Weekly Comment - February 13, 2018

Feb 13, 2018 | Nick Foglietta


Clearly, there are lots of other crazy stories floating around the media about why financial markets have taken a turn for the worse. So, why am I stuck on talking about interest rates?

Keep calm and keep watching

Let’s start this week with the summary statement I left you with in last Monday’s comment.

“Interest rates need to take notice of weaker stock prices and stop going up.”

That simple statement did not take hold last week.

Even though on the week the S&P 500 lost 5.2% and the TSX 3.7%, interest rates barely budged.

Clearly, there are lots of other crazy stories floating around the media about why financial markets have taken a turn for the worse. Most are likely true and partly to blame for the weakness.

So, why am I stuck on talking about interest rates as being such a key to financial markets?

One reason: DEBT!

Debt oozes out of every corner and crevice of the global financial landscape.

Debt is at record levels for individuals, corporations and governments.

Debt has enjoyed 10 years of nearly zero interest rates, and higher interest rates are kryptonite for inflated asset prices.

What drives interest rates higher?

Inflation. Or more specifically, anticipated future inflation.

Here is the way John Menard Keynes explained the narrative for how financial markets account for potential inflation in financial markets. (Taken from Wiki)

“Keynes described the action of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose the six most attractive faces from a hundred photographs. Those who picked the most popular faces are then eligible for a prize.

A naive strategy would be to choose the face that, in the opinion of the entrant, is the most handsome. A more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of attractive is, and then make a selection based on some inference from his knowledge of public perceptions. This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents.

"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees." (Keynes, General Theory of Employment, Interest and Money, 1936).

Keynes believed that similar behavior was at work within the stock market. This would have people pricing shares not based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is, or what everybody else would predict the average assessment of value to be.”

So to summarize what I am presenting: If investors believe that other investors believe interest rates are going higher because inflation is rising they will sell stocks and bonds to get ahead everyone else.

Understanding this principle is key to staying in touch with the financial markets at major turning points.

The mainstream media will keep talking about how “the fundamentals are still great” and “earnings are still forecast to rise.”

An example of this thinking is contained in the graphic below presented by RBC Dominion Securities advising investors to “keep calm and stay the course.”

But, if the narrative is changing and financial markets are at a medium-term turning point, then asset prices will likely be most responsive to the perceived changes in the financial landscape (inflation) and not fundamentals and earnings.

My advice: Let some of these potential changes become more entrenched. As stated earlier, it is too early to tell if the narrative has changed.

Using the Canadian TSX as an example, let me show you how I would look for clues to see if things have changed. The green line bouncing higher off the low levels just under 15,000 on the TSX is my base expectation over the next week or so.

If the TSX can hold the blue 200 day moving average line at 15,600 for three consecutive days it would be a strong case for the end of the correction in Canadian stocks.

If the TSX cannot hold the 200 day moving average and falls back into the “danger zone” markets by the red arrows in the 14,750 – 15,000 range it would make a strong argument for lower prices still.

Feel free to write your thoughts on this topic. It is always a pleasure to include your thoughts in the weekly comments!

Closing Thoughts

I happened on the chart above during the week. It made me think about how many nations have “privatized” away their “piggy banks.” No wonder nations are so eager to take on more debt; the traditional assets have been used up already.

When I came across the next chart it verified so many of the observations made as we live in our communities.

The workforce looks older. We notice it in so many places. Fast food outlets, retail places, non-trendy restaurants and many other service industries.

It makes sense too. Older workers are often just supplementing other income sources so they don’t need full time and are very dependable.

But still, there is something disturbing about the chart above! How can the wide spread of hiring between the above 55 and below 55 age demographics be a healthy development long term?