Thursday, December 30, 2010

First tripwire for market weakness

The Christmas Chinese rate hike took the markets by surprise and in ensuing sessions, the Shanghai Composite, which is shown below, dropped through important technical support as well as a Fibonacci retracement level.

There are a couple of good reasons why this could be the early signs of market weakness. First, China has been a bright spot of global growth and a slowing or worse, a Chinese hard-landing, would be highly negative for the world's economy. In addition, investor sentiment has been excessively bullish, which is contrarian bearish and makes stocks vulnerable to market weakness.

Intermediate term top or correction?
Given that commodity prices and cyclically sensitive stock markets, such as Australia, Canada and South Korea, remain in uptrends (see my previous analysis here), I am inclined to give the bulls the benefit of the doubt for now. Even if this were the start of a market correction, my base case calls for a minor pullback of 5% or so.

Were the markets to weaken, here are some signs that I am watch for to see whether this is just a minor correction or the start of a more serious downturn:
  • How does investor sentiment behave? I will be monitoring the sentiment measures to see whether investors panic, which would be bullish, or if they remain sanguine and buy the dip, which would be bearish.
  • What about China?  My base case is that China does not crash here. Here are three reasons why China won't experience a hard landing. I would also add a fourth, namely that the Chinese have sufficient financial reserves to mitigate the effects of a hard landing (for this cycle). Nevertheless, I would welcome signs of panic from analysts such as Mish, Andy Xie and others as signs of sentiment capitulation.

  • How do the financials behave? A prerequisite for a financial crisis is the technical deterioration of the financials. The chart below shows the relative returns of the BKX Banking Index relative to the market. The Banks, after undergoing an extensive relative downturn, have actually begun to improve and outperform the market. This canary in the financial mine seems to be chirping quite happily.

I have written extensively about the macro risks to the global economy in this blog, but the problems of China, Europe and America are 2H 2011 stories, rather than immediate threats to the market. For the time being, I am still inclined that the intermediate term is up and any problems are more likely to manifest themselves as we move into the summer and fall.

Monday, December 27, 2010

A test of political will

Meredith Whitney recently went on 60 Minutes and warned about widespread municipal defaults. Rick Bookstaber also indicated that the munipal bond market is an accident waiting to happen.

Many American cities are in deep trouble. No doubt that hard choices will have to be made. People are starting to speak up. For instance, Mish has been on a crusade to point out unaffordability of the compensation packages of many state and municipal workers.

Is there the political will to act?
What's more, failures are starting to occur. The New York Times published an article about the town of Pritchard, AL that stopped sending out pension checks. This has had a devastating effect on retirees:
Since then, Nettie Banks, 68, a retired Prichard police and fire dispatcher, has filed for bankruptcy. Alfred Arnold, a 66-year-old retired fire captain, has gone back to work as a shopping mall security guard to try to keep his house. Eddie Ragland, 59, a retired police captain, accepted help from colleagues, bake sales and collection jars after he was shot by a robber, leaving him badly wounded and unable to get to his new job as a police officer at the regional airport.

Far worse was the retired fire marshal who died in June. Like many of the others, he was too young to collect Social Security. “When they found him, he had no electricity and no running water in his house,” said David Anders, 58, a retired district fire chief. “He was a proud enough man that he wouldn’t accept help.”

As government worker bashing becomes more popular, expect to see more stories like these about retired dedicated police officers and fire fighters who can't cope. Will the political will be there to make those cutbacks?

People are getting cranky and The political environment is becoming more volatile. Watch out.

Wednesday, December 22, 2010

Tuesday, December 21, 2010

Hedge fund commoditization

I see that HFRX is now listing their HFRX Global Hedge Fund Index as an ETF:
UBS AG and Hedge Fund Research (HFR) have launched the UBS ETFs plc - HFRX Global Hedge Fund Index SF, the first Exchange-Traded Fund (ETF) built on the industry’s most widely used standard investable benchmark of hedge fund performance globally, it was announced today.

The UBS ETFs plc - HFRX Global Hedge Fund Index SF-I was listed on the Deutsche Boerse Exchange on 3 December 2010 (symbol UIQG). The “SF-I” share class is targeting qualified investors. UBS and HFR anticipate additional listings in coming weeks. The ETF is UCITS III compliant.
I rhetorically asked in my first post in November 2007 why investors were paying 2 and 20 for hedge funds. While I recognize that the returns of HFRXGL includes fees, this is another step in the commoditization of hedge fund strategies.

Monday, December 20, 2010

Inflation, here is thy sting

Last Thurday, David Rosenberg wrote a headline entitled Inflation, Where is Thy Sting? (subscription required). He outlined his bull case for bonds by showing the chart below of core CPI and went on to comment that there are many disinflationary and deflationary forces at work in the economy.

The mistake that economists like Rosie and central bankers make, IMHO, is to look at core CPI, or the Consumer Price Index ex-food and energy. Inflation is happening in hard assets, i.e. commodity prices. QE2 is blowing a hard asset bubble and it is precisely this blinkered view of measuring inflation as inflation ex-inflation that created the conditions for the last financial crisis.

My Inflation Deflation Timer Model defines inflation as commodity inflation. It is in commodity and hard asset prices that we see inflation. Take a look at the point and figure chart of the CRB Index, which shows the reflation in commodity prices much more clearly.

Inflation stinging in emerging market economies
The sting of inflation is showing up in the emerging market economies, where rising food prices are stinging the consumer. (Oh sorry I forgot, food inflation isn't inflation!)

China has a de facto USD peg and that policy means that, in the absence of other action, US monetary policy is Chinese monetary policy. The tsunami of liquidity that the Fed loosened on the markets is washing up on Chinese shores, where it has resulted in see-through buildings and empty cities (see the satellite photos here). What's more, all that liquidity sloshing around has fueled a boom in Chinese antiques, where stories of record prices paid for an antique vase and for jade carvings abound.

That is where inflation is stinging. Asset bubbles never end well. The latest round of QE is just a case of pouring gasoline on the fire.

Commodity prices are the canaries in the mine
Eventually, Rosie will be right. I wrote before that today's conditions feel like late 2007/early 2008. Tactically, we are seeing a commodity price blowoff and world stock markets are rallying. For now, the path of least resistance is up.

Commodity prices are the canaries in the mine. The CRB is facing a technical hurdle of double-top resistance. How that chart pattern resolves itself is an important "tell" of where the markets move in the near term. Longer term, should any of the economic timebombs blow up, the path of commodity prices will also be an important important signal of the market direction, of whether it is a Dubai-event to be shrugged off or a Russia event that brings down the house of cards.

Wednesday, December 15, 2010

Europe 2010 = Subprime 2007?

The news out of Europe seems to get worse and worse. Last week Bloomberg reported that the price of default protection, or credit default swaps, of American banks (despite all of their problems) were lower than those of European banks. Then IMF chief Dominique Strauss-Kahn criticized Europeans for taking a piecemeal approach to solving their problems, rather than to undertake a big picture comprehensive solution.

Many eurozone supporters have been afriad to say this, but the traditional IMF solutions to sovereign debt crises would not work in Europe. When a country gets into trouble and asks the IMF for help, the usual package is to offer loan assistance in return for the demands that the country goes on a fiscal diet (cut spending drastically) and get a job, any job (currency devaluation). Devaluation, it is believed, gives the economy a shot of export adrenaline and the reduced spending puts the budget in better shape to benefit from the export jolt. In the case if the PIIGS, devaluation isn't possible, so only fiscal austerity is left to support any adjustments. Even the post-crisis pains that we have seen in places in Argentina, Indonesia and Malyasia won't be enough in the wake of the lack of currency devaluation.

The only obvious solution is default, which the Germans, French and other core eurozone countries will not tolerate because of the threat to their banking system. In fact, Dani Rodrik was to latest to suggest that an amicable divorce is the best solution for Europe.

Still in denial
Europeans appear to be in denial over their problems. Dylan Grice of Societe Generale wrote about the three stages of denial:
The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us.

Right now, it seems that European pronouncements are somewhere between stage one (not a problem) and stage two (not a big problem). They sound a lot like the US reaction to the subprime crisis. As late as March 2007, Ben Bernanke testified before Congress and stated [my emphasis]:
At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.
There is no need to panic, yet. Grice wrote that "When they start blaming everyone else for their problems, we’ll know their crisis is nearly over Until then, their plight likely has some way to go. " To be sure, despite his criticism of European policy, Dominique Strauss-Kahn also stated that he expects that the euro will still exist in five years.

A repeat of 2007/8?
For me, the markets today have a feel of late 2007/early 2008 to them. We have a commodity price blowoff now much like the price blowoff that began in late 2007, which are typical signs that we in the late innings of the bull market cyclical rotation. Problems are mounting (Europe and China) but the bull is roaring ahead.

I recognize that history doesn't repeat but rhymes. However, given the psychology of the eurozone's PIIGS problems, it seems to me that any blow-up is likely a 2H 2011 or 2012 event. In the meantime, enjoy the bull but don't forget your risk control discipline.

Monday, December 13, 2010

A (bullish) tour around the world

The headlines read Market breaks out to new highs, but how real is this move?

Technicians often look to other indices for confirmation of a trend. So I decided to review both US and international indices to see what the patterns are in those averages. By and large, my trip around the world shows that this bull move does look real.

In the US, the picture is mixed. The broader NYSE Composite is still flirting with resistance.

While small caps have broken out to the upside and appear to be in an uptrend:

Europe looks constructive
In Europe, equities look constructive. The broad STOXX Index seems to be shaking off the bad news. The pattern is a rising wedge, with the average not far from overhead resistance.

The German DAX Index has already broken out and is in an uptrend, which is perhaps reflective of the strength of the German economy:

Cyclically sensitive and resource markets look good
Back when I was at Mother Merrill, we used to watch the South Korean KOSPI closely because Korea was believed to be highly sensitive to global cyclical influences. Here we can see that the KOSPI has broken out to the upside and it's in a well defined uptrend.

The pattern of another cyclically sensitive market looks constructive. The resource-heavy Australian All-Ords looks like the European STOXX: in a rising wedge with overhead resistance ahead.

Here in Canada, which also has a resource tilted market, the TSX has already broken out to the upside and it is in a well defined uptrend:

The R/J CRB Index of commodity prices has already broken out and it's now testing upside resistance:

All in all, these charts other markets show either clearly bullish or constructive patterns.

The technical risks
There are, however, a few risks to the bullish outlook. The elephant in the room is China. The Shanghai Composite has been pulling back, but it is resting on a level of Fibonacci support, which is hopeful for the bulls.

In addition, the Baltic Dry Index, which is an indicator of shipping rates, is weak and near the bottom of its range. This pattern is indicative of possible weakening global trade patterns.

For the time being, markets are very overbought in the face of a tsunami of Fed induced liquidity (see sentiment comments and readings herehere and here). My former Merrill colleague Walter Murphy used to term some conditions as a "good overbought" and the current circumstances seem to fit that criteria. Equities could tactically pull back at any time but I would view any pullback as a buying opportunity.

Looking out over the intermediate term timeframe, both my Inflation-Deflation Timer Model remains bullish on the reflation trade. However, I am watching these last two charts carefully for advance indications of deterioration in the bullish picture.

Wednesday, December 8, 2010

What could go wrong

Further to my last post indicating that the bulls are firmly in control of the stock market, I received a number of comments to the effect of "what are risks in your forecast?"

Bullish call for traders only
First of all, I would emphasize that my bullish call is for traders only. Investors should be cognizant of the macro risks inherent in this market. I agree with John Hussman that central bank action is only propping up a house of cards and the macro risks are considerable [my emphasis]:
I continue to view Bernanke's apparent objective for QE2 - to create a "wealth effect" by encouraging speculation in risk assets - to be dangerously misguided. Historically, the elasticity of GDP to changes in the stock market is on the order of 0.03 to 0.05, and is transitory at that. In plain English, this means that even large changes in the value of the stock market do not translate well into changes in GDP. This is because consumers correctly consume on the basis of what they see as their "permanent income," and are well aware that changes in volatile assets tend to be transitory when they are not accompanied by growth in real output and incomes. Bernanke is not thinking as an economist in this regard. He is thinking like a witch doctor calling on animal spirits (ooh, eee, ooh-aah-aah, ting, tang, walla-walla bing-bang).
And the ECB seems to be getting into the act as well:
Finally, last week, Jean Claude Trichet, the head of the European Central Bank, provided early indications that the ECB would be stepping up its buying peripheral government debt issued by Ireland, Greece, Portugal and Spain. Of course, the ECB prefers to "sterilize" these interventions, so it can be expected to sell the debt of stronger members such as Germany. Accordingly, yields dropped on the debt of credit-strained European countries, while German yields pushed to fresh yearly highs.

It doesn't take much thought to recognize that, like Bernanke's actions, the actions of the ECB are ultimately likely to represent not monetary policy but fiscal policy. When you buy the debt of countries that have a high likelihood of defaulting on this debt, or will avoid default only by the creation of currency that could have been issued to finance fiscal expenditures, it follows that you are engaging in fiscal policy without the authorization of elected governments.
For the time being, my inner trader continues to believe that central bankers are intent on throwing a huge party - so enjoy it while you can (but don't forget to keep an eye on the exit).

Keep an eye on China
While the risks posed by the actions of the Federal Reserve and the ECB are longer term in nature, the biggest risk to the near term outlook continues to be China.

The Chinese economy may be slowing. Indicators such as the Baltic Dry Index are suggestive of incipient weakness. The Chinese have indicated that they are worried about inflation and  they may take further stepss to tighten monetary policy by increasing banking reserve ratios in 2011. Other analysts have indicated that the Chinese authorities may resort to interest rate increase and possibly price controls.

I believe that as long as the RMB-USD peg remains, Federal Reserve actions (QE2, QE3...) are likely to export asset price inflation to China and the Chinese authorities have limited tools available to combat domestic inflationary pressures. The real risk becomes one of China going overboard on the limited toolset that they have and send their economy into a hard landing.
Moreover, with the US recovery continuing to be anemic for the forseeable future and the 2012 presidential election just over the horizon next year, trade tensions with China are likely to rise in 2011 because of domestic political considerations.
What happens if either Washington or Beijing miscalculates?

Watch for signs of weakness
For the time being, I am watching the Shanghai market closely. The chart below shows that while that market has retreated from recent highs, it appears to be only corrective action (for now). Should the Shanghai Composite weaken further, along with other indicators such as the Baltic Dry and more signs of Chinese tightening, then it's time for the bulls to head for the exits.

Monday, December 6, 2010

Risk on!

Further to my last post about climbing a wall of worry, market technicals point to a continuation of the bullish momentum seen last week. I call this the QE2 risk trade and what we saw last week could be the start of a significant move higher in risky assets. My Inflation-Deflation Timer Model agrees and remains at an inflation reading as it calls for the high beta trade of  commodities and emerging markets.

Cyclicals look healthy
Market relative charts can be revealing. The chart below of the Morgan Stanley Cyclicals Index compared to the market shows that the cyclicals staged a relative breakout last week, indicating that investors are piling on the QE2 train. The US economy is showing surprising resilience and Barry Ritholz has speculated that we could even be in for an upside cyclical surprise in 2011.

Speculation is not excessive
The QE2 risk trade has much more upside potential. Since QE2 is a form of currency debasement, its effects should show up in gold and commodity prices. As a measure of investor sentiment in this trade, consider the action in gold stocks.

Despite gold prices moving to all-time highs, levels of speculation in the precious metal equities are not excessive. Take a look at this chart of GOX vs. HUI. GOX is an equal-weighted index and therefore gives higher weight to smaller capitalization gold stocks, while HUI is a capitalization-weighted index and gives a higher weight to the more senior names. The chart shows that small cap golds have actually been lagging large caps. These are not signs of speculative blowoffs that accompany major tops.

Here in Canada, I also watch the performance of the TSX Venture Index, which represent the small cap juniors, compare to the more senior TSX Composite. The chart below shows that the small caps have been fair steadily outperforming the large caps since late 2008. While the TSX Venture Index is at an important Fibonacci retracement level relative to the TSX Composite, they are nowhere near their previous highs indicating that speculation is not excessive.

Giving in to the Dark Side
The social and economic risks of the current backdrop are enormous and when it blows up it will be a doozy. As well, central bankers tend to be closed-mouthed and reserved in their comments by their very nature. (Paul Volcker once quipped that when he went to a restaurant during his tenure as Fed Chairman he was compelled to say "I'll have the steak but that doesn't mean I don't like the lobster.")

When a central banker speaks out and actually takes a position, you have to sit up and take notice. Thomas Hoenig of the Kansas City Fed wrote a New York Times Op-Ed about the social risks of the class divide between Wall Street and Main Street [my emphasis]:

Americans are angry in part because they sense that the government was as much a cause of the crisis as its cure. They realize that more must be done to address a threat that remains increasingly a part of our economy: financial institutions that are “too big to fail.”
In spite of the public assistance required to sustain the industry, little has changed on Wall Street. Two years later, the largest firms are again operating with bonus and compensation schemes that reflect success, not the reality of recent failures. Contrast this with the hundreds of smaller banks and businesses that failed and the millions of people who lost their jobs during the Wall Street-fueled recession.
He went on to warn about the social risks of the Wall Street/Main Street Divide [my emphasis]:
Crises will always be a part of our capitalist system. But an absence of accountability and blatant inequities in treatment are why Americans remain angry. Without accountability, we cannot hope to build a national consensus around the sacrifices needed to eliminate our fiscal deficits and rebuild our economy.

Party on dude!
The Divide is large and growing. This November the GOP regained control of the House and the wrangling over tax cut extensions have begun. The newly emboldened Republicans have vowed to hold up the extension of jobless benefits until their tax cut proposals pass and the tax cut proposals have bogged down in the Senate. Consider what this price relative chart of Tiffany's vs. WalMart says about the current environment:

I could rail all day about the inequities in the system. I could also say that this path is highly risky and it will all end in tears. I agree with John Hussman that equity valuations are stretched. My inner trader tells me that none of this matters, until it matters. Even Jeremy Grantham has allowed that the SPX could rally up to 1500 before falling to GMO's fair value estimate of 900 (my comment: but markets always overshoot fair value so expect another 2008-like episode with 50-ish% haircuts.)

For now, it's time to take a walk on the Dark Side and ride the Wildness. Just don't forget your risk controls and overstay the party.

Saturday, December 4, 2010

Weekend reading

Some things to consider on the weekend:
  • Australia's social and political divide: When outsiders look at countries like Australia and Canada, they just see a resource-based economy. This is an excellent story about the social and economic divide in Australia between the mining based economy in the west and the finance and manufacturing in the southeast. Here in Canada we have a similar problem with the mining and energy economies of BC/Alberta/Saskatchewan/Newfoundland and the population heavy manufacturing/finance of southern Ontario and (partly) Quebec.
  • David Wilmott worries about algo-based high frequency trading (HFT) excesses. Be prepared for more flash-crash like volatility?
  • See this fascinating video on the effects of wealth on population health (via Slope of Hope). These are important points to consider for emerging market investors when thinking about development economics.

Thursday, December 2, 2010

Climbing a wall of worry

It is always instructive to see how markets react to events. Right now, traders are focusing on the positives in the market and ignoring the negatives, for now.

Mark Hulbert made a couple of important points this week. First, TrimTabs reported that the long fund inflow by fund investors into bond funds may be over. Net flows into bond funds turned negative last week. The rolling 3-month correlation of daily returns between SPY, as a proxy for stocks, and AGG, as a proxy for bonds, is negative and has varied between -0.1 and -0.5 in 2010. With fund flows into bond funds going negative, could they more likely to buy stocks?
Hulbert also reported investor sentiment has pulled back from bullish extremes to a more neutral reading after a minor correction. These sentiment readings are supportive of higher equity prices.
More importantly, the financial sector of the stock market outperformed on Monday and Tuesday when the markets hiccupped over fears of an Irish contagion spreading to the other peripheral eurozone countries. The chart below shows the performance of the financials relative to the S+P 500. The news that Ireland had to be rescued by her EU partners and that WikiLeaks announced that the next set of paper dump “would target a major bank” should have sent the financials reeling. Instead, they outperformed.

This suggests to my inner trader that the markets are washed out and the path of least resistance is up in the near term.

Tuesday, November 30, 2010

Humble Student is three!

My first post was three years ago on November 30, 2007. Not much has changed in the hedge fund world, hedge fund returns remain correlated to the stock market - an indication that it's all one giant risk trade.

What has changed in the last three years is that I have moved out of semi-retirement to become the portfolio manager of a mutual fund, namely the Qwest Inflation-Deflation Trend Allocation Class. Here is the press release:
Capitalizing on Economic Volatility
Mr. Maurice Levesque, Managing Director, President of Qwest Investment Management ("Qwest") said, "Investors around the world have been challenged by the volatility stemming from significant outbreaks of asset inflation and deflation. Prominent economists and investors remain completely divided in their opinions on the macro-economic outlook. Individual investors will be faced with volatile swings in the markets in the years ahead and will need to know when these major trends change and what assets will respond positively to the change in trend." In response to this investment environment, Mr. Hui developed and launched, in 2009, the Qwest Inflation-Deflation Timer Model (the "Timer Model"), a proprietary quantitative investment model used to identify inflation and deflation trend changes. Mr. Hui explained, "I will use the trend signals from the Timer Model to allocate the Fund's assets into specific asset classes that traditionally respond positively during an inflation trend, a deflation trend or a neutral trend."
The fund is available to Canadian residents only. If you would like a prospectus please contact Cindy Bower at cbower at qwestfunds dot com (note the spam protected email address).

Monday, November 29, 2010

Jeremy Grantham and me

I don't know Jeremy Grantham personally, but we both worked at Batterymarch Financial Management, which was the firm he was at just before he left to found Grantham Mayo Van Otterloo (GMO), an asset management firm with over $100 billion in assets.

I finally got around to watching the recent Grantham interview with Maria Bartiromo of CNBC outlining his outlook, which is well worth the 29 minutes of your time. I was surprised to see how much my outlook agreed with Grantham's. While there were some minor points of disagreement, they were minor.

Inner investor vs. inner trader
Grantham's views sound a lot my inner investor vs. inner trader debate. Despite his reservations about equity valuations and macro risks, he seems to be resigned that the S+P 500 may be frothy enough to rally to as high as 1500, before falling to GMO's fair value estimate of about 900 on the index.

I agree with Grantham's belief, which I have written about before, that there is significant macro risk in the financial system. The Federal Reserve has undertanken to blow serial asset bubbles, the latest being QE2, which will lead to rolling boom-bust cycles. The Fed balance sheet is already precarious in the wake of QE2. While they may be able to rescue the situation right now, at some point it will all come down like a house of cards. When that happens, the fallout is going to be really, really ugly.

What's more, QE2 is a form of currency depreciation, which is upsetting America's trading partners and risking currency wars. Its effects are showing up, not so much in the FX markets, but in commodity prices.
On the other hand, just as my inner trader told me not to worry and enjoy the party that the Fed was throwing. Grantham reluctantly allowed that the stock market could rise even further from current levels.

Our differences are one of approach
So far I have outlined the points where we agree. Our differences are few and relatively minor:
  • We are both long-term commodity bulls but for different reasons. Grantham's bullishness stems from his belief that the supply-demand equation has shifted from commodity consumers to producers. Emerging market countries are growing a lot faster and their rising resource intensity is putting upward pressure on demand. Where I differ: I am a little bit more skeptical about the commodity bullish supply-demand story. I am a long-term commodity bull because I believe that the pressures from overly accommodative global fiscal and monetary policy are likely to manifest themselves in higher commodity prices.
  • Grantham believes that the biggest macro risk is a full-blown currency war, which would have similar effects as the Smoot-Hawley tariffs had during the Great Depression. Where I differ: I just worry about tail risk, which can be either inflationary or deflationary. In no particular order, here are some of the events that may set off another crisis: China slows into a hard landing, more deflationary pressures in Europe, e.g. Spanish real estate falls another 30%, or the Germans balk at supporting their EU brethrens, the fragile US economy slips into a double-dip recession. Should any one of these time bombs blow up, how will the authorities respond?
  • GMO's assets of choice are high quality US stocks and emerging market equities. These are reasonable investment solutions for institutional investors who are constrained largely to a buy-and-hold discipline. In some ways, the high quality stock approach is a close cousin of David Rosenberg's SIRP (Safety and Income at a Reasonable Price) strategy. Where I differ: Given the backdrop of low returns and a volatile economic outlook (i.e. a rolling series of financial crises), I believe that investors should employ more dynamic asset allocation strategies to play the swings, such as my Inflation-Deflation Timer Model.
In summary, we both agree that there are significant macro risks. We just differ on how investors should address the situation.

A silver lining in the global outlook?

David Leonhart has an extensive article in the New York Times about how China may move from a country driven by infrastructure and capital goods growth engines to a consumer led growth. It's well worth the read and puts into perspective many of the points that experienced China watchers have talked about. Consider, for example, on what he says about the scale of the infrastructure and capital goods growth story:
China now spends about 50 percent of its gross domestic product on a broad category economists call investment — roads, bridges, trains, ports, technology, factories and office buildings. That is the highest share in recorded history. During their great booms in the 1960s and ’70s, Japan and South Korea never topped 40 percent. China itself was spending 35 percent only a decade ago.
But that growth path may be reaching its limits:

Perhaps the most telling sign that China’s economic model is reaching its limits is a decline in its efficiency. To maintain 10 percent annual economic growth, it has had to invest more and more in roads, buildings and the like. In other words, the return on its investments has begun to fall, which is never a good sign. “We’ve got a problem,” Guo, the bank chairman, told me. “We realize this kind of growth is not sustainable. It’s not the kind of problem like a financial crisis. But if such inefficiencies accumulate for quite a long time, you reach the point where, suddenly, maybe things burst.”
I have cautioned, as have many others, about about pushing China too hard on the currency question. The Chinese are afraid of political and civil unrest. Leonhard puts this fear into perspective:
One businessman told me he knew that most outsiders thought of China as a top-down, centralized country. “But China is a collection of special interests,” he said, “like the U.S.” Leaders understand that suppressing labor unrest may help economic growth in the short term by holding down wages and thus the price of exports. But many also know that economic discontent risks political instability of the kind that in the last century alone toppled an emperor and Chiang Kai-shek, led to the chaos of the Cultural Revolution and threatened the current regime in Tiananmen Square.

More balanced global growth?
Analyst like Stephen Roach of Morgan Stanley has warned for years about the risks of uneven global growth. Put simply, Americans consume too much and the Chinese consume too little. Indeed, the main planks of China's latest five year plan is to encourage more domestic consumer spending and to migrate up to the value-added ladder to more design oriented growth.

Liu He, a vice minister at the central government’s Office of the Central Leading Group on Financial and Economic Affairs, recently commented in a Caixin inteview on the five-year plan to be launched in 2011 [emphasis added]:
The most obvious and most prominent consideration for the 12th Five-Year Plan is, where will the global market go in the future? And an important question is, how do we create a large domestic market?
He went on:
In the past, what was proposed was transforming the economic growth model. Transforming the economic growth model means increasing efficiency, which involves Paul M. Romer’s New Growth theory, which is to improve total factor productivity and the knowledge content of growth. Transforming the economic growth model is really improving the efficiency of supply.

The transformation of economic development proposed by the 17th National People’s Congress mainly implies three things. The first is the transformation of the aggregate demand structure, which means shifting from economic growth that relies on exports and investment to a model of balanced consumption, exports and investment.

The second is transforming the supply structure from a model of growth driven by secondary industry to a model of balanced growth driven by primary, secondary and tertiary industries, with the service industry in particular playing a larger role.  
Third is the transformation of factor inputs, from quantitative expansion to comprehensive growth relying on knowledge, technology, management, etc.
Michael Pettis agrees. He believes that such a transformation in the character of Chinese growth would mean a Chinese growth slowdown, but its global effects could be relatively benign:
If China indeed experiences a rapid slowdown in GDP growth, the impact on the rest of the world may be far less than we expect. The real key is the evolution of the Chinese trade surplus. If it contracts, it will provide an expansionary boost to the rest of the world, not a contractionary one.

Of course that doesn’t mean that the world will grow quickly. My expectation is that global demand growth over the next several years is likely to be anemic with or without China. But it does man that a slowdown in Chinese growth might not be the disaster for the world that many believe.
Also a rapid slowdown in Chinese growth does not mean a social or political disaster domestically It depends on how serious China is about rebalancing its economy. If policymakers are willing to force up interest rates and wages, most of the adjustment pain will be borne by SOEs and the state sector, not by the household sector. In that case we might see a slowdown in Chinese consumption growth, but one not nearly as severe as the slowdown in Chinese GDP growth. Since the Chinese, like everyone else, probably measures their well-being in terms of purchasing power per capita, rather than GDP per capita, a sharp slowdown might not be nearly as painful as we assume.
If China were to gradually achieve more balanced growth in the next decade, then this could indeed be a silver lining for the outlook in the decade ahead.

Wednesday, November 24, 2010

Don't panic!

When equities sold off on euro-contagion fears and on the news from Korea on Tuesday after failing at key resistance levels, is it time to panic?

My inner trader continues to believe that the Fed wants to throw a party. So let's have some fun, maintain trailing stops and don't worry. The one caveat to this outlook is - we should party as long as China doesn't slow down into a hard landing.

All eyes on China
Gluskin Sheff chief economist David Rosenberg agrees with my risk assessment. He wrote on November 22, 2010:

So long as China does not overdo it on its tightening moves — raising reserve requirements is indeed preferable to interest rate hikes — then commodity prices in general should remain on an uptrend even if a corrective phase should be expected after the QE2-related surge of the past few months. There is enough evidence supporting the notion that the Asian economy has decoupled from the U.S. consumer, and therefore, basic materials should still be a core holding in any given investment portfolio.
How much will China slow? Bloomberg recently reported that, according to their sources:

China’s biggest banks are poised to hit government-set caps on lending and plan to stop expanding their loan books to avoid exceeding the annual quotas.
With news like that, we will no doubt see a China growth scare in the weeks to come. The key to the market’s outlook is the Chinese plans for next year. Will they continue to tighten? Or with growth slowing, which heightens the risk of economic pressures and unrest from rising unemployment, will the Chinese authorities step on the accelerator again?

I believe that the latest round of quantitative easing by the Federal Reserve will have the effect of exporting asset price inflation to China, whose effects are unavoidable as long as China maintains a managed USD-RMB peg. Any administrative effects such as restricting bank loans or raising reserve requirements are therefore likely to have minor effects on the Chinese economy.

Does the US avoid a double-dip?
As Americans sit down to Thanksgiving dinner, it appears that the US may have avoided a double-dip recession. The 3Q GDP print at 2.5% was ahead of the consensus of 2.4% seems to be one sign that the economy is more robust than the bears believe.

I have also been monitoring the relative performance of the Morgan Stanley Cyclical Index (CYC), which is shown below. The CYC appears to be forming a bullish ascending triangle relative to the market. While the formation isn't complete until we see an upside breakout, these are not signs of a market that is likely to show significant weakness beyond the normal 5-10% corrections that may occur from time to time.

On the bearish side, the market remains overbought and sentiment is at or very close to crowded long territory, which is contrarian bearish. These factors suggest that equities are vulnerable to minor corrections but should be bought on weakness.

Monday, November 22, 2010

Down that road lies Zimbabwe

It is said that the road to hell is paved with good intentions. Little by little, I see that the independence of central banks is waning. The Buttonwood blog at The Economist recently commented:
I get the feeling that we are approaching the end of an era. Independent central banks appeared to solve the problem of defeating inflation, but there was always a democratic issue. We have now reached the stage when central banks are being asked to do things that politicians know that the electrorate would not be willing to support, a trend that arguably goes back to the Mexican bailout of the mid-1990s. It does not seem sustainable.

The Federal Reserve, after facing much criticism of its QE2 program, has had to take the unusual step of publicly defending itself.

Across the pond, Bundesbank president Max Weber warned six months ago that the ECB is eroding "its independence by financing debt-strapped nations and keeping banks on life support as Europe’s debt crisis persists." Now those warnings of those risks may be materializing as beyond Ireland lie the other periphery eurozone countries.

A counterweight to fiscal policy
One of the roles of monetary policy played by central banks is to act as a counterweight to fiscal policy, which tends to be more politically driven. While I have expressed my own concerns about the effectiveness of QE2 and I do believe that the Fed's operations are overly opaque and audits may be beneficial, I would nevertheless support the principle of central bank independence.

If central bankers were to come under the power of politicians, then monetary policy can no longer be the counterweight to fiscal policy. Down that road is economic instability, banana republics and Zimbabwe.

Thursday, November 18, 2010

Will the real Warren Buffett please stand up?

On Tuesday November 16, 2010 Warren Buffett wrote a New York Times Op-Ed praising government actions in the financial crisis:
When the crisis struck, I felt you would understand the role you had to play. But you’ve never been known for speed, and in a meltdown minutes matter. I worried whether the barrage of shattering surprises would disorient you. You would have to improvise solutions on the run, stretch legal boundaries and avoid slowdowns, like Congressional hearings and studies. You would also need to get turf-conscious departments to work together in mounting your counterattack. The challenge was huge, and many people thought you were not up to it.

Well, Uncle Sam, you delivered. People will second-guess your specific decisions; you can always count on that. But just as there is a fog of war, there is a fog of panic — and, overall, your actions were remarkably effective.
One of the "people" who second guessed Uncle Sam`s decision turned out to be Buffett himself. Contrast Buffett`s latest comments with the Op-Ed he wrote back in August 18, 2009, where he warned about the risks of rising fiscal deficits and "unchecked greenback emissions":
Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.
Since the 2009 Op-Ed, the current account deficit has widened and the fiscal deficit has taken off like a rocket. We now have unprecedented levels of "greenback emissions" in the form of QE2.

How is the government then doing such a good job?
I suppose that the better question might be: "Who are you and what have you done with Warren?"

Tuesday, November 16, 2010

The Geithner Gang rides again?

In the bad old days when emerging markets were really, really emerging, there were stories out of places like Russia where property rights were blatantly ignored. Share registers were routinely changed, or shareholders would be physically barred from shareholders' meetings by thugs, where existing shareholders' interests were diluted to nothing, sometimes without disclosure or warning.

These bad old days seem to coming to the developed world, where the likes of Tim Geithner et al have decided that it's ok to bail out financial institutions without either bondholders or shareholders taking a hit, as per capitalist principles. The latest rumor comes from Neil Garfield, who comments on the MERS mortgage registration mess (via FT Alphaville):
The legislation is already being drafted under the interstate commerce clause to ratify MERS and everything it did retroactively. It appears that the Obama administration is ready to pardon all the securitization deviants by signing this bill into law.
If this rumor is true, then the Geithner Gang is ready to ride again. Where is the outrage?

Monday, November 15, 2010

China and oil usage

Back on August 23, 2010, the Center for Geoeconomic Studies showed this chart of crude oil usage intensity of China and other countries in a blog posting:

Their comment was that China is rapidly approaching the $15,000 GDP per capita level when oil consumption intensity starts to rise. Given the vastness of Chinese population, this would mean that global oil demand would take off like a rocket [emphasis added]: "Were China’s per capita oil consumption to be brought up to South Korea’s, its share of global consumption would increase from today’s 10% to over 70%."

By implication, such a development would be incredibly bullish for oil and other energy prices.

Does the new five year plan mitigate demand?
Or does it?

In some ways, China's communist based central planning approach gives us a better picture of her intentions. In a recent interview with Caixin, Liu He, a vice minister of the Office of the Central Leading Group on Financial and Economic Affairs, expounded on the Chinese government's latest five-year plan:

In other words, China's aim in the latest five year plan is to move from low value-added production up to higher value added production, both for domestic consumption and export. Romer calls it growth based on creativity, i.e. more design. Michael Porter would call it moving up the value-chain.

In the past, China's insatiable demand for natural resources has been the result in some silly projects, e.g. inefficient steel plants. This mis-allocation of capital has gobbled up a lot of natural resources such as iron, copper, coal, oil, etc. A transformation of the economy that is more oriented to higher value-added and more creative design oriented output is likely to dampen some of the oil and other raw material intensity nature of the Chinese economy.

Long-term bullish or bearish for energy?
Does this mean that crude oil demand intensity is not poised to skyrocket as per the Center for Geoeconomic Study chart above? On the bullish side, we have seen this same level of rising affluence drive up energy demand in other countries. On the bearish side, the Chinese government seems to be at some level working to restrain energy and other natural resource intensity of their economy. Don't forget the transformation in the American economy in the 1980's, when prolonged oil prices resulted in more efficient use of energy, e.g. smaller cars, etc., and oil demand dropped as a result.

I am still leaning bullish on the case for rising oil demand. However, there are risks to this story and the bearish case shouldn't be ignored.

Addendum: Further to my post, I see that the latest IEA report concludes that oil demand would peak in 2020 if CO2 is cut aggressively (also see story here). While it is unlikely that individual countries would adhere to global accords on CO2 emissions, it does show that efforts to cut consumption, such as fossil fuel subsidy reductions, can have a significant impact on demand.

In the past, what was proposed was transforming the economic growth model. Transforming the economic growth model means increasing efficiency, which involves Paul M. Romer’s New Growth theory, which is to improve total factor productivity and the knowledge content of growth. Transforming the economic growth model is really improving the efficiency of supply.

Thursday, November 11, 2010

War drums on Remembrance/Veterans' Day?

Yesterday Todd Harrison of Minyanville wrote an article entitled An unfortunate needle points to war, where he expressed his concerns about all the social crankiness that comes with economic stress leading to geopolitical tensions:
I ate dinner with Don Graham of the Washington Post a year or so ago and he asked what worried me most. Before I could self-edit, I said “World War III; global conflicts are usually born from economic hardship and that’s where the needle seems to be pointing.”
He went on:
The signs are pointing towards an unfortunate destination. Earlier this year, we wrote about the percolating cross-border problems, from the Flotilla friction to Iran tensions to saber rattling on the Korean Peninsula to leaks of Afghan war logs, with European social strife on the rise and a global play for crude mixed in for good measure. Sovereign posturing is ever-present and on the rise. Can you feel it?

Personally, I think that Harrison's point about World War III are a little over the top. Nevertheless, his contention is well taken. It seems to be that while there is no immediate threat of war, the current economic conditions represent fertile ground for conflict over the next few years, regardless of whether it's economic or the fix-the-bayonets-and-go-over-the-hill kind.
QE2 is proving to be a sore point. The criticism has been coming from virtually everyone, including Federal Reserve presidents. Michael Pettis wrote:
I think there is a very good chance that in retrospect QE2 will be seen as the equivalent of the Plaza Accord. If the US continues to pursue quantitative easing, it could spell the last stage of China’s great growth spurt followed by the beginning of the big adjustment. And like the Plaza Accord it will sow many years of suspicion and conspiracy theories.

In addition, Pettis pointed out some of the misunderstandings surrounding the Chinese and American positions on both sides which are likely to heighten tensions. He pointed to an FT article by Yao Yang, director of Peking University’s CCER, which stated:
China’s leaders believe that, when the political dust of the midterm elections falls to earth, Americans will see they benefit from the cheap goods a weak renminbi provides. They also gain little from an upward valuation. Research suggests that even a 20 per cent appreciation will have minimal impact on the US economy. China, on the other hand, will see employment and GDP drop by over 3 per cent.

No wonder there is a firm belief among China’s elites that rational American policymakers are not serious about appreciation, because it makes no sense for a rational actor to inflict costs on others without gains.
It's these kinds of misunderstandings and miscalculations about the other side's intentions that lead to conflict. Recall April Glaspie's famous statement to Saddam Hussein:
We have no opinion on your Arab-Arab conflicts, such as your dispute with Kuwait. Secretary Baker has directed me to emphasize the instruction, first given to Iraq in the 1960s, that the Kuwait issue is not associated with America.

I agree with Harrison that people are nervous, cranky and jumpy all over. Risks are therefore rising. Personally, I believe that the risks are more tilted towards social and economic risks than a shooting war but the probability of war over the next few years is not zero.

Tuesday, November 9, 2010

Another way to think about pensions

In May 2009 I wrote that pension fund management needed a new analytical framework and asked for input from my readers. Now I see that the Boston chapter of QWAFAFEW (Quantitative Work Alliance For Applied Finance, Education and Wisdom, otherwise known as quaff-a-few) is hosting a talk entitled "Using Factors to Dynamically Manage Pension Fund Risk" on Tuesday November 16, 2010. Here is the abstract:
Using Factors to Dynamically Manage Pension Fund Risk - Pension Funds are complex systems with many moving parts. A sponsor needs to be concerned about the behavior of the assets, the behavior of the liabilities, and how the two interact. We look at representative Canadian plan and its sensitivities on both the asset and liability side and how they interact and then suggest some asset allocation strategies that can be used to better manage the return dynamics and funding stability of the plan.

If you are around in Boston next Tuesday, you may consider attending. Click on the link above to get all the details.

Monday, November 8, 2010

The neighbors complain about Ben's party

The reaction to the Fed's QE2 program has come hot and fast. Emerging market authorities are complaining loudly about QE2. From Brazil to South Africa, the reaction has been swift and negative. China’s Vice-Foreign Minister Cui Tankai said that the US “owes us some explanation on their decision” and PBoC governor Zhou Xiaochuan complained that QE2 “is not necessarily optimal policy for the world”.  In central banker-speak, that's somewhat akin to Emperor Hirohito's announcement to the Japanese people at the end of WW II "that the war has not necessary unfolded to our advantage.

Beyond the complaints, it will be telling to see how the capital exporters like the OPEC Gulf states and China react. QE2 will export asset inflation to China and push up the prices of real estate and rare antiques.

The critics come out of the woodwork
Beyond other governmental and central bank authorities, the critics have been out in force. Portfolio manager John Hussman was scathing in his criticism. Bernanke, Hussman believes, is blowing another asset bubble and repeating the mistakes that Greenspan made and this will end very badly [emphasis added]:

It is difficult to interpret Bernanke's defense of QE2 as anything else but an attempt to replace the recent bubble with yet another - to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the "wealth" as permanent. The problem here is that unlike housing, which consumers had viewed as immune from major price declines, investors have observed two separate stock market plunges of over 50% each, within the past decade alone. While investors have obviously demonstrated an aptitude for ignoring risk over short periods of time, it is a simple fact that raising the price of a risky asset comes at the sacrifice of lower long-term returns, except when there is a proportional increase in the long-term stream cash flows that can be expected from the security.

As a result of Bernanke's actions, investors now own higher priced securities that can be expected to deliver commensurately lower long-term returns, leaving their lifetime "wealth" unaffected, but exposing them to enormous risk of price declines over the intermediate (2-5 year) horizon. This is not a basis on which consumers are likely to shift their spending patterns. What Bernanke doesn't seem to absorb is that stocks are nothing but a claim on a long-term stream of cash flows that investors expect to be delivered over time. Propping up the price of stocks changes the distribution of long-term investment returns, but it doesn't materially affect the cash flows. This reckless policy has done nothing but to promote further overvaluation of already overvalued assets. The current Shiller P/E above 22 has historically been associated with subsequent total returns in the S&P 500 of less than 5% annually, on average, over every investment horizon shorter than a decade.
Andy Xie believes that QE2 won't work to devalue the USD because "most major economies will do something to keep their currencies down":
The world seems full of smoke ahead of a world currency war. The weapon of choice is quantitative easing (QE). If you print a trillion, I'll print a trillion. No change in exchange rate after a trillion? Let's do it again, QE2.

Unintended consequences
Paradoxically, QE2 may have the opposite of depressing the US economy in a couple of ways. If China allows wages to rise and pass the costs along, it would raise the prices of consumer goods in the US. In addition, Andy Xie thinks that the RMB is overvalued:
I think China's currency is overvalued. China's money supply has exploded in the past decade, rising from RMB 12 to 70 trillion. Every currency has experienced depreciation after a pronged bout of money growth. China's industry has risen tremendously to justify part of the growth. However, a massive amount is in the overvalued property market. When it normalizes, the money flows out and the currency depreciation pressure happens. We should see this within two years.

As well, QE2 is pushing up commodity prices, which include food, which is depressing the American consumer's already weakened spending power. (Oh I forgot, central bankers look at inflation ex-food and energy, which is where the inflation is, so therefore there won't be any inflationary effect...)

Michael Panzner posted a graph showing the disconnect between Wall Street and Main Street, in the form of the stock market and US consumer confidence. Notice how they tracked each other until the Lehman Crisis, when the market took off but consumer confidence stayed flat.

QE2 is likely to increase that gap by rewarding the holders of capital by blowing another asset bubble while the suppliers of labor have to suffer the consequences of higher food costs and possibly higher prices of consumer goods made in China.

Recall that even the worse days of the Weimar Republic hyper-inflation, there were clear winners and losers. All that stimulus meant a roaring stock market, which rewarded the holders of capital, while the ordinary working people suffered. We know how that story ended.

It may not come to a repeat of the German experience, but the risks are there. Barry Ritholz points out that already, affluent Americans are more confident now than 2009. I also suggested before that QE2 has the potential to ignite class warfare.

Meanwhile, my inner trader says that the Fed is intent on throwing a party so let's enjoy it and maintain tight trailing stops. Don't worry, be happy!

Friday, November 5, 2010

The Markets have spoken

On Monday I wrote that this would be a momentous week for the financial prices and suggested that it may be time to sell the news. Now that the mid-term elections and the FOMC decision has come and gone, what's the verdict?

In the spirit of elections, where conceding politicians use the words "the People have spoken", I now write "the Markets have spoken."

Fed chairman Ben Bernanke had an important Op-Ed in the Washington Post, in which he admitted that the Fed was targeting stock and other asset prices [emphasis added]:
The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
When the Fed chairman mensions stock prices twice in the same paragraph, it would be foolish not to pay attention. In reaction, commodity prices are skyrocketing and the USD has fallen through an interim support level.

Substantial risks remain
My inner investor tells me that substantial risks remain in the market. First of all, there are the valuation and economic risks of a slowdown or double-dip, as the likes of John Hussman has repeated warned us about. Moreover, political gridlock may not be good for the markets after all. Bernanke concluded his Op-Ed with [emphasis mine]:
The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.
If there is gridlock, then monetary policy will have to do all the heavy lifting. That will lead to a highly risky unbalanced policy by the United States.

More telling is Kid Dynamite's characterization of the comments of Bill Gross, which is "sold to you sucka" as a response to the Fed's QE2 program.

Don't fight the Fed
Does that mean that Bill Gross is fighting the Fed? Let's see what he actually said:
"To your question of selling or buying treasuries - I think for the most part those that should have bought them have bought them already and that would include PIMCO and that we would be looking forward to "handing them off" so to speak as we accelerate towards that outer orbit."

In other words, Gross and others front-ran the Fed in its QE2 program and is now "handing them off" to the Fed. If an institution the size of Pimco wanted to sell, the Fed would be a perfect candidate as a buyer. The rest of us mortals whose portfolios are a fraction the size of Pimco's AUM and the Fed's balance sheet can afford to be more nimble.

My inner trader, who vehemently disagrees with my inner investor, believes that the Fed is intent on blowing another asset bubble. Already, we have commentators like Barry Ritholz and Simon Johnson warning against the likely watering down of the Volcker Rule. Such actions, it is believed, will lead to a repeat of the financial excesses that toppled Bear Stearns and Lehman Brothers.

My inner trader says, "Don't worry, be happy! These policies are bubblicious. They are supportive of the asset bubble that the Fed wants to blow, so relax and go with the flow."

In that case, this will mean a momentum driven market where fundamental don't matter.

Monday, November 1, 2010

Sell the news?

The first week in November will indeed be momentous and full of wild cards. We will see the US mid-term elections, followed by the FOMC meeting in which QE2 is expected to be announced. Right now, the market consensus for both events are both equity bullish. However, it's important to examine the implications of these events to see if they are indeed bullish.

Is deadlock really market bullish?
The Republicans are expected to take back the House, but the Democrats are expected to narrowly retain its Senate majority. The Street consensus has been "deadlocks are bullish for the markets", but is it really in this case?

FT Alphaville highlighted the analysis from the strategy team at RBS. Highlights include (my comments in parentheses):
  • Political deadlock means deadlock on fiscal policy. Monetary policy will have to do the heavy lifting (we are back to that QE2 again...)
  • It also means regulatory uncertainty. (Do we really want "little" issues like the foreclosure crisis to linger?)

High market expectations for QE2
As for the upcoming FOMC meeting, I wrote about it before here and pointed out the risks that QE2 could spell the end of Bretton Woods 2. The market is pricing in about $1 trillion in QE2, while signals from the Fed is that it will be substantially less, with room for "flexibility" to raise the program if necessary. This, to me, seems to be a recipe for disappointment.
Fed watcher Tim Duy echoed some of the concerns of the RBS team about fiscal policy when he wrote last week [emphasis added]:
The Obama Administration is poised to turn its attention to deficit reduction, seemingly oblivious to the historical errors of Japanese fiscal policy, not to mention the US experience in the Great Depression. For better or worse, that leaves monetary policy to bear the burden. But the Federal Reserve is signaling they are poised to deliver far less than necessary to meet expectations, expectations that already were likely overly optimistic. 

And does the issue of "flexibility" only go one way?
To be sure, Fed policymakers will argue that they are trying to preserve flexibility. Why is it that "flexibility" means the ability to scale up? Why can't "flexibility" mean the ability to scale down? Seriously, it is not as if the Fed is in any danger of hitting either of the objectives in the dual mandate anytime soon. And does Bernanke really believe that it will be any easier to offer a credible commitment to scale up once Dallas Federal Reserve Chairman Richard Fisher is a voting member of the FOMC?
Are the markets getting leery?
While the markets seem to have very high expectations for QE2, early market action is indicating that the tide is turning. The US Dollar, which had been falling on expectations of QE2, seems to be stabilizing:

Interest rates are backing up:

Gold prices have also pulled back:

Bespoke's analysis of the stock market during mid-term elections indicated that equities have an upward bias for election day and for the week. Given the high expectations and the risks to these events, perhaps it's time to "sell the news"?

Friday, October 29, 2010

Signs of the Apocalypse?

As we approach Halloween, here are some signs of the Apocalypse:
Do you think that examples such as the banks hiding behind the slogan of "paperwork technical problems" when there was widespread fraud and claiming that no one was thrown out of their home who shouldn't have might have something to do with the "integrity deficit" in America?

Wednesday, October 27, 2010

How bad are the Financials?

The bad news keeps coming on a daily basis for the Financials:
  • FDIC's Bair sounds alarm on foreclosure litigation - Sheila Bair: ""I fear that the litigation generated by this issue could ultimately be very damaging to our housing markets if it ends up unduly prolonging those foreclosures that are necessary and justified. The regrettable truth is that many of the properties currently in the foreclosure process are either vacant or occupied by borrowers who simply cannot make even a significantly reduced payment and have been in arrears for an extended time."
  • New York Fed and bond investors gear up for a battle on MBS - Bloomberg has reported that the New York Fed, Blackrock and others has hired Kathy Patrick, a lawyer who has been characterized as a "pit bull on steroids", to take on BoA and others on the mortgage foreclosure litigation.
  • Another analyst rhetorically asked the question if student loans are the next bubble [emphasis added]:
According to, student loan debt is now surpassing credit card debt. College graduates no owe $850 billion in student loans versus the $828 billion consumers owe credit card companies. This number is staggering. We’ll have to look it up, but it seems like this is the first time in history, given the short history of student loans, that credit card debt is less than student loan debt in the United States.
Moving forward, we will need to keep our eyes on two key metrics. First, we want to watch the number of defaults on student debt. Student debt is the only debt in our legal system that cannot be ‘forgiven’ during a personal bankruptcy. We could seriously find a generation without a job, without capabilities to pay the debt, and with no choice but to be servants to the banks to some degree. Although a “Lost Generation” is very unlikely, it is still a very small possibility. Secondly, we want to watch the employment rate. If employment does not improve, all of these new graduates will face uncertain futures moving forward. Some schools require students to take out six figures of debt which they could be paying on until the day they die. This grim future could be a reality for many. Could Sallie Mae (SLM) be the new owner of a slave generation induced by student debt?
I suggested a week ago that the relative performance of the Financials to the stock market is one indicator to watch of market health. The chart below shows that the sector has broken down from a relative support level and remains in a relative downtrend.

Is this another Lehman waiting to happen?
I think that everyone needs to take a deep breath. The market is starting to discount the Apocalypse for the sector.

I have heard bandied around is that the banks will have to take losses in the order of $100 billion. While that is a big number, it's not the kind of world ending figure that took down Bear Stearns and Lehman Brothers. $100 billion is roughly the total market capitalization of Citigroup, or about 10% of the BKX.

Yves Smith, who has been all over the foreclosure problems, believes that the magnitude of the problem may be overblown:
We did a quick and dirty analysis last week that showed that even if this effort succeeds, the recovery amount is likely to be far less than is widely anticipated.

In this excellent post on the problem, Smith went on the detail some of the legal and procedural issues surrounding the litigation and concluded:
We are no fans of Countrywide, but that should not stand in the way of recognizing that not every legal case against them is necessarily a slam dunk.
As for the student loan problem, which has a high probability of becoming a drag on economic growth and consumer spending, does not have the size to spark another Lehman-like crisis. (Note that the entire student loan market is $850 billion and not all of them are going to go sour.)

A correction likely, but this is not 2008
Today, investor sentiment is overly bullish, the market is overbought and showing signs of rolling over. These conditions are suggestive of an intermediate term top, followed by a correction with a 10-15% downside risk.

Barring some other unforeseen catastrophe, the problems of the Financials do not have the potential to return the major market indices to their 2008-9 lows.

Monday, October 25, 2010

Too much complacency

Just as the SPX sees a golden cross, sentiment measures aren't looking particular positive for equity bulls.

Last week I saw several posts in the blogosphere about stock market technicals breaking down. As well, sentiment measures seem to be indicating excessive complacency - which is contrarian bearish. AAII bullish sentiment is at 50%. Surveys of other measures also show signs of a crowded long in stocks and Mark Hulbert reported that the lastest Vickers report shows that corporate insiders are now selling.

Maybe the best warning for the bulls is when China's 9.6% growth rate is a disappointment, what other possible good news could propel the market higher?