Hours Away from the Cliff’s Edge

December 31, 2012

The S&P500 fell almost 2% last week with much of the week’s losses realized on Friday when it looked like there would be no “solution” to the US fiscal cliff problem. Keep in mind that any so-called solution would in fact be no such thing; it would be merely another bubble-gum and tape patch that kicks the actual fiscal problem further down the road, perhaps a year or two.

Volume was light in equities trading, mainly due to the end of the year holiday season. But volatility rose….again suggesting that traders weren’t really selling down positions to reduce risk, but were only buying insurance to protect existing positions against possible losses.

In US macro news, housing prices continue to benefit from the Fed’s downward manipulation of interest rates (which increases demand and therefore pushes prices up) and of the government’s backdoor support of banks in their goal of preventing foreclosed homes from flooding the market (which reduces supply and therefore increases prices). The Richmond Fed manufacturing index disappointed. Initial jobless claims fell, but mostly due to lower activity at the end of the year. Consumer confidence plunged. And the Chicago PMI slightly beat expectations but its employment sub-component collapsed to a three year low.

The technical picture, after last week, weakened  for the S&P500….especially on the daily charts. If some sort of patch for the fiscal cliff is not worked out ASAP, then this bearish development could continue to build momentum. This would then echo the events from the summer of 2011, when the S&P fell by almost 20% before a compromise on the debt ceiling was agreed to (ironically, today’s fiscal cliff was part of that 2011 compromise solution). On the weekly charts, the downtrend that began in September is still in effect.

So how close are we to going over the cliff? Well as expected here last week, there was no deal over the last 4-5 days, leaving the government only hours away from “going over the cliff”.

And as of this writing, it still appears that no deal is close to being reached. This suggests that the cliff will not be averted and the US will start to kick in expense reductions and tax increases on January 1, 2013.

This could lead to a market sell-off providing more pressure on politicians to “do something”. As a result of this and public pressure in the first few weeks of January, it is very likely that some sort of compromise can-kicking deal will be reached reversing some, but most likely not all, of the revenue increases and expense reductions.

As part of this “deal” the limit on the US federal debt will also be increased to something over $18 trillion (remember that the debt was closer to $10 trillion when the president took office only four years ago).

Markets could then rally somewhat as the Fed continues its QE “forever” money printing program. But later this spring, US macro data will most likely continue to disappoint and US corporate earnings will also struggle.

This will leave the equity markets with a choice: to accept much lower earnings but keep stock prices elevated via higher PE multiples (with the hope of a quick recovery in the economy and earnings), OR to accept these much lower earnings with lower PE multiples and therefore lower stock prices (with the belief that a quick recovery will not be forthcoming).

The next two to three weeks will be very telling.

Going Over the Cliff?

December 24, 2012

The S&P500 edged up 1.1% last week on moderate volume. Interestingly, the volatility index for the S&P rose quite notably, suggesting that traders were buying insurance against near-term losses using options, rather than actually selling down their long positions.

US macro mews was mixed, and to the extent it was positive, there are indications that post-hurricane economic activity provided the boost. Nice to have, but certainly not sustainable. On the negative side, Empire State manufacturing missed badly. Housing starts also failed to hit estimates. Initial jobless claims were worse than predicted. And consumer sentiment plunged, when it was expected to rise. On the positive side, durable goods orders and the Philly Fed survey beat expectations. Personal expenditures only met expectations, but personal income exceeded them.

Technically, the S&P500 is approaching a crossroads on the daily charts. It is appearing to turn away from the downtrend line that began in September. If this price retreat continues, then the downtrend will still be in effect. If prices continue to climb, then the downtrend will get broken, to the upside.

And just what might provide the catalyst to push prices lower? Well it seems that the US fiscal cliff—and the failure to resolve it—could be it.

As of Friday, with only a handful of business days left in the year, there was no viable deal between the Democrats and the Republicans. What’s worse, the Republicans could not even agree among themselves to offer anything to the Democrats. A bill their leadership devised was not voted on because it would have failed to get approved by the Republican controlled House.

So as it stands, unless a Hail Mary deal gets passed over the next four days, the US will automatically see major tax increases and spending cuts hit the economy starting on January 1, 2013. While this will improve the fiscal condition of the Federal Government (by reducing the deficit), this will be in effect an anti-stimulus. one that could hurt GDP growth by 4-5%.

And even if a deal does come about, after January 1st, some damage will have already been done. Related to this damage is the fact that corporate earnings continue to fall.

As a result, the pressure on stock prices will be great. Despite the fact that the Fed has stepped up its money printing schemes, Ben Bernanke has warned that if a solution to the fiscal cliff is not achieved, then there’s little the Fed could do to stop the damage to the economy. If we do end up with some compromise solution, then the damage could be limited.

Either way, this is not a prescription for higher stock prices. It appears that the two most likely scenarios are 1) economic recession and big market correction, or 2) economic stagnation and stalling market action.

There is certainly little to be bullish about, at this time.

“The Anti-Bernanke”

December 16, 2012

The S&P500 slipped about 0.3% last week on light volume. Volatility, one the other hand, rose slightly; but it still hovers near multi-year lows, suggesting that the equity markets are very complacent.

Interestingly, as the edge of the US “fiscal cliff” draws near, the markets are yawning, almost taking for granted that a solution will be found and that no damage to the economy will come about—from either falling over the fiscal cliff or from any compromise solutions that would nevertheless reduce fiscal stimulus.

For now, we’re watching a “What, me worry?” market. We’ll know in a couple of weeks if the complacency was warranted.

Meanwhile, recent US economic data is still struggling to get better. International trade was worse than expected. Small business confidence is plunging. Retail sales disappointed. Inflation, at least according to the officially published figures, remains mild, and it truly is for all folks who don’t drive cars or eat food. Industrial production jumped, but unfortunately almost all of the increase came from auto manufacturers who are merely stuffing their dealer lots with inventory, rather than selling cars to end users.

Technically, the uptrend on the daily charts is still in tact. But the downtrend on the weekly charts is also still in tact. Breath is mixed. The McClellan Oscillator weakened substantially last week. On the other hand the percent of stocks above the 50 day and 150 day moving averages rose.

Last week, we profiled the concerns of the BIS, the central bank to the central banks of the world. This week, the WSJ published an interview with the former head of the Polish central bank, Leszek Balcerowicz whose monetary policies in the mid-2000’s helped Poland avoid a credit bubble and the bust that hit most of the world.

As the WSJ notes, Poland was the only nation in the EU that avoided a recession in 2009, and has been the fastest growing economy since then.

How did Mr. Balcerowicz pull off such a feat?

Quite simply, he fought the political tendencies to over spend and over print. He forced his nation to strictly limit its scope in the economy and let market forces work themselves out.

What he avoided was a shift to more statism and ultimately stagnation and crisis. He avoided the short-term, feel-good BandAids that “save the day” yet sow the seeds for failure in the long-term.

What does Mr. Balcerowicz think of the Fed and Bernanke’s policies?

In a few words—“unprecedented”, “a complete anathema”, “uncharted waters”. He argues that Bernanke is trapping the US economy in an unvirtuous cycle. But as in Japan, Bernanke’s unconventional measures will fail to spur true organic growth, which means that Bernanke will not be able to stop the monetary easing.

With Bernanke’s perpetual emergency measures, governments avoid fiscal reforms and banks avoid restructuring their bad loans. He argues that this “Fed model” is a form of dangerous form of hubris where a small group of elite central bankers believe that the “know better” than the markets, which is impossible because it assumes that there exists a super-class of people, working for the state, who are  smarter than the normal people working in the markets.

And in the not too distant future, we’ll learn if this is true. We’ll discover if the Bernanke led Fed is truly smarter than everyone else in the private sector.

But if it turns out that Bernanke was wrong, then there will be hell to pay….. for the US economy and the rest of the world.

Warning from a Central Bank

December 10, 2012

The S&P500 was almost unchanged last week on light volume. Volatility also barely moved. It felt as if the equity markets were in a holding pattern waiting for greater clarity on the US fiscal cliff stand-off which showed no signs of getting resolved. Breadth was modestly positive—the percent of stocks above the 50 and 150 day moving averages inched slightly higher.

The US macro data were mixed. While ISM manufacturing stunned everyone with a shocking collapse below 50, the ISM services index beat expectations. Factory orders also beat expectations. Initial jobless claims are settling in at a level far higher than they averaged earlier this year, but at a level below 400,000. And the payrolls results also appeared to beat expectations; both payrolls and unemployment came in better than expected. The problem is that the only reason the unemployment rate appeared to improve is because more folks left the labor force than were actually hired. In fact, there were fewer people actually working (on payrolls) in November than there were in October. Not good. In terms of the payrolls beat, if the economy is really slowing (and most of the new orders and inventory sub-components of the national surveys suggest that it is), then today’s payrolls “beat” will be revised lower, just as the payrolls for October and September were revised much lower on Friday. Finally, consumer sentiment badly missed expectations.

Technically, the uptrend on the daily charts is losing momentum, but it is still in effect. Amazingly, without any resolution to the huge fiscal uncertainties—the same fiscal uncertainties that crashed the S&P500 by 20% in the summer of 2011—the S&P today is holding out hope that things will turn out just fine, and that the stock markets will continue on their merry way into year end and beyond, climbing without any serious setbacks.

Speaking of levitating stock prices, the Bank of International Settlements (the central banks’ central bank located in Switzerland) just issued a warning that asset prices (especially stock prices) have risen to levels not seen since the credit boom peaked about five years ago.

In its report, the bank stated that “asset prices appeared highly valued in a historical context relative to indicators of their riskiness”. In other words, prices are losing touch with economic reality.

This bank, a respected financial institution, has a strong track record for issuing accurate warnings. It was one of the few institutions that warned of a global debt crisis in the months before the Global Financial Crisis broke in late 2007.

Today, specifically, it points out how unusual it is for asset prices to rise in the face of a deteriorating global economic outlook. GDP growth forecasts are falling, corporate sales and earnings are dropping, and bond defaults look like they’re set to rise. Yet stock prices are booming.

This is an institution with a record of getting it right. It’s a group without the bias that afflicts most of Wall Street—the need to peddle products no matter how inappropriate the price.

Wisely, the BIS did not issue a date by which prices will correct. Nobody can predict with certainty when valuation reality will return to markets.

But this is a warning that should not be ignored. Sadly, just as it was ignored by most in 2006, this warning will likely be ignored by most folks today.

Odds are high that most of these folks will get hurt…..again.

“Waiting for Something to go Kaboom”

December 2, 2012

The S&P500 managed to squeeze out another gain last week, but this time for only 0.5%. Volume was light for a week that was not holiday shorted. Volatility actually rose, but it did so from a still extremely low, or complacent, level. Breadth was reasonably strong; the percent of stocks above the 50 day moving average continued to rise and is not almost 60%. And the new highs minus the new lows advanced, but it’s not back to levels seen during most of the summer.

US macro data, on average, disappointed last week. The Chicago Fed missed  badly, as did the Dallas Fed survey and the Kansas City Fed survey. Durable goods orders beat expectations, but mostly due to inventory builds, which is not a good sign if it’s not selling. A key sub-index, new orders, plunged by the greatest percentage since 2009. New home sales disappointed. GDP missed expectations. Initial jobless claims were greater than predicted and still near the ominous 400,000 threshold. Personal income and personal spending both badly missed.

Technically, the S&P500 is overbought on the daily charts. Yet the uptrend is still in effect. On a weekly basis, the downtrend is still intact. As a result, the S&P is nearing a crossroads. For the weekly downtrend to break, the S&P must continue rallying in the face of its overbought headwinds. The next two weeks will determine if the weekly downtrend holds, or not.

Recently, Jeffrey Gundlach of DoubleLine Capital was profiled in Bloomberg and spoke about his views on the US economy, that of the rest of the world, and markets.

What stood out were his worries.

Gundlach is convinced that a more ominous, “phase three” of the global financial crisis is on its way. But he doesn’t think there will be an “early warning” that it’s about to hit.

In fact, he calls this process “waiting for something to go Kaboom”.

What’s he doing about it?

Since he believes that the amount of money folks could make in this phase three will “dwarf” what the can make now, he’s building cash by reducing US equity exposure.

He insists that “if phase three takes two years, it’s worth waiting for. The markets don’t have lots of opportunity now.”

For sure, these thoughts are far from the consensus view that “things will work out just fine in the end, so buy buy buy stocks.”

But coming from an investor whose performance has been outstanding for over 20 years, these thoughts are worth considering.