Chinese Buyers Defaulting On Commodity Shipments As Prices Plunge

Monday, May 21st, 2012

One can come up with massively complicated explanations for why the Chinese commodity bubble is popping including inventory of various colors, repos, etc, but when all is said and done, the explanation is quite simple, and is reminiscent of what happened in the US with housing back in 2007: everyone was convinced prices would only go up, and underlying assets was pledged as debt collateral at > 100 LTV… and then everything blew up. Precisely the same thing is happening in China right now, where buyers of commodities thought prices could only go up, up, up and instead got a nasty surprise: prices went down. Big. As a result, many are not even waiting for their orders to come in, but are defaulting on orders with shipments en route.

From Reuters: “Chinese buyers are deferring delivery or have defaulted on coal and iron ore deliveries following a drop in prices, traders said, providing more evidence that a slowdown in the world’s second-largest economy is hitting its appetite for commodities. China is the world’s biggest consumer of iron ore, coal and other base metals, but recent data has shown the economy cooling more quickly than expected, with industrial output growth slowing sharply in April and fixed asset investment, a key driver of the economy, hitting its lowest in nearly a decade. “There are a few distressed cargoes but no one is gung-ho enough to take them. Chinese utilities aren’t buying because they have a lot of coal and traders are also afraid of getting burnt. It’s very bearish now,” said a trader. The defaults in thermal coal over the past week has come after a fall in prices over the past 1 1/2 months, with key coal prices indices in Australia, South Africa and Europe all having fallen around $10 a tonne since early April.” And this is the country that over the weekend was rumored to be bailing out the world again? We wonder: will China also bail out FaceBook longs, or will it merely focus on preventing a collapse in its own various commodity bubbles which are starting to pop one after another?

More from Reuters:

At least six defaulted thermal coal cargoes were being re-offered at a discount, traders said, including contracts for shipments from the United States, Colombia and South Africa.

 

“Many of them signed for the spot cargoes in early April and prices have fallen around $10 a tonne since then. Say if the Chinese traders were buying a cape-sized shipment, they’d be suffering a loss of nearly $1.5 million alone,” said a trader at an international firm who has been offered defaulted cargoes.

 

“That doesn’t even take into account the losses on freight rates. So rather than being bankrupted by these deals, they would rather dishonour the contract to survive.”

 

China’s premier called for additional efforts to support growth on Sunday, signalling Beijing’s willingness to take action to bolster its sagging economy.

And if the Chinese commodity appetite is over, that means very bad news for commodity exporters the world over:

Reflecting greater caution, BHP Billiton, the world’s biggest miner, has put the brakes on an $80 billion plan to grow the company’s iron ore, copper and energy operations.

 

Slumping commodity prices and escalating costs have squeezed cash flows, pushing BHP to join rival Rio Tinto reconsidering the pace of their long-term expansion in countries such as Australia and Canada.

For another perspective of just how stuffed to the gills with commodity inventory is we again go to Reuters, which gives us the following scary summary:

When metals warehouses in top consumer China are so full that workers start stockpiling iron ore in granaries and copper in car parks, you know the global economy could be in trouble.

 

At Qingdao Port, home to one of China’s largest iron ore terminals, hundreds of mounds of iron ore, each as tall as a three-storey building, spill over into an area signposted “grains storage” and almost to the street.

 

Further south, some bonded warehouses in Shanghai are using carparks to store swollen copper stockpiles – another unusual phenomenon that bodes ill for global metal prices and raises questions about China’s ability to sustain its economic growth as the rest of the world falters.

 

Commodity markets are used to seeing China’s inventories swell in the first quarter, when manufacturing slows down due to the Lunar New Year holidays, and then gradually decline during the second quarter when industrial activity picks up.

 

This year, however, is different.

 

Copper stocks in Shanghai’s bonded storage, the biggest in China, are now double the 300,000 metric tons (330,693 tons) average of the past four years and iron ore stocks are about a third more than their 74 million metric tons average.

This time may be differernt indeed:

Four years ago, however, the global financial crisis triggered by the collapse of Lehman Brothers broadsided the economy: factories shut down suddenly, millions of workers got laid off, ports ground to a halt. The situation only perked up after the government introduced a $600 billion stimulus scheme.

Probably the biggest difference is that back then Europe wasn’t broke and the US debt/GDP was well below 100%. Both of those are no longer the case.

And to think we were wondering just last week if the biggest construction bubble in history was sustainable.

Tags: Appetite, Asset Investment, Base Metals, Cargoes, Coal Prices, Collateral, Commodities Prices, Commodity Prices, Commodity Shipments, Deliveries, Explanations, Iron Ore, Longs, Nasty Surprise, Plunge, Reuters, Slowdown, Thermal Coal, Tonne
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ECRI Repeats Recession Call Based on Coincident Indicators, Especially Income

Sunday, May 13th, 2012

Once again Economic Cycle Research Institute’s Lakshman Achuthan repeats his recession call, this time saying within three months.

His call is based on coincident indicators, especially income. According to Achuthan, income growth in the last three months is lower than at the start of any of the last 10 recessions.

Link if video does not play: Why U.S. Economy is Heading Back Into Recession

Once again I tend to agree with him, yet once again I find some things that sound rather disingenuous.

When asked “Can the Federal Reserve do anything about this?”, Achuthan responded “no”.

Specifically Achuthan replied “It’s so ironic. We’re all free-marketeers. …. the free market has indigenous inherent business cycles which means ups and downs. It’s ironic that we think that the Fed or other policies could just stave off a recession“.

I agree. However, the statement represents one hell of an attitude change as the following flashbacks show.

Window of Opportunity

Friday, January 25, 2008
ECRI Says There Is A Window of Opportunity for the US Economy

The U.S. economy is now in a clear window of vulnerability, given the plunge in ECRI’s Weekly Leading Index (WLI) since last spring. Yet there is a brief window of opportunity within that window of vulnerability to avert a recession. That is why ECRI has not yet forecast a recession. ….

This is why, having correctly predicted the last two recessions in real time without crying wolf in between, we are not forecasting one yet.

ECRI Denial

The ECRI laid it on pretty thick, openly mocking the “best advertised [recession] in history” while claiming “This is why, having correctly predicted the last two recessions in real time without crying wolf in between, we are not forecasting one yet.”

The irony is the recession was about 2 months old at the time.

Recession of Choice

Friday, March 28, 2008
ECRI Calls it “A Recession of Choice”

The U.S. economy is now on a recession track. Yet this is a recession that could have been averted. In January, given the plunge in the Weekly Leading Index, we declared that the economy had entered a clear window of vulnerability. Yet we emphasized the brief window of opportunity within that window of vulnerability for timely policy stimulus to head off a recession.

It is a somewhat different story with regard to GDP, because the cyclically volatile manufacturing sector still accounts for 36% of GDP. A mild downturn in that sector should limit the decline in GDP in this recession.

Question for Achuthan

If it was a recession of choice in 2008 (after the recession already started), why isn’t it a question of choice now? Of course, it is entirely possible Achuthan has changed his mind about what is or isn’t possible.

Then again, is that change of heart a new fundamental belief or simply a necessary statement because his call is now recession as opposed to no recession in late 2007 and early 2008 (while later taking credit for predicting a recession).

It is not my intent to keep bringing this discrepancy up, but Achuthan has come out with yet another reason for his call that is dramatically different that what the ECRI has stated before.

The key point however is the forecast, and on that score I side with Achuthan. I also side with Achuthan that he Fed cannot do much to stave off recessions. History will show who is correct.

Mike “Mish” Shedlock

http://globaleconomicanalysis.blogspot.com

Tags: Attitude Change, Business Cycles, Crying Wolf, Economic Cycle Research Institute, Ecri, Federal Reserve, Flashbacks, Free Marketeers, Irony, Lakshman, Lakshman Achuthan, Last Spring, Plunge, Recession, Recessions, Ups, Ups And Downs, Vulnerability, Window Of Opportunity, Wli
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Garbage In, Garbage Adjustments, Garbage Out (Tchir)

Friday, April 20th, 2012

by Peter Tchir, TF Market Advisors

It is hard to ignore the fact that this year is shaping up a lot like 2011 and 2010. I’m not a big fan of seasonal patterns, so what else could it be. Could it just be that all of our adjustments are a total mess?

I understand why we attempt to “seasonally” and otherwise adjust numbers. We crave smooth data. It makes charts look better. It puts a number into context, but what if the adjustments are just horribly wrong? The magnitude of the adjustments is large, so even a small mistake could have a huge impact.

Did the plunge in the economy in the months following Lehman cause adjustments that consistently make the Dec-Feb period look better than it should. Did the rebound, which really started in March 2009 affect those adjustments so that they reduce the jobs by too much? We have gone through some violent shifts in the economy since at least 2008. Industries like homebuilding, which had a huge seasonal component, are far less important in today’s economies. So much has gone on, and so much has changed, are the adjustments overwhelming the data and giving us bad reads? I have only picked on payroll, but I am becoming convinced that much of what we see as growth, followed by decline, is just bad data in the first place, further messed up by bad adjustments. We pretend like 50,000 difference in a month is meaningful (when even BLS says that is in their confidence error), when the data shows that probably anything within 250,000 of the real job growth would be a lucky guess.

As you get ready for next week’s deluge of data, it is worth keeping in mind. Expect bad data.

One last rant, I find it interesting that every American has to basically fill in the same forms, in the same way for their taxes, and yet the half a dozen money center banks, thriving on Fed support, each report basically everything in their own way, making it very hard to compare bank to bank or quarter to quarter. Couldn’t the SEC, Fed, OOC, or FDIC insist on a consistent summary format for reporting earnings?

Markets are a little better on the back of German confidence. Those rallies rarely last.

I would be shocked though if we don’t get some commitment to commit out of the G20 and IMF this weekend, so although I think we will fade a little from here, we should see some strength into the European close as everyone gets ready for more “firewall” money. This meeting highlights the ascent of China and the decline of the U.S. as it is Chinese money “coming to the rescue”.

Credit is very quiet this morning. IG, MAIN, XOVER, and HY are virtually unchanged. High Yield bonds remain well bid, HYG and JNK remain strong, but HY18 continues to struggle. TIPS have continued to do very well in spite of how “transitory” inflation is.

Tags: Confidence, Decline, Deluge, Economy, Garbage, Half A Dozen, Homebuilding, Job, Lehman, Lucky Guess, Magnitude, Mistake, Money Center Banks, Nbsp, Payroll, Plunge, Rant, Rebound, Seasonal Patterns, Tf
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Comfortably Numb: Have Investors Become Too Complacent?

Wednesday, April 4th, 2012

Comfortably Numb: Have Investors Become Too Complacent?

April 2, 2012

Let’s get right to the point: It was the best first quarter for the stock market since 1998. The total return of the S&P 500 index® was 12.6% for the quarter; up nearly 30% from the October 3, 2011 low. What was particularly notable about the surge since then has been the attendant plunge in volatility.

Complacency?

As you can see in the chart below, the CBOE Volatility Index (VIX) has dropped dramatically from its high of 48 last August (when Washington’s fearless leaders failed to construct a debt deal, leading to Standard & Poor’s downgrade of US debt) to 15 recently.

Plunging Volatility

Source: FactSet, as of March 30, 2012.

Many investors—notably those painfully on the sidelines—have suggested this shows a high level of complacency. And the fact that trading volume has been weak has been another pillar in the bears’ case for why the “rally isn’t for real.” (See more on trading volume later in this report.)

Most readers know I have been optimistic, and remain so. But, the contrarian in me does have some sympathy for the case that optimism has become elevated enough to offer a headwind for the market in the near term.

I am a big fan of the sentiment work done by Ned Davis Research (NDR) and SentimenTrader.com. NDR noted recently in a report that the recent backup in Treasury yields has accompanied a rise in optimism by investors, and this combined indicator did flash a short-term sell signal for the market. That said, NDR argues, and I concur, that yields remain extremely low and as such, are not “biting” stocks yet.

Elevated optimism = near-term headwind

Below is NDR’s most widely-followed sentiment measure, its Crowd Sentiment Poll, and as you can see, accompanying the market’s rally has been a surge in optimism into the “uncomfortable” zone. Given a bit choppier action lately by stocks, I am hopeful we will see a waning of this optimism, at least back into the neutral zone.

Elevated Optimism

Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2012 © Ned Davis Research, Inc. All rights reserved.), as of March 27, 2012.

Another sentiment metric showing elevated optimism is SentimenTrader’s Smart Money/Dumb Money Confidence index, shown below.

Smart Money Warming Up to Market

Source: FactSet, SentimenTrader.com, as of March 30, 2012.

Although no where near the recent extremes of smart money pessimism and dumb money optimism, it bears watching. The good news is that the gap has begun to narrow in a favorable way. Remember, as the labels suggest, the smart money tends to be right at extremes of sentiment, while the dumb money tends to be wrong.

Crash worries still abound

But not all sentiment metrics are created equal. One I discovered recently is put together by the folks at Yale and it measures the perceptions about the likelihood of a stock market crash among individual and institutional investors. I quibble with the way they pose the question, making the chart a little difficult to decipher, but let me explain. First, see the chart below:

Crash Likelihood Still Seen as High

Source: FactSet, Yale School of Management/International Center for Finance, as of February 28, 2012.

The question is asked in a way that the reading expresses the percentage of survey respondents that believe a crash will not occur. In other words, as per the latest readings, less than 25% of the survey’s respondents, either individual or institutional, believe the market won’t suffer a crash. Put another way, more than 75% believe there’s a high likelihood of a crash. This is a clear sign that the “wall of worry” the stock market likes to climb is still very much intact.

Investors loving bonds

Much of what I’ve highlighted above are sentiment measures of attitudes, not actions. One clear way to judge the latter is to look at mutual fund flows. Given that the past five years have seen a record $1.3 trillion spread in favor of bonds over stocks, I agree with the notion that investors have yet to become overly enthused by stocks.

All About Bonds

Source: FactSet, Investment Company Institute, as of February 28, 2012.

I also think fund flows help explain why trading volume has been so low. Simply, the retail investor has not been engaged with this market rally and much money has remained on the sidelines. Add to that the fact that high-frequency traders (HFT), which accounted for over 70% of last year’s trading volume at times, are under a magnifying glass held by the Securities and Exchange Commission (SEC) for questionable trading practices. This has likely kept many of the HFTs in hibernation.

Businesses happy; consumers less so

Let me step off the market path for a moment and share another interesting sentiment analysis. Last Wednesday, the Business Roundtable recently released its first quarter CEO Economic Outlook Survey, preceded the day before by the release of the Conference Board’s measure of consumer confidence. CEOs are now as optimistic as they were during much of the pre-recession period. Although they cite headwinds including Europe, China, oil prices and US political uncertainty, they do not believe they will materially impact their business.

On the other hand, consumer confidence pulled back from a still-weak reading in the latest report. It had risen sharply in February. The level of confidence, with a headline of 70, is well below where the index stood during prior economic expansions.

For what it’s worth, CEO confidence has historically acted in a similar manner as the aforementioned “smart money” and its high level of confidence is comforting. On the other hand, very weak periods of consumer confidence have typically been accompanied by higher stock market gains, as the consumer has historically acted in a similar manner as the aforementioned “dumb money.”

Schwab’s survey says

Finally, we have a new survey from Schwab of its active traders. The latest Charles Schwab Active Trader Sentiment Survey polled 421 individual investors who trade frequently and found 51% now consider themselves bullish—the highest level since we began tracking active trader sentiment in April 2008. This is up from only 25% in October 2011. Only 14% say they are currently bearish.

In sum, my optimism in the medium-to-long-term has not been dented by the latest sentiment readings. Last week was the 26th consecutive week of better-than-expected economic news. Of the 17 indicators that ISI tracks that did a good job tracking 2010 and 2011 double-dip recession concerns, only two are presently weakening, with First Call’s earnings revision index notably strong. However, I do think the market has become more vulnerable to negative news in the short term.

Important Disclosures

Tags: Cboe Volatility Index, Charles Schwab, Chief Investment Strategist, China, Complacency, Contrarian Indicator, Debt Deal, Factset, Fearless Leaders, Headwind, Liz Ann, Ndr, Ned Davis Research, Optimism, Plunge, Senior Vice President, Sentimentrader, Sidelines, Stock Market, Treasury Yields, Volatility Index Vix
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Some Observations On Recent Gold (And Silver) Volatility

Wednesday, March 7th, 2012

Submitted by Jeff Clark of Casey Research

The Face of Volatility

On February 29, gold dropped 4.8% and silver 6.2% (based on London fix prices). That’s quite the fall for one day. We’ve seen prices that have risen that much, too. But as I’m about to show, these ain’t nothin’, baby.

Based on our experience, we’ve been saying for some time that volatility will increase as the markets fight their way to the mania phase of this cycle – and that once there, the gyrations will jump even higher. This call doesn’t exactly require one to go out on a limb; it makes sense since more investors will be crowding in – and volatility was high in the 1979-’80 mania.

First, let’s put last Wednesday’s big plunge in perspective. Here’s a picture of the daily changes in the gold price since 2003, based on London fix prices. (This chart is very busy, but I want to show the bulk of the bull market in one visual.)

(Click on image to enlarge)

A 4.8% decline is one of gold’s bigger one-day movements over the past nine-plus years. But as you can see, there have been a number of days where gold rose or fell more than 5%. And it exceeded 6% on five occasions.

Here are the data for silver.

(Click on image to enlarge)

Last Wednesday’s decline of 6.2% was one of the metal’s bigger one-day movements. However, it’s exceeded 10% on 14 occasions, 15% three times, and rose an incredible 20.06% on September 18, 2008.

You might think this kind of volatility is high – and it’s true. Worse – or better, depending on how you see things – the volatility in the underlying commodity is magnified in the related company stocks. This is why Doug Casey calls mining stocks, especially the juniors, “the most volatile stocks on earth.” But the thing is, metals volatility has been higher in the past, particularly during a mania.

Here’s what I mean.

The following chart documents gold’s daily price changes from 1976 through the end of 1980. Take a look at the jump in volatility in 1979-’80.

(Click on image to enlarge)

Volatility became the norm in 1979 and especially 1980. Fluctuations of 4% or more were not uncommon.

Here’s the same chart for silver. The metal’s volatility during the 1979-’80 period became extreme.

(Click on image to enlarge)

Daily price movements of 6% or more didn’t occur once prior to 1979 – but then they became commonplace.

I wanted to take a closer look at the biggest price fluctuations during this period, so I ferreted out the largest days of volatility for each metal. For gold, I selected daily movements of greater than 5%.

(Click on image to enlarge)

During this five-year period, gold saw fluctuations greater than 5% on 38 days (19 up, 19 down). Not surprisingly, more “up” days occurred leading up to gold’s peak of January 21, 1980, and more down days came after it.

And yes, gold rose an incredible 13.3% on January 3, 1980. As it turned out, that biggest one-day rise was only 18 calendar days away from the very peak of the market. And the biggest decline of 13.2% on January 22, 1980 was the signal that the top was in.

For silver, I used one-day movements of 10% or more, all of which occurred in 1979 and 1980.

(Click on image to enlarge)

The silver price had fluctuations of 10% or more on 34 days (17 up, 17 down). They occurred over a period of only 15 months, an average of more than two per month.

And yes, silver really did rise a whopping 36.5% on September 18, 1979.

So while last Wednesday’s price movements for gold and silver were big, we simply haven’t seen this kind of volatility in our current bull market.

Now let’s have some fun. Let’s say we match the most volatile days from 1979-’80 at some point before the current bull market is over. If we use gold’s biggest up day (13.3%) and biggest down day (13.2%), here’s what would happen to prices from various levels. Remember, these are one-day gains and retreats:

Imagine gold jumping from $1,800 to $2,039.40 in one day!

However, unless you think $1,800 is the level from which the mania starts, it’s more likely we’d see a 13.3% advance (or something similar) from a higher starting point. We’d thus probably see gold jumping to $5,665 from $5,000, for example. And further, that would probably signal we’re near the top.

Keep in mind that volatility worked both ways during the mania, so dropping from $4,000 to $3,472 or something similar is likely to occur as well.

Here’s the same table for silver, with its biggest up day of 36.5% and down day of 18.5%.

Can you imagine silver starting the day at $80 and hitting $109.20 before you go to bed that night? Something like that will probably happen at least once before this bull market is over. As with gold, though, that kind of movement is more likely to take place from a higher level, such as $100 or $125 (or higher?). And a fall like $100 to $81.50 will probably be part of the trend as well.

There are some definite conclusions we can draw from the historical picture:

• First, if history repeats, or even rhymes, our biggest days of volatility are ahead. And they will be normal.
• Second, big price fluctuations will be common as we enter the mania and approach the peak. In fact, when large daily movements become the norm, the historical record suggests we will be nearing the end of the cycle.
• Third, since current volatility has thus far been lower than what was experienced during the final phase of the 1970s bull market, we are not in a bubble, nor yet in the mania phase, and nowhere near the top. Remember that the next time you hear some nincompoop spew bubble talk on CNBC.

What can an investor do with this information? Prepare yourself for bigger daily swings – in both directions. And buying on those outsized drops is probably a good strategy…

Because we now know what volatility looks like.

Tags: Chart Documents, Commodity, Company Stocks, Decline, Doug Casey, Gold And Silver, Gold Price, Gold Rose, Gyrations, Juniors, Metals, Occasions, Perspective, Plunge, Price Changes, Related Company, September 18, Three Times, Volatile Stocks, Volatility
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Warning: A New Who’s Who of Awful Times to Invest

Sunday, March 4th, 2012

by John P. Hussman, Ph.D.

Last week, the estimated return/risk profile of the S&P 500 fell to the worst 2.5% of all observations in history on our measures. This is not a runaway bull market. Rather, it is a market that again stands near the highs of an extended but volatile trading range. I am convinced that the breakdown of the market from this range has been deferred only through repeated and extraordinary central bank actions.

Importantly, the market is again characterized by an extreme set of conditions that we’ve previously associated with a “Who’s Who of Awful Times to Invest.” The rare instances we’ve seen this syndrome historically are reviewed in that previous weekly comment. They include the 1972-73 and 1987 market peaks, and several instances since 1998. The more recent instances of this syndrome are shown by the blue bands on the chart below. Note that each of the separate instances in the 1999-2000 period were followed in short order by intermediate market declines of between 10-18%, and of course, ultimately by a plunge of more than 50% in 2000-2002. Likewise, the 2007 instance was followed in short order by a correction of nearly 10%, and a few months later by a plunge of more than 50% in 2007-2009. The more recent instances in 2010 and 2011 have also been followed by substantial market selloffs in each case, though with a longer lag in 2011 (due to ongoing QE2 operations). Aggressive monetary policy did not prevent the ultimate declines, though massive central bank interventions have undoubtedly helped to short-circuit the more violent follow-through that occurred in 1973-1974, 1987, 2000-2002, and 2007-2009, at least to-date.

A word of caution. While a few of the highlighted instances were followed by immediate weakness, it is more typical for these conditions to persist for several weeks and even longer in some cases (for example, the wide blue strip in late-2010 and early 2011). When we look at longer-term charts like the one above, it’s easy to see how fleeting the intervening gains turned out to be in hindsight. However, it’s easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that “this time it’s different.” For us, it’s particularly uncomfortable on days when our stocks don’t perform in line with the overall market, or when the “implied volatility” declines on our option hedges.

We can narrow the blue bands to a range within a few weeks of the exact peaks in 1999, 2000, 2007, 2010 and 2011 by further restricting to periods where the Shiller multiple was above 22 and advisory bullishness was above 50. While that restriction is so tight that it excludes several critical market peaks in history, such as August 1987, it actually still retains the present environment.

Even so, my greatest concern as an investment manager is the possibility that some number of our shareholders will grow so exasperated with remaining defensive during these periods that they capitulate and take a significant position in the market at the worst possible point. In a market that has now underperformed Treasury bills for more than 13 years, with two plunges of more than 50% in the interim (all of which we anticipated), my hope is that shareholders recognize our record in identifying major downside risks, and understand – if not fully agree with – my insistence on stress-testing our methods against Depression-era data in 2009 in response to the credit crisis (see the semi-annual report for more on that subject).

The S&P 500 has experienced repeated bouts of volatility since early 2010, when even our existing ensemble approach would have moved to a defensive stance, but it is notable that the S&P 500 would have to decline all of 11% to return to its April 2010 level. The completion of the present bull-bear market cycle (and it will be completed) will undoubtedly present strong opportunities to play offense, but today stands among a Who’s Who of the worst historical times to do so. Particularly for investors who do not have a large number of future cycles between now and the point they will need to draw significantly on their assets, a defensive stance is crucial here.

While our defensive stance may seem interminable, it is important to keep in mind exactly where we are in terms of valuations, and exactly where we have been over the past decade. Since we can easily examine the investment positions that would have been supported by our ensemble analysis throughout market history, a few benchmarks may be helpful.

In market history prior to 1998, the ensemble methods that we presently use in practice would have supported a mostly or completely unhedged investment stance about two-thirds of the time. In contrast, since 1998, they would have supported such a position less than 20% of the time – periods which included 2003 (when in fact we lifted about 70% of our hedges), as well as much of 2009 and early 2010. Conversely, a tightly hedged investment stance was appropriate in pre-1998 data well under than one-third of the time, while a full hedge has been appropriate the majority of the time since then. As for “hard negative” periods where we find ourselves openly using the word “warning,” we find only 3% of pre-1998 periods that justified such a view, but fully 23% of periods since 1998 – including today – where our market views would have been so unfavorable. As noted at the outset of this comment, the present situation is actually somewhat worse than that, standing in the bottom 2.5% of all historical periods in terms of the prospective tradeoff between return and risk.

In short, the period since 2008 has been extraordinary in terms of how often a hedged investment stance has been appropriate. The validation for such a defensive stance should be obvious given the fact that stocks have underperformed Treasury bills since that time, including two separate market plunges in excess of 50%. While much more frequent hedging has been required, even the past decade supports the expectation that the completion of the present bull-bear cycle will produce substantial opportunities to accept market risk. Our present defensiveness is unlikely to persist a great while longer, but my hope is that the basis for our current position is clear.

A Menu of Bitter Pills

“Over the past 30 years, an offensively minded Federal Reserve and their global counterparts were printing money, lowering yields and bringing forward a false sense of monetary wealth. Successful investing in a deleveraging, low interest rate environment will require defensive in addition to offensive skills. Interest rates have a mathematical bottom and when they get there, the washing of the financial market’s hair produces a lot less lather when it’s wet, and a lot less body after the blow dry. At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the financial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry. The offensively oriented investment world that we have grown so used to over the past three decades is being stonewalled by a zero bound goal line stand. Investment defense is coming of age.”

- Bill Gross, PIMCO March 2012 Letter

“You simply cannot create investment opportunities when they’re not there. When prices are high, it’s inescapable that prospective returns are low. That single sentence provides a great deal of guidance as to appropriate portfolio actions. Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit. That same pattern of taking new and bigger risks in order to perpetuate return often repeats in a cyclical pattern. The motto of those who reach for return seems to be: ‘If you can’t get the return you need from safe investments, pursue it via risky investments.’ It takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment. Patient opportunism – waiting for bargains – is often your best strategy.”

- Howard Marks, Oaktree Capital, The Most Important Thing (2011)

The present menu of investment opportunities continues to be among the worst in history. Treasury bill yields stand at only a few basis points. The 10-year Treasury yield is just 2%. The 30-year Treasury yield is just 3.1% to maturity. Corporate bond yields are at 3.2%, the lowest level since 1955. Meanwhile, we presently estimate that the S&P 500 is likely to achieve an average (nominal) total return of just 4.3% annually over the coming decade.

With respect to projected stock market returns, our standard valuation methodology has provided an extremely accurate guide, both historically and even over the decade through last week. The only notable exception was the result of the late-1990′s bubble, which was so unusual that we have now seen 13 years of sub-Treasury-bill total returns for the S&P 500. We did observe a brief period of undervaluation in early 2009, but at present market levels, valuations continue to be challenging. Better valuations will emerge as the present market cycle is completed. Arguments that stocks are “cheap on the basis of forward operating earnings” fail to adjust for the record high level of profit margins (about 50% above their historical norms), and also apply bubble-era norms for price-to-forward earnings multiples. This is the same argument that analysts made in 2007, and it is dangerously wrong.

Now, just because stocks are likely to achieve a total return of only 4.3% over the coming decade, we can’t conclude that it is impossible for prices to move higher and prospective returns to move lower (as they did during the late 1990′s tech bubble and the housing bubble ending in 2007). It’s just that with market conditions now extremely overvalued, overbought, and overbullish, the declines that generally follow have easily wiped out the speculative “tails” of already mature advances. Indeed, the typical bear market wipes out more than half of the preceding bull market gain.

Even assuming that reasonably positive economic growth is more than enough to offset any tendency for record profit margins to normalize, a further 10% market advance over a period of a year would reduce the prospective 10-year return for the S&P 500 to somewhere between 3.3% and 3.6%. Nothing in the evidence suggests that outcome, but should we speculate on that hope, given that previous ventures to such low prospective returns were ultimately followed by violent losses that wiped any temporary speculative gains? For our part, the answer is simply no.

Economic concerns remain difficult to escape

It’s worth emphasizing that our concerns about the financial markets here are distinct from our economic views, in the sense that the present syndrome of overvalued, overbought, overbullish conditions would be hostile even if we were more optimistic about economic prospects. But it is also worth emphasizing that many aspects of recent economic data have been more favorable than we observed last summer.

For my part, I have no interest in overstating the case for recession risk, but I am also convinced that these concerns have been abandoned much more vigorously by investors than is really warranted by the evidence.

In terms of coincident indicators, we can get a good overall picture of the improvement in the recent data by taking the average standardized value of multiple regional and national surveys. The recent bounce is clear, but we are still very close to the zero line, and of course, we observed a similar bounce in the lead-up to the 2007-2009 recession. So the recent coincident data certainly feels better, but we know from historical correlation profiles that there is not a great deal of leading usefulness in this data (see Leading Indicators and the Risk of a Blindside Recession ).

A week ago, Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) reiterated his own case for an oncoming recession saying “Consider it reaffirmed.” Achuthan observed that given a broad aggregate of GDP growth, real sales, personal disposable income, industrial production, and other measures, we’ve never observed a similar decline in year-over-year growth without seeing a recession. Note that Achuthan does not simply consider the extent of the decline from a growth peak, but instead defines a downturn based on what he calls the “three P’s” – pronounced, persistent, and pervasive. On this feature of the data, we are in agreement with ECRI – we’ve observed a uniformity of recession warnings in a broad set of leading data that we simply haven’t observed across history except in association with recession.

At the same time, we’ve also seen an improvement in some measures – particularly new claims for unemployment – where the extent of positive progress we’ve seen is not at all typical of pre-recession periods. Similarly, while year-over-year employment growth remains quite tepid, that growth rate has been rising rather than falling (though we also saw that just before the 1981-1982 recession). While we know that payrolls and new claims for unemployment are actually lagging indicators, not leading ones, we still generally see new claims for unemployment creeping higher before recessions, unlike today.

So from our standpoint, the essential question is whether the improvement in job growth negates the evidence from leading indicators, and from coincident indicators that are now at year-over-year growth rates also associated with oncoming recessions. As uncomfortable as it is to contemplate a renewed economic downturn, the weight of the evidence still leans to the leading indicators and coincident growth rates. Achuthan made this point very precisely, noting that “downturns in job growth lag downturns in consumer spending growth, which is very clearly in a downturn. That’s the sequence: jobs growth follows consumer spending growth, not the other way around.”

Tags: Amp, Blue Strip, Caution, Hussman, Interventions, Invest, Market Declines, Measures, Monetary Policy, Plunge, Rare Instances, Risk Profile, Selloffs, Short Circuit, Substantial Market, Term Charts
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Credit Plunge Signals “All is Not Well”

Tuesday, February 14th, 2012

European (like US) stocks remain in a narrow range just above the cliff of the unbelievably good NFP print of 2/3. US and European credit markets have lost significant ground since then and it seems equity investors just want to ignore this ‘uglier’ reality for now. The BE500 (Bloomberg’s broad European equity index) is unchanged from immediately after the NFP ‘jump’, investment grade credit is +10bps from its post-NFP tights, crossover (or high yield) credit is around 50bps wider, Subordinated financial credit is +50bps off its post-NFP wides at 382bps, and senior financial credit is an incredible 36bps wider at 225bps (by far the largest on a beta adjusted basis). The divergence is very large, increasing, and a week old now and perhaps most importantly as we look forward to LTRO Part Deux, LTRO-ridden banks have underperformed dramatically (40bps wider since 2/7 as opposed to non-LTRO banks which are only 10bps wider) – how’s that for a Stigma? Some ‘banks’ have suggested the underperformance of credit is due to ‘technicals’ from profit-taking in the CDS market – perhaps they should reflect on why there is profit-taking as opposed to relying on recency bias to maintain their bullish and self-interest positioning as the clear message across all of the credit asset class is – all is not well.

European financial credit is at over a two-week wide here and across the board credit markets have underperformed since the NFP print – perhaps they saw through the headline numbers?

European financial stocks ignored credit last week and then caught up, we now see the divergence growing dramatically. If nothing else, its an arbitrage opportunity but the drift in spreads is much more than technicals here and we suspect is a realization of the growing impact on the capital structure of banks of the ECB sucking up all the collateral supporting it (while capital is not exactly being raised hand over fist).

The most glaring divide remains the ‘stigma-trade’ where we have seen LTRO banks underperform dramatically (wider by 40bps) over non-LTRO banks (wider by only 10bps) and this is perhaps the key for why banks overall are underperforming.

Either way, it should be drastically clear to any and all (that choose to look and not ignore relaity in the interest of a fiat-currency-numeraire-based stock market ‘hoping’ for more printing) that all is not well in the Euro-zone. It is also not just Europe (as we have discussed for a week now) as high-yield credit in the US is also sending warning signals.

Charts: Bloomberg

Tags: Adjusted Basis, Arbitrage, asset class, Bias, Capital Structure, Credit Markets, Crossover, Divergence, Drift, ECB, Equity Index, Equity Investors, European Equity, financial stocks, Hand Over Fist, Investment Grade, Plunge, Realization, Self Interest, Stigma
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The Dow – a Scary Chart Indeed

Thursday, November 24th, 2011

With the Dow’s plunge of more than 90 points during the last hour of trading yesterday, the Index’s closing level of 11,257 came within a whisker of registering an ominous technical break on its Point & Figure chart. In fact, the Index needs to breach 11,250 – a mere seven points away – to add another “O” to the chart.

With the Dow future back at about 11,300 this morning the jury is still out, but the picture certainly looks scary enough to warrant caution.

Click here to learn more about P&F charts.

Source: StockCharts.com, November 23, 2011.

Tags: Amp, Caution, Dow Future, Plunge, Scary, Seven Points, Stocks, Warrant, Whisker
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Dollar/Yen Pair Plummets To New Post WW2 Low

Friday, October 21st, 2011

The USD just dumped across all major pairs after the recent support in the USDJPY at 76.65 was just broken, leading to a huge plunge first in the Dollar-Yen, to a fresh post WW2 lowm and then in all other pairs. It is unclear what is driving this: probably some combination of QE3 expectations and technical trading now that the bottom has been taken out. The signal is irrelevant: it all originates at the central banks these days anyway. Expect imminent chatter of BOJ intervention to protect its exporters.

Intraday:

Longer-view:

Tags: Central Banks, Dollar Yen, Intervention, Pairs, Plummets, Plunge, Usdjpy
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Art Cashin’s Take on the ‘Twist’

Thursday, September 22nd, 2011

As usual getting Art Cashin’s pragmatic take on something as important as the Fed’s decision (which at this rate will need to be revised very soon), is quite a morning coffee, or for some, “fermentation”, treat.

From UBS’ Art “The Chairman Of The Fermentation Committee Ain’t Not Rogue Trader” Cashin

Analysis And Reaction On The Fly - This morning we will vary the format just a bit. Yesterday’s action appears to have been egregiously misinterpreted by a broad group of TV pundits.

There was an initial selloff that was clearly related to the FOMC and new policies (Operation Twist, etc.). That reaction ended around 2:45 and stocks began to rally sharply until about 3:10. Then stocks rolled over and went into near free-fall as the Euro plunged and the dollar soared. That plunge continued into the closing bell with nary a look back.

To put things in more real time style perspective here is an email I sent to some friends (trading types and journalists).

Untwisting “the twist”. As the closing bell approached Wednesday, I was approached by two different folks about the sharpening selloff and outlook for the Thursday opening.

I told Patti Domm of CNBC that only part of the selloff was a response to the Fed’s statement. I attributed more than half the anxiety to vague rumors out of Europe that things were rapidly unraveling. The rumors seemed to suggest that things in Greece or Italy – or both – were coming apart. I pointed to a violent spike up in the dollar (DXY) in the final hour of U.S. equity trading.

The other person was a floor friend who had a client with an error who was concerned about Thursday’s opening. Based on the above analysis (rumors/dollar), I suggested the opening could look ugly to downright nasty.

If you look at the minute by minute charts, the post Fed statement selloff had exhausted by 2:45 and stocks rallied into the beginning of the final hour.

As to “Operation Twist” – two key take-aways concerned mortgages and operational problems. The Fed will now reinvest maturing MBS payouts in new MBS purchases. They had been using the MBS dough to buy treasuries. By shifting mortgage payouts back into mortgages (and also targeting the 10 year Treasury) suggests the Fed is going “all in” to cut mortgages and dislodge a frozen real estate market. It would also put the Fed in a good spot to help facilitate a major government sponsored re-financing initiative (rumored for weeks). When Republicans awaken to this, expect a good deal of pushback on the “helping the re-election” mode.

The operational problem is in implementing “Twist” itself. Part of twist requires selling – or at least not buying short term treasuries (6 month to three years). At the same time, the Fed is committed to holding rates very low in this area until 2013. Somewhat like cross purposes.

Sorry for the lengthy note – but with TV pundits so far off base on what happened, I had to get my two cents in. Pull up a minute by minute chart and it will all jump off the page for you.

The Euro went into a virtual death spiral about 20 minutes before the Fed statement hit (and before stocks had any significant reaction of any kind).

That seems logical since the foreign exchange (currency) markets would be most sensitive to rumors on banks and bailouts.

Tags: Art Cashin, Broad Group, Closing Bell, Cnbc, Domm, Dxy, Email, Equity Trading, Final Hour, Fomc, Minute Charts, Morning Coffee, Outlook, Plunge, Rogue Trader, Selloff, Spike, Time Style, Tv Pundits, Ubs, Vague Rumors
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