We all know that central bank intervention plays a key role in how today’s markets move. Recently, a piece of information came out that so beautifully illustrates the dynamics of markets today – and why algorithms are so important when it comes to managing capital – that I had to stop and write about it.
In fact, there’s never been a piece of news that proves the relevance of our recent article (about central bank intervention, algorithms and individual investors) more so than this new information.
In that recent article, we discussed at length the fact that if you are still using old tools (such as valuations, P/E ratios, etc.) to make investment strategy decisions then you’re going to be in big trouble. To be fair, those types of old tools worked for a long time (over 100 years). After 2008, however, the world changed dramatically. With the introduction of massive central bank intervention, the relevance of old tools seriously declined.
I’m about to share with you a recent statistic about the European Central Bank (ECB). It’s a fact that puts the old tools/new tools debate (and the change it requires) into stark relief.
Listen to the podcast for colorful commentary — or continue reading…
The Impact of Central Bank Intervention
The widespread impact of central bank intervention challenges the old approach to portfolio management for the individual investor. Learning how to adapt (and why) is critical in the process of creating a new investment strategy to protect your nest egg.
Straight from the Rosenthal Capital Management trading desk, Head Trader and Principal, Bret Rosenthal, explains the effects of central bank intervention, plus an overview of how the individual investor can adapt his approach to protect capital.
Have questions about what you hear on the podcast or read in the investment algorithm article? We love answering follow ups: Call or email us.
CENTRAL BANK INTERVENTION BEFORE AND AFTER 2008
Prior to 2008, central bank intervention in the form of outright private asset purchases (corporate debt and equity) while not illegal, was certainly not an advocated process. Moreover, no one could have predicted the extent to which it occurs today.
[DISCLOSURE: I have to do some research on this kind of central bank intervention. If it wasn’t illegal it certainly was frowned upon. I’m not even sure it was done prior to 2008.]
Post-2008, however, has been an entirely different story. In the past nine years Central Banks have literally created currencies out of thin air and scooped up all kinds of private assets all under the guise of market stabilization. The old story of governments trying to save the people from themselves through massive manipulation. These stories never end well.
As investors, we are living in a new world. This is your wake-up call.
PROTECTING YOUR NEST EGG IN THE MIDST OF CENTRAL BANK INTERVENTION
Maybe you’re shaking your head, saying,
- “I’m a buy and holder”
- “The market’s up big!”
- “Who cares about protecting capital because markets always go up?”
If any of that sounds familiar then I would ask you to go look in the mirror and ask yourself these questions:
- “How did I feel in late 2008 when my nest egg was cracked and scrambled?”
- “Is it ok if that happens again to my nest egg?”
- “Will I be content to wait and hope for another government bailout?”
- “Is this really an investment strategy?”
Today, if your answers to these questions are sanguine and perhaps cavalier, then I submit to you that you won’t even need a 50% correction to change your opinion.
Imagine looking in the same mirror after your assets have dropped 25% in six, eight or twelve weeks. What will you your answers be then? Will buying and holding still be your answer of choice? Probably not.
In that moment if you ask yourself these questions again you will probably get different answers.
Addressing these issues today when markets are making new highs – and everyone feels complacent – is the time when it can be helpful. Having this conversation after markets have dropped 30-40% will be much less helpful.
I commend you for getting to this point and reading further. This is the hard work that will make you a better stock market investor long-term.
THE IMPACT OF CENTRAL BANK INTERVENTION
Central banks are controlling the market right now. But don’t get used to it. Here’s a worrisome fact:
We will never know when central banks decide to stop controlling the market.
Instead, we’ll only know after it happens. For example, after the market drops 25-30% in a short period of time. Then, news will come out explaining that central banks have done x, y and z and are no longer liquefying the market.
Right now, of course, it seems like that will never happen. These days it seems like central banks creating currencies out of thin air and buying equities is “the new normal.” But that’s not true. There will be some reason and the liquefaction will end.
CENTRAL BANK INTERVENTION: New Heights of Manipulative Arrogance
Now, here’s the startling statistic I referenced at the beginning of the post:
The European Central Bank holds 13.4% of the entire European corporate bond market. That’s $650 billion Euros roughly.
Let’s get some perspective from these details:
- The 2008 collapse led the US Fed to invent the Quantitative Easing (QE) process.
- Even at the height of financial market stress the US Fed only bought US government debt.
- Many have questioned whether using the Fed’s balance sheet to buy US debt was legal. (Can you imagine the uproar if the Fed started buying shares of Apple (AAPL)?)
Fast forward to today:
The European Central Bank continues to print currency and buy corporate debt and corporate equities. (As we discussed in a recent podcast: The Central Bank of Switzerland now holds more public shares of Facebook than Mark Zuckerberg).
Here’s what’s going on in Europe courtesy of the Central Bank of Europe (ECB):
- Last month the ECB purchased 401mm Euros of corporate debt – at a higher rate than the average run rate of the year, which has been around 365mm Euros.
- So, in just the last few weeks alone the ECB is upping its activity in buying more European corporate debt.
Manipulative Arrogance Leads to Insane Valuations
(Caution: reading the next paragraph may be hazardous to your financial sanity. Proceed at your own risk.)
As a direct result of ECB intervention, European junk bonds are now yielding less than 20+ Year U.S. Treasuries.
Ultimately, this means that European junk debt (corporations that have a credit rating of junk) have yields lower than the U. S. Treasury debt.
In essence, the markets are saying that right now it’s safer to buy European junk bonds than long-dated U.S. Treasuries.
ADAPTING TO CENTRAL BANK INTERVENTION: Adjust Your Investment Strategy
In response to central bank intervention we must adjust how we run money. Let me show you what I’m talking about:
If you’re still using the old tools of valuations, P/E ratios (or however you would come up with the correct value of junk bonds in Europe) then you would conclude a short position in European junk bonds is a portfolio imperative. Probably, you would have come to that conclusion months ago. If you did, you’d be out of a job right now. Your investment thesis would have been destroyed care of the ECB.
But here’s the truth: You wouldn’t have been wrong. The problem would have been that the tools you were using are wrong.
Those valuation tools that used to work for decades don’t work in a world where a central bank intervention will buy so much of a debt market that it pushes junk bond rates below 20+ Year U.S. Treasuries. In a world like that you have three choices:
- Close your eyes and hold on to equities and hope that they always go up.
- Take your money out of the market completely (but then where do you go with it because rates are so low everywhere on short-term paper you can’t get a return for your money?).
- Say, “I need new tools to help me manage my risk and still capture reward.”
To us, of course, that third answer is our choice. The new tool we employ today is the algorithm. That’s where we find our edge. Where is yours?