FYI | Dec 09 2010
By BTIG market strategist Mike O'Rourke
On several occasions, we have referred to QE2 as a market distraction. The reason we think of it as a distraction is that the logic behind QE trades is simple yet seemingly compelling. The reason for the trade in Treasuries was simply to buy them knowing that a bigger buyer was coming into the market. The other theme has primarily focused on sparking a round of currency debasement and aggressive inflation (or even hyperinflation).
The way one would prepare for such an environment would be to buy Commodities and/or short the Dollar. Shorting the reserve currency is a tough task, even tougher when the EU is dealing with problems of its member nations. We never bought into the QE trade because to achieve the troublesome level of inflation that is feared, there would need to be a notable pick-up in credit expansion to increase the money supply.
We would never rule anything out, but markets have already priced in something that is very unlikely to unfold for some time. At the current levels of excess capacity and no credit growth, even if the economy's recovery continues next year, it will likely still be too early to be playing for inflation. It will take a rapid economic expansion to get inflation started. Nonetheless, these trades have worked on a number of levels. There are many investors who have been positioned for such moves for well over a year, and the Fed, in combination with market perception, sped these gains up.
The Continuous Commodity Index (CCI) rose 22% since the end of August. None of the 50, 40, 30 and 20 year compound annual growth rates for the CCI through the end of last year exceeded 3.8%. In the commodity run of the past decade, the annual growth rate was 9%. Needless to say, we believe this trade got ahead of itself in recent months and much of the gains were fueled by speculative QE trades. A month ago, we highlighted near record levels of speculator longs in what we called faux-flation. Today, the WSJ highlighted the high level of "investor" activity.
We have continued to favor Equities, believing that the state of disfavor in which they have been for several years will end as the economy recovers. Most investors are well aware of the strong rotation from Equity to fixed income over the past two years. Although the S&P 500 closed at a new recovery high today, domestic Equity mutual funds have only experienced inflows in 3 of the last 16 months and 11 of the last 43 months.
For 3 ½ years, investors have been selling Equities. There is similar data to illustrate that the vanilla institutional community has also shied away from Equities. At this point, it will only take low single digit earnings growth in 2011 for the S&P 500 to post a record year of earnings. That prospect will soon begin to resonate with investors. Those who have been overweight other assets at the expense of Equities should begin to reverse course.
One retort to our argument is that the S&P 500 has risen 17% since the end of August, which is a move in the same ballpark as the Continuous Commodity Index. To counter that, below are a series of charts comparing the cumulative year to date volume versus last year in Equities as well as futures contracts on Treasuries, several Commodities, the S&P 500 and the Euro. Charts 1, 2 and 3 apply to the Equity markets.
One can see how volume in 2010 has consistently been below that of 2009 and in the past few months, the gap continued to widen. We believe this is an indication that investors have not flocked back into Equities in the manner that a 17% rally may indicate. The trends are similar in the S&P futures where e-mini volumes in 2010 are on par with 2009, but the large contract volumes in 2010 are well below that of 2009.
With the exception of Crude and Soybeans (where 2010 volume is on par with 2009), charts 4 through 13 all depict the same thing – whether it is Treasury Bonds futures, Euro futures or any other Commodity future, 2010 volumes are far out pacing 2009. That is why we refer to QE2 as a distraction. This is where all the action has gone, but these are trades, not investments. Even if they were investments, the price action will turn them into trades.
We view the real long term upside potential to be in Equities, where that prospect of record earnings gets enticing. Those who focused primarily upon QE trades have already missed an impressive Equity move in the past few months, but unlike many of the QE trades, Equities have not hit record levels. The question is whether investors will rotate back to Equities after they pull the ripcord on Commodities? We expect that faster money will look for the entry point to Equities because, at the very least, they will want to be there before the vanilla flows reverse course after 3 ½ years of selling.
The views expressed are O'Rourke's, not FNArena's (see our disclaimer).
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If you are reading this story through a third party distribution channel and you cannot see the charts included, we apologise, but technical limitations are to blame.
