Bulls and Bears and tops and bottoms.

For every seller there's a buyer, but at what price??

Early and Wrong??

In my post of Sunday, January 29, 2012 Is Anyone Thinking About Japan I wrote, "Let's keep our eyes on the East, Japan and China in particular, for clues to the next phase of the financial crisis." Eighteen months have passed since that observation and nothing too dramatic has happened yet in Japan or China that would, in isolation, constitute a threat to the global unrecovery.

The highly interdependent second and third largest economies of the world are going in opposite directions in order avoid or to postpone the inevitable economic pain that is inherent in cyclical and secular adjustments. The actions of both countries have contributed to increased volatility in their respective financial markets and economies, which of course are connected to other financial markets and more importantly, to other economies. 

Japan is attempting to stimulate and inflate to devalue and to reduce, in real terms, its unsustainable debt load. The BOJ is engaged in one of the greatest monetary policy experiments ever seen of which the medium and long term outcomes and consequences are anything but certain. 

The PBOC is allowing, if not causing, tight monetary conditions in order reign in runaway credit creation by non bank entities which threaten the health, stability and sustainability of centrally planned economic growth.  The chinese "economic miracle" has resulted in badly misallocated capital and the authorities are trying to address this problem though moral suasion and limits to short term funding for non banks.  China would like to rebalance its economy with a growing emphasis on domestic consumption over exports and capital formation. Here, like in Japan, the outcome and consequences of these policies is highly uncertain.

When central bankers and central planners meddle in financial markets and market economies (or quasi market economies) they pervert the price discovery mechanism and distort the risk and liquidity premiums that are fundamental to the efficient allocation of capital and resources. In the near term interventionist policies can alleviate some pain or create apparently favorable market conditions (QE induced rallies) but in the longer term these policies create complacency at the cost of superficial and incomplete analysis of underlying micro and macroeconomic activity and risks.

I'll speculate that fundamentals eventually will matter again and when they do it will be imperative to have estimated how much systemic risk, because of the mispricing of risk, has been created by manipulative policy.  Start your (independent) analysis early.  Where are we? How did we get here? Under which conditions are the current  risk premiums and valuations sustainable? And most importantly how much can I lose if I'm late to the party and wrong?

Pay Attention to the Data

Moments ago Ben Bernanke indicated under which conditions the FED would begin tapering and the time frame for completing the "normalization" of the abnormal FED Policy: it will depend on the incoming economic data. More precisely, the FED will taper and will finish tapering (Q2/Q3 2014) IF the economic data confirm the FED's forecasts for an improving economy. (Unemployment trending to 6,75% and inflation approaching 1,8/2,0%. )

The FED basically said that fundamentals will count (remember what those are?). We should pay more attention to what the FED in monitoring and less to what they're doing, that is continued QE. What happens IF the FED forecasts prove to be too optimistic or even wrong?  Sure the markets are already discounting that the FED will be right, but the FED has continually over estimated economic growth and its sustanability during this recavery.  Do your own analysis and pay attention to the data, finally we have an indication from the FED that economic data are important once again.

Equilibrium and Transition

Economics suffers from physics envy and often attempts to model the world with the precision of classical physics, which of course cannot be done.  What one can do, however, is to look for analogies between complex evolving systems, human behavior and the economic ecosystem. Predicting economic and financial market outcomes is very uncertain (think about meteorology) and we must recognize the importance of the initial conditions of a system while attempting to forecast and to understand outcomes in both natural phenomena and economic phenomena.  In short, recognizing a chaotic path dependence anchored to the initial state and the attractor (think of a single factor that influences the entire system) of a complex system.

Presently, in the major developed economies the initial state (expectations) are for low growth, artificially low interest rates, thanks to global quantitative easing, and continued disinflation, if not outright deflation. Investors and economic agents have their behaviors, and their asset allocations decisions anchored to these initial conditions. Right or wrong, this is our "equilibrium condition" which until recently has been unquestioned for the last few years.

In last few months a butterfly has been flapping its wings in Japan and has agitated financial market conditions throughout the globe.  In fact, the objective of the current policy of the Bank of  Japan is to move the deflationary expectations away from the actual "equilibrium" state to a new state of inflation. Change in a system or a condition is not usually instantaneous, heat must be applied to ice in order to transition to water in the liquid state : the water molecules must become "volatile". The financial markets were crystallized in a low volatility environment in which the status quo was the discounted future outcome and now have begun to transition to a new and yet uncertain equilibrium state.

In the month of May the bond markets around the world had their worst monthly performance in four years as investors began to rethink how a different future (one not previously considered imminently possible) might effect portfolio returns.  The BOJ has ignited a flame on bond market volatility and the FED,  which has raised doubts in the mind of market participants about the flow and sustainability of quantitative easing, has turned up the flame, accelerating the transition to a new initial state with new expectations.

The markets were in a state of low or negative real yields, very low absolute yields, compressed credit spreads and low liquidity premiums.  In short, all the sources of risk premiums were reduced or non existent.  Passing from this condition to one in which the markets will require compensation for risk has been facilitated by selling in all segments and geographic regions of the bond market and in all currencies, especially those for which no expectations for depreciation were incorporated.

The future paths for this chaotic, deterministic system are uncertain but we can arrive at possible scenarios if we keep in mind from which initial conditions we are transitioning. In evaluating possible outcomes, and positioning a portfolio,  it is more important to understand what expectations are discounted in present valuations (initial conditions) than forecasting the timing and the precise levels of yields, prices or indexes.