Archive for October 18th, 2012
Thursday, October 18th, 2012
From Art Cashin of UBS Securities
On this day (+1) in 1987 (that’s 25 years ago, if you are burdened with a graduate degree), the NYSE had one of its most dramatic trading days in its 220 year history.
It suffered its largest single day percentage loss (22%) and its largest one day point loss up until that day (508 points). No one who was on the floor that day will ever forget it.
While it was an unforgettable single day, there were months of events that went intoits making.
The first two-thirds of 1987 were nothing other than spectacular on Wall Street. From New Year to shortly before Labor Day, the Dow rallied a rather stunning 43%.
Fear seemed to disappear. Junior traders laughed at their cautious elders and told each other to “buy strength” rather than sell it, as each rally leg was soon followed by another.
One thing that also helped banish fear was a new process called “portfolio insurance”. It involved use of the newly expanded S&P futures. Somewhat counterintuitively, it involved selling when prices turned down.
The rally topped out about August 25th with the Dow hitting 2722. Interest rates had begun creeping up amid concerns of early signs of inflation.
Treasury Secretary Baker began a rather open debate with the Germans on the relationship of the dollar and the Dmark. Soon the weakness in the market was turning into a visible correction. By the middle of October, the Dow fell to break an uptrend line that had protected it for over 1000 points. The flurry of takeovers and leveraged buyouts that had flourished all year began to dry up.
On Wednesday, October 14th, there were widely discussed rumors of a new punitive tax on takeover profits. Selling turned a bit ugly and the Dow fell 96 points by the close (a record point drop at the time). The next day there was no bounce and the Dow fell another 58 points.
Friday, the 16th was an option expiration day. There was a very bad storm in London and that market closed, which forced more people to seek liquidity in New York. Stocks faced a steady wave of selling. As the close neared, rumors spread that the First Lady, Nancy Reagan, the President’s right hand, might be admitted to the hospital with cancer. The selling intensified and the Dow closed down 108 points, on the low and a new record point drop.
The weekend was a rumormonger’s delight. Nancy was admitted to the hospital.
Japan was considering a confiscatory 96% tax on real estate speculation. Germany proposed a change in taxes on some interest rates, which would make U.S. Treasuries unattractive to Germans. Rep. Gephardt was talking about a trade bill that would freeze imports. Treasury Secretary Baker went on a Sunday talk show and openly challenged the Germans on currency. There were even rumors of U.S. planes engaging Iran.
At the time, I was running the floor for PaineWebber. Monday morning I got up well before dawn and saw that Hong Kong was down about 10% and other markets were looking equally weak before their openings. I headed for the NYSE to check on our systems and staffing. I reached out asking the team to get in early.
Once I had checked out the systems and verified staffing, I went with a partner up to the Luncheon Club for a quick coffee. With markets around the globe all down about 10%, I didn’t know if we’d get to a coffee – or anything else after we opened.
We sat about two tables away from a table where NYSE Chairman John Phelan sat with several directors and some staff.
Every ten minutes or so, someone would rush up to Phelan and slip him a note or whisper in his ear. It was evident that things were deteriorating. As I headed for the floor, I went past Phelan’s table, put my right arm across my chest and said – “Nos Morituri Te Salutamus Esse”. It was the gladiator’s salute to the Emperor – “We, who are about to die, salute you”. Phelan nodded without a smile.
The opening was not an outright disaster, but that was primarily due to the fact that many stocks did not open immediately. They were delayed, with indications to warn investors of the prices that they might open at (with hopes of inviting bargain hunters). Meanwhile, in Chicago, where you could short without a plus-tick, prices headed for freefall.
Soon prices were lower in Chicago than in New York. That brought even more selling pressure to New York. Shortly after the opening, as it became clear that this would be a very special and very dangerous day, several NYSE directors met in Chairman Phelan’s office. They checked around the street to gauge any new trends in the selling pressure.
They were also on the phone with the White House via former Senator Howard Baker, who was White House Chief of Staff.
Meanwhile, back on the floor, the situation felt more unreal. Orders flowed in faster and faster and the tape ran later and later. (The tape was linear and the human eye can only recognize a certain number of symbols per second, 900 I think. To run faster than that would make the tape an unreadable blur. Traders can trade faster than the maximum reading speed – so the tape ran late.) One broker said it was like a bizarre dream sequence – nothing seemed real.
In late morning there were signs that the markets might begin to stabilize. Then the newly appointed Chairman of the SEC, David Ruder, was intercepted by reporters leaving a meeting at the Mayflower Hotel in Washington. Whatever they asked and whatever he said, it somehow was reported that the markets might have to be halted. Later, he would swear it was a typo but you can’t un-ring a bell. The fear of a halt sent buyers scurrying away. Stocks went into virtual freefall.
The interaction with the futures saw prices melt away. The Dow closed down 508 points. One specialist, who made too good a market, ran out of funds and the firm was sold to Merrill Lynch that very night. At watering hole after watering hole, traders and specialists reported again and again how strained their resources were. Wall Street could not survive another day like this. Luckily, innkeepers, like Harry let them put the drinks on a tab.
What is often lost in the retelling is that the next day, Tuesday, was far more dangerous. It was the day that the wheels almost did come off the locomotive.
The Dow opened up about 200 points Tuesday to a round of cheers on the floor. But, stocks quickly turned lower. The 200 point gain was erased and the Dow went negative, accompanied by an audible gasp on the floor. Soon it was nearing -100 and trading was being halted in several of the Blue Chips that make up the Dow.
Then we learned that several key banks were shutting down the credit lines of market makers and NYSE specialists. The banks feared exposure to an apparently collapsing stock market.
NYSE Chairman Phelan reached out to the recently appointed head of the Fed, Alan Greenspan. Unfortunately, Greenspan was on a plane. Desperate, Phelan called the President of the New York Fed, Gerry Corrigan. He sensed the danger immediately and began calling the banks to reopen the credit lines. They were reluctant but Corrigan ultimately cajoled them. The credit lines were reopened and the halted stocks were reopened. Best of all, the market started to rally and closed higher on the day.
It was an incredible time and the financial system was within hours (and a few phone calls) of an absolute collapse. It was a time I’ll never forget.
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Thursday, October 18th, 2012
Upcoming US Events for Today:
- Weekly Jobless Claims will be released at 8:30am. The market expects Initial Claims to show 365K versus 339K previous. Continuing Claims are expected to reveal 3275K versus 3273K previous.
- The Philadelphia Fed Index for October will be released at 10:00am. The market expects 0.5 versus –1.9 previous.
- Leading Indicators for September will be released at 10:00am. The market expects an increase of 0.2% versus a decline of 0.1% previous.
Upcoming International Events for Today:
- Great Britain Retail Sales for September will be released at 4:30am EST. The market expects a year-over-year increase of 2.5% versus an increase of 2.7% previous.
Markets traded higher on Wednesday, boosted by better than expected housing data in the US and optimism pertaining to the debt situation in Europe. Housing starts for September were reported at the highest level in more than four years, fueling speculation that the housing market has turned a corner as record low mortgage rates aid the recovery in the industry.
Homebuilding stocks jumped following the result, trading back around multi-year highs. Still, stocks in the industry remain well off of the highs set prior to the recession, about 38% below the peak in the case of the Homebuilders ETF. Homebuilding stocks enter a period of seasonal strength into the fourth quarter as companies in the industry prepare for the Spring building season. Stocks in the space have been outperforming the market for the past year.
Adding to the optimism on Wednesday was a decision from Moody’s to leave Spain’s investment grade ratings unchanged amid signs the government is moving closer to making a bailout request. Yields in the country fell to the lowest level since March, breaking below the recent consolidation range.
A drop in borrowing costs for the region fueled gains in the Euro, which is pushing back toward the highs set in the Spring. The US Dollar index subsequently pushed towards support around 78.60. Weakness for the US Dollar Index below 78.60 would be very bullish for risk assets, including stocks and commodities. Seasonal tendencies for the currency remain flat to positive through the month of November.
With the gains in equity markets over the past three days, benchmarks, such as the S&P 500, have essentially erased all of last week’s losses and are now back at resistance. Despite all of this bullishness, the short-term trend remains negative as a lower-lows and lower-highs dominate the trading activity. A breakout of this range is critical to resume the intermediate bullish trend that began back in June. Given the period of seasonal strength for equities is right around the corner, the chance of a breakout is likely.
Catalysts that could trigger a breakout include a breakdown of the US Dollar Index below support, continued declines in Spanish bond yields, continued weakness in US treasury prices, earnings optimism and improved growth expectations, a rebound in strength in the Technology sector following a month of declines in shares of Apple, clarity over which candidate will win the US Presidency, and optimism that the fiscal cliff will be solved prior to year-end.
Turning to the earnings front, reaction to reports remains fairly negative with IBM and Intel the latest stocks to take a hit following the release of results. According to Bespoke, the earnings beat rate as of yesterday stood at 59%, while the beat rate on revenues is only 43%, thus far. Investors continue to look for top and bottom line beats as well as strong guidance in order to be reassured of future growth prospects. However, the results are showing that companies are failing to provide this reassurance as reports struggle to overcome already significantly lowered expectations.
Earnings growth expectations for the fourth quarter continue to top 10%, rebounding from the expected third quarter decline of 2.6% as end of year spending is thought to boost earnings power. Companies reporting earnings today include Baxter, Boston Scientific, Diamond Offshore, Genuine Parts, Morgan Stanley, Nokia, Nucor, Phillip Morris, Southwest Airlines, Travelers, Union Pacific, Verizon, Advanced Micro Devices, Capital One Financial, Google, Microsoft, SanDisk, and Wynn Resorts.
Sentiment on Wednesday, according to the put-call ratio, ended bullish at 0.79
Chart Courtesy of StockCharts.com
Chart Courtesy of StockCharts.com
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Thursday, October 18th, 2012
Long/Short Investing: Bon Appétit
by Geoffrey Johnson, PIMCO
- “Long/short equity” is a distinct investment approach that seeks to reduce downside risk while still capturing much of the equity market’s upside potential.
- By removing the long-only constraint, long/short managers have an expanded opportunity set with the potential to generate returns and mitigate risk from both long and short investment ideas.
- Long/short equity strategies have a lower long-term volatility and risk profile than the market as a whole and have captured a good percentage of price movement in up markets and a smaller percentage in down markets.
When I’m not busy looking for the next great stock opportunity one of my pastimes is cooking, so much so that my cookbook collection has completely overtaken all our available shelf space. In response, my wife has issued a rule: No new cookbook enters the house without one leaving. I’ve kept implementation at bay so far, but if she insists, then my 1973 copy of “Seven Hundred Years of English Cooking” will be the first to go. I admit it hasn’t seen much action.
When it comes to picking a favorite cuisine, I admit I’m non-committal. As the late American food writer and gourmand James Beard said, “I don’t like ‘this’ cooking, or ‘that’ cooking, I just like good cooking.”
Beard’s omnivorous, no-rules approach – call it unconstrained – can be applied to all manner of activities, even investing, an enterprise with no shortage of dictums describing how it should and shouldn’t be done. Think “buy and hold,” don’t carry too much cash, and stay away from shorting.
Unfortunately, after these rules were coded into gospel, the stock market in the late 1990s took off on what has been a 12-year volatility ride that has included two bear markets that cut U.S. stocks by half or more. During such a roller coaster ride, the ability to sell some stocks in the face of rising risks, raise some cash or put on a short or two might be a welcome alternative to all the mutual funds offering long-only, fully invested entrees. It’s not that long-only, buy-and-hold, fully-invested doesn’t have a place. It most certainly does. But it’s not the only dish, and not the one you always want or need.
When people hear of investing alternatives such as “long/short” they often think of complex, exotic strategies that are even more risky than traditional investments – the investing equivalent of today’s high-end molecular gastronomy. However, long/short investing can be driven by strategies that we believe offer a prudent approach to seeking equity-like returns with improved downside-risk and volatility mitigation over the long term.
Relaxing the long-only constraint
In many ways, long/short strategies are similar to long-only strategies. Managers of these active strategies seek to form an investment view on which stocks are likely to rise in value and which stocks are likely to decline.
Long-only managers implement these views by investing in stocks they believe will rise and avoiding stocks they believe will decline. Long/short managers will also own stocks they expect to appreciate. However, long/short is distinct in that these managers can take short positions in stocks they believe will fall. By removing the long-only constraint, long/short managers have an expanded opportunity set with the potential to generate returns from both long and short investment ideas. The more flexible mandate of long/short strategies provides additional tools in an effort to generate returns and manage risk.
Nuances of long/short investing
There is a wide variety of investment strategies that incorporate both long and short positions. However, “long/short equity” specifies a distinct investment approach that seeks to reduce downside risk while still capturing much of the equity market’s upside potential. This is different from the market neutral and 130/30 strategies that are commonly associated with long/short investing.
Figure 1 provides a quick review of some of the key differences between these distinct investment strategies:
- Market neutral: As their name implies, market neutral strategies seek to minimize their exposure to the market. This is often achieved by investing an equal amount of the fund’s assets in both long and short positions so that the net exposure of the fund is zero. For example, if 50% of the fund was invested in long securities and 50% was invested in short, the net exposure to the market would be 0%. A well run market neutral strategy has a beta (exposure relative to the benchmark) close to zero and relatively low volatility. Market neutral strategies aim to consistently deliver modest gains, slightly above the nominal risk-free-rate*, regardless of the market environment.
- Leveraged long/short (130/30):These strategies are most similar to long-only strategies in that they are fully exposed to the equity market (i.e. beta of 1.0**). Leveraged long/short strategies reinvest the proceeds of their short sales to obtain additional long exposure to the market. A common example of a leveraged long/short strategy is a 130/30 (or 120/20, 150/50, etc.) fund. These funds invest 130% of their assets in long positions and 30% in short positions, resulting in a net market exposure of 100%. Leveraged long/short strategies seek to generate returns above an equity benchmark and have volatility similar to the equity markets.
- Long/short: Long/short equity strategies come in a variety of flavors and a wide range of market beta, but they all aim to have lower long-term volatility and risk profiles than the equity market as a whole. Success in this category is seen to be widely dependent on a manager’s ability not only to select stocks, but also to know when to have more or less exposure to the overall market. Long/short strategies invest up to 100% of their assets in long positions while taking varying short positions. Generally these strategies are long-biased, meaning their short positions do not fully offset their long positions.
The spectrum of long/short investing is broad – with some strategies being fully hedged to the market and others being fully exposed to the market. While each type of strategy can play a unique role in a client portfolio, investors should understand the typical exposures they provide and how they are likely to perform in various market environments. Unlike market neutral, which will almost certainly lag in up markets, and 130/30, which is likely to provide little downside risk mitigation during periods of market stress, long/short has the potential to perform well in both up and down markets and historically with a return profile in between that of market neutral and 130/30.
How have long/short strategies performed?
Figure 2 captures the returns of long/short relative to the broad market from January 1994 to June 2012. Over this more than 17-year period, long/short strategies have delivered stronger returns with lower volatility than the broad equity market. To be sure, long/short strategies have historically lagged the broad equity market during strong market rallies, such as in the bull market of the late ‘90s through early 2000s. A key component of this superior performance has been long/short’s ability to mitigate losses and preserve capital during the two large market drawdowns in 2002 and 2008. In falling market environments, long/short strategies are able to hedge risk and reduce equity market exposure in an effort to preserve capital.
To be sure, long/short strategies have historically lagged the broad equity market during strong market rallies. This is an important point for investors considering a long/short equity strategy. By running a hedged portfolio with lower equity market exposure, long/short strategies can participate in market rallies, but are unlikely to capture all of the upside.
But remember, long/short strategies seek to outperform by avoiding significant losses during market declines – not by capturing outsized gains. Long/short’s ability to participate in market upside while minimizing drawdowns has allowed for attractive long-term compounded returns over full market cycles, as Figure 3 demonstrates. As you can see in the capture ratios, long/short has preserved capital in down markets while participating in up markets. That is, it captured 54.4% of the gains in up markets while only capturing 42.1% of the losses in down markets.
By reducing losses while capturing gains, long/short strategies have delivered similar returns with lower volatility than the broad equity market (see Figure 4).
Why consider a long/short equity strategy?
For many investors, equity market exposure represents an important expected driver of long-term capital appreciation. However, as we have experienced over the last several years, equity markets do not always deliver positive returns and may be characterized by periods of heightened volatility. We believe equity market volatility is likely to persist as the world today faces significant macroeconomic risks: high debt levels in Europe, a fiscal cliff and political polarization in the U.S., and slowing global growth. In the current environment of unusual uncertainty in the global economy and financial markets, extreme events are not only possible but they are probable. In an effort to guard against extreme macro events, PIMCO believes investors would be well served to choose strategies that seek to dampen downside risk.
Many investors have come to recognize that the constraints placed on traditional equity managers may limit their ability to manage risk and add value. At PIMCO, we see greater potential benefit from strategies that are flexible, unconstrained and incorporate downside-risk mitigation. All of our equity strategies incorporate downside risk mitigation whether it be through low-volatility or dividend-focused investing, tail-risk hedging, or in the case of our long/short strategy, the freedom to short stocks or raise cash.
From alternative to mainstream
Historically, long/short equity strategies were primarily only available in the form of hedge funds and limited partnerships. Today long/short equity strategies have migrated into more easily accessible, registered investment vehicles like 1940-Act mutual funds. These liquid alternatives offer daily liquidity and full transparency of portfolio holdings on a regular basis. Consequently, long/short equity strategies are becoming increasingly more popular as many investors are seeking strategies that provide exposure to the potential long-term benefits of owning stock, while also offering downside risk mitigation. We believe utilizing a long/short strategy as a complement to an existing long-only equity allocation can help an investor achieve these goals.
It was not that long ago in this country that dining in all but the largest cities was defined by a steak house, often with a salad bar; a “Continental” restaurant; an Italian-American eatery; and Chinese takeout. As our food culture blossoms even diners in some of the most remote outposts are finding their options expand.
After two stomach-churning bear markets, investors might also be ready to sample an alternative to the standard equity mutual fund fare. Something with the opportunity for a little downside risk mitigation could very well be the kind of good cooking investors are craving.
Laura Schlockman contributed to this article.
The products and services provided by PIMCO Canada Corp. may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose.
*The “risk free” rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.
**Beta is a measure of price sensitivity to market movements. Market beta is 1.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in securities of smaller capitalization and mid-capitalization companies tend to be more volatile and less liquid than securities of larger companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
Dow Jones Credit Suisse Long Short Equity Index is an asset-weighted hedge fund index derived from the TASS database of more than 5,000 funds. The directional strategy involves equity oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from the value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional, such as long/short U.S. or European equity, or sector specific, such as long and short technology or healthcare stocks. Long/Short equity funds tend to build and hold portfolios that are more concentrated than those traditional stock funds. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.
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Thursday, October 18th, 2012
by Joseph G. Paul, AllianceBernstein
Investors have been flocking to high-dividend-paying stocks, lured by their predictable, bondlike income and downside defenses. But investors may be getting more risk than they bargained for.
The widespread pursuit of safety in high-yielding stocks has driven up their valuations and increased market concentration in these stocks. It has also caused an alarming surge in their correlation to bonds, so investors may be getting a lot less diversification than they realize.
Let’s look at valuations first. High-yield stocks are as pricey as they’ve been since the early 1950s, trading at a modest premium to the market versus a long-term average discount of 20%. We don’t view this premium as exorbitant given the current market anxieties, but it does limit upside potential and makes these stocks more vulnerable than others if sentiment turns. Most of the high-priced dividend-paying stocks are in mature, slow-growth sectors such as consumer staples, telecom and utilities, which are likely to look less appealing than more economically sensitive stocks in a sustained economic recovery.
What’s more, high-yield stocks now account for a much bigger share of the market, elevating the risk that arises when the market becomes overly concentrated in an overpriced subset—such as technology stocks in the late 1990s. In the US, where this trend is most pronounced, stocks with yields 20% or more above the market’s now account for 44% of the S&P 500 Index on a cap-weighted basis. That’s their highest share in the last three decades and well above the historical average of 36%, as shown in the display just below.
More menacing is the extent to which high-yielding stocks are behaving like bonds. Correlations between the relative returns of the highest-yielding S&P 500 stocks and total returns of 10-year US Treasuries have soared to 80% on a two-year-trailing basis. That’s more than 11 times its historical average of 7%, as shown in the second display, below. That’s the highest it’s been in more than 60 years. This means high-yield stock investors may be far more exposed to bond-market risks—such as an eventual rise in interest rates—than they want to be.
Investors need to understand the growing risks of overplaying the defense card. As a countermeasure, they may want to add more cyclical, deeper-value names that have been lagging on doubts about the economic recovery and future earnings. In our view, these will also enhance their equity alpha potential. When recovery comes, we expect these overly cheap stocks, many of them in better financial shape than before the crisis, to lead.
Investors who are passively invested in cap-weighted indices should pay attention to these trends, too, because the market embeds the growing dangers of overexposure to expensive safety stocks and higher-than-usual correlations to the bond market. Active investing strategies, backed by research, can take advantage of the opportunities these distortions create—and can avoid some of the risks.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Joseph G. Paul is Chief Investment Officer of North American Value Equities at AllianceBernstein.
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Thursday, October 18th, 2012
October 16, 2012
- By definition, inflection points are characterized by maximum weakness.
- Many US economic readings are again suggesting notable signs of life.
- Will the improvement be enough to offset the “fiscal cliff”?
One of the more interesting characteristics of the skepticism that has met the economic recovery over the past several years is the fact that it’s overly focused on the absolute versus the relative. By that I mean when discussing an improvement in economic data, it’s met with comments like, “yes, but we’re nowhere near prior levels of growth.” This phenomenon can be applied toward the economy overall, but also to segments, such as housing.
Inflection points versus absolute recoveries
As an analyst of the economy (and markets), I believe it’s important to look for inflection points, not to wait until the “all’s clear” bell is rung. Remember, the stock market is a leading indicator, while many of the most widely watched economic indicators are laggards (such as the unemployment rate). By definition, leading indicators will move first; the economy will follow; and lagging indicators will pick up the slack.
Also, by definition, inflection points (when moving from weakness to strength) occur at moments of maximum weakness in the data. It’s at that point that I’m generally most intrigued … not after the recovery is in full swing.
Today’s report is an attempt at inflection-point discovery. We recently experienced a third consecutive mid-year economic slowdown, all of which have had similar triggers. All three years’ soft patches were partly triggered by the eurozone crisis, and politics figured into at least two (2011′s debt ceiling debacle/Standard & Poor’s downgrade of US debt and 2012′s “fiscal cliff” concerns). This year’s also had a heavy dose of concern about China’s slowdown.
US leading economic indicators looking much better than global
In the three charts below, you can see the relative strength of the leading indicators for the United States compared to either the eurozone or China. Our growth is no great shakes, but we haven’t suffered to the same degree.
OECD Composite Leading Indicators
Source: FactSet, Organisation for Economic Co-operation and Development (OECD), as of August 31, 2012.
It appears as if the United States is at least stabilizing, if not pulling out of its latest slump. There are even a few signs of improvements within the eurozone and China: eurozone industrial production has increased nearly 3% over the past four months (even in Greece), and China’s M2 money supply and exports both recently moved well above expectations. By no means does that mean we think US or global growth will be robust—only that the worst may be behind us for now.
I believe an appropriate comparison is between our economy today and in 1998—that was the year during which the Asian financial crisis erupted. Pessimistic assumptions about the impact on US growth did not pan out, as domestic growth was sufficient to offset the drag from overseas weakness. Like then, the aggressive easing of monetary policy could be the necessary offset to keep the weakness contained to the eurozone and China.
One of the key indicator sets I track often are diffusion indexes of dozens of high-frequency economic indicators. ISI has the most comprehensive set of indexes, which measure strength minus weakness. As such, when the lines are ascending it indicates increasing strength relative to weakness and vice versa.
US Indicators Turning Up … But Not Yet Global
Source: FactSet, ISI Group, as of October 8, 2012.
In the US index above, you can see the three-year repetition—but also the latest turn for the better. At the inflection points in 2010 and 2011, we began to see a much healthier stock market, and I think the latest upturn in the data will be met with the same. This turn has occurred in spite of the still-weak reading of the global diffusion index.
Where’s the improvement domestically?
Much has been made of last week’s much-better-than-expected drop in the unemployment rate, thanks to a surge in the “household survey” measure of job growth (from which the unemployment rate is calculated). Conspiracy theorists jumped all over the numbers, and although I understand the basis, given how extreme an outlier the unemployment rate’s drop was, I don’t subscribe to the theory that the numbers were rigged. The household survey is notoriously volatile, and we should all keep a close eye on subsequent revisions to judge the ultimate trend.
But supportive of a better jobs outlook have been several notable economic readings:
- The aforementioned improvement in the jobs picture
- The bounce in both the manufacturing and non-manufacturing ISM indices (in the case of the former, back above the 50 contraction/expansion line, after three months below it)
- The bounce in consumer confidence and sentiment readings
- Strong retail sales (even excluding gasoline), along with positive revisions to prior months
- Much better housing data, including a five-year low in foreclosure filings
- The 14th consecutive week of improvement in ECRI’s weekly leading index
In particular, consumers have gotten a lift recently, tied to the improvement in confidence. Notably, both of the largest components of household net worth—homes and stocks—have been boosts. In fact, a broad measure of consumer stress is at a fairly low level.
Consumers less stressed out
Several years ago I created a “consumer stress index,” incorporating a variety of metrics all designed to gauge the level of stress on consumers. It’s made up of several market, inflation, housing and debt indicators, and as you can see in the chart below, its present level is fairly low by historical standards.
Lower Consumer Stress
Consumer Stress Index Components: average year-over-year percentage change of S&P 500® index, nonfarm payrolls, real disposable personal income, median home price; and inverse of oil price, medical care inflation, household liabilities and CRB (Commodity Research Bureau) Foodstuffs Index. Source: FactSet, as of October 12, 2012.
What if we don’t fall off the fiscal cliff?
In fairness, I’ll conclude with my oft-stated concerns about the fiscal cliff—the one major impediment to a continuation of the growth turn we appear to be witnessing. Housing is presently a notable bright spot, but is unlikely to be a significant enough growth driver to prevent a recession if we fully fall off the fiscal cliff. Concerns about the cliff largely explain the reluctance of businesses to invest and/or hire, standing in stark contrast to recent improvement in consumer confidence.
But what if the consensus is wrong? What if our politicians actually get their act together and construct a solution to the fiscal cliff? I’m fond of saying I’m always more intrigued by the story no one is telling and less intrigued by the story everyone is telling. Many have lost faith in our politicians’ willingness or ability to get anything done, but the possibility we don’t topple off the cliff is not built into expectations, in my opinion, and could be a very “positive tail risk” for the market.
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Thursday, October 18th, 2012
From John Aziz of Azizonomics
The Latest Bubble?
Subsidies encourage the type of behaviour they are subsidising.
And the Federal Reserve’s QE Infinity is subsidising the market for mortgage backed securities by taking them out of the market at a price floor.
Unsurprisingly, the market for mortgage-backed securities is near all-time highs:
And Wall Street is doing some wild and wacky things.
UBS has just launched a 16-times-leveraged MBS ETN. The ETN, called the ETRACS Monthly Pay 2x Leveraged Mortgage REIT, offers double the return of the Market Vectors Global Mortgage REITs Index – itself an investment vehicle 8x leveraged to mortgage-backed securities.
The idea appears to be that with the Fed acting as a buyer-of-last-resort that prices will take a smooth upward trajectory and that 16:1 leverage makes sense for retail investors as a bet on a sure thing.
Of course, back in the real world, there is no such thing as a sure thing. As Pedro Da Costa recently noted, banks are sitting on the proceeds of MBS purchases, rather than passing on the money to customers in the form of lower interest rates. As the New York Fed’s William Dudley recently noted:
The incomplete pass-through from agency MBS yields into primary mortgage rates is due to several factors—including a concentration of mortgage origination volumes at a few key financial institutions and mortgage rep and warranty requirements that discourage lending for home purchases and make financial institutions reluctant to refinance mortgages that have been originated elsewhere.
Those leveraging up on MBS might want to consider the implications if the Fed were to change its QE3 transmission mechanism — a transmission mechanism that William Dudley is willing to admit is broken — and buy other assets instead of MBS. Without a buyer of last resort with a printing press, prices would seem to be at current levels unsustainable. And those junk MBS products that the market is leveraging up on now in the hope that the Fed will buy them all will be left out in the cold. Such an event would bad news for anyone leveraged 16:1 on MBS.
But such an event would be an ingenious pump and dump, shifting the burden of junk MBS off Bulge Bracket balance sheets and onto the books of not only the Fed — which has already sucked up huge swathes of toxic junk — but also small-time speculators looking to book leveraged gains, but who end up taking the hit.
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Thursday, October 18th, 2012
by Mark Hanna, Market Montage
Monday, the question was how far the oversold bounce could go, and thus far it’s been a good two day move. After the “worst week since June” markets have generally regained a good portion of those losses in just two sessions. There really have been no obvious culprits for the move other than a technical bounce and a lot of the same comments about an imminent request for bailout from Spain. I remember asking myself in the 2010-2011 period how many times they could rally the market on “imminent bailout” for Greece and a lesson was learned: the answer is countless. It still is bemusing to watch stocks move on the exact same news over and over – yes we all know a Spain bailout is coming but that doesn’t stop us from reacting as if it’s earth shattering news each time it is rumored.
Outside of that constant news item, economic data has been a mixed bag as have earnings. In fact, Intel and IBM both had poor reactions to their reports/guidance last evening (and this morning) but futures are up. There used to be a time that companies like these mattered but it’s all about handouts/bailouts/rescues and the “central banker put” now… until it is not.
Taking a look at the charts we can see the S&P 500 fell to the low end of an ascending channel it has been in June; frankly it is a bit surprising the index stopped right on a dime when this level is now so obvious to everyone. You’d think there would a test of bulls resolve by a break of this level to shake out the weak before a potential reversal but that is not how it turned out.
The NASDAQ is more problematic and choppy but frankly as we all know it is all about Apple. The fate of the index will lie in the reaction to earnings of the stock next week. The two charts are very similar of late.
A lot of high beta tech has been struggling as there has been some rotation this week into commodity type areas… the Chinese stock market might be putting in some form of low as investors speculate for…. (wait for it) … imminent central banker/fiscal intervention. Low inflation figures from China over the weekend (how convenient) are serving to stoke the idea that the magic wand will soon come forth. With that the normal subjects (coal, steel, iron) are rallying. This has been the upteempth rally in some of these groups (see the chart of U.S. steel the past few months!) based on the same thesis or deflation of said thesis.
So at this point there has been the decent dead cat bounce but there are very few leadership sectors at this point. If anything some of the financials have been leading, but many of the groups of the past few months were hit very hard last week and their charts sustained some serious damage. Maybe they can simply “V shape” bounce as if it doesn’t matter but this would be an atypical result. Seeing the NASDAQ and Russell 2000 lag is also an issue as these are the traditional “risk on” indexes – instead we have leadership by the Dow and S&P 500.
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