OUR PERSPECTIVES


The Matrix

You take the blue pill, the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill, you stay in Wonderland, and I show you how deep the rabbit hole goes.

Morpheus to Neo, The Matrix 1999

 

In the story of a messiah-like protagonist set against a modern backdrop, The Matrix combined technical wizardry and contextual brilliance that, Keanu Reeves’ acting aside, set a new benchmark for sci-fi films. Thomas Anderson is a mild mannered computer programmer by day, but by night he is a hacker known as “Neo”. He has always questioned his reality, but the truth, as shown to him by fellow-hacker Morpheus (Fishburne), is far beyond his imagination. The real world is a ravaged wasteland where most of humanity has been captured by a race of machines (to farm their body heat) and their minds have been imprisoned within an artificial reality known as the Matrix.

In many ways, the prevailing Fed narrative appears to believe in some alternate reality – a “world without rules and controls, without borders or boundaries – a world where anything is possible” – a world where current account deficits run wild, national debt is barely able to be serviced, and money will remain artificially cheap forever. The stock market always goes up, creating a positive wealth effect for all, and there can be no debt reckoning because they will be paid off in future dollars created from future gains in productivity. Laws of mathematics are conveniently forgotten.

In fact, we think the Fed has created its own Matrix (“Fedtrix”) whereby all these short-term feelgood factors has the vast majority feeling comfortably numb (S&P up 24% this year, property up) and not asking what the ultimate exit strategy is. Ultimately, if we are to assume that the US will not “hard default”, and that demographic headwinds will prevent them ever actually paying off their debt in today’s dollars – then the only answer left is that they will pay via freshly printed currency (default by devaluation) which will cause stockmarket and FX volatility. How long can the central bankers pretend all is well? Bernanke’s replacement, Janet Yellen, is cut from the same cloth, and recent statements to a Senate Committee confirmed the printing presses will stay active for some time yet. Perhaps this dual comfort of low borrowing costs plus the Pavlovian “more money=higher stocks” dynamic explains NYSE margin debt at record highs? (Updated chart below)

Thus, the volatility that we should be experiencing today has been put off the “another day” (kicking the can). It cannot, however, be permanently suppressed, and the longer it builds up for, the greater the pressure. There are two relationships which have held well over the past thirty years or so, and they are 1) When volatility increases, stocks do notgo up, and 2) When US stocks go down, Australian stocks do not go up (except October 2007, a 1 month alleged “decouple” lag, before the dynamic vigorously reasserted itself). So if the US stockmarket indexed looks fairly priced and then some, and has become captive to the Fedtrix game of happily ever after, what should one do?

The first is to establish appropriate valuations at an index level. Looking at Crestmont research’s analysis, with the S&P500 trading at a cyclically adjusted P/E (CAPE) of 24, this cyclical bull rally within a secular bear market is far closer to the end than the start. Charts below show the typical start and endpoints for secular bull and bear markets. Note that the P/E is relatively lower since inception of the secular bear market (2000), but valuations are still so high in absolute terms because of where 1999 (tech boom) finished. Even 2009 only took the CAPE down to 15, whereas sub-10 was required to commence a genuine bull market. The other problem is that earnings appear to be linearly extrapolated, completely ignoring the business cycle. Typically, corporate earnings enjoy a three to five year expansion, followed by a one to two year contraction. The chart below shows S&P earnings yoy growth since 1950. 2013 and 2014, if positive as estimated, would be the 5th and 6th years of earnings expansion in the business cycle. Time to be wary.

As stated last month, a combination of near term trading headwinds, medium term political concerns and questions over long term fundamental US liquidity and solvency, has us assessing portfolios to ensure they are of a sufficiently conservative stance. The Matrix’s tagline in Australia was “The Future is not User Friendly”. The Fedtrix may well prove not to be either.