Time to Batten Down the Hatches?

June 25, 2011

Not a good sign.  While the S&P500 slipped only a quarter of a percent last week, it was sorely overdue for a relief rally, and yet it failed to get one.  Volume jumped, but only on the sell-off days—another bad sign.   Although volatility dipped slightly, it was roaring back up by the end of the week.  Also not a good sign.

In terms of macro data, the news flow was light.  Existing home sales fell (month over month) but not as badly as expected.  Still, sales were down 15.3% year-over-year, and prices were down almost 5% (also yoy).  Initial jobless claims again disappointed, printing a figure (429,000) that’s solidly in the recession zone.  New home sales were a bit higher than expected, but still near depression levels when compared to the last ten years.  Durable goods orders were also a bit better than expected, but when aircraft orders were stripped out, the results were worse than expected.

Technically, the S&P is still very oversold in the short-term.  While a bounce has been expected for the last two weeks, the fact that it hasn’t happened is an ominous sign—equity markets are struggling to lure in the dip buyers, the same dip buyers who have been helping (the Fed has been the greatest driver) push the markets higher for the last couple of years.  We could still see a bounce next week, or the week after.  But if it doesn’t happen by then, then watch out.  The S&P is now sitting just a little above its 200 day moving average.  If it doesn’t bounce and starts breaking down below the 200dma, then there may not be a lot of buyers willing to jump in until prices fall well below 1,200.

The Fed’s quantitative easing program, which has had a 90% correlation with the stock market rally since September 2010, will be ending next week.  As a reminder, last year’s QE1 program ended on March 31 2010.  A couple of weeks later, the S&P500 hit a new high for the year.  Then near the end of April, the S&P started breaking down. A week later, in early May, we saw the Flash Crash.  And a couple of months later, the S&P was down almost 20%.

Arresting this budding bear market was the Fed.  First it announced QE-lite in mid summer, which slowed the bleeding, but didn’t stop it. Then, at the end of August, Bernanke pre-announced QE2 and stocks have been rallying ever since.

Well not only will QE2 end in a few short days, but the Fed has just reminded all market participants, that QE2 will NOT be followed by QE3 anytime soon.  And this, shockingly, took the wind out of the stock market’s sails.  It seems that the main reason stocks had not anticipated the end of QE2 by selling off hard by now was the strong hope that the Fed would save the day once again.  The markets have been conditioned to expect the Fed to ALWAYS provide a tailwind.

But last week these hopes were dashed.  Suddenly, risk market participants are digesting the fact that the Fed will really pull away the punch bowl for a while.  And without the massive stimulus, the party will no longer be so fun anymore.

In fact, things could get downright ugly.  So the smartest money is making preparations, taking money off the table and battening down the hatches.

What will a risk-off period look like, more specifically?

Aside from a continued erosion in stock prices (hardest hit will be the smaller caps in the Russell 2000, followed by the NASDAQ, and least damaged should be the S&P), look for declines in:

  • Commodities, including precious metals
  • High yield corporate debt
  • The Euro, the Australian dollar, the Canadian dollar, and the British Pound

What, if anything, would RISE in price?

  • The US dollar
  • US Treasuries, although they’ve may have less room to rise given that they’ve move up so much already.

Again, this may not happen next week or the week after, when a bounce up in risk assets would be very normal to see.

But if the bounce doesn’t happen, and even if it does, we should expect the odds of a serious decline in risk assets to jump…..in the near future.

US Treasuries Soar……As Predicted

June 18, 2011

The S&P500 finished the week essentially unchanged, after dropping for six consecutive weeks.  Yet because prices fluctuated wildly during the week, volatility soared almost 16%, as measured by the VIX index.  Volume was also stronger.  This is a sign that the market’s melt-up complacency, that dominated for the last eight months, is coming to an end.  Investors are becoming more defensive and buying puts to protect against severe downside movements.

The macro data were not encouraging.  Producer and consumer prices rose more than expected (both headline and core), but if the economy continues to slow down dramatically, look for these inflation pressures to ease—just as they did in late 2008 and late 2010.  Retail sales rose less than expected.  The Empire State Manufacturing survey collapsed into negative territory, as did the Philly Fed survey.  Both were projected to rise!   Initial jobless claims were still solidly in the 400 thousand range.  While May housing starts were a bit stronger than expected, they’re still scraping near record lows (and were well below May 2010 levels).  Finally, consumer sentiment was much lower than the consensus forecast.

Technically, the S&P is still quite oversold, on a short-term basis.  It’s as if investors are looking for any reasonable excuse to bounce higher, at which time many take the opportunity to sell.  Only the most die hard bulls will continue to accumulate shares.  The S&P broke many important support levels, but for now, it did manage to bounce up from the 200 day moving average.  Over the next few weeks, after the much anticipated bounce (if it happens), the S&P will very likely retest the 200 day moving average.  Should it not hold, expect a much more severe sell off, perhaps taking  the S&P down below 1,200 for a consolidation phase.

Almost six months ago, this blog submitted an entry titled “US Treasuries on Sale?” where a case was made to BUY Treasuries—not so much for the current coupon, but for the strong probability of capital appreciation.

Here was the argument:

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.

What’s happened now….four and a half months later?

From 3.62%, the US 10 year yield touched 2.89% a couple of days ago. Depending on the exact security you bought (on the run, nearby or futures contract), your profit—had you bought them when they yielded 3.62%—would be about 6 percent, including accrued interest, or roughly a 16 percent return on an annualized basis.  In this same time frame, the S&P500 has fallen about 3 percent.

Not bad.

What’s most interesting is that this call in February flew in the face of conventional wisdom.  Bond gurus like Bill Gross, from PIMCO, were on every business news channel screaming that Treasury prices were about to plummet.


By the way, today is not the time to jump into the 10 year Treasury very aggressively.  While there could still be some more room for appreciation, the odds of further gains are not nearly as strong as they were back in February.

Sadly, the crowd will very likely not understand this, and will pile into Treasuries—in a few weeks or months, especially if we see a strong push down in the equity markets—right around the time when yields could be near their lows for this cycle.

Sometime after this last push down in yields, the smart money will be preparing to go……short.  So will we.

Housing Depression Resumes……As Predicted

June 11, 2011

Uh oh.  Usually that’s how these blog entries end, but this time, it’s an appropriate way to begin.

The S&P500 has now declined for six consecutive seeks, losing another 2.2% last week. The Dow is in its longest losing streak since 2002. The NASDAQ is now down for the year.  Volume rose, which means that there was conviction behind the selling.  While volatility (VIX) rose 5%, it’s still nowhere near panic levels.  On the one hand, this means that investors are not heading for the exits; on the other hand, it means that should they begin to panic, the selling could get much more severe.

The economy continues to slow down.  Initial jobless claims again rose more than expected and are now inching closer to the 450,000 range (solidly in recession territory). Consumer credit crept higher, but all of the increase came from government funded student loans; without federal funds, consumer credit would have continued to shrink.

Technically, the S&P is oversold in the short-term.  While the risk of additional declines is still very high, it would be perfectly normal for equities to bounce up for a while—before resuming their decline.  The reasons for further declines are more obvious on the weekly charts, where very important multi-year trendlines have been broken… to the downside.  The next—and very critical—area of support is the 200 day moving average at 1,250 on the S&P.  Should this not hold, then look out below!

Last week, Robert Shiller (professor of economics at Yale, and co-founder of the Case-Shiller Home Price Index) made headlines with his assessment of the US housing market, which is now five years removed from its peak in early 2006.  Remember, Shiller was one of the few economists who correctly predicted that the US had a housing bubble…. well before it burst.

Recently, Shiller warned that housing prices in the US could fall ANOTHER 10% to 25% from their current levels.  Note that as of today, US home prices have already fallen 33% from their bubble peak in early 2006.

He reminded us that in Japan, home prices have fallen over 66% since they collapsed almost 20 years ago.  Home price in the US could follow a similar path.

Interestingly, this blog predicted in 2009 and early 2010 that home prices in the US had much further to fall.

The main reason?  Case-Shiller’s long-term database of real home price data implied that prices 1.5 years ago were still 30% above their 100+ year trendline.

What’s happened since these calls?  Well, it’s now (unlike the consensus back then) very clear that home prices have resumed falling.  The latest—as of March—report from Case-Shiller has revealed that prices are have now fallen to new post-bubble lows.

The US housing market is double dipping, no question.

What’s next?

Well the same analysis that accurately predicted that housing had NOT bottomed almost two years ago is suggesting that prices need to fall by an ADDITIONAL 20+% to finally reach this magical 100+ year Case-Shiller trendline.

It’s nice to know that Robert Shiller agrees!

Economy Tanking, Stocks at a Crossroads

June 4, 2011

The S&P500 fell for the fifth consecutive week, this time dropping 2.3%.  The volume was light, but part of that can be explained by the holiday shortened week, rather than the lack of conviction behind the selling.  Volatility turned back up, investors took notice, asking if the recent downtrend is simply another buying opportunity, or the beginning of a stronger and deeper wave of selling.

What sparked the selling was the undeniably horrible economic news.  There is very little doubt that the US economy is turning down.  The main question is whether it’s merely entering a short-lived soft patch or if it’s falling into a double-dip recession.

Housing, no doubt, is double-dipping.  Case-Shiller printed home prices that were much worse than expected; the 20 city index reached new post-bubble lows in much of the nation.  Chicago PMI collapsed, when it was expected to simply slip a bit.  The critically important ISM Manufacturing index (because it’s one of the best leading indicators of cyclical turns in the economy) plunged to the lowest level since September 2009. Initial jobless claims, also a key leading indicator, disappointed again with a 422,000 print, which was also worse than expected.  Factory orders also sank.  And finally, May’s jobs report was horrendously bad.  While expert economists were busy slashing their prior estimates, the 54,000 jobs number was far worse than the revised consensus estimate.  The headline unemployment rate also rose to 9.1%, when it was expected to fall to 8.9%.  What’s worse, the government’s magical Birth/Death model conjured up 206,000 jobs as part of the headline results. While this 206,000 figure can’t simply be subtracted from the 54,000 (due to season adjustment differences), a big chunk of the can be set aside.  So if even only 150,000 of the concocted 206,000 Birth/Death jobs are subtracted, then the economy really lost about 100,000 jobs in May!  And this is supposed to be a recovery?

Technically, the S&P is at a crossroads.  Ever since QE2 was pre-announced by Ben Bernanke in late August 2010, the S&P has always bounced back up from a multi-week correction right about ……… now.  This means, that if the S&P doesn’t move back up above its 50 day moving average by the end of next week, then a lot of traders might start running for cover—to protect the profits that they’ve made over the last 9 months.

If so, there’s a lot of air between last week’s 1,300 closing level and support at the 1,250 level which is the 200 day moving average.  See the chart below.

The good news for the bulls is that the S&P has only lost about 5% from its April peak. That’s not a lot of damage for five straight weeks of losses.  With respect to the economy, the bulls will look for the downturn to be no less severe than a temporary soft patch, one that gets brushed off quickly and replaced with more robust 3%+ GDP growth in the third and fourth quarters of this year.

But the bears have several major forces on their side.  Just as the economy was about to double dip in the summer of last year, the Fed ran to the rescue with QE2, which sent the stock markets soaring in September.  To add to the Fed’s monetary stimulus, the Congress added several fiscal boosts in December of that same year, notably the temporary reduction in Social Security taxes, the extension of the Bush tax cuts, and the extension of the emergency unemployment benefits.

Most of these positive forces are about to expire.  Most importantly, QE2 ends in a couple of weeks.  On the fiscal front, there’s very little doubt that stimulus will be dropping off over the second half of 2011 and into the foreseeable future after that.  The Democrats and the Republicans are under tremendous pressure to reduce the deficit (from its insanely unsustainable $1.5 trillion per year level), and the only question is how much spending they cut and how soon.  Taxes may also rise.  Both—spending cuts and tax hikes—will not only remove stimulus from the economy, but they will create outright headwinds to future growth.

So there’s very little doubt that the economy is facing some tough times ahead.  The more open question is whether the stock market will follow the economy down, or will it continue ignoring the warning signals…..for a while longer.