This issue of CTD was written with significant input from Thatsabet and others. All charts and tables are from Bloomberg.
Equities: The week started off with the much anticipated official bankruptcy of GM. A clear case of sell the rumor, buy the news, the market shrugged off the immediate implications and started higher. Yes, GM and C are going to be replaced in the Dow Industrials by TRV and CSCO. The academic literature would suggest that GM and C will now go on to outperform TRV and CSCO, but this is a recap of the week. For those interested, check out New Evidence on Stock Price Effects Associated with Charges in the S&P 500 Index, by Anthony W. Lynch and Richard R. Mendenhall (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1298790) and countless others.
The main story this week in the equity markets was the 2-10 spread in bonds (see our bonds summary). The moves in bonds and FX are signaling some big mispricings (adjustments?). For starters, check out this chart:
This is the SPX and EUR/JPY. EUR/JPY is the ultimate carry pair and has been a pretty good barometer of risk in the global markets. While the rise of EUR/USD is at politically sensitive levels after the recent rise, the JPY is also at critical levels. Thatsabet believes that should the 94.5 level be violated, it might lead to an unwind in the EURJPY which in turn could cause an unwind and lead to pressure on global equities.
Thatsabet also points out that many people like Japanese equities here for a long-term investment. The Japanese are 20 years ahead of us in their path to clear the imbalances of bubbles. The chart below shows the correlation of the US 10-year yield and the NKY. Depending on the cause of the rise in US yields, the JPY could get stronger as Japanese repatriate their currency and drive their local markets higher. Full disclosure, I have been increasing exposure in client accounts to small cap Japanese equities for the past few months for fundamental, valuation reasons, but this confirms some of our initial hypotheses. The Japanese small cap stocks represent some of the best value opportunities globally at this juncture. We have been buying JOF and other yen exposure.
This week is full of charts because the pictures really capture a thousand words. So three more charts:
First, SPXFX – This is the SPX from the March lows until now valued in different currencies. In USD terms, we have experienced the biggest rally since the 1930’s, yet in AUD terms, the market is only up roughly 5%. The currency markets are not confirming the equity strength and are calling into question the US’s ability to fund its future liabilities.
Second, XLFSPX – This is what the banks (XLF) have done relative to the SPX since 07. This spread is still trending lower until we see that .15 is decisively taken out. More time is needed in order to determine the validity of this rally. Thatsabet compared buying XLF here to buying XLK (technology) in 2001.
Lastly, let’s head to the emerging markets. From 2003 to 2007, with reflation and decoupling a virtual given, the emerging markets continued to outperform relative to the SPX. Then, the world stopped. EEM fell off a cliff (at a rate significantly faster than the SPX – remember this is the ratio of EEM:SPX). Just as violently, the ratio shot right back up. Thatsabet defines himself as a cautious decoupler. I personally don’t believe the decoupling trade or mentality. I believe that the interconnected nature of the currency, bond, and equity markets along with labor mobility, decrease in international trade barriers, etc. means that decoupling is not the driver of the trade. It’s the reason we look at NKY and TNX and examine the interconnectedness of markets now more than ever. Decoupling will be a topic we discuss at greater length in the next few weeks.
Bonds: LQDTLT – This is what being long LQD (Corporate Debt) and short Treasuries has produced: 
Since the break in 4Q07, corporate debt has been in a bear mkt. What is now occurring is either an “exhale” and corporate debt is cheap (concur) or the markets are realizing that the US government has taken over the leverage from the private citizen and will have to issue more debt to fund the fiscal gaps. Thatsabet goes so far as to think that over the next several years, US GOVT yields will be higher than corporate debt and emerging market debt. I tend to disagree in the near to medium term, at least.
Looking at US 10-year yields, we are approaching 3.9% and may test the 4% levels. What are the implications for home refinancings, which have already slowed? What about asset allocation models for big institutions? At what point will they be comfortable with the yield and move from stocks to bonds? At what point will the higher yields be an impediment to any imminent growth? Just as critical will be the shape of the yield curve. A flat or inverted yield curve often signals a coming recession (it also makes it extremely difficult for banks to make money). We have been seeing a steepening yield curve with the 2-10 spread rising to levels not seen since the 70’s or longer. A steep yield curve implies that investors do not want to own long dated fixed income securities, often because of fear of inflation. Julian Robertson (article posted) is playing this for size. Pretty amazing seeing that it is already historically wide. He thinks yields are headed to 7% and possibly as high as 18%.
Currencies: The sentiment this week has been one of mixed messages. Dollar negative news continues, with gold rallying, yet no clear winner on the other side. The Euro continues to face its own headwinds, despite some recent strengths, and no viable alternative to the USD. The GBP is going through its own issues with Gordon’s government facing mounting pressures. Safe havens are becoming scarce.
Commodities: Check out the CRB in USD and EUR since Mid Feb (prior to rally). Broad index is up only 10% vs 25% in USD. The affects from USD weakness is being felt more by the US and USD fixed currencies. Either the USD catches a bid and fast or the world better quickly adjust to ever higher CRB prices. 
This is gold in USD AUD EUR JPY since the start of the 4Q08 selloff. Gold is positive in every FX to the tune of 20% except JPY which has been bid due to the carry unwind. I expect the XAUEUR to be the next blast off as the EURUSD is bound to correct. With everyone focused on DXY and the 78-80 level one needs to understand that the index is 57% EUR. The EU members will be finding it difficult to export with such a strong FX. A correction is in the cards.
On the energy front, oil is hitting the $70 mark and being used as evidence of a recovery. This is a chart of Mexico’s Oil Production. Their production seems to have peaked in 2003 and has been steadily declining since. Can they ramp up production or is the peak theory crowd correct? If the peak oil crowd is correct, what will happen to energy prices when demand really does rebound?
Economy: Jobs. Jobs. Jobs. US Initial Jobless Claims: We are currently at the highest level since 1979 (give or take). With today’s figures out, the unemployment rate is at 9.4%. That’s almost 1 in 10 people unemployed AND that’s with the numbers calculated very differently than 30 years ago. At the same time, Steve Ballmer of Microsoft threatened to move jobs abroad if the current administration continues to move towards making it prohibitively expensive to hire workers in the US. With labor movement into the US reversing as opportunities in emerging markets relative to the US increase, where will the growth come from? From where will we get the young people needed to balance our aging population. Note this chart was from yesterday and doesn’t include this mornings numbers.
And to top it off, our usual performance tables…first, are the major markets we’re following, and second are the main sectors’ performances relative to the S&P500.
Connect The Dots | Yaron Sadan | 
July 10, 2009 7:54 pm | 
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