Market Analysis

Capital Tug of War

tug of warAs most of you know I continue to expect very volatile markets in 2015 with wild price swings in both directions. I wanted to share some thoughts on what’s likely to drive this volatility from a macro perspective. As we embark on a conflicting news cycle of ECB and BOJ QE on the one hand and a Federal Reserve potentially tightening on the other, these news events will continue to fundamentally impact on how equity prices will evolve in the months ahead.

Last week’s SNB disaster should leave no doubt on how drastically fast these policies can change the flow of capital.

Let’s face it: Equity prices are the result of a very intricate supply & demand equation. These past few years the world has seen new record highs in US equity markets at least partially as a result of the US Fed manipulating the demand equation by forcing cash to be deployed into equities and through ZIRP effecting an environment incredibly conducive for corporate buybacks.

The results are very much self evident:

Companies have been buying back shares in increasing amounts making EPS look pretty:


This capital friendly environment has attracted record amount of foreign capital allocations to US markets:

equity flows

With predictable results as valuations have soared:


QE ended in the US at the end of October 2014, but ZIRP remains in effect and so do buybacks. Since the US QE program ended the BOJ has turbocharged their program and now the ECB is upon us this week to supposedly finally announce their program.

Many claim that US markets have done well without QE since October. The actual data shows that this argument still has to be proven out. One could easily argue that equity markets finished the year in typical seasonal strong mark-up fashion, but within only two weeks of trading markets are right back where they were when QE ended:


So the “QE is not needed for higher prices” camp still has a lot to prove.

But TINA (there is no alternative) still prevails, unless of course there is an alternative. And capital flows to where it finds comfort. Rates remain low and buybacks will continue until this changes. So investors can continue to count on this large marginal source of equity share buying to remain until of course the Fed raises rates in a noticeable fashion. This policy debate will dominate every Fed meeting this year.

And let there be no doubt: This buyback game will change over time as rates rise. After all many companies have been able to borrow cheaply to buy back their own shares. And once borrowing becomes more expensive buybacks will likely ease. And then earnings growth has to come from actual organic growth. But that’s a debate for down the road.

The immediate issue will be the ECB announcement and the impact on the flow of capital. The ECB’s Draghi is on the hook to deliver and expectations are high:

Draghi’s goal at a press conference after the Governing Council gathers will be to convince investors he has a strategy big and bold enough to reinvigorate the moribund economy. Speculation over his plans has already sent the euro to an 11-year low, with the fund flows probably contributing to the Swiss National Bank’s shock decision to end a cap on the franc.

“Market expectations now are stellar,” said Attilio Bertini, head of research at Credito Valtellinese SC in Sondrio, Italy. There must be “no disappointment” and “the ECB’s next move should be pervasive, risk-transferring and long-lasting,” he said.

The larger question for investors has to be: Where will capital flow toward?

So far, in 2015, the judgement has been into bonds and Europe, Germany in particular. As US markets have struggled, the #DAX made record highs this past Friday much in anticipation of Draghi’s upcoming QE announcement no doubt.

The chart then makes clear how high the stakes are: Will the breakout to new highs sustain itself on lofty QE or will it fail:


We can’t know the answer until Draghi makes his announcement in typical “whatever it takes” fashion this week.

More detail on the our current technical view on the #DAX and markets can be found here in: “Cutting through the fog“.

What we do know is that the fight for capital flows is on as the specter of deflation looms large. And this battle will drive volatility for much of 2015 as global investors will have to make ongoing decisions on allocation.

Concurrently investors will watch Q4 earnings rolling in. Retail sales fell disappointingly by 0.9% in December and thus crushed the narrative of increased consumption due to falling oil prices. Looks like buybacks will have to save the day.

And if buybacks or growth can’t save the day in the months ahead investors can find solace in the fact that there’s still a third management tool available to boost earnings: Layoffs.

And hence the stakes couldn’t be higher: Years of QE have produced record stock prices, but little wage growth and so the consumer seems rather spent. So where does revenue growth come from? The global economic picture makes rather clear it’s not coming from the consumer.

Central banks have hoped that all their efforts would produce debt fueled growth transitioning into organic growth. The debt fueled part has taken hold in the US. The organic has yet to materialize.

But if layoffs are the next big thing it may never happen of course.

But good news for those of the 99% worried about impending wealth transfer from the middle class to the very wealthy. It won’t happen. It already has:

Billionaires and politicians gathering in Switzerland this week will come under pressure to tackle rising inequality after a study found that – on current trends – by next year, 1% of the world’s population will own more wealth than the other 99%.

And so it turns out George Carlin turned out to be a bit of a prophet when he predicted that “they’ll get it all from you sooner or later” (NSFW):

Buckle in, it’ll be a wild ride.

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