Debt, Food and Energy

February 26, 2011

In what’s become an unusual event, the S&P500 actally sold off, giving up 1.7% on the week.  Tellingly, volume jumped in this period, as opposed to falling when stocks rise in price.  This is lends more credibility to the sell off, meaning that there’s more conviction among investors and traders when stocks fall rather than when they rise.  Volatility also spiked.

The macro data were mixed.  Housing is definitely double-dipping as confirmed by Case-Shiller which reported another month of price drops for single family homes across the country.  While consumer sentiment and confidence rose, it did so in the face of low job creation, house price deterioration and soaring gas and food prices; the uptick in confidence will likely reverse itself soon.  Existing home sales were slightly better than the miserably low forecast set by the experts; new home sales was even worse than the grim expectations.  Durable goods orders disappointed badly, especially when government-driven military and aircraft orders were removed.  Initial jobless claims were slightly better than expected, but a whole slew of states estimated their figures due to the holiday shortened week.  Finally, 4th quarter 2010 GDP missed expectations, which had risen from 3.2% to 3.4%.  Instead, GDP growth fell to 2.8%, which is an amazingly poor figure given that we’re in the middle of a so-called recovery.

Technically, the uptrend in the S&P, when examined on the weekly charts, is still in effect.  The S&P would have to close and remain well below 1,300 for this uptrend to break.  On the daily charts, traders can look to potential shorting opportunities next week.  If the S&P fails to return to its recent highs, then there will be a fairly high probability that the index will fall further.  Adding to this probability are all the long-term bearish divergences that have been building over the last four months.

Almost all of the economic and financial forecasting that affects the markets revolves uses, as a starting point, the fiscal and monetary policies of the US and the rest of the world.  Deficit spending by the US, for example, is a form of stimulus that helps promote GDP growth and stability.  Monetary policy, lately, has dominated the news because of its extremely stimulative measures, namely quantitative easing, and they way in which they have clearly propped up financial asset prices over the last two years.

So naturally, when analysts look to risks and other factors that could derail the financial markets, most search changes in these two hugely important policy measures.

But what many analysts take for granted are several foundational assumptions that may have an even greater impact on the economy and financial markets:  food and energy.

And what’s key is not simply the availability of food and energy, but the availability of CHEAP food and energy.


Because a large amount of the world’s economic growth over the last 30 years can be explained by the existence of cheap food and energy, specifically oil.

As much as the massive ballooning of debt has pushed GDP growth, the availability of cheap food and oil have been equally important pillars of this growth.

But the problem is that–unlike the growth of debt, a financial instrument–cheap food and cheap oil may not be as easily managed by the leading governments of the world.

While the US central bank can print dollars, it cannot print food and oil.

And over the last few weeks, we have seen just a bit of the consequences when the assumptions of cheap food and oil do not hold.  As Tunisia, Egypt, Libya, Bahrain and probably others soon are transforming themselves politically, the price of oil has skyrocketed.  As the world’s population grows (demand rises) and climate changes repeatedly destroy production through heat, fire and flooding (supply falls), the price of basic food grains has soared.

Both developments have the potential to crush economic growth.  And both developments cannot be magically cured by more fiscal or monetary stimulus (in fact, money printing adds fuel to the rise in food and oil prices).

So the world’s leaders are in a major pickle today.  As much as they have yet to fix the financial imbalances that led to the global financial crisis and the Great Recession, they will now have to grapple with two other major headwinds:  the soaring price of food and oil.

If the odds of another future financial crisis were high already, the odds have now gotten even higher.

Thoughts from the Bond King

February 19, 2011

The S&P500 inched up another 1.0% last week.  In what many experts are calling surreal, the melt up continues.  But there’s really nothing surreal about it.  It’s fairly simple really, and The Economist’s Buttonwood column locked in on the true explanation: “When you buy equities, you are betting of Ben [Bernanke]”.

Technical divergences abounded.  Volume again went down.  Volatility jumped.  Momentum continued to wane.  Money flows were not as strong as they were a few months ago.  The advance-decline line is weakening. 

But none of this matters, as long as Ben keeps printing.  And as long as no big shock event emerges.  So the key signal to watch will be the market’s behavior as QE2 winds down in about two months.

The macro data were mixed. Retail sales (headline and ex-auto) in January were lower than expected.  Housing starts were better than expected; permits were lower.  Still, starts in January were 2.6% below the level in January 2010.  Industrial production missed badly; it was expected to rise 0.5%, but instead it fell 0.1%.  PPI and CPI came in hotter than expected, but that’s no surprise to analysts who point to the negative side-effects of the Fed’s massive printing programs.  Initial jobless claims met expectations, solidly in the 400,000 range.  Leading indicators disappointed.  The Philly Fed survey beat estimates, but the prices paid (less prices received) component was higher than at any point since 1979.  This does not bode well for corporate profit margins.

Gracing this week’s cover of Barron’s is Jeffrey Gundlach, who is being promoted as a better bond fund manager than even Bill Gross, perhaps one of the most successful bond managers over the last 25 years. 

Gundlach reads the economy well; for example, he accurately forecast the housing crisis in 2006.  But more importantly, he has translated his insightful macro analysis into outstanding investment performance, beating the legendary Bill Gross over the last several years.

What does Gundlach see now?

With stocks, he thinks “the Standard & Poor’s 500, which is now over 1300, will hit 500 in the next couple of years.”  In other words, the stock market is at high risk of falling by almost 65%.

What a coincidence; so does PNN Capital Management.

With respect to housing, “Gundlach expects home prices to fall by another 10% to 15%.”

That’s funny; so does PNN Capital Management.  Actually, another 15% to 30% drop cannot be ruled out.

What about Treasuries?  Gundlach “sees little chance in the near term of a surge in inflation that would send Treasury bond yields soaring.”  In fact, Gundlach considers that a renewed slowdown in the economy would drive the 10-year bond yields sharply lower”.

Bingo; so does PNN Capital Management.

Finally, how about the sell-off in the muni bond market.  Gundlach “foresees a major collapse in the municipal bond market, beyond the declines to date”.  And he’s preparing to swoop in with purchases “in the next year or so when the predicted apocalypse arrives”. 

Wow.  So does PNN Capital Management.

Thank you Jeffrey Gundlach.  While nobody can be sure with absolute certainty what will happen in the markets in the future, it’s still reassuring that the “Bond King” sees the markets in ways that are very similar to one’s own.

Is this 2007….all over again?

February 12, 2011

The S&P500 inched up another 1.4% last week, on decreasing volume.  While the VIX (or fear) index barely changed for the week, two important points need to be made.  First, the VIX is scraping along near the bottom of its historical range.  This is a level that’s always associated with complacency and from which price pullbacks, minor or severe, usually begin.  Second, the Fed’s money creation artificially pushes down volatility, because it acts as the writer a put option on the stock market.  This causes other market participants to avoid buying as much insurance against price drops as they otherwise would buy.  The result is that the VIX has less relevance than it does when QE is not taking place.  So after QE ends in a couple of months, expect the VIX to surge in importance.

There weren’t a lot of economic releases last week.  Consumer credit rose more than expected, but with the number of employed people at or near cycle lows, and with the 99 week unemployment program spitting out hundreds of thousands of people every month, a plausible reason for the credit jump is that folks are borrowing more just to make ends meet.  Not a healthy reason for consumer credit growth.  Initial jobless claims dropped below 400,000 but the unadjusted claims level is still in the mid-400,000 range.  Finally, international trade results were slightly worse than expected; we’re importing more than we export, and this unhealthy–and unsustainable–activity is not getting better, as it should.

Technically, since the stock market continues to correlate almost perfectly with the Fed’s QE program, traditional analysis is less relevant.  The stock markets melt up, as long as the Fed keeps printing.  Period.  Soaring commodity price inflation, revolutions in the Middle East, and near-record unemployment levels in the US hae been no match for the Fed……so far. 

So unless some “shock event” can overwhelm the Fed’s monetary fire-hose, then the world will wait to see how well the risk asset markets can stand on their own when the Fed stops QE2 in a few short months.

But what to do in the next 60 days?  Should new money be “put to work” in the US stock market? 

David Rosenberg of Gluskin Sheff (and formerly Merrill Lynch) puts it bluntly: “sorry, but that time has passed.  But we will probably get another kick at the can because we are sure that the “event risk”, which caused so much turbulence and buying opportunities in 2010 will come around again in 2011.  But this is one overextended US stock market, that is for sure.”

David then neatly highlights some key metrics comparing the stock market today to the market at other fully valued times:

1. The S&P500’s dividend yield is 1.8% with a 10 year Treasury yield at 3.7%.  This dividend yield is exactly where it was at the market peak in October 2007.

2. The cyclically adjusted P/E ratio on the S&P is now 23.3, exactly where it was in May 2008, well before the massive market meltdown occurred.

3. The Investor Intelligence survey now registers 53% of market participants as bulls and 23% as bears.  At the March 2009 lows, these figures were reversed.

4. Equity money managers report only 3.5% cash ratios.  The last time they had so little cash available was in September 2007, about a month before the peak.

5. At the March 2009 lows, economic indicators like the ISM were at 36, meaning they could only rise.  Today, at 61, they are much more likely to fall than to rise.   

So the bottom line is this: today is NOT a great time to put new money to work in the stock market.  If you do, you’re essentially betting that you can capture some more upside for the short time that the Fed will keep propping up the stock markets.  You’re also betting–like pretty much every pro in the business–that should some shock event shove the market down before the Fed ends QE2, that you’ll be the first to escape out the exit door.

Reality is not so rosy.  When the market turns–especially when it’s overextended–almost all of the pros (and especially the retail amateurs) will NOT get out in time.  In almost every major downturn, the pros get burned….badly….and seek solace in the “hey everybody got hurt because nobody saw it coming” excuse.

We can see it coming.  Don’t get burned. 

Unless you run a high frequency stock trading scheme, you should approach the stock market as you would a marathon.  Don’t try to sprint out of the gate looking to clock the best time at every mile.  If you do, well before you ever reach the finish line, you’ll die from a heart attack.

US Treasuries on Sale?

February 5, 2011

Nothing, it seems, can stop the Fed’s QE2 from pumping up the S&P500.  Despite a near revolution in Egypt and a whole host of other domestic and international pressures,  the S&P rose 2.7%, but on lower volume, meaning that the investor conviction was lacking.  The VIX retreated, also as expected, if investors keep believing that the Fed’s “put” will make a meaningful drop in stock prices impossible. 

The economic data were mixed.  Personal income (boosted by the government’s transfer programs) met expectations; personal spending rose more than expected, implying that personal savings rates fell.  The ISM manufacturing index was stronger than predicted. Construction spending fell when it was expected to rise.  Initial jobless claims were about as expected–stubbornly stuck in the 400,000 range that’s associated with recessions.  The ISM services index was stronger than expected.  The big number of the week was payrolls, and it was a big miss, coming in over a 100,000 below expectations.  While the headline unemployment rate dropped, all of the apparent improvement came as a result of folks giving up on looking for jobs.  To back that up, the labor force participation rate (the % of folks between 16 and 64 who are working or looking for a job) fell to 64.2%, the lowest since 1984.  Also, the straightforward percentage of the US population that’s employed fell to 57.6%.  Both of these rates point to a grim and deteriorating employment situation.  More and more people are simply giving up–because job opportunities are so poor–and leaving the ranks of the UNemployed.  That’s the reason the unemployment rate fell, and it points to more economic problems ahead.

Technically, the S&P500 hass all the markings of  market that’s not behaving naturally.  Retail investors have pulled about $100 billion out of the stock markets over the last year; mutual funds have run out of spare cash to invest.  Yet the markets melt up. Why?  Because the Fed prints dollars out of thin air and openly promotes the virtues of artificially stimulating the stock market. Nevermind the total failure to create jobs.  The Fed pumps the money into the markets, daily, in the late mornings.  On many mornings the stock markets sell off in the first two hours, but in almost every case, the “recover” by late morning and early afternoon–right after the Fed’s securities buying ends.   What happens when the Fed stops QE in a couple of months?  How can the end of QE possibly end well?

So we’re in a time where most risky assets are fully valued or over valued.  Almost everything you can buy for investment is not cheap:  stocks, investment grade bonds, high yield bonds, commodities, international equities and many other asset classes are priced near the high-end of their long-term ranges.

But is anything cheap?  What’s priced relatively well, providing an investor with a better margin of safety? 

A few weeks ago, we discussed municipal bonds.  They’re one asset class that’s in a correcting phase.  But they’re not ready to be bought.  Prices are still falling and many of the fundamental reasons sparking the original sell-off have not yet been resolved.

But interestingly, there’s one asset class that’s been crushed over the last three months, and may be much closer to price levels that could be bought more safely. 

US Treasuries have suddenly become cheap.  The 10 year yielded as little as 2.33% in October.  Today, it offers 3.62%.  In the Treasury world, that’s a massive sell-off.

Also, it’s interesting to note what happened to Treasury prices the last time the Fed’s QE program wound down.  Back in April 2010, when QE1 officially ended, the 10 year Treasury began monster move up in prices (down in yield) that lasted six months. 

The Fed’s current QE program is scheduled to wind down in a couple of months–after a huge price reduction in Treasuries has already begun. 

If Treasury prices stop falling over the next 60 days, and risk assets start selling off (as QE2 winds down), then a repeat of the 2010 sequence would make a lot of sense, as investors rushed into a deep, liquid and relatively safe harbor to park cash for a few months. 

The middle of the yield curve could prove to be especially attractive, as the spreads over the two year Treasuries near (or even exceed) record highs.  And 5 -10 year Treasuries will also offer somewhat attractive yields (that, unlike stock dividends, accrue daily)  to pay you while you wait for prices to rise.

Don’t buy Treasuries yet.  And certainly don’t buy Treasuries as a long-term investment (the government’s fiscal mess is getting worse every year).  But consider them as a potential contrarian play that a lot of big money could rush into once QE2 starts to peter out.