Quarter End

Posted by: Michael Williams on Wednesday, March 30, 2016

The quarter end is traditionally a time when the financial world reports their returns, makes forecasts for the next quarter, and of course the unspoken game of “marking”, which my colleagues will not find my brute honesty humorous, but it is true nonetheless. It is also the time for the government to make their forecasts and report the economic conditions. We have seen some huge volatility in the first quarter and a couple of the indices have made it back to positive territory for the year. The question remains, will we continue to see prosperity or are we faced with more volatility.

Quarter End

Gross Domestic Problem The gulf between government headline data and the actual economic landscape has widen considerably. Even the main-stream media, which at one time never questioned the big three government headline data (Labor Report, CPI, and GDP) has woken up to some rather odd occurrences. Most recently CNBC economist Steve Liesman did a case study on the rather large and oddly consistent margin of error in the GDP. So much so that the general conclusion is that the initial report is useless as to any measure of economic growth. What is shocking is Liesman had remained a devote believer in government headline numbers without question. When staunch Keynesians and believers in government data are beginning to question its validity, perhaps we all need to take notice. I do feel somewhat vindicated over my skeptical critique of government data, thanks to someone that I am typically at odds with, Steve Liesman. CNBC Liesman questions GDP
Fed knows the truth Yet even before Liesman’s realization of the problems of GDP, one can measure the validity of government headline data vs. Fed action. As I have often repeated, words are one thing and action is another. If the government headlines are to be believed, how come the Fed has not reverse course in their dovish policy? Why haven’t they raised rates, reduce the money supply, stop the financing of bonds and mortgage back securities, and unwind their balance sheet? The lack of Fed action should be proof enough that even the Fed has little faith in government headline numbers. Yellen has stated publicly and it has even shown up in the occasional FOMC statements that while government headline numbers have improved, there remains structural problems in the economy that perhaps are NOT measured accurately by the government headline numbers. Phrases in the FOMC statement like; “A range of recent labor market indicators, including strong job gains, points to some additional decline in underutilization of labor resources.” clearly indicates that while there was reportedly strong job gains and a lower unemployment the Fed is still concerned about the labor market. The statement alone implies their real concern is what the government headline number is NOT measuring or perhaps is obfuscating.
QE continues While the Fed has stated and the media has repeated, without question, that Quantitative Easing (QE) has ended, in truth – simply by measure of their actions and their own admission – it continues. If, as QE was defined by Bernanke to Congress, consists of the Fed purchasing assets (US treasuries and Mortgage Back Securities), then QE has not ended. By looking at the data published by the Fed, they continue to buy both Bonds and MBS assets and in their own FOMC statement they admit to the continuation of doing so. MARCH 16 2016 FOMC STATEMENT The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. The question is, how could they say they ended it? This is just a semantics game as the Fed has entered the world of political optics. The Fed was able to say that QE has ended simply because they are not printing any NEW monies to buy the assets, but that doesn’t preclude them from continuing to buy assets with short-term maturities as they come due. Additionally and ironically, they ARE printing new money by a simple measure of the increase in the money supply. Perhaps it is all an accounting game. It is the nuance on how EXACTLY you define the purchasing of assets (bonds and MBS), "IS" it with new money or "IS" it existing money? I guess it depends on how you define "IS". It reminds me of the famous quote by President Bill Clinton on the definition of “IS” as he tried to define himself out of actually having a sexual relation with Monica Lewinski. I have to admit, Bill had some cojones just to attempt such apparent semantics argument. The Fed is certainly operating in the same obfuscating semantic league as Bill, but rather than sexual escapades we are talking about monetary policy. President Bill Clinton 1998: "It depends on what the meaning of the word 'is' is. If the--if he--if 'is' means is and never has been, that is not--that is one thing. If it means there is none, that was a completely true statement....Now, if someone had asked me on that day, are you having any kind of sexual relations with Ms. Lewinsky, that is, asked me a question in the present tense, I would have said no. And it would have been completely true." Courtesy of wikipedia
Yellen remains Dovish I had predicted Yellen would become Fed Chair and had predicted for a lengthy time the Fed would never raise rates (except in December). Predicted that the Fed wouldn’t raise rates in the first two FOMC meetings of 2016. Predicted that they won’t at the next meeting. Yet I am not a genius nor am I privy to any insider information that is not readily available to all. So how can I continue to be right about Fed policy and Yellen’s disposition? I must admit that objectivity is probably one of humanities most difficult traits to achieve. I would be lying if I said that bias never creeps into my analysis, as it does with everyone. However, we must try to remain as objective as possible and cast ideology to the side when making observations. Courtesy of wikipedia There are two distinct reasons why Yellen remains dovish: Disposition: The first is just a review of her long history, which consists mostly of lectures and papers she wrote. I have read several prior to her becoming the Fed Chair. They tend to overtly support government interventionism with strong Keynesian undertones. One of her papers goes as far as government subsidizing businesses to raise wages. Her views and papers mix monetary policy with fiscal policies, which is the basis of Socialism. We can also look at her voting record as well as discussions at the FOMC while the San Francisco Fed President. Again I reviewed them prior to her appointment as the Fed Chair, there too she remains Dovish and supports more stimulus efforts at almost every turn. At no point could I find her make a case for strong dollar policies or hawkish tones. Clearly she hails from the Socialist side of the Democratic Party and remains an ardent believer of central planning in which monetary and fiscal policies co-mingle. Of course I believe her intentions are admirable, but as the saying goes; “Hell is paved with good intentions.” From Yellen's Brooking's institute Paper 1991: "We propose a program of self-eliminating flexible employment bonuses (SEFEBs) to eliminate this gap. Our analysis shows that such a program would give many workers a chance to keep their jobs and would also raise the level of new job creation through faster private investment. According to our estimates, even deep wage subsidies (for example, an employment bonus equal to 75 percent of current wages) would have very low budgetary costs. " Fed’s Position: The second reason why Yellen remains dovish is the Fed’s current balance vs. the current market liquidity. Even if Yellen was a Hawk, she would have difficulties unwinding her balance sheet and ending the asset purchases. This is just simple math as measured in terms of liquidity. Currently the Fed is the largest purchaser of U.S. treasuries, this has allowed them to fix price (holding down yields). If the Fed were to stop purchasing treasuries, who would fill their shoes? Even if you could find another buyer of that magnitude, they certainly would NOT be willing to accept the current rates and we would see bond prices fall and yields rise. In essence the Fed is stuck, they can’t stop purchasing and certainly can’t unwind their balance sheet, without facing significant liquidity issues in the bond markets, which would send bonds lower and yields higher. No doubt the yield curve would steepen radically. Additionally, the MBS market remains weak. In order to continue financing the housing market – especially in what I would call (but the banks don’t) the sub-prime market – yeah it still exists and it is big, the Fed needs to continue to back the MBS market. Even though Freddie and Fannie failed, they are continued to be backed by the US government, continue to operate high risk loans, and now we are again seeing significant problems at Freddie and Fannie. The Fed remains the buyer of last resorts. Lastly, there is inflationary risk exposure. The strong dollar has certainly helped the consumer, but at the same time the Fed is dreadfully concerned with deflationary risk. As I have pointed out in the past the CPI is not a true measure of inflation, but rather a measure of the adjusted cost of living (COL), which is impacted by real inflation (ironically). The Fed can’t raise rates without the fear of further strengthening the dollar, driving disinflation which could turn to deflation. With the rest of the world in an easing mode lowering rates (negative) and increasing their stimulus efforts, the Fed is forced to play along or face deflationary risk. In essence the Fed is stuck, unless they are willing to see bond prices fall precipitously and deflation risk to rise. Of course I could make the point that this is an election year and the President Obama appointed Fed Chair and all the governors of similar disposition are certainly not going to rock the boat of their party’s attempt to win the White House or Congress. However, this is more conjecture and I believe the two points I have made about Yellen’s disposition and ideology, along with the current Fed balance sheet problems has made it clear that Fed and Yellen will remain Dovish.
Quarter End The market did read into Yellen’s recent lecture and heard ever dovish note. It came just at the right time, quarter end. This will certainly help push the equity markets higher. The dovish tone was also felt in the bond market, as we saw yields fall. Certainly the bond market is not predicting in near-term rate hikes. Quarter end is certainly important for the long-only investment fund community that will be generating their quarterly reports. The joking term of “marking” is really no joke. Kidding aside, the sell side volume will be lite and we will see strong closing as buyers will put in MOC (market on close) buy orders. One fund manager I know (don’t hate me) always called the quarter end – his Window Dressing time. Why I pull back the Kimono to expose such efforts is only distancing me from my colleagues, however my readers are mostly my colleagues with an occasional retail investor so I don’t think I am really spilling the beans to anyone that matters.
Next Quarter So while we should expect “Good Marks” for quarter end the real question is how the market will move forward next quarter. Our analysis is actually raising alarms that more volatility is to follow. In fact long-only positions at these equity levels come with significant risk factors. The VIX and other measures of volatility are reaching complacent levels, almost as if casting risk concerns to the wind. In my letter to investors for the KFYIELD fund I conclude that we will remain over-hedge in the coming quarter and to expect more volatility. Certainly the Fed will remain Dovish and that should help continue to drive margin driven long positions (cheap money) higher, but economic realities as seen with weaker China import-exports, weaker growth in top line revenues, and lower forecasts – despite government headline data, should inject a pause with buyers at these levels and perhaps drive more volatility.

Support & Resistance

INDU 17,200 – 17,800 The market got a good push into the quarter end and Yellen gave the market what it wanted by lowering expected rate hikes and furthering a dovish tone. Expect the market to push higher and I don’t be surprise if we get a 17,800 print for quarter end. NDX 4500 – 4600 We could very well see a jolt higher that could fuel a short-covering rally. Getting above 4500 is not a problem and a rock move to 4600 in a couple of days to cap the quarter end is not out of the question. It’s a long traders market in the short-term, just be ready for volatility. SPX 2060 – 2100 While I think it is more realistic to get a 2080 print for quarter end marking, I think with enough short-covering and some big MOC orders in the over-weights in this index we could see a 2100 print. Perhaps that is wishful thinking. RUT 1120 – 1140 The broader Russell doesn’t get the help of the big over weights to drive it higher or lower, so getting huge spikes is usually not an occurrence. However, if we see offers lift and selling lite, we could get a run to 1140 or perhaps higher. I would look at REAL resistance to start at the 1120 range.
While I am making bold calls about quarter end marking and a short-term rally from here over the next couple of days, this is only based on historical experience. While a two day rally into quarter end is nice, are we to assume it to continue? There is certainly something to be said of the psychological impact of a strong quarter end rally and how it could lift moral and generate optimism to help push the market even higher. No doubt the media will be in good spirits as the market rallies and irrational exuberance can certainly be infectious. Of course as I pointed out the Fed will remain dovish, which can push markets higher. Yet the Fed not raising rates and staying the course is a far cry from lowering rates or perhaps even a Negative Interest Rate Policy (NIRP). The Fed does have room, how much more is debatable. For now not raising rates is good enough to get the market to move higher, but to continue the rally the Fed may have to become more accommodative and with Yellen at the helm that is certainly not out of the question. NIRP is a real possibility.


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