Brexit and its Implications

June 27, 2016

After the shocking Brexit event, the S&P500 ended the week on another down note, losing 1.6% by Friday’s close. Volume jumped, as would be expected in a down week. And volatility also spiked, but only to summer highs, and still nowhere near the panic levels seen in January and February.

While warped a bit by the British political vote, the technicals stayed true their trends. The downtrend in price that began in early July has been re-established by last Friday’s major losses.  And the strength of the move on Friday suggests that more, follow-on selling — and losses — would be normal to see.  On a longer term basis, the topping formation that began two years ago is in full force. And after last Friday’s massive loss, this formation has only gotten stronger.

In US economic news, almost all of last week’s reports were bad. The FHFA house price index disappointed, and so did existing home sales. The Chicago Fed national activity index was a disaster. New home sales missed. Leading indicators crashed into negative territory instead of rising as expected. Durable goods orders plunged—both headline and ex-transportation. Just about the only good news was a slight beat in the weekly initial jobless claims report.

The big news of the week, and arguably the biggest news of the year so far, was the shocking vote in Great Britain to leave the European Union. Almost all polls and experts had expected the nation to remain in the EU. So when the results started coming in, with Brexit leading, the risk asset markets around the world started plunging, as did the British pound.

Just about the only assets that rose in price were government bonds and gold….both functioning as safe harbors for the storm that Brexit created.

The biggest question about the aftermath of Brexit is whether or not it will be the trigger that finally leads to material price drops in risk assets, especially in the US. Even after Friday’s drop, the S&P had only fallen a few measly percentage points from its all-time highs. And a true “bear market” had not been seen in the S&P since the Great Recession hit in early 2008.

The key point to consider is that risk assets, especially in the US, are still very highly valued, and that this high valuation—not any particular trigger—would be the fundamental cause of any future bear market. The trigger would be only that—a catalyst for the correction of some more fundamental distortion in valuations.

And at this point, it’s absolutely not clear if Brexit will be THE trigger, like Lehman was in late 2008….or if Brexit will only be a step toward the bear market, like Bear Stearns was in early 2008.

Unfortunately, answering this question accurately will take much more time, and it will be finalized only after the fact.

US Treasuries Soar in Price

June 20, 2016

Not surprisingly, the S&P500 lost some ground last week. The bell-weather US equity index dropped about 1.2%. Volume rose somewhat over the prior week’s volume… indication that there was a bit of conviction behind the selling. Volatility, unsurprisingly, also jumped; the VIX index spike well over 20 during the peak selling phases of last week’s price retreat.

So technically, the S&P500 more clearly established a downturn….after two consecutive weeks during which upward momentum stalled. That said. much of last week’s price drop was driven by headline risk coming out of the UK—specifically, the looming vote to remain or exit the European Union. But by the end of last week, some of this risk had suddenly abated, and despite the continuing technical signals for more price weakness to come, the sudden headline change could overcome these shorter term (daily) technical forces. On a longer-term basis (weekly), the two-year topping formation is still clearly visible and shows no signs of ending soon. So technical traders need to remain on alert ….. for this pattern to resolve itself, which is usually some sort of meaningful correction.

In terms of US economic news, the flow was a bit lighter last week. Headline retail sales beat expectations, but once the volatile auto numbers are stripped out, the results only met expectations—not better, not worse. Producer prices, both headline and core, beat consensus estimates… analysts might start to worry that higher corporate costs could eat into future profits. Industrial production missed expectations, badly. Initial jobless claims also missed. On the positive side, the Empire State Manufacturing survey beat consensus estimates. The Philly Fed Business Outlook Survey also exceeded expectations. And finally, housing starts came in slightly stronger than expected.

Last week, we noted how US stock prices (going up) were diverging from US Treasury yields (going down), and how this divergence rarely lasts for long. Back then, the US 10 year Treasury was yielding in the mid 1.6% range while the S&P500 was still hovering near all-time highs. In the middle of last week, however, the US 10 year yield plunged—temporarily—all the way down to 1.51%, while once again the S&P500 was down only modestly. This dip down to 1.51% represents the lowest yield since 1.4% was touched back in 2012….or a four year low in yields. And once again, this super low yield is screaming that something is wrong in the world of investing—specifically, it’s suggesting that investors are willing to accept a muli-year low in returns just to protect their assets from severe losses.

So while the US 10 year yield did recover back up to about 1.6% by Friday’s close, it’s extremely concerning to see the S&P still near all-time highs while the 10 year yield touches four year lows.

As mentioned last week, this state of affairs cannot continue for very long—-one way or another, the two figures must converge: we must see yields go up, or the S&P go down, or some combination of the two.

Treasuries Screaming; Stocks Yawning

June 13, 2016

For the second week in a row, the S&P500 barely budged. After the prior week’s unchanged result, last week the index inched down very slightly—by 0.15%. Volume was abysmally low, so there was very little conviction behind the selling, which makes sense since the index moved so little in price anyway. On the other hand, volatility did rise, and this is a cause for concern. The VIX index jumped from near the lows of the year to the mid-teens.

In economic news, the number of reports was on the light side, but as usual, the news was mostly poor. Gallup consumer spending fell. The labor market conditions index also deteriorated. Productivity, while meeting expectations, also fell by quite a large percentage; this drives up unit labor costs, which in turn puts downward pressure on corporate profits. Consumer credit rose by much less than expected. And consumer sentiment came in below expectations. On the positive side, initial jobless claims were a bit better than expected and wholesale trade beat consensus estimates.

The technical picture is once again showing a stock market that has lost its upward momentum (two weeks of essentially no change supports this argument) but near or at record high levels, which suggests that the risk to the downside is greater than the risk to the upside…..over the next few weeks. This potential turn is quite visible on the daily charts and it’s also visible on the longer-term weekly charts where the nearly two year old topping formation is still in tact.

Finally, the global government bond market has been sending a danger signal lately. Over the last several weeks, the yields of not only the US Treasury market, but also the yields in Europe and Japan have been crashing. In Japan, the 10 year government bond has been offering a negative yield for many months now, and in Germany, the 10 year government bond is essentially yielding 0 percent. In the US, the 10 year Treasury is approaching the lows of the year (in terms of yield).

What does all this mean?  The biggest takeaway is that huge and mostly sophisticated money is running for cover. By accepting near zero or even below zero yields, these big money investors are saying that they’d rather lose a little bit of money (and guaranteed to do so) rather than risk losing a lot of money in the risk asset markets such as stocks and high yield corporate debt.

The problem is that stock markets (in the US especially) and the junk bond markets have not behaved in a manner consistent with global government bond yields; instead, they have held onto or near record high prices.

So it’s almost a certainty the this discrepancy, or divergence, will not continue. And the big question is how will this divergence correct itself—will government bond prices fall…..or will risk asset prices fall?


US Payrolls Disaster…Recession Looming?

June 6, 2016

The S&P500 closed the week essentially unchanged from the week before. Volume was very light……confirming the lack of direction in the price movement of the index. And volatility edged even lower, which suggests that the market is still very complacent about any potential downside risks.

The technical picture — due to the fact that the S&P closed unchanged — has also not changed much since last week. The S&P is still hovering near, but quite at, all-time highs, and the upward momentum has weakened considerably. In fact,  four times over the last year, when the S&P has exceeded 2,100 it has failed to move materially higher and has always retreated, sometimes by only 100 points (late May 2016) and sometimes by 300 points (February 2016). So the S&P is still facing an upward breakout test—-to succeed in moving materially higher, it must decisively break out and over the 2,125 level and stay there. On the other hand, if last week’s loss of momentum continues to develop, then there’s a material downside that’s already been established earlier this year—down 300 points to the low 1,800’s level.

Last week’s economic reports were mostly weak, as usual. Chicago PMI missed badly, and is now in contraction mode. Consumer confidence plunged. The Dallas Fed manufacturing survey also plummeted. Construction spending went negative (it was supposed to rise). Factory orders missed expectations. ISM services also missed, but very badly.

The big story of the week was the US payrolls report, which turned out to be a complete disaster. Instead of rising by about 160,000 jobs, the report showed that only 38,000 jobs were created. This turns out to be the worst month for US jobs growth since September 2010!  The problem obviously is that the biggest data point supporting the bullish economic view that the US economy is growing steadily if not robustly was monthly jobs gains (despite the fact that most of the jobs gained were low paying and un-benefited—think bartenders and waitresses) just got thrown out the window. If job growth evaporates, then the odds of an upcoming US recession begin to jump materially. Evaporating job growth means lower incomes to purchase goods and services, and lower purchases mean lower corporate sales and lower corporate profits, which unfortunately translates into corporate layoffs. As a result, we would see a self-reinforcing negative economic cycle ….. one that breaks after a lot of people have put out of work.

Remember, it’s been about seven years since the US was in its last recession—a big one that began with the global financial crisis in 2007. So based on 100+ year economic history, the US is—-today in 2016—-already overdue for another recession.

Based on last Friday’s payrolls report, it looks increasingly likely that this recession is just around the corner.