Price Is Lying

Well, I guess that’s that, Brexit was no big deal. I mean hell, the Dow is back making kissy faces with 18,000 and the S&P is flirting with all-time highs again, all must be good with the world! 
Not so fast.

The hardest thing for investors to evaluate is whether a post-event rally, like we’ve seen since Brexit, is for real or if it’s a trap. As one of the best minds in global macro, John Burbank, says, “price is a liar.” He’s right and the S&P 500 is lying to you. 

Burbank’s perspective is that the price of a security at any given time can’t possibly discount all of the various probabilities that exist about future events, both known and unknown. Anyone who has traded markets for any reasonable period of time knows this to be true. 
I know this type of “there is more to markets than price” talk riles up all of the Da Vinci code wielding Elliot Wave Theorists with their Fibonacci sequences and their C waves.  Settle down boys. Feel free to continue charting out the next coming of the Illuminati and believing that you can forecast markets based on whether an “A wave” was longer or shorter than a “B wave.” In a zero sum game, it means more money for the rest of us.

As a firm believer that price is a liar, distilling information from a broad range of sources is a big part of my framework. Last week, UBS released a research piece by the CIO of UBS Wealth Management “Brexit- Navigating the Aftermath.” 

The research piece begins by laying out the political risks and the high probability for economic contagion from Brexit. It began very well thought out and articulate. Then we make our way down to the investment recommendations section and here is where things get interesting. “US equities have fallen today but we remain overweight…a material underperformance of US stocks may offer opportunities for us to increase the size of our equity overweight.” 

My head almost exploded. Don’t get me wrong, the US equity market is the tallest of the pygmies right now. Just pull up a price chart of any other equity market in the world. The only one you would want to own, based on price action alone, is the US. But remember price is a liar. You cannot make investment decisions on the basis of price action alone. 

There is absolutely no reason on God’s green earth to be LONG US equities right now, much less overweight! 

What makes this even worse is that UBS is the largest private bank in the world with $2T in assets and the CIO, the guy in charge of investing, is telling clients to head long into US equities. 

To make matters worse, this is the exact type of research that advisors regurgitate like Polly parrot after an event like Brexit to calm clients down, and more importantly, keep them invested. Advisors and firms don’t earn any fees on your cash positions. They are incentivized to keep you in the game, even if the conditions are ominous.

I’m not just picking on UBS here, bank research in the US has been just as abysmal in the Brexit aftermath. 

Both Bank of America and Goldman Sachs lowered their forecasts for yields during Q3. Really?! Ya think? I honestly have no idea where yields will be when Q3 wraps up but based on what we know about the world today, it seems like a fairly safe bet that yields will decline further. The trajectory of both global growth and central policy almost ensure it.

Goldman even brought out the big guns in their yield analysis using what they refer to as their “Sudoku Bond Model” to estimate the fair value of 10-year government bonds. I kid you not, the Sudoku Bond Model. Yes, Sudoku, the numbers game in newspapers. This is Goldman Sachs we’re talking about here, not some middle aged dentist turned finance blogger who got the idea for this model while visiting his grandmother in Sarasota. 

But the real kicker is that both firms think the Fed will raise “just once this year.” I’m sorry, just “once”? Up until Brexit occurred you two still thought there was a chance the Fed would raise more than once. I swear it’s like playing “Sorry” with my sister’s kids. This is the fifth time we’ve played, how many times do I have to explain that when someone draws a Sorry card out of the deck and you aren’t in the “safety zone” you get sent back to start? 

I have no idea what the world will look like in December but based on what we know today, it's complete lunacy to come out and reiterate a view that the Fed is going to raise rates this year. 
Have you seen the US economy lately? No, Wall Street, the S&P is not the economy and just because the S&P is at all-time highs doesn’t mean the US economy is at all-time highs too. Remember, price is a liar.

In fact, just last week we got an up-to-date look at both the manufacturing and service sectors of the US economy. The short version is that manufacturing, while expanding, is still firmly entrenched in the downtrend that began in mid-2014. Manufacturing’s struggle with a strong US Dollar and the ripple effects of the energy sector decline is going to continue for the foreseeable future. 

The service sector is in a similar downtrend and can’t seem to pick up steam for more than a month or two at a time. However, the most disconcerting part of the latest survey is that business confidence looking forward 12 months from now is at the lowest level since right after the Financial Crisis. If corporate decision makers are that worried, why isn’t Wall Street? 

It’s not just the economy, investor behavior is saying that the entire S&P rally off the February lows is a façade. Investors have pulled money from US stock funds for 16 consecutive weeks, according to Lipper. Investors yanked $3B out of US equity funds just last week. 

If US equities are the place to be then why are people running out of US stock funds faster than people out of a nightclub after an NFL player shoots himself in the leg? When rallies are sustainable we see conviction from investors through fund inflows, we don’t see record outflows.

If you’re still not convinced that price is a liar, then here is but one of many quantitative nuggets for you to ponder. The Russell 2000 index, which represents a basket of US small caps, tends to lead a sustainable rally in the S&P. Year-to-date US small caps are trailing the S&P by 140 basis points. What’s more, US small caps lost twice as much as the S&P during the week Brexit occurred but only gained back half as much last week. US small caps know that the S&P is lying.

All of this and I haven’t even mentioned the rest of the world. 

Despite popular belief here in The States, the US cannot decouple from the rest of the world. At some point, what’s occurring in the Eurozone, China and Japan will severely impact the US economy. If the US economy is already teetering, what happens when the decoupling ends? Bad things, very bad things. You don’t want to be all hopped up on US equities in your 401k account (or any other account) when that happens.

I don’t just write this stuff for fun, I practice what I preach. I re-SHORTED the S&P 500 into Thursday’s close in client accounts. I’ve been wrong on 3 other occasions this year, will the 4th time be the charm?  I don’t know if it will or not, but I feel good about the trade. Based on the way I evaluate markets, the probabilities are leaning heavily in my favor. I’m happy to once again be fading the consensus. 

It’s all about reward-to-risk and while the S&P could certainly go on to make newer all-time highs, how much further can it go without a solid economic foundation and investor conviction?  I’m betting not far. And please, if your advisor calls and says this is a “buying opportunity” hang up the phone. 

He’s managing career risk, not your portfolio. He’s looking at your account that is probably already trailing the S&P this year and he’s worried you’re going to fire him at the end of the year. Period.

Whenever I see a divergence between what investors should be doing and what they are actually doing, I get as giddy as a secretary pool when it's somebody’s birthday and there is cake in the break room. Right now, the S&P is elevating and there is not one factor in my entire framework that is bullish the S&P except for the price action. Price is lying. I’m SHORT dishonesty and you should be too.