Tuesday, June 28, 2011

Good and bad news from Wen Jaibao

As I read Macro Man's hilarious account of Wen Jaibao's tour of Europe, which begins as:
Dearest Papa,

Our grand tour of Europe continues and I must tell you, Papa, that it is just magical. The locals are so delightfully kind to us and have enthusiastically welcomed our entourage into their homes. But, Papa, their smallholdings are so sad, mainly untended and barely fit to support the livestock they keep. Their pigs are far from healthy, being underfed and almost at death's door. I feel so sorry for them, Papa. Please would you allow me to buy them some feed?
...and gets funnier still:
Today we have just returned from the most delightful village of Hungary, just outside Vienna. Their cheery demeanor was so charming I felt I just had to leave them one of your One Billion credit line notes. The joy in their eyes made it well worthwhile and, Papa, I so wished you could have been there to hear them singing your praises from the tops of their churches to St Reuters and St Bloomberg. Their delight was such that they have even promised 20% of their wheat harvest for the next 20 seasons, for your delectation! Oh Papa, would you believe it?
Seriously though - there is some good news and bad news coming out of Wen Jaibao's European tour. First, some good news came as the cries from the steeples of "St. Bloomberg" blared "Wen Says China Will Keep Investing in European Bonds in Vote of Confidence" [emphasis added]:

“China has actually increased the purchase of government bonds of some European countries, and we haven’t cut back on our euro holdings,” Wen told the British Broadcasting Corp. yesterday in an interview. These acts “show our confidence in the economies of Europe and the euro-zone.”
Some good news for a change. However, economic forecasting firm Global Economics warned not to expect China to hold up the eurozone:
Despite warm words of support from China's leaders, there is no reason to believe that China has the ability to solve the euro-zone's debt crisis. We estimate that China has already bought more than 40bn of euro-denominated assets this year, many in peripheral economies, and yet the crisis rolls on.

More tightening in China
On the bad news front, "St. Reuters" reported that China's Wen signals doubt inflation goal can be met:
Chinese Premier Wen Jiabao signalled for the first time that China would struggle to meet its 4 percent inflation target this year, underlining expectations that interest rates will rise further even as economic growth slows down.
This news signaled further tightening moves in China:

Wen's latest comments sounded somewhat less sanguine than his remarks on Friday, when he said China's inflation was firmly under control this year and should cool steadily. However, they may not alter investors' thinking about monetary policy.
...which increases the chances of a policy overshoot and a hard landing in China, though some brokers believe that the Chinese market is already priced in for a hard landing, which is a signal to buy:

Citic Securities Co. and China International Capital Corp., which predicted the drop this quarter, say the market will rally in the second half as inflation peaks and the government sustains the economic expansion by easing credit. EvenNouriel Roubini, the New York University economist who says China may face a “hard landing” after 2013, expects growth of at least 8.8 percent in 2011 and 2012.

“The market has basically priced in a very pessimistic outlook for the economy,” said Ling Peng, chief strategist at Shanghai-based Shenyin & Wanguo Securities Co., ranked China’s most influential research provider by New Fortune magazine last year. “A hard landing of the economy is very unlikely,” he said, forecasting the Shanghai index will advance as much as 15 percent by the end of the year to about 3,150.
This market is poised for a breakout but given the powerful cross-currents, I don't have any strong conviction about direction. While my most recent review of global markets tilts my bias to the downside, I am waiting for the signals from the Asset Inflation Deflation Timer Model and other indicators for some definitive confirmation.

Monday, June 27, 2011

Bear are in control around the world

As US equities tests its 200 day moving average, I took a tour around the world. The picture isn't pretty. It shows a market environment of the bears in control of the tape.

Starting in the US, a look at the SPX shows that the average is testing its 200 day moving average. Note how the 50 and 200 day moving averages are converging with the 50 day MA falling and the 200 day MA rising. Unless the market stages a significant rally here, we are likely to see a Dark Cross (indicating that a downtrend has begun) within a month from now.

Markets are breaking down in Europe
Moving across the Atlantic, the UK market has already broken down its 200 day moving average. At this rate, it could see a Dark Cross within a week.

On the Continent, the STOXX 50 has already experienced a Dark Cross indicating a downtrend in prices.

China plays look bearish
In Hong Kong, the Hang Seng broken support in mid-June and saw a Dark Cross last week:

The picture for the Shanghai market is a little better. Although the Shanghai Composite did see a Dark Cross last week, it rallied above a key resistance line after Premier Wen Jaibao declared victory over inflation in an FT Op-Ed  last week.

It looks ugly in CommodityLand
Regular readers know that I watch commodity prices closely as the canaries in the coal mine of global growth and asset inflationary expectations and commodity prices offer a slim ray of hope. A look at the CRB Index shows that commodity prices are testing its 200-day moving average, but the 50 and 200 day moving averages are also exhibitng the same pattern of convergence. We are likely to see a Dark Cross indicating a downtrend within a month.

The charts of the stock markets of the commodity tilted economies look uglier than the commodity complex. Here in Canada, the S&P/TSX Composite has already broken down below its 200 day moving average and it's showing the same pattern of converging moving averages leading to a pending Dark Cross.

Australia looks worse than Canada. The All-Ords has already seen a Dark Cross and the market appears to be in a well-defined downtrend.

The Russian market also broken down below its 200-day moving average for the second time last week.

Other BRICs in downtrend since March
No review of global stock markets would be complete without a visit to all of the BRIC countries. Here the picture looks uglier. Brazil saw a Dark Cross back in March and the market is in a well-defined downtrend.

The Indian market also saw a Dark Cross in March, though it is trying to stage a rally up to test a key resistance level.

A ray of hope?
The one ray of hope that I can offer the bulls is a mild positive diveragence showing that the market internals appear to be turning around a little bit. My favorite measure of risk appetite, namely the relative returns of Consumer Discretionary to Consumer Staples, is turning up. As the chart below shows, that ratio is rallying up to test a relative downtrend line.

The cyclicals are also showing a similar pattern of rallying on a relative basis.

I will be watching this space closely to see if risk appetite can come back in this sea of gloom. Given my previous observation about the weakness of the banks signaling rising systemic risk in the financial system, I am tilting bearish but I remain willing to be convinced otherwise (see my previous comments here and here).

Saturday, June 25, 2011

A glimmer of hope for the bulls

Further to my recent post entitled China to the rescue? Bloomberg reported that Chinese Premier Wen Jiabao stated that China will continue to buy European sovereign debt, including Hungarian government bonds, and support the euro:
China pledged to buy Hungarian government bonds and said it will “consistently” support the euro as Europe battles to fight its way out of a sovereign debt crisis.

China will buy a “certain amount” of Hungarian government bonds and remains a “long-term investor” in European debt markets, Chinese Premier Wen Jiabao said in Budapest today. This afternoon, Wen travels to the U.K. and then on to Germany on his three-country European tour.

“China is a long term investor in Europe’s sovereign debt market,” Wen said in translated comments at a press conference with Hungarian Prime Minister Viktor Orban. “In recent years we have increased by quite a big margin our holdings of government bonds. We will consistently continue to support Europe and the euro.”
Whether the "certain amount" is a token amount or the sign of significant commitment, it's impossible to know. Nevertheless, this is a glimmer of hope for the bulls in a world that is increasingly tilting bearish.

Friday, June 24, 2011

China to the rescue?

I recently speculated that there is an off chance that the Chinese could ride to Europe's rescue:
Chinese premier Wen Jaibao will be in Europe this weekend. Given that there have been reports that the Chinese have been diversifying away from USD assets and into euros, it would be in their interest to seen the euro remain a stable currency and minimize the risk of a breakup of the euro. As a result, China has a vested interest in the health of the euro and if a crisis were to occur, the PBoC could conceivably ride to the rescue.
See this Op-Ed by Wen Jaibao in the FT ahead of his visit entitled How China plans to reinforce the global economy. First, he takes a victory lap by stating that China came out of the Financial Crisis well with its stimulus program. As a result, China has stimulated domestic demand and lowered its trade surplus, expanded its social safety net, controlling inflation and the RMB has gained 5.3% since June 2010. He concluded with:
China will continue to work with other countries with common responsibilities. We should make concerted efforts to strengthen the co-ordination of macroeconomic policies, fight protectionism, improve the international monetary system and tackle climate change and other challenges. We should welcome the fast development of emerging economies, respect different models of development, increase help to least developed countries to enhance their capacity for self-development, and promote strong, sustainable and balanced growth of the global economy.
All this is highly speculative and I have no inside track on any information, but this sounds like it could be the precursor to a Chinese rescue package of the European banking system.

How do you say "QE3" in Chinese?

Wednesday, June 22, 2011

Don't get too excited about this relief rally

I have been expecting a relief rally for some time now (see Poised for a "transitory" rally). After the market strength yesterday and the news after the close that the Greek government had survived a non-confidence vote, stocks appear to be poised for a rally.

Indeed, my favorite overbought/oversold indicator, which had dipped into oversold territory, has now flashed a "buy" signal by rising above the 0.50 oversold line. Such conditions have historically resulted in a market rally that has lasted 1-3 weeks.

Don't get too bullish
Despite the short-term bullish bias to the market, I wouldn't get too excited about the upside potential of this market. I wrote on Monday that "I would be using market strength as a opportunity to lighten positions" and I stand by that comment.

First of all, it is rather disturbing that there was no relief rally in the Financials. Despite the market strength on Tuesday, the Banks underperformed on a relative basis. Note that I had warned that relative market weakness in the banking sector is a signal of growing systemic risk in the financial system that that assessment remains unchanged.

Second, Mark Hulbert reports that while bullish sentiment has retreated along with the market, consensus market sentiment is not bearish enough to signal a bottom:
The bottom line? While bullish sentiment has fallen since late April, its decline is less than the average drop at the beginning of past bear markets. And this was the case for all four of the sentiment indexes studied.

What could go right for the bulls
To be sure, there is a gleam of hope for the bulls. Fed Chairman Ben Bernanke could surprise the markets by hinting at QE3 on Wednesday - which would spark another "risk on" trade of enormous proportions.

In addition, Chinese premier Wen Jaibao will be in Europe this weekend. Given that there have been reports that the Chinese have been diversifying away from USD assets and into euros, it would be in their interest to seen the euro remain a stable currency and minimize the risk of a breakup of the euro. As a result, China has a vested interest in the health of the euro and if a crisis were to occur, the PBoC could conceivably ride to the rescue.

All this, of course, is just speculation about policy direction of different players on the world stage. The weight of the evidence, for the time being, remains with the bears.

Tuesday, June 21, 2011

RIMM vs. Nokia

Marketwatch recently conducted a poll: Nokia vs. Research in Motion: Who's in worse shape?

Who I am not crazy about the long-term competitive position of RIMM compared to Nokia, who I believe to be in comparatively better shape, tactically RIMM seems to be in a better technical position than NOK. Consider this chart of the relative performance of the two stocks:

RIMM is at the bottom of the trading range against NOK in the last two years. Tactically, this sets up RIMM to outperform NOK in the short term.

I would add that the caveat that putting on this pair trade is fraught with company specific risk and anyone who enters into this does so at their own risk. I would further suggest to define your risk and target levels before entering into such a speculative trade.

Monday, June 20, 2011

The dam breaks

When it rains, it pours. On Friday Macro Man detailed the big macro concerns the market faces (TMM=Team Macro Man), namely the US, Europe and China:
TMM reckon that the current state of the World can be described as follows:

The US: The slowdown is dramatic (more on this below) but positive actual GDP prints, a Pavlovian dog-like response in the form of dip-buying on weakness (learned over the past two years), and a belief in the Fed coming to the rescue have prevented both the PhD and punting community from embracing a negative view.

Europe: Smoke is coming out of the tail pipe, kangaroo-ing down the the road. Going to break down soon.

China: "DON'T TALK ABOUT ANYTHING NEGATIVE!" as China is the only hope the West has. It seems to TMM as though punters are looking through to the peak in inflation and holding onto the soft-landing view - something they sense from the fact that most commentaries on China they receive seem to talk about how too many people are fearful of a hard landing/inflation etc... where is the *real* consensus?
Of the three, I am least concerned about the US macro outlook. It appears that market is pricing in growth of about 2% but it is about to decelerate to 1%. Add in the end of a dose of QE2 market steroids, the adjustment process for the equity market will likely be painful, but such a move is best classified as a plain vanilla correction of 10-20%.

Europe's Bear Stearns moment?
The problems in Europe and China, however, have Russia Crisis or Lehman Crisis written all over them. Matthew Lynn, writing in Marketwatch, expresses the consensus opinion that a deal will be done to save Greece:
Forget all you’ve read about it being a catastrophe for the markets when it happens, however. Only things that nobody really forecast make prices move in any dramatic fashion. A Greek default is about as unexpected as Rafael Nadal making the finals at Wimbledon this year.

In reality, it is already priced in. And the Germans and the French aren’t going to let it happen until they know their banking systems are safe — so there isn’t going to be a Lehman-syle collapse.
Felix Salmon, on the other hand, believes that a Greek default has not been priced in by the market:
[N]o one has any idea what would actually happen in the event of a Greek default. In order for markets to be pricing in a default, traders would have to be buying debt now on the expectation that if Greece defaults the price of its debt would not fall further. I don’t think anybody’s doing that yet — as Stopford says, they might be taking risk off, but they’re not expecting catastrophe. If Greece were actually to default, I’m pretty sure that markets would fall further.

In 2008, Bear Stearns' hedge fund imploded in July - a precursor to the Lehman collapse a few months later. The Greek situation is starting to look a lot like Europe's Bear Stearns moment. Looking more closely, Joseph Cotterill at FT Alphaville writes that the ECB is caught between a rock and a hard place. Greek banks are experiencing a run on their assets, but where do they go for funding?
But whatever has caused the depositor flight, it’s odd that not many are making the connections to Greek bank funding at the European Central Bank. Having fewer deposits to draw on, the only other place Greek banks can go for replacement funding is from the ECB. That means pledging more, not less, Greek government-backed collateral.

So, what are we to make of the ECB’s repeated threats to cut off the collateral’s eligibility if the Bank is prevented from dictating terms on a bond rollover?
I have been closely watching the relative strength of the Banking Index (BKX) as a barometer of the market perception of systemic risk in the financial system. Previous technical breakdowns have been signals of serious problem, i.e. Russia Crisis (1998) and Subprime Crisis (2007). Looking at the chart, the relative strength of the BKX just broke down:
The relative performance of the BKX is important is because exposure to European credit doesn't stop at the shores of the Atlantic. No one quite knows how much indirect exposure American financials have to European credit in through the credit default swap (CDS) market. Kash at The Street Light has made a stab at estimating the exposure:
As last week's new BIS data showed, it appears that US banks indirectly have substantial exposure to the peripheral Euro-zone countries that are teetering on the edge of bankruptcy. Exactly what form that exposure takes is a bit uncertain, though it seems likely that much of it is in the form of credit default swaps (CDS) written by the US banks to provide insurance against default to the holders of bonds from Greece, Ireland, and Portugal.

But it's a bit frustrating not to have a clearer understanding of exactly what form this exposure takes. So I've been trying to see if there is any public information that can give us a hint about exactly how the big US banks have incurred such exposure.
The problem is, no one really know. Here are his tentative conclusions:
1. Bank of America, Morgan Stanley, and Goldman Sachs are the most aggressive in terms of taking open positions on default outcomes. But we have absolutely no idea how much of those positions (if any) were with peripheral Euro assets. Also, while the last two firms don't break out income attributable to CDS activities (at least not that I could find), B of A made a huge portion of their profits in 2010 from them. (Note that Citi did not indicate how much of the CDS protection that they sold was covered by purchases of CDS insurance, so they may or may not be in that list as well.)

2. The aggregate CDS exposures of the big US banks are certainly large enough to be plausibly consistent with the BIS estimate of about $100 bn in indirect exposures to peripheral Europe. If you add up the highlighted numbers (and make a guess at Citi's position), it seems reasonable to guess that the total net open positions on CDS protection sold to third parties by the big US banks is between $1,500 and $2,000billion. Attributing $35 bn of that (about 2%) to Greece, which has certainly had one of the most active markets (proportionally) for CDS contracts over the past year, doesn't seem to be a stretch.

3. Banks do not have to provide much detail about the indirect credit exposures that they take on when they sell default insurance through the CDS market. We have incredibly scant information about the positions that US banks take through default insurance, and therefore no idea about how any individual bank will be affected by a Greek default.

4. It's hard to find any other potential exposures to Greece, Ireland, and Portugal in the banks' public filings, other than through CDS contracts. Combined with points 2 and 3 above, the process of elimination suggests to me that CDS contracts are indeed likely to be the source of the bulk of US banks' indirect exposures to a Euro-zone default.
As for the current Greek crisis, I am sure that the troika will find the few measly euros to tide the Greeks over to the next deadline (though Mish has reported that Der Spiegel claims the agreement negotiated between  Merkel and  president Sarkozy has collapsed and Bloomberg reports Europe will pressure Greece by withholding half of the next tranche of money). In the next round of negotations that begin in July, the rescue numbers start to get much bigger. If the Greeks default or restructure, the Apocalypse looms. Here is what I think happens next:
  • The Irish, the Portuguese and the other peripheral countries will cry, "What about us?" The troika may the resources to rescue the Greeks, but they will be faced with a wall of protests to "reschedule" other peripheral debt. As an example, consider this interview with Kevin O'Rourke on the Irish attitude that the EU "owes" Ireland for bailing out the Irish banks and therefore deserving of relief.
  • A flight to safety will ensue. Risky assets get sold - the result is a cascading "margin clerk" market where everything gets sold.
Does this sound like a Lehman moment about to happen?

China: The elephant in the room
In addition to the looming crisis in Europe, the risk of a hard landing in China is real and it could spark a substantial selloff in risky assets as the markets price in a synchronized global recession. Such a prospect is too scary to contemplate in a fragile global economy.

The indications of a China slowdown are already there and real estate prices are cooling. Last week Standard and Poor downgraded Chinese developers' outlook from "stable" to "negative". Moreover, the Hang Seng Index has decisively broken support, which is a sign of trouble.

The technical picture of the Shanghai Composite is more complicated. It has broken an initial level, but arguably it is now trading in a support zone.

Will the Chinese authorities be able to engineer a soft landing? It's starting to look a little dicey, given the economic headwinds of China's trading partners in North America and Europe.

Given that the markets are oversold and poised for a tactical rally, I would be using market strength as a opportunity to lighten positions.

Addendum: David Merkel pointed out to me that Bear Stearns blew up in 2007, not 2008. I stand corrected.

Wednesday, June 15, 2011

Getting the China call right

In the current investment environment, getting the China call right can make or break a career. The bull case for China and the emerging markets is well known. For the bear case, just consider this CNBC interview with noted China bear Jim Chanos. In the wake of poor loan growth figures, Doug Tao of Credit Suisse now believes that the risk of a hard landing is rising.

So it is with great interest that I read some more balanced comments about China's excesses from Patrick Chovanec. Here is an example about the property bubble in China:
It will take a significant change in attitude for Chinese investors to starting bailing out of property. How and when that will happen, I am not sure. But of course, that’s the tricky thing about bubbles — since the beliefs that sustain them are not based in economic reality, but in economic misconceptions, psychology, not economics, is what finally tilts the balance one way or the other. If the market stumbles, and that stumble confirms growing fears on the part of investors, the turn in sentiment can be severe, all out of proportion to any real change in underlying conditions. Will this happen in China, now that property prices seem to be going soft? Possibly.
If the Chinese sell property, Chovanec rhetorically asks, "Where would the money go?"
If the Chinese do start pulling their money out of real estate, one reporter called to ask me, where would they put it? After all, one of my arguments for why people in China use property as a “store of value” is lack of attractive alernatives. Well, assuming they successfully find a buyer (which is always the problem when everybody decides to sell), there are three possibilities:
  1. They put it into other assets. Last spring, when Chinese investors got spooked about government plans to “cool” the real estate sector, a lot of them started putting their money into gold instead. Jade, artwork, antiques, or even stockpiles of commodities like copper or nickel are potential alternatives. We could even see a situation where Chinese investors bail out of real estate in some cities, which they see as vulnerable, only to buy property in others — in which case, we could see some markets drop while others continue rising, for now at least.
  2. They spend the proceeds. If Chinese investors decide to cash out of real estate, and try to turn the proceeds into buying power to improve their quality of life, expect a surge in consumer inflation. Given the explosion in China’s money supply (by more than 50% over the past two years), the question isn’t why inflation is treading 5%, but why we haven’t seen more inflation sooner. The main reason is because most of that new money went into investment rather than consumption, mainly fueling asset inflation. But if those inflated asset values are suddenly transformed into higher consumer demand, the CPI rates we’ve seen so far will look like small potatoes.
  3. They hoard the cash. If this happens, the velocity of money will drop and the money supply will decline — in effect, a lot of the money that was created the past two years will simply disappear. This is what happens during a credit crisis, and it’s called liquidation. The good news: no more worries about inflation. The bad news: a lot of financial assets people thought they owned will go up in smoke.
The post is well worth reading in its entirety. In addition to addressing concerns about the property bubble, he addresses other issues such as political unrest, Chinese foreign policy, etc.

Timing the turn
There is no doubt in my mind that China will both soar and crash, but timing the turns in China will not be easy. There are certainly signs of froth in China today. Consider, for example, this story from earlier this year about a Chinese multi-millionaire paying GBP 1 million for a dog because it's a good investment. Is this a sign of a major top?

When you are in a bubble or mania, the difference between the investment hero and goat is timing. During the internet bubble, I recall looking at the Netscape IPO and concluding that it was a sign of froth and it would be wise to stay away from the sector. That assessment eventually proved to be correct, but in the meantime, the markets saw the run up in internet stalwarts like AOL, Amazon, Yahoo! and a whole host of others, as well as the takeover of Netscape by AOL, before the whole house of cards collapsed on us. Yet others who timed the Tech Wreck top correctly are (rightly) hailed as heroes.

The lesson I learned from my Tech Bubble experience is that while it's good to be right, making money is more meaningful. While it is important to consider fundamentals, it's also ok to embrace the dark side and buy fundamentally overvalued assets with strong price momentum. These days, I depend on trend following models to spot intermediate term economic trends. Assuming that you have the right risk controls in place, these models should take you out when the trend reverses itself.
As for the question of making the right China call, I use commodity prices as the canaries in the coal mine of global growth and inflationary expectations. If and when they turn down, that will be the signal to exit the risk trade in general and China specifically.

Monday, June 13, 2011

Poised for a "transitory" rally

After six straight weeks of losses, the stock market is poised for a "transitory" rally. Investor sentiment has turned decidedly bearish, which is contrarian bullish. Most overbought/oversold indicators are well into oversold territory.

NYSE New Highs - New Lows
My favorite intermediate term overbought/oversold indicator is also signaling that the market is poised for a countertrend rally lasting 1-3 weeks.

Here is another warning for the bears. We are heading into option expiry week this week, which historically has had a bullish bias.

No all-clear for bulls
Nevertheless, the intermediate and longer term pictures doesn't look very positive. Measures of risk appetite has already turned down and the risk-off trade is in a well-defined downtrend.

Long term headwinds
In addition, Lakshman Achuthan of economic forecasting firm ECRI, which has corrected call previous recessions, stated that the US economy is on the verge of a sustained slowdown.

More worrisome is the technical position of the financials. I wrote before here that the BKX was on the verge of a relative breakdown. Such events have been associated with high levels of systemic risk in the financial system (i.e. Russia Crisis and Subprime Crisis). Well, the BKX definitively broke down last week, though it rallied on Friday to test the bottom of the relative support zone.

This relative breakdown is confirmed by the performance of the broader financials against the market.

Bottom line: The equity market appears to be setting up for a decline of unknown proportions. The decline could be just a plain vanilla 10-15% correction. However, there is a definite possibility that it could be something more serious, such as a repeat of the Lehman Crisis of 2008.

The markets are poised for a tactical rally. My inner investor is extremely cautious and inclined to be very defensive. On the other hand, my inner trader tells me that despite the technical breakdowns, don't start new short positions at this time.

Wednesday, June 8, 2011

The Fed's (inadvertent) role in the class war

To give some context to Bernanke's remarks yesterday about inflation being "transitory" and his apparent blindness to commodity inflation, investors should consider the recent paper by Gauti Eggertsson of the New York Fed which asked, "Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?"

Eggertsson discussed the episode in 1937 when the Fed saw a burst of commodity inflation and responded with a tightening policy. He rhetorically asked:
The question for the contemporary reader is this: If we could transport a modern-day economist back to 1937, would he or she have made the same mistake? My suggested answer—admittedly somewhat hopeful—is no. I base this view on the fact that most economists today distinguish between the temporary movements in the consumer price index that stem from volatility in commodity prices and the movements that reflect fundamental inflation pressures. Hence a modern economist most likely would have identified the price rise in 1936 and 1937 as a temporary upswing in commodity prices that did not signal a significant increase in overall inflation.
In other words, modern economists would view the current episode of commodity and asset inflation as transitory and the Fed should not react with a tighter monetary policy.

Different kinds of inflation = Different winners and losers
While there are the usual caveats to the Eggertsson discussion that it does not represent the views of the New York Fed, it is clear to me that the sanguine attitude towards commodity and asset inflation is dominant at the Bernanke Fed.

This got me to thinking about central bankers think about inflation, which is mainly measured as core CPI, or some inflation measure ex-food and energy, i.e. commodity prices. The central bankers of the developed world today learned in the 1970's the way to break the back of inflationary expectations is watch labor costs carefully. If you don't allow labor costs to rise, then you suppress the feedback loop that leads to ever rising inflationary expectations. (Meanwhile outside of the West, things are different. Consider this iMFDirect comment about how food inflation has affected the Middle East).

Indeed, we can see that philosophy at work at the Fed. The accompanying chart shows that US hourly earnings (red line) have lagged the increase in CPI (blue line) for the past few decades.

While that approach may be a solution to controlling inflation, such a technique creates different winners and losers. When the Fed turns a blind eye to asset inflation and but remains vigilant on wage inflation, it tilts the playing field in favor of the owners of capital and away from the suppliers of labor.

Add that to that the current ugly employment situation...

...a record low in labor's share of national income (as per David Rosenberg)...

...and the fiscal ingredient of ever present calls for lower individual and corporate income tax rates (but not payroll tax rates), you have the ingredients of a class war. Taken to its logical end, America loses its competitiveness and becomes Argentina.

Monday, June 6, 2011

The bulls attempt a goal-line stand

At the end of the week, the major equity market averages were looking dicey. The US equity market was at a level where it was testing support:

Moving around the world, a similar pattern can be found in the stock market in Europe:

...in Shanghai:

...Hong Kong:

...commodity sensitive Australia:

...and commodity sensitive Canada:

A tactical rally possible, but intermediate term internals point south
Given that the markets worldwide at now resting on technical support, look oversold on a short-term basis and investor sentiment is decidedly bearish, I would be prepared for a tactical rally lasting 1-3 weeks. After that, the market internals still look terrible.

Consider my favorite indicator of risk appetite, namely the relative performance of US Consumer Discretionary to Consumer Staple stocks. This measure shows that its relative uptrend was broken in mid-March, indicating that "risk on" trade was coming off, and went into a downtrend indicating that the "risk off" trade is now definitely on.

A similar pattern can be seen in the relative strength of the cyclicals, as measured by the Morgan Stanley Cyclical Index against the market.

The Industrials, which had been strong leaders since July 2009, are now rolling over and leadership change is often an indication of a sea change in market direction.

Rising systemic risk
As I have noted before (see On the fence, watch for an Apocalypse), the deteriorating relative performance of the financials is worrying. I am closely watching the relative performance of the BKX against the market. The violation a major relative support level has historically signaled rising systemic risk and financial panics (Russia Crisis in 1998 and Subprime Crisis in 2007). Looking at the chart today, the BKX has arguably already violated a primary relative support level, shown in blue. One could argue, however, that it is still testing a secondary support level, shown in violet.

In this week's newsletter [free registration required], John Mauldin pointed out to analysis from hedge fund GaveKal that came to a similar conclusion. GaveKal also found that their stress indicators are headed south:
As we have highlighted in recent Dailies, our Velocity Indicator has been heading south rather rapidly. At first glance, this might appear surprising as there are few signs of stress in the financial system today: corporate spreads are decently tight, IPOs continue to roll out, and the VIX remains low. Sure, Greek debt has now been downgraded below Montenegro’s and stands at the same ratings as Cuba’s, but even acknowledging this, the recent depths reached by our Velocity Indicator is still somewhat surprising. Why, in the face of fairly benign markets, is our indicator so weak?
GaveKal and I independently found the same result, which is the underperformance of banks is a sign of concerns over systemic risk [emphasis added]:
The answer is very simple and it is linked to the recent underperformance of banks almost everywhere. Indeed, with short rates still low everywhere, and yield curves positively sloped, we are in the phase of the cycle when banks should be outperforming. The fact that they are not has to be seen as a concern. So does the underperformance come from the fact that the market senses that losses have yet to be booked (Europe?)? Is it a reflection of a lack of demand for loans (US?) or that more losses and write-offs are just around the corner (Japan?)? Is the bank underperformance signaling that we are on the verge of a new banking crisis, most likely linked to the possibility of European debt restructurings? Or perhaps it is linked to the coming end of QE2 and consequential tightening in the liquidity environment (see our Quarterly published earlier today for more on this topic)?
In our view, any of the above could potentially explain the recent bank underperformance. But whatever the reasons may be, it has to be seen as a worrying sign. One of our ‘rules of thumb’ is that if banks do not manage to outperform when yield curves are steep, the market must be worried about the financial sectors’ balance sheets (given that, with a steep yield curve, there are few reasons to worry about the bank’s income statement).
Mauldin went on to warn about the contagion risk from Europe [emphasis added]:
There is $600 trillion in derivatives now loose in the world. Who knows which banks have written them and to whom? Who are the counterparties? We did not fix this with the last political fix. The next crisis has the potential to be just as bad or worse than 2008, which is why I think Europe’s leaders are so dead set on avoiding a day of reckoning.

Apocalypse not yet, but watch this space!
In addition, FT Alphaville highlighted a research note from Ruslan Bikbov and Priya Misra of BoA/Merrill Lynch. These analysts looked at cross-asset correlation, which is an indicator of systemic risk, and observed:
It is very unusual, however, to see high levels of cross-asset correlation together with declining volatility. This is because cross-asset correlations tend to rise during times of market stress, and these times normally experience high volatility.
They went on the point out the contagion risk which could result in another financial panic [emphasis added]:
Given that the assets under management of macro hedge funds are 30% higher than in 2007 and leverage has likely increased since the peak of the crisis, crossasset portfolios could be a potential for a contagion risk, which can be amplified further by the net short volatility base of the hedge fund community. The collapse of LTCM in September 1998 is a case in point. At that time a seemingly small shock in the EM (Russian default) resulted in severe global market volatility due to fire sales of an over-leveraged hedge fund community.
Given the likely oversold rally that is just around the corner, I interpret these conditions as Apocalypse Not Yet - but watch this space.

Investors should take steps and ensure that their portfolios are protected in case downside volatility (another financial crisis) and positioned to profit in the case upside volatility (QE3). I am, with the Inflation-Deflation Timer Model.

Friday, June 3, 2011

Where is the next bubble going to be?

Most recently, Paul Kedrosky wrote the following about investment bubbles:
The whole point of venture capital is to create and ride bubbles. To pretend otherwise is hopelessly silly, not to mention naive.

[On the subject of LinkedIn and the existence of a technology bubble:] And we are in the middle of major transformations, mostly driven by technology. It’s not surprising that public and private markets are excited about it all — there is much to be excited about, from mobile, to location technologies, to social technologies, to exa-data and on and on. The only thing that would be surprising is if all this didn’t get markets and investors jazzed.
Beyond following goings and comings of VC investment flows, how can we spot the next bubble? Qwest Investment Management just published my monthly article that considers the question of Where is the bubble going to be? If you are looking for a bubble, here is a chart of the mother of all bubbles:

Yup, it's a picture of human population growth. Bubbles will emerge from the story of rising human population, rising demand and human ingenuity. In the article, I examine the question of the next investment bubble and identify five possible candidates as investment themes:
  • Agriculture: It's the story of rising demand from newly affluent emerging market economies.
  • Water: We are running out of fresh water, which is essential for human survival.
  • Alternative Energy: The appearance of Peak Oil is likely to hasten the search for alternative energy sources.
  • Biotech: There will likely be a raft of life extension technology commercilization opportunities in the next ten years.
  • Nanotech: Nanotechnology advances are still in the lab but there are some mind blowing applications and truly transformative technologies to be seen.
More details here.