MacroView

This is a new feature we’re trying out that might become a regular addition for our subscribers: a daily MacroView, including a compilation of the most pertinent charts from different global markets. Please let us know your feedback.

macroviewFEB16

A new year, but not much has changed…

Sure, it will take a couple of weeks to get used to the “idea” of 2011, if not the reality. The main changes with any new year, in terms of investments, are structural. Tax losses have been taken, performance numbers have been set, bonuses have been calculated, etc. It is also a time of prediction, which is always a fun game.

For me, though, it’s also a time for reflecting. I spent most of 2010 getting increasingly concerned about valuation and inter-market relationships, most important of those is the impact that currency relationships will impact other asset classes. As I turned the annual leaf, I thought I would reexamine that posture, from both a numbers perspective, but also a bigger, more conceptual perspective.

It ain’t pretty. From a valuation perspective, the equity markets are as overvalued now as they were at multiple other peak, except 2000:

• The relationship of the S&P 500 to a regression trendline (more)
• The cyclical P/E ratio using the trailing 10-year earnings as the divisor (more)
• The Q Ratio – the total price of the market divided by its replacement cost (more)

“To facilitate comparisons, I’ve adjusted the Q Ratio and P/E10 to their arithmetic mean, which I represent as zero. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which I’m using as a surrogate for fair value,” said Doug.

According to this methodology, the Index is overvalued by 63%, 43% or 38%, depending on which of the three metrics you choose.

Source: dshort.com

These fundamental indicators are really bad timing mechanisms, because each of them could continue extending, but they all point to the same thing: equities are in a danger-zone.

What about treasuries? When Bill Gross, who in 2008 supported a trillion dollar deficit, now writes:

• American politicians and citizens alike have no clear vision of the costs of a seemingly perpetual trillion-dollar annual deficit.
• Policy stimulus is focused on maintaining current consumption as opposed to making the United States more competitive in the global marketplace.
• Dollar depreciation will sap the purchasing power of U.S. consumers, as well as the global valuation of dollar denominated assets.

Read the full article here.

Do we need to fear gold and USD going up together?

Spoiler alert: If you’re a serious inflationista, stop reading here. For those readers who are still open-minded and like to look at some other ideas…

For a while, we’ve been tossing around the different implications of inflation or deflation, stagflation or biflation. The ideas get complicated with ZIRP because at the limit, free money makes all relationships incoherent (think of the implications of negative TIPS yields, while experiencing deflation-like low rates in the 5 year treasuries; or the blowing out of the 10-30 spread – good for banks riding the curve, but for economy when banks prefer to lend to US goven’t rather than businesses).

The theme that I’ve been most inclined towards is some sort of biflation. To the same extent as “stagflation” was unthinkable until the 1970′s, biflation right now is unthinkable. Biflation will occur when we have deflationary pressures through a stronger dollar and lower asset (equities, bonds, real estate), coupled with increasing rates (contrary to any policy the Fed will implement). It means that cheap dollars won’t be recycled into risky assets and government securities. It is a new paradigm, and one which the Fed is not equipped to handle with its current set of tools.

Let’s start with the dollar. What would cause it to go up? The dollar will go up when investors realize two equally important things: the euro is flawed and eventually doomed and the yen is doomed.

How soon can the flight from the euro and yen begin? I think the turning point is upon us. Greece was a wakeup call that no one heeded and investors pressed the snooze button. Ireland is the next one. And if we fail to wake up, more calls will come. Already, German’s are starting to grumble about having to bailout their profligate brethren.

Taking one step back, the role of a currency is 4 fold:

• as a medium of exchange
• as a measure of value
• as a unit of account, and
• as a store of value

Each currency has some advantages and disadvantages in each category (for example, it’s really tough to use gold units in an accounting ledger, but it is bettter as a storage mechanism than a piece of paper that can be printed at will).

That digression brings us to why the USD and gold can go up together in this scenario. As flight from the euro and yen becomes a reality, US deflationary pressures will heighten with a stronger currency. At the same time, fear will drive assets towards gold. As one trader never fails to mention to me, “Gold will peak on fear, not greed”. He speaks truth. Perhaps its my own cognitive dissonance that allows me to think that gold and the USD can go up together, but the key is relative to what. I’m not making a call on which one will outperform on a relative basis (to each other). Rather, relative to all other assets or stores of value, both will benefit.

Which brings us to the ineffectiveness of the Fed. With a steep yield curve, banks have less and less motivation to lend to businesses – why should they if they can earn NIM by lending to the Fed? They shouldn’t. The translation mechanism from Fed to consumer is broken and QE is going to increasingly be seen as a pro-establishment, pro-Wall Street bonuses measure and the average US citizen will retaliate. First, let’s recognize that a steepening yield curve is not beneficial to anyone but the banks, and maybe that’s important as they try to fix their balance sheets, but maybe they should just take the charges and move on instead of putting taxpayers on the hook. Second, the money rushing around now looking for yield and return in risky assets is much like the money sloshing around in 1999 – misappropriated and bound for disappointment.

I have been discussing some of these themes for a long time, and have only been partially right (for example, metals have rallied since we spoke about them 2 years ago, but the yen is up significantly since last year when we went short). What makes me think now is any different? Even a broken clock is right twice a day. True. Yet, I will push back by saying that I was also early in advising clients to play it safe in 1998 and 1999 – 2 years early, in fact. However, the eventual collapse that clients avoided was not worth the potential upside. The same is here. The yen might go up from here, but the significant risk is to the downside. Same with equities. They might rally more, hit new temporary highs for a few days or weeks or months, but they will falter and it’s not worth the risk.

So, as we go into a weekend, after a huge run-up, QEII, elections, massive moves in currencies and gold at record highs, energy rallies (I like energy long term), unemployment numbers that are mixed at best, etc. I am wary and believe the fingers of instability are large and worrisome. We are indeed in a new normal, but it will not be a black swan when the corrections come.

Is anything down today? Oh yeah, our sanity.

If the Fed was targeting stock prices, which seems to be the case, then at least for the time being he was successful. So let’s review, in a situation where money is already dirt cheap but not lending is happening, the Federal Reserve decided to target stock prices (call it, asset prices in general to give it the benefit of the doubt) that are held by relatively few people. Hmmm.

Gold is close to an all time high and certainly at a 20 year high:

Meanwhile, the dollar is down, although not at it’s lowest point:

But it doesn’t matter where you look today, it seems like the reflation trade is back on, deflationists be damned. Except, the yield on the 10 year is going down. What gives?

This is the result of investors front-running the Fed purchases.

I hate sounding like a downer, and I hate that I keep beating the negativity drum, and I’m certainly not any perma-bear. But this is not sustainable, valuations are not where you’d expect for any long term decent return on investment, and any quantitatively driven excess returns will be met with a more serious downside impact that will show up in future returns, but more importantly show up in future standards of living. We will look back at this period with astonished incredulity at our own lack of foresight.

In 1999, a relatively few advisors and analysts were pointing out that valuations were unsustainable. Then we pointed out that accounting gimmicks, such as recognition of revenues, channel stuffing, etc. were unsustainable and only represented “borrowing” sales from the future. We now have the same two factors in play. In terms of the latter, we are borrowing from future consumption and GDP growth, but eventually we will need to pay it back. We see it on the macro and the micro level. Financial institutions are “borrowing” earnings from reserves, while on the macro front we are literally borrowing some GDP growth.

Could it be my own bias that is keeping me from fully participating in this rally? I’ve been examining whether my own stance has led me to a position that is difficult to back down from, and therefore all the analysis is skewed to confirm my hypothesis. The answer is – maybe. I say maybe because maybe we are in a new world, but I seriously doubt it. ZIRP might mean that stocks are undervalued, but I don’t think so. $600 Billion might stimulate job growth that will compensate for the cost of the program, but I doubt it. The Fed might be effective in reaching their goal of a weaker dollar, but I don’t have any faith that they can be effective in anything other than causing uncertainty. Japan’s currency might continuously get stronger, but I doubt it. China might grow endlessly and not have a real estate bubble, but, again, I don’t think so. No matter where I look at the underlying fundamentals and money flows, there are disconnects that will need to correct. Certainly, some big investors disagree with me, so it is not without hesitation that I take the other side of their trades. However, as a disciplined fact-based investor, I can’t allow myself to be dissuaded from the research – and for now, all signs point to trouble.

China – The Mother of All Grey Swans

New post from Vitaliy Katsenelson on China and Japan. The short version is that China is COMMUNIST! and the numbers can’t be trusted, while Japan is past the point of no return.

On China: I already mentioned that Russia used to do the same thing with numbers and ghost towns that looked great to observers, but were shams.

On Japan: The government won’t have an internal market due to demographics, and as the savings rate decreases, the international community will not continue funding JGB’s at 0% rates.

http://contrarianedge.com/2010/10/30/china-the-mother-of-all-grey-swans/

Look at the presentation. Understand the dynamics of overcapacity in China. Understand that demographics doom Japan’s currency.

Invest accordingly.

What I’m watching

It’s Friday evening and the markets are closed.

“Bombs on UPS plane” barely registered, but I have to think that the terrorists have an awful sense of timing. Next weeks elections already look set to place more Republicans in power, and whether you agree with the different parties or not, as a terrorist, I have to assume you like the Democrats on the margin. Which begs the question – why would you put national security back at the top of the agenda? Same goes for North Korea, where there are reports of some shots being exchanged on in the DMZ. Why now?

In my little corner of the world, I’m reviewing. Let’s start with the yen. It’s at new highs…again! This is a 20 year chart of the yen index:

Why? There are things in this  world, Horatio…

I continue to maintain my short exposure, without much fear. I’m not levered, it’s a small position, and I’m confident that the long term prospects of the yen are even worse than the USD, even with the QEII that might be announced next week. The risk is still to the downside for the yen.

Back here in the US, I’m reviewing both the 10 year yield and the 10-30 spread.

Bill Gross came out and said two words about the end of the bull market and everybody suddenly listens. The Fed can announce QEII and commit to purchasing bonds ad nauseum; however, this market doesn’t need easing, it needs jobs and confidence, neither of which will be accomplished by Bernanke if they continue on their current path.

Take a look at the 10-30 yield spread. This is a monthly chart of the past 20 years:

It has spent most of its time in the 0.9 range, but hit all-time lows earlier this month of under 0.6. Now, where do you think the risk lies? For spread to continue getting weaker? No. The 30 is leading the way, but the 10 will follow.

Which brings me to Dr. Copper. I can’t tell you how many people bring up metals and commodities, with a view that there is no end to the upside potential. Maybe. Probably not.

Take a look at the S&P to the commodity equity index:

It doesn’t matter which representation you look at. Look at SPX to gold if you prefer:

What does it mean? It might mean that Dr. Copper is telling us that the recovery is full-steam ahead and that equities will start to outperform on the upside. I doubt that. The other option is that commodities are going to pull back and lead equities down with them, albeit not at the same rate. Considering that GLD is one of the most widely held securities in Merrills retail brokerage accounts, guess which way I think we’re going.

Meanwhile, financials are weak and facing continued weak real estate conditions, limited visibility on their portfolios, and weakening consumer lending conditions. Real estate and jobs continue to be the big macro hurdles. The elections are already done and the incumbents are screwed, even the ones that will stay in power will do so only through extremely difficult conditions – this is a non-story and already discounted.

What happens when everything happens?

The past couple of days have been a little odd, and they’ve left me less time to put pen to paper (keyboard to screen?) – what happens when the very things we anticipated start happening?

Let’s start with yields…For months we’ve been discussing the historic levels of the 10/30 spread:

It’s couldn’t get wider forever and as a value-guy at heart, I like finding these types of extensions and looking for reversions to the mean. We’re getting it, but there’s more to go.

What about on an absolute level? 10 year yields could go down to 2%, but the risk is definitely to the upside (for yields, downside for prices).

What about currencies? The USD index is finding some support, and I think it’s found a floor. There is a lot of speculative money that is short the USD (short USD/long equities was THE trade for the past few months).

Lastly, what about equities? Equities are overvalued on a fundamental basis. No matter what justification is used, bull markets do NOT start from these valuations. There could be rallies, and powerful ones at that, but we are looking at 10%-15% upside potential with 30-40% downside risk. That’s a bad trade and a recipe for permanent investment losses.

The arguments floating around that QE will push assets up are valid. I get them. The arguments that USD debasement will continue are valid. But they are flawed. The Fed believes these arguments and is basing their decisions on them. The idea is push asset prices higher to stimulate spending (the wealth effect) and get the economy going.

It will fail due to two gaping flaw: the market has already discounted the efforts and is valued based on those assumptions. In order to get prices higher, the Fed would need to surprise the market with ever increasing levels of QE. The second gaping hole is the assumption that prices will actually rise. Prices of real estate are poised for 20% more downside based on various valuation methods, or more in certain areas with excess inventory of up to 18 years worth of homes!! Prices of stocks are 30% overvalued based on the q-ratio, and at best fairly valued, so room for upside is limited. Prices of bonds are already extended and have no place to go but down. So you have the 3 main stores of wealth poised for declines. There is nothing the Fed can do to change that.

Waiting with bated breath…

It seems as if every market is at a critical juncture and just waiting with bated breath. Which ones? Well, there are the important ones: currencies and bonds. Equities aren’t on the list of important ones right now, because they are just following the moves in other markets. The trade has been short USD, long equities – a reflation trade. The 10/30 spread has been blowing up as rates on the long end jump and rates on 10 years and shorter have been locked down. Great if you want to start a bank, not great if you’re poor and milk prices are rising at the supermarket.

Let’s start with the USD:

If the USD bounces here, it will generate an unwinding process where equities will have to be sold. It will be a domino effect that will cause one big Wall Street margin call. I’m positioned for this scenario. Many, if not most, investors are positioned for the USD to continue falling, believing the Fed can re-inflate the economy and seeking safety in equity earnings that they believe will rise with inflation.

If the USD doesn’t bounce here, then we can get some inflationary pressures. Equities might benefit, but the real beneficiaries will be the commodities and related companies. DBA certainly looks strong and has had a very nice move recently:

DBA, while a follower of the currency moves, also has something else going for it: geopolitics. With some freak draughts and weather related incidents causing additional strain to the already tense political maneuvering, DBA could benefit from increased protectionism as countries move to protect their domestic supplies. It could provide a good support, but this, again, is a critical juncture.

Meanwhile, the 10/30 spread, while off it’s historic lows is still at incredibly low levels:

In the meantime, EEM is possibly rolling over. I say possibly, because it hasn’t broken it’s uptrend, but with continuous inflows on the one hand, but emerging economies trying to dissuade those same inflows on the other, it can go either way – depending on the market’s view on the USD.

And on and on we go. The financials have been significant underperformers this year, and at some point (I think in the very near future), the large hedge funds holding the financials might be squeezed out. They’ll have to either liquidate their positions in BAC, WFC and the like, or they’ll have to liquidate in other markets (gold? USD? treasuries?). And let’s be real – can the equity market have a sustainable rally without the banks? I think not.

Every market I track is waiting to see what happens with the USD. I have been calling for a reversal day for a while, but I think it’s coming (maybe today is the day), which will signify the need to unwind the risk trade. That unwinding will involve USD getting stronger, equities and commodities getting hit hard. The real problem with that scenario is that there will be no place to park and hide.

10 o’clock update

All China all the time. China hiked rates by 25 bps because USD weakness is equal to Chinese inflation. Since China is the driver of commodity price demand these days, obviously commodities are taking it on the chin:

Meanwhile, between Chinese rate hike and Geithner making a “we won’t devalue the dollar” statement gold is feeling what happens when speculators get caught. Silver is taking it even harder. If you got in hoping to get catch the blast off, you should have remembered that “hope” is not a strategy.

And if that weren’t enough to keep you occupied, Apple is hovering back at $300, give of take $10, GS came out with earnings, that while good and keeping the stock up, weren’t as good as last year and in the meantime, the rest of the financial sector is back under some pressure.

Morning Update

Should have come sooner, but Citi is keeping me on the phones.

They need to do a SNL “REALLY?!” skit about Citi. Revenue dips, earnings surge. Really? Turns out loan loss provisions are down to where they were before the recession. Really? Citi sees less credit losses coming now than it forecast in 2007? And what about putting some funds aside for the whole mortgage mess? JPM put aside a billion dollars. Citi? About $300 million. Really? And on, and on…

Here’s Citi’s weekly chart.

Meanwhile, Apple continues it’s surge:

Why am I focusing on individual names (no position in either stock) when I usually focus on the bigger picture stuff? Well, because the individual companies are all that’s left to hold this market up. Apple is in essence the Nasdaq. Citi is driving the financials today. It certainly isn’t BAC nor WFC which got crushed last week. They’re barely holding on.

So the story is that the market is looking to these bits and pieces of mildly good news (although in my mind the news is awful and shows increased risk in the system) as reasons to rally. It won’t last. The turning point is upon us, and if I’m off, it’s by a matter of weeks or months, not years. It’s a bit scary to take the other side of the trade from Tepper & Co., but our continued focus on fundamentals and valuations warrants it.

The Week Ahead 10/18/2010

10 o’clock briefing

Markets are under pressure again. Dollar is holding up though and might have found a bottom.

In the meantime, banks continue to be under pressure from fraudclosuregate:

While the market awaits the Fed report on currency manipulation. This report will probably say nothing of substance, hope to put some shallow pressure on China, and leave it at that. But treasuries are selling off anyway with yield rising:

Elsewhere, oil is holding up remarkably well, GOOG is holding up the Nasdaq with a 10% gain after last nights earnings report, and consumer sentiment declined more than expected.

Let’s see if this is just profit taking or the beginning of the realignment we anticipate.

10 o’clock check in

Where to begin today? We’re a little late on the uptake because so much is new and so much is old.

The dollar continues its downward spiral with Singapore joining the rest of the world against the USD and Bernanke’s campaign for inflation. The currency wars are raging, and I’m not sure if winning is good.

Meanwhile, August trade balance is at -$46.3 billion – worse than expected. Assuming it doesn’t get revised even lower, it will still have a negative impact on GDP revisions for Q3. At the same time, the China bashing continues in Washington (as if that’s the problem).

PPI came in a 0.4%. We have been discussing the duality of the market – inflation in expenses, deflation in wealth. Well, food and energy were the main drivers of the increase. Sans those, and PPI was only 0.1%. That being said, most people don’t exclude energy and food prices from their monthly bills, so the average person is feeling it in their pocketbook.

Jobless claims came in at 462K (up from 445K), and the prior number was revised higher (no surprise).

On the other side of sanity, Paul Krugman discusses the need to increase QE by $8-$10 Trillion, while on the same day, the St. Louis Fed comes out with a report on why QE is bound to fail. It’s a mad world.

10 o’clock update

Looking around the markets it’s tough to discern fear from euphoria today.

Transports are running:

…while the bank index ($BKX) is lagging:

I’m hearing more and more people come out to describe a global inflection point, such as Marc Faber, but I don’t follow their logic entirely. Walk with me…

Interest rates are at a turning point and will start heading higher. Faber, and others, are recommending piling into stocks as the safe haven. I just don’t get it. Interest rates aren’t rising as a result of inflationary pressure. Incomes aren’t being pushed up, and earnings aren’t going to grow. Valuations such as q-ratio and Shiller P/E are showing equities to be 30-40% overvalued and even with printing, velocity of money has collapsed. During the last QE sessions, the US Fed pumped roughly $1.6 Trillion into the markets, without stimulating job growth, asset inflation, etc. So while I agree about interest rates rising, I am not convinced that equities are the place to park cash.

JPM reported and is heading lower – in an up market? Is this market move sustainable without the banks?

Meanwhile, even with additional fodder that the Fed will be supporting the treasury markets through QEII, and talk of targeting a 2% rate on the 10 year as a possible policy, the 10 year yield is rising. Sell the news?

10 o’clock check up

We’re constantly trying out new ways to update our subscribers, so we’ll start with a few charts to review:

The USD was due for a bounce and it’s lucky we’re getting one. Why? Because holders of US assets, specifically bonds have been taking it on the chin. Even though bonds have stayed strong, they’ve been losing on the currency translations. How long would they be willing to pour money into our treasuries? Probably not long. The Fed recognizes this and is stepping in as the purchaser of last resort. Fine for US investors, not great for the bulk of our treasury holders who need the USD to strengthen or we’ll see massive dumping. Its the world vs. the Fed in trying to determine USD strength and I’m not sure any of the outcomes are good.

Commodities are hot and they’re all over the news, and I live my wheat as much as the next guy, but these things look stretched. How much of this move is fundamental, demand-driven and how much is a reflection of a weak USD? Not sure, but Dennis Gartman postulated that the recent corn report may have been the result of some government shenanigans to drive up prices:

The farming communities in the Midwest are going to be resurgent, and the equipment manufacturers, the fertiliser sales organisations, the grain elevators and perhaps most of all the small local banks will benefit manifest and continually. After a decade of weakness, strength returns to the farming Midwest.

Read about it in the FT.com here.

I wouldn’t be surprised, but regardless, I’m wary of taking new positions in the space.

And a last couple of notes:

• Pfizer buys King Pharma (KG) for $3.6 billion cash. Nice.
• Fed minutes come out today at 2PM.
• Thailand tried to cool their currency by imposing a bond tax.