Contagion

Volatility is back and so are the caution flags. You know the list. It includes geopolitical issues such as the Ukraine and Gaza. Economic issues like inflation and jobs reports. A default from Argentina and a runaway virus like something out of a science fiction movie. The thought of an Ebola contagion was not the only contagion making the rounds. A European banking contagion may have stoked more fear this week than the Ebola Virus. Portuguese banking issues sent European stock markets reeling.

One issue that has had our attention for weeks is the drawdown of Federal Reserve purchasing in the marketplace. Each month the Federal Reserve has cut back its purchases by $10 billion in an attempt to exit the monetary easing business. That tapering of purchases has not had an immediate effect on the market until this month. The Fed’s purchases, while steady, actually had an increasing effect as the supply of bonds shrank along with the US fiscal deficit. The Fed was actually purchasing a larger percentage of supply each month. This month is the first month of the tapering where the percentage of Fed purchases actually shrank and it may not be a coincidence that we also saw the market shrink.

How bubbly are we? From Richard Fisher President of the Dallas Federal Reserve comes this speech given on the campus of the University of Southern California on July 16th of this year titled Monetary Policy and the Maginot Line.

To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwin’s front-page, above-the-fold article in the July 8 issue of the New York Times, titled “From Stocks to Farmland, All’s Booming, or Bubbling.” “Welcome to … the Everything Bubble,” it reads. “Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.” Irwin’s comments bear heeding, although it may be difficult to disentangle how much these lofty valuations are distorted by the historically low “risk-free” interest rate that underpins all financial asset valuations that we at the Fed have engineered. http://www.dallasfed.org/news/speeches/fisher/2014/fs140716.cfm

Just about every asset class is overvalued but if history is our guide as the Fed exits QE bonds will hold steady while equities put in a bit of a retreat. For hints on that retreat we refer to the small cap space as the canary in the coalmine. The Russell 2000 is showing signs of a classic double top. A double top is a cute way of saying that we got to the highs twice and lacked the conviction to break through. We now need to test the lows of its recent range and the bull’s conviction. The Russell is now at 1114.89. A close decisively below 1090 would indicate a move to 970. A move 12.9% lower which would develop rather quickly. Keep one eye on the Russell 2000.

Fisher wants less accommodation but Yellen, as seen in her Humphrey Hawkins testimony below, plans on being quite accommodative. In this battle Yellen wins for now. Look to Fisher for the truth but look to Yellen for the Fed’s next move. The market seems to be siding with Fisher for now and fears that the Fed may be behind the curve.

“We need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates,” … “I think the forward guidance that we have provided in the policies that we have put in place are providing a great deal of accommodation to the economy to make sure that it is on a solid trajectory.” Janet Yellen – Humphrey Hawkins Testimony Congress July 2014 http://www.cnbc.com/id/101836922

Small caps are our map while US Treasuries and Gold continue to be our risk temperature gauge. Also keep an eye on the VIX index. As it spikes the Fed may try to calm fears.  

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

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Published in: on August 2, 2014 at 2:25 pm  Leave a Comment  
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