Blind Manʹs Bluff.

June 4, 2013

The timeless children's game, Blind Man's Bluff (actually called Blind Man's Buff, originally), in which an individual is blindfolded and set to groping about a spacious, hopefully safe area in an effort to touch one of the other players, who then takes the blindfold and a turn.
Groping blindly for moving targets in a spacious area? Sounds difficult. But, so does grasping for economic targets using unprecedented fiscal and monetary tactics with no idea as to how this could all end up. Which is exactly what the Fed is doing in its continuing efforts to revive our moribund economy.
Blindfolded. Face wrought with false confidence. Groping for something, anything, to signal an end to this uncomfortable exercise in the unknown.
The last two months we have warned that a correction was likely coming. While we drew comparisons to 1995, a year in which markets shot higher while experiencing little more than a 3.5 percent pullback, we also explained that such unchecked advances are rare. And so, brace yourself, for a pullback is nigh.
Well, here we go. Perhaps...
These last two weeks have seen the S&P 500 fall 2.4 percent. Concurrently, the VIX volatility index leapt 27-percent higher, signaling a return in market volatility. While the relative drop in the major indices has thus far been minimal and expected, it's that which is transpiring behind the scenes that worries us.
Last week, the London Telegraph's venerable economics columnist Ambrose Evans-Pritchard penned a piece entitled, "No savior in sight as world credit cycle rolls over." Therein, he makes a compelling case as to why the global economic cycle has topped, and how this portends ominous times ahead.
According to Pritchard, the HSBC index for the global business cycle hit a three-year high in April, and has since rolled over. He notes that any nation having failed to lock in a sustainable recovery by now is S.O.L. (my term, not his).
Evidence is mounting for a cyclical downturn. The Eurozone remains marred in recession at a point when the cyclical economic indicators should have peaked. In other words, as many global economic factors point towards a near-term high in the world economy, Europe remains crippled. Manufacturing is down. Unemployment is at European Monetary Union highs. Nor does the situation appear to be improving.
All of which stands in stark contrast to the U.S. central bank's recent commentary in which officials considered the onset of "tapering," a time when the Fed will begin to wind down its monthly $85 billion bond purchases.
I've seen a few disconnects in my time. Mostly involving young ladies and my awkward teenage attempts at dating. However, this one stands alone for its size and audaciousness. As the rest of the world braces for impact, the Fed is acting as if it hasn't a care in the world.
Is the Fed simply posturing?
Commodities prices topped last September. The Dutch CPB index of world trade contracted from February through March. Still, equity markets have continued to race upward. So, should investors be reeling in their speculative bets as fast as they can, or are the markets -- which tend to lead economic turns, as opposed to follow - simply alluding to better times ahead?
It is quite possible that the unprecedented ineptitude of our Federal government's handling of sequestration and the fiscal cliff is serving to steer down economic indicators the world over. More so than many economists felt possible. Further, as the Fed begins broaching an end to quantitative easing, savvy global investors flash back to the Fed's great policy error in 1937. Then, a post-Great Depression fledgling economic recovery was killed in cold blood as the Fed got too aggressive pulling the baby from the mother's milk.
Yet, that is exactly what markets are scared of. Well, that and a potential global economic contraction before a recovery even begins to sustain itself.
If the HSBC economic cycle forecasts are correct, then we can expect rough seas ahead. Interest rates remain at zero throughout the developed world. Public debt remains higher than in 2007. European unemployment remains at record post-currency union highs. And this time, the emerging BRIC nations are nowhere near as strong as they were in 2007, when they were able to weather the storm and inject much needed credit and liquidity into the global economy.
The potential for rising rates may scare investors enough to seriously hinder the current bull market. Or, not.
Already, the banking and financial sectors are benefiting by potential rate rises, with their respective indexes up nearly 2 percent apiece even as markets in general have fallen. As rates rise, banks stocks benefit by a boost in their net interest margins, or their ability to borrow cheaply, lend at a higher rate and pocket the spreads. In the last three months, as the S&P 500 has added seven percent, the Financial Sector SPDR (XLF) is up 12 percent. That disparity can only widen if rates trend upwards.
Likewise, retailers, semiconductors, healthcare, regional banks, financial services and biotech have outperformed. Otherwise, most sectors have fallen behind, of late.
Of course, Bernanke and the Fed could simply be talking the markets down. Attempting to cool off what has been seen by some as spurious market gains. Still, the market may call the Fed's bluff. Because there is still much room for optimism. And the trend remains bullish.
Until the game is over, the Fed, and so the rest of us, will continue to blindly grope for something tangible. Some good news indicating that we can remove our blind folds, stop this uncomfortable exercise and move on to something more grounded in reality.

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