The T Report: Fuzzy Wuzzy Was a Bear

Bullish Sentiment Still Not as Aggressive as Bearish Sentiment

I read report after report that pointed out the Bear Case. The Demise of Europe, Hard Landing in China, and Fiscal Cliff dominated the analysis, roughly in that order.

I agree with a lot of the Bear case. I can see it. I can argue it, heck, since much of it is focused on the bond market I think I could argue it better than most. The problem with the bear case isn’t that it isn’t compelling, just that it hasn’t worked.

So what is wrong with the Bear Case?

For one, the bear case, in many instances is done with as much “fluff” as cheerleading bull arguments.

If Spain rolls 1 billion of debt, no new debt was created. Sometimes, the “debt on debt” argument is devolving into a rant. If a country can replace 4% average coupon debt with 2% average coupon, that is useful. It decreases current deficit. It reduces how much money has to be borrowed to pay interest. I’m not convinced this will happen, and I am concerned that the focus is on the short end, but average coupon does matter, access to cheap debt to roll old debt does matter. So this is one area where the bears are potentially too pessimistic.

Underestimating the impact of a Eurozone break-up is also something the bears miss. The fear of re-denomination risk impacting Europe. The economies are slowing, on top of everything else, but because the uncertainty is huge. This isn’t uncertainty about an incredibly complex healthcare bill, or whether some percent of the population will have to pay some higher percentage of tax on a percentage of their income. This is, OMG, what am I going to do with Pesetas uncertainty! Or, wow, how the heck do I break this contract with Germany now that they have moved to the Deutschemark.

While it has common to underestimate the impact of a break-up, I think many overestimate how hard it is to see some return to growth. This is where it gets more interesting for the bulls. If Europe can spur growth, through stimulus and cheap money, then China and the U.S. will benefit as well. Europe is a big reason for Chinese weakness. A return to growth in Europe would filter to the rest of the world. Again, this isn’t easy, but it is not impossible either,

Which leads me to the last question, why is it suddenly it is common knowledge that QE doesn’t work? That it has diminishing returns. In many ways I agree, but in some ways I don’t.

I don’t think QE does much for the economy. The economy already has low rates and I see no evidence that QE boosts final demand, which is what is really needed. On the other hand, QE does cause asset inflation. Not all the money sits in t-bills, some moves out the curve, eventually finding its way into corporate bond risk or even equities.

QE2 was far less successful than QE1 in terms of boosting the markets and impacting the economy. That has lead to the conclusion that there are diminishing returns from QE. That ignores the fact that QE1 was far more aggressive than QE2. It is like comparing the NFL to the CFL – in theory the same sport, but not that similar. Also, many of the reports look at the percentage returns during QE. Percentage returns are misleading. The “wealth effect” to the extent it exists isn’t based on percentages, but actual wealth. The key is to look at change in market value during the period. QE2, in market value change, was less disappointing than when looked at on a percentage change, and don’t forget to take into account that QE2 wasn’t as aggressive a program as QE1.

Operation Twist is a joke to me. Economists can talk about it, but the way we get asset inflation is new money pumping into the system – particularly at these rates. I never expected much from Operation Twist, so arguing that OT is another example of diminishing returns from Fed action is a waste of time. In fact, I would argue that LTRO, which occurred during OT, explains far more of stock price action that Operation Twist, but that is a level of complexity that is as hard to prove as it is easy to ignore in an attempt to diminish the impact of QE on the markets.

Which leads me to the final question of the bear case, where is Europe in terms of QE? While we may be contemplating QE3, it looks like Europe is heading to their version of QE1. LTRO was close to QE and that had a major impact. What impact would a true European QE and stimulus have? Europe may only be on QE1, so in spite of being jaded about the possible impact of further Fed QE, the same rationale may not apply.

Trading This Market

I continue to fluctuate between being 50% and 25% long. I continue to look at S&P September 1,350 puts as a potential hedge, or outright short. I think that Europe, Banks, and CDS can outperform U.S., Industrials, and Bonds as too much “disconnection” has been priced in, and the areas that receive direct benefit have the most room to outperform.

I cut into the weekend, but will continue to buy when we sell off on headlines that to me are “expected’ and part of the “process” and don’t change anything. I have a 1,425 target on S&P that i think is absolute max for now. I will continue to look for signs that the market is too complacent (getting there but feels about balanced). I am constantly questioning my weak bull theory (I’m only 25%-50% long), but more often than not, the questioning has lead me to add risk rather than sell, or even get short.

A lot is going on. Europe has a tendency to disappoint. So many other reasons to be bearish, but for now I continue to think bears are under estimating what can be accomplished and remain too pessimistic and are dismissing facts as much as the bulls often have.

The PAIN trade is looking more and more like it is low volume grind. It doesn’t help funds as once again, they look behind many other asset classes and that could create some interesting trading motivations.