Impatient Bubbles

Where do Bubbles Come From?

Doing some thinking about various predictions I made in older posts along with predictions made by other bloggers, and it seems as if they are generally correct. Which got me to thinking if that isn't how bubbles begin - with widely predictable environments.

General macroeconomic developments are not that difficult to wrap your mind around and anticipate. Inflation isn't going to go from 2.7% to 0%, or to 5% overnight. It seems like bubbles really pick up steam when a majority of market participants correctly predict market events, and are not the result of wild "speculators" and other fools who placed incorrect bets.

The creation of bubbles seem (at least to me) to be the result of individuals following a very rational, typical line of reasoning. To the individual investor, you make a prediction about how the market is going to unfold over the next couple days, weeks, months, and even years. You then base your investment decisions based upon those predictions. Data is constantly coming in, and as data seems to corroborate your position, do you stick to your original allocation? Most likely not - you would act AGAIN based upon the same prediction. Even though your prediction is already priced into the market. Maybe you wouldn't act immediately, but as you see it is becoming a consistently winning sector or strategy, the impatience and urge to act again builds.
This is especially true if your prediction is initially luke-warm, but gains steam over the long run. You tend to pat yourself on the back by re-investing based upon your predictions. This process repeats itself numerous times, and across the market among many investors - as events unfold according to widely predicted events, investors are increasingly pursuing the same strategy, and upping their positions as data shows that they were right. And as the market is revealing its verdict that the prediction was correct, the predictions become more optimistic, even though nothing has fundamentally changed save other investors agreeing with your strategy.

The whole point of this is that the market has correctly been anticipating a slowdown for some time now, and as that scenario is slowly unfolding, several "congratulations" rallies have occurred. The market has congratulated itself for correctly (up to this point) predicting macroeconomic conditions, but can't seem to remember what the initial investment rationale was behind the positioning. Large Caps are the place to be in this slowing environment (who didn't see that one coming, the return of large-caps has been discussed for years now), but in a slowing environment should they be leading the market to all-time highs on a routine basis?

I think that impatience gets the best of investors in the formation of bubbles, and there is certainly plenty of that going around in this market. That is not to say that the current investment environment is frothy, but it seems to be inching closer.

Not so NYSE

Total Capitalization for the combined NYSE and Euronext has gone up 44% to 26.6 billion (as of this post). The breakdown for each stock is a 32% increase in Euronext Price, 56% increase in NYSE price since 5/31 closing prices (the day prior to the release of the merger details).

Euronext shares are getting hammered today, off 5.3% thus far on the news of Deutsche Bourse backing out of merger talks, however NYSE shares are up.

The point of all this is that NYSE stock is extremely overbought - I can't imagine that the merger with Euronext will make the company 44% more valuable (profitable) than they were as separate entities, and I think the new NYSE/Euronext stock is in for a bumpy ride as a result. Especially when you consider NYSE shares have outgained Euronext shares by more than 20%, and have not been affected to this point by the news that DB is no longer pursuing Euronext. Less competition means less bidding up of the stock, and NYSE shares would be expected to drop on this news.

The fact that NYSE shares have not been dragged down by the DB news and Euronext share plummeting isn't the only unique aspect of this merger. Typically the acquiring company doesn't outperform the target company's stock by 20%, especially considering each company will operate in a different regulatory environment. Combine this with some of the public statements by Mr. Thain guaranteeing the deal will go through (back when the NYSE share price was not that attractive and DB was still in play), and the NYSE appreciation smells a little funny. A lot of institutional investors have a vested interest in ensuring that the NYSE share price is attractive enough to see the deal through, and some of the one-day returns are abnormal to say the least. Seems as if the share price has become detached from the reality of the deal and any type of outlook on future profitability and is being driven more by the collective self-interest of NYSE shareholders. Almost every day after the NYSE price jumps significantly, it drops back on profit-taking. Can't say I blame them, I'd probably cash out at this point as well.

Thain Train

In a WSJ article this morning John Thain was fairly confident that the offer on the table will be accepted by Eurnoext in December:

"Our deal has to look economically attractive at the time they vote -- and it will"

I'm not sure how he can make this type of a guarantee when NYSE stock has been as volatile as it has been since the deal was announced in June, but let's assume for the time being that he is correct and the price of NYSE shares holds up, at least until December.

Keep that in mind while reading the following paragraph from the article:

The NYSE and Euronext plan to combine technology platforms, but not the markets they operate. European officials prefer this because it keeps U.S. regulations out of Europe. Mr. Thain said the exchanges aren't contemplating merging operations, but he did say convergence of regulation across borders would be desirable, particularly if changes are made to the U.S. Sarbanes-Oxley law.

A couple questions for Mr. Thain - Tell me again what will be combined? So the current NYSE price will hold up, but you're not merging operations? What IS merging other than the human resources and I.T. departments?

The recent NYSE appreciation seems a little steep for some new computers and a snazzy marketing campaign...I don't see how this deal can justify the recent NYSE share appreciation when the efficiencies you would expect from the deal are hampered by the details of the deal itself. The deal sounds great in principle, but I think the new shares are in for a bumpy ride. Especially when you consider that since the deal was announced, NYSE shares have outperformed Euronext shares on the back of this week's gains:


Volatility in the NYSE, as measured by a 5-day moving average of hi-low spread, is at its highest level since the merger was announced, while Euronext has logged steadier gains with less volatility.

The timing of Mr. Thain's announcement (on the heels of a 3.7% price jump in a single day) is just a little suspect - is it out of the question to think that an exchange such as the NYSE could call in a few favors to boost its share price? Conspiracy theories aside, the current valuation of the NYSE is high no matter how you look at it compared with the additional profitability and value added to the NYSE by this deal.

Yesterday

Here's yesterday's chart with the S&P 500 added, and the FF Rate/2-YR spread flipped around to represent the amount that 2-year treasuries yield over the target FF rate:


As noted yesterday, the only other time on this chart when the 2-year yield was below the FF rate and above the 10-year yield was in 2000.

Stock and Bond markets as predictors

The WSJ ran an article this morning re: the strong rallies we're seeing in stocks and bonds, and the competing views of the future these rallies imply. Either growth will remain strong and inflation under control and stocks have it right, or growth will disappoint to the point where rate cuts will be needed to stimulate the economy and inflation will be a peripheral concern. I have posted on this topic previously, and I still tend to side with the bond bulls.

A couple things - first, the Fed's stated focus on inflation is at this time a bit overblown and behind the times given the data, and I think the only reason they have not altered their statement to reflect any downside growth risk is that BB must still live up to the Fed's history as a staunch inflation fighter. His not wanting to include downside growth risks along with inflation risks has single-handedly brought the markets to near all-time highs, and by the time growth slows to the point of revising the Fed statement, it will come as a HUGE surprise to the stock market. Expect this to happen early next year.

Second, here is a chart showing that if history is any guide the FF rate will be in for some hefty adjustments next year. The only other time since 1990 the yield curve was inverted (measured here by 10-yr/2-yr spread) AND the 2-yr yield was below the target FF rate was in 2000...

Obviously the past is not necessarily indicative of the future, but I think the Fed has to ease at some point next year. The likelihood that they hit it dead-on with 5.25% is next to none, and another rate increase would absolutely rattle the markets at this point - it's a little shaky as it is. I think the Fed is pigeonholed into keeping rates steady for the remainder of this year to preserve its inflation-fighting cred, but as soon as BB thinks he can get away with it, the Fed will cut.

Who Determines Rates on Bonds of Varying Maturity

Pondering yesterday's post on Accrued Interest re: implied rate odds and the yield curve got me thinking about the relationship between the fed funds rate and bond yields at its most basic levels. There is an enormous amount of complexity and variety that now goes in to analyzing this relationship, and I wanted to shy away from that at the moment. I thought it would be interesting to take a look at what length of maturity the Fed likes to trade in.

Wish I had some more up-to-date numbers, but this graph will have to do to illustrate the point. Using data from an older FRB document covering the years 1975-1997 it looks at the average maturity of bond portfolios held by the Fed and by the market:


Prior to 1980 the Fed had a longer maturity portfolio than the market, however the 80's saw a rapid turnaround with the market having portfolios of bonds with twice the maturity by 1991 and sustained this trend through 1997. The Fed during this period essentially dealt with 3-year bonds or less. The Fed apparently decided that it would only attempt to influence rates on the short end at let the market make up its mind regarding longer maturities. You can see that anything beyond 5 years is simply the market placing bets amongst itself and taking cues from the Fed on the short end.

So High

Oil at $60 and the Dow finishes at 11613.19 - 4th best all time, and only 29.46 points off the year's high of 11642.65. How quickly things change. A few weeks ago oil was still around $73 and the market was hitting severe headwinds, up one day and down the next.

A month ago when it was still debatable as to which direction oil prices were headed I posted my thoughts on the Dow testing its 2006 highs. Here we are, and I still believe that this rally is setting itself up for a sizable drop off. The run-up in oil prices didn't dent profit growth, I doubt the slump in prices will have the reverse effect. Sans oil not much has fundamentally changed about the economy since a month ago (even the National Federation for the Blind saw the housing slump coming) - so what gives?

If you predict that it will rain tomorrow and you act on that prediction by purchasing a raincoat, when it rains the next day do you buy another one or are you content with the position you took prior to your prediction? Supposedly the market priced all of this in months ago, right? Housing slowdown, commodity slowdown, oil relief...it goes on and on - so why the rally now? When everything goes as scripted it might just be time to worry.

Keeping One Eye on the Road

Driving a car is an activity where the range of potential distractions necessitates you keep an eye on the road at all times. Whether you're passing a 5 car pile-up or have a screaming child in the backseat, other drivers on the road and passengers in your car count on you to sidestep those distractions and pay just enough attention to the road to arrive at your destination safely. You depend on the other driver as much as you do yourself to remain in one piece.

Much like driving a car, both the market and the Fed must not only be aware of where the other is, but they must also keep an eye on the road - the objective economic environment (outside of the FF rate, bond yields, and equity prices). Earlier today I thought I saw two drivers staring at each other, and not minding the road ahead of them - TickerSense mentioned that (at least) one Fed governor believes in the predictive powers of the yield curve. Now I know that the bond market is fixated on the Fed, but if the Fed were to be staring back with the same focus the situation would be a little uncomfortable.

With the Fed looking at the yield curve, the yield curve being derived from FF rate expectations - who exactly would be doing the driving? This is not to say the Fed should not look at bond yields or consider their impact, but if the almighty Fed believes the bond market can predict future economic conditions then why have the Fed meetings and all their black-box calculations enter into the decision at all? Why not just peg the FF rate to the 10 year? Probably because it would be a disaster. Probably because what makes the system work is that the Fed and the bond market represent two distinct interpretations of the same objective economic conditions that are both necessary. That the conclusions are often the same is not important, often they are not, and what is important is that there remains two separate methodologies for processing data and formulating ideas about the state of future economic affairs. Hopefully the two don't stare directly at each other and they keep at least one eye focused on the road.