Pressure Points In The Market

I just took a look at areas of prospective bubbles in the market the other day and concluded there was nothing significant poking its head out. But I wanted to revisit that question and articulate or expand on a couple more pressure points in the market today:

1. The large decline in oil prices has crushed the energy sector which had been one of the drivers of growth in the US. There may be more risk and implications there than what the market is indicating.
2. The large decline in commodity prices, predicated on the slowdown in China, which has crushed Australia, Brazil and Canada. Australia, China, Canada and the UK have large residential real estate bubbles.
3. ECB QE and the financial repression of NIRP is leading to a recalibrating of currencies and a fight to the bottom. 
4. Japan QE and rebalancing could push Japan over the edge as the curtain is finally pulled back.
5. Geopolitical risks could escape beyond borders and proxies - Ukraine, Syria.

Why Are Interest Rates So Low?

Quite frankly, I don't really know and I can't make heads or tails of it. The current environment is a classic case of my habit of missing regime/paradigm shifts. The scales usually drop way after the trend or the event has manifested itself.

There are numerous reasons posited:

• Savings glut (this one is a mystery to me when you look at savings rates relative to history and trends...the argument is the savings glut comes from China/Russia/Brazil).
• Supply deficit (can't quite work this argument out; I think it relates to QE and lack of collateral).
• QE (combination of reduced supply and scramble for collateral).
• Financial repression (combination of debt overhang and distorted price signals from QE).
• Low inflation (yes inflation is low and has been trending down...let's call it declining inflation, but it is still positive and real rates are low). 
• Fears of deflation (I don't see deflation...commodities have taken it on the chin in the last year, but asset prices have gone through the roof and commodity prices are cyclical).
• Fears of market collapse/capital protection (maybe...but those Wally's have all missed the boat).
• Currency wars (fight to the bottom). 

I just can't understand why any investor would settle for a negative interest rate. This makes no sense to me at all. US rates look as attractive as ever relative to European rates. European rates are crazy. What are they telling us? Imminent collapse in the Euro? Maybe!

It should be noted, that you can't talk about why interest rates are so low in the US without taking account as to why they are so low (or even much lower) elsewhere.

Distorted Price Signals

ZIRP distorts price signals throughout an economy.

Starting with asset prices and asset pricing, ZIRP creates not just a moral hazard by allowing firms to borrow at low rates to buyback stock (thereby boosting EPS and distorting that important price signal) but also factors prominently into asset valuation models artificially lowering the discount rate (which has a multiplicative and not a linear effect in valuation) to distort asset prices with follow-on effects for M&A and resource allocation decisions throughout the economy.

ZIRP just throws the cat among the pigeons. And so long as everyone is dancing to the music, it creates a game of chicken whereby everyone knows it will end badly one day, but everyone is also planning on being the first out the door when the music stops.

The New Dividend Investing Approach Is The Same As The Old Dividend Investing Approach

QE and financial repression through ZIRP have pushed up prices and forced savers into riskier investments.

One area where investors are doing a deal with the devil is dividend paying stocks. Investors are being pushed up the risk curve (by pushing up prices), hoping that an investment in a dividend paying stock is better than a non-dividend paying stock and that such an approach serves as a proxy for bond yield.  They are wrong on both accounts. Theory posits that there is no difference between a dividend paying stock and a non-dividend paying stock (Modigliani equivalence theorem). Evidence shows that when the market swoons, dividend paying stocks swoon just as much as non-dividend paying stocks. Equity risk is still equity risk. If it is true that ZIRP has artificially pushed up dividend stocks relative to non-dividend stocks, then there will be an additional cost to pay when valuations across the equity market equalize.

Hoping that dividend paying stocks provide a bond-like cushion with equity like appreciation is wishful thinking. There is no free lunch in the markets.

Additional Notes:

This is true of investors seeking dividend cover in tech stocks. I doubt they are fully factoring business risk.

It is especially important for investors to not be pennywise and pound foolish. Seeking a 3% yield vs a 2% yield for the market infers taking on additional risk. And it is especially important for investors to beware the addition of a 3% yield pales in significance to a 25% fall in price.

Finally, once dividend cuts come down the pike they have a double whammy effect wrt to falling dividend and falling price. What worked on the way up - increasing dividend, increasing price - works in reverse on the way down (as Cramer would say, "that is a house of pain")

Where Does The Biggest Risk(s) Lie?

In reflecting upon the many doomsayers prognostications regarding systemic risk in the system and their attempts to make the case that it is worse now than in 2008, I see their points but struggle to see the timing. Sure, we are likely to see a cyclical decline or recession. The markets no doubt will be hamstrung by that, but I don't get the sense of a systemic risk event predicated upon a Minskian leverage moment. To be true, corporate balance sheets are not as strong as the aggregate numbers may propose. Much of the cash outstanding is concentrated among a small number of mega sized firms, and that is quickly being netted off against debt issuance to fund stock buybacks. A troubling development in my book and one for caution. There are many who point to the "too big to fail" banks having grown even bigger. There are many who point to the economic recovery being anemic. There are many who point to ZIRP and QE as creating an artifice for asset prices. There are many who point to China. Many who point to the potential for hyperinflation. Many who point to the obesity of the Fed's balance sheet. The global financial system is connected and interconnected. It is a tightly coupled complex system prone to collapse. But I think it takes significant time to build imbalances via increasing leverage brought about by growing confidence leading to complacency and hubris. I don't think we are there yet. The greatest accumulation of debt/leverage has taken place on central bank balance sheets and country debt. I think that is where the next crisis will arise from. But until confidence is punctured, central banks and countries can continue to issue bonds and increase their liabilities. The puncture is likely to be an "emperor has no clothes" moment and will forever re-shape the global financial system as central banks become ground zero for fear and contagion.

Short term could be positive, but if it is...

I think the positive case for the market in the relative short term is reasonable.

(1) We've had a nice correction - cleared technically overbought condition.
(2) The Fed has affirmed "exceptionally low rates for an extended period" - go for it, boys.
(3) The only thing we have an oversupply of right now is doom and gloom - great for climbing that wall of worry and catching people on the sidelines.
(4) Earnings and revenues have been solid leading to positive revisions - got 4Q09 earnings season out of the way, now let us party in the vacuum.
(5) Market valuation is looking very attractive in the context of recovery - come on in the waters fine.
(6) 1H10 GDP has a decent chance of surprising on the upside.
(7) ZIRP drives incentives and therefore market behavior - banks got to do something with that cash.
(8) At some point, the retailees who went to bonds and missed the move will convince themselves that it is safe to get back in - liquidity filip.
(9) EU won't let Greece spoil the party.
(10) Oh yeah. There is more fiscal stimulus from last year due to hit.

And so, although it grates against my bigger picture outlook, I think there is a decent chance we could get a pretty substantial rally. But if it does rally strongly, it sets up a good fade and short.

The Cash Dilemma

What do you do as an investor if you have cash sitting in the bank gathering dust, the markets are running, and you see inflation in the outlook?

What do you do if you are a corporate with cash burning a hole in the balance sheet, shareholders demanding a return on investment, and you see inflation in the outlook?

You deploy your cash.

ZIRP forces cash from the sidelines into the market, almost irrespective of the fundamental outlook.

Investors are scarred and highly skeptical of the markets, and are not surprisingly reluctant to leave those sidelines. But many have no option. That cash is slowly but surely getting squeezed back into the markets.

What happens if/when that cash is redeployed and the market fesses up to reality? A potential disaster waiting to happen.