right now?

Market Structure

The markets expressed approval for the Fed’s decision amid a continued raft of strong corporate earnings results ($AAPL $CAT). The flight to risk is on as evidenced by the charts below:

While smaller capitalization high beta ETFs such as $GDXJ and $IWM have performed remarkably well during 2012 (GDXJ 20.81% and IWM 8.09%) the S&P 500 has achieved a more modest 5% gain year to date:

Correlations have begun to thaw as is to be expected in a normal market uptrend and market participants have begun to move down the food chain into the smaller, riskier names in search of alpha. Therefore, you can expect to hear people mention $SPX levels less often as they speak more in terms of individual names and in which sectors they want to be invested.

Where’s the Volume?

Many have pointed out the lack of volume during the recent rally and the fact that the only high volume days seem to come on down days. In fact, Peter L. Brandt went as far as to state that the inverted H&S in the NASDAQ ($COMPQ $NQ_F) is invalid due to the lack of volume. I have thought about this phenomenon a great deal in recent weeks and I have a few theories on our new market structure.

• The volume at lows and on sell-offs has been HUGE…someone has to be doing the buying at these lows. They are the strong hands.
• Rallies have seen very little retail participation, so it is a battle of professional investors with a lot of HFT and short term trader churning in between.
• The lack of volume is a sign that perhaps the rally doesn’t have a lot of energy to carry it higher, however, shares are mostly in strong hands (institutions who bought at lower levels) which means the market isn’t vulnerable to a huge sell-off either.
• Volume is a by-product of widespread participation in the market move (people suddenly wanting in or out of the market) – the early August plunge was a perfect example of market turmoil generating a tremendous amount of market activity i.e. volume.
• The October 4th low was an example of a market being “sold out” – in other words the market was falling on a lack of buying, the only sellers left were short term traders.
• The same way a market can fall on a relative lack of buying, a market can rise on a relative lack of selling. Short sellers have largely given up, longs are enjoying the rally and gradually selling shares into the daily advances, and perhaps most importantly the daily advances have not been particularly dramatic (nothing worthy of generating a lot of interest) and have mostly been achieved by way of overnight gaps.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.