Monday, August 31, 2009

Macro Indicator Summary

I am impressed with markets' resilience in the face of China's 6.7% sell-off overnight. Aside from Hong-Kong, global equity markets have shrugged-off the new Chinese bear market with a disinterested grunt. Here in Canada, banks are mostly higher on the day despite a 1.5% drop in the index, while the U.S. banking sector continues to consolidate sideways, off just 0.75% today.

4:30pm update: Volume was lower across the board, so institutions are sitting on their hands.

9:30pm update: After-hours volume pushed end-of-day numbers well above yesterday's levels, registering a 'distribution day'.
Note: Please click on any and all charts for a larger image.

The clear losers from the China sell-off are commodities, with oil down $3 to below $70, and copper off 12 cents at 2.83. Oil is at critical support from a trend-line going back to late April (see chart of DBO below), while copper has reversed off important resistance at the 61.8% Fibonacci retracement level of $3.00 (See copper Fibs below).
DBO Oil Fund ETF

Copper Market with Fibonacci Levels

Commodity currencies, like the CAD and AUD sold off substantially earlier in the day but have since rebounded, especially against the Yen. The CAD/USD found support from its 50 day moving average slightly below 90 in the morning, and is likely to test its multi-week trend-line (currently at ~89) before finding further direction.

Canadian Dollar ETF

Canadian Dollar ETF / Japanese Yen ETF Ratio

We monitor the Asian Dollar Index for macroeconomic strength in that region. The index has been consolidating for several weeks in a pennant formation which is likely to break up or down in the next few days. Given the ADXY's strength in the face of China's panic sell-off overnight, an upside breakout is more likely. On an upward break-out, there is resistance at the previous high (~109) which, if broken, would signal further emerging market strength, led by Asia. 
Asian Dollar Index
Source: Bloomberg

Bonds are confirming the bearish story in commodities, with long-term Treasuries rallying to resistance for the second time in 2 days. 
 20+ Year US Treasury Bond ETF

The 10-year TIPS breakeven rate, a measure of bond traders' future inflation expectations, is testing key support today, suggesting that traders are skeptical of current commodity strength.
10-Year TIPS Breakeven Rate
Source: Bloomberg

10-year yields have also been consolidating in a pennant formation; a break of 3.25% would indicate a major change in the trend of 10-year rates, at which point equity bulls would necessarily be put on the defensive.

10-Year US Bond Yield
Source: Bloomberg

Gold continues to consolidate in its intermediate-term pennant structure forming the right shoulder of what looks like a huge inverse head and shoulders formation. This structure suggests higher prices lie ahead. However, there are two clear resistance levels that must be breached before we can celebrate gold's new up-trend. Using the GLD ETF chart, the first resistance line sits at ~$94.25, with the longer-term line at ~$95.50. These are important levels to watch. A breach of the upper resistance line would suggest a re-test of the previous highs near $99, with potential for a test of it's all-time high of $100.44.

Source: Stockcharts

Meanwhile, credit spreads seem impervious to the macro fragility implied by the charts above. CDS spreads in Europe and the U.S. continue to consolidate near their intermediate-term lows.
US and European CDS Indices
Source: BMO CM Research

In conclusion, several important macro indicators are testing important resistance and support levels, but the pennant-shaped consolidation patterns suggest trend-continuation at this time. As such, stock markets are likely to move sideways in the short-term, with the potential for a short-term correction driven by commodity weakness. The most likely intermediate-term direction for stocks is up, with the potential for the S&P to move as high as 1200 before we begin wave 3 down. Should 980 be taken out on the S&P, we would look for a more immediate, steeper decline to ensue.
For longer-term context, I leave you with Doug Short's most recent chart of the Three Mega Bear Markets.


Sunday, August 23, 2009

Sirens in the Distance

"The American Republic will endure until the day Congress discovers how to bribe the public with the public's money."

-  Alexander Fraser Tytler

"The hardest thing to explain is the glaringly evident which everybody has decided not to see."

- Ayn Rand

Never in modern history has a voting majority confiscated so much from its children, by incurring so much debt to preserve its own excesses. Debt is simply a form of deferred payment which accrues geometrically compounding costs in the form of interest. Given the response of governments to the current economic downturn, and the acquiescence of voters to unprecedented government deficits, one is compelled to question the values and motives of contemporary citizens. 

In fact, there are only three possible explanations. One involves a form of pervasive, illusory expectation in which this debt is somehow repaid during the voting public's remaining lifespan out of current meager savings. A second possibility is that voters are convinced that bailouts and record deficits are a better legacy for future generations than a period of retrenchment. Thirdly, existing voters may be ambivalent to the fate of future generations when faced with the alternative of thrift. 

I will draw on simple math and personal experience to illustrate an important facet of the existing conundrum. It is well known in the financial planning community that, under optimistic assumptions, one's savings at retirement must be at least 20 times one's expected retirement income when adjusted for inflation. For example, a couple retiring at age 65 that requires a consistent $100,000 pre-tax purchasing power in retirement must have at least $2 million in savings. A $150,000 pre-tax retirement income, adjusted for annual inflation, requires $3 million in savings.

Source: Butler|Philbrick & Associates
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The data suggests that just a small fraction of non-pensioned families have enough savings to support their lifestyle objectives in retirement. Many are ill-equipped to fund even a basic retirement under current lifespan assumptions. What proportion of people you know that are nearing retirement have an appropriate level of savings according to the above model?

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In the public and private pension worlds, data suggests the situation is not much better.  A majority of pensions, both private and public, were underfunded even before the current global bear-market. Companies, municipalities, and provincial and federal governments have deferred pension contributions for many years to avoid tax hikes or program cuts or, in the case of private companies, to enhance current earnings. This deferral serves the goals of politicians and company managers who are rewarded in the short-term for program and earnings largesse. These same people are unlikely to face the consequences of these actions during their terms. Worse, when stock and bond markets fail to meet performance expectations, as in 2000-2003 and 2008, politicians alter the rules to allow even greater deferrals to preserve corporate earnings or avoid raising taxes during challenging economic periods. The misguided hope is, of course, that an even more stressed and over-leveraged economy will provide such a boost to asset prices that managers can grow their way out of deficits. For many reasons, this is less likely now than ever.

One reason this is unlikely is that insufficient savings will produce one of two outcomes: higher savings in the years before retirement, or lower spending in retirement. Given that consumer spending represents around 60% - 70% of Gross Domestic Product in developed economies, a reduction in consumer spending due to higher savings rates and/or lower retirement incomes will surely cause much slower economic growth over the next several years. Further, the U.S. consumer is responsible for no less than 16.6% of total global GDP, followed by Japan (8.1%), China (7.3%), and Germany (6.0%). 

Many people point to growth in relatively young emerging economies as a reason for optimism. Indeed, growth in these economies, under more likely global financial trajectories, may buffer the impact of lower spending in developed nations. However, there are significant hurdles that will limit the impact of emerging market growth. The first is the mercantilist structure of these economies. Growth in emerging markets has largely resulted from the migration of Western domestic manufacturing to lower cost jurisdictions. This migration, which is a mutually beneficial arrangement under the right (Schumpeterian) circumstances, is the first step in the evolution of any young economy into a mature capitalist democracy. The 'Asian Tigers', which include Taiwan, Singapore, South Korea and Hong-Kong, managed very rapid growth from the early 1960s through the 1990s by successfully leveraging this export-driven model to become mature capitalist states. China, and to a lesser degree India, have also adopted this model to support their aggressive growth ambitions. Unfortunately, demographic and secular forces have likely conspired to delay the best laid plans of Indian and Chinese central policy makers. They are unlikely to achieve the same level of prosperity on the same timeline, or using the same methods as the Asian Tigers.

Productivity is the degree to which a labour force can achieve higher output with a constant level of inputs. There are two ways to drive productivity growth: leverage and innovation. Innovation is a sustainable resource, limited exclusively by the creativity and courage of humanity. It is a function of risk-taking, which depends on a society's tolerance for failure. Leverage is the degree to which a society embraces debt to amplify growth. All economies can accommodate a degree of leverage, but the sustainable leverage ratio in an economy depends on economic productivity, flexibility, workforce mobility, ratio of services to goods, and other factors. This ratio is constantly changing, but the ratio should fluctuate in a slowly increasing range; it should not grow exponentially. The drawback to leverage is that it also amplifies the volatility of economic growth, with higher leverage leading to a higher degree of economic fluctuation.

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Demographic forces related to the average age of a population largely influence the flexibility, creativity and productivity of economies. Leap-frog innovation generally occurs when the bulk of a population is in their early twenties and thirties. This is a point of maximum risk-taking, and risk is a necessary input to innovation. One must be willing to fail many times in the pursuit of a better mousetrap, and people in their twenties can more easily start over. People in their thirties and forties are focused on raising a family and accumulating domestic necessities such as shelter, transportation and early schooling for children. This necessitates a more conservative approach to life and career. As people move through their forties and fifties, post-graduate education for children becomes the priority, and lifestyle and retirement considerations enter the picture. These priorities limit risk-taking, which in turn limit innovation.

Source: Harry S. Dent, The Great Depression Ahead, 2009
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The 'Baby Boomer' demographic cohort is generally considered to encompass the generation born between 1946 and 1964. Thus, the first Boomers entered their prime innovation years during the early 1970s, and innovation likely peaked around 1980. The Boomers rode the information technology innovation wave, which was pioneered by 5 people born between the years 1954 and 1956: Bill Gates (Microsoft), Steve Jobs (Apple), Steve Ballmer (Microsoft), Scott McNealy (Sun Microsystems) and Eric Schmidt (Sun Microsystems, Novell). The innovations developed and commercialized by these creative Boomers generated enormous productivity gains throughout the 1980s and early 1990s.

Another innovation wave that occurred during the 1960s and impacted the economy through the early 1990s was the rise of feminism and the migration of women from the home into the paid workforce. GDP growth is simply the product of the growth of GDP per capita (productivity) and the growth in the working population. The migration of women from the home expanded the pool of paid workers, as homemaking was not, and unfortunately still is not, recognized as productive labour in GDP calculations. This magnified the gains from the information technology innovation wave, and significantly contributed to Western GDP growth during this period.

Source: Bureau of Labour Statistics, Mckinsey Global Institute
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The Asian Tigers capitalized on this innovation wave by developing their economies around domestic high-tech engineering, and manufacturing for export to a prosperous and fast-growing Western population which was rapidly adopting microcomputers and networking. They were further fed by the maturation of the Japanese consumption wave and credit bubble, which peaked in 1989. Without these massive external demand stimuli, Asian Tiger economic prosperity would have never gotten off the ground. They benefitted from thirty-five to forty years of growing Western demand while an entire generation of ‘Tigers’ was educated, entered the workforce, and gained middle-class levels of prosperity. This pervasive middle-class prosperity is one of the key defining characteristics of a mature capitalist democracy.

Despite over a decade of 7%+ GDP growth, China and India are still a very long way from achieving the same level of economic prosperity as the Asian Tigers. Further, their domestic economies are still highly reliant on exports for economic growth. This combination makes them especially vulnerable to a slowdown in demand from mature Western economies.

China and India captured very little of the information technology innovation wave that crested in the early 1990s because their rapid economic growth did not begin until the early 1990s. Instead, these countries have relied on, and to a large degree financed, the phase of Western growth from the mid-1990s through 2007 that was based largely on an increase in leverage. In the period from 1993 through 2005, U.S. households went from saving 8% of disposable personal income to spending almost 1% in excess of disposable income. In the same period, U.S total debt to GDP, a measure of aggregate economic leverage, rose from 230% to over 350%. For context, the total leverage at the peak of the roaring 20s, before the 1929 stock crash, was 265%. It was 110% of GDP just prior to WWII, and rose to 143% at the peak during the war. This magnitude of debt creation is unprecedented in modern history, and is the legacy we leave to our children.

Source: CalculatedRiskBlog, Butler|Philbrick & Associates
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China and India, and to a lesser extent other developing nations in Asia, South and Central America, have relied on Western profligacy to sustain their economic ‘miracle’. The productivity benefits of innovation in Western countries peaked in the 1980s and early 1990s. Productivity gains experienced from the early 1990s through 2005 were largely, if not completely due to an expansion of debt ratios in developed economies.

If Westerners accrued so much debt, it is natural to ask, ‘who lent us all this money?’. The answer is that the export-driven economies of China, India, and Japan loaned Western economies money so that they could continue buying their exported goods. Chinese, Indians, and Japanese are excellent savers. The Chinese save almost 40% of their disposable income. Income earned from exports goes directly into savings, and this savings is lent to Western consumers so that they can continue to spend. This global vendor-financing arrangement suited everyone until Western consumers ran out of borrowing capacity.

Source: Brad Setser, Council on Foreign Relations

Western consumers felt comfortable spending more than they earned so long as their assets, in the form of homes and stock portfolios, were growing faster than their liabilities. Why should one save an extra $5,000 per year when the savings are dwarfed by the increase in the value of one’s home? If the value of one’s assets are increasing by $20,000 per year, why not spend the extra $5,000 on a vacation? Better yet, why not borrow $10,000 against the $20,000 increase in the value of the home to finance a down-payment on a car lease?

Homeowners extracted record amounts of equity from their homes over the past few years to finance lifestyles beyond their means. Thirty years ago, those Americans with mortgages owned 50% of the equity in their houses. Now they own less than 20%. At the peak in 2005, home equity withdrawals directly financed almost 10% of GDP!  For many people, their home is their principal asset, and they relied on constant appreciation in the price of this asset to fund their retirement. With U.S. home prices down 25 or more percent from their peak, a record number of homeowners now owe more on their mortgages than their house is worth. This has had a devastating impact on people’s sense of wealth and stability.

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This same dynamic is at play across the globe, with property values down precipitously in many parts of Europe, the Middle-East, and Asia. Commercial properties, such as hotels, condominiums, and malls, are experiencing massive drops in value.

With consumers unable to increase their spending, governments around the world have stepped-in to fill the void. U.S. government deficit spending this year is a whopping 15% of GDP. Chinese spending and loan growth amounts to nearly 35% of GDP. U.K. and Japanese deficit spending is at record levels. Yet even with this record stimulus, GDP is likely to contract this year in all of the above countries save China. Put another way, government is stimulating the economy to the tune of 15% of GDP, but the economy is not growing. How much must the rest of the economy be contracting so that a 15% adrenaline shot can not kick-start growth?

It is important to recognize that deficit spending is nothing more than the government attempting to bribe its citizens with their children’s money. Deficit spending during times of economic weakness was first advocated by Keynes in the early 20th century. Keynes suggested that governments might attenuate normal boom and bust cycles in the economy by increasing spending during recessions to replace slack demand. Deficits incurred during these periods would then be paid back when the economy recovered.

Unfortunately, the 4 year political election cycle works against Keynes’ policy recommendations. When times are tough, politicians generally have no problem loosening the purse strings. However, when the economy is growing, politicians find reasons to cut taxes and expand programs rather than paying down deficits. Thus, Western democracies have spent over 80% of years since Keynes’ policies were first introduced incurring deficits despite the fact that the economy has been in growth mode more than 90% of the time.

At this point, one is likely asking, ‘So what is the solution?’ In this age of flu shots, antibiotics, high-fructose corn syrup, on-demand video, Rock-Star energy drinks, Ultimate Fighting, and 24 hour business news, it may come as a shock to discover that the answer can not be summarized in a 140 character ‘Tweet’ a la Twitter.

The inescapable truth is that the only sustainable solution to the current crisis is a prolonged period of retrenchment and slower growth around the world. Boomers will have to work longer to afford  less robust retirement lifestyles. Unemployment will remain elevated for many years as producers adjust to a period of significantly lower aggregate demand. Enormous overcapacity in manufacturing and real-estate will result in low inflation and, for a while, deflation in the price of goods. People that lived beyond their means for many years will spend many years living below their level of disposable income as they use more of this income to pay off debt. Families will lose their homes and will end-up renting or living with family members. Income levels will fall across the spectrum, but incomes in the highest brackets, such as those of bankers and tort lawyers, stand to fall the most. People will travel less, camp more, golf less, and spend more time with their families. People in large cities will finally meet their neighbors, but they will gather for barbecued hot-dogs instead of Kobe strip-loins. Families may start raising their own children instead of outsourcing to day-cares and nanny services. Married children will be more likely to settle close to their parents to raise their families.

Notice that some of the above outcomes do not sound all that bad. In fact, during periods of economic retrenchment, cultures tend to get back in touch with core beliefs and values. Obesity levels and the incidence of stroke and heart-disease are reduced. Divorce is less frequent as individuals are less likely to perceive that the grass is greener elsewhere. This is bad news for ubiquitous divorce lawyers, but great news for community attachment, which in turn lowers levels of juvenile delinquency, and drug and alcohol addiction.

What does this mean for stock and bond portfolios? It almost certainly means that stock and bond prices are likely to drop substantially over the next few years once this rally runs its course in the next few weeks and months. Real return expectations must be lowered, and financial plans must be re-visited. Savings must replace portfolio growth as the means to financial independence. ‘Buy and Hold’ or, more accurately, ‘Buy and Hope’ strategies will prove disastrous for a while. Investors must position themselves to take advantage of large market swings rather than a long period of rising prices. Trading is in, investing is out.

In summary, global citizens have enjoyed an almost unprecedented period of economic prosperity and peace. This period was a natural consequence of several positive trends catalyzed by post WWII euphoria. Boomers drove an innovation wave in technology, and women around the world joined the workforce to drive a wave of GDP growth and productivity from the late 1960s through the early 1990s. Once innovation and the feminist movement crested in the early 1990s, Western citizens refused to curtail extravagant lifestyles born of prior innovation waves. Like an alcoholic who drinks coffee to keep the party going, Westerners turned to debt to sustain their excessive spending habits. But coffee can only delay the hangover for so long. One can hear the sirens in the distance. And when they raid the house of ill repute, even the good girls and the piano player go to jail. 

The Fallacy of Cash on the Sidelines

Merrill Lynch posted the results of its most recent Survey of Fund Managers for August this morning. The survey covered 204 fund managers in 80 countries who control $554 billion in assets, and the data dispels the myth of excess cash on the sidelines.

Barry Ritholtz at summarized the findings. Note that U.S. markets peaked in September 2007:

• Cash balances plunge to 3.5%, lowest since July'07;

• Highest equity allocation (34% from 7%) since Oct'07;

• Bond allocation (-28% from -12%) lowest since April'07;

• Tech (28%) is the most favored sector everywhere.

Barry concluded, 'While I keep hearing about cash on the sidelines, the professionals seem to be "All In."'

As an addendum to the Merrill Lynch survey (full release pasted below), please see the attached chart of US commercial paper and Money Market assets. The chart was originally posted by using US Federal Reserve data. Annotations in red are my own.

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Conclusion: Investable Money Market fund assets are no higher than at the peak of markets in September 2007. Retail holdings of MM funds have now retraced to the levels of Sept 2007. The spike in Institutional MM assets from Sept 2007 is exactly equivalent to the drop in CP assets over the same time period, offering compelling evidence that companies have simply moved treasury working capital out of CP and into IMM funds. This is NOT parked investment capital, and is unlikely to find its way into stocks.

Investors appear to be exactly as fully invested as they were in September 2007, at the peak of the bull market. This dovetails nicely with the Merrill survey.

That said, the Primary Dealers are swimming in reserves. Liquidity parked in Securities Open Market Accounts at Primary Dealers is also back at September 2007 levels (See PD Liquidity Chart). If the money-centre banks decided to leverage these reserves into the system, they could single-handedly push stocks, commodities and corporate bonds higher. It remains to be seen whether banks will hold these as reserves against 'Level III' assets on their balance sheets or put it to work speculating.

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Original Press Release


Questions over Imbalances in Early Stages of Recovery
NEW YORK and LONDON, Aug. 19 /PRNewswire/ -- Investor optimism about the global economy has soared to its highest level in nearly six years, with portfolio managers putting their cash back into equity markets, according to the Merrill Lynch Survey of Fund Managers for August.

A net 75 percent of survey respondents believe the world economy will strengthen in the coming 12 months, the highest reading since November 2003 and up from 63 percent in July. Confidence about corporate health is at its highest since January 2004. A net 70 percent of the panel respondents expect global corporate profits to rise in the coming year, up from 51 percent last month.

August's survey shows that investors are matching their sentiment with action, by putting cash to work. Average cash balances have fallen to 3.5 percent from 4.7 percent in July, their lowest level since July 2007. Equity allocations have risen sharply month-over-month with a net 34 percent of respondents overweight the asset class, up from a net 7 percent in July. Merrill Lynch's Risk and Liquidity Indicator, a measure of risk appetite, has risen to 41, the highest in two years.

"Strong optimism in August represents a big turnaround from the apocalyptic bearishness of March. And yet with four out of five investors predicting below trend growth for the year ahead, a nagging lack of conviction about the durability of the recovery remains," said Michael Hartnett, chief global equities strategist at Banc of America Securities-Merrill Lynch Research. "The equity rally has been narrowly led by China and tech stocks. We have yet to see investors fully embrace cyclical regions such as Japan or Europe, or Western bank stocks."

Lasting recovery requires greater balance

Global emerging markets, led by China, and technology stocks are the strongest engines behind the early recovery. Investors would rather be overweight emerging markets than any other region, and by some distance. A net 33 percent of the panel prefers to overweight emerging markets while investor consensus is to remain underweight the U.S., the eurozone, the U.K. and Japan.

Technology remains the number one sector, with 28 percent of the global panel overweight the industry. Industrials and Materials lag with global fund managers holding 11 percent and 12 percent overweight positions respectively.

Further behind are Banks. Global fund managers remain concerned about the sector, holding a 10 percent underweight position. In contrast, investors within emerging markets are positive about Banks with a net 17 percent of fund managers in the regional survey overweight bank stocks.

Some of these sectoral and regional imbalances are starting to erode, however. Global fund managers have scaled back their underweight positions in bank stocks from 20 percent in July. Industrials and Materials have recovered from underweight positions one month ago. Emerging markets are less popular than in July when 48 percent of the panel most wanted to overweight the region. And Europe is a lot less unpopular. In July, a net 30 percent of respondents wanted to underweight the eurozone. That figure has dropped to just 2 percent in August.

Improved outlook for Europe, but investors drag their feet

Within Europe, fund managers appear as excited about the outlook as their global colleagues. A net 66 percent of respondents to the regional survey expect the European economy to improve in the coming year, up from a net 34 percent in July.

The net percentage expecting earnings per share to rise nearly trebled, reaching 62 compared with a net 23 percent a month ago. Investors in the region took an overweight position in Basic Resources, a cyclical sector, and radically scaled back their overweight position in Pharmaceuticals, a defensive sector.

In contrast to global respondents, those in Europe have failed to inject new money. "European growth optimism has finally caught up with other regions, but fund managers have yet to fully act on this and cash levels have actually increased and overall sector conviction is near record lows," said Patrik Schowitz, European equity strategist at Banc of America Securities-Merrill Lynch Research.

Survey of Fund Managers

A total of 204 fund managers, managing a total of US$554 billion, participated in the global survey from 7 August to 12 August. A total of 177 managers, managing US$370 billion, participated in the regional surveys. The survey was conducted by Banc of America Securities - Merrill Lynch Research with the help of market research company TNS. Through its international network in more than 50 countries, TNS provides market information services in over 80 countries to national and multi-national organizations. It is ranked as the fourth-largest market information group in the world.

Saturday, August 22, 2009

Forever Blowing Bubbles

Those tortured souls who have thus far clung faithfully to the rules of capitalism, finance and economics they learned in business school have surely been disillusioned by the markets' most recent break to new highs. Like children who have finally relinquished the corporeal reality of Santa Claus, these poor souls may be searching for new rules and theories to legitimize their discipline. After all, we can't all be technical analysts, can we? Someone has to take the first step, buy the first shares in order to break a stock to new highs and trigger the technical feeding frenzy!

Those looking for new meaning in the markets may have already discovered the refreshing empiricism of behavioral economics to fill the theoretical void left from the now incontrovertible refutation of the efficient markets hypothesis and CAPM. Surely everyone now realizes that the only factors that impact asset prices are liquidity and sentiment. The former is measurable, though definitions vary considerably. Volume, cash on the sidelines, monetary growth and velocity, reserves held at Primary Dealers and foreign capital flows all contribute to a predictive measurement of liquidity. Sentiment is more esoteric, but can still be measured using surveys and studies of actual trader commitments. Of course, sentiment is only really predictive of market direction when it reaches extreme levels; extreme levels of bullish sentiment often signal important market tops (who is left on to buy more stock?), while extreme bearishness often signals market bottoms (who is left to sell stocks?).

James Montier of Societe Generale is perhaps the most widely followed practitioner of behavioral finance (as opposed to researchers and theorists like Thaler, Kahneman, Tversky and Smith). A recent missive of his was particularly interesting, as it described the results of a remarkable experiment in behavioral finance that may have some bearing on the present market environment.

From the report:

"As the US market is now back at fair value [950 at time of writing], I've been pondering what could drive the market higher. Jeremy Grantham provides some answers in his latest missive to clients. He argues that "the greatest monetary and fiscal stimulus by far in US history" coupled with a "super colossal dose of moral hazard" could generate a stock market rally "far in excess of anything justified by…economic fundamentals". This viewpoint receives support from the latest finding from experimental economics. The evidence from this field shows that even amongst the normally well behaved 'experienced' subjects, a very large liquidity shock can reignite a bubble!"

Mr. Montier then goes on to describe the results of an important study involving experimental markets (in which participants trade an equity-like asset against one another in a simulation), which suggests that experience helps to prevent bubbles - but that it takes more than one experience to change behavior. Explains Montier, "The first time people play the game, they create a massive bubble (like the bubble). The second time people play the game, they create yet another bubble. However, this seems to be driven by overconfidence that this time they will get out before the top. The third time subjects encounter the game, they generally end up with prices close to fundamental value."

To reiterate, experimental results indicate that even subjects who have experienced the euphoria and losses from the creation and eventual implosion of one market bubble will almost always go on to create another bubble under similar conditions. When surveyed after the fact to explain why they made the same mistake a second time, subjects overwhelmingly indicated that they were confident they could get out ahead of the crash. When subjects realized after their second failed attempt that they were unlikely to outsmart the bubble, they finally refused to create a bubble on their third encounter with the game.

Of particular interest in today's environment, the experimenters took the simulation one step further to discover whether, under the right conditions, they could cause the same experienced participants to create yet another bubble. It turns out that all it takes to re-ignite another bubble among experienced game participants is a massive liquidity injection. To wit, "new research by the godfather of experimental economics, Vernon Smith, shows that it is possible to reignite bubbles even amongst the normally staid and well behaved subjects who have played multiple bubble games. The key to this rekindling is massive liquidity creation. In fact, in his experiments Smith doubled the amount of liquidity available."
Why is this relevant to today's market situation? For starters, the Fed has essentially doubled the monetary base from $850 billion to $1.7 trillion in the past 12 months. Keep in mind that, given the leverage in the system ($~2 trillion in money supplied by the Fed supporting $56 trillion of credit), this has the potential to create a liquidity shock of epic proportions.

Source: FRB

However, given the stagnation in the growth of monetary aggregates (M2 and MZM), banks are not currently leveraging these new reserves. In fact, of the $850 billion added to the monetary base by the Fed, $733 billion has been re-deposited at the Fed by the money-centre banks rather than serving as reserves against new credit creation, suggesting that banks are not yet ready to initiate a new credit cycle. I have attached to charts to this email from the St. Louis Fed for illustrative purposes.

Source: FRB

In conclusion, the Fed and other central banks (notably the Bank of China) have certainly done everything in their power to create the elements necessary to catalyze another asset bubble powered by a new wave of credit creation by the money-centre banks. It remains to be seen whether markets will fall for the same trick a third time. Should the Fed succeed, and new bubbles form, investors would be wise to heed the lesson learned by participants in the market simulation cited above, and beware the trap of overconfidence. Not every investor can be quick enough to avoid the inevitable burst - are your tools up to the task?