Weekend Special: Paging Mr. Billy Shears

It was twenty years ago today
Sgt. Pepper taught the band to play

- The Beatles, "Sgt. Pepper's Loney Hearts Club Band"

Macro Man was out of the office on Friday, missing not only the decimation of equities and the dollar, and the concomitant uber-bull in bonds, but also the inevitable bevy of retrospectives on what was a defining moment of modern finance, the Black Monday crash of 1987.

In many ways, the situation today does resemble that of 1987. Stocks have had an excellent run over the past few years but begun to roll over. M&A/LBOs/Henry Kravis are front page news. The dollar has had a shellacking the past few years, and there's even a weekend announcement on currencies (the tepid G7 communique this weekend, the announcement of a derisory 0.25% rate cut from the Bundesbank in 1987).

So should we expect a once in a generation decimation of equities tomorrow? Somehow Macro Man thinks not. The primary difference between now and then is valuation. In October 1987, stocks were bum-clenchingly expensive by just about any measure; tod♠ay, they continue to look cheap when compared to Treasuries. Macro Man looked at this issue nearly a year ago, and circumstances haven't really changed since.

The dollar, meanwhile, is also not a good parallel. In 1987, Treasury Secretary James Baker was actively trying to resuscitate the dollar after two years of post-Plaza Accord bollocking. The primary policy prescription of this weekend's G7 meeting was "the dollar needs to go down against the Chinese renminbi". Sure, Hank Paulson said that he sure does love a strong dollar...but also noted that he's not really prepared to do anything about it.

The real issue for stocks is one of earnings. Since the money market ruptures of early August, consensus 12 month forward earnings estimates for the S&P 500 have fallen by roughly $1.50 per share. All else being equal, this should produce modestly lower stock prices. Of course, all else is not equal. The Fed has cut 0.50% and looks set to do more, while Treasury yields are now at or towards their lows and the curve has steepened.
This latter factor should generate a multiple expansion, which could perversely propel stock prices higher even as earnings expectations are marked significantly lower. Given that the magnitude of the change in discount factor has been substantially greater than the actual change in earnings expectations, Macro Man continues to view the medium-term outlook for stock prices as relatively good. The current 1500 level is a reasonable technical support, though self-fulfilling "Black Monday, mark II" fears may well propel share prices lower tomorrow. Unfortunately, Macro Man never got around to adding fresh index hedges, and at this point he's not sure if the cost of doing so justifies the potential rewards.

In any event, Friday was just another piece of evidence that the low-volatility world of the past few years is receding into the rearview mirror.
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David Pearson
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October 21, 2007 at 5:24 PM ×

Macro man,

You know this, but here goes anyway:

Wrong bubble.

Stocks are not ridiculously expensive, but credit was until recently. In reality, credit is 'crashing'; the stock market is just pretending not to see it. If (when?) the pretense ebbs, the stock market is susceptible to a crash as well. In fact maybe more susceptible than credit given that the stock market is: 1) the most junior debt; and 2) the longest duration; and 3) the fastest to reprice.

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Macro Man
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October 21, 2007 at 6:05 PM ×

David, I'd concur that credit may have been a bubble, but then so again has "risk-free" credit, e.g. Treasuries. And this latter bubble shows no signs of crashing.

Until it does, stocks will look relatively cheap in comparison. And while the deterioration of the prvivte sector credit environment will have an impact on earnings (which we see in the chart in this post), it is not clear to mke that that will necessitate a stock market decline. Indeed, unless the Treausry bubble does burst, a multiple expansion would seem the most likely outcome.

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david pearson
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October 21, 2007 at 6:21 PM ×

Macro man,

I guess another way to state it is that this will be an "E" crash and not a "P" one. The important thing about CAT/MMM/HON on Friday was that it finally gave credence to the perma-bear whining about peak margins.

I take your point about Treasuries, though. The shoe to drop there is currency, which holds the key to whether the Fed can influence the long end of the curve (in the right direction). The thing is that the currency and credit shoes are connected (their shoelaces are tied, so to speak). No such thing as "asset classes" any more, just appendages of the same 2002 reflation beast.

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Macro Man
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October 21, 2007 at 6:37 PM ×

I think you need to be talking recession to get the bite to "E" that would start a new equity bear. I am still not convinced....

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"Cassandra"
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October 21, 2007 at 8:47 PM ×

the Fed model IS assininely stupid, being only reflective of some non-stochastic clueless vaccuum-like world in which the investor is deemed to be more or less favorably inclined depending upon relative yield. When yield's are low, the equity buyer - encouraged to view equity favorably - is implicitly short the put on bonds LARGE. When Yields are high, equity is viewed most unfavourably despite the buyer being LONG the call on BOTH bonds and earnings. Here, we sit, somewhere in the middle, and the buyer of equity is short the put on the bonds(inflation), short the call on bonds(recession) , short the put on earnings(recession), with perhaps the only convexity being in a continuination of the status quo where real rates remain low to negative AND munificent strangers continue to heap credit upon Americans, AND no one in the world over ventures to do anything about thei own double digit inflation.

Go read Cliff Asness' thrashing of the Fed model, that more or less debunks each and every LONG term justification for its validity. Whihc the best (and most amusing) of critiques.

I wioll grant you that there is some merit short-term in doing something (a trade) given statistical "efficacy" even when it is contra long-term sensibilities, for short-term, the dog may be wagged by the behavioural tail. But one must be careful, for to be short caught out when reality sets in can be so very painful indeed...

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Macro Man
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October 21, 2007 at 9:22 PM ×

What you missed out is that the equity holder is long a call on Voldemort being Voldemort, and mercantilists being mercantilists. And that is a more valuable option than all the other put together.

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Anonymous
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October 21, 2007 at 9:45 PM ×

Meanwhile is Voldemort long a call on the consumer somewhere/anywhere but home?, and the credit he is providing reaching the parts that income does not refresh?

If so that then is underlying your most valuable option.

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Macro Man
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October 21, 2007 at 9:54 PM ×

I don't know if Voldemort is long a call on the US consumer, but I'm pretty sure he's short a put. Either way, he has a long delta exposure, but the payoff profile can be markedly different in times of stress.

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Anantha
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October 22, 2007 at 5:20 AM ×

rsxwmdYou state that you are constructive on equities and that you do not see this as the onset of a once-in-a-generation bear market on equities.

At a relatively mundane level, it does not seem to fit with your inflation-alertness.

At a less mundane level, it is not consistent with the eventual addressing of the macro imbalance and asset price bubble in China (one day, they will have to do something about it?), with the impact of oil price on global economies including in Asia (again, if oil did not hurt at USD 50 or 60 or 70, there must be some price level at which it hurts?) and with the political instability that is breeding in Pakistan and one that could spread from there into the Middle East.

A facile treatment of the risks lurking is most surprising coming from you.

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Macro Man
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October 22, 2007 at 5:41 AM ×

Oh Dear. Now you're making me feel ashamed of myself. The geopolitical risk is, for me, the easiest to dismiss. To my mind, those types of issues add rather a lot of noise without necessarily delivering a clear signal. When a concrete conflict emerges in Pakistan, or Iran, then it is perhaps worth addressing. Until then, I find it easiest to ignore, as I've been unable to discern a meaningful impact on securities prices from geopolitics over the years.

Oil is of course a concern, but at this juncture the rise in crude has been relatively 'healthy.' By that, I mean that it has been largely demand driven rather than some sort of supply shock (whether cartel- or hurricane-driven.) Moreover, the fall in crack spreads has meant that the end consumer has not felt the full brunt of the rise in crude; retail gasoline prices are well off their highs of this year (and 2006, and 2005.) Should petrol prices zoom higher a la crude, then I do of course reserve the right to change my mind.

Which leads me to inflation, where I am perhaps most culpable. But even there, my concerns are more medium term than immediate, per se, especially given the gasoline price issue noted above. And I do have a hedge in place on that front, via the TIPS position.

On my side, of course, is the fact that global liquidity conditions are, by my calculation, still easy courtesy of our friends in Moscow and Beijing (and Washington, too, perhaps?) And it is this factor that provides comfort for a constructive equity view.

Lost in the hoo-hah over the shocking TIC data for August is that by last week, Fed custody holdings of Treasuries and Agencies made a new all-time high. To my mind, that means the liquidity tap is still on. When reflation generates real policmaker concernws over inflation (i.e., producing tightening despite poor activity data), then the time to be in equities is past. For now, I don't see that as the likely outcome over the next few months, given the price action in Treasuries.

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flipper
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October 22, 2007 at 6:36 PM ×

Have you read Kevin's Fisher book?

It may be very questionable sometimes, but he has a very interesting points there, one of them beeing how strong was the equity market in the past to many shocks. Such as in the beginning of century during hispanic flue then millions of people were dying all over the world global markets rose, etc.

Imho people tend to over estimate various shocks and disater's influence over the market.

I completely agree with you view on relative valuations. That is also important, while the margin is high, short interestt is also all time high and retail investor participation is at all time low.

Imho before the market crashes situation with global liquidity will create another bubble globaly, not inly in China.

My simple question to all bears is - there the money will go?

Real estate and debt are overpriced globaly, and Fed is ready to cut further, as fed funds option tell us. Japan's and Europe are low buy historical comparison...

With overvalued US dollar treasuries are a sucker's game anyway...

I think the ney big thing is BUBBLE in EM, not only chine. Then the money is cheap it chases growth stories as with nasdaq, and growth is in the EM now. And we are seeing fiers signs of that now.

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"Cassandra"
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October 22, 2007 at 8:06 PM ×

equities appear resilient long-term because the largest component of nominal returns (according to Ibbotsen) is money illusion. So yes, you short equity at your financial peril. That said, when real equity prices get destroyed they get completely and utterly obliterated (something like -75% 1974-81 in real terms).

fliiper may of course be right, perhaps there is another hurrah! to come. But when you are on the edge of a precipice, it is important to watch your step, since a wrong move has an increased likelihood of being fatal.

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Macro Man
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October 22, 2007 at 9:51 PM ×

When it becomes evident that inflation is a peril, then I agree that stock prices will head lower, most likely in nominal as well as real terms.

But m,y sense is that professional investors worried about inflation at this juncture are in the minority, the the Boskined- and PCE'd- adjusted inflation rates perhaps allow further leeway than an alternative reality. For all we know, perhaps real stock price growth is already negative, based on the true cost of living to Mr. and Mrs. John Q. Stockholder. I can assure you that the real return of my US equity holdings to me this year has been virtually zero, given the rise in UK inflation and the dollar shagfest vis-a-vis sterling.

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Anantha
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October 23, 2007 at 2:48 AM ×

I agree that political risk is mostly noise. But, I would not have brought it up even as a point to mention in a blog-comment had it not been for the proximity of Ms. Bhutto's horrific rre-entry into Pakistan.

Coincidentally, I read that Newsweek is coming out with a story on how Pakistan causes sleepless nights to many worried about the next move of Al Queda, et al.

On crude oil, point taken that gasoline prices are not moving lockstep with crude oil but it could matter to many Asian nations.

Finally, I do share your view that the supply of liquidity from China, Russia and from oil exporters provides a positive backdrop for the creation and breeding of equity price bubbles in EM world.

Just that wanted to check how seriously concerned you were about the risks that, I concede, do not appear very threatening or proximate.

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Anonymous
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December 15, 2007 at 7:17 AM ×

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