Wednesday, June 11, 2014

On complacency, sentiment and inflation...

In last Thursday's Wall Street Journal, Dan Greenhaus listed 26 things investors are worried about and chided the pundits who believe complacency has gripped the stock market.

A snippet:
“We get that there are no shortage of indicators to which pundits may point as evidence investors are missing their warnings/concerns,” Mr. Greenhaus said. “However, from our vantage point, there is one indicator to rule them all; our client conversations. And our client conversations clearly suggest there are no shortage of worries.”

“To say investors are ‘complacent’ is, in our minds, utter and total nonsense,” Mr. Greenhaus said. “There is much to worry about as there was in 2010, 2011, 2012 and 2013. And worry everyone did.

But let’s be honest; saying others are ‘complacent’ is a shorter way of saying ‘I’ve been concerned about X and thought Y would happen as a result..and it didn’t, so everyone else must be complacent,’” he added. “Because an outcome someone thought might happen didn’t happen, doesn’t mean others are complacent. It means they were correct.”

Greenhaus's tune should be music to the ears of those who worry that the market is on the precipice of at least a decent correction. I've stated numerous times that if I were a market timer, which I ain't, investor sentiment would be the indicator with the highest influence on my trading activity.

And while I don't doubt for a second that Greenhaus's firm's clients are voicing their concerns, the data isn't suggesting that they're putting their money where their fears are. When I look at the AAII (individual investors) Sentiment Survey showing rising bullishness (from 28% to 45% over the past month), the current Consensus Index (professionals) at 62% bullish (a high reading), the volume of puts running at about half the volume of calls, short interest for the S&P 500 at a 52 week low,  and a very tight junk bond spread, I'm thinking investors are feeling scary-bullish. And that should worry anyone who worries over the potential for near-term downward volatility. I.e., market corrections are often preceded by high levels of optimism.

Now, being a long-term investor/advisor who knows he doesn't know (nor, honestly, care all that much about) what the market's about to deliver in the short-run, I look at lots of other stuff too.

Such as, all the economic data my brain can digest, which, on balance, could be signaling continued growth---maybe even an acceleration into the back half of this year. Some of the highlights come from places such as the recent ISM Manufacturing and Non-Manufacturing Indexes, the NFIB Small Business Optimism Index and this Year's CEO Roundtable survey, all of which point to a pick up in capital investment and hiring going forward. Not blowout numbers mind you, but maybe enough to move the needle a bit on the economy. (Notice all the "maybes" and "could bes". The economy, like the market, is difficult (if not impossible) to predict)...

As for market valuations, while there are areas that we're paring back due to high relative valuations, in an overall sense I can't say the market looks expensive or cheap. So, "fairly valued" sounds fair to me. My sentiment there will change if earnings begin to accelerate faster than share prices (cheaper), or if multiples expand (expensive), or if interest rates rise a bunch (expensive).

Speaking of interest rates, that's the one signal that might suggest there remains substantial pessimism out there. I mean, if everyone's so bullish about the stock market, shouldn't they be selling bonds (pushing up interest rates) and buying stocks? Of course, as I suggested recently, low bond yields could mean other things as well.

Lastly, I can't speak of interest rates without speaking of inflation, since inflation is the one thing that will surely force interest rates higher. By standard measures such as the Consumer Price Index (CPI), the Personal Consumption Expenditures (PCE) Deflator and the TIPS spread (the yield spread between treasury inflation protected bonds and regular treasury bonds), inflation---and expectations for inflation---remains tame. However, as I look at things such as the ISM's reported rising costs of commodity inputs, rising employment costs in some sectors, and the inching higher of capacity utilization, I'm seeing the potential for a pick up in inflation going forward.

That said, what I'm not seeing is what today's commentators all too often fail to mention: that you really can't have true inflation---by today's definition (all things rising in price)---without an increase in the money supply. Think about it, if the increase in California's minimum wage means you have to pay more at your favorite restaurant, if you don't have more money than you did before the wage hike---and you insist on eating out---you'll sacrifice something else. As that happens en masse the lower demand for all those something elses will force their prices lower---offsetting the higher price of a meal out. Only when there's an increase in the amount of money in circulation can we have true inflation. And, contrary to what I know you're thinking, there has been very little increase in the supply of money circulating. Most of that money the Fed's been "printing" sits in bank excess reserve accounts at the Fed. Now, should that money start moving, should we see a pick up in "velocity" (the measure of money turnover in the economy)---which I suspect, at some point, we will---then we'll have something to talk about.

As you can gather from the St. Louis Fed's Velocity of M2 Money Stock chart below---if inflation is caused by a growing amount of money chasing goods and services at a pace exceeding their production---inflation has remained tame due to a general lack of chasing:

velocity of m2

Bottom line:

Presently high bullish sentiment substantially increases the odds of a near-term correction. Take heed if you're a short-term trader. Take a deep breath if you're a long-term, risk tolerant investor, and stay your course---after perhaps hedging a bit for future inflation.

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