Living on the Edge

September 25, 2010

The S&P500 climbed 2 % last week, with virtually all of the net gain arriving on Friday.  Volume was still light, almost equal to the volume in the prior week when the S&P rose by a smaller percentage.  The VIX (or fear) index did not validate the price rise; it dipped only 1 %.  A much larger drop would have better supported the price move. 

The economic data were not strong.  The home builders’ index came in at the lowest level since March 2009.  Housing starts, although slightly better than expected, were still anemic.  What’s worse, the primary reason starts rose at all was due to a spike in apartment starts, not single family homes.  FHFA home prices fell more than expected, also supporting the claim that the double dip in the housing market has already begun.  Initial jobless claims were worse than expected.  Existing home sales were slightly better than expected; but they were still almost 20% BELOW August 2009 levels.  Leading economic indicators rose, but they are being distorted by the yield curve component, which is being massively distorted by the Fed.  Durable goods orders fell more than expected.  New home sales were unchanged from the prior month, and rotting at depression type lows.

Technically, the S&P has rapidly become overbought on a daily basis.  The VIX, and several momentum indicators are diverging, so that a pullback from these levels is becoming very overdue.

Last week, speaking at a conference hosted by the Federal Reserve Bank of Chicago, Paul Volcker made an eye-opening remark to his audience.  He said:

The financial system is broken. We can use that term in late 2008, and I think it’s fair to still use the term unfortunately. We know that parts of it are absolutely broken, like the mortgage market which only happens to be the most important part of our capital markets [and has] become a subsidiary of the U.S. government.

A couple of days later, the Wall Street Journal published a cover piece titled:  “On the Secret Committee to Save the Euro”  and in it, the authors described how, despite the formation and diligent work of “a small group of European leaders set up a secret task force—one so secret that they dubbed it ‘the group that doesn’t exist.'”, the “euro zone was on the verge of breaking apart” in May of this year.

Two years ago, after the implosion of Lehman Brothers, AIG, Fannie and Freddie in the US and many other financial behemoths in Europe, the world’s financial system almost melted down.  Literally, banks were hours away from forced closures; billions of people and businesses were on the verge of running out of money. 

In 1998, the Long Term Capital Management debacle prompted the creation of the “Committee to Save the World” according to Time Magazine.  Back then, the NY Fed intervened to avert a devastating financial crisis that would have blown up major commercial banks and investment banks in the US and Europe.

And today, after these (and several other!) near-death experiences, the question is–what’s changed?  What’s been done to improve this perilous condition of the global economy?

In a word:  NOTHING.

Shockingly, almost ALL of the conditions that led to the previous systemic meltdowns are in existence today.  The total (government, corporate and household) debt load, the poor regulation by regulators captured by the monied interests, the predatory and fraudulent practices of the banksters, suspension of accounting rules, bubble-enabling monetary policy by the Fed, fiscal irresponsibility by the government, a culture rooted in consumption, and many many others. 

What we’ve been hearing from our government leaders is nothing short of propaganda.  For over a year now, ever since Ben Bernanke and Barack Obama hatched the concept of Green Shoots, many folks on Main Street believed, in part, much of this hopeful message.  But today, this effect is wearing off.  It doesn’t take a PhD to figure out that Obama’s and Geithner’s Recovery Summer message was a bald-faced lie.  Folks on Main Street, average people with little advanced education, are getting it.  And they’re also getting angry.

So what’s the future going to look like? 

We WILL have another systemic crisis.  We WILL not be able to bounce back from it as easily.  We WILL be at serious risk of facing social and political unrest.

Another Reason Why the Fed’s Plan is Doomed?

September 18, 2010

Unsurprisingly, the S&P500 inched up another 1.5% last week.  Although volume rose, it was options expiration week and volume tends to rise–regardless of price direction–during these weeks.  The VIX (or fear) index inched up however, signalling that the markets may not be completely comfortable with the increase in price.

The economic data were fairly weak, as usual.  The Treasury’s budget deficit was $91 billion in August; what’s surprising is that the federal debt rose by $212 billion in August.  Could the Treasury be understating the monthly deficit?  Retail sales rose slightly more than expected in August; but much of the extra gain came from the reinstatement of one-time tax holidays in several states.  Business inventories rose more than expected, and the problem with this is that the sales to inventory ratio is falling, so this could lead to serious production cutbacks unless sales pick up soon.  The Empire State manufacturing survey was worse than expected.  Producer and Consumer prices all rose fairly in line with expectations.  The Philadelphia Fed survey was much worse than predicted; and the leading components in this survey were very bearish.  Finally, consumer sentiment fell, when it was expected to rise; ominously, this was the lowest sentiment reading since August 2009.

Technically, the S&P is still showing a bearish formation.  The 50 day moving average is still below the 200 day.  A long-term head and shoulders topping formation is still in effect.  And several market breadth indicators are pointing to strongly overbought conditions,  conditions that often lead to a pullback in the near term.

The Economist this week, in its Buttonwood column, identified another serious, but unforseen, pitfall that the Fed’s monetary stimulus policy is likely to suffer from.  Since the Fed has slashed its short-term rates to near zero, and pumped in over $1.5 trillion into the Treasury and mortgage markets, it has caused all interest rates–short-term, medium and long-term–to collapse over the last couple of years. 

The goal was to stimulate spending by consumers and investment by businesses.

Well, all is not going according to plan.  Instead of spending money that became cheaper to borrow, consumers began to reduce borrowing–despite to cheap cost of credit.  And businesses, as they refinanced their older costlier loans, began to hoard the added cash, instead of investing it in new plants or equipment.

The main reason consumers said no to more borrowing and spending was that they were already up to their eyeballs in debt.  By any traditional measure, such as household debt to GDP, or debt to income, consumers were over-leveraged and thus less inclined to borrow more.  Low cost was no longer enough to make them borrow more.

But what The Economist highlighted was an additional burden on consumers.  Many are beginning to fear that the ultra-low rates are here to stay.  So if consumers will earn less than half of what they were conditioned to expect to earn from their fixed income investments in retirement, then they would need to SAVE considerably MORE than they originally had planned to save. 

The result?  Consumers are pulling even more cash away from spending, thereby depressing spending and economic growth.  And at the institutional level, pension funds and other retirement schemes will also be forced to demand more contributions from future retirees or public and private employers.  In either case, there will be less cash available to spend in the economy.

So perversely, the Fed’s “stimulus” policy, namely driving down interest rates, may ultimately serve to do the exact opposite:  throw a heavy anchor on the economy and suppress the prospects of recovery.

Waiting for the Avalanche

September 11, 2010

The S&P500 eked out a tiny 0.46% gain for the week.  Volume was the lowest of the year, so far.  The low volume removes all conviction behind the small price gain.  And the VIX (or fear) index rose about 3%, also calling into question the importance of the price rise.   

There wasn’t a lot of macro data in this holiday shortened (Labor Day) week.  The Fed released its most recent beige book of economic conditions around the country.  The most notable quote from the report was that there are now “widespread signs of deceleration” in economic activity.  Consumer credit fell again, by slightly more than expected.  International trade data showed that the US imported almost $43 billion more than it exported.  Although an improvement over the prior month’s $50 billion figure, the bottom line is that the US trade deficit is stubbornly high and still hurting GDP growth.  Initial jobless claims appeared to improve with a 451,000 print, but it was soon revealed that claims for nine states (including California) were estimated due to the Labor Day holiday.  Chances are very high, the actual claims were worse than estimated. 

Technically,  the bounce that began two weeks ago is losing some steam.  Although there is still some room for more upside movement, the 200 day moving average will provide stiff resistance as it did at the end of July.  This suggests that prices could rise up to 1,120 to 1,130 before they begin to struggle to rise further.  On the weekly charts, prices are at the upper end of the downward sloping channel that began in April.   The downtrend has not been broken, and a strong catalyst will be needed to propel prices up much further.

The S&P at the end of August (1,040) was near the same level that was reached at the end of July last year.  So essentially, the S&P has gone nowhere in over a year.  And now, dozens of new economic reports are calling into question the entire recovery story that was sold to the public over the past year.  Monetary and fiscal policy do not seem to be working.  Unemployment (the official headline number) is 9.6%, near the highest levels in 70 years.  And it’s climbing.   The Fed has shot most of its bullets:  the fed funds rate is near zero and it has printed over $1.5 trillion in additional dollars to pump into the economy.  The Treasury and Congress have pumped about a trillion dollars into the economy, and there is no public support for enacting another stimulus program.

So as economic growth slides back down to zero, and unemployment hovers near record highs, the stock market’s jump from the 600 range to 1,040–in anticipation of the economic recovery–becomes extremely vulnerable to a strong and prolonged correction. 

So why hasn’t it occurred yet?   Well, some of it has.  The S&P is well off its highs near 1,220 reached in late April.  The question becomes, if the economic recovery is not going to be V-shaped, bringing the US back to where it was back in early 2007 (the prior peak in GDP growth and employment), then when—exactly—will the stock market crack and let go of the false hope implicit in its current 1,100 valuation?

The answer is:  who knows.  And a fitting metaphor might the forces and timing involved in setting off an avalanche.  When snow piles up on an unstable (steep surface) foundation, experience teaches us that the risks of a catastrophic avalanche grow.  But the price time when the avalanche is triggered is never knowable.  And the exact trigger is also usually unknowable. 

But, that doesn’t mean that the risk of a tragic outcome is not real, or that it won’t happen.  The Flash Crash gave us a taste of what an avalanche in the stock markets feels like.  And today, four months later, the underlying conditions that led to the crash have not changed.  Instead, more snow has been piling up; more stress has been building. 

Sooner or later, the equity markets will crack—again.  It’s not a question of if.  It’s a question of when.

The End of the Equity Cult?

September 4, 2010

Just as expected, the S&P500 continued to bounce up last week, for a total gain of 3.75%.   But volume–as has been typical with weeks that rise–fell off, giving the rise less validity.  The VIX (or fear) index slumped to three month lows and not far above the 2010 lows reached in April.  This fall off in the VIX reading is a sign of growing complacency, complacency that may not be warranted.

The macro data were not uniformly grim–for a change.  Personal income was lower than expected; personal spending was slightly higher.  The result:  the personal savings rate dipped in July.  ISM Manufacturing was better than forecast; ISM Services was worse.  Initial jobless claims were slightly higher than the consensus estimate; and total continuing claims (regular, extended, and emergency) has been hovering around shockingly high 10 million for several months now.  Factory orders were worse than expected.  The headline unemployment rate rose to 9.6%.  While “reported” nonfarm payrolls fell 54,000, when the loss of 114,000 census workers and the addition of 115,000 birth/death fantasy workers are factored out, then about 55,000 jobs were actually lost in August.  Almost three years after the recession began, the US economy is still losing jobs.  Not good.

A few months ago, The Economist and more recently, Citibank put forth an argument that the Cult of Equity, that has dominated the investment world for over 50 years, is coming to an end. 

What does this mean?  After decades when pension funds, endowments and other institutional asset managers shifted their allocation to equities to well above 50%, the reverse is now starting to happen:  these managers are shifting back into bonds and out of equities.

Why is this happening?  For starters, two market meltdowns over the last ten years has spooked even the most risk-tolerant investors.  The great moderation in business cycles is now shattered, and volatility has skyrocketed.  Second, the baby boomer demographics are driving retiring investors to shun riskier assets (ie. equities) and seek out more reliable income generators (ie. bonds), especially as more defined contribution plans (eg. 401k) shift the return risk to individuals and away from employers. 

So it is no surprise that, as of last week, equity mutual funds have suffered from 17 consecutive weekly outflows, according to ICI.  

More ominously, there is much more potential selling to come.  If institutional equity allocations revert back to their pre-1959 levels (about 20% of assets) then–in the US private sector pension space alone–almost $2 trillion of equities could be sold. 

If Japan is a model (and it’s becoming an accurate model for the US for many other aspects of the economy), then the equity allocation could drop to less than 36% of total assets (from over 55%).  This would translate to almost $1.5 trillion of stock liquidation.

So even if the US economy doesn’t fall apart again over the next six months, it’s highly unlikely that investor will rush back into the stock market–especially when trillions of additional dollars will be needed to fund the US government’s massive and unending budget deficit. 

When you follow this money trail, it strongly suggests that stocks will be struggling for many years to come.