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October 20, 2008

Weekly Wrap-Up: Dislocation
by Adam Oliensis

Dear Speculators,

The following article was originally published at The Agile Trader on Sunday, October 19, 2008. If you would like a free one-month trial to our twice-daily service, please click HERE and then click the red "subscribe" link at left.

The stock market is clearly terrified right now, despite last week's SPX gain, which was the largest in percentage terms since February. The VIX is above 70% and 20-day historical volatility is above 77%.

As you can see, spikes on the VIX, which are very strongly correlated with spikes in historical volatility, have a very strong association with important market lows. (See highlighted areas on the chart above.)

But no market indicators are perfect. When markets are scared, they tend to be scared of something that is actually significant. And, as fearful as investors are currently, it's always possible for the market to become still-more scared...and even cheaper.

So, what, precisely, is the market scared of now? Well, the fear is in response to a whole family of factors, but when I look at the tens and hundreds of charts that I study each weekend, it is pretty clear that the market is reacting in a way that is out of scale to virtually every factor but one.

Earnings are deteriorating. The consensus for forward 52-wk operating earnings declined last week, as did trailing operating earnings and reported earnings for the S&P 500.

These deteriorations were being well represented in the SPX's decline from 1550-ish to 1250-ish. However, the SPX decline from the 1250 area down below 900 has disconnected it from the deterioration in earnings. While the SPX has fallen down into the range from which it bottomed in '02-'03, all 3 of our earnings lines remain between 50% and 100% higher than they were at that last cyclical market low.

Indeed, the anatomy of the decline on the earnings lines may now be showing us a constructively disinflationary picture with the lion's share of the most recent decline in earnings coming from the Energy sector.

The consensus estimate for forward earnings in the Financials has essentially been stable since the end of August. Meanwhile, Energy-sector earnings were 19.5% higher in early September than they are now. And this decline is strongly correlated with the roughly-50% decline in the price of Oil (which is intensely disinflationary).

Looking at SPX earnings growth ex-financials, ex-energy, we see that, while the picture is not terrifically encouraging, it is not horrifying either. Expectations for forward earnings growth are 2.9% above where they were 1 year ago (red line below), while trailing operating earnings (blue line below) are 4% above where they were a year ago.

Both the red and blue lines are well below trend rates of growth. However, while both are showing deceleration, neither is showing a negative growth rate. Moreover, the consensus for forward earnings relative to trailing earnings (black line above) shows an expectation of 13.25% in earnings growth over the coming 52 weeks.

Is that last estimate too high? Perhaps. And it may fall sharply from its current above-trend height. But, at present, it represents yet another metric from which the stock market has disconnected itself.

This next chart shows us Y/Y growth of trailing earnings (red line) plotted against the Y/Y change in the SPX (blue line). (This next includes both Energy and Financials.) Trailing earnings are down about -27.5 % right now. This is the second deepest cyclical trough in Y/Y trailing earnings since the Great Depression.

Meanwhile, the SPX is down -42.4% Y/Y, the deepest decline since the Great Depression.

While these numbers are egregious, the encouraging thing is that, as you can see, earnings growth tends to be extremely cyclical. It tends to move up and down, across the zero line, with the stock market often LEADING in terms of forming troughs, by periods of a year or more. Normal cyclical troughs in which the blue line hits a nadir either roughly a year ahead of, or at about the same time as the red line are highlighted in yellow. So, it is probable that from whatever low is finally formed on the red line, the stock market's Y/Y performance (blue line) will rise BEFORE the red line troughs.

Obviously, we have no clear indication of a reversal in either the blue or red line right now, but we do have a very deep trough, the kind of low from which the market has very strongly tended to rise in every cycle since the Great Depression.

Turning to the credit markets, Treasury Inflation Protected Securities (TIPS) market is dislocated as well. The 5-Yr TIPS Breakeven Inflation Rate (proxy for inflation expectations over the term of the security) has fallen, recently dipping BELOW 0% to -0.04%. That rate has bounced modestly back up to +0.04% as of Friday's close. Meanwhile the Real Yield (proxy for real growth expectations in the US economy) on the same security has risen as high as +2.88% (2.79% at Friday's close). The sum of these 2 figures (2.79% + .04% = 2.83%) is the yield on the 5-Yr Treasury. And the difference between the two (2.79% - .04% = 2.75%) is what I call the Goldilocks Spread, as it represents the relationship between expectations for growth and inflation. When the Goldilocks Spread is high and/or rising, that suggests that the market expects growth to outstrip inflation or to rise relative to inflation. In either case, historically, that has been associated with rising stock market. However, the current unprecedented height of the Goldilocks Spread (red line below), in combination with the crashing stock market, tells us that something is "broken" in the markets.

According to Bloomberg.com:

Bond dealers trimmed their holdings of TIPS as the credit crisis accelerated and lending dried up, causing investors to demand the most easily traded government debt. While TIPS account for almost 11 percent of the Treasury market, they make up less than 2 percent of the average daily trading volume among the 17 primary dealers of U.S. government securities, according to Federal Reserve data.

The supply of TIPS by the primary dealers that trade directly with the Federal Reserve fell by $986 million to $3.54 billion in the week ended Oct. 1, the lowest since July. Daily transaction volume fell 18 percent, according to Fed data.

"Breakeven rates reflect the extreme sensitivity to liquidity in the market," said Nils Overdahl, a bond-fund manager at New Century in Bethesda, Maryland, which oversees $500 million. "All markets right now are broken and to the extent that sentiment improves you will see everything gravitate back toward a more fundamental valuation."

As further evidence of dislocation, the SPX has disconnected itself from the ABX Index, which tracks the mark-to-market price of a tranche of Triple-A-rated mortgage bonds issued in late '07. During most of the stock market's decline the SPX and the ABX Index were strongly correlated, however, since the Freddie/Fannie bailout the ABX Index has risen (subsequently retracing some of its gain) while the SPX has crashed.

It is axiomatic in a "normal" real estate market that there are 3 important factors in determining value: location, location, and location. However, in the stock market right now the 3 important factors appear to be dislocation, dislocation, and dislocation.

So, what IS the stock market connected to? There are only 2 charts that have been making a connection. The first is the 3-month TED Spread (blue line below), which is the difference between the 3-mo. LIBOR and the 3-mo. Treasury yield. When the TED Spread is high it means that banks are demanding a very high premium in order to lend to one another. They remain terrified of the risk of default when lending to other banks. (Not exactly confidence-inspiring.)

The TED Spread recently peaked near 4.6%, up from a normal range of 0.5-1% in the long term. It has, however, dropped about 100 basis points (1%) since that peak, and it may be indicating that the worst of the crunch in the short-term credit market is easing.

So far, however, all the liquidity pumping from the Fed, as well as from a host of other central banks, has been slow to improve conditions in financial markets of all stripes. The process of de-leveraging banks' (and hedge funds') balance sheets has been ongoing. But, then again, we do have evidence that liquidity pumping tends to work through the system and into markets with a lag. This last chart shows the 13-wk annualized growth rate of M2 (the broadest measure of money supply still published by the Fed), set ahead by 8 weeks (red line) against the SPX (black line).

While the peaks and troughs of these 2 series disconnected in the '02-'04 time frame, historically there has been a pretty good correlation between the fluctuations on this chart. Clearly the Fed's money-supply-tightening regime following the March '08 surge worked to de-monetize commodity prices (Oil is down about 50% from its high). But it also de-monetized financial markets to an unprecedented extent. The most recent surge in M2 growth implies that there has been sufficient growth in money supply to support a rally of some size in the stock market, beginning as early as this coming week. However, as the example of '02-'03 brings to light, in periods of severe market stress, such money-pumping operations may need to be sustained in order to have their intended salubrious effects.

Given the sharp retrenchments of commodity prices, weakness in the labor markets, and the high probabilities of both domestic and global recessions, it would appear that the Fed has plenty of room to keep the liquidity spigot wide open for some time. They're basically committed to doing so by the Big Bailout plan, among other bailout commitments, as well as by their forecast for both slow economic growth and low inflation.

God help us if they don't. I'd hate to see a nasty recession turn into an economic era comparable to the 1930s.

Best regards and good trading!

Adam Oliensis,
Editor The Agile Trader

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