Archive for October 15th, 2012
Monday, October 15th, 2012
by Jeffrey Saut, Chief Investment Strategist, Raymond James
October 15, 2012
Most people acknowledge that losses will happen regardless of the type of business venture. A light bulb manufacturer knows that two out of three hundred bulbs will break. A fruit dealer knows that two out of one hundred apples will rot. Losses per se don’t bother them; unexpected losses and losing on balance does. Acknowledging that losses are part of business is one thing; taking and accepting those losses in the markets is something else entirely. In the markets, people tend to have difficulty actively (as opposed to passively as in the case of the fruit dealer and the bulb manufacturer) taking losses (i.e., accepting and controlling losses so that the business venture itself doesn’t become a loser). This is because all losses are treated as failure; in every other area of our lives, the word loss has negative connotations. People tend to regard the words loss, wrong, bad, and failure as the same, and win, right, good and success as the same. For instance, we lose points for wrong answers on tests in school. Likewise, when we lose money in the market we think we must have been wrong.
… “What I Leaned Losing a Million Dollars,” by Jim Paul and Brendan Moynihan
What determines your stock market performance is not how you manage your winners, but how you manage your losers. Indeed, everyone knows how to win, but few know how to lose! Yet the secret to making money in the market is knowing how to lose; or how to control your losses. Listen to the pros:
“I’m always thinking about losing money as opposed to making money. Don’t focus on making money; focus on protecting what you have.” – Paul Tudor Jones
“The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and costs them dearly.” – William O’Neil
One investor’s two rules of investing:
1) Never Lose Money
2) Never forget rule No. 1 – Warren Buffett
All of those pros have different market philosophies. They have contradictory strategies for making money. Some are traders; some are value players; some are growth-stock advocates; others are emerging-growth seekers; etc., etc., etc. But the message is clear – “Learning how not to lose money is more important than learning how to make money!”
Last week “losing” came back in focus on the Street of Dreams as all three of the major market indices posted their largest weekly declines since the first week of June. Of the three, the NASDAQ Composite (COMP/4457.86) fared the worst with a 2.94% “hit,” while the S&P 500 (SPX/1428.59) suffered a 2.21% slide and the D-J Industrials (INDU/13328.85) lost 2.07%. Why such paltry declines have caused a massive return to “fear” in the stock market is a mystery to me because such market pullbacks are pretty common. Indeed, according to Ned Davis Research, since 1928 there have been 294 “dips” in the SPX of 5% or more. Ninety four of them were moderate corrections of 10% or more, 43 were severe declines of 15% or greater, and 25 of them were classified as bear markets (20%+). Further, since the SPX has not experienced as much as a 5% fade in 93 trading sessions, the third-longest such stint since 2002, one is certainly due. In fact, we warned of such in mid-September in a report titled, “The Philosophy of Tops.” Since then the major indices have struggled.
Sticking with the technicals, the SPX and INDU have pulled back to their respective 50-day moving averages and are holding them. Unfortunately, the COMP has decisively broken below its 50-DMA (read: negative). The COMP’s weakness is attributable to the heavy weighting of technology stocks that populate the index. Because the technology sector has the largest weighting (20%) of the 10 macro sectors, with only 29% of the tech stocks above their 50-DMAs is it any wonder the overall stock market is struggling? Plainly the tech sector is having issues, probably because the tech stocks have the most exposure to Euroquake. The tech trauma has left that sector pretty oversold and likely within 3-5% of a bottom. Part of tech’s problem has been the weakness in Apple (AAPL/$629.71/Outperform), which has also decisively broken below its 50-DMA; yet, as the brainy folks at the Bespoke organization note:
“As shown (see chart on page 3), breaks below the 50-day have historically not been bad for Apple. Typically the stock bounces back pretty quickly. In the month following 50-day breaks, AAPL has averaged a gain of 1.84% (median 3.05%). Over the next three months, AAPL has averaged a gain of 9.29% (median 8.31%).”
Meanwhile, as our markets struggle the major European markets are holding up rather well despite the Euroquake worries. In last week’s letter I wrote, “When markets ignore bad news, that’s good news.” Said quote applies to markets abroad, as well as here. In past missives I have suggested one on the better ways to increase international equity exposure is using the MFS International Diversification Fund (MDIDX/$13.69), managed by my friend Thomas Melendez, who I will be “breaking bread” with later this week. Also, in last week’s verbal strategy comments I opined that China is looking attractive again. In fact, the iShares FTSE China 25 Index Fund (FXI/$36.38) is up about 14% since the beginning of September and last week accomplished another upside breakout in the charts (see chart on page 3).
Turning to the economy, despite my sense that corporate America has stepped to the sidelines until there is more clarity on the Presidential election and the fiscal cliff with a resultant softening in economic statistics, of the nine economic indicators released last week seven came in above expectations. Offsetting that are earnings expectations because for every one company announcing they expect better than anticipated profits, there were more than four companies warning about their upcoming 3Q12 earnings. This week will get a tidal wave of earnings reports, as well as some significant economic reports (Retail Sales, CPI, Industrial Production, Philly Fed, Leading Economic Indicators, Existing Home Sales, etc.). Accordingly, it will be interesting this week if the SPX will hold in the 1420 – 1430 zone, or if we will fall to the major support zone of 1400 – 1420.
In conclusion, in last Monday’s missive I suggested one of the better ways to gain exposure to the financials was via the FBR SmallCap Financial fund (FBRSX/$19.36) managed by my friend David Ellison. That statement caused a number of requests for individual stocks favorably rated by our fundamental analysts. Screening our research universe for such names that are under $10 per share produced these names: Bank America (BAC/$9.12/Strong Buy); Huntington Bancshares (HBAN/$6.93/Strong Buy); and KeyCorp (KEY/$8.33/Outperform).
The call for this week: Last week the COMP broke below its 50-DMA, but the INDU and SPX did not, potentially setting the stage for downside non-confirmation. Moreover, it was a pretty strange week. Take Thursday’s action, most of the major averages were flat to down for the session, but advancing stocks beat declining stocks by a ratio of 2-to-1! Still, the mood on Wall Street has deteriorated, as confirmed by Friday’s high CBOE Put/Call Ratio. So, while the universal spin is that the stock market has made a major top, the pullback has produced a fairly oversold and extremely pessimistic condition. Meanwhile, there remains a full load of internal energy to power stocks higher as long as 1390 on the SPX is not breached. Clearly, I don’t believe that will happen.
P.S. – I am recording this Sunday because I will be in Michigan all week speaking at conferences and seeing accounts.
Copyright © Raymond James
Monday, October 15th, 2012
While this market is subject to a strong dead cat bounce at any moment there continues to be degradation under the surface. Just about all the leadership areas of the past month have been hit on a rotational basis. Hence any trend following strategy is now going to be rather useless as relative strength no longer offers assurances of sustained moves up. I mentioned the bond market yesterday and the well followed iShares 20+ Year Treasury Bond (TLT) ETF has this morning broken over the trend line of highs of the past few months. This of course can reverse at any moment but for now it’s another cautionary indicator.
As for the S&P 500 it is sitting just above the 50 day moving average for the third day in a row – bulls certainly are attempting to defend that area with great vigor. For now this is the battleground.
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Monday, October 15th, 2012
From Gluskin Sheff’s David Rosenberg
Well, things are getting quite interesting.
The consensus view was that QE3 was going to send the stock market to the moon. Yet the peak level on the S&P 500 was 1,465 on September 14th, the day after the FOMC meeting.
The consensus view was that the lagging hedge funds were going to be forced to play some major catch-up and take the stock market to the moon too. Surveys show that the hedge funds have already made this adjustment.
Meanwhile, divergences are appearing almost everywhere — high volume on the selling days, as we saw on Friday where composite volume surpassed 2.1 billion. Breadth is bad — for every stock rising, almost two fell on the NYSE.
The defensives are outperforming, with consumer staples the leader to close out the week. Transports are lagging. So are the small caps. Financials are sagging even though this is the group that should be a prime beneficiary of the Fed’s endless largess.
Meanwhile, the VIX index continues to reveal a high level of complacency and surveys continue to highlight many more bulls out there than bears. We are sure Bob Farrell would have a thing or two to say about that from a contrary perspective.
The S&P 500 was down 2.2% for the week — the opening week of the earnings season. It is becoming apparent that investors are becoming much more discerning. Wells Fargo and .1P Morgan appeared to heat consensus estimates, yet their stock prices slid on the back of narrower net interest margins — the fly-in-the-ointment from the Fed’s ultra-low-rate policy.
Alcoa also beat estimates, but like the World Bank and IMF, downgraded the global demand outlook.
And Advanced Micro Devices saw its stock punished on the news that revenues sagged 10% last quarter in what is clearly now a demand problem across the PC industry as opposed to just a market share situation.
On top of that, Q3 EPS estimates are still coming down and now stand at -3% YoY from -2% at the start of October.
For now, the S&P 500 is sitting right on its 50-day moving average, in what the Saturday NYT biz section aptly characterized as “a technical red flag hanging over the market”. The article right below (on page B3) titled A Global Perspective: More Economic Slowing leaves one wondering whether the deteriorating macro outlook will trigger a break of this technical support line.
One thing seems sure which is that consumer sentiment surveys jumping to a five-year high (of 83.1 from 78.3 in August as per the UofM poll) are obviously no match for the earnings contraction. If they were, the market would have closed higher on Friday. In fact, not even the ECB-induced rallies in the Italian and Spanish bond markets managed to seep into firmer equity valuations as was the case through most of the summer Again, the eroding global economic outlook and negative trim in corporate profits may be too swift a current. After all, this is the first time the Fed embarked on a nonconventional easing initiative with the market overbought and with profits and earning expectations on a discernible downtrend. The flattening in the core producer prices in August and the -0.1% reading in capital goods prices attests to the exceedingly challenging top-line environment
Not only that, but the fact the pace of U.S. economic activity is still running below a 2% annual rate, which is less than half of what is normal at this stage of the business cycle with the massive amount of government stimulus, is truly remarkable. Not just zero percent rates for four years and a tripling of the Fed balance sheet but yet another year of trillion-dollar-plus fiscal deficits. It is a whole new world where everyone is worried about a fiscal cliff at a time when the budgetary gap is 7% of GDP! The fact that the Treasury market closed the week with a bid (the 10-year note yield at 1.66%) attests to the view that the bond market crowd is more consumed now with downside economic risks than on sustained large-scale deficits. Keep an eye on the debt ceiling being re-tested — the cap is $16.394 trillion and we are now at $16.119 trillion. This is likely to make the headlines again before year-end — the rating agencies may not be taking off much time for a Christmas break.
The power of the earnings cycle is so acute that the fact that Romney has caught up with Obama at the polls (46% support for both in the just-released IBD/TIPP survey) could elicit a rally in the stock market. That really says something because one would think that Wall Street would greet a Mitt victory with noisy applause.
GOLD LOOKS GOOD
Look at what the yellow metal has accomplished. And we haven’t even seen the inflation yet! Wait till that happens (in fact, at 2.6%. UofM long-term inflation expectations from Friday’s report for September came in at its lightest level since March 2009!).
What matters most are real rates, which the Fed has pledged to keep negative as far as the eye can see. It was commented on at the excellent Big Picture conference last week that none of the speakers even mentioned gold (including me!). That is a huge contrary bullish standpoint.
Even Byron Wien (see his superb interview on page 38 of Barron’s) has become constructive on the outlook for bullion, and like me, he sees it as a steady alternative to paper currencies — a currency in its own right that is no government’s liability and has a much more inelastic supply curve. I have to say that the venerable Buttonwood column on page 84 of the Economist also contained numerous reasons to have core exposure to gold — imagine one of the biggest buyers have been developed world central banks (I guess they want to get ahead of the big inflation they want to generate as debts get monetized). The article goes on to say, by the way, that the current level of negative rates is consistent with a gold price of $2,000 an ounce.
As an aside. the gold mining stocks have finally started to outperform and have a ton of catching up to do. This is one area of the market we are excited about Gold and income-generating securities. Its called the bond-bullion barbell.
Monday, October 15th, 2012
Upcoming US Events for Today:
- Producer Price Index for September will be released at 8:30am. The market expects an increase of 0.8% versus an increase of 1.7% previous.
- Consumer Sentiment for October will be released at 9:55am. The market expects 78.3, unchanged from the previous report.
- Treasury Budget for September will be released at 2:00pm.
Upcoming International Events for Today:
- Euro-Zone Industrial Production for August will be released at 5:00am EST. The market expects a decline of 0.5% versus an increase of 0.6% previous.
Equity markets faded early gains on Thursday as the enthusiasm surrounding upbeat employment data was dismissed as being an anomaly. Initial jobless claims were reported at the lowest level in over four years, but the result was distorted by a significant abnormal drop in claims posted by one state, leaving investors to doubt the improving employment data. Most equity benchmarks ended near the flatline as analysts wait for further economic and earnings data in the days to come.
On Friday, two financial titans report earnings before the opening bell. Wells Fargo and JP Morgan are expected to report earnings growth of around 20% compared to the year ago period, bucking the contraction that is expected to be realized for the broad market as a whole. Each stock currently portrays a reasonably strong technical profile with positive trends holding above 20-day moving averages and outperformance compared to the market remaining evident over recent weeks. However, momentum indicators that are presently showing a neutral trend gives little reason to expect any significant positive drive over the intermediate term, a trend that is typical on a seasonal basis in the fourth quarter. Seasonal tendencies for the financial stocks during the fourth quarter, albeit showing a positive bias on the charts, are largely variable, gaining more from the positive influences of the broad market rather than being a driver of it. US financials find their period of seasonal strength within the first and second quarter of the year as positive outlooks for the the year lift stocks during the fist half.
Yesterday we provided a chart of the percent of stocks trading above 200-day moving averages and how it coincided with market declines as the indicator fell below its 50-day moving average. Here is another similar indicator that has coincided well with market pullbacks over the last many years. The NYSE Summation Index, an indication of breadth, has broken below its 50-day moving average, signaling weakness within equity markets as technical indicators continue to deteriorate. As you can see from the chart below, this is more of a coincident indicator, confirming the pullback, rather than a leading indicator, anticipating one.
Other indicators of breadth are equally cautionary. The NYSE Advance-Decline line has seemingly stalled at its highs set in September, while the NASDAQ Advance Decline line has started to show lower-highs and lower-lows, indicative of a negative trend. Each of these breadth indicators are confirming the lack of positive momentum that has followed the unveiling of the recent quantitative easing program in the US as investors focus on the cautionary events ahead, such as earnings season and the fiscal cliff at the end of this year.
And finally, the US Dollar index has been acting as a weight on stocks and commodities as the currency resumes this counter-trend rally, pushing above its 20-day moving average for the first time since early summer. The index has also broken through the declining trendline following the two and a half month pullback. A retest of broken support at 81.00 appears likely, keeping pressure on commodities over the short-term during a period when hard assets, such as gold and oil, typically decline. Seasonal tendencies for the US Dollar index between now and mid-November are flat to positive. Negative seasonal tendencies resume during the month of December.
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
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Monday, October 15th, 2012
Weighing the Week Ahead: Will Q3 Earnings Disappoint?
by Jeff Miller, A Dash of Insight
Earnings season follows a familiar, four-step pattern.
- Preliminary — Analyst estimates are too optimistic, perhaps because they “go native.“
- Confession — Adjustment and warnings as companies “pre-announce,” usually when the report will be a disappointment.
- Announcement — Actual results with explanations and outlook for the future. There is an initial market reaction to the news.
- Interpretation and Spin — The company does a conference call where analysts either congratulate management or ask probing questions. The stock usually keeps trading during the conference call, and often provides a real-time interpretation of the management discussion.
It is often not easy to interpret. The conventional wisdom is that analysts are too bullish on earnings estimates and also set the bar too low for the actual report. Most seem not to notice that these are contradictory positions.
Rather than starting from scratch on this subject, I recommend that readers take another look at something I wrote more than two years ago. I explained one of our regular themes at “A Dash.” Most of the punditry uses words rather than data. The key point is that the earnings story is complicated, which provides many opportunities for spinning.
“Instead, there is a long laundry list of tests:
- Earnings — comps from last year.
- Earnings — meeting expectations.
- Earnings — meeting the “whisper number.”
- Revenues — should meet all of the above. The market is very skeptical of earnings from cost-cutting, even though that shows smart management and can easily be reversed. It is a clear-cut bias.
- Gross margins falling — another thing that can be wrong. Even though it might be correct to compete by cutting margins, the pundits will pounce.
- Gross margins rising — evidence of unsustainable earnings on a long-term basis.
- Foreign sales — another no-win area for management. If you suggest that sales were lower, then pundits will infer Europe weakness. If you try to cite currency changes, you get the opposite spin.
- Ignore current earnings. Look backward.
- Ignore forward earnings. Look backward.
- Ignore strong earnings. Look at multiple year growth estimates.
- Ignore long-term growth estimates. Those are too bullish.
The added complexity of the earnings story is not helpful to the investor. For consideration by investors who want to look more deeply into this process, I now posit “The Miller Rule.”
The more variables, the more spin potential.”
Even those who are accurate in forecasting actual earnings may be losers in the short run based upon this list. I’ll offer my own take in the conclusion, but first let us do our regular review of last week’s news.
Background on “Weighing the Week Ahead”
There are many good lists of upcoming events. One source I especially like is the weekly post from the WSJ’s Market Beat blog. There is a nice combination of data, speeches, and earnings reports.
In contrast, I highlight a smaller group of events. My theme is an expert guess about what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
This is unlike my other articles at “A Dash” where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.
Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!
Last Week’s Data
Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:
- The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially — no politics.
- It is better than expectations.
The news last week was mostly positive, including these highlights.
- The dollar death cross has triggered! For more than a year the dollar has been inversely correlated with stock prices, so this technical indicator is bearish for the dollar and bullish for stocks. See Min Zing in the WSJ for a full account.
- Romney pulls even among likely voters according to the Pew Research Center, among others. (Please note the above definition of good=market-friendly. We are not cheering for either candidate. We are analyzing the implications for investments. Right or wrong, the market likes Romney). The effect did not last for even a day, however, perhaps because of some tortured logic about Romney firing Bernanke, whose term ends in January, 2014. Sites analyzing the Electoral College result still show Obama in the lead.
- Initial jobless claims dropped dramatically. This sparked more silliness about manipulation of the data. The seasonal adjustments can be tricky at this time of year, which is why we emphasize the four-week moving average. Hats off to Invictus and Barry Ritholtz (see here as well) for helping everyone keep focus on this issue. Here is a helpful chart from Calculated Risk:
- Michigan consumer sentiment spiked almost to pre-recession levels. This report deserves more respect. It is an excellent concurrent indicator, but reflecting several factors. In the last year or so the spike in gas prices and the political shenanigans have polluted the results. Normally this is a good indication of employment and consumption. For it to increase at a time when gas prices are elevated and the political silly season is in full swing is very positive for employment. Here is Doug Short’s excellent chart, my favorite for this series:
We are almost back to normal levels.
The actual data last week was pretty good, but the stock result was bad. This happens, and it can be meaningful. Let us take a closer look.
- The world economy is weakening with the threat of a double-dip recession according to new reports from the IMF and Brookings. (via the FT).
- Insider selling sends a warning (via Mark Hulbert). I am a big fan of Mark Hulbert, but I am a little uncomfortable with this article. There are always reasons for insiders to sell, since the stock and options are part of a compensation package. (I am the chair of the comp committee for a small public company). It is also natural that selling is higher when the stock price is higher. Insider buying is a much better indicator than selling. But we should watch all indicators, so I advance this for discussion.
- The Fed Beige Book suggests only modest growth. Steven Hansen at GEI reports. His research provides an interesting compendium of Fed comments before the last two recessions, which have an eerily similar quality.
- Gasoline prices threaten the consumer. The Bonddad Blog tracks this and many other high-frequency indicators (some of which are positive). You really need to follow the complete weekly article — just as I do:)
- The early reaction to earnings. We will know a lot more about this next week, but the early indication is intense skepticism. There seems to be a negative tone.
- Small business reactions and forecasts remain negative, especially from the highly partisan National Federation of Independent Businesses (NFIB). Here is a nice account from GEI, and a chart from Doug Short:
The Silver Bullet
I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger.
This week’s award goes to Cardiff Garcia at FTAlphaville for his thoughtful and reasonable analysis of the housing turnaround. It started with Roger Altman’s op-ed piece in the FT has a nice explanation of why A housing boom will lift the US economy.This is an unpopular viewpoint, so the mocking tweets started. Garcia waded into the fray with a well-timed and data-filled rebuttal. Rather than attempting a summary which could not do justice to the original post, I urge you to read it. This topic is absolutely crucial to understanding economic prospects.
The Indicator Snapshot
It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:
- The St. Louis Financial Stress Index.
- The key measures from our “Felix” ETF model.
- An updated analysis of recession probability.
The SLFSI reports with a one-week lag. This means that the reported values do not include last week’s market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a “warning range” that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.
The SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events. It uses data, mostly from credit markets, to reach an objective risk assessment. The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.
The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli’s “aggregate spread.”
Bob and I recently did some videos explaining the recession history. I am working on a post that will show how to use this method. As I have written for many months, there is no imminent recession concern. I recently showed the significance of by explaining the relationship to the business cycle.
The ECRI recession call is now over a year old. Many have forgotten that at the time of the original prediction, the ECRI claimed that the recession was already underway by September of 2011. See New Deal Democrat’s carefully documented discussion, including the original video, at the Bonddad Blog.
The ECRI keeps moving the goal posts on this prediction, suggesting that we will only know about a recession after many months because the data will be revised lower. For the few die-hards who are still taking this seriously, you should read the careful, thoughtful, and data-driven work from Dwaine Van Vuuren. He is taking up the key elements in determining recessions and looking at whether revisions affected the timing of past recessions. He does this by comparing the difference between the original observations and the final revised version.
Please note that Dwaine has actually done this research, while the ECRI has not supported its claims.
Here is a key chart on employment:
“The first is that the real-time data results in several false positives (false alarms) as indicated by the “1″ markings. The second observation is that for the most part, the signalling of the start of recessions is near-identical between the real-time and revised versions of the growth rate. The only exceptions are 2008 (tagged “2″), 1957 and 1959 where the revised data signalled recession earlier (meaning the real-time observer would have been late in his/her assessment that a recession was indeed underway) and point “3″ where the real-time data was actually earlier in signalling recession.On the whole, the revised data provided earlier signalling 2 more times than the real-time data, giving it a slight edge. Whilst revised data results in a 3-month smoothed growth rate that can differ to that of the real-time growth rate, that difference seems to be isolated to the expansions and contractions, but not so much around the turning points themselves.”
Dwaine’s RecessionAlert service offers a free sample report. Anyone following them over the last year would have had useful and profitable guidance on the economy.
Doug Short’s most recent update asks, ECRI Weekly Leading Indicators: Time to Recant the Recession Call? Doug has been an open-minded monitor of the various arguments, so his analysis deserves respect. I do question his premise this week, however. Rather than recanting the recession call, I think that the ECRI should predict the end of the recession. After all, the ECRI said that we were in a new economic era of slow growth and more frequent recessions. Their WLI has turned higher, which everyone following their data sees as good news. Maybe it is time for them to “predict” that the recession will end within the next few months!
Readers might also want to review my new Recession Resource Page, which explains many of the concepts people get wrong.
Our “Felix” model is the basis for our “official” vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions. This week we continued our neutral forecast. These are one-month forecasts for the poll, but Felix has a three-week horizon. Felix’s ratings have continued to drift lower. The penalty box percentage measures our confidence in the forecast. That indicator is moving higher, indicating less confidence in the neutral rating. It has been a close call over the last few weeks, as the ratings moved out of bullish territory.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
This week brings plenty of economic data, and much, much more.
The “A List” includes the following:
- The next Presidential debate (T). Playing to undecided voters in swing states.
- Initial jobless claims (Th). Extra interest after last week’s “mystery” decline.
- Building permits (W). The best leading indicator for housing.
- Chinese GDP (W).
The “B” List” includes these entries:
- Retail sales (M). Confirmation of solid consumer confidence?
- Industrial production (T). Important component of economic growth.
- Housing starts (W). Widely followed, but volatile.
- Leading indicators (Th). A favorite recession indicator for some.
- Existing home sales (F). Will the bottoming in housing continue?
The other news includes regional Fed surveys from NY and Philly. I put little stock in these, but a big surprise moves the market. We also have European leaders meeting at the end of the week. and some Fed speeches.
The most important news will be earnings!
Trading Time Frame
Felix has continued the neutral posture of the last few weeks. It has been a close call between neutral and bullish for several weeks. Felix has done very well this year, becoming more aggressive in a timely fashion, near the start of the summer rally. Since we only require three buyable sectors, the trading accounts look for the “bull market somewhere” even when the overall picture is neutral. The ratings have moved lower again this week, and we are now down to one trading position, as I predicted last week. We might be completely in cash by the end of this week.
Investor Time Frame
Each week I think about the market from the perspective of different participants. The right move often depends upon your time frame and risk tolerance. Individual investors too frequently try to imitate traders, guessing whether to be “all in” or “all out.”
Many have been out of the market and worry that they have missed the rally. A few months ago there were too many worries for them to invest. Now there is a fresh supply.
The traders (including Felix) are getting more cautious for a variety of reasons. Some are trying to lock in profits to earn their bonuses. Investors face a completely different problem.
Take what the market is giving you!
If you have been following our regular advice, you have done the following, in a proportion appropriate for your individual circumstances:
- Replaced your bond mutual funds with individual bonds (bond funds are very risky!)
- Sold some calls against your modest dividend stocks to enhance yield to the 10% range.
- Added some octane with a reasonable allocation of good stocks.
These opportunities are still available, but it might be a limited time offer. We have collected some of our recent recommendations in a new investor resource page — a starting point for the long-term investor. (Comments and suggestions welcome. I am trying to be helpful and I love feedback. We have a good discussion going on bonds versus funds, and I plan a separate article that will provide a further forum.)
Final Thoughts on Earnings Season
Last week I noted that we were entering the season of fear. There was definitely a change in tone last week, with little response to good news. Stocks had the worst week in months while the data were actually somewhat positive.
Thousands of companies will report earnings in the next few weeks. When the overall earnings story is mixed, we can expect many to present a downbeat outlook. There is little reason to make bold predictions. Executives can be cautious, citing problems in Europe, China, and Washington.
The actual earnings “beat rate” will probably be close to historical norms, but the short-term outlook depends on psychology and trader sentiment. Just as it did last week, this can change swiftly.
This is why agile traders can afford to be cautious, while investors should be seizing opportunities.
Copyright © A Dash of Insight
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Monday, October 15th, 2012
Mr. Dimon Wishes He Hadn’t Bought Bear Stearns and So Do I
For many people, the point of no return in policy in this country was when JPM bought Bear Stearns in a hastily constructed deal, motivated as much by fear of the unknown as an rational business argument.
Short dated Bear Stearns bonds were trading wildly the day before that weekend at prices around 50 cents on the dollar. Many in the market were expecting Bear to fail. Some were expecting Bear to be saved. Almost no one expected Bear to be bought for $2 a share. That headline was stunning, people were tapping their screens to see if a zero was missing.
The deal had many unique features, not the least of which was that JPM would immediately and irrevocably guarantee all the Bear Stearns derivatives contracts. Some haphazard guarantee was crafted, but in the end we were told by government officials to not worry about it. That JPM would back it all and trade appropriately. No real transaction would have been designed in such a way and it highlighted that regulators and politicians were horrified of the derivative books.
In many ways this was the point of no return. I have always believed we would have been better off letting Bear Stearns fail. It wasn’t that big of a bank. It was big, but I believe manageable. In the end we won’t know whether or not I was correct, because they did bail it out.
The focus on the derivatives book at the time is interesting on two fronts.
The first is that the policy makers did nothing about derivatives after that. Within weeks the derivative markets were full on business as usual. In fact when people had threatened to pull lines to places like Lehman, the government stepped in and total companies that wasn’t in the interest of the markets. So rather than encouraging weak banks to get out of the business, good banks to tighten their standards, and demanding actions to shrink the notional amount outstanding, the policy makers actually encouraged bad practices. The immediate relief wasn’t used to fix core problems, it was used to mask it further and hope it goes away. We have seen this behavior over and over during the crisis, most recently with the story that Basel III will be delayed in Europe.
The second is that for all the focus on derivatives, the big problem when Lehman went under was much simpler. The amount of short term debt was the real problem. Investors in short term debt tend to rely on it being paid back (no offence to money market funds). These investors aren’t compensated enough to bear any loss whatsoever, so that froze money markets. The repo business took far longer to unwind and led to far more lawsuits than the derivatives business. To my knowledge there was not a single lawsuit specifically tied to Lehman’s involvement in the credit derivatives market, but the simple repo business, ignored by regulators, caused far more problems.
Lehman was let go, which surprised many, especially those that bought bonds on the Friday hoping for another Bear Stearns like announcement. Merrill was saved. Morgan Stanley managed to remain independent with some help from the Fed, the FDIC, and Treasury. AIG FP and the holding company were bailed out by the government as well. We will never know what would have happened if Bear Stearns had failed, but I remain convinced we would have been better off today had it not. Heck, we would be better off had someone done something in the 6 months leading up to Lehman to fix the core problem rather than pretending one didn’t exist.
Sowing the Seeds for the Next Crisis
For the first time since the Fed began its new programs for intervention in the markets, affectionately known as Quantitative Easing, I think the banks may actually be frustrated by it. Wells Fargo so a drastic decline in Net Interest Margin. With borrowing costs pretty much stuck at zero, they cannot benefit much from improvement in their cost of funds, without creating non FDIC insured deposits (don’t laugh, since the FDIC fees may be higher than the rate paid to actual depositors). But with their cost of funding floored, the impact of ever lower yields on the loans they make is taking its toll.
So banks will do what they can do keep profits high, lend more and lend riskier.
The banks will do what they can to protect their NIM. They will employ fewer if any hedges. They will look for riskier deals to finance (this isn’t just occurring at banks as the number of PIK and dividend deals getting done in the high yield bond market has spiked recently).
While the economy is grinding along, these riskier and under-hedged lending portfolios will do just fine, but if we don’t see stabilization in housing or the economy, then banks will be left with too much exposure once again. This isn’t an immediate problem, but it is happening already and may explain why the market reacted so negatively to WFC’s earnings.
Bigger for Less – The Problems with VAR
JPM has once again changed their VAR calculation. Regardless of the specifics at JPM we are likely to see the VAR for most portfolios reduce.
On a very basic and simplistic level, VAR is meant to give some indication of how much risk a bank (or fund) is taking. How much can a portfolio move in a given time period. There is a “confidence interval” around this. Say 99% of the time, the portfolio won’t move more than X.
The VAR model is often reliant on certain inputs, which change over time. Most models that I know of use a variety of methods to calculate the inputs, some blend of historical rates, levels that can be determined by the market etc. In general models are more focused on being conservative and not adjusting down as quickly as they may have back in 2005 to 2008.
In any case, cross asset correlation is a big input. As correlation between assets drops, it usually requires less VAR to support the same size portfolio. So if a portfolio produced $100 million of VAR under a high correlation assumption, it might produce only $75 million of VAR under a reduced correlation assumption. What often happens, especially in low return environment, is that the institution increases the size of the portfolio so that it still uses $100 million of VAR. That is the key problem, in low return environments, the portfolio is increasing, the opposite of buy low sell high.
As we move farther away from the U.S. financial crisis, we lose some periods of high correlation, and recently correlation has dropped. Whether any individual firm’s model is impacted in such a way, I don’t know, but I have reason to believe it is.
Volatility is another key input. If volatility is decreasing, then institutions can run larger portfolios for the same amount of VAR. Again, this is happening at a time of record low yields, encouraging risk taking at the wrong time.
I struggle to name a single bank that got in trouble because they bought too much CCC paper at the lows. I can name institution after institution that got in trouble loading up on “safe” paper at the tights.
I don’t like the banks right now, but that is more a question of valuation and my belief that the European Spanish bailout, when it arrives, will be a dud. It would also be just about perfect timing if some more LIBOR headlines hit the tape. I would think democrats are busy doing all they can to make some noise about LIBOR and bank punishment ahead of the elections. I am not yet worried about any more severe stress for U.S. banks, but heading back down a path of bigger, riskier banks is concerning.
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Monday, October 15th, 2012
Via Citi’s Credit Strategy team
“Liquidity trap” was a term coined by John Maynard Keynes in the aftermath of the Great Depression. He argued that when yields are low enough, expanding money supply won’t stimulate growth because bonds and cash are already near-equivalents when bonds pay (almost) no interest. Some would say that it is a pretty apt description of the state of play these days.
However, most economists today would contend that monetary policy doesn’t just impact the economy through interest rates, but also through other several channels, one of which is asset prices.
To our minds, there is very little doubt that central banks have played an absolutely crucial role in propping up asset prices in recent years. We’ll leave the debate about the link between asset prices and growth for another day, but we do believe that in so doing they have prevented a much faster and more vicious deleveraging process.
Just look at Figure 2 below, which compares the 3-month change in liquidity provided by the central banks with the 3-month change in global equity markets. We could have used credit spreads instead and it would have made very little difference. Every time the central banks have injected liquidity, markets have responded, although recently most of the response has been preemptive.
Why have markets responded so resolutely when growth hasn’t?
The answer, we think, is that in their attempts to free markets from the liquidity trap, central banks are ensnaring markets in what we’ll call a “liquidity lure”. That lure is three pronged:
- By lowering rates to zero (and potentially promising to keep them there), central banks are forcing money out of money markets and deposits into riskier assets for higher returns. In corporate credit, the corollary has been almost continuous inflows since late 2008.
- Through balance sheet expansion – that is buying assets or funding them for a long period of time without rehypothecating them (lending them out) – the central bank is shrinking the universe of investable assets in the market. The red line in Figure 3 below, which shows the net issuance of securities in Europe on a rolling 12-month basis after the effect of long-term ECB repo operations, clearly illustrates the point.
- Lastly, through the signalling value. By sending an implicit message to markets that the central bank is intent on supporting asset valuations, perceptions of risk/reward change – it is much more uncomfortable to be underweight/short unless there is a specific, tangible negative catalyst.
In the initial phases, strong asset returns make the lure too enticing to resist – who would have predicted that investment grade credit would generate total returns of 10.5% in 2012?
Yet the catch is equally obvious: When the returns have been had, investors end up with a distorted trade-off between risk premia and fundamentals. Or more bluntly, swamped with cash and faced with fewer assets on offer, investors end up buying assets at levels where they don’t perceive they are being fully compensated for the risks they are ultimately running. From that position, there is no painless escape.
Conclusion: Hooked until it snaps again
Central banks, especially when they are acting in coordinated fashion, have the ability to create an equilibrium for asset prices and credit risk premia that differs markedly from the ‘natural’ state – at least temporarily. The credit market is just a microcosm of that broader story.
Quite simply, they will (indirectly) keep investor pockets filled with cash, whilst restricting the volume of assets for sale. Remember how tight credit spreads got in the middle of an extended recession and deflationary environment in Japan?
But Europe is evidently not Japan. Many sovereigns today do not have the “luxury” of a big current account surplus and the ability to run large fiscal deficits for more than a decade as Japan did. Tail risks, be it Grexit, Catalan independence, Italian elections or “just” popular unrest, are bound to resurface in our view.
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Monday, October 15th, 2012
If you follow small cap stocks at all, you know they have been underperforming for quite awhile now. The chart below shows the relative strength of the Russell 2000 vs the S&P 500 over the last 12 months. When the line is rising, small cap stocks are outperforming the S&P 500 and vice versa. As shown, small caps have been making a number of lower highs relative to the S&P 500 over the last several months. Interestingly, the most recent peak came on 9/14, which was the exact day that the S&P 500 peaked. For those that would argue that the market needs small caps to lead in any rally, this chart would be exhibit one.
Copyright © Bespoke Investment Group
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Monday, October 15th, 2012
by David Rosenberg of Gluskin Sheff
Wealth Effect R.I.P.?
So the Fed is pinning its hopes on stimulating the economy via the wealth effect again, as it did when it revived the post-tech-wreck asset bubble in housing and credit in that now infamous 2003-07 period of radical excess. But here’s the rub. While there is a wealth effect on spending, the correlation going back to 1952 is only 57%. But the correlation between spending and after-tax personal incomes is more like 75%. The impact is leagues apart. And that is the problem here, as we saw real disposable personal income decline 0.3% in August for the largest setback of the year. The QE2 trend of 1.7% is about half the 3.2% trend that was in place at the time of 0E2. Not only that, but the personal savings rate is too low to kick-start spending, even if the Fed is successful in generating significant asset price inflation. The savings rate now is at a mere 3.7%, whereas it was 6% at the time of QE1 back in 2009 and over 5% at the time of QE2 2010 — in other words, there is less pent-up demand right now and a much greater need to rebuild rather than draw down the personal savings rate. This is a key obstacle even in the face of higher net worth.
What is fascinating is that the rise in net worth looks fairly tenuous. Yes, home prices have risen on the back of tighter supplies but the builders have ramped up production by nearly 30% over the past year. And the first-time buyer is dormant, which means that the key source of demand in the food chain is still missing, and investor-based buying will only go so far in terms of sustaining any further home price appreciation.
But it is the action in the equity market that is most telling. This is the first time after any major central bank incursion — QE1, QE2, Operation Twist and LTRO — that 13 (trading) days after the announcement, the stock market is lower. The S&P 500 has dropped 1% since the day of the Fed meeting whereas it was up an average of 4% at this juncture following the other four announcements. I had said earlier that the Fed has likely established a firm floor but it looks clear that the more ominous global economic backdrop has also established a ceiling — I mean, weren’t the lagging hedge funds supposed to have been piling in by now? And all of the cyclical sectors are lower which again is highly atypical—all down around 2%. And if there was a group that the Fed was really trying to support it was the Financials and this sector is down 3% along with basic materials. Go figure. The more defensive areas like Health care, Utilities and staples have outperformed, which is very rare after a QE announcement out of the Fed.
At the same time, the yield on the 10-year T-note. which is usually steady around this time following a post-QE announcement, has fallen more than 10 basis points this time around. The TSX has turned in a similar though less dramatic swing this time – Financials and Materials, which had cheapened up far more going into this than their U.S. counterparts, have actually hung in, as has the overall Canadian market (though to be fair, it is usually up 2% by now).
As the accompanied charts illustrate, one obstacle for the equity market of late has been sentiment and positioning. The Market Vane Bullishness index is at the high end of the range and as the latest CFTC (Commodity Futures Trading Commission) data indicate, the net speculative long positions on the S&P 500 and Nasdaq on the CME have already surged to record high levels. In other words, a lot of the buying power that pundits were expecting has already been exhauisted.
The pace of economic activity is weakening, with all deference to ISM. With profits faltering and wage earnings slowing down, we have a situation where Gross Domestic Income softened to a mere 1.7% annual rate in Q2 from 6.1% in Q1 and 4.6% in Q4 of last year. This was the weakest performance since the third quarter of 2009 just as the worst recession in seven decades was ebbing. In real terms, GDI actually stagnated — up a mere 0.16% annual rate, a buzz-cut from the 3.8% pace in Q1 and 4.5% in Q4, again the weakest tally since Q3 last year and the second weakest since Q2 2009. This puts the GDP slowdown in Q2 into perspective. GDP is all about spending. GDI is all about income. And it is income that drives confidence, spending, and ultimately prosperity — not the other way around.
Copyright © Gluskin Sheff