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« Weighing the Week Ahead: Are Consumers Ready to Buy? What about Housing? | Main | Weighing the Week Ahead: Are You Ready for Some Fedspeak? »

May 14, 2013

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oldprof

AB -- You seem to have a mission that includes a variety of topics. I am not going to answer all in the comments. Many of these are frequent topics of mine, including the Q ratio, Shiller PE, etc.

It is interesting that you lead off with "unmitigated bullish bias." Like you, I am trying to serve investors. It is fundamental to my success. My programs do not require a bull market. If I am bullish, it is a conclusion -not a bias.

Sticking to the part of your comment that relates to the article:

1) You misuse the term "marginal buyer" as do many others. The sources that I criticize sling this around as if the Fed is determining the price. You might try comparing end-of-day prices to the Fed purchase, learning that the marginal buyer changes.

2) You choose to cite a source suggesting a relatively higher impact from the total Fed operations. I am familiar with that paper. I cited the Fed's own conclusion that shows a range of possible results. Neither of us knows which conclusion is correct, but why pick an extreme point?

3) You seem to think that "normalized" interest rates should be used in any comparison. Other bears also want to "normalize" profit margins. You cannot pick a single variable and assume that everything else is unchanged! I have written about this several times. When interest rates return to normal, you will also see stronger economic growth and better profits. It all works together.

You have probably noticed that you cannot trade on "normalized" rates, which is why people compare different assets in choosing a portfolio -- the sweet spot of your expertise.

I hope you will join in again on the next installment in this discussion!

Jeff

oldprof

Robert - Yes - increasing quantity. Thanks.

As to the shape of the supply curve, this is exactly the point. The market supply, not just new issuance, is the result of a comparison with all other investments. There is some literature on the actual shape of the curves, but it is difficult to infer from data.

Thanks again.

Jeff

AB

Given the unmitigated bullish bias you've adopted in the bulk of your posts, I'm certain this comment won't give you much pause, but I'm compelled to point out a glaring flaw in your logic about the Fed's impact on rates, and all asset markets via the discount mechanism.

In markets, an asset's price is set by the marginal buyer or seller. This means that the total amount of trading volume in a market tells us nothing about the impact of marginal flows of capital.

Total U.S. Treasury and Agency debt outstanding is about $12 trillion. These are the securities that are eligible for Fed purchases. Given that the Fed is concentrating on the longer end of the curve, the aggregate value of eligible securities is substantially less than that, perhaps less than half. The Fed is currently purchasing $85 billion per month, or about 1.4% of outstanding eligible securities, which represents marginal demand that would not exist otherwise. All things equal, this demand would push prices up 18% per year, lowering yields commensurately.

The Bank for International Settlements models calculate the total impact of Fed purchases on the 10 year rate to be about 180 bps as of Q2 2011. Since that time the Fed has purchased almost another $trillion of securities. I don't have time to run the numbers given subsequent issuance, but the impact is certainly much more than 180 bps in aggregate now. If you're keen, do the math yourself: http://www.bis.org/publ/qtrpdf/r_qt1203e.pdf

The Fed paper that Tepper referenced indicated that at normalized interest rates the ERP would be negative at all but the shortest of horizons. Only at today's artificially low rates can anyone begin to suggest that the risk premium is high. And one would have to assume today's rates ad infinitum for this high risk premium to be relevant over meaningful investment horizons.

The bottom line is that using any statistically meaningful measures of market valuation (Graham PE, Q Ratio, Market Cap / GNP, Price Regression, Absolute Dividend Yields, etc.), the market is currently more expensive than at any other time outside of 1929, the bubble years of 1994 - 1999, and 2006-07. There is no value in this market, it is a speculatively frenzy driven by the same type of misapprehensions that supported the tech bubble, the RE bubble, and the roaring 20s bubble. Today's meme is very low interest rates, but it is just this cycle's version of all the other narratives that drove speculative bubbles in the past.

Critically, this does not mean that markets can't continue to run much higher still in the short term - indeed price momentum suggests it still has room to run. But remember that every point of price appreciation from these valuation extremes is simply a point that is borrowed from future long-term returns. Get 'em while you can!

Robert Simmons

"For the QE exit, look to the chart on the left. The Fed will be a seller, slightly reducing price and quantity."
Don't you mean increasing quantity?
Also, shouldn't the supply curve be vertical, or close to it? Debt issuance isn't really affected by the interest rate.

Pacioli

I am an avid reader of your blog, have been for quite some time. I always find interesting tidbits, so I keep coming back. One thing I have noticed as a common theme, though, is that the ‘body’ of your entries rarely supports the title/header.

In this case, the title trots out “A flaw in the Tepper analysis”, leading readers to expect a breakdown of how Tepper’s analysis is flawed. The article, like so many before it, does no such thing. At least in this case you fairly point out that all of Tepper’s main conclusions are right on.

The 3 bullet points of “reality” that you present as an alleged counter to “the prevailing discussion of bond trading” in no way detract from the points Tepper made. To wit, Tepper specifically describes the upcoming changes in STOCK of fixed income securities over the next six months, noting that the Fed will purchase roughly ~$500B while net new issuance will barely exceed ~$100B. It’s just a simple description of how the overall STOCK of securities will likely change in the next six months.

Your first point on daily trading volume is irrelevant to overall STOCK levels. It is merely a commentary on how FLOWS change hands on a typical daily basis, and the depth (volume) of the market. The second point is related, and also correspondingly weak in disproving any portion of Tepper’s analysis. The Fed’s daily participation does not have to be large (more than 1%) on a daily basis in order to affect prevailing market prices, which are more a function of market participants’ understanding and expectation of the STOCK dynamics described above. In other words, the Fed does not have to purchase a high percentage of overall volume, because the market price is already reflecting the Fed’s effect on STOCK of securities.

The third and final point is particularly suspect, referring to Fed auction bid-to-cover ratios as “strong evidence!”. The bid-to-cover is just the result of the mandated mechanics of the primary dealers. Nothing more, nothing less. They are required to bid, in exchange for the privilege of maintaining PD status. While there may or may not be ample appetite for the debt, the bid-to-cover ratios are not a convincing piece of evidence, since they result from mandated institutional construction, rather than from a purely free-willed market participant eagerly snapping up the securities.

Your final couple of sentences could be compelling and interesting, if adequately developed. “He is catering to the popular mistaken belief. I disagree with his analysis, but not the investment implication.”

What, EXACTLY, is the “popular mistaken belief”? A proper enumeration of this and why it is mistaken (which readers were hoping for based on the title of the post) would be quite compelling.

Mark S.

I'm surprised by your endorsement: Tepper says that investors (as opposed to traders) should be very cautious about stocks right now. His last line seems to recommend zero stock investments. In contrast to your standard investment rec. I would think Tepper would be a prime candidate for your "wall of worry"!

Maybe I misunderstand your recommendations for investors. Or perhaps you just mean to say "don't dump Treasuries in panic"' that is all? But I don't think you mean to say "be cautious about stock investments now", as Tepper does - do you?

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