Market Temperature Update

April 28, 2012

The S&P500 rose 1.8% last week on declining volume. Volatility dipped slightly. And the percent of stocks, in the S&P, that are above the 150 day moving average inched up but barely.

What’s interesting is that the US stock market—unlike most every other major stock market in the world—is rising in the face of deteriorating macro data. Lately, the worse the macro news, it seems, the better the US stock market performance. Why? Because in the US, investors have been conditioned to believe that the Fed will always “be there” to save the day, with more quantitative easing, another operation twist, or whatever it takes. So when the economy stumbles, the markets cheer because surely the Fed will print more money and make everything OK. Of course, should the economy roar back to life—something it has NEVER done since the Great Recession supposedly ended in mid-2009—then the stock markets would love that too.

Investors have been trained to believe that they simply can’t lose.

Apparently, the 2008-09 meltdown must have been an aberration, something that is best not mentioned. Because today, of course, something like that could never happen. This time is different.

We’ll see.

In the meantime, back to the macro numbers. The Case-Shiller home price index was disappointing. Home prices fell more than expected in the 20 city index. New home sales fell from last month. Durable goods orders—both headline and ex-transportation—were a disaster, both falling far more than expected. Initial jobless claims were far worse than consensus estimates. And finally, real GDP rose far less than expected. And that’s with a generously low deflator that boosted even this disappointing figure; using a more honest (larger inflation deflator) would mean that real GDP did not grow at all.

Technically, the S&P500 is still below the highs reached in late March, and as long as that remains true, the downtrend is still in effect. Breadth has not jumped, despite last week’s price rise. And many other correlated markets are pointing down—industrial metals, Treasuries, and international equity markets.

So where do we stand at the end of April?

US stock markets are overbought and overvalued. Not coincidentally, this is almost exactly where they were in the spring of 2010 and 2011. What happened then? In each prior spring, a Fed easing program ended……and markets promptly tanked.

This year, another easing program is scheduled to end in June: Operation Twist. And there is very little reason why this year US equity markets will behave differently.

In fact, one can argue that there are several new dangers that lie ahead…..dangers that did not exist in either 2010 or 2011.  First, in the US, there’s a fiscal cliff that’s fast approaching. At the end of 2012, several major spending programs are scheduled to end; and several key tax rates will be going  up. Second, the European situation is fast deteriorating. While the crises over the last two years revolved around relatively small periphery states (think Greece), the crisis is now spreading to the larger states (think Spain and Italy). And it will be almost impossible to sweep Spain’s problem under the rug, as was done with Greece. Third, China is rapidly slowing. And this time—unlike the 2008—China may not be able to respond with a massive credit stimulus that kept the economy on its super-fast rate of growth. Finally, Japan, with its ever-growing government debt load, is even closer to tipping over into a credit and currency crisis.

Also, let’s not forget raw valuations. The Shiller (cyclically adjusted) PE ration for the entire S&P500 is now at 23x. This is FAR above its long-term historic average, which is closer to 16x.

Simply put, the US stock markets are overvalued. They will correct. And unless this time is truly different (highly unlikely), the correction may be severe.

Coal Miners: On Sale?

April 21, 2012

The S&P500 inched up only 0.6%c last week on moderate volume. Volatility, as measured by the VIX, slipped almost 11%. Several breadth indicators continued to deteriorate. The summation index, for example, dropped further, as did the percent of stocks above the 150 day moving average. The bullish percentage index also dipped, and the weekly flow of retail funds continues to show a seemingly never-ending move from stocks and into bonds.

Almost every macro news announcement missed expectations. The exception was retail sales which rose slightly more than consensus (for sales ex-autos). Almost everything else was a disaster. Empire State manufacturing plunged. Housing starts came in far below expectations, as did existing home sales. Industrial production was supposed to rise 0.3%; instead, it showed zero growth. Initial jobless claims spiked again, this time to 386,000—well above the consensus of 365,000. Finally, the Philly Fed survey missed badly.

Technically, the S&P500 is moving into a wedge formation where, in the near term, stocks ought to break one way or another—decisively. They’re coiling for what could be a big move. The breakdown that started in early April has damaged many of the four-month bullish trendlines and it wouldn’t be surprising if the big move were a continuation to the downside, where last week we saw the formation of a bearish flag (or counter trend bounce that reverses itself quickly). The next week should be telling.

But while most of the major sectors in the S&P500 are still near their multi-year highs, highs attained courtesy of the Fed’s continuing liquidity programs, there have been a few notable breakdowns.

First, the market darlings. Priceline and especially Apple have been the strongest market leaders, or “generals”, paving the way for gains in the broader market over the last four months. But over the last two weeks, these two leaders have broken down…..badly. Priceline is off almost 8% from its recent highs, and more importantly, Apple is down 12% from its highs. Given how important these two are to the broader markets, this is not a good omen if their sell off continues next week.

Second, the coal miners have now fallen to lows last seen during the general market meltdown in late 2008 and early 2009. Large, well capitalized coal miners, that generate strong cash flows—such as Peabody Energy, CONSOL Energy, and Alpha Natural Resources—are on offer today at prices 70% to almost 90% below their 2008 highs. And unlike natural gas, which is falling to decade lows due to seemingly endless inventory builds (mainly because of a new drilling technology called fracking), coal is still in relatively limited supply, difficult to get out of the ground, and needed for the majority of US and global electricity generation. Simply put, there’s very little risk of coal being substituted or replaced in the next few years.

So while several key market leaders are cracking, a deep value opportunity is presenting itself in the coal mining industry. Make no mistake, these stocks could fall even further from their current low prices, but buying near today’s bargain price points could offer a solid margin of safety as well as the prospect of strong returns in the future.

Risk Off?

April 14, 2012

The S&P500 lost 2% last week, its largest weekly loss of the year, and its only second consecutive weekly loss of the year. Volume jumped, which implies that the selling was meaningful. And volatility soared 17%, suggesting that the complacency of the last three months is ending.

What caused this sudden acceleration of losses? Exactly what we mentioned as the greatest risk factors here last week and the week before—a slowing US economy and the return of the euro crisis, particularly in Spain.

First, the US macro news. Import prices rose much faster than export prices; the result is that corporate margins are getting squeezed. Core producer prices rose faster than expected. This also squeezes corporate profits, and it makes it more difficult for the Fed to print more money. Initial jobless claims spiked to 380,000—the highest level in several months. Finally, consumer sentiment fell, instead of rising slightly as expected.

The bottom line is that the US economy is most likely NOT decoupling from the rest of the world, which has slowed markedly….or even entered a recession. It seems more and more likely that the parade of positive (or not so bad) economic news over the last three months was nothing more than a burst of pulled forward demand that came from the historically warm weather enjoyed by most of the country. Folks simply bought things, and did things, in February and March instead of waiting for April and May. And now that April has arrived, there’s LESS to do. The parade of positive news as a flash in the pan. Now, it’s time to economic return to reality, a reality which is nothing to write home about.

In Europe, the euro crisis is roaring back, especially in Spain. Government debt prices (in Spain, Italy and other periphery state) are plunging. Major bank stock and bond prices are plunging. The sugar highs from the LTRO program administered by the ECB is clearly wearing off. And the terrible truth—that the peripheral states and their banking systems are insolvent—is being exposed once again.

Sadly, only a couple of months ago, the leaders of the core states tried to claim otherwise. “Today the problem is solved” asserted French president Sarkozy, who continued “how happy I am a solution to the Greek crisis ….. has been found”.

He was wrong.

And this time, it’s could get much uglier. Spain is the 4th largest economy in Europe, and the 12th largest in the world. Greece was a pimple compared to Spain.

And the pain in spain goes far beyond public and financial debt. Total private debt in Spain is almost 300% of GDP. It’s housing market is collapsing……just now. It’s unemployment rate is almost 25% and youth unemployment is almost 50%.

The Spanish economy is officially back in recession, and to top it all off, the new prime minister is about to impose a massive fiscal shock by slashing the government deficit, which will lead to even greater economic pain, higher unemployment, and more borrowing relative to GDP.

So let’s hope that the problems in Spain remain only that–problems. Because there is a growing risk that if Spain loses control or if the stronger core states lose patience with weakening states like Spain, that a disorderly break-up of the eurozone and a series of massive sovereign defaults all become more likely.

In that case, “risk off” would not even begin to describe the sell-off that would follow.

US Job Market Falters and Economy Slows

April 7, 2012

The S&P500 slipped 0.74% last week, but it would have fallen about 2% had the week not been shortened by a holiday. While the actual stock markets were closed on Friday, the stock futures markets were open of about an hour and they fell well over 1%. Volume for the week was light, but would have soared if markets were open on Friday. And volatility jumped up almost 8%, which would also have been markedly higher had markets been open all week.

Momentum and breadth have turned down, and if equities do sell off on Monday, then they could even become oversold on a short-term basis. And the uptrend that began in October last year is still in effect.

So what caused equities to turn down? Precisely the two factors cited here last week—new signs that “Spain’s Pain” is expanding, and several ominous signs that the “US economy appears to be slowing down”.

Spain had a horrible sovereign bond auction causing yields to soar across the board. The 10 year bond is now rapidly returning to an unsustainable 6%. Spain’s real estate market appears to poised to crash; its banks are heading for insolvency. Its unemployment is soaring toward 25%, and its economy is rapidly contracting.

Most importantly, if these trends all continue (and they’re showing no signs of getting better), then Spain may soon require a sovereign or banking system bailout. There’s only one problem with that—unlike Greece, Spain may be too large to bail out.

Next, US macro news continued to disappoint badly. Only one piece of news beat expectations (ISM manufacturing) and only slightly. The rest missed. These included consumer spending, factory orders, ISM services, initial jobless claims, and consumer credit. The biggest headline miss of the week was the jobs report which came in almost 50% below expectations, lending support to the minority of analysts who argued that the US economy was never really as strong as it appeared early this year. Instead, the record warm weather pulled forward demand (and job creation) from the spring months. And now it’s payback time….and a return to reality, a reality which does not point to a strong recovery.

Adding to these market negatives was the release of the Federal Reserve’s minutes from its most recent meeting. Contrary to what all the market pumpers had claimed (that the equity markets were jumping because of organic economic strength, not because of an addiction to monetary stimulus), it does appear that stock markets are extremely dependent on the Fed’s money printing.  Why? Because the Fed minutes hinted that further easing (eg. QE3) is not around the corner. And what did the markets do? The promptly fell.

So we’re left with markets that may fall further. If Spain’s (and Europe’s) woes continue to grow, if US economic growth continues to wane, if China continues to slow down, and if Japan continues to stagnate, and if the Fed continues to refrain from printing, then all risk markets will very likely suffer.

If so, expect the US dollar and Treasury prices to climb. And pretty much everything else to get cheaper—commodities, other currencies, bonds and stocks.

Risk markets had been grinding higher in the face of many warnings for several months now. Even without the headwinds outlined above, prices were very overdue for a correction. Perhaps now, they will return back closer to earth.

Expect many assets to become much more reasonably priced over the next two to four weeks. And the more prices fall, the better the bargains will be.