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December
16
2020

Winning The Beauty Contest
 Joseph Y. Calhoun III

One of the hardest things to understand as an investor is that markets sometimes – often – don’t line up with economic reality. Markets rarely reflect current economic conditions and at times they seem to discount a future that seems highly unlikely at best, and delusional at worst. That seems to be the case today, as stocks sit near all-time highs and the economic recovery falters in the face of the renewed virus outbreak (or whatever cause you want to assign). But it isn’t just stocks that seem to be discounting a better economic future.

We spend a lot of time watching the bond market as it often seems the wisest of the market crowds. The outlook from bonds has improved recently, although most of the rise in nominal rates is just a reflection of higher inflation expectations. Since November 6th, the 10-year breakeven inflation rate has risen from 1.64% to 1.89%. The change was driven by a rise in nominal rates (15 basis points) and a fall in real yields (10 basis points). The drop in TIPs yields can be read as a drop in real growth expectations, which certainly doesn’t sound like good news, although the market certainly seemed to interpret it that way. The S&P 500 rose 5.4% over the same time frame.

These are not large changes, but inflation expectations have fully recovered from the spring and today are little different than they’ve been since 2014. The larger issue, at least to me, is that real rates remain solidly negative. The 10-year TIPS yield is only slightly above its all-time low and the 5-year TIPS yield is in a similar condition. Real interest rates are an indication of weak investment demand and are inversely correlated with gold prices. Falling real rates make gold an attractive investment alternative, which really tells you all you need to know about how investors view the future.

Other markets are, however, looking more positive, and while we think bond markets are particularly insightful, they are also infected at the moment with price-insensitive buyers, namely this group called the Federal Reserve. So, I’m not very sure that the signal we get from bonds these days is as useful as it has been in the past. I think it is quite important to look at other indicators of growth and inflation to capture how all investors are positioning for the coming end of the pandemic.

When we do that, markets other than bonds are pretty positive about the future economy. The general commodity indexes have risen strongly in recent months. From its low in April, the Goldman Sachs Commodity Index (GSCI) is up 56%. Crude oil is also up from its spring foray into negative territory; how could it not be? More important, I think, is that commodities have rallied strongly over the last month (GSCI, +14%), even as the economic recovery has moderated. The V portion of the recovery is obviously over but markets – people – look ahead and they are increasingly positive about the post-pandemic future. That doesn’t mean they’ll be right of course, but economics is, more than anything, about human behavior, so maybe the markets are making the future rather than just reflecting some misplaced hope about it.

Copper, another widely cited indicator of growth, is also on the rise, up 15.5% just since the beginning of November. More importantly, gold has confirmed the move in growth-oriented commodities like copper. Gold peaked in early August at $2089 and fell 15% to $1767 by the end of November. The copper to gold ratio has risen over 40% from its low and 10-year Treasury yields have risen too, albeit not as much as we might expect. Those are all confirming signals of improving nominal growth expectations.

Having said that, futures market positioning indicates that markets may be getting too far ahead of the real economy. Speculators are increasingly piled into the long commodity trade with large long positions in copper and a host of other growth-oriented commodities, including crude oil. The crude market has been rallying in the face of a contango in pricing, which is generally bearish, but that has been relieved with most of the curve now in backwardation (normal). I also see some extremely bullish positioning in agricultural commodities, particularly soybeans and corn.

On the other hand, other markets where we might expect extremes don’t show them at all. Rising commodity prices are often associated with a falling dollar but large specs are well balanced in the dollar index. I don’t see extremes in the so-called commodity currencies, the C$ and A$ either. There are, however, a lot of longs in the Euro and a fair number in the Yen as well. In the bond complex, speculators are lopsidedly short the long bond, but we don’t see similar extremes in the 10-year Treasury or Eurodollars. Obviously, there are some contradictions here but skepticism is usually warranted when sentiment swings too far in either direction, and market positioning right now is very positive on the reflation trade. It probably makes sense from a risk standpoint to pull back a little and let sentiment come off the boil.

The title of this article is a reference to the Keynesian beauty contest view of markets. If you aren’t familiar with this way of thinking, I’d suggest you read up on it (Here). Investing is not like the lottery where the numbers are what they are and you win or you don’t. Investing is much more like poker where the cards are important but how the other players react is much more so. In investing, the data is important but much more important is how Mr. Market reacts to it.

Our job is to figure out what the crowd is focused on; how the majority views the economy. Markets don’t reflect the economy of today. Markets move based on the majority’s view of how the present will change in the future. An investor’s job is to judge whether that future is realistic, whether the economy can bridge the divide between where we are and where everyone thinks we’re going.

It seems obvious today that markets are looking toward the end of the virus, to what happens to the economy as things normalize. Consensus also seems to be coalescing around the idea that by late spring/early summer the vaccines will have done their job and activity levels will return to normal. Rising inflation expectations make sense if you believe the end of the virus will see pent up demand meet diminished supply. Everyone, it seems, has plans for what they want to do when this is all over. Travel seems to be at the top of everyone’s list, but everyday activities such as eating out or going to a concert will also be in high demand. With airlines shutting down routes and flights and restaurants failing in bunches, you might want to consider making your plans now.

Of course, we have to get from here to there without going broke so virus relief legislation is also top of mind for investors. Aggregate incomes have been maintained so far in the COVID recession and savings have risen. There is ample cash to fund that little post-pandemic boom, at least for now. The biggest risk at this point seems to be a change in the timeline. Can we get to the boom before the next bust?

 

 

 

Joe Calhoun is the President of Alhambra Investments, an SEC-registered Investment Advisory firm doing business since 2006. Joe developed Alhambra's unique all-weather, multiple asset class portfolios.

 

 

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