Tuesday, October 31, 2017

The End of QE Didn't Kill The Bull Market. The Start of QT Won't Either

Summary:  Quantitative Easing (QE) ended 3 years ago today. This was widely expected to mark the end to the bull market (post). Instead, US stocks have risen another 37%.

Why was this view wrong? In truth, the narrative about the Fed's policy has shifted over time as equities have risen. As late as 2012, QE was viewed as bearish. Into 2014, it was only the continued QE inflows that were considered bullish. When stocks kept rising after QE ended, the narrative shifted to the large Fed "balance sheet" and then to global central bank actions.

The Fed's policies have clearly led US equities higher, but not in the way that it has been popularly perceived. The Fed established the conditions for fundamental growth in consumption, investment, employment and corporate profits, creating the confidence in investors to place their cash into the financial markets. All of these factors have a strong causal relationship to share price that long pre-date 2009 and the QE programs.

The Fed will now embark on a reduction of its balance sheet (QT). This appears to be the most pivotal event facing markets in 2018. But it stands to reason that so long as the positive fundamental conditions continue, US equities can be expected to remain firm.

None of this implies that the US equity market will continue to appreciate without any interim drama. As noted in the charts that follow, investor sentiment is very bullish and equity valuations are very high. Since 1980, it has been normal for the S&P to correct by an average of 10% during the course of each year of a bull market. With the last correction of that magnitude starting 2 years ago, one of that magnitude, or larger, is arguably overdue in the coming months. That, not the tapering of the Fed's balance sheet, is the relevant risk for investors to focus on in 2018.

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On September 20th, the Fed formally announced that it will begin to reduce its balance sheet, primarily by ceasing reinvestment from maturing bonds. This process is being termed "Quantitative Tightening" (QT) as it is the reverse of the bond buying program known as Quantitative Easing (QE).

QT will begin slowly, with a reduction of just $10b per month during the first 3 months. If there are no major market disruptions, then the pace of QT will be increased by $10b per month every quarter. To put that in perspective, $10b equals 0.2% of the Fed's total assets. By the end of the year, the Fed's balance sheet will have been reduced by less than 1% (from JPM). Enlarge any image by clicking on it.

Monday, October 30, 2017

Investor Psychology, Part III: Seeking and Avoiding Risk At Exactly The Wrong Time

Summary:  Too often, investors sell their winners early and hold on to their losers in order to avoid taking a loss. Put another way, when faced with a gain, investors avoid risk; when faced with a loss, they seek risk. It's the exact opposite of what a rational, profit-maximizing investor would be expected to do. This is another paradox of human behavior that helps explain why most investors perform badly.

Why do investors act in this way and how can this behavior be avoided?

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In a recent post, we described how prominent, but rare, events are mistakenly ascribed a high likelihood. Bear markets and crashes are objectively uncommon but feature prominently in our decision making. As a result, the average investor earns a return that is barely higher than the annual rate of inflation (that post is here).

To make matters worse, active investors engage in risk at exactly the wrong time, and avoid risk when they should instead be taking it.

 Imagine you are given the choice between:
a. $1 million guaranteed, or
b. A 50/50 chance to receive either $2 million or zero. 

The expected payoff of both options is the same, but most individuals choose a guarantee of $1 million (option a) rather than a chance to win $2 million. When faced with a gain, risk is avoided.

Now imagine you are given the choice between:
c. A certain loss of $1 million, or
d. A 50/50 chance of losing $2 million or losing nothing. 

The expected payoff is once again the same for both options, but this time most individuals avoid the guaranteed loss and favor gambling in order to breakeven (option d). When faced with a loss, risk is preferred (see note at the bottom of this page).

Friday, October 27, 2017

Investor Psychology, Part II: Following The Stock Market Is Bad For Your Returns

Summary:  The irony of equity investing is this: if you knew nothing about the stock market and did not follow any financial news, you have probably made a very handsome return on your investment, but if you tried to be a little bit smarter and read any commentary from experienced managers, you probably performed poorly.

The human mind has a tendency to assess risk based on prominent events that are easily remembered. The 1987 crash, the tech bubble, the financial crisis and the flash crash in 2010 are all events that are easily recalled. The mind automatically assigns a high probability to prominent (but rare) events. It ignores the more important "base rate" probability that better informs decisions. The fact that the stock market rises in 76% of all years, that it gains an average of 7.5% per year and that annual falls greater than 20% occur less than 5% of the time, are ignored in decision making. The mind interprets every 10% correction as the beginning of something much worse, even though a 10% fall is a typical, annual occurrence during bull markets.

Bearish market commentary that highlight risk conjure gravitas. Bullish commentary often seems shallow. But remember, in the absence of relevant data, the "base rate" probability is your best guide. Conflating prominent, but rare, events with high probability is an ongoing impediment to better investment returns. Recognizing this inherent deficiency in our decision making is perhaps the biggest potential source for improvement for most investors.

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In the past 12 months, the S&P has returned 22%. In the 3 years since the end of QE3, the total return is 37%. In the past 5 years, returns are over 100%.

Yet, throughout this period, investors with even a passing interest in financial news have regularly seen commentary from experienced managers that the stock market is highly likely to plunge now (from Daniel Miller). Enlarge any chart by clicking on it.

Sunday, October 22, 2017

Investor Psychology, Part I: Using Time, Scaling and Inflation to Frame Data (and Mislead Readers)

Summary:  How data is presented has a significant affect on the conclusion a reader will draw. Behavioral economists call this framing: "what you see is all there is." Presented below is a mental trick used to mislead readers.

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Over the past 85 years, the S&P stock index has grown 35,600%. The rise looks parabolic. The conclusion appears to be that it is unsustainable (data from Robert Shiller).

Friday, October 6, 2017

October Macro Update: Hurricanes End 83-Month Employment Expansion

SummaryThe macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

The bond market agrees with the macro data. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (arrows). The lag between inversion and the start of the next recession has been long: at least a year and in several instances as long as 2-3 years. On this basis, the current expansion will last well into 2018 at a minimum. Enlarge any image by clicking on it.