Weekly Wrap-Up: Frozen Credit

By: Adam Oliensis | Mon, Oct 6, 2008
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The following article was originally published at The Agile Trader on Sunday, October 5, 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.

Dear Speculators,

Financial markets across the globe are locked in vicious downtrends, collapsing under the weight of the unwinding of leverage, especially in Financial companies. The S&P 500 (SPX) is now approaching a 62% Fibonacci retracement of its rally off the 2002 low, at 1077.

Note: All data below, as of Friday, October 3.

There is some reason to look for support to hold at that level, but in the context of the freezing up of credit markets, support at this level is by no means a certainty.

Should 1077 hold as support, then a rally up to resistance near 1267 would represent a 38% retracement of the decline from the '07 high. Should 1077 fail as support, then a drop to 959 would represent a 76.4% retracement of the '02-'07 rally and would test the December '02 high (horizontal yellow highlight).

There are numerous fundamental divergences in various financial markets (charted below) that suggest that stocks should be in a bullish bounceback phase right now. However, presently, the seizing up of the short-term credit markets has trumped those bullish divergences. As you can see in our next chart, the TED Spread (difference between the 3-month LIBOR and the 3-month Treasury yield) has widened to a multi-decade high (it may be an all-time high -- Bloomberg.com's data only goes back to 1984).

As you can also see on this chart, when the TED Spread (blue line) has been rising during the past year, that has been bearish for stocks. Indeed, since last October, 4 of the 5 primary down legs on the SPX have been associated with spikes on the TED Spread.

The current TED Spread spike is approaching an altitude that is 2% above the prior high, which suggests that banks are just about shutting down the operations of lending to one another. To this point, all the various bailouts (Frannie & Freddie, Bear Stearns, and the Big Bailout, passed by the House of Representatives on Friday) have failed to sufficiently incentivize banks to begin lending again. They remain in capital-preservation mode, just trying to survive the current crisis without being taken over or going bankrupt, and not at all in profit-seeking mode.

A reversal in the TED Spread (among other short-term credit-market indicators) would be a positive for financial markets of all stripes (except, perhaps US Treasuries).


Before we look into the developing positive divergences (which should start to have some sort of salubrious effect on stocks by the end of this month), we should look at the underlying fundamental problem: the housing market.

For decades, the ratio of Median Home Price to Median Family Income lived in the range of 2.75-3.0. However, when the Fed began responding to the stock-market crash of '00-'02 by lowering interest rates and pumping money into the economy (especially after 9/11), this ratio began to elevate out of its accustomed range, finally rising to 4.1 by the middle of '05.

This ratio has declined since the middle of '05 to 3.33 or about 2/3 of the way back to its median level (2.92). If the current rate of decline continues, we will be back to a ratio of 3 by about the end of 2009, at which point the obvious "bubble" will have been deflated. At the current rate of decline, this ratio is projected to reach the median target in roughly 20 months, or around June of 2010.

The deflation of the housing bubble has been having a deleterious effect on the rest of the economy for some time, including in the jobs market, where Friday we got data on the 9th consecutive month of declines in the Nonfarm Payrolls data. The Employment/Population Ratio (EM Ratio) has now fallen to 62% from a high in December '06 of 63.4%.

As you can see on this chart, since the 1940s, declines of more than one percentage point on the EM Ratio have shown a perfect correlation with the NBER's ex post facto declarations of recessions. Moreover, declines of more than 1% almost always devolve into declines of at least 2% on the EM Ratio. So, on this series as well, it looks like we're probably no more than 2/3 of the way through the economic downturn.


Ok, that's a sampling of the bad news.

The good news (if you want to view it that way) is that there continue to be some parts of the financial markets that are responding positively to the Fed's liquidity pumping and bailout (or rescue) operations.

First off, mortgage bonds and various collateralized debt swaps (CDSs) have continued to trend higher following the Treasury's bailout of Freddie and Fannie.

This chart of the ABX Index (a tranche of Triple-A-rated mortgage bonds issued in late '07 declined this past week, but remains above the important support level of 50. A move above 55 would be a vote of confidence in the Big Bailout Bill ($700B or more) that passed through Congress last week. The prospects of both the (partial?) suspension of mark-to-market accounting requirements for illiquid securities (among which many mortgage bonds are numbered) and the Big Bailout have had the ironic effect of raising their mark-to-market prices; the promise of better liquidity/solvency conditions is having at least a modestly positive effect on liquidity/solvency conditions.

As far as government action goes, we also see that the Effective Fed Funds Rate is now operating more than a percentage point below the official target of 2%. The Fed has, at least on a temporary basis, executed a de facto rate cut, flooding the world with US dollars and reducing the cost of borrowing from them. Moreover, we can see the effects of Fed liquidity pumping in the growth of money supply; during the week of September 22 (which is the last data point available -- it's published with a lag) , the Fed pumped more than $165B into M2 (the broadest measure of money supply still published by the Fed). That is the largest weekly increase in M2 since the week following 9/11.

This next chart plots 13-wk annualized M2 growth (red line), set forward 8 weeks, against the SPX (black line).

Since 2001, with the exception of during the climactic bear-market low in '02-'03, which included the run-up into the Iraq War, there has been a pretty smart correlation between peaks and troughs in these 2 series (again, with M2 set ahead by 8 weeks).

The surge in M2 growth during the week of 9/22 up to a 10.91% annualized rate, projects for a fairly aggressive rally in the stock market, beginning by 10/27 (give or take a couple of weeks).

Of course, it's possible that fundamental economic/de-leveraging issues will cause some distortion of the bullish implications of the surge in M2 growth. But it certainly primes the pump. And, then, of course, there's the $700B promised by Treasury for buying up more distressed assets...which should have some kind of follow-on positive effect on the markets at some point fairly soon (especially if the ABX Index keeps rising, thereby diminishing the necessity of actually spending at least some of the $700B).

Finally, the Treasury Inflation Protected Securities (TIPS) market continues to discount decelerating inflation over the next 5 years (Breakeven Inflation Rate down to a multi-year low of 0.96%), and an uptrending Real Yield (proxy for Real GDP growth ) of 1.68%.

The combination of a rising trend in growth expectations and a falling trend in inflation expectations is historically extremely positive for the stock market. (It speaks to an increasingly "Goldilocks-ish" set of expectations.) And we can quantify this combination by subtracting the Breakeven Inflation Rate from the Real Yield. When we do that, we see that this spread (we'll call it the Goldilocks Spread, charted below in red) is now at a very high level of +0.72%, just off the last week's high of 1.04%, and at its highest level since the beginning of our database in 2003.

First of all, on this chart you can see how out of character is the wild surge in the Goldilocks Spread. (That's significantly a function of the decline in the price of Oil since July.) Next, you'll notice that I've highlighted in yellow periods when the Goldilocks Spread has been trending sharply higher. It's pretty clear, over the past 5 years, that whenever the Goldilocks Spread is trending sharply higher (yellow highlights) the SPX also tends to trend sharply higher.

This correlation suggests that the rally in the Goldilocks Spread from <-2% up to ~+1% "should" be associated with a very sizable rally on the SPX.

Except...

...that the squeeze in the short-term credit markets is bollixing up the whole system, and working to either obliterate or delay all historical precedents.

Finally, the SPX currently has a forward earnings yield of 9.01%. (That's 9%, with the 5-Yr TIPS Breakeven Inflation Rate of <1%!). Meanwhile the 10-Yr Treasury is yielding 3.64%. The spread between these yields (9.01% -3.64%) is 5.37%. We call this spread our Equity Risk Premium (ERP, pink line on the chart below)), as it represents the excess earnings yield that investors demand in order to take the risk of investing in stocks (relative to risk-free Treasuries).

The average ERP since 1960 is about 0.2%. As you can see, extremely elevated ERP (above 2 standard deviations from the median, near 4%) tends to be associated with market lows, not market tops, and has only occurred during 4 previous episodes: around the Bay of Pigs incident in 1962, around Nixon's resignation in 1974, in 1977-79 when inflation was headed up to 14%, and finally in the aftermath of 9/11.

While it remains terrifically difficult to call a local bottom on the SPX in the short term, if the incredible amount of liquidity being pumped into financial markets can work to unfreeze short-term credit markets (say, bringing down the TED Spread), we have all kinds of indicators (Equity Risk Premium, TIPS market's Goldilocks Spread, M2 growth, ABX Index) suggesting that a very significant mid-term market low is in the process of being hammered out. If, on the other hand, liquidity-pumping cannot unstick short-term credit, then ...well, then the economy has a real good chance of experiencing the worst economic downturn since the Great Depression. This latter is, in my view, a low-odds proposition, especially in light of the (perhaps overly) pro-active prophylactic monetary and fiscal policies being implemented.

Best regards and good trading!

 


 

Adam Oliensis

Author: Adam Oliensis

Adam Oliensis,
Editor The Agile Trader

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