David R. Kotok
Cumberland Advisors, October 13, 2013
A whipsaw is a “long, narrowing, tapering ripsaw, usually set in a frame and worked by one or two persons.” Webster’s Unabridged Dictionary, second edition.
What a play on words.
“Long,” as in, we are now passing two weeks of shutdown. Different scenarios take this Washington theatre out to Thanksgiving, Christmas, or into January. A few weeks’ delay may not resolve anything.
“Narrowing,” as in the cash balance at the US Treasury. Will the Treasury run out of cash on October 17? We think not. Will the crunch hit in November, starting with the Social Security payments on November 1? And be exacerbated by the November debt payments? We think that might be a more likely pressure point. Will the Republicans point to the Treasury on October 18 and say, “See, the world did not end yesterday; you misled us”? Get ready for that political round.
“Tapering,” as in the on-again, off-again Fed policy of reducing the amount of new purchases of securities. Current Fed policy is to buy $85 billion a month. What does the Fed do when the debt-limit debate stops the creation of new securities? Is any potential policy change being injected into the debate? The actual federal deficit is now under $700 billion and falling. The amount of newly created, federally backed mortgage paper is limited. The Fed is already buying more than 100% of what is newly created. And we may see no debt limit increase by Congress and therefore a forced balanced budget. That would mean no additional net new Treasury debt.
The political scene is a whipsaw of news flows and surprises. As a money manager, we know that this is a dangerous way to make investment decisions. We have seen two major whipsaws. Let’s talk about each of them.
The first resulted from the rhetorical buildup implying that tapering was coming. This started in mid-May, 2013, and we saw a continuous flow of Federal Reserve officials offering discussions of tapering and accompanying policy. Then came the September FOMC meeting, where the Fed announced there would be no tapering, even though the markets had been primed to expect – and had priced in – the onset of mild tapering. That development triggered a stock market explosion followed by a reality check and sell-off.
So whipsaw number one we can blame on the Fed. They created an expectation; they seemed to affirm and reaffirm it; and then they surprised to the contrary. Now they face an October meeting, and markets do not know what to expect. It seems markets are discounting an extension of present Fed policy for several more months, until there is clarity on the budget and debt-limit fights. But if Fed policy is now without much efficacy, does delaying tapering actually help matters? Markets are involved in this debate. So are Fed members.
The second whipsaw is underway. It was not long after the tapering whipsaw had reverberated through the markets that the continuing-resolution, budget, debt-limit fight flared up on schedule and escalated to the present impasse. All hope of compromise was smashed, and a resolution has yet to materialize. The intensity of the fight led to the market’s perception of a possible risk of US default. We never thought the odds of default were very high, but the intensity of the rhetoric was sufficient to raise them above zero. Markets reacted. US credit default swap pricing spiked. In response, very short-term Treasury obligations became elevated in yield, and the very short end of the Treasury yield curve actually inverted. Announcements came: some large institutions were divesting themselves of short-term Treasurys. The self-perpetuating momentum of fear and panic drove the VIX above 20. A rising VIX and a rising CDS on the United States have always coincided with stock market weakness.
Now we have another news flow shift as the whipsaw heads back in the opposite direction. Just because politicians are talking with each other, for two days stock markets have again exploded. I guess the market is celebrating its relief that politicians are talking at each other rather than past each other. How much of the rally was short covering and how much was based on belief that policy will change is impossible to determine. So if the basis for the rally was the expectation that there is a durable political deal actually in the offing, the market’s celebratory response seems premature to us. Hence we can expect more whipsaw.
Stock prices are based upon many things. The dominant strategic factors are earnings and the prospect for growth of earnings. Earnings come out of profits. The GDP profit share in the National Income and Product Accounts (NIPA) is consistently measured and exhibited in data. These days we cannot obtain current data because of the government shutdown, but we do have ways to estimate what the data would reveal. Without corroborating official statistics the estimates are guesstimates, but the profit share that we can estimate is currently at a very high level. Can it go higher? Yes. Will it? That is much harder to discern.
Meanwhile the US economy is operating at a tepid growth rate. Estimates of that growth rate are falling as uncertainty wrought by irresponsible political brinksmanship only acts to slow growth to a lower level than it would otherwise be. All this whipsaw uncertainty created by the government (Congress and the White House) and by the Fed does not help growth accelerate; it causes it to decelerate.
Slow economic growth means low earnings growth. The profit share is at a peak level, so risk is rising. Therefore, plunging back into the stock market without dissecting the sectors and being able to clearly see earnings prospects is a dangerous game. Investment actions driven by political whipsaws are not valid, data-driven decisions; they are gambler’s’ actions.
We have not chased the rally; we are still maintaining cash reserves. Of course, we would like to see the US government operate in accordance with the principles of good governance. Of course, we would like to see the political leaders of our country reach longer-term, sustainable, and dependable agreements on the budget and debt, and proceed to implement them.
But the truth is, we distrust politicians, and what we are watching is failed governance. This is true for the White House, the Senate, and the House of Representatives, and for Democrats as well as Republicans.
We have to watch their actions and not their words. And we need to hold some cash reserves.
Whipsawing will be with us for a while. Stock market entry points for a fully invested position are best found either when cheap pricing and high negative sentiment combine or when there is clarity of policy. Right now, neither of these exists.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors