The Forces of Stability and Chaos, From David Kelly, chief market strategist, JPMorgan Funds
In theory, it’s quite simple: The value of stocks and bonds should be determined by profits and interest rates. These in turn depend upon relatively slow-moving variables such as economic growth, inflation, productivity, wage growth and the general attitude of policy makers. By these benchmarks, the outlook for U.S. and global stocks should be very bright and, while bond yields might rise, balanced investors should be able to look forward to a few years of comfort and gain in a general global economic recovery.
However, in the hyper-fast, hyper-connected and hyper-sensitive markets of 2010, investors have had little assurance that slow-improving fundamentals would yield financial gains or even be sustained in the face of financial convulsions. These opposing forces were fully on display last week and may renew their conflict this week.
However, as of this morning, the forces of stability should have an edge. Last night, European Union governments, acting in concert with the ECB, international central banks and the IMF, took some dramatic steps to calm the sovereign debt crisis.
- First, they agreed to establish a huge €750 billion fund to lend to countries whose debt is seen as under attack by speculators. This fund is being financed by €440 in contributions from Euro-member governments, €60 billion from the EU budget, and €250 billion from the IMF.
- Second, and crucially, these moves are being enhanced by an ECB decision to intervene in both public and private debt markets to “ensure depth and liquidity in those markets which are dysfunctional.” The ECB has also announced that it intends to sterilize these purchases, presumably selling the debt of more stable countries while buying the debt of more vulnerable ones. This can allow it both effectively to control the overall growth of the money supply and to maintain the principle of not “monetizing” government deficits in general.
- Finally, the ECB has announced other measures in coordination with the Federal Reserve and other major central banks designed to stabilize short-term money markets.
This package contains a commitment by many European nations to take aggressive steps to meet deficit targets both this year and over the next few years, a fiscal tightening which could slow the European recovery and have some more modest negative impacts on growth around the world. However, if fully implemented, this massive package should have a good chance of routing the forces of chaos, at least for now, allowing U.S. investors to refocus on fundamentals.
While the volatility of last week has reawakened memories of the awful fourth quarter of 2008, it also appears to have spurred European policymakers into decisive and united action. If they can maintain both their resolve and their unity in the months ahead, the sell-off of the last two weeks may well prove to have provided a better entry point for investors willing, once again, to take on board risk, particularly in the stock market.
After last week’s “wilt,” some questions, from Jeffrey Saut, chief invesment strategist, Raymond James
Just like a heart-attack patient doesn’t get right up off the gurney and run the 100-yard dash, the equity markets will probably have to convalesce before resuming their upward march. This does not mean that if the gusher in the Gulf is “capped,” and the European Union allays fears regarding Greece, those two things could not combine with Friday’s stellar employment report to produce a sharp “throwback rally” in the equity markets. But, I doubt such a rally would extend very far, or last for very long.
Because of last week’s “wilt” I received numerous questions about if said decline registered a Dow Theory “sell signal?” The answer to that question is a resounding “NO!” For me to get a Dow Theory “sell signal” would require the DJIA to close below its February 5, 2010 closing “low” of 10012.23 with a confirming close by the D-J Transportation Average below its February 4, 2010 closing low of 3813.91. Obviously, we are nowhere near those levels.
The second most asked question of the week was about Greece and its attendant impact on Europe. In my opinion the Club Med countries’ electorates will not tolerate the macro austerity and personal “belt tightening” necessary to rein in their burgeoning deficits. This is already being reflected in the streets of Athens. As the civil unrest grows, extreme political parties will emerge to take advantage of the situation. By my pencil Greece will eventually default, along with some of the other Mediterranean countries, causing severe consternations for European banks. And that, ladies and gents, is why for years I have opined, “While there are certainly some g-r-e-a-t European companies, strategically I am avoiding Europe (my apologies to all my European friends).”
The third question of the week was about the U.S. dollar. Long-time readers of these epistles will recall my turning negative on the greenback, as well as bullish on “stuff” (energy, metals, agriculture, cement, timber, etc.), in the fourth quarter of 2001. In the 4Q07, while still remaining friendly towards stuff (albeit much more cautiously), I recommended shutting down ALL those anti-dollar “bets” with the Dollar Index around 75. Since then, I have been neutral on the Buck.
Last week, however, the Dollar Index decisively broke out to the upside in the charts and no longer looks neutral. Instead, it looks like the first leg of a new bull market. Bettering its March 2009 reaction high of ~90 would confirm a new bull market in the U.S. Dollar Index. Regrettably, the dollar’s strength could pose near-term problems for commodities and our beloved “stuff stocks.” Nevertheless, I like tangibles over the longer term because of rising demand from the emerging/frontier countries—and due to my unshakable belief that higher inflation will eventually surface.
The Sovereign Debt Question, From Charles Biderman, CO TrimTabs Investment Research
The sovereign debt crisis spun out of control in the past week, and we see no easy way to resolve it. Governments in most developed countries—not just Greece, Portugal and Spain—are grappling with aging populations, huge debt loads, high taxes and uncompetitive labor markets. Many of these governments have no realistic way to repay their debts except by printing money. We suspect it will take a lot of time and a lot of pain for the sovereign debt crisis to be resolved. We also think the rally from March 2009 through April 2010 was not the start of a secular bull market but merely a temporary spike amid a longer-term decline, much like the rallies in the early 1930s. Our key indicators give us further cause to move to the sidelines:
1. The U.S. economy is recovering only gradually. Adjusting for tax changes, income tax withholdings rose 4.5% y-o-y in the past two weeks, slightly higher than the 4.1% y-o-y growth in the past three months. While we estimate that the economy added 262,000 jobs in April, several temporary factors that have been boosting the economy—including census hiring, government stimulus programs and tax refunds—will be fading or ending soon. We are surprised the economy is not performing better because the U.S. government is spending $125 billion per month more than it receives in revenue in this fiscal year. To put this amount into perspective, it is equal to one-quarter of the roughly $500 billion per month in after-tax income earned by all U.S. taxpayers.
2. Our corporate liquidity indicators are mixed. On the buy side, new stock buybacks have averaged a solid $1.5 billion daily in earnings season, but only $8.9 billion was used to buy U.S. public companies in the past month. On the sell side, new offerings rose to a three-week high of $4.4 billion in the past week despite the sell-off, and insider selling has climbed to the highest level since January 2008.
3. Our demand-side indicators have turned a bit less bullish. The TrimTabs Demand Index, which aggregates 21 flow and sentiment indicators, was 84.9 on Thursday, May 6, almost seven points below the interim high of 91.8 on Monday, April 5. It is particularly worrisome that investors are piling into U.S. equity ETFs, which received $6.2 billion (1.3% of assets) on the past 12 trading days. Equity ETF flows are one of the best contrary indicators in our flow data.
Random Noise, From Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication
The Dow’s intraday market somersault on 5/6/10 saw it drop nearly 1,000 points before rallying back to a loss of “only” about 347 points (-3.20%) for the day. One rumor is that an online trader had hit the “b” key on his computer for billion instead of the “m” key for million while selling Proctor and Gamble shares. When the order entered the system, it triggered a trading cascade because P&G is one of the companies in the Dow. When the Dow fell, it triggered even more sell orders on automatic trading systems, and down went the Dow.
If the rumor turns out to be true, this would represent the sort of random event that creates what researchers refer to as random noise in the overall trend. It may take awhile for the memory to fade that markets can move abruptly and severely. And the fact that the system did not flag such a large trade for scrutiny has already, as expected, led to talk of an investigation.
This incident offers the opportunity for some perspectives on market movements. The worst one-day percentage drop in market history occurred on Oct. 19, 1987 (-23%). How would someone feel who had bought in on the day before?
Pretty bad, obviously. But more important, where would they be 10 years later if they stayed invested in spite of the drop? Turns out they would have earned slightly better than 13% per year because they would have captured much of the Great Bull run of the 1990’s. Had they stayed out of the market, they would have suffered a severe case of seller’s remorse.
Barber and Odean (2000) showed how individual investors trying to time the market gave up significant long-term returns compared to those who stayed the course and stayed invested through turbulent markets. This week’s turbulence is yet another reminder that the ability to predict random events continues to elude even the most seasoned analysts. Thus the key to clients’ long-term success is to help them find an asset allocation they understand and can stick to so they don’t sell into the noise and trade away long-term returns.
What About China? From Jeffrey Kleintop, chief market strategist, LPL Financial
China recently raised banks’ reserve requirements, ordering banks to set aside more deposits as reserves, for the third time this year. The government seeks to deflate a building property bubble and rising inflation after property prices jumped by a record in March and economic growth surged 11.9% in the first quarter, as measured by Gross Domestic Product (GDP)—the most since before the downturn began in the second quarter of 2007. In February, China’s consumer prices rose 2.7%, the most in 16 months. In March, property prices rose 11.7% from a year earlier, the most since data began in 2005. China’s government is attempting to slow credit growth to 7.5 trillion yuan ($1.4 trillion) this year from a record 9.59 trillion yuan in 2009. In the first three months of 2010, banks lent 35% of their annual quota.
Measures to cool the pace of rapid growth and rising prices have included raising reserve requirements, a ban on loans for third-home purchases, raising mortgage rates, and down-payment requirements for second- home purchases. However, the Chinese government has yet to raise interest rates (which remain at crisis levels) and has yet to allow the currency to appreciate again. Below is a timeline of significant events in China with market moving significance.
May 9-13: Data - Key Chinese economic reports for the month of April will be released, including: housing prices, new loans made in April, money supply growth, trade balance, industrial production, retail sales, and consumer and producer prices,
May 10: Withdrawal – The bank reserve requirements are set to increase 50 basis points, effectively withdrawing 300 billion yuan ($44 billion) from the financial system.
June 10: Rate hike – The Peoples Bank of China may make their first interest rate hike following the June 10 report of the May Consumer Price Index, which may reach the 3% threshold for action. Europe’s debt crisis will likely delay this move from May into June. Europe is the largest market for China, the world’s biggest exporting nation.
June 25: Yuan floats – China is likely to return to a steady appreciation in the yuan in June just before the June 26-27 G20 summit in Canada, when China will face enormous pressure by trading partners if no action is taken, no matter how modest, to float the currency. A move is also supported by U.S. Treasury Secretary Tim Geithner’s unscheduled meeting with Chinese officials, and by his move to delay a report that could name China a currency manipulator.
July 1: Property Tax –The rapid rise of housing prices is one of China’s most pressing concerns. It appears the new property tax pilot programs in Beijing, Shanghai, Chongqing and Shenzhen will be targeted toward luxury urban properties that have seen dramatic price gains.
Volatility and Perspective, From Gerald “Buetow, Ph.D., Innealta Capital
Friday morning, as we were digesting Thursday’s extraordinary volatility, the Bureau of Labor Statistics released the employment report for April. Of course, the government propaganda machine began immediately to tout the 290,000 top-line job number. The ever-cooperating media assisted in spinning the data into a tremendous accomplishment. However, the details are far less promising. And it seems that the markets—at least initially—seemed to understand this reality, trading off meaningfully even after Thursday’s debacle. In addition to the headline 9.9% unemployment rate, the broadest measure of unemployment, the so-called U6 (unemployed plus ‘discouraged’ workers who believe there’s no work for them plus ‘marginally attached’ workers who want to work but have stopped looking, plus part-time workers who want full-time work) increased to 17.1% and the U4 measure (stops counting at ‘marginally attached’) hit an all-time high of 10.6%. Additionally, the average and median duration of unemployment also hit all-time highs of 33.0 and 21.6 weeks, respectively.
These levels are meaningfully above anything seen over the past few decades. We now have 7.2 million people who have been unemployed for over 27 weeks, accounting for a record of 46% of the total jobless pool. And now they all can get benefits for up to 99 weeks— no small price tag. Given these statistics, it’s no surprise wage growth is nonexistent. It’ll probably remain so for the foreseeable future, too. From where will consumer spending come if wages continue to decline? This is even more disturbing when we consider that personal consumption as a percent of GDP remains just a sniff off a record high over 70%. Recent retail sales figures corroborate the tribulations of the consumer. Combine this with the problems in Europe and it is not difficult to understand why economic growth will be challenged over the coming years.
Developments on the first-quarter earnings front are also noteworthy. Particularly striking was the loss posted by Freddie Mac: $6.7 billion For Q1. Despite the recent government-enabled uptick in mortgage applications, we question whether the problems facing residential real estate are truly resolved.
Tuesday, May 11:
Retail Sales (weekly), March Wholesale Trade
Wednesday, May 12:
Mortgage Applications (weekly), March International Trade
Thursday, May 13:
Jobless Claims (weekly), April Import/Export Prices
Friday, May 14:
April Retail Sales, April Industrial Production, May Consumer Sentiment, March Business Inventories