Saturday, July 17, 2010

Is The Yo-Yo Market Forewarning Doom?

Andy Kessler, a former hedge fund manager, wrote an op-ed article in the WSJ, The Yo-Yo Market and You:

Bull markets, it is said, climb a wall of worry. Smart investors buy in early when worries about profits or inflation or wars scare away the faint of heart. Latecomers then bid up stocks as each worry becomes unfounded, until there is nothing left to worry about. Once there is only good news, the market peaks as there is no one left to buy.

Bear markets, on the other hand, fall into what I like to call the pit of doom. Forget about worries—actual bad stuff happens, until nothing bad is left to happen and the market bottoms as there is no one left to sell.

From early May through last week, the market dropped 1500 points into the pit, on the backs of gushing BP oil, riots in Europe, a 30% drop in pending home sales and the news that maybe your next door neighbor is a Russian spy. But now we've seen 680 Dow points added over seven straight up days before a slight decline yesterday. What the heck is going on?

Call it the yo-yo market—from the top of the wall to the bottom of the pit and back—and you better get used to it. It's hard to tell which market moves are real and based on prospects for better profits, as opposed to moves that are driven by all the extraordinary government measures to prop up the world economy. Until a few things are resolved, you'd better learn the yo-yo sleeper trick—that is, keep spinning at the bottom without going up.

ZIRP: We live in abnormal times. The Fed is running what is essentially a zero interest rate policy, aka ZIRP. The stock market lacks a compass, a true north, to find its way.

Good news, like the private sector adding 80,000 workers in May, or container shipping up 12% over last year, is truly good news. Bad news, like Portugal's debt downgrade or a 10.8% drop in auto sales in June, suggests the economy is slowing. No wonder the market can't figure out which is the dominant trend. And so it goes up and down, up and down.

To make things worse, the Fed's zero policy is wreaking havoc in the real world, not just on Wall Street. In most companies, projects are funded when expected returns are higher than the risk-free rate of return, i.e., investing in T-bills.

But the risk-free rate today is a big fat zero! Every project makes sense, which can't possibly be right, so corporate planners sit on their hands and companies just sit on their piles of cash. The sooner we zip the ZIRP, the sooner we return to some sort of normal.

Crutches: We all know that the economy is being held up on crutches—the biggest being the Fed printing dollars, a quantitative easing that saw the monetary base jump to $2 trillion today from $800 billion in September 2008. That program stopped March 31 and at some point has to reverse. May's 33% drop in home sales, despite record low mortgage rates, happened because an $8,000 tax credit expired at the end of April. Auto sales are down as "Cash for Clunkers" expired eight months ago.

But we still have the crutch of the remaining funds (about half) from the 2009 stimulus bill. And now the Europeans are threatening a new round of euro printing. The stock market won't believe that growth and profits are real until it sees the economy without these crutches. Until then, the yo-yo.

Taxes/Seizures: January 2011 will most likely see the expiration of the Bush tax cuts. ObamaCare means higher levies on most Americans. There is talk of a value-added tax and a lame duck Congress porkfest.

What is even more troubling is the prospect of government seizures built into the Dodd-Frank financial bill. This is much like the seizure of property from auto industry bond holders (denounced as speculators) in the bankruptcy of GM and Chrysler.

Dodd-Frank also provides government leeway to seize firms it considers a systemic risk, without really defining what that systemic risk is. Why anyone would provide debt to large financial institutions (or auto makers) is beyond me, certainly not without demanding a huge premium for the seizure risk. The cost of capital for the U.S. economy is sure to rise, slowing growth.

Until public policy returns to some semblance of stability, or at least more certainty, get used to 1000 point swings. Get used to the fans of gold and canned goods leading us to the pit of doom one week and bullish optimists up the wall of worry the next. For me, I like to get my bad news over with.

I'm waiting for Spain to melt down the World Cup to pay off its debts, or more seriously, real defaults from Spain, Greece and maybe California and New York. Let's get on with it and put the structural reforms behind us. That would be a true buy signal.

Mr. Kessler isn't the only one who thinks we're in for a long tough slug ahead. David Stevenson of MoneyWeek reports that the US banking recovery is a sham:

The arcane-sounding FASB 157 rule may seem deadly dull, but for bankers it's very important – and very controversial, too. Here's how it works. When banks want to borrow money, they often do so by selling bonds. These are in effect IOUs. FASB 157 lets these banks pretend they'll buy back their IOUs at current market rates, even though they may have no real intention of doing so.

Now let's say that a bank's IOUs drop in price – for example, because it's reckoned by the market to be dodgier than was previously thought, meaning that the risk of holding those IOUs rises.

Although the face value – the actual amount owed on the IOUs – stays the same, the bank is now allowed to assume that it owes less money to its creditors. So it can book the difference between the previous IOU value and the current, lower price as a profit.

Bank of America, the biggest US bank by assets, may record a $1bn second-quarter gain from writing down its debts to their market value, says Keith Horowitz at Citigroup. Morgan Stanley will also probably record $1bn in such debt valuation adjustments in the second quarter, he says, equal to 60% of his estimate for the firm's pre-tax income.

Chris Kotowski at Oppenheimer is very clear what this really means. It's an accounting "abomination", he says, because fluctuations in the value of the debt don't change the amount the banks owe.

Then there's 'mark to model'. To cut a long story short, this lets banks put valuations on their assets that are more likely than not to be higher than a true market price. In turn, that difference can be added back to boost profits.

And Bob Chapman thinks Debt Overhang Hinders the Recovery:

The availability of cheap money allowed banks to search for new markets. They had no compunction in making loans, because of the euro zone guarantee. It wasn’t long before they were making many subprime loans and they were in way over their heads, especially in Eastern Europe.

Such strong guarantees and low profit margins tempted German banks and savings banks to use derivatives and to buy US CDOs, and other toxic assets.

No one thought about demographics and resale as the European birthrate collapsed.

There is much consternation over issuing bank interest rates in the interbank circuit. The secret is banks again do not want to lend to each other, because they do not trust each other. This is the wholesale money market known as LIBOR. The ECB has stepped in to augment lending, but the solution is to only temporary lend. If confidence doesn’t return rates could shoot back up to near 5%. Last time the Fed came to the rescue, and it may end up that way again.

Contrary to what the IMF’s experts think global growth is about to take another swan dive and all banks with problems won’t be able to grow out of their problem. Making matters worse the clock is ticking. It is very obvious European banks are in serious trouble. Over the past year, if you add up all the loans received from the ECB, the total was $1.15 trillion.

In order to roll these loans and expand profits these institutions and the total economies have to have growth and that won’t happen unless there is more quantitative easing, both in Europe as well as in the US and the UK.

We don’t know how they expect to accomplish this in Europe under austerity programs. Remember as well that the euro zone consists of 16 members and the EU has 27 members of which the 16 are part of. Efforts are being made to coordinate another European centralized bank regulator, which to us is the antithesis of what is needed. The ECB wasn’t able to prevent the fiasco of the past several years, so what makes the bureaucrats in Brussels and Frankfurt think a centralized regulator will work? Here we are back to more centralization. Europe has a banking crisis just like the UK and US have. They might consider fixing that first. Throwing temporary funds at insolvent institutions is not the answer. In the meantime banks still do not want to lend to each other and except for AAA companies they are reluctant to lend at all. The same syndrome is prevalent in the US, where business loans to small and medium sized businesses are off over 25%. This is a waiting game to see who goes under first. In addition, these banks, state banks, have issued $3.78 trillion in state debt. In order to pay back such loans governments have to reduce spending, which, of course, curtails growth. In socialist Europe governments make up a large part of overall spending.

We believe the austerity program will work long term, but in the interim Europe not only faces giant debt to service, but also could easily fall into depression. If this happens the profits needed to help banks recover won’t be there. The bottom line is Europe’s banks, like those in the US and UK, are in a box and they cannot get out. Almost all of them are insolvent and no matter what they do there is no easy way out. Now you can understand why another war is being prepared. It is to be a major distraction from these terrible economic and financial problems.

Now, before you go out an sell your equities to invest in long-term bonds, I think you should take these bearish articles with a shaker of salt. Earlier this week, David Spurr of Displaced EMA, sent me an interesting observation, Quarterly Rail Traffic Correlation to GDP = 88%:

The above is a critically important piece of information and one of the primary reasons that I continue to monitor rail traffic. It provides the most timely data on the economy. The above suggests that if the correlation of 88% between US GDP and Q/Q rail traffic holds in the second quarter of 2010...(and there's not really any reason to believe that it wouldn't hold - judging from prior history) then Q2 2010 vs. Q2 2009 GDP could be 5% higher. This would make the "headline" number for q2 2010 9.3% higher than q1 2010.

This announcement on July 30 would most likely be a surprise to the upside for equity and risk markets. Most likely the markets are starting to discount this information already - it will be interesting to see what happens to the market when GDP is announced. The charts below represent the actual data from the BEA website.
I doubt headline GDP will come in 9.3% higher than Q1 2010, but it wouldn't shock me if the headline number handily beats expectations on the upside. But we still need job growth to make this a sustainable recovery, and the jury is still out on that front. I leave you with a couple of interesting Bloomberg interviews, well worth watching (click on hyperlinks below):

Seery Sees S&P 500 Falling to 900s; Cites `No Growth': Video

Gais Sees `No Doubt' U.S. States Need More Stimulus Aid: Video

And one final interview below with Christopher Whalen, managing director at Institutional Risk Analytics who says: "It's hard to build a bull case for banks when their revenues are shrinking and their expenses are going up." Indeed the bull case for banks can't be made until the economic recovery takes hold. And if deflation and deleveraging continue, banks are cooked.

But before you jump on the pessimism bandwagon, watch the upcoming US economic releases, especially the next few non-farm payrolls reports. Growth will decelerate, but in my opinion concerns of a double-dip recession are way overblown.

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