A Flaw in the Tepper Analysis

When David Tepper speaks, the market listens.

In Autumn, 2010, Tepper, the highly successful billionaire hedge fund manager, explained that for stock investors, the Fed had your back. Using options jargon he said that there was a "put" (downside protection) regardless of what the economy did. While causation is always hard to prove, the comments came on a 2% rally day in the market and the rally continued from there.

Today Tepper went public again, with a very bullish prognosis. A key part of his analysis was that the Fed purchases under QE, even if tapered off, would be greater than the net new issuance of debt by the Treasury. You can check out CNBC's site to see the entire interview.

Tepper goes on to discuss the historic highs in the equity risk premium and why this represents a major opportunity for investors in stocks.

Background

There is a sharp divide in the analysis of this topic. I want to emphasize that readers are consumers of this analysis – and so am I. The difference is that I have some training that helps me figure out what is silly and what is helpful.

On one side we have "the bond guys." These are investment firms that are selling bond funds and also the research firms that cater to the bond community. Think Gross and Gundlach for the first group, and Lacy Hunt and Jim Bianco for the second group. They are on a mission. There is a world that has been widely embraced in the trading community. The basic idea is that the Fed prints some money and hustles out to buy government debt. They describe the world as if it were a market with two counter parties. The results of this transaction are somehow reflected not only in bond prices, but also stocks, oil, gold, and tortillas. Sheesh!

On the other side there are those who are more thoughtful in their analysis. This week we have seen some great commentary.

• Brad DeLong explains why the big-name hedge fund traders have taken the wrong side of the trade;
• Josh Brown does a careful analysis of the incremental steps involved in QE tapering. This is market savvy applied to the current economic questions, so it deserves respect.
• Michigan economist Miles Kimball explains why QE has worked and suggests how to measure the impact. On the way he refutes Martin Feldstein's WSJ op-ed piece.

My Contribution -- Reality

My perspective is a little different: I am trying to draw together the very best sources and conclusions with an emphasis on finding the best investments. From both formal training and experience I know about both economics and markets.

I am shocked by what I see.

The prevailing discussion of bond trading is that the Treasury is selling and the Fed is buying. The result is a simplistic depiction of a two-party market with resulting stupid conclusions. This is what led to Bill Gross foolishly asking "Who will buy Treasuries when QE II stops?" The flawed two-party model continues.

The reality is that the following:

• The average daily trading volume in Treasuries is $550 billion.
• The Fed participation is less than one percent, even on a big day.
• There is plenty of appetite for debt. Regular auctions do not include the Fed, and they have a high bid-to-cover ratio. Strong evidence!

Consider it as supply and demand on a daily basis. It is a huge market. The Fed adds to demand, probably reducing the price elasticity of the demand curve. It is something like this (diagram borrowed from a helpful and educational site).

For QE buying, look to the chart on the right. The demand curve has shifted a bit, leading to a somewhat higher price, higher quantity, and lower yield than would otherwise have occurred.

For the QE exit, look to the chart on the left. The Fed will be a seller, slightly reducing price and increasing quantity.

Failing to consider the Fed purchases (and future sales) within the context of the overall market is a simple mistake. One can argue about the shape of the curve and the exact magnitude of the impact, but it is not just a matter of comparing net issuance to Fed purchases or sales. The changes are relatively modest.

The prevailing analysis is so bad that I would call it a blunder, albeit a knowing one on the part of some.

Conclusions

There are some obvious implications for your analysis of QE and the effects:

1. The effects of FED QE accomplishments to date are dramatically overstated. The QE policies moved rates a bit lower, but the asset markets also reflect earnings – both current and expected. The Fed's internal estimate, as of last autumn, was about 1% on the ten-year note. We can all speculate what this meant for the job market.

   
   "How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve's large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points.¹² Three studies considering the cumulative influence of all the Federal Reserve's asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield.¹³ These effects are economically meaningful."

2. The entire mechanism for analyzing QE effects is mistaken. Why continue to listen to those who have been wrong for years? Maybe a new model is needed.

There is also the flip side.

1. The ending of QE is not as scary as portrayed by most "pop economist" pundits.
2. Since the initial impact of QE was an "overbid" the winding down will be as well.

Investment Implication

David Tepper is right on all of the key points.

• He is accurate on Fed policy.
• He is accurate on overall market valuation – the equity risk premium.
• He is accurate on the right posture for most investors.

Why do I disagree? I am not trying to pick nits. I mean to analyze what is actually happening, explaining why investors should not fixate on Fed policy.

Tepper is meeting the critics on their own terms – discussing net debt, even if that is the wrong measure. He is catering to the popular mistaken belief. I disagree with his analysis, but not the investment implication.

[Update - description of Fed exit impact on quantity corrected - thanks RS.]

Comments

[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?