A Flaw in the Tepper Analysis
When David Tepper speaks, the market listens.
In Autumn, 2010, Tepper, the highly successful billionaire hedge fund manager, explained that for stock investors, the Fed had your back. Using options jargon he said that there was a "put" (downside protection) regardless of what the economy did. While causation is always hard to prove, the comments came on a 2% rally day in the market and the rally continued from there.
Today Tepper went public again, with a very bullish prognosis. A key part of his analysis was that the Fed purchases under QE, even if tapered off, would be greater than the net new issuance of debt by the Treasury. You can check out CNBC's site to see the entire interview.
Tepper goes on to discuss the historic highs in the equity risk premium and why this represents a major opportunity for investors in stocks.
There is a sharp divide in the analysis of this topic. I want to emphasize that readers are consumers of this analysis – and so am I. The difference is that I have some training that helps me figure out what is silly and what is helpful.
On one side we have "the bond guys." These are investment firms that are selling bond funds and also the research firms that cater to the bond community. Think Gross and Gundlach for the first group, and Lacy Hunt and Jim Bianco for the second group. They are on a mission. There is a world that has been widely embraced in the trading community. The basic idea is that the Fed prints some money and hustles out to buy government debt. They describe the world as if it were a market with two counter parties. The results of this transaction are somehow reflected not only in bond prices, but also stocks, oil, gold, and tortillas. Sheesh!
On the other side there are those who are more thoughtful in their analysis. This week we have seen some great commentary.
- Brad DeLong explains why the big-name hedge fund traders have taken the wrong side of the trade;
- Josh Brown does a careful analysis of the incremental steps involved in QE tapering. This is market savvy applied to the current economic questions, so it deserves respect.
- Michigan economist Miles Kimball explains why QE has worked and suggests how to measure the impact. On the way he refutes Martin Feldstein's WSJ op-ed piece.
My Contribution — Reality
My perspective is a little different: I am trying to draw together the very best sources and conclusions with an emphasis on finding the best investments. From both formal training and experience I know about both economics and markets.
I am shocked by what I see.
The prevailing discussion of bond trading is that the Treasury is selling and the Fed is buying. The result is a simplistic depiction of a two-party market with resulting stupid conclusions. This is what led to Bill Gross foolishly asking "Who will buy Treasuries when QE II stops?" The flawed two-party model continues.
The reality is that the following:
- The average daily trading volume in Treasuries is $550 billion.
- The Fed participation is less than one percent, even on a big day.
- There is plenty of appetite for debt. Regular auctions do not include the Fed, and they have a high bid-to-cover ratio. Strong evidence!
Consider it as supply and demand on a daily basis. It is a huge market. The Fed adds to demand, probably reducing the price elasticity of the demand curve. It is something like this (diagram borrowed from a helpful and educational site).
For QE buying, look to the chart on the right. The demand curve has shifted a bit, leading to a somewhat higher price, higher quantity, and lower yield than would otherwise have occurred.
For the QE exit, look to the chart on the left. The Fed will be a seller, slightly reducing price and increasing quantity.
Failing to consider the Fed purchases (and future sales) within the context of the overall market is a simple mistake. One can argue about the shape of the curve and the exact magnitude of the impact, but it is not just a matter of comparing net issuance to Fed purchases or sales. The changes are relatively modest.
The prevailing analysis is so bad that I would call it a blunder, albeit a knowing one on the part of some.
There are some obvious implications for your analysis of QE and the effects:
The effects of FED QE accomplishments to date are dramatically overstated. The QE policies moved rates a bit lower, but the asset markets also reflect earnings – both current and expected. The Fed's internal estimate, as of last autumn, was about 1% on the ten-year note. We can all speculate what this meant for the job market.
"How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve's large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points.12 Three studies considering the cumulative influence of all the Federal Reserve's asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield.13 These effects are economically meaningful."
- The entire mechanism for analyzing QE effects is mistaken. Why continue to listen to those who have been wrong for years? Maybe a new model is needed.
There is also the flip side.
- The ending of QE is not as scary as portrayed by most "pop economist" pundits.
- Since the initial impact of QE was an "overbid" the winding down will be as well.
David Tepper is right on all of the key points.
- He is accurate on Fed policy.
- He is accurate on overall market valuation – the equity risk premium.
- He is accurate on the right posture for most investors.
Why do I disagree? I am not trying to pick nits. I mean to analyze what is actually happening, explaining why investors should not fixate on Fed policy.
Tepper is meeting the critics on their own terms – discussing net debt, even if that is the wrong measure. He is catering to the popular mistaken belief. I disagree with his analysis, but not the investment implication.
[Update – description of Fed exit impact on quantity corrected – thanks RS.]