Europe’s Currency Crisis: A Look at Possible Scenarios (Michel)

Friday, June 8th, 2012

by Tatjana Michel, Director, Currency Analysis, Schwab Center for Financial Research

Key points

• A Greek exit from the eurozone has gone from “unthinkable” to a distinct possibility. Years of steep economic decline and unsustainable public debt have increased the odds that the country will once again default on its debt and possibly return to the drachma.
• A Greek default/exit would present risks to the European banking system, could cause a severe downturn in the Greek economy and might trigger contagion that spreads to countries like Spain, Ireland and Portugal.
• The European Central Bank and other institutions theoretically have tools to lower contagion risk, but may lack the time and political will to use them.
• Ultimately, the exit of one country from the euro could lead to the exits of other countries and a breakup of the euro as it’s currently known.
• We suggest investors limit exposure to European bond markets and the euro, both of which are likely to experience more downside.

The May 6 elections in Greece ousted the party that had negotiated and agreed to the bailout package offered by the European Central Bank (ECB), International Monetary Fund (IMF) and European Commission (EC). This group, often referred to as the “troika,” provided bailout funding to the Greek government so that it could cover its debt payments in exchange for a promise that the country would bring its budget deficit and debt down by reducing spending and raising taxes. Greek voters have effectively rejected the agreement because of the negative impact that spending cuts have on their economy, which is already in deep recession. No party won a majority in parliament in the May elections and a coalition could not be formed. Therefore, new elections are scheduled on June 17.

If the new government insists on renegotiating the terms of the current bailout plan, new talks with the troika will have to take place shortly after the election. If there is no agreement, the troika could decide to deny Greece its next chunk of bail-out money, which would likely lead to a default on Greece’s sovereign bonds.

Greece needs to form a new government and reach an agreement with the troika before it runs out of money in July 2012. If they reach an agreement, Greece is likely to stay in the eurozone but would need to stick to the new austerity plan to continue receiving aid.

Greek opinion polls show elections are wide open

According to recent poll results, the June 17 elections are wide open and could very well lead to a government that meets Europe’s terms for keeping Greece in the euro. However, it could also put in power a coalition government that’s firmly against austerity—positioning Greece for an exit from the euro.

Scenario 1: Coalition around New Democracy keeps Greece in

Although traditionally powerful Greek political parties like the Pan-Hellenic Socialist Movement (PASOK) and New Democracy (ND) have seen their influence wane in recent years, ND has been catching up with the anti-austerity Coalition of the Radical Left (SYRIZA) party since May 6. Should ND be able to get the upper hand in the June 17 elections, it would increase the likelihood of an agreement with the troika.

Source: Greek Ministry of Interior
*PASOK (Pan-Hellenic Socialist Movement), ND (New Democracy), DISY (Democratic Alliance), KKE (Communist Party of Greece), LAOS (Popular Orthodox Rally), SYRIZA (Coalition of the Radical Left), DIMAR (Democratic Left), ANEL (Independent Greeks), XA (Popular Union). ** Projected estimate of vote tally, after disregarding all blank votes and absentees, and after adjusting for the “likely votes” of “undecided voters.

Scenario 2: Coalition around SYRIZA precipitates Greece’s exit

SYRIZA, on the other hand, has denounced the current austerity plan. Party leader Alexis Tsipras believes Greece can stay in the euro and continue receiving money while cutting austerity measures—something Germany and other creditors probably aren’t going to like. If SYRIZA gains control, it would likely make the negotiations with the troika difficult and increase the risk of a Greek default and exit.

Tags: Bailout Package, Bailout Plan, Budget Deficit, Contagion, Currency Analysis, Currency Crisis, Debt Payments, Distinct Possibility, Drachma, Economic Decline, Elections In Greece, ETF, ETFs, European Banking System, European Bond Markets, Eurozone, Greek Economy, Greek Government, International Monetary Fund, International Monetary Fund Imf, Public Debt, Troika
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The Axis of Weeble is Definitely Wobbling

Monday, May 14th, 2012

Weebles wobbling, spinning tops running out of energy, running out of room to kick the can, whatever analogy you want to use, the world seems like an incredibly dangerous place.

Greece is going to leave the Euro. That is now pretty much everyone’s expectation. I continue to believe that although they are highly likely to leave, it isn’t for a few more months, and that there will be some real effort from the Troika, led by the ECB to resolve this situation. This isn’t about helping Greece. This is about saving what is left of Europe. What does a new currency really do for Greece? It sounds exciting and the conventional wisdom is that it lets them inflate their way out of their problem. I think all it will do is inflate them into a “Mad Max” world. How is Greece going to be able to afford gas and food if they revert to the Drachma on short notice? Greece doesn’t export enough to get a huge immediate benefit. Yes, it will be cheaper to produce in Greece, but very little is set up to take advantage of that right now.

But it is the ECB and the rest of Europe that need to worry. Greece needs further debt cuts even more than it needs a new currency. Not only would the ECB’s and IMF’s existing holdings be converted to the new currency, Greece may decide to default outright. The ECB and IMF are both staring at massive losses. If Greece goes to the Drachma and doesn’t change the debt to Drachma, then they will have killed themselves. That just isn’t possible. So switching to drachma, and then possibly even defaulting is what is necessary. How will the ECB and IMF deal with it? The ECB might have to make a capital call. That would send tremors through the system. The IMF will deal with it, but expect talk about countries pulling out of the firewall. There is talk about having the EFSF make the ECB whole. That’s not even taking money from one pocket and shifting it to another, it’s the same damn pocket. The market will not like that.

Shorting Germany, preferably bunds, is my favorite way to play this (with French bonds a close second). I think the next leg if it occurs wipes out the myth of Germany as “safe haven”. If Greece goes, losses to the Troika will be real and any attempt to paint over them will be too obvious. The staggering size of the commitments that will ultimately flow onto the shoulders of Germany and France will end the idea that somehow their credit is somehow better. The guarantees matter, and these bonds will be affected.

I still expect some “surprise” headlines bringing all the people involved to some form of resolution, that won’t obviously fix everything, but will buy time. Notice Draghi has not once said anything about this, and really he seems far and away the most competent person at the ECB.

Then back here, we can focus more on JP Morgan. Since 2007, JPM had a loss in one quarter only. They lost 9 cents in Q4 2008. The just made 1.70 in Q1 of this year. Citi had 9 quarters of losses in that period. Their worst quarter was -23.80 per share compared to a tiny 1.11 per share in Q1. MS had 6 quarters of losses, with the biggest being 3.61 AND they lost money in 2 quarters last year. Yes, $2 billion is a big number. It may have grown, it may turn out smaller. In any case, it is unlikely JPM will have a loss this quarter. This group and the overall risk management of the firm is part of why they have done so well relative to their peers. If you want to focus on the fact that $2 billion is a huge number to a normal person, that is fine, but you may be getting more angry than you should. The reality is that JPM, with $2.3 trillion in assets is huge, and every business they are in is big, and P&L swings will be large in $ terms, but seem completely reasonable in percentage terms.

Yes, regulatory scrutiny will intensify, but this is a problem at all big banks. The specific risk of this trade has been overdone. Unfortunately it is hard to tell how much of the price move is specific to one aspect or the other, so I can’t quite get comfortable with the situation in terms of getting long JPM, but will be looking at outperformance trades.

Futures have already had a wild ride, and I would expect that to continue throughout the day. MAIN is out to 169 +12 bps on the day. XOVER is at 718 +36 bps on the day. It is ugly, with minimal liquidity – even the best market makers are back to making 1 bp markets in MAIN. IG18 is opening at 112, which is 3.5 bps wider, and HY18 is at 94 3/8, so down about 5/8. The moves in XOVER and HY relative to MAIN and IG seem more normal than Friday, when we saw almost amazing outperformance in the HY space (where JPM is allegedly short).

Spain and Italy are under attack again. Ten year yields have hit 6.26% and 5.70% respectively while CDS is at 640 and 480 respectively. Scary numbers, though Spanish 10 year may be getting to the point where we see some ECB intervention in the secondary markets.

So with problems across the globe and the mood so dim, I can’t help but think we are set up for a rally on the back of any scrap of good news. I don’t see Greece hitting the breaking point just yet, and the market will digest the JPM loss as it thinks more rationally, and Spain and Italy are not so heinous that they should respond well to any ECB intervention.

Tags: Analogy, Axis, Conventional Wisdom, Currency, Dangerous Place, Drachma, ECB, Efsf, Expectation, Firewall, Gas And Food, Greece, Imf Deal, Mad Max, Massive Losses, Max World, Spinning Tops, Tremors, Troika, Weeble, Weebles
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Unscrambling the Euro Eggs (Krasting)

Thursday, May 10th, 2012

by Bruce Krasting

On April 17 I wrote about a conversation (link) with an individual who lives in Athens. He had this to say about the coming Greek elections:

“The other parties are communists, radicals and crazies. If they have a hand in the new government, then on May 7 Greece will be forced to take dramatic steps. The whole idea that the country should suffer, so the bankers can get paid will have to change.”

He also said this:

“The attitude in Brussels and Bonn towards Athens will change after the election as well!”

He had that right, so I called him back to get an post-election update.

BK: Is it true that you will soon spending Drachmas?

Athens: This seems to be the only possible outcome. Germany will no longer support Greece, neither will the IMF.

BK: What would the new Drachma be worth in Euros?

Athens: Far less than the rate that was used to convert Drachma to Euros in 2001. At least 50% less. For Greece, the exchange rate for the Euro will be the key, but you can’t forget that the Drachma will also have a new exchange rate for the dollar.

Greece joined the Euro in 2001 at a fixed conversion of 341Greek Drachmas to the Euro (EURGDR). In the period preceding the link, the USDGDR was 328. Assume the Drachma floats freely and promptly loses half of its value versus the Euro. The market rate would be EURGDR 682. If the EURUSD was trading at 1.3000 it would mean that the USDGDR would be 568. The GDR would lose half its value against the Euro but it would only lose on 37% versus the dollar. I asked the fellow from Athens about this:

Athens: There is the proof. The Euro is too high against the dollar.

I thought that was an interesting comment. I went back and looked at the original conversion rates to the Euro for France, Italy and Spain and compared them to what the USD exchange rates would be today:

- The +11% results for these countries versus the USA looks wrong to me. I considered what the local currency rates would be if the Euro were lower in value versus the dollar. A rate of EURUSD 1.20 still doesn’t get it done for me. It starts to “look right” with the EURUSD at 1.10

- If the Euro were to be broken back into its original pieces, the old legacy currencies would trade around the Deutche Mark (DM). It is a very safe bet that if there was a free float of the currencies, the DM would increase in value versus all of the other EU members. It’s an equally safe bet that the USDDM of ~1.67 that was posted on 12/31/98 (last day of the DM) is going to also be much weaker (DM strength).

If the DM is going to make a comeback it will create a very nice new reserve currency. Money will migrate from both Switzerland and Japan to a different “safe” place. It will end up in Frankfurt. These are my estimate for what may happen:
USDYEN = +10%

USDCHF = +10%

DMYEN = +30% (1999 to date)

USDDM = -40% (1999 to date)

USDDM = Parity

DMCHF = Parity

DMFF = +15% (1999 to date)

DMLIRE = +20% (1999 to date)

DMPESETA = + 40% (1999 to date)

DMDRACHMA = +60% (2001 to date)

DMESCUDO = +50% (1999 to date)

DMGUILDER = +10% (1999 to date)

Of course these are just estimates, but I think the directional moves I describe will take place. The issue is how long it will it take and how violent the markets will be. On that score, I would estimate that it would take at least a year for these adjustments to take effect, the process of making these adjustments will be very violent indeed. One thing is clear to me, Germany is going to take the brunt of the adjustments that must follow.

The Germans are going to get hit from all sides. Its currency will rise against all the EU countries, it will rise against the Dollar and the Yen. This reality is the reason that Germany has done what they have to avoid a breakup of the Euro. I don’t think they can avoid the consequences much longer. Germany is now stuck between a rock and a hard place.

Tags: Athens, Bk, Communists, Conversion Euro, Conversion Rates, Crazies, Currency Rates, Drachma, Drachmas, Dramatic Steps, Election Update, Eurusd, Exchange Rate, Gdr, Greek Elections, Imf, Nbsp, New Exchange, Radicals, Usd Exchange Rates
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The Axis of Weeble (Tchir)

Thursday, May 10th, 2012

by Peter Tchir, TF Market Advisors

Weebles wobble, but they don’t fall down. Europe, and the Euro in particular might fall, but right now they are close to the bottom of this current wobble and are about to start another upswing (seriously, as I kid, you could make a Weeble fall down, but it was hard).

Greece is a basket case. It may or may not have a government. The eventual government may or may not want to stay in the Euro. That is all true, but will take time. Greece will and should attempt to renegotiate the bailout package. Our analysis yesterday might be a good place for Greece to start. The results of the renegotiation will determine the timing and necessity of Greece leaving the Euro. Until the Greek’s have had time to attempt to renegotiate and have actually planned for an exit back to the Drachma they will not risk a hard default where they really don’t know the consequences. So look for more hard-line headlines but expect May payments to go smoothly. I think the post PSI bonds, down a touch again today, offer good risk/reward opportunities.

Spain may be less of a basket case than Greece, but it is a far bigger basket. Spain nationalized Bankia, the 4^th largest bank. So far the market is reacting positively. I think that this will turn out to be a “head fake” over time. While encouraging that Spain was willing to act a lot is left uncertain. Is this even enough to fix Bankia? Problem banks have a tendency to be bigger money pits than anyone at first realizes. Look for doubts to creep back in about the success of this recapitalization. Then there is the question of how many other banks need how much money? The figure will be staggering. That brings us to the last question, how will Spain get all the money? Spain will be back to test the lows, but with the IBEX index at 9 year lows, a lot has been priced in and these little actions should be enough to provide a decent pop. I recommended long IBEX vs short DAX into the European close yesterday.

Germany has its own set of problems. The people voted and made it clear that the bailout programs Germany is creating don’t sit well with the people. So Merkel cannot easily back down and make things easier for Greece or Spain (or Italy, or Portugal, or Ireland, for that matter). She has to talk tough, but there is no way she has gone this far and will let it fail easily. She is likely to insist on the same level of budget cuts, but may be less concerned about the timing. She has to pander to her base, so look for disruptive statements from Germany, but their bark will be worse than their bite. Behind the scenes she will be a little more conciliatory and flexible.

France has been surprisingly quiet since the elections. Mr. Hollande is not forced to embrace the policies of Merkozy and is free to carve his own role in Europe. The French elections seemed to have less to do with bailouts and more to do with a renewed focus on France and a push for growth. So while he has to spend more time on domestic issues than the previous government, he also has the ability to push the growth agenda throughout Europe. He can be a leader in a “new” European plan, one focused on “growth”. Since “growth” is just code for spending, most of the politicians will get behind him. The equity markets love growth and are always happy to drown out the screams and protests of the fixed income markets. The failure of the “growth” agenda will become apparent and markets will sell off, but that could take some time. Fortunately for the bond market and the sovereign debt crisis, the fallacy of the “growth” argument will become apparent before more debt has been issued to fund elaborate spending projects. It does continue to amaze me that “austerity” is so hated and not an option, when in spite of all the votes, and approvals, very little actual austerity has occurred.

Jobless Claims have the potential to move the markets. To me, the revision is key to how the market will respond. If we get another upward revision to last week’s data, the market will show little enthusiasm for the number unless it is below 350k. If we get 365k and even a small downward revision to last week we could see a significant pop. That’s because the market largely ignored last week’s number with so much else going on, and because after Friday, the “we have jobs” portion of the rally took a serious beating. If we get a 365k print will another upward revision, expect the market to be rather blasé about it. I like being a little long U.S. risk coming into the number, but will take my read more from the revision than the data itself.

Credit is mixed this morning, but by and large unchanged. Spanish and Italian bonds are trading much better. There is still pressure on CDS, but even there I think it is less of a warning sign than a market that is about to get squeezed badly. U.S. CDS is trading a bit better with both IG18 and HY18 trading fractionally tighter. Futures have managed to retrace back to almost session highs, and given how many people seemed to expect overnight problems in Europe, expect buying to continue, especially if jobless claims are good.

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E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Tags: Axis, Bailout Package, Basket Case, Bonds, DAX, Doubts, Drachma, Last Question, Lows, Pits, Problem Banks, Psi, Recapitalization, Renegotiation, Risk Reward, Spain Money, Tendency, Tf, Upswing, Yest
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Europe’s Cash-For-Trash LTRO-’Scam’ And The Indentured Servitude Of The Citizenry

Friday, February 24th, 2012

In a must-watch follow-up to his original Punk Economics Lesson, David McWilliams describes how the new bankocracy in Europe will lead to a massive injection of liquidity; blowing bubbles in financial assets while the citizenry is bled dry (ring any recent bells?). The banks again get all the money they need while the average citizen shoulders the burden. Specifically in the case of the Greeks, they are left with the uncertainty of a return to the Drachma or the certainty of decades of indentured servitude. Enter the ECB with their cash-for-trash deal. This is a scam, he proclaims correctly, insolvent banks lending to insolvent governments and we are calling it success? The banks can turn a tidy profit, but the straight-talking Irishmen asks the question every Greek citizen should be asking: “where does the profit come from?” The answer: the average tax-paying European citizen, and it is this that provides the comfort for the Germans to allow the Greeks to default without bringing down every bank in Europe in a contagious cascade of margin calls, un-hypothecation and deleveraging. Critically, the question is not if or when Greece will default but will they be allowed to default enough? The lesson for all is that to stay in the Euro, all European nations have to become more like Germany – which is very different from the community of equal nations that the Europeans signed up for 20 years ago at Maastricht. Don’t be fooled that the European debt story is over, it is not. In fact, he finishes – rather ominously, the interesting bit hasn’t even started yet.

While austerity is argued not to work, we think it can if countries manage to cut expenses while keeping a balance. We once again remind readers that alas, the balance is out of skew due to 30 years of runaway full-Keynesianism, which leads indeed to the problems that McWilliams so well espouses.

Tags: Austerity, Blowing Bubbles, Citizenry, David Mcwilliams, Drachma, ECB, European Citizen, Europeans, Financial Assets, Germans, Greek Citizen, Greeks, Hypothecation, Indentured Servitude, Insolvent Banks, Irishmen, Keynesianism, liquidity, Massive Injection, Tidy Profit
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John Taylor’s Open Letter To Greece: “Get Out Greece! Get Out Right Now!”

Thursday, February 2nd, 2012

From John Taylor, Chief Investment Officer Of FX Concepts

Open Letter To Greece

Get out Greece! Get out right now! You should have moved two years ago; you missed that chance, but now it is much better than later. Summer vacations are being planned while we speak, you must move fast to get the biggest advantage out of bolting from the euro. Don’t let the next global recession bare its teeth. Investors still have money and they are interested in buying your assets when the prices are knocked down – each day you wait their value is deteriorating and you are looking more desperate.

Most important: don’t listen to the naysayers in Brussels who are warning you of disaster outside of the ‘protective euro blanket.’ It’s much better outside, even the Turks know this. Do pay attention to Angela Merkel and Wolfgang Schäuble; they are telling you the truth – there is no hope within the euro. Even though the latest German plan to take away your financial freedom has been blocked, the PSI deal is almost as toxic. We read in the press that about 94% of your government debt is written under Greek law, which means you have control over it, but after the deal with the private creditors is signed all of this debt will be written under British law. Your parliament and your judges will be insignificant.

Right now you have control over the currency of your debt, like any real country, but after the PSI you will become no more than a province of the greater Eurozone, unable to modify your debt. Whether it is Brussels, Berlin, Washington or London that is calling the shots, you can be sure that after these negotiations and the next tranche from the Troika is in place, Athens will be powerless. Right now you have the power to lessen the debt burden by jumping the euro ship and valuing the new drachma at something like 50% of the current euro value. By doing this you have marked down the private sector and the public sector debt holders – this is a great advantage without even defaulting on those 94% written under Greek law. Don’t be shy, value the drachma aggressively lower, below where you think it should be, and then peg it. Euros will circulate together with the new drachma for a few days but Gresham’s Law guarantees that won’t last for long. When the euros are gone, drop the peg. The financial system will be a mess and the banks will be totally bankrupt. However, they are acting as if they already are, not making loans or assisting the economy in any way, so you won’t be losing too much, and you’re going to nationalize the banks anyway. It would be wonderful if the ECB helped out by supporting the new drachma for a year or so, but don’t count on it, as the Eurozone is in too much trouble to help. Remember, first one out is the winner and the pressure will shift to those remaining.

The self-serving cacophony from Euro-officials and Eurozone politicians arguing that you will be far worse outside the euro than in it are only promoting their own interests – not yours. For the last decade, Greece has been a great place to sell products, and Greece has been less and less a competitor in the marketplace as it was priced out of Europe. They’ve been making a fortune while Greek manufacturing has collapsed. Most important, Greece has been priced out of the vacation market. Aegean bound visitors now head to Turkey and on the Adriatic side they go to Croatia. With the new drachma dropping prices, TUI, Thomson Travel, and the other package vacation outfits will flock to your beaches setting off a boom. The negative side is that BMWs will be very expensive, as will all other imported items, so there will be some deprivation and inflation. Although there will be aggressive wage demands, you don’t have to give in. You will be free again to choose your course.

The standard of living will drop for everyone, but the offset is that tourism will come to life, manufacturing will be profitable again and the real estate market will be humming. All of a sudden, Greece will be a country where it is possible to make a living. Turkey has been locked out of Europe and has had a great time.

Tags: Angela Merkel, Calling The Shots, Chief Investment Officer, Deb, Debt Burden, Drachma, Euro Value, Financial Freedom, Fx Concepts, German Plan, Global Recession, Government Debt, Greek Law, John Taylor, Naysayers, Private Creditors, Psi, Summer Vacations, Tranche, Troika
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“Ich bin ein Berliner” (Saut)

Tuesday, November 8th, 2011

“Ich bin ein Berliner”
November 07, 2011

by Jeffrey Saut, Chief Investment Strategist, Raymond James

“Ich bin ein Berliner” was a German phrase used by President John F. Kennedy in his famous Berlin speech where he was emphasizing the U.S. support for West Germany after the Soviet-supported East Germany erected the Berlin Wall as a barrier to prevent movement between East and West Berlin. Last week at the G20, like John Kennedy, President Barack Obama tried to emphasize America’s support for a German bailout plan to prevent a Greek tragedy. The tragedy’s trajectory rose sharply on Tuesday when Greek Prime Minister George Papandreou announced there would be a referendum to decide if the new austerity measures for a second bailout (the first was on July 21, 2011) would be acceptable to the Greek people. That news shocked the world’s equity markets, which was reflected by the Dow’s Dive of some 297 points. I was seeing portfolio managers at the time and told them that in my opinion Papandreou’s prose was telegraphing a Greek withdrawal from the EU. A withdrawal because the Prime Minister knew the Greek people would never vote for such measures and because the vote most likely would not be held until next year. Further, Papandreou knew that given the uncertainty of an austerity vote the IMF would probably hold back its already scheduled disbursement of funds. To be sure, the IMF’s funding conditions require a clear horizon for 12 months, so Greece’s €8-billion tranche, which would come from the IMF, probably would have never showed up.

A Greek withdrawal from the Euro-zone would also be quite messy. Firstly, leaving the euro and returning to the drachma should cause a sharp devaluation in the drachma’s value vis-à-vis other currencies. A good example of this is the monetary breakup of the Austro-Hungarian Monetary Union in 1919. Secondly, the switching of currencies requires changing domestic laws to allow wages and incomes to be paid in the new currency. As well, domestic debt has to be recalibrated for the new currency. Thirdly, Greece’s government would be unable to borrow from the financial markets and thus forced to cut its budget deficit to zero. As The Wall Street Journal notes:

“[Greece’s] debt burden – the weight of government debt as a proportion of economic output – would soar. The economy would shrink as the new national currency depreciated against the euro, but most of the government bonds would still be euro-denominated. If that weren’t enough, many economists argue that the economic benefits of a sharp currency depreciation could quickly be dissipated by wage inflation.”

Then there are things like preparing for capital flight, bank holidays to slow withdrawals, reprogramming cash registers/vending machines/etc., making new notes and coins, well you get the idea. Indeed, it’s all Greek to me … pass the ouzo!

Comes Thursday, however, Papandreou drops his controversial referendum proposal as he faced a “no confidence” vote on Friday. Interestingly, he survived that vote, but surprisingly the DJIA (11983.24) didn’t follow on to Thursday’s Triumph (+208.43). And that, dear reader, raises the question – is the stock market merely reacting to the on/off news from Greece and the EU? – or, has the October rally been more about the better than expected economic news in the U.S.? Our sense is the rally from the “undercut low” of October 4, 2011 has been driven by better than estimated economic reports. Verily, the economy has been doing better than most expected. For example, the recent real GDP report showed an uptick to 2.5%. But, the real GDP, less the change in private inventories, increased by 3.6% (seasonally adjusted annual rate) during 3Q11 versus +1.6% in 2Q11. This suggests companies chose to meet the stronger demand by selling inventories rather than increasing output. This only reinforces our belief that corporate America will have to build inventories, which should add ~1% to this quarter’s GDP report. Then there was the strength in producers’ durable equipment, which jumped 17.4% during 3Q11. Hereto, this plays to our argument that spending on capital equipment (capex) should torque up into year-end, spurred by the ability to expense capex. The fear here is that the 100% expensing feature is slated to expire on December 31, 2011 unless it is extended.

As stated in last Monday’s missive, about three-quarters of October’s economic releases have been coming in better than expected. Unfortunately, that skein was broken last week with seven of the 18 economic releases better than estimates, eight weaker, and three in line. And maybe that, rather than Greece, was the reason for the early week two-day train wreck of down 573.15 points for the senior index. The downside two-step registered back-to-back 90% Downside Days whereby both the declining volume, and the number of downside points, equal or exceed 90% of the total volume and total points traded. Typically, such back-to-back Downside Days tend to temporarily exhaust the sellers, which was the case last week as Wednesday and Thursday’s sessions recorded back-to-back 80% Upside Days. For the past few weeks we have been suggesting some kind of pause/pullback was due, commenting that the McClellan Oscillator was about as overbought as it ever gets. Ditto the percentage of stocks in the S&P 500 (SPX/1253.23) that were above their respective 50-day moving averages (only 4% in early October versus 93.6% as of last Monday morning); and the fact that according to our “day count” sequence, with October 27th being session 17 in the typical 17 – 25 Buying Stampede, the straight up rally was long of tooth.

As for earnings season, earnings continue to track above expectations as with 432 companies in the S&P 500 reporting, earnings are better by 22.2%, with a 12.2% increase in revenues, year over year. The question then arises, “Why are fundamental analysts lowering their forward estimates?” Indeed, there have been noticeable declines in estimates for eight of the S&P’s ten macro sectors. The two sectors where estimates have not been lowered are Healthcare and Utilities. Nevertheless, it has indeed been a great earnings season and we expect more of the same into the Christmas selling season. To that point, there is a high correlation between strength in the stock market and a good Christmas “sell through.” Accordingly, we expect a decent Christmas and suggest investors consider select retailers as investments. As the keen-sighted folks at the Bespoke Investment Group opine:

“In order provide a more detailed look at the performance of retail related groups’ pre and post Thanksgiving, in the table we show the annual returns of the S&P 500, the S&P 500 Retailing group, as well as the various subgroups in the Retail sector from the start of November through Thanksgiving. From 2000 through 2010, the S&P 500 has averaged a gain of 0.9% from 11/1 through Thanksgiving with positive returns nearly three quarters of the time. Retailers, on the other hand, have done even better. From 2000 through 2010, the S&P 500 Retailing group has seen an average gain of 1.6% with positive returns nearly two-thirds of the time. Looking at individual sub-groups shows that Internet retailers (beginning in 2002) have seen the best returns in November with an average gain of 4.8%. After online sales, the next best groups are Apparel (3.1%) and Restaurants (2.8%). If you are looking to generate alpha, both of these groups have outperformed the S&P 500 73% of the time since 2000.”

Some Strong Buy-rated names for Raymond James’ universe of stocks playing to this theme are: Bed Bath & Beyond (BBBY/$62.03); Big Lots (BIG/$41.32); Family Dollar Stores (FDO/$58.97); O’Reilly Automotive (ORLY/$76.90); Red Robin Gourmet Burgers (RRGB/$26.57); Select Comfort (SCSS/$20.77); and Wal-Mart Stores (WMT/$57.50).

The call for this week: Last Monday I wrote, “To us, the real question is – will the SPX get a pullback to the often mentioned pivot point of 1217, or will any pullback be short and shallow? Well, by our work the equity markets still have a lot of internal energy to power their way higher, so our sense is the SPX will keep pushing higher in the months ahead with only shallow pullbacks and sideways pauses along the way.” While falling from 1284.59 to 1218.28 the first two days of last week hardly qualifies as “shallow,” I do find it interesting that on the numerological date of 11/1/11 the S&P 500 closed near the aforementioned pivot point of 1217 and then rallied. Accordingly, we would view a decisive close below that 1217 pivot point as a negative, suggesting a decline back into the 1100s. A more likely outcome, however, is for the SPX to spend some time consolidating before resuming its advance.

P.S. – I am actually here all week …

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Copyright © Raymond James

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