Published on September 28, 2015
1. Investors witnessed another rally in Pan American and European equities in June 2014. On the 5 th June European Stocks neared a 6 year high and Germany’s DAX Index briefly topped 10,000 for the first time, Bloomberg, 5 th June 2014. Global stocks also hit a new all time high on Monday 9 th June, with the FTSE All World Index trading at 281.48. This activity occurred on the back of the record rally on the S&P 500 in the US which went above an all time high of 1900 basis points earlier in June. Investors seeking to profit from bullish sentiment in the market may be buoyed by another happy coincidence, volatility on the stock markets of Europe and America neared multi year lows in June. Wall streets ‘Fear Guage’ the VIX (Exchange Volatility Index) hit 11.5 by Friday 7 th June, the same week as the surge in the stock markets. Along with a similar index for global currency volatility the VIX is flirting with lows that have existed for centuries. For risk averse investors, a tanking VIX may give confidence to call the top of the market and become a catalyst to throw caution to the wind and pile into stocks where they otherwise would not. This is not altogether surprising as in theory the VIX reflects the price investors are prepared to pay to insure against future volatility in equity portfolios, thus acting as a gauge of future volatility. The lower the VIX the less fear there is in the market. The consensus view is that such lows in volatility bounce off perceptions that ‘official interest rates will remain exceptionally low for a long time’, Financial Times, Ralph Atkins & Michael McKenzie, 9 th June 2014. In our view this type of punditry from the corporate mainstream only serves to fuel speculation in this market. Linear analysts have previously discussed the high stakes bet we believe stock investors in America are making with the S&P and DOW, assisted by the sentiment survey industry, in a classic hedge on tightening of central bank liquidity. Stock and Debt Securities Rally: Is There Safety in The Numbers? Prepared by Dr. Marcus Bent, Head Of Global Wealth Y O U R E Y E O N T H E F I N A N C I A L M A R K E T S Research Note 4 24th June 2014 T H E F U L L R E S E A R C H R E P O R T I S M A D E A V A L I A B L E T O T R A D I N G C L I E N T S O F E N G F I N C A P I T A L M A N A G E M E N T We believe this will have market moving implications in 2014/15, more of which we will discuss later. For the average investor trying to make sense of all the data there may be a temptation to resort to a baseline reduction like, this must all mean risk is low and returns are high right? This would be incorrect in our opinion. Linear analysts take the view that most of the recent rise in stock market performance in the USA and hence Europe is based on valuation anomalies, not on company profits or productivity. For example analysis by the USA Commerce Department's Bureau of Economics suggest profits by U.S corporations fell 13.7% in Q1 2014 alone, Reuters, May 29 th 2014. US company profits are therefore the lowest since 2010 and dropped sharply from the record highs produced in the last 2 years. The fall in US corporate profits is contextualised by a general slowdown in the US economy. According to the same report real GDP in the first quarter fell at an annual rate of -1.0 per cent. Optimism in the US equity market seems to be misplaced, but can be explained. Linear analysts reported in March that Margin Debt on the NYSE hit a record high in the same period as the market surge Q1 2014 and currently stands at over $451bn against brokerage accounts, (see Linear report, An Analysis of Risk in Global Capital Markets’ 06 /03/2014). This means investors have levered themselves to the ears, courtesy of loans direct from central banks, in order to speculate on stocks, pushing stock values higher. To illustrate the principle of co-determination between the S&P 500 and margin debt, see graphs A & B overleaf. If one compares the performance of the S&P 500 1998-2014 (Graph A) and margin debt over the same period (Graph B), it is clear the movement of one index tracks the other closely.
2. Stocks & Security Rally: Is There Safety in Numbers (cont.) Graph A: (S&P 500 Index) Graph B: Margin Debt Index T H E F U L L R E S E A R C H R E P O R T I S M A D E A V A L I A B L E T O T R A D I N G C L I E N T S O F E N G F I N C A P I T A L M A N A G E M E N T
3. The S&P 500 index tested resistance levels of 1,500 basis points in 2001 and 2008 and briefly brakes out of this range before a market correction ensues. This phenomena roughly coincides with peaks in margin debt on the NYSE in 2000 and 2007 at approx. $2.7bn and $3.7bn, respectively. The slight time lag between bursting of the margin debt and speculative bubbles on the NYSE in this time frame are in line with what one would expect as risk averse retail investors buck the trend and typically pile into the market at the top of the curve. The ‘twin peaks’ oscillation in the indexes in this time frame is stark. This should tell investors a couple of key things: between 1998-2014 the S&P index tracks rising debt allocation to speculators. The movement also suggests we are nearing the top of both indexes. Investors should now turn attention to what happened to the S&P 500 after margin debt topped in 2000 and 2007! Also look at how far above those tops the current high is. Linear analysts believe this is not good news for equity portfolio holders going forward. The news on valuations doesn’t get any better unfortunately. The New York Post recently reported that companies on the S&P 500 issued a record amount of debt in Q1 2014 (around $160bn) mostly used to buy back their own shares in order to return value to shareholders. This again has inflated the value of stocks. This suggests corporate America is the US stock market’s biggest customer this year and companies like APPLE, IBM, Goldman Sachs, Exxon are driving up share price through alternatives to productivity. Debt issuance for buy backs has not only ‘propelled the DOW and CEO compensations to new records, but has also propped up the equity market around a time when stock market volume plummeted by around 15% April to May 2014. Current stock market volume is approx 19.5% lower than the five-year average’, New York Post, John Byrne, May 31, 2014. In other words what investors are seeing is a speculative bubble in the equity markets. Judging by the current focus on the rally in securities in the business press, Linear analysts suspect many investors have not been given the full picture about the low volatility we are witnessing. Right now volatility in equities, currencies and bonds are near historic lows. This should not happen in ordinary market conditions. Wily investors will know that people flock to equities in the good times and away from lower risk investments like bonds. High volatility in the equity market usually occurs during periods of low volatility in the bond markets when the trading ranges on yields tend to be more narrow and vice versa. Investors are also advised to consider another peculiar feature of these markets. From the year 1990 to date, near record lows in volatility of bonds and equities have only occurred at the same time twice. Three guesses for when? In 1998 and 2007. A significant market correction has followed each time. Investors are no doubt starting to see a similar pattern emerge now. The parallel between current bond and equity markets do not end with volatility levels. The activity of corporations and those of the central banks are moving in alignment in a worrying fashion. Investors would do well to remember the central banks have re- written the book on interference with the free market in the last 6 years and are essentially another big market participant engaging in buyouts of whole market sectors, namely through purchases in the mortgage and treasury securities sectors. Large corporations seem to have realised fair value can no longer be driven by fundamentals so consequently have attempted to copy central bank policies. Linear analysts believe recent share buyback trends have evidently inflated asset prices temporarily and reduced market liquidity. The by-product of this activity is that ordinary investors are being pushed out of both markets, assets are being hoarded by fewer counter-parties and liquidity is slowly drying up. This is a worrying trend. Shrewd investors will be attuned to the signal the market is sending through sky high valuations and will look at rebalancing their portfolios in the short term. For all the reasons cited above it is our view that the stock markets in America and Europe are in bubble territory and may be due for a significant correction in 2014. A prudent fund manager with a focus on preserving wealth will advise clients to immediately manage this risk, as our portfolio managers have done. For further information contact Dr Marcus Bent, Head of Global Wealth, Linear Investments Ltd. Our analysts work closely with our portfolio managers to present clients with opportunities on an advisory & discretionary basis. Our flagship Cassandran Hedge portfolio is uniquely structured to take advantage of long-term emerging trends. These are mixed with highly active trading strategies whilst implementing a capital protection approach in line with our contrarian view. T H E F U L L R E S E A R C H R E P O R T I S M A D E A V A L I A B L E T O T R A D I N G C L I E N T S O F E N G F I N C A P I T A L M A N A G E M E N T
4. The return of investor appetite for fixed income products is one of the big market stories of 2014. A bounce in bond prices has been most keenly felt in the UK and America where borrowing costs are currently near 300 and 240 year lows respectively. According to Bloomberg, bond yields have halved in the last 5 years to an average of 1.78%, bringing options on US Treasuries to within 0.1 percentage point of an all time low, Bloomberg, June 16, 2014. At the same time, the difference between the yields of 5 and 30 year securities has narrowed to the lowest point since 2009 as the long bond rallied, Bloomberg, 23 rd June 2014. The record low yields evident in bond markets around the world this year would suggest investors are flocking back to low risk investments. If ever there were a litmus test for revival of debt markets this year, demand for European Sovereign debt is a good candidate. The popularity of this type of investment surprised many this Easter. Portugal which had only returned to the bond market in January 2013 after exiting in April 2011, managed to raise €6.25bn through sales this April. Portugal's 10 year securities, which if one remembers were trading at yields of 18.29% in January 2012 sold for value $1.04bn. In the same month Greece resumed its debt sales so successfully that it had to limit debt issuance to €3bn from an order book of €20bn, CNN Money, April 10 th 2014. Cyprus beat all market expectations when it returned to the bond market in June 2014 with a $1.02bn bond valuation for 5 year debt from an order book of €2bn, Reuters, June 18 th 2014. As the country that set the bank bail in precedent for Europe last year, Cyprus wasn’t the obvious candidate for the fastest comeback to the market of any bailed out euro zone country. Yet many investors chased yields which gave Cyprus among the highest returns for 5 year debt in the euro zone! Bond Investors it would appear have short memories and are piling into investments they would not have touched with a barge pole as recently as a year earlier, as in the case of Cyprus. With Portuguese 10 year securities now yielding at roughly half the level of January 2011 (3.35%), 10 year Greek debt yielding around 5.75% (less than a third of levels in January 2012), and 5 year Cypriat debt yielding among the lowest for the peripheral region at 5.85%, the temptation may be there for investors to use bonds to hedge more risky bets in the market. Linear Investments analysts believe few investors in peripheral debt are stopping to ask themselves whether the growth expectations in said countries in the range of -3.9% to 0.8%, warrant current bond valuations. To illustrate the point, growth is barely above negative territory in the euro zone and the economies in question were in solidly negative territory last year (Greece -4%, Portugal -1.8%, Cyprus -8.7%), EUbusiness.com, 5 th November, 2013. Whilst bond values soar and yields drop investors are eyeing the opportunity as opposed to the cost. In the fast moving bond markets of 2013/14, a couple of months appear to be a long time! Liquidity in the international bond market has recently become a serious issue. On 16 th June, Bloomberg reported on risk in the bond market, “A boom in fixed income derivatives trading is exposing a hidden risk in the debt markets around the world: The inability of investors to buy and sell bonds”. It would appear that whilst the value of government bonds soar and yields are at record lows, trading volume in some maturities has plummeted by a third as investors pile into derivative contracts to hedge against future rate rises. One casualty is the market for day trades, particularly for large order trades. For example 'In Japan's $9.6 trillion debt market, the second largest in the world, the benchmark Note opened late 4 days and didn't trade until midday for 2 of those days, in 2 nd week of June 2014’. This was largely due to lack of volume. Japanese bonds failed to trade at all on April 14 th that year the first time since 2000. In other words Japan's bond market “virtually ground to a halt” as its central bank took 70% of the interest-bearing debt trade that month leaving little for other counterparties to buy. According to Bloomberg, a similar lack of liquidity occurred in Italy last month, the World’s third largest Sovereign bond market, causing transaction costs to spike and an eightfold surge in Italian futures'. Although the decline in daily trading volume in bonds may have accelerated in recent months, this seems to be part of a longer term trend. The fact that Italy, Europe’s second largest Sovereign debt market worth some $2.43tn, saw daily trading volumes fall by 57% in the last decade whilst derivatives have soared by 800%, should make all investors in the regions debt pause for thought. Debt Reduction Predicts Growth in US: Is Yellen’s Word Her Bond? For those investors who think the American bond market is a safer refuge from liquidity risk, think again. ‘Even the US which has the deepest most liquid government debt market worth more than $12tn has seen buying and selling activity shrink’ at a time when bonds have seen stellar performance. For instance, weekly trading of US T-Notes with maturities of between 7 and 11 years fell by 32% ($96.3bn) from a year ago’, according to Bloomberg, June 16 th . Another casualty is dealing volume in the bond market is starting dry up. Bloomberg reported that ‘global dealer inventories have declined by 75% since the start of the crisis in 2007. Five of the 6 biggest Wall Street firms said trading revenue fell in fixed income divisions in Q1 2014’. The view of the mainstream is that this is an unintended side effect from central bank monetary policy to purchase debt and keep rates low. The concern now is that ‘investors may be more vulnerable to losses when yields rise from historic lows leading to a “squeeze” as they try to exit their positions’, Bloomberg, Anchalee Worrachate and Liz McCormick, June 16 th , 2014. As we approach Q3 2014, a curious situation exists in the international bond markets. On paper, bonds, particularly US and UK, look the most appetizing they have done for years, yet ordinary government bond buyers are crowded out of the market by the official sector, are forced into derivative contracts (bond securities) worth $100tn and may not be able to exit all positions as the market turns and rates rise, due to lack of buyers. To add to the slightly surreal feel of current bond markets, central banks are showing no sign of reversing the historically low base rates and tapering that are now draining liquidity and volatility from the bond markets
5. Debt Reduction Predicts Growth in US: Is Yellen’s Word Her Bond (continued) Shrewd investors might think that a low rate environment will be difficult to justify for much longer in view of growth projections for the UK and America. However if tapering proceeds unabated as the liquidity crisis continues in the bond markets and this causes values to start falling rapidly, Linear analysts believe investors will start to ask serious questions before investing in debt or keeping capital in that market. The first question the central banks have so far dodged and will have to answer is why after 6 years have emergency measures like zero/negative interest rates and QE not succeeded at injecting sufficient liquidity into the bond markets? The second question is why central banks still own most government debt and cannot sell it, 6 years on? Our guess is the banks cannot answer these questions in a satisfactory manner. The plain truth is interest rates have been kept low to prevent deflation from spiraling, there is no plan B, and plan A is starting to unravel and the bond markets are picking up on this signal. If growth falters in the UK, US or the euro zone and the central banks are forced to admit ZIRP and QE are a permanent feature of the landscape, the printing presses will start up again, and investors will realise the game is up and exodus the bond markets en-mass. In the meantime the US FED appears to be oblivious to the deflationary risks inherent to the large scale reduction of bond purchases and historically low rates, even though this is now beginning to impact liquidity, volume and volatility in the international bond markets. On the 18 th June, Janet Yellen announced in a FED news conference that ‘growth was bouncing back and the job market was improving’ as it reduced the monthly pace of asset purchases by $10bn for a fifth straight meeting, Bloomberg, Cordell Eddings, June 23, 2014. Linear analysts believe that by ignoring this risk Janet Yellen is playing with fire and bond investors will be one of the biggest casualties. The squeeze in liquidity in international bond markets has surprised Linear analysts much less than the timing. Whilst the market looked on in wonder at the surge in the bond markets this year, our analysts were warning investors about risk in this market. In fact we anticipated a liquidity squeeze much earlier in the tapering cycle, in tandem with a spike in short and long term rates in Europe and America. The combination of these outcomes we thought might threaten to derail asset purchases much earlier than appears to be the case. For example In March 2014 we warned investors that a $10bn per month reduction in asset purchases by the FED and the effective removal of the biggest buying counter party for US Treasuries would lead to deflation risk in the bond markets of Europe and America in 2014. We noted that a spike in 10 year T-Notes and Gilts both of which virtually doubled in value to around the 3% mark over 8 months last year and a spike in the normally stable German Bund, after taper speculation last summer, was a prescient warning to investors. We also warned investors that this would be just the start of the problem as the $440tn worth of interest linked swaps in the global derivatives market began to unwind. In the view of our analysts “the sheer size of the liabilities floating around in the credit derivative market render alternatives to QE an absurdity, (See Linear report: 'An Analysis of Risk in Developed Capital Markets', 6 th March 2014). For bond investors the question of why a rupture in the debt markets has not followed tapering by the FED, matters now more than ever. As we saw last summer, if the market does eventually react negatively to the tightening of credit, bond yields could spike and many bond investors will find themselves trapped. At that point investors will feel the current bond market liquidity squeeze much more keenly as they struggle to find willing buyers for debt. The market has offered some explanation for the fact bond yields have tanked and not spiked this year. Susan Walker of Bloomberg offered a view shared by many in the market that a $460bn dollar shortfall in the debt supply is the reason bond values have increased, Bloomberg, June 10 th , 2014. Therefore the view of the mainstream is that removal of debt from the market through central bank asset purchases has decreased debt supply globally and pushed bond yields down. Linear analysts and many others believe this simply does not stand up to scrutiny. In the context of $4tn plus extension of the FED’s balance sheet since 2006, and a substantially larger increase in the balance sheet of the BOJ, a $460bn dollar reduction in the debt supply should not drive bond yields to record lows. Linear analysts think the critique put forward by Michael Pento of Pento Portfolio Strategies LLC is highly persuasive. Citing data on American fiscal policy in the last 15 years he shows that record low T-Note yields are not correlated to debt levels seen in recent times. For example yields on 10 year T-Notes were trading in the 5-6% range between 1998-2001 when the US ran a budget surplus ( 0.6% - 2.2% GDP), and nominal debt was on average $5.5tn. If yields are correlated to the debt supply it is unlikely 10 yr T-Notes would now be trading at half the yield spreads of 14 years ago when the current US budget is in deficit (negative 3% GDP) and nominal debt is now three times higher ($17.5tn).
6. So what then of a credible explanation for bond yield performance during the taper cycle? Michael Mackenzie and co at the Financial Times delivered the knockout blow on taper talk recently. According to their analysis the FED may not be tapering asset purchases in any meaningful way at all in 2014. It appears the Bank of Belgium has been buying US treasuries at an alarming rate recently. For example ‘Belgium’s holdings of US debt rose by $30.9bn this February alone, according to US Treasury data released 8 th April 2014’. Since last August, the month before tapering was announced, US Treasury debt attributed to Belgium more than doubled from $160bn to $341.2bn, according to official US data. This means a small country with a population of 11m, no previous record as a financial centre in Europe, has this year become the third largest holder of US Treasuries, a holding almost equal in size to its Gross Domestic Product ($484bn). In view of this information bond Investors may not be surprised to learn that the FED reported a record weekly drop of $105bn in foreign holdings of US Treasuries in March 2014. It would also appear that Belgium is not a unique case. Euroclear, which holds more than €22tn worth assets under custody announced its volume of US Treasuries had “gone up dramatically in recent months”, Financial Times, April 15 th , 2014. Linear analysts take the view this activity indicates the ‘taper’ of $10bn treasuries per month is more than offset by bond purchases by similar counterparties from Q3 2013 to present. The message to bond holders is very clear. The FED is more than likely supporting its bond buying programme via off balance sheet purchases of US debt via other central banks. This means the central banks are propping up the bond market with cheap liquidity at an even greater rate than before the ‘taper’ and are so concerned about deflation in this market they are prepared to risk the inflation of other asset classes like equities, property and commodities, and are misleading investors in order to preserve this policy. For Linear analysts this is a credible explanation for why bond yields are falling rather than rising during the taper cycle. Except as our analysis shows, after 6 years the bond markets are now showing sign of fatigue with central bank easing policy and deflation is beginning to surface anyway. Our analysts think this state of affairs should not fill existing bond holders with confidence in the performance of this asset class after 2014. The stakes could not be any higher for bond investors. Currently bond holders seem to be buying the message from the central banks on future economic growth and stability of markets. If this proves to be as incorrect as Linear analysts believe, bond holders could be in for a very difficult time within the next 6-12 months. The warning signals given to bond investors recently are ominous: On the 25 th June, growth forecasts for the US economy were revised down by 3% after US GDP contracted by 2.9% Q1 2014 according to figures released by the US Commerce Department. This is the US economies worst performance in 5 years, The Economic Times, 25 th June 2014. Yet just one week earlier the present FED chairperson projected growth for the US economy and described a 2% increase in inflation as “noise”. Bloomberg, June 23 rd 2014. If the mainstream view is this wrong, investors must be prepared to rethink the market forecasts that view supports. We urge investors to take on board our forecast that current rallies in the debt securities market will not last beyond Q2 2015 and advanced economies in the west are not recovering in the fashion mainstream market analysts suggest. Investors are urged to consider an alternative view. Perhaps the record low yields in government debt around the world, record low volatility, shrinking liquidity and volume, and now a tanking US economy, are a signal from the market that serious deflation exists in the global economy and this is set to accelerate in 2015? A shrewd investor should be looking to cut their exposure to government debt at the top of the market which we believe to be now. As our analysis has shown, the distortion of the capital markets through central bank interference has now meant that the bond markets have substantial downside risk which will affect bondholders in the near future. Central Bank activity has been a game changer for the bond markets. Prior to 2006 investors priced bonds based on market fundamentals whereas now policy announcements are a major component of the bond price. Bond buyers are now required to navigate a market in which interest rates may turn over night, investors are behaving irrationally and are simply chasing momentum and economic data is a less important indicator of price action. In this environment few bond holders can afford to park their capital in bonds and rely on the coupon premium to protect their investment. In view of the risks identified in this analysis we suggest bond holders seek advice on diversification of their assets and risk spread. Linear Portfolio managers specialise in helping investment clients to manage risk. A prudent fund manager with a focus on preserving wealth will advise clients to manage this risk, as our portfolio managers have done. For further information contact Dr Marcus Bent, Head of Global Wealth, Linear Investments Ltd. Linear analysts work closely with our portfolio managers to present clients with opportunities on an advisory & discretionary basis. The flagship Cassandran Hedge portfolio is uniquely structured to take advantage of long-term emerging trends. These are mixed with some highly active trading strategies whilst implementing a capital protection approach in line with our contrarian view. Debt Reduction Predicts Growth in US: Is Yellen’s Word Her Bond (continued)
7. . CASSANDRAN HEDGE PORTFOLIO The information given in this document is for information only and does not constitute investment, legal, accounting or tax advice, or representation that any investment or service is suitable or appropriate to your individual circumstances. You should seek professional advice before making any investment decision. The value of investments, and the income from them, can fall as well as rise. An investor may not get back the amount of money invested. Past performance is not a guide to future performance. The facts and opinions expressed are those of the author of the document as of the date of writing and are liable to change without notice. We do not make any representation as to the accuracy or completeness of the material and do not accept liability for any loss arising from the use hereof. We are under no obligation to ensure that updates to the document are brought to the attention of any recipient of this material. The report author is a fully FCA approved person under Linear Investment Ltd. Linear Investment Ltd is a fully FCA regulated entity. FRN: 53738 Risk Warning Asset allocation is often the primary determinant of long-term investment performance. Our portfolio managers allocate assets in order to spread risk and maximise investment performance. The portfolio allocation is designed to facilitate capital protection. Each client portfolio is assigned strategic and tactical investment strategies in order to achieve investment goals and match risk profiles Main Office: 8-10 Grosvenor Gardens London SW1W ODH DL: +44 (0) 203 603 9833 Email: email@example.com www.linearinvestment.com Wealth Preservation Strategic Asset Alocation Tactial Asset Allocation
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