Is the Correction Over?

I'm wondering. On Monday the closing Tick on the NYSE was over 1000 for the first time since May 18th. The VIX dropped Tuesday to within a whisker of its July 1 low, its lowest level since September of last year, when the S&P 500 was closer to 1200 than to 900. I must say I've been surprised at how the VIX has fallen along with the S&P over the past weeks. Market participants have seemed quite sure that we've just been having a pesky correction, nothing to lose any sleep over...

Market Does Some Quick Repricing

So the Conference Board's Consumer Confidence number for June was worse than expected, and suddenly all hell broke loose in the stock and FX markets, with the Treasury market having a bit of a more muted and lagged response. The consensus was for the index to rise to 56 from 54.8 in May. Instead the index fell to 49.3. Stocks fell, gold and oil dropped like rocks, the VIX awakened from its slumber, and the dollar rallied...

The value of consumer confidence data is suspect - it tends to rise and fall with the stock market and/or the general news backdrop, and attempts to derive predictive value from it have generally proved less than fruitful. Still, it's hard to resist the allure of consumer surveys. The most timely is the daily Rasmussen survey. The polls are taken pretty much every day and the results represent a rolling 3 day average. The Rasmussen consumer index reached a 2009 high of 77.2 on June 4th, and has been in the high 60s and low 70s since then. So why the consensus was for the Conference Board's number to improve over May, I don't know.

The other negative news item Tuesday, dated, but more substantive than the consumer confidence data, is that delinquencies on prime mortgages during Q1 doubled from a year earlier.

The takeaway would seem to be that for at least one data point, there was a large divergence between what the markets expected and what they got. It will be interesting to see how things close.

If conditions are improving so much...

... then shouldn't regional banks be doing better?




The problem is that regional banks have a lot of exposure to commercial real estate and default rates on CRE are expected to climb through 2011 or beyond.

US Dollar Talk

The knee-jerk trading reactions to the back and forth about the future of the US dollar as the world's reserve currency are getting a bit silly. I would be very surprised if any fiat currencies survive this century, but in the meantime, the dollar is going to be around for a while, especially since the alternatives are less than compelling. The Japanese worry about a strengthening Yen, the Canadians and Aussies worry about strengthening dollars, and just last week the Swiss National Bank may have stepped in to curb the rise of the franc. And of course, the Chinese decided back in July of 2008 that, US Congressional bloviations notwithstanding, enough was enough -



And then we have gold, which also appears to be at a key juncture - either readying another assault on the 990 zone, or preparing to break below its 50 dma.

Juncture

The markets often seem to be at a critical juncture, but this is one of those times where it is really the case. Weekly charts of the major stock indexes and the CRB index look like rollovers following bear market corrections, but the chart posted below is a daily chart of the Euro versus the Yen. The relation between these two currencies is a good proxy for risk appetite.




The ratio is hovering above its 50 dma, and the uptrend from the lows of January is still intact. What happens next, over the coming days and weeks, will be critical.

Mixed Signals

The persistent weakness in the closing Tick (noted in prior posts) sets up something of a divergence with the price action lately, which has only been mildly corrective - nothing suggesting liquidation. Also the VIX has been fairly tame throughout this sideways to down move in the indexes. Interesting how even after the post FOMC announcement reversal, the VIX only moved moderately, and is still down materially on the day...

As for the reversal, which may just be noise, it looks like the Fed is no longer worried about deflation, as the following sentence from the April 29th release was dropped today -

Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

Maybe that has made some participants nervous about a "tightening" cycle starting soon. Yeah, like that's gonna happen...

Rollover

The chart below shows the 20 dma of the percentage of NYSE stocks above their 50 dma. It looks like rollover time.



A lot of stocks sliced through their 50 day moving averages on Monday, as the percentage of stocks above that level dropped from 68% as of Friday's close to 45% on Monday. As has been the case lately, the close of trading was weak, with the last tick at -1100.

As mentioned a few posts ago, the markets now have adopted a "show me" attitude. Economic data and corporate earnings are going have to confirm the recovery bets or they will come off in a hurry.

Tock

The title is a bit of a joke, but the subject matter isn't. The Treasury just keeps on issuing, with $104 billion planned for next week, and an estimated $65 billion the following week.

As Treasury yields rise, yields on mortgage securities may rise more , (as they did on Thursday), creating additional headwinds for the housing sensitive recovery.

As the graphic below from Bloomberg shows, real yields are at their highest since 1994. So perhaps the sell off in longer dated Treasuries is "overdone". Yes, this is actually my view, but, oh, how many times over the years have I heard someone say some market move was "overdone" only to see it go on and on and on...

Tick

The chart below is the 20 dma of the closing tick on the NYSE. You can see that for years (2004-2006) this indicator did not break much below 200. It currently sits at 140. Between March 10 and May 18 there were 18 days in which the closing tick was over 1000. Since May 19 there have been none. The closing tick has now been negative for 4 days in a row, something that last occurred February 26 - March 3rd of this year.

Show Me

According to BCA Research , the narrowing in corporate credit spreads has largely run its course, and any further compression will need to come from a decline in corporate credit risk. Yet corporate credit quality remains weak.

The chart below shows the ratio of the high yield ETF, JNK, to the ETF for the 7-10 year Treasury, IEF. From March till the middle of last week, the high yield market had been on a tear. Now, it looks like things could be rolling over in credit land -




The cautious outlook from FedEx Wednesday threw cold water on those who think a meaningful recovery is a done deal -

"The operating environment for our first two quarters in fiscal 2010 is expected to be extremely difficult,” said Alan B. Graf, Jr., FedEx Corp. executive vice president and chief financial officer. “Manufacturing activity is expected to be substantially negative year over year through the summer and last year’s first quarter results benefited from stronger economic activity, making earnings comparisons difficult. Also, the recent run-up in fuel prices will have a significant negative impact on our first quarter’s results. At this time we do not have enough visibility into the economic recovery and jet fuel prices to provide a meaningful annual earnings forecast. However, we believe that FedEx will be poised for growth in our fiscal second half, as our many cost-saving initiatives gain traction and the economy begins to improve."

It would make sense at this point for both equity and bond market participants to adopt a "show me" attitude. If the fundamentals improve, then the reflation rallies can resume. Otherwise...

30 Year Auction Goes Well

There has been a lot of nervousness in the Treasury market of late regarding the massive issuance, fears that Fed policies will ultimately prove inflationary, and questions about the dollar's future as a reserve currency. Recently even the short end has been hit by fears that the Fed will be imminently embarking on a campaign of rate hikes. My own view is that the only immediate problem is the supply issue.

The bonds auctioned Thursday yielded 4.72%, with a bid to cover ratio of 2.68, compared to last month's ratio of 2.14. Indirect bidders, among them foreign central banks, bought nearly half the issuance.

The TLT is up almost 1% as I write this. It's too soon to call a bottom, but yesterday's huge volume in the TLT suggested capitulation, so we'll see.

I've read some commentary stating that as long as corporate yields are coming down, there's no cause for concern. Well sure, if what's been happening in the Treasury market is just part of the shift in risk appetite, then fine, no worries mate! Those who view the recent rise in yields as the beginning of a secular bear market in government debt however, see nasty knock-on effects hitting the mortgage market, and then corporate financing as well.

Speaking of potential bottoms, natural gas has been basing for a while, and the volume in UNG, the natural gas ETF, has swelled over the last 6 sessions. The ratio of the price of crude oil to natural gas is around 19.2-1, about 68% above its 200 dma.That doesn't mean it can't go higher, but at some point a trade entry becomes compelling.

More Treasury Market Weirdness

Take a look at the chart below from Trend Macro and you can see how one "better than expected" employment report (more on that later) brought out the sellers of Treasuries, but at the short end of the curve this time. The thick line represents the view of the future fed funds rate on Friday, the thin line the view on Thursday.



Suddenly, the Fed is going to be raising rates by December and the Fed funds rate will be near 1.5% by next July. The yield on the 2 year note shot up by 36 bps, from .96 on Thursday, to 1.32 on Friday.

So, that must have been some really bullish employment report, huh? Not exactly. The econobears favorite employment measure, U-6, which consists of "total unemployed, plus all marginally attached workers plus total employed part time for economic reasons, as a percent of all civilian labor force plus all marginally attached workers" rose to a new seasonally adjusted high of 16.4%. A chart is below -



Average weekly hours declined, and average hourly earnings ticked up a weak .1%. It seems absurd, especially in light of Bernanke's testimony before Congress earlier this week , to think that the Fed is going to be soon embarking on a rate hiking campaign. In Bernanke's own words -

Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low. The slack in resource utilization remains sizable, and, notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008...

There are currently any number of conundrums in the Treasury market, not least of which is the Fed's next step with regard to QE. Step up and buy more to force yields back down? But what if the "bond vigilantes" jack the yields right back up on fears of money printing? And how would the currency markets react to more QE from the Fed?
So maybe the Fed should lay low for a while? But then can the market as it is really absorb all the supply? And if yields climb higher won't that risk uprooting the green shoots?

It would seem that we are at a point where both higher yields and higher commodity prices, currently taken as signs of a recovery, could be viewed as increasing the risks of a deflationary outcome...

ISM Supports Econobulls

The Purchasing Managers Index in the ISM Manufacturing Survey for May was 42.8, still in contraction territory, but the 5th straight rise in the index. Most notably, the new orders component rose above 50 (51.1, to be exact) for the first time since November 2007, one month before the recession began according to the NBER. The chart below shows the new orders component, and you can see that since the late 1940s when the index began, by the time it rises above 50, most recessions are either over or almost over.




But you can also see that in a couple of instances, the index rose briefly above 50, only to fall back again. Things are never easy.

And longer term investors can take some comfort that the Coppock curve has turned up, indicating that stocks are a "buy" for the first time in 6 years. According to the linked to article, U.S. stocks have advanced 16 out of 17 times in the year after the indicator turned bullish.



On a shorter term basis, the global reflation bets are looking very stretched. A scan of stocks and ETFs that moved above their upper Bollinger band, with an average daily trading volume of over 80k and an average share price greater than $5, turned up 672 candidates. The 50 dma of advancers less decliners on the NYSE recently spiked above 550, something that hasn't happened since the late spring of 2003.

As for currencies, both the Canadian and Australian dollars are looking very stretched versus the greenback. Here's a chart of FXC, the Currency Shares Canadian Dollar Trust -

A Benign Perspective on the Move in Treasuries

In general what we've seen in equity, currency, and fixed income markets has been an unwinding of panic. Deflation trades have been closed out and reflation trades put on as market players try to anticipate and adjust to the new normal.

Let's start with the spread between 3 month US dollar LIBOR and the Fed funds rate. The data for the chart below is through April. The spread has fallen further since then, and is currently down around .5 -




The TED spread has also eased into a more normal range -



The VIX is below 30 after holding above that level for about 6 months -



The commodity currency par excellence, the Australian dollar, has risen back to its level of last September -



And JNK, the ETF for the high yield market, has retraced most of its post-Lehman loss -




So, should it really be all that surprising that the yield on the 10 year Treasury has returned to the 3.5% zone? -



A Bloomberg article warns that the "bond vigilantes" may be back. Indeed they may, and the massive debt issuance could be problematic if "the Treasury bull market is over" crowd is correct (yes, it's circular!). But for now, in the context of what's been happening in other markets, the move up in longer term Treasury yields can be viewed as part of the markets' search for the new normal. Consider the chart below, which can be used as a proxy for future inflation expectations -



Yet another chart which has moved back to a level last seen in the early fall of 2008. The question is whether is just keeps on rising, or not.

Subprime Fractal

The long end of the Treasury market has been getting pummelled lately, and as I write this, the Treasury sell-off is even headlined on The Drudge Report. Wasn't the whole point of quantitative easing to bring yields down, or at least keep them low?

Corporate debt has been doing very well as spreads have tightened more than Treasury yields have risen. But this can only go on for so long. Mortgage rates are likely to rise in sympathy as well.

Where does it end?



Contrarians can argue that by the time the climb in Treasury yields becomes a Drudge headline, the bulk of the move may well be over. Yet there seems to be no end to the debt issuance. The expression "inflate or die" comes to mind, though "inflate or default" might be more precise. The estimable Marc Faber, who was onto the credit bubble years ago, said on Bloomberg that he was "100% sure the U.S. will go into hyperinflation".

But that time may be years away.

New Playbook

The days when a 2% drop in the S&P 500 (as I write this) was reliably accompanied by a fall in long term Treasury yields are gone for a while. The prospect of $101 billion in new Treasury supply next week was more than the market could stomach. Following the Treasury announcement, gold turned higher and the US dollar index eased lower. The scenario of a weak US economy, a falling dollar and rising interest rates has been the scenario of the uber bears for many a year. Is this what lies in store?

Real Rates

Below is a chart showing the 6 month moving average of the yield on the 10 year Treasury less the yoy % change in the CPI -




The rise in real rates is typical for this part of the cycle. The question is how high they go, and at what point the rise in long Treasury yields would disrupt the stock market and when and if we get there.

As long as the roots are not severed...

...all will be well in the garden. Chance the Gardener in "Being There".

I thought the green shoots meme peaked a few weeks ago, but no, it is still very much with us. So let's play along and take note of both green shoots and the brown weeds that could choke them off in the financial markets and global economy.

Some Shoots
The rate of deterioration has slowed in any number of economic areas - initial jobless claims, layoff announcements, ISM PMIs for both manufacturing and services, industrial production, and new home sales. The upturn in the 2nd derivative is not limited to US data.

Consumer confidence has risen substantially. As of Saturday May 16, Rasmussen's Consumer and Investor indexes are both near their highs for 2009.

The TED spread, a good measure of the degree of stress in the financial system, which spiked to over 460 bps following the Lehman collapse last September, dropped below 70 bps on Friday, its lowest level since August 2007.

The Baltic Dry Index has been in a steady uptrend since bottoming in December (with a strong correction from March to April) and closed Friday at its highest level since October last year, and within a whisker of its 200 day moving average.

As mentioned in the previous post, the weekly leading indicators from the ECRI are rising, "making it increasingly likely that the U.S. recession will end this summer" in the words of its director Lakshman Achuthan.

Some Threats to the Shoots

This is not a normal recession, but a post asset bubble "balance sheet" recession, which historically have taken years to resolve themselves. A study by Carmen Reinhart and Kenneth Rogoff - "The Aftermath of Financial Crises" - noted that the asset market collapses following such crises tend to be deep and prolonged, with equity prices declining an average of 55% over a period of 3.5 years and real housing price declines of 35% over 6 years. In addition, the unemployment rate tends to climb by 7 percentage points during the down phase of the cycle, which lasts an average of 4 years. The decline in output, about 9% from peak to trough, lasts about 2 years. And by the way, during the post war crises, the real value of government debt rises an average of 86%, due primarily to a combination of collapsing tax revenue and ambitious countercyclical fiscal policies.

While it is a relief that financial Armageddon has been averted, any ensuing recovery is going to be extremely weak. For there to be net job growth in the economy, initial jobless claims will likely need to fall below 350k at least. (The latest 4 week moving average of initial claims is 630,500.) Given the amount of wealth destruction that has occurred in the housing market alone, combined with still historically low savings rates, "the consumer" is going to have a rough time of it and it will take a very long time for the economy to return to its trend growth rate. The BLS's U-6, defined as "total unemployed, plus all marginally attached workers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers" reached a seasonally adjusted all time high of 15.8% in April. Credit card default rates rose to record highs in April. Personal income rose a paltry .3% in March (yoy), the lowest since the data series began in 1959. And what if the savings rate should return to the levels of the recessions in the 70s and 80s of more than 10%? What then?

More on the employment situation - a NBER study titled "Credit Market Shocks and Economic Fluctuations:Evidence from Corporate Bond and Stock Markets" explored the value of credit spreads in predicting economic variables. According to the authors' model, the US economy will lose another 7.8 million jobs. Was this scenario incorporated in the "stress tests"? Haha...


The government's involvement in the mortgage industry, the insurance industry, the banking industry, and the auto industry will likely result in a less efficient economy, with a lower potential growth rate. Remember how corporate profits as a percentage of national income reached an all time high back in 2006, around the same time that compensation as a percent of national income was reaching an all time low? The pendulum has already begun to swing the other way, the question is how far will it go? A chart is shown below -



An interesting exercise might be to look at those periods when, as a percentage of GDP, government consumption was rising, household consumption was falling, the trade deficit was narrowing, and where investment was rising - as that would seem to be the scenario on the horizon.

As for the equity market, the current divergence between "operating earnings" and "as reported earnings" is enormous. (Until the early part of this decade, the difference was negligible.) So, one can't help but wonder, as of Friday's close, is the PE for the S&P 500 (based on 2009 earnings estimates) a modest, if not cheap, 16.3, or is it an expensive 31.8? The former uses operating earnings estimates, the latter "as reported".

Friday Potpourri

The OECD's Composite Leading Indicators for March point to a possible trough in France, Italy, the UK, and China, but a continued strong slowdown in Canada, the US, Japan, Germany, Brazil, India, and Russia.

The ECRI's Weekly Leading Index rose to a 28 week high in the latest period, however, suggesting that the recession in the US may end in a few months.

Meanwhile, it seems that now that there has been a bit of healing in the financial markets, everybody wants to issue more stock or bonds. According to the WSJ , this year has been the busiest for follow-on stock issuance since the year 2000, with $54.9 billion raised ytd (as of May 14th). And investment grade bond sales are having their strongest year since 1995, when Dealogic began tracking them.

In normal circumstances, this rush into the market could be viewed as a positive - companies see the business cycle turning and want to raise money to take advantage of it. But these are not normal circumstances, and as one CIO quoted in the article linked to above observed - "there is a sense of desperation in the capital raising these days..."

According to one estimate, REITs alone will need to raise $40 billion in stock sales over the next few years.

And from Bloomberg , an interview with Mark Kiesel at PIMCO, who sees a positive sea-change in sentiment from the ability of banks to raise money in the unsecured bond market. He expects a pause in the narrowing of corporate spreads, and notes that the rally in the high yield market has been somewhat analogous to that in the stock market - with some of the weakest companies rallying the most.

I don't think I can recall a time when so many very astute market participants had such opposite views as to what lay in store over the intermediate term - say 6 months to 2 years. One of my favorite "bears" is Howard Davidowitz, who has had two great video interviews with Aaron Task on Yahoo Finance - the most recent of which is here. Davidowitz described the "stress tests" as part of a con game to get private money to provide financing to the banks in question because the Treasury couldn't get any more money from the Congress.

China Strength Called into Question

One of the memes used to justify the current risk rally is that the Chinese economy is responding to the government's 4 trillion yuan stimulus package and is on track to expand close to the 8% growth target. This thesis would seem to be critical to the reflation trades that have been working so well of late.

Two stories Thursday called this assumption into question. The first was about how the recent record imports of iron ore into China are being investigated by the China Iron and Steel Association, whose Secretary General accused the Big Three iron mining companies (VALE, BHP, RTP) of importing the iron themselves and thereby "faking" demand. Oh dear, you mean it's not all going to infrastructure projects?

The second was a story from the International Energy Administration which noted that China's declining oil and electricity demand did not jive with its official 6.1% growth in real GDP for the first quarter. The possibility was raised that China's official GDP figure may need some downward revising. China's exports for April fell over 22% yoy, the 6th straight monthly decline. The Ministry of Commerce admits that domestic demand cannot pick up the slack, and expects global trade to shrink further.