QE Correlation Does Not Imply QE Causation
Following this week's FOMC meeting Chairman Bernanke held a press conference to allow members of the financial media to ask questions about the direction and efficacy of monetary policy. Chairman Bernanke has tried to increase transparency by providing more communication of monetary methodologies and intentions, however the members of the media have failed miserably at extracting information that is not already spoon-fed to the markets. This past week was a glaring example of how inept and downright negligent the financial media has become in evaluating Fed policy.
The line of questioning can be categorized in four basic subjects: the remaining duration of QE, too big to fail, Cyprus, and Bernanke's tenure as Chairman. There were a few outlier questions but basically all addressed these matters.
The first three questions from the Washington Post, Financial Times and CNBC all pestered Bernanke about when the Fed would exit from QE. The Wall Street Journal's Fed reporter, deemed Fed leaker by many in the market, lobbed in a softball question about what the Chairman planned to do after his term is completed.
Fox Business News asked if it was too late to get long stocks and whether Bernanke considered it mission accomplished. Shockingly Bernanke entertained this idiocy by responding that "we're not targeting asset prices or measuring success in terms of the stock market," but if we were, "we don't see at this point anything that's out of line with historical patterns."
Aside from these few questions that skirted with an intelligent debate, the press conference was a complete waste of time. Honestly I don't understand why the major media outlets, and frankly the Street's research analysts, can't better frame the debate. There are much more important questions that I would like to see answered such as the following:
Mr. Chairman:
How does QE lower bond yields when at the margin the Fed doesn't represent any larger source of demand than they have historically?
If you believe that it's the stock that matters and not the flow then why did you need to continue QE with interest rates already so low?
Is your unemployment rate and inflation target a de facto nominal GDP target?
From what year do you extrapolate the output gap, and assuming your 4.0-4.5% implied nominal GDP forecast, how long will it take to close it at that growth rate?
Why does the velocity of money continue to collapse, and is it because the capacity of the banking system is too large to support the demand for credit?
With banks increasing their allocation to securities in lieu of making loans, isn't the banking system's interest rate risk exposure just as high as its credit risk exposure before the financial crisis?
Does devaluing the global reserve currency risk alienating our foreign lenders which we desperately depend on to finance our deficit?
The problem lies in the universal belief in the Fed's omnipotence. Without actually investigating participants, just accept the fact that the Fed's actions are responsible for market activity. The Fed has launched this radical quantitative easing, injecting trillions into the banking system by purchasing bonds, and at the same time bond yields are falling and stock prices are rising, therefore QE is responsible for driving market prices. It's virtually an undisputed fact. But is it true?
Instead of taking their word for it, let's examine the actual numbers as QE pertains to the Treasury market. Depending on the maturity the Fed is buying up to $5 billion Treasuries per day. It is estimated that the cash market trades approximately $500 billion per day in bills and coupons with between $250 and $300 billion traded in maturities over three years. The Fed is buying an amount equal to 1% of the total daily cash volume and roughly 2% of volume in the longer maturities. If the Fed didn't announce what they were doing it would likely go unnoticed.
Some (including the Fed) might argue that QE is continually reducing the outstanding stock of Treasury supply, therefore exerting downward pressure on yields. But as I argued in Quantitative Easing: The Greatest Con Ever Sold, the Fed's holdings are just keeping up with the increasing supply. They are just maintaining the same ownership as a percent of outstanding stock as they have historically. At the margin they do not represent a larger source of demand than they have in the last 50 years.
Think about it this way. If the Fed was buying a like amount of Apple (AAPL) stock as they do in cash Treasuries, they would be buying 180,000 shares per day in a stock that trades 18 million. At the same time AAPL would be issuing 9 million in new shares per year. Would the Fed buying 180,000 shares a day have any influence on AAPL's price? I think most would agree that just because AAPL is rallying and the Fed is buying doesn't mean AAPL is rallying because the Fed is buying.
One of the most fundamental rules in statistics is that correlation does not imply causation. It's a fallacy. Just because two variables look to be related doesn't mean they are. Yet it seems the entire financial economy is built on this false presumption. Everyday you can turn on the financial news, read the paper, read an analyst report or find it in the blogosphere. Take last Friday as an example. Saturday's Wall Street Journal:
US stocks gained ground Friday, nearly erasing the week's losses for the Dow Industrials (INDEXDJX:.DJI) as investors started to look past the latest eurozone debt drama.
The day before when stocks were down it was the opposite. From CNBC.com on Thursday:
Stocks finished in negative territory Thursday, dragged by techs, amid ongoing concerns over Cyprus' ability to get a bailout.
There is way too much reliance on the assumed cause and effect. The news from Cyprus was bad, and stocks fell, so Cyprus caused stocks to fall or conversely stocks rose so stocks are looking past Cyprus. This is ridiculous.
It's the same with the Fed and QE. First it was that stocks were rallying as the Fed was trying to reflate assets, therefore stocks were rallying because the Fed was reflating. Now stocks are rallying to new highs and bond yields are rising so the markets must be responding to an improving economy. Thus a great rotation out of bonds and into stocks is underway.
The markets are much more sophisticated than the basic cause and effect analogies that constantly bombard investors. These correlations are passed off as obviously related yet they fail the most basic statistical test. Is the whole industry operating under a fundamental flaw?
The smart money doesn't buy into these correlations because fading them is how they make money. In September 2011 Bloomberg's Erik Schatzker interviewed Bridgewater's Ray Dalio who is perhaps one of the most successful fund managers. Schatzker asked about asset correlations (emphasis mine):
Schatzker: People say correlation among different asset classes is increasing, making the job of being a macro hedge fund manager harder. Is that true?
Dalio: No.... I think that there is an intrinsic characteristic that determines the returns of asset classes. So, a very simple example would be if you knew that the – if inflation was to come down by a certain amount, you multiply that times the duration of the bonds, and all things being equal it will carry over to the bond return. And so that there's a certain structure that exists in asset classes.
There is no such thing as in intrinsic classic correlation. So, the relationship between bonds and stocks, for example, could either be positively correlated or negatively correlated depending – and both of them make sense if you know what determines the pricing of the asset class.
So bonds are always logical in that way. Stocks are always logical. But if you come into a time, for example, when economic uncertainty and volatility is greater, then they'll be negatively correlated. If you're in a period of time where inflation uncertainty and volatility is greater, they will be positively correlated.
Both of those things are logical if you know how they behave; therefore, it's that understanding, not a fixed notion that there should be a correlation. That fixed notion of a correlation doesn't exist. There's no such thing as correlation. There's only the logical behavior of each of those two markets that then will determine its relationship.
I think investors are making a big mistake interpreting price action as reflective of a resolution in Europe, global central bank intervention, or improving economic growth. There is something happening under the surface that trumps the elementary cause and effect. This rally in stocks has been a multi-year squeeze in negative sentiment, and I believe it is beginning to climax.
When I wrote Trading the Wrong Playbook Bubble in June of 2012, I tried to get investors to focus not on the headlines but on what I believed to be behind the market price action:
If this market truly is just back-filling the gaps left behind by the financial crisis then making this area of support is very bullish and could point to new all time highs going into the fall.
The massive underperformance of the investment community is attributable to a wrong playbook bubble. This market cycle doesn't care about growth or discount, it cares about positioning and sentiment.
ES COT Large Speculators Net Position
After being net short for a full year, large speculators finally got long after the market had rallied 35% in their face. When the S&P (^INX) e-mini futures contract (ES) crossed the previous high at 1400 specs top ticked the market as we saw a subsequent 7% correction into November. They reinitiated long positions into year end only to reduce as the rally continued into the 1500 level, and by the middle of February, were essentially net flat with the S&P at 1515. When the S&P held the 1500 level on the brief February correction, the specs piled in and quickly jammed ES into the 1550 level where stocks have vibrated for three weeks.
This week's CFTC commitment of traders report showed large speculators increased their net long position by an astounding 152,000 contracts to 256,000. This would be the longest specs have been since coming out of the 2009 low and exceeds any period in the rally between 2002 and 2007.
This change in positioning is very important because, as evidenced by the increase in volume since the beginning of the month, I believe there has been a big shift in ownership of this market from real money into levered accounts.
Market Picture
Last week the ES June contract traded 10 million shares and the average weekly volume for the month of March has been 9.27 million. The week ended 3/1 ES volume was $13.2 million. Contrast those with the average weekly volume since the November 2012 low of $6.6 million. The 4-week move from 1515 to 1550 saw volume increase 50% more than during the 14-week move from 1405 to 1515.
The ES contract closed the week ended 3/8 at 1549.50 on 9.2 million contracts, the week ended 3/15 at 1553.50 on 8.57 million contracts and last week at 1552.00 on 10 million contracts. This past week we saw three straight 20-point ranges with volume exceeding 2.5 million shares on Tuesday, a feat only accomplished five times this year. The volume weighted average price (VWAP) for the ES contract this week was 1545.90 with 65% of the volume trading between 1545 and 1550 despite a total range between 1530 and 1556. And you'll notice that the 1550 bucket saw the highest volume at 35% of the total and 8x the 1555 bucket.
ES VWAP
Clearly the 1550 area is bringing out the big sellers and the buyers have exhausted a lot of ammo in order to absorb the supply. Considering the recent spike in speculator positions I believe the levered money is trying to defend this 1550 level. The question for the future direction of the market is whether they have the bullets left to take the market higher.
S&P Weekly Working Count
So here we are. In June I posited that the negative sentiment and positioning would lead to a short squeeze rally to new highs. I had mapped this move as a C wave diagonal which needed a "throw over" to complete the last leg. In this last leg the large speculators that were short at the 1265 low have been the engine behind the entire rally. They have covered and are now the longest they have been in a decade. As the market has hit these levels the volume has substantially increased and it appears the ownership has turned over from real money to levered accounts.
The true catalyst that has taken us this far has been a massive short squeeze of speculative positions which are now massively long. The confirmation bias is reaching for items such as improved economic growth, an accommodative Bank of Japan, a resolution in Cyprus, a great rotation, or whatever else they can think of to maintain their bullish position. I'm not saying the market can't go higher, but we have seen a shift from extreme bearish to extreme bullish positions. And as I've said many times before, there will be no bears left when this market tops.
Twitter: @exantefactor
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