S&P 500 and VIX: Bearish on S&P 500 (expecting a major correction after or sometime before the Fed exits the current QE program) and Bullish on VIX (towards the end of the taper); Fed is likely to bring back the QE after negative economic fundamentals hit expectations without QE support, as of 06/29/2014

We often say predicting/forecasting the future is almost impossible, as there are various unknown factors that shape the future. However given the fact that the Federal Reserve has been constantly intervening financial markets, it makes the prediction of the long term trend of the financial markets easier than the past, as Fed’s actions/intentions have become the main source of factors in the markets; these policy actions have eliminated numerous factors from pricing any type of financial asset in a spontaneous order. This article is written to present an observation of the current market based on such distortions.

Reflexivity Theory 

Based on Reflexivity Theory developed by George Soros, the essential part of the market mechanism is the “lack of correspondence, the inherent divergence, between the participants’ views and the actual state of affairs” (Soros); until such expectations/views come back to the fundamental reality (such event may very likely be triggered by the Fed’s own ignorance), which it can go far from expected, riding the trend with the Fed’s monetary policies so far have been the right decisions. However, based on S&P 500 performance during the QE era shown on the chart below from DoubleLine Funds, every time period with no policy or every time period towards the end of QE policy has been volatile, such as the period between March 2010 and November 2010 and the period between July 2011 and November 2011.

Relationship between Equities and Bonds Under the QE Era

During the QE programs, the market participants expect that Fed is capable of supporting the economic recovery; therefore majority of participants allocate their assets from bonds to equities. When there is no such policy, the market participants fear of economic dip without Fed’s life support and fly into the so called “safe assets” (which will not be safe either). Between March 2010 and November 2010, when there was no QE program, the stock market had a major correction in April and May, and the 10-year U.S. treasury yield dropped by 126 bps as shown on the following chart from Double Line Funds. During QE2, S&P 500 increased by approximately 10%, however the 10-year treasury yield went up by 50 bps (inversely, the price dropped). Subsequently between May 2011 and September 2011, when there was no QE program, the stock market once again had a 11% correction and the 10-year treasury yield dropped by 130 bps. Between September 2011 and November 2013, the Fed did not end/exit the QE programs; the equity index increased from approximately 1200 to a high of approximately 1800, and the 10-year treasury yield increased from approximately 1.8% to approximately 2.8%. As soon as the Fed announced the taper plan, the 10-year treasury yield has dropped by 20 bps to 2.7% as of March 2014, as some of the market participants once again feared and flied into treasury securities.

Based on a recent article by WSJ, Global Macro hedge funds have been hurt and caught up with surprises of the drop of treasury yields. If one understands what has been happening to the relationship bewteen equities and bonds during the QE era, such price movements should not have been surprises and can be profited ahead of time.

Global Macro Funds Could Be Wrong, Once Again

Based on latest report from JP Morgan (reported by Zero Hedge), the rolling 21-day beta of Global Macro hedge funds, which represents the average exposure of such funds to equities over the last 21 days, have increased exponentially since the last month.  If “buy when Fed buys and sell when/before Fed sells” still stays true, then it seems like the Global Macro hedge funds in general have stepped into the wrong direction. Once again, the availability of massive cheap money provided by the Fed’s monetary policies, have distorted the healthy market reflections on the fundamentals so much, that investors investing based on the fundamentals (bearish) have been crushed by the bullish performance of equity indexes. In addition, the volatility, which the Global Macro funds have relied on to make money, has also been tamed by the Fed during the last couple years. However, Contrarian Capitalist thinks the volatility will come back towards the end of the taper, should the course of the taper continues. As a result based on discussions aforementioned, the U.S. equity market is likely to trend downward after (or sometime before) the Fed exits the current QE program.

Will the Fed Bring Back the QE?

Yes, very likely. But when? That is very hard to say, but it is likely to come after the hard and negative economic fundamentals, without QE to support, to crush market participants’ expectations of the recovery. The change of the expectations is likely to cause a major correction. As the the final revision of the 1Q14 U.S. GDP reports a negative growth rate of -2.9%, which represents the biggest drop since the recent recession in 2009. The shocked (of course) main stream economists blamed the drop on the severe weather conditions without questioning the fact that how severe weather conditions can have such negative impacts on the broad economy. Contrarian Capitalist thinks the market is likely to start pricing in the difference between reality (the economic recovery is a house of cards) and expectation in second half of 2014 or first half of 2015; the feedback loop of reflexivity mechanism will resume (Calandro). But, once again, we don’t know exactly when that will happen. If the Fed reverses the taper before it exits the whole program, in that case, the equity market might not have a correction; depending on the size of the continuing program, the market participants might expect the economy will continue to be supported by the QE program (based on reflexivity theory, the expectations can shape the reality to some extent), until such expectations change in the future.

Source:

Soros, George . “George Soros Theory of Reflexivity MIT Speech.” . The MIT Department of Economics World Economy, 26 Apr. 1994. Web. 29 June 2014. <http://churchandstate.org.uk/2011/04/george-soros-theory-of-reflexivity-mit-speech/&gt;.

Calandro, Joseph. “Reflexivity, Business Cycles, And The New Economy.” The Quarterly Journal of Austrian Economics 7: 54. Mises Institute. Web. 29 June 2014.