Global Macro Roundtable
The following is an excerpt from our GMR #2 of 14 March.
Some Market Concerns
I've been sitting in my office recently, smoking my pipe occassionally, mumbling to myself and scratching my chin - I'm not senile yet though. In fact, dear readers, I'm going to give you the straight medicine - I am concerned. I just had a full check-up and my blood levels were all good - not bad for a middle-aged writer and market observer scurrying over piles upon piles of economic reports these last 7 or 8 days. The market check-up is not looking so good: it comes down to a foggy picture with a negative bias. As opposed to Clif I am a bit less optimistic as to the US housing outlook but that is just one concern. Others lurk. As can be seen right, lately the consumer index has taken a hit and gone far into negative territory while the green up-trendline has been broken. This is not to say that the US consumer per se has started a full retreat but it certainly is a MAJOR warning sign that the housing market has certainly shaken overall confidence - and what are markets about? - psychology. Today we see a new wave of lost confidence in late asian markets triggering a spill over into the European and US markets by the perceived weakness of US subprime mortgage lenders and markets continue down. This is not really news as the "unwinding" has been happening in waves but now it has been saddled upon more negative psychology along with sell triggers in black-box computer trading to create a frenzy of worry as to the underlying market fundamentals. It is likely that after a consolidation from the previous drop new lows will be tested in the coming weeks. The question I have is not so much whether this correction is over but rather if it is a "sustainable" correction. What do I mean? I mean that an equity market so intent upon a bullish bias for so long has come to the point where a market adjustment was necessary to wash out some of the weaker players as a 5yr. global liquidity ponzi scheme cannot forever ratchet up higher yields. But with global liquidity still quite abundant even with sustained tightening among central banks it must be questioned whether the markets will get a more robust washout or the markets will simply settle in from a lower correction without any major underlying behavioural or structural changes. It is doubtful whether large financial institutions are willing or even able to unravel complex investment instruments. Investment strategies combined with human tinkering (e.g. complex non-transparent ponzis and or high-risk yield strategies) is what may be the fundamental underlying RISK and not simply a percentage of mortgages not being repaid or defaulted upon.
So while the housing market has yet to test the July 2006 low in the chart (HGX) I believe we will see further downside to the 210-200 levels and expect a test of the July 2006 upcoming - possibly within the next 8-10 weeks.
In an interesting comment on Bloomberg by an economist, it was re-iterated that "sub" prime means exactly that ... sub standard. In the $8 trillion dollar mortgage market approx. 10% is listed as subprime (see graphic farther down), ie. it is not necessarily an unknown entity. The more interesting question is whether a "sector" event like US subprime mortgage financing becomes a more problematic "macro" event for the world economy. The logic would point to a "no" yet I remain worried by the possibility of contracted US growth due to consumer fears of the subprime issue (psychology) + historical issues shown in the chart below whereby the red box remains unknown and the fact that year on year earnings growth is set to contract more markedly as witnessed by the table below for the S&P 500. These factors combined with the fact that central banks around the world continue their monetary tightening across the board. The bottom-line is that a contracting monetary base (less liquidity RELATIVELY speaking, i.e. relative to what it has been considered "normal" these last years) combined with consumer fears on the back of mortgage defaults and the incumbent worries of the equity markets are facilitating a deflationary backdrop. Greenspan was not necessarily wrong in his comments that the markets are at or near the end of a cycle(s) - liquidity cycle, earnings cycle and housing cycle.
Courtesy: The Chartstore.com
What does this mean? It means that although the Fed may continue to speak of a "sector" event not threatening the underlying "strong" fundamentals of the US economy, they are seriously worried as to the psychological nature of its impact on the markets - they may control monetary policy but they do not control psychological perception, human fears nor do they really have complete transparency as to the risks associated with the stream of mortgage lenders whose subprime percentages have now reached 20+% in 2005 and 2006 of all mortgages lent. With housing "overhang" now totaling near 8 months of supply it must certainly be questioned how mortgage equity withdrawals (MEWs) could sustain consumers with ever increasing amounts of spending money while home prices are bound to fall in price - the simple answer is, they can't. On top of that, banks will now be less likely to give credit more freely. No, I say we are in for a correction and the Fed will adjust their FOMC statements accordingly.
Let us summarize the main points:
- Subprime mortgage credit sector is weak and will likely fall further
- Housing starts have dropped dramatically
- Housing oversupply points to falling prices ; consumers "feel" poorer à bearish
- Banks will likely tighten lending credentials à bearish
- We are now late in various cycles - central bank liquidity, earnings, housing
- Yield curves remain inverted (FFR or 3 mth. Treasury bill verses long)
- Real GDP has again been adjusted downward to just above 2%
- Capital spending has contracted in the last 3 quarters à bearish
- US manufacturing plunged 5.6% in January à bearish
- US Trade (im)Balance has now reached 8.2%
- Rising labour costs and downward pressure on profit margins à bearish
- Consumer credit is slowing substantially indicating consumer caution à bearish
- More lender risks lie around the corner - Fed may want to support via interest rate cuts
Going forward it is now my conviction that the Fed will be required to introduce more conciliatory language regarding the market outlook, and if as Greenspan stated the various cycles are ending, then likely it is now time the Fed return to a more preemptive loosening of monetary policy in order to provide "support" to the markets. As shown in the last GMR, the likelihood of the Fed holding rates was reduced but since then the markets have dropped substantially hence it is now even more likely that by Q3 07 the Fed will need to drop rates again and by year-end or Q1 08 we forecast here a rate of 4.50 to 4.75.
Although the EU markets have been caught up in the recent market correction, the Euro has in fact gained in recent weeks. As was mentioned above, what do US subprime mortgages have to do with the european economy ? Not a lot probably but it's about perception and psychology. Trade between the US and Euroland is a large block and should weakness spill over into the US then of course european exporters are at a double disadvantage of weak US consumption and potentially a stronger Euro.
The current spotlight in the eurozone remains strongly on the ECB and their outlook on the economy. With growth now seen to be on par with that of the US, the Euro economy looks stronger than we had in the past expected.
In most of the major economic surveys, Euroland businesses see stronger manufacturing and continued strength in exports especially to the expanded EU states, Russia and Asia. Likewise with falling or stabilizing unemployment figures, there is an inclination at this point to give EU business the benefit of the doubt concerning stronger growth. And this is what the ECB and Trichet are pointing to.
With their recent, and expected, rate increase by 25 bp to 3.75%, the ECB is falling in line with expectations especially with respect to their hardline on inflation, some have even now called the ECB the "new Bundesbank" referring to Germany's Bundesbank in the glory days of a strong Deutsche Mark.
As can be shown above, the ECB must now be nearing its rate hike regime in accordance with the Taylor rule thereby suggesting also, as with the Fed, that we are now late in the monetary tightening cycle whereby, admittedly, the ECB and other central banks have been trailing the US Fed.
At the last ECB meeting, Trichet had dropped a number of statements pointing that rates would likely need to continue higher for now by stating that :
"After today's increase, given the favourable economic environment, our monetary policy continues to be on the accommodative side, with the key ECB interest rates moderate, money and credit growth vigorous, and liquidity in the euro area ample by all plausible measures. Therefore, looking ahead, acting in a firm and timely manner to ensure price stability in the medium term is warranted."
It remains yet to be seen however how the ECB might react to the equity market correction of the last few weeks. An article by Matthew Lynn at Bloomberg stated that in a global correction risk-averse investors could potentially repatriate any risk back to their "home currency" thus increasing the EUR. But then again, if that hypothesis were to hold, the USD must also gain in relative terms. Nevertheless, a doubly tightening - a rate increase plus a strengthening EUR might be just a bit too much medicine for the eurozone economies. I suspect the ECB will do nothing in terms of rate movement for at least another few months into the summer timeframe before determining how far equity market corrections have run and whether the EUR has gained substantial strength by moving over the recent 1.34 high of December 2006.
The chance has increased, albeit minimally thus far, that the ECB will not raise rates, the question is only how much. Currently we project that the ECB will make good on its promise to raise once again and maintain their bias towards tighter monetary policy but thereafter we foresee a steadying rate of 4% by year end in line with a weakening US economy.
Market well on its way toward recovery
Here we are more than a week following last week's selling panic and stocks have held up well in the aftermath. The tape action of the past week shows strong underlying support and a drastically improving internal condition in the wake of the mini-crash. Yet the tape also shows that the market has its work cut out for it in the short term and the bottoming process isn't over yet.
The advance/decline volume ratio on Tuesday, March 6, was simply fantastic. It was something we haven't seen in a long while and I take it as a bullish indication. Interestingly, Investor's Business Daily and some other financial publications characterized Tuesday's (Mar. 6) recovery rally as occurring on "light volume." This simply isn't true as the *ratio* of buying to selling volume was extremely high and even total volume, while not as high as previous days, was still fairly high compared to the 52-week average. The bottom line is that the trading volume on Tuesday's rally was in line with what one would expect to see in the early stages of a meaningful bottoming process.
The latest AAII investor sentiment poll came out on Thursday, Mar. 8, and presented a picture of investors still scared over last week's decline. It showed the highest disparity in favor of the bears since Nov. 1, 2006, which marked a short-term turning point in the market from down to up. The percentage of bullish investors was reported by AAII this week at only 36%, the lowest reading since last summer. Meanwhile the bearish percentage was reported at 45%, the highest reading since last November. This is taken as a sign the market's "Wall of Worry" is still intact and is positive from a contrarian standpoint.
The foreign stock markets have been the major focus of the financial press
since the late February panic sell-off. As we've discussed before, even-related
market panics always tend to bottom quickly and go on to recover their losses,
often making new highs in the process when all is said and done. While there
may be an exception to this rule, off the top of my head I can't remember a
single exception. This holds true for any financial market.
Two weeks have passed since the panic selling, which started when Cheng Siwei, Vice Chairman of China's highest legislative body, made negative comments about the Chinese stock market. "We must force the children out," were his words in reference to his statement that 70 percent of China's domestically traded companies were worthless and should be de-listed. That remark sent China's stock market tumbling, along with a host of other foreign markets, spilling over into U.S. equities.
Yet here we are two weeks later and already China's Shanghai Composite Index (SSE) has recovered most of its losses and is just below the historic 3,000 level where it stood in late February, once again proving that panic- and event-driven sell-offs rarely last very long. The words spoken by Cheng Siwei, regardless of the veracity of his statement, were just words and did nothing to change the fundamental or even the momentum backdrop to China's stock market. That's why the recovery was so quick.
Here at home the panic selling in the S&P on Feb. 27 is being called a "phantom crash" by some since it technically came out of nowhere. The market technical and fundamental backdrop was in fine shape preceding the crash and there was no major cycle peak or bottom, either. Granted, you could make a case that short-term investor psychology at that time was too bullish, thus making the market vulnerable to a correction. But the severity of that correction in terms of time was unaccounted for by technical explanations alone. It was, plain and simple, a reactionary panic.
Speaking of market psychology, the main psychology indicators are in a super-oversold position right now following the panic decline. Some indicators have reached their biggest oversold reading in years, including the Total Put/Call Ratio, which recently exceeded the super-oversold reading from last July's intermediate-term bottom. Market psychology is sending a strong buy signal right now that's hard to ignore.
In the past few reports we've taken a look at some of the market's main psychology indicators, most of which are flashing major buy signals in the wake of last week's decline. One of the newer psychology indicators currently flashing a buy signal includes the Leveraged Fund Ratio, which combines the total funds committed to the bull and bear market ETFs and mutual funds offered by Rydex and Proshares (see chart below). This indicator is giving its strongest reading to date going back to 2005. In previous years it gave strong buy signals by indicating that too many investors were initiating short positions in the ETFs and mutual funds and of course when this happens the market inevitably reverses to the frustrate the sellers. Previous buy signals in this indicator were made April 2005 (major interim market low), October 2005 (another major low), June-July 2006 (major low), and now. In fact, the current reading of this indicator has reached the lowest level since August 2004, which at that time preceded a 200-point rally in the S&P 500.
The ARMS Index recently hit one of the biggest, if not *the* biggest, oversold extremes in its history, including the wake of the 1987 stock market crash. The Volatility Index (VIX) has hit its highest reading since the major market low of last June. AAII Investor sentiment last Thursday (Mar. 8) hit its lowest oversold reading of the year to date and one of the lowest since last June. The ISEE Sentiment Index has hit its most oversold reading since last October, which began an extended rally for the S&P 500. No matter how you dissect the put/call data you come up with major buy signals based on investor psychology alone.
The net reading of the market's psychology and internal indicators is that while the bottoming/consolidation process isn't over yet, the market is well on its way toward recovery. Money supply creation also continues to improve and this is helping to pave the way for an improving stock market outlook. Notice the latest yearly percentage change chart for MZM money supply (below). This is a major improvement from last year and it should translate into a bullish outlook for growth stocks as well as general economic improvement.
On the pop culture front, a motion picture described as "bloody" by the New York Times raked in an estimated $70 million in ticket sales this past week to become Hollywood's biggest hit at the present. The move "300" is based on Frank Miller's graphic novel about the Battle of Thermopylae in 480 B.C. It's a little hard to miss the graphic symbolism the film portrays and online media outlets were featuring promotional scenes from the film depicting a screaming and bloodied soldier with a sword in his hand. For years we've argued that the old Wall Street saying, "Buy when there's blood in the streets," can be applied literally as well as metaphorically. At past market bottoms we've brought to your attention blood-related themes (cultural, military, political, economic) that marked major lows in mass psychology and in turn presaged upward turns in the stock market. Could this be the latest sign that mass psychology has hit a major low with a stock market turnaround to follow? You already know that we believe the market indicators, and especially the psychology indicators, are flashing buy signals. We feel that the surge in popularity of the movie "300" is just one more indicator pointing to an internal low being in place.
A word on insider buying is in order. According to Scott Gambill of Emergent Financial, insider buying among the Russell 3000 stocks has spiked following the late February sell-off. Insider buying has been running at its highest level since the June 2006 market bottom following the recent panic decline. This is very significant and suggests a worthwhile broad market rally is likely to commence soon.