Friday, February 3, 2012

The Absolute Return Letter - February 2012: The Unlikely Bull Market

Europe is going from crisis to crisis at the same time as stock markets climb higher. Meanwhile, investors are left confused. The key to understanding the apparent disconnect between stock market behaviour and economic fundamentals is the aggressive policy being pursued by the ECB which has eased credit conditions in the crisis-stricken European banking industry. With more QE from the ECB in the pipeline, we expect equity prices to benefit.



"The emergence of the internet as a provider of (usually) independent and (occasionally) high quality research has made it more important than ever not to take everything you read at face value. I am referring to the thousands of market commentators cum economists (let’s just call them bloggers although, strictly speaking, they don’t all blog) who see it as their call in life to comment on every bit of economic and market news, whatever the relevance to the rest of us.

Now, I shall be the first to admit that many bloggers do a very respectable job and their services are certainly needed as an antidote to the self-promoting investment banks which have always done – and always will do - everything in their power to talk the markets up. Having said that, many bloggers are as negatively biased as the investment banks are positively inclined, so the neutral needs to understand that there is bias in both camps.

The other and bigger problem is that most bloggers do not manage money. Talk is cheap when there is no accountability. Back in the late 1990s, fund manager Tony Dye became a household name in the UK for sticking to his view that equity markets were dramatically overvalued. His employers began to lose clients and finally lost patience with Tony who was sacked in February 2000 (no points for guessing when the markets topped out). Tony was a fund manager with great vision who was prepared to stand by his views, but he paid the price for getting his timing wrong.

Where am I going with this? You are about to find out. In the blogging sphere timing rarely matters. Bloggers can operate on a completely different level from market practitioners, and most of them do. Good friend and fellow investment manager Kim Asger Olsen of Origo (see here) refers to it as Economists’ Hypothetical Time (EHT) versus Real Market Time (RMT). His point – and I wholeheartedly agree – is that, whereas market practitioners (those who manage money and thus have an effect on markets) are forced to operate in RMT if they have any desire to make money for their clients, bloggers tend to work in EHT (this is a polite way of saying that they dwell for too long on what already belongs in the past in RMT).

Market practitioners no longer care about Greece. Neither do they care about Portugal for that matter. In RMT these countries no longer matter in the bigger scheme of things (to my friends in those countries: don’t take it personally, but that is the reality). So, when Portuguese bond yields blow out as they have done in the last week (chart 6), the reaction in the markets is muted to say the least. EHTers think it spells the end of the world. RMTers, on the other hand, know that Portugal doesn’t need to finance itself through the bond markets for at least another 30 months. Hence they ignore the Portuguese predicament. Instead they are now entirely focused on whether Italy and Spain can ride out the storm and, on the evidence of the recent performance of European markets, the verdict is that they can.

Much of the €489 billion that the ECB dished out in December has come back into the coffers of the ECB as overnight deposits (which may have disappointed the ECB somewhat) but, irrespective of that, the programme still did the bond markets in the eurozone’s periphery a world of good. Charts 7 a-b below show the Spanish and Italian yield curves as at 7 December (the day before the ECB announcement) and [28 January] respectively. The improvement is significant, in particular on 2-4 year maturities where the effect of the LTRO has been the greatest.

We can debate from now ‘til the cows come home whether Italy can afford to pay 6% on its 10-year debt, and that is precisely what occupies the minds of those operating in EHT, but what matters to RMTers is that Italy can finance itself cheaper now than they could 8 weeks ago. Doomsday has moved further away and equity markets have reacted accordingly. Who said QE doesn’t work?"