“Davidson” gives us his take on why the market sells-off on good employment news.
One needs to step back a bit and observe that there are many types of investors with many views of the economy, markets and means and styles of investing. Importantly, not all investors have the same time perspective and this provides the crux of confusing market behavior.
What is good for the economy is in fact not good for those betting against the economy.
My explanation goes like this:
Numerous investors especially hedge funds and professional traders with significant capital have assumed from past experience that excessively low interest rates and issuance of US$ based credit will result in rampant inflation and a decline in the value of the US$ itself. The media have provide ample fuel for this view’s profusion. The decision to buy commodity investments by shorting the US$ to fund this hedge is called the “Carry Trade”. Actually, any shorting of one security to buy another is called the “Carry Trade” as the investor is seeking to reap profit from the net return expected without having to actually put up 100% of their own capital. The shorted position acts as a loan and the “Carries” cost of the position which is expected to produce the highes net gain.
If investors expect high inflation then the first ones to buy commodities which are priced in currency will make the most gain as other investors pile in afterwards. But, betting on inflation has multiple assumptions that many fail to fully ascertain completely. We often see simplistic approaches by investors with huge bets on particular directions. Markets are complicated and no one in my view has a complete understanding of cause and effect because human nature adjusts to circumstance in ways that may be new and unpredictable. The bet for high inflation in a continued collapsing economy is a non sequitur. Inflation cannot be high just because a few investors believe that commodity prices will rise and thus bid up prices. Society has the option of simply not spending and limiting the effect of the inflation bets of hedge funds. If the general population, you and me, decide to slow our spending then high commodity prices do not cause inflation throughout the economy and the commodity inflation bet can literally fall apart. Much depends precisely on societal behavior.
Hedge fund reversal is part of what we have been seeing the past 2 days. Bets on continued low interest rates and economic stimulus have been bolstered with prolonged and widly disseminated forecasts of the government need to inflate in order to pay back the deficit spending with cheaper US$’s. But, the sudden rise in employment is consistent with hiring back to the “Economic Rplacement Level” as businesses had over-cut employees with the financial scare of frozen money markets and credit markets Fall 2008. Yes, the country has what I would call an “Economic Replacement Level”. This is the level over the past 70yrs at which the economy must operate just to handle basic needs. This can been seen in the Lower Band of the earnings trend channel (chart below) which has been very consistent and is one of the fundamental underpinnings of our economy. Call this our lowest level of economic survival to maintain the standard of living range to which we have become accustomed.
The “Economic Replacement Level” I define as that level at which individuals, governments and CEOs will spend to buy “Band Aides” to maintain basic needs. If a child needs a doctor then regareless of the cost a parent will go to the doctor. If a car needs a new tire or a replacement part so the individual can get to a place of employment, then that replacement part will be purchased even on credit. If a company or a home needs to be heated to make it fit to occupy or to preserve it for later use, then it will be heated, repaired and basically maintained even if larger projects are put off for better times. Government will spend to repair a key road or a key bridge in the face of the harshest economic environments cancelling all other less needy projects. There is a wide swing in the long term mean earnings trend of 6.1% that accompanies the changing societal penchant to spend. This wide band in our spending is represented by the Lower and Upper Bands to the Annual Earnings Growth Trend Line and are -/+ 38% relative to the long term trend. In our society our willingness to spend on survival basics to maintain ourselves is very strong and is the reason for the Lower Band having significance at this time.
Hedge fund investors make investment bets on trends and do not take into account that markets have fundamental underpinnings. When employment suddenly improves, they must reverse previous assumptions. Higher employment means that government stimulus can end far sooner than they had previously assumed. With the reversal of stimulus now a possibility, the pressure of endless inflation pressure and collapsing US$ no longer seem as likely. The net action by hedge funds is to sell Treasuries, commodities and commodity stocks and buy back the shorted US$. That this change of perception comes into the market over a short period of time is the nature of hedge funds and causes greater downward movement in commodity companies ~5% than was offset in the upward movement in companies such as banks, industrials and etc. which respond over longer periods.
Whenever one looks at markets, even the SP500 by itself, one needs to go into great detail. The greatest error one can make is to assume that a single report will have a single market response. Friday’s report was very positive in my view, but not for those investing with long term US$ deterioration and endless inflation as a premise. How markets respond to economic trends is in the details.
Our approach is on the details and over the long term. I remain positive for almost all asset classes even Natural Resources with a long term perspective. The only asset classes to avoid at the moment are US Treasuries and Sovereign Debt as neither has an attractive return vs. the Market Cap. Rate of ~4.6%.