My Grandmother from Scotland, after serving afternoon tea, would sometimes examine the patterns in each person’s cup for clues to what the future might hold. To a degree, much of what we all do on Wall Street is like Nana reading the tea leaves. So here is what my reading tells me as to the outlook for markets in the year's second half.
| JOE MCALINDEN's MARKET VIEWPOINT
June 5, 2015
For the PDF Version, please click HERE
My Grandmother from Scotland never served afternoon tea using tea bags. Only fresh tea in a proper teapot would do. There’s no doubt it tasted better, but there was more than that to her preference. When served, loose tea leaves would fall into a guest’s cup, and a collection would always be left at the bottom. Friends and family would gather round as Nana would offer to examine the patterns in each person’s cup for clues to what the future might hold. They were convinced that she had a special gift. I do not remember if Nana was always right; or if she was ever right. I do remember that everyone always listened very carefully.
To a degree, much of what we all do on Wall Street is like Nana reading the tea leaves. But, surely we are not just pseudo-psychic fortunetellers. After all, we don’t just look at tea leaves; we carefully study lots of data and draw upon our education and years of experience to reach informed conclusions. We do, right?
Some of us mainly look at past prices to discern what will happen in the future, even though for half a century, academics have argued that past patterns tell us nothing, and security price movements are totally random. Just spend five minutes watching the financial media or skimming through Twitter’s markets-oriented tweets and it becomes clear that no matter what the academics say, lots of folks still take predicting future securities prices based on past trends very seriously.
Others are dismissive of so-called technical analysis. Instead, they pride themselves on focusing exclusively on important fundamentals: monetary and fiscal policies, GDP growth, corporate profits, demographics, innovation… factors that we logically believe should affect market prices. Yet, it can be argued that everything that’s knowable is already known by all and, therefore, is already priced into the markets. With that said, why is it then that we still have bear markets, crashes, mini crashes and corrections? It is because sometimes things change and often do so quickly. By definition, the change is typically unexpected by the consensus.
A look at what is currently expected for U.S. equities is instructive. The consensus of 21 Wall Street strategists surveyed by Bloomberg is looking for roughly a 6% further gain in the S&P 500 between now and year end. Some 19 out of 21 expect the S&P 500 to close the year above its current level; the two who think it will not are both looking for flat; the most bullish foresees a 12% gain. Indeed, if I were in agreement with the Fed Fund futures traders about the trend of rates, I’d be somewhere in that pack… maybe even on the high end. But I am not.
It is important to remember, that no one… NO ONE… knows what the future will bring. So then, what was Nana’s gift? According to Psychology Today magazine, “We think of intuition as a magical phenomenon—but hunches are formed out of our past experiences and knowledge. So while relying on gut feelings doesn't always lead to good decisions, it's not nearly as flighty a tactic as it may sound.” Most likely, my Nana’s “gift” was pure intuition: perspective gained from decades of life experiences and observations that formed patterns she recognized, at times, subconsciously. Neuroscientists call it unconscious recognition memory. After five decades of real world Wall Street experience, I might have some of that stuff rattling around my head, influencing my view of the current market environment.
It makes me worry about the exuberance that has gripped the markets, and I believe it will end badly. Regular readers will know that my fear is not about Greece, or the Brexit, or a strong-dollar induced U.S. slowdown. Rather, my main concern continues to be the disconnect between the market’s expectation about the outlook for U.S. short-term interest rates and that of the Federal Open Market Committee members. It is an accident waiting to happen.
Investors who drill into the Fed’s quarterly forecast summary can see committee members’ expectations for growth, inflation, and the Fed Funds rate for the next few years. For Fed Funds, the median expectation of the 17 FOMC members, last published in late March is 0.625% for end of this year, 1.875% for end of next year, and 3.125% for end of 2017. By contrast, the current futures market has 0.345%, 1.120% and 1.795%. The difference of the three years is 0.280%, 0.755%, and 1.330%, respectively.
Some will be quick to remind me that, so far, the futures markets have been right and the FOMC members wrong… quarter after quarter delaying their scenario for rate hikes to something more like what the market had earlier predicted. Fans of James Surowiecki would not be surprised by the crowd’s wisdom. But, some two-thirds of today’s traders have never operated in a complete Fed tightening cycle. At some point, informed by the largest economics department in the world, the FOMC members will be right and the futures market wrong. My hunch is that time is now imminent.
So here is what my reading of the tea leaves tells me as to the outlook for the two major asset classes. Both bonds and equities are on the verge of a nasty downturn sometime in the year’s second half, precipitated by an adjustment of market expectations to being more in line with those of the FOMC. For bonds, it will be an extension of a cyclical bear market that is already underway; bonds may also be starting a secular bear as well. For stocks, I think it will be a violent correction within a very long-term bull market that may recover much of what it loses within a few months followed by new highs ... something along the lines of 1962 or 1987. Managers should be considering maximum portfolio hedges.
There will be a new set of forecasts from the FOMC in a couple of weeks. No one knows how the numbers will change. We are to believe that the course of policy is data-dependent, but the recent economic data has been mixed, although beginning to tilt toward gathering strength, e.g. the May employment report. Nevertheless, if the June FOMC numbers come out anywhere near where they were in March, or become more hawkish, I think the markets will react adversely; and begin a correction in both stocks and bonds that will be double-digit in magnitude. I am continuing to raise cash in my personal account.
|Joseph McAlinden, CFA, is the founder of McAlinden Research Partners and its parent company, Catalpa Capital Advisors. He has over 50 years of investment experience. Previously, he was at Morgan Stanley Investment Management for over 12 years, first as chief investment officer and then as chief global strategist. During his 10 year tenure as CIO, Joe was responsible for directing MSIM’s daily investment activities and oversaw more than $400 billion in assets. As chief global strategist, he developed and articulated the firm’s investment policy and outlook. Joe frequently appears in the financial media including Bloomberg Television. Follow JoeMac on Twitter|
230 Park Avenue | New York, NY 10169 | (212) 231-8701 | Inquiries: firstname.lastname@example.org