Prices Rise as Volumes Fall

July 29, 2013

The S&P500 hovered near its record high levels, closing the week virtually unchanged. What stands out, however, is the total lack of volume. Investors are simply refusing to rush in and buy stocks at all-time highs when dozens of economic metrics fall to multi-decade lows; real wages are not only not growing, they’re sinking. And the percent of people working in the US population has fallen to lows last seen in the 1980’s. And there’s more.

Meanwhile, corporate profits and stock prices are at record highs.

How can this be? Simple—the US government’s has been racking up record deficits for almost five years now. and consumers have nearly stopped saving any money to support their consumption habits.

But both of these forces clearly cannot be sustained. And while the US government has begun to pull back on its spending (remember the sequester), the US consumer has not to save again.

So as government deficits continue to shrink and consumers begin to save again—both of which MUST happen eventually—then corporate profits MUST begin to shrink back down to more normal levels.

Then assuming that P/E multiples don’t explode higher, stock prices MUST edge back down. In fact, given how severely they’re stretched right now, stock prices will likely do more than edge back down; they’re more than likely plunge back down.

The most recent US economic data is still very weak. The Chicago Fed National Activity index, one of the broadest leading indicators of US economic activity, badly missed expectations, by contracting when it was supposed to be growing slightly. Existing home sales also badly missed. New home sales beat estimates, but only because of a big plunge in new home prices (in other words, new homes went on clearance sale). The Richmond Fed missed. Durable goods orders, excluding transportation (this is done because transportation orders are famously volatile on a month to month basis), also missed badly. Initial jobless claims were worse than expected. Yet consumer sentiment beat expectations, perhaps because of the rising stock market.

Technically, the S&P500 is extremely overbought, hovering above its upper Bollinger band on the weekly resolution. On the daily charts, the S&P is also very overbought but it’s appearing to be losing some of its upward momentum. We’ll know in a week or two, if this is only a pause in its volume-less march to new highs or the start of a more severe pullback.

But in the meantime, the lack of volume is critically important. Should even a modest percentage of stock holders decide to sell, the lack of volume implies that there will be precious few buyers to whom those would-be sellers could unload their shares. This means that the only way to entice actual new buyers into buying US stocks will be through a fire sale in price. If prices were to fall by say 10% or 20% or 30%, then many savvy buyers would emerge and make investments for the long-term.

Unlike today’s buyers of stocks however, such investors would be increasing the odds of earning favorable returns.

Low Return World

July 22, 2013

The S&P500 crept up 0.7% last week, once again proving how far Wall Street is separated from Main Street. Why? Because last week, Detroit—a perfect example of Main Street, and once America’s fourth largest city—filed for bankruptcy, the largest municipal bankruptcy in the history of the United States. Meanwhile, on Wall Street, stock markets were hitting new highs.

Sustainable? In the long run, it seems hard to believe that this divergence can continue. But in the short run, it most certainly is continuing.

At the same time, equity volumes were anemic. In other words, the buyers were not rushing to get in. It’s only during sell-offs that volumes seem to surge. This is not a good sign; it suggests that the foundation of this latest bull market surge is built on sand. Also, complacency returned to historically low levels, also suggesting that investors have been lulled into a false sense of security, once where they believe that stock prices can only move in one direction…..up.

Other hard data on the US economy is not encouraging, as usual. Retail sales, ex-autos, missed badly; instead of rising 0.5% as expected, they came in completely flat. Headline retail sales, including autos, also missed badly. Consumer prices rose more than expected, on the back of higher oil and fuel prices. Industrial production, on the other hand, slightly beat consensus estimates, as did initial jobless claims. On the other hand, housing starts plunged, as soaring mortgage rates filter through the housing industry. Leading economic indicators also disappointed.

Technically, the S&P500 is now overbought on the daily and the weekly charts. Investors have come to believe that all dips must be bought and that nothing can really stop this market from rising more. So the markets have returned to a severely over-bullish condition. According to Investors Intelligence, over 52% of advisors are bullish, while only 20% are bearish. And the Shiller PE ratio is now about 24 times, a level associated with major market tops over the last 100 years.

Howard Marks, a 40 year investing veteran cited here in prior posts, has recently reminded us that we, courtesy of the Fed, currently live in a “low return world”.

He makes the point that the US 30 year Treasury is a critical benchmark that sets the benchmark for long-term risk-free returns.

In prior years, when the 30 year yielded 6% risk free, investors could reasonably make 11% if they accepted moderate amounts of risk and bought high-yield bonds or equities.

But now that the 30 year Treasury yields something closer to 3%, investors are making a terrible mistake if they insist on ‘making’ the same 11% total return.

Why? Because the only way to reach for that 11% return is not by accepting the same moderate amount of risk, which would yield them only about 6-7% today. Instead, an investor would have to accept a HUGE amount of risk to reach for that older and higher 11% of yield.

The point he’s making is that investors are NOT aware of the huge amount of risk they’re taking on when they reach for those older, higher yields today. They’re blindly taking on this risk to earn the returns they ‘expect’ and ‘deserve’.

But because they’re doing this in a low return world, the much higher risk they’re naively accepting will very likely lead to much higher losses, permanent losses, of their capital.

And this will come as a rude shock to those who are are rejecting reality by not lowering their expectations.

The market, he says, is not an ‘accommodating machine’. It will not ‘give you’ the consistently high returns that most people think it should give them.

Thanks for the words of wisdom Mr. Marks.

The Average Citizen Understands

July 13, 2013

Words. Nothing more t than a few carefully chosen words, from Ben Bernanke, was all that was needed to power the US stock market—and most other dollar based risk assets–up, up and away. The S&P500 jumped 2.96% after Bernanke simply hinted, at a conference in Boston, that the Fed is not rushing to taper its permanent QE program. So high yield jumped over 3%. Gold spiked over 5%. Oil motored 3% higher. And investment grade bonds also moved up about 1.5%.

In the short term, it’s amazing how much power the words of one man, an un-elected official of a semi-private institution have on the world’s markets. And if you’re a trader, then very few signals are more important than the news coming out of the Federal Reserve. But if you’re an investor, you must not forget that this is the same Federal Reserve that oversaw the onset of the Great Depression, the dot-com tech bubble, and the recent real estate bubble. As powerful as they’re words are in the short-term, those words were not powerful enough to prevent 50-85% losses in the US stock markets during these prior crashes.

Technically, the US stock market, by breaking out to new highs, has re-established an uptrend, both on the daily and the weekly resolutions. In fact, at the daily resolution, the S&P is actually quite over-bought and ripe for a reflexive pullback, even if only a minor one. On the weekly charts, the 200 day moving average was never violated and its slope is still positive. So the technical momentum players will continue to ride the wave.

Off Wall Street, in the real economy on Main Street, the struggle continues. Wholesale trade plunged. Initial jobless claims jumped to 360,000. Producer prices skyrocketed, driven primarily by the surge in oil prices—which are on track to pushing average national gas prices above the dangerous $4.00 a gallon level. Finally, consumer sentiment came in lower than expected.

Several times over the last few years, we’ve quoted Seth Klarman, a very long-time hedge fund manager who runs over $30 billion, making him one of the largest and most successful managers in the industry. In his most recent commentary, as reported by ZeroHedge, he argued that the average American is not fooled by the faux economic recovery, the artificially engineered market bubble, and the dangerous state of the US government’s fiscal condition.

Here are some key quotes:

Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions.

They regard with skepticism those who don’t accept that we have a debt problem, or insist that inflation will remain under control. Indeed they know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station.

When an economist tells them that growing the nation’s debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute.

They know that a society’s wealth is not unlimited, and that if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse. For if you must rescue everything, then ultimately you will be able to rescue nothing.

We agree Mr. Klarman. We agree.

Corporate Earnings are Fading

July 8, 2013

The bounce in equities continued last week. The S&P500 added another 1.6% on dramatically lower volume, partly explained by the holiday-shortened week. Volatility, as measured by the VIX index, fell back into complacent territory, as hedges against further losses in equities were lifted. Breadth recovered slightly. The index of new highs minus new lows jumped up, and the percent of stocks above their 50 day moving average also rebounded.

Technically, the strong rebound in prices suggests that the bounce may have more room to run. And the daily charts on the S&P are supporting this view because they’re now turning bullish. The weekly charts, on the other hand, are still showing the weakness that began in June. A new high on the S&P500 would be required to reverse the weekly charts and build a bullish case.

In no way does any bullishness in the charts, however, change the fundamental problem that equity markets are not cheap and they’re still overly bullish. The Shiller P/E ratio is still at nose-bleed levels, levels associated with major turning points (down) over the past 100 years. And Investors’ Intelligence is still reporting that professionals are about 44% bullish and only about 20% bearish. As a reminder, over the past 100 years, as John Hussman has carefully pointed out, when markets are extremely over-valued and over-bullish, prospective returns have always disappointed, often leading to severe losses over the medium turn.

The US economy continues to limp along. ISM manufacturing is hovering just above the contraction line. Construction spending disappointed. Factory orders met expectations. International trade plunged; this will hurt the next quarter’s GDP report. ISM services, and remember that services account for 70% of the US economy, missed fairly badly. Initial jobless claims met expectations. And the big number of the week was the jobs report. On the surface, the news was good—195,000 new jobs were created, well more than the consensus forecast of 161,000. But on closer inspection, the news was not so rosy. The type of jobs created was lousy—all were part-time, not full-time ‘breadwinner’ jobs. Almost 400,000 part-time jobs were created in June, yet at the same time, over 200,000 full-time jobs were lost. Yet the establishment survey counts each new part-time job as a ‘new job’. The U-6 unemployment rate, which takes into account people working part-time for economic reasons, reflected this ugly development by soaring from 13.8% to 14.3% in one month. Also disappointing were the labor force participation rate and the employment to population ratio which both stagnated near multi-decade lows.

Finally, there’s a developing story on the earnings front. As stock prices rise back up to all-time highs, corporate earnings are fading away. The simple concept of ‘reversion to the mean’ suggests that earnings which have reached record levels relative to GDP and sales, were due to revert back down to more normal levels. The question was only when.

Well it seems as if this process has begun.

ThomsonReuters has recently reported that the ratio of firms giving negative to positive guidance has soared to about 7 to 1. Not only is this ratio much higher than it was during the meltdown of the Great Recession in 2009, but it’s at the highest level since 2001.

Therefore, in the face of collapsing earnings growth, the only way for the stock market to keep on rising is for it to be valued at an ever higher multiple.

It’s possible. But history shows that—eventually—equity values and multiples always catch up to corporate earnings.


Reflex Bounce?

July 1, 2013

To nobody’s great surprise, the S&P500 paused from its multi-week slide and bounced just under 0.90% last week. Volume was low to moderate, and volatility fell back 10%, as one would expect in a week where prices generally rose.

Technically, the pullback—as seen from the weekly charts—is still in effect. The daily charts highlight the bounce as being a natural reaction to a short-term oversold condition. The breadth indices are still not very bullish. These market internals show that the rebound wasn’t ┬ádriven by a wide range of companies. Instead, it was fairly narrow. The percent of stocks above the 50 day moving average, for example, still displays a severe breakdown in breadth, a breakdown that began several weeks ago.

The US economy is still struggling, as it has for the past four years, to reach ‘escape velocity’, which means that the economy has not been able to grow at a healthy rate on its own. Instead, it’s still dependent on massive fiscal stimulus (eg. federal government deficit spending to make up for lowered private sector spending) and massive monetary stimulus (eg. the emergency near-zero interest rates and quantitative easing programs are still very much in place) to prevent a depression-like collapse. And now, many are beginning to question whether the monetary stimulus is even doing anything positive; it could be that this medicine is actually poisoning the patient.

Economic reports continue to disappoint. The Chicago Fed national activity index missed expectations. Durable goods orders, on the other hand, beat. New home sales also beat expectations, but this measure is very much backward looking. Since interest rates have surged higher over the last four weeks, upcoming home sales will become stressed due to the much higher mortgage rates. The latest report for quarterly US GDP growth was much lower than expected. Initial jobless claims disappointed. Personal spending also missed; but personal income was higher than estimated. The Dallas Fed beat; the Kansas City Fed missed. Finally, Chicago PMI—one of the most important leading indicators of US economic activity—missed badly.

And for equity markets, this presents a problem. If US economic news were to disappoint badly, across the board, then the Fed would have a harder time considering any reduction, or tapering, to its ‘QE Forever’ program. It could conveniently continue to ignore the huge distortions this program has been creating in the financial markets (ie. blowing big bubbles in equities and fixed income and real estate….again), and focus on the ‘bad news’ to keep on printing at the rate expected by markets.

But that’s not happening. Instead, the economic reports are somewhat mixed, leaving the Fed to suffer from criticism focused on market distortions, distortions which we know by now could lead to financial distress and dislocations (also known as financial crises and crashes).

And that’s where we are left today, wondering whether or not the Fed will taper the rate of QE. If markets believe that the economy is too weak, and distortions are not too great, then tapering might be put off, and equity markets can rally further.

If markets believe that the economy is not so weak, and that the market distortions are becoming too great, then tapering will happen and sooner than later. This will cause the markets to sell off further.

And after last week’s bounce, we are technically at a crossroads. If the rally continues then the markets could be buying into the first scenario and technical support for more price gains would build.

But if the rally falters, then the markets could be buying into the second scenario, and last week’s bounce would be seen as just that, a reflex bounce that is followed by continued price declines.