Central Banks vs Asset Prices

One of the most popular charts to post in the financial community is the S&P 500 correlation link with the Fed’s balance sheet, especially since the bull market began in early parts of 2009. Just about every trader, investor, analyst, economist, market “guru” and media anchor quotes it on regular basis. If everyone says it, then it must be true… right? Well, maybe it isn’t.

But what if this relationship stops correlating soon and the Fed loses the control of the stock market? Or maybe it never had the control in the first place? Historically, there is nothing new under the sun (Jesse Livermore quote), so a bull market will stay in a bull market until buyers get exhausted.

Chart 1: Central banks policy & equity prices don’t always correlate

Stock Prices & Central BanksSource: Deutsche Bank, Ed Yardeni Blog & BCA Research

The chart above is broken into three sections. Firstly, Deutsche Bank shows how S&P and Fed’s balance sheet are moving in link since March 2009. Secondly, Ed Yardeni shows how ECB has reduced its balance sheet since mid-2012, while Fed has increased its starting in late 2012. Finally, BCA shows how despite the falling ECB balance sheet, German DAX 30 has moved up a like a rocket. Here are some interesting points to think about:

  • So how can one market move up when its local central bank is increasing its balance sheet and yet another market also move up while its local central bank is decreasing its balance sheet?
  • Do you remember the correlation charts link to Gold and central banks? That one worked for awhile, but just as everyone was expecting it to work the third time around… it stopped.
  • What about the correlation between the Euro and commodities, and in particular Gold? Rising Euro usually meant falling Dollar, so Gold would rally too… however in 2013 as Fed increased its balance sheet and ECB reduced its own, Euro gained against the Dollar while Gold had a worst annual loss since 1981.

It seems to me that certain correlations between central banks and assets work until they don’t, while the majority of the analysts in the industry just guess and make up the reasoning behind the moves. I do not have the answer for all of the questions above, as I do not pay too much attention to what central banks do. I believe in following markets and I believe that assets eventually reflect fundamentals in the long run.

Asset Class Performance For The Cycle

I thought sharing this chart would be extremely interesting since we are closely approaching two major milestones. The first is year-end performance and the second is a five year anniversary of the bull market in equities. Since the majority of assets bottom between late 2008 and early 2009, the chart above also shows how they have performed for the overall investment cycle.

Chart 1: Performance of various major assets for the investment cycle

Performance Since Late 2008Source: Deutsche Bank Research

I bet if I told you that the top two performing assets are Copper and European High Yield, considering all of the issues both China and Europe have been through since 2011, you would tell me I am lying. Remaining in the top 5 best performers, the ones that are easier to pick would be US assets such as S&P 500 and US High Yield. Interestingly Russian equities as well as the overall Emerging Market stock complex is also seen near the top. The fact is that these assets had tremendous moves out of their lows and funnily enough, just about all of the investors missed it.

Not too many assets have lost ground, but a couple comes to mind, such as the Greek stock market and the Japanese Yen (with its recent crash). Surpassingly, Euro-Dollar exchange rate has been essentially flat. Despite ongoing media coverage of bond performance during the Euro Crisis (2011 and 2012) Treasures and Bunds have really lagged rest of the asset classes. One could argue that these assets outperform during recessions like that did during 2007/08 period.

Observing this chart, where do you see the value and what do you rate overly expensive?

Another Look At Breadth

Chart 1: Despite new highs, breadth continues to bearishly diverge

S&P 500 vs 200 MASource: Short Side of Long

Just a quick update on one of my favorite indicators for the stock market – the percentage of stocks within the S&P 500 trading above the 200-day moving average. The indicator continues to flash a warning signal, something I have discussed on my blog for the last few months. So far the market has turned a cold shoulder to ongoing bearish divergence as it continues to tear higher into record territory.

Chart 2: The stock market has been overbought for the whole of 2013

S&P 500 Overbought vs OversoldSource: Short Side of Long 

And while bearish divergence is in progress, the same indicator can also be looked at from another perspective – either an overbought or an oversold level. As we can clearly see in Chart 2, the overall stock market breadth has remained overbought for the whole of 2013. Breadth isn’t the only group of indicators flashing overbought levels, as technical indicators, as well as sentiment, are also flashing warning signals.

Contrarian Approach

Here at Short Side of Long blog, contrarian analysis is the core of executing investments, while fundamental research is the selective process between asset classes. And while I understand that being a contrarian doesn’t always work, over the long term it is definitely one of the better ways to invest. This is also confirmed by the recent study conducted by Russell Jame of the University of Kentucky. Bloomberg writes:

“The best hedge fund managers tend to find profits in short-term, contrarian bets.

That’s the finding of a study published this year by Russell Jame of the University of Kentucky and set to be presented next month at the American Economic Association’s annual meeting in Philadelphia.

Star hedge funds secure profits over short periods, with more than 25 percent of an annual outperformance occurring within a month after a trade. The profits are also often made when managers have bet against the prevailing market view.

Personally, I do not trade as frequently as some of these market experts, but I do find that the contrarian approach works just as well over the long term. Just remember that in this game, patience is a virtue. In other words, buy something and wait five years (instead of just five weeks haha!).