Bernanke's Dogs

Topics Covered

• Pavlov trained dogs, just as well as Bernanke trained investors

Weekly Overview

Nothing new to report. Refer to the side menu for previous articles.

Global Macro

Nothing new to report. Refer to the side menu for previous articles.

Economic Data

I am not actually sure if Mr Ben Bernanke, the chairman of FOMC, has any pets including dogs. However, this article has less to do with animals and more to do with psychology. In the late 1800s, a Russian Nobel prizing winning scientist and a psychologist by the name of Ivan Pavlov was experimenting with animals, specifically dogs, on basic reflexive conditioning. It might not sound all to fancy today, due to huge advancement in human knowledge and technology, but what Mr Pavlov discovered back in late 1800s was quite a break through for his day in age and it obviously still applies today, especially in fields like financial markets where human psychology tends to be the dominant factor.

Mr Pavlov knew that a common natural response for a dog that is about to be fed was to salivate, as we can see in Fig 1 in the chart above; and furthermore he also knew that various "stimulants" like ringing of the bell or blowing of a whistle did not create the same response (Fig 2). However, what Mr Pavlov discovered back in his day, was the fact that if a stimulant was constantly introduced while the dog was fed food (Fig 3), it would be conditioned to remember that specific stimulant (Fig 4) and start salivating even without the presence of food itself. It was a huge break through back in his day. Eventually, Mr Pavlov discovered that the dogs salivated as much to a stimulant (whistle, bell, noise) as to food itself, as they were trained and conditioned to do so. For further explanation, refer to this video.

So you are probably thinking, what does this have to do with investing and the current state of financial markets?

Good question. Let us assume for the sake of this write up that Ivan Pavlov is Ben Bernanke, Pavlov's dogs are global financial investors like you and I, the bell is quantitative easing also known as QE and finally, food is actual global growth. Can you see how all of it perfectly falls into place now, especially if you look at the chart above?

The basic concept of investment is that risk assets like equities need at least decent growth to perform well. All one needs to do is look at the performance of manufacturing against stock prices, to understand that economic expansions create positive returns and economic contractions create negative returns. This is because in a growth environment companies earn profits and therefore this becomes reflected in their share price / dividend payouts. Obviously, during periods of growth (food), investors (dogs) act bullishly and buy stocks (salivate).

However, since late 2008, dogs (global investors) have become reflexively conditioned by Ivan Pavlov (Ben Bernanke) through a stimulant of bell ringing (quantitative easing or QE). Whenever Mr Bernanke even mentions the fact that he will try and stimulate the economy, global investors start buying risk assets, front running the Fed prior to their official announcement. Now let me rephrase that in another way based on the concept in this article - whenever Mr Pavlov rings the bell and pretends he will bring food out, the dog starts salivating.

Unfortunately, the dog is not smart enough to realise that bell ringing alone will not feed his empty stomach. For that food is required. One would assume global investors are smarter than dogs, but it doesn't seem to be so. Majority should know by now that money printing programs do not stimulate the economy, but mainly stimulate financial markets for a short period of time. QE has not created sustainable growth in both employment and nominal GDP, both of which resemble the slowest recovery since World War II. Therefore, without food the dog will eventually starve, no matter how many times Mr Pavlov rings his bell, or to put in in financial terms - without growth company revenues and earnings will eventually fall and mean revert during a recession, no matter how many times Mr Bernanke does another round of QE.

The reason I bring this up is because Bernanke's dogs have been in salivation for weeks on end, as rumours circulate that Mr Bernanke is about to ring the bell on QE 3. Global investors are hanging onto  hope, which is quite a famous emotion present at the beginning of bear markets and prior to recessions. Further printing of money is not going to help company earnings rise, it is not going to help profit margins expand further, it is not going to help nominal GDP expand, it is not going to help global exports volumes increase, it is not going to help the unemployment fall, it is not going to help Greece from eventually defaulting and it is not going to help Spain with its borrowing costs. Printing money will only make prices of food, energy and metals (especially the precious type) rise dramatically.

Equity Markets

Nothing new to report. Refer to the side menu for previous articles.

Bond Markets

Nothing new to report. Refer to the side menu for previous articles.

Currency Markets

Nothing new to report. Refer to the side menu for previous articles.

Commodity Markets

Nothing new to report. Refer to the side menu for previous articles.

Credit Markets

Nothing new to report. Refer to the side menu for previous articles.

Trading Diary

• Outlook: I believe that we in a bear market as the global economy starts slowing down meaningfully. US GDP has grown 5 quarters at around 2% or lower which tends to be stall speed. Over the last 60 years, whenever the economy grows at subpar levels it has always entered a recession. Recessions occur every 4 years of expansion during secular bear markets, so next year we are overdue for a slowdown. However, it could be much earlier as leading indicators show not all is well right now. At the same time corporate earnings and gross profit margins are at record highs, so I expect a mean reversion. On average earnings tend to fall by 25%, so a drop to $70 from current levels in earnings could take the S&P down below 1,000 points on a 12 times multiple. Cash levels in money market funds are extremely low, financial stress is starting to rise, volatility is at very complacent levels and credit spreads are very narrow relative to fundamentals, so I expect a risk off scenario in due time.

• Positioning: I've positioned myself towards long PMs especially Silver (SLV, PSLV, SIVR) and have recently just accumulated more, because I believe central banks will continue to print money and devalue currencies whenever the economy gets worse. Furthermore, investors were heavily exposed to US Dollar and the sentiment on Silver is also extremely negative, so from a contrarian point it makes a lot of sense. On the other side of my book, I have recent opened a short on Junk Bonds (HYG, JNK), as I believe credit spreads will spike into the future, similar to the VIX. I have also shorted various US stock sectors, including Technology (XLK) and Dow Transportation (IYT), former because the sector is much loved by the global fund managers and the latter because I believe economically sensitive stocks will suffer during a recession. Finally, I have recently hedged Silver longs and plan to do more if the triangle breaks below $26 support. If the triangle breaks on the upside, I will take my hedges off and most likely buy more.

• Watch-list: A major short in due time will be US Treasury long bonds (TLT), as they are extremely overbought and in a mist of a huge bubble mania. Other than that, not too much is on my watch list right now.