First and Goal For Risk?

Nothing like an early morning workout to clear your mind and get your day going. Even went to the track to walk a little in the cold, crisp weather as the sun came out (love it). Speaking of clearing things up, I am going to be investing a lot more time cleaning up my blog links. Already got rid of many blogs that are not publishing anymore and will clean up other links too. If you have blogs or links worthy of being on Pension Pulse, please forward them to me (LKolivakis@gmail.com).

On Monday I discussed how pensions are wrestling with return rates. US stocks rallied sharply led by financials (FAS), real estate (DRN), and emerging market shares. A U.S.-listed exchange traded fund that invests in Chinese stocks jumped more than 5% on Monday and after a nearly 3% gain for the S&P 500, the index and 7 of its sectors are now back above their 50-day moving averages. Given these moves, Barry Ritholtz of the Big Picture blog notes, First and Goal for Risk:

We asked last week if the S&P500 (our proxy for risk markets) was capable of clearing the “red zone”, the zone of resistance between 1175-1195, which included the 50-day moving average. The market’s answer? Like a hot knife through butter!

Interestingly, the S&P500 closed at its high of the day at? 1194.91! Not a sold out crowd today as the volume was super light. Nevertheless, impressive. The bears need to take a goal line stance right here and push back the momentum or the next stop is S&P500 1230, the top of the recent trading range which began with the August collapse.

We have posted several pieces on the three macro bears that have been weighing on equities: 1) Europe’s sovereign debt and banking crisis; 2) The slowing of the U.S. economy and employment problem; and 3) China hard landing concerns. We’re not sure — and have our doubts — all three bears have gone into hibernation for the winter, but they do appear to be, at least, napping.

Today’s intervention to support the banking system by the Chinese government was a big, yet under appreciated, catalyst for the rally, in our opinion. The FT writes,

Central Huijin, the domestic arm of China’s sovereign wealth fund, will purchase shares in Agricultural Bank of China, Bank of China, China Construction Bank and Industrial and Commercial Bank of China, the official Xinhua news agency announced on Monday. Xinhua added that the purchases by Huijin – its first such public intervention since a similar decision at the onset of the financial crisis three years ago – would “support the healthy operations and development of key state-owned financial institutions and stabilise the share prices of state-owned commercial banks”.

The announcement came too late for the Chinese stock market, which had closed at a 30-month low, but had an immediate effect on late trading in Hong Kong. ICBC’s Hong Kong-listed shares, which had been down 3 per cent, rallied to close up 1 per cent.

The U.S. economic data looks to be improving and Europe has a plan to have a plan to recapitalize the banks and fire break the contagion of a Greek default.

We’re always flying blind with China due the country’s lack of transparency, but the equity markets have been hammered over there and should rebound on the intervention news providing more confidence for the global markets. The announcement of intervention came after the market closed but Asian ETFs were up big in New York trading.

The U.S. data, including Friday’s employment number, are not great, but beating to the upside. The key now is for earnings to confirm the U.S. economy is not sliding into recession. Company outlooks are more important in this season than almost any we can recall.

We’re most worried about Europe. There is more time for the markets to continue to hope as the E.U. summit meeting has been postponed to October 23rd to give policymakers more time to hammer out the details. They really need to get this right.

A big commitment by a national government to backstop its banking system could have adverse consequences for the sovereign’s credit rating, which negates the positive contribution of the recapitalization. This destablizing feedback took down Ireland and the worries seem to be the biggest point of disagreement between Merkel and Sarkozy.

The markets aren’t focused on these concerns and want to believe the three bears are hibernating for winter. They want to rebound from the August collapse like a beach ball held underwater. And that they are. Stay tuned.

I agree with this analysis but there are still risks in these markets which I continuously tweet on (follow me on twitter @PensionPulse). For example, the bond market is now pricing in a 60% chance of recession:

The bond market indicator that has predicted every U.S. recession since 1970 shows that the economy has about a 60 percent chance of contracting within 12 months.

The so-called Treasury yield curve, adjusted for distortions caused by the Federal Reserve’s record low zero to 0.25 percent target interest rate for overnight loans between banks, shows that two-year notes yield 20 basis points, or 0.20 percentage point, less than five-year notes, according to Bank of America Corp. research. The unadjusted gap of 79 basis points at the end of last week indicates the chance of recession at about 15 percent.

Short-term rates have been higher than longer-term yields, or inverted, before each of the seven recessions since 1970. A contraction would make it harder for U.S. President Barack Obama to reduce unemployment, which has held at or above 9 percent every month except two since May 2009, including a reading of 9.1 percent in September. It may also help bolster Treasuries and keep yields near all-time lows.

“The adjusted curve is giving a powerful signal for an upcoming U.S. recession,” said Ruslan Bikbov, a fixed-income strategist in New York at Bank of America, one of the 22 primary dealers of U.S. government securities that trade with the Fed. “If that happens, the Fed’s target rate could remain near zero beyond 2014,” more than a year longer than the central bank has indicated, he said in an interview on Oct. 3.

An inverted yield curve is the last thing banks and financial service companies need or want. Banks like to borrow for free on the short end and lock in spread by investing in Treasuries on the long end. Reuters quotes a Citigroup analyst stating that Goldman Sachs will likely record a loss in the third quarter, only the second quarterly loss in the Wall Street titan's history, hurt by weakness across trading and investment banking, equity market declines and wider credit spreads during the period (my hunch is they made money shorting this market).

Moreover, CNN reports that millions of unemployed Americans are waiting for Congress to do something other than trade barbs over their job creation plans. More than 6 million Americans are set to lose federal unemployment benefits in 2012, with 1.8 million running out in January alone, according to new figures from the National Employment Law Project.

And the European "soap opera" continues. Bloomberg reports that European Central Bank President Jean-Claude Trichet warned of threats to the financial system as the conflict among political leaders intensified over how to extricate Europe from the debt crisis. They are now openly discussing a 60% haircut on Greek bonds but I wouldn't be surprised if it ends up being closer to 80%. Whatever the case, I agree with Rio, the European debt crisis is overdone as China thrives (once again, Chanos disagrees).

Early Tuesday, stock index futures were lower as investors await the results of a key vote by Slovakia on expanding the euro zone rescue fund. Since when do we allow smaller European nations like Slovakia, Austria and others to vote on the future of the global financial system? the US, Germany and France should tell them to "fuck off" and toe the line (no offense to Slovakians or Austrians but that's how I truly feel).

All this to say that even though markets are likely to rally further, there remain serious challenges in the near and long-term. Q3 earnings season begins on Tuesday and earnings expectations are set to disappoint as estimates remain high, but my hunch is investors will buy the dips. Finally, in the interview below, Jim Strugger, derivatives strategist at MKM Partners warns investors to focus on risk as we are currently experiencing the highest level of volatility we have seen since the 1940's when you exclude the spike to 72 in 2008 and the crash of 1987. So while I'm cautiously optimistic as financials could rally more from these levels, hedge accordingly because tail risks have not disappeared.