No Man’s Land

October 5, 2016
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no_mans_landan anomalous, ambiguous, or indefinite area especially of operation, application, or jurisdiction

definition two: financial market direction over the 2015-2016 period

The meandering, low-volatility, sine wave oscillations of the tape continue. How did markets arrive at a point where a 3% pull-back is petrifying, and a 5% pull-back feels like a crash? The Brexit pull-back in June, was just about 5% on the nose, but it lasted only 2-days.

Policy maker support of markets , vis-a-vis central bank actions, and ultra-low interest rates, stumble upon the end of the rainbow. Now what? The pressure on the Fed to assert its independence from politics, specifically the democratic party, is rising. Last week, Janet Yellen short circuited (in this clip) when confronted by Representative Scott Garrett of New Jersey. Donald Trump, is calling for heads at the Fed, and focusing attention on political bias. The Fed dissenters are getting vocal again, and will continue to pressure for another hike. A November rate hike still appears unlikely with liberals Yellen/Brainard calling the ultimate shots. So we don’t really go down, but at a full market valuation, it feels downright dangerous to play for that “just little bit more”.

So therein lies the rub. Investors are increasingly conditioned to very high asset valuations and very low risks of significant losses of capital. When few investors see any risk (VIX crush to 12), risks are often greatest (all the good stuff is expected). The S&P 500 is up some 5% over 2015-2016, add to that another 3.5% or so from 20 months of dividends. 8-9% returns over two-years isn’t terrible, but there is a feeling that the best part of the current recovery cycle is past, and after 8-years of an economic recovery, the market needs to go:

1) full bubble – something happens to take rate hikes off the table, without a recession, and the S&P 500 multiple shoots up to 20x. That would catapult the market towards 2,500, some 14% higher.

2) market predicts a recession in the out year – the economy doesn’t bounce after the election, the expansion exhausts, a shock happens, and the market reverts back to 15x into the predictive recession phase. A 20% pull-back to 1,700 would likely be in the cards.

In the meantime, we oscillate in no man’s land. A torturous period for momentum investors. Individual stock returns are often dominated by sector rotations into and out of, “thing’s getting better” or “things slowing down” stock sectors.

A good time to tread more carefully.

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