Tuesday, February 9, 2016

What's Behind The Market Turmoil?

Matt Philips of Quartz reports, China’s crisis, Europe’s debt, and the US oil bust have become one big worldwide mess:
It’s finally happened. The Chinese economic slump, the global energy bust, the European debt crisis, and the increasingly uncertain American economy have finally fused into one very large, unpleasant economic story.

The latest economic data out of China show Chinese authorities continue to buy up yuan with the country’s foreign exchange reserves in an effort to prop up the currency.


In part because of sluggish demand from China—the world’s largest consumer of commodities—stock prices of commodities producers have slid sharply, pushing markets in the US closer to a bear market.


In the US, investors dumped shares of Chesapeake Energy, the second-largest US producer of natural gas, after news reports that the company hired restructuring attorneys. Chesapeake stressed that it has no plans to pursue bankruptcy.


The stock market selloff has helped push investors into government securities, pushing yields on bonds to their lowest levels in a year. (Bond yields fall as prices rise.)


Those lower long-term bond yields—along with potential exposure to the slumping energy sector and China—are weighing on bank shares. (When long term bond yields fall it hurts banks because it effectively lowers interest rates that they can charge borrowers, squeezing profits.)

Deutsche Bank, a bank that has gotten attention for its exposure to energy over the last few days, got clobbered today after a credit analyst brought up the prospect that it wouldn’t be able to make a payment on an obscure set of its bonds. (Deutsche has vigorously contested that notion.)


On top of all those concerns, banks in Europe are getting burned by a fresh flare-up of the European debt crisis.

In short, the markets are about as messy right now as they’ve been at any time over the last couple years. So when Janet Yellen appears before the US Congress on Wednesday as part of her semiannual testimony, everyone is going to be waiting to hear some soothing words.

If she doesn’t sing the market’s tune, look out below.
Watch out below is right, these markets are brutal. And the hits keep on coming:
  • Bloomberg reports American International Group Inc. (AIG) plans to exit at least half the hedge funds in which the insurer is invested. According to people familiar with the company’s portfolio, the insurer has holdings in more than 100 funds and plans to cut that number to 50 or fewer. I guess they are tired of seeing their hedge funds getting crushed in this market and paying them 2 & 20 for leveraged beta. As hedge funds underperform, redemptions will rise, forcing a wave of liquidations at the worst possible time (this is already happening).
  • Perhaps sensing this, Perry Capital, a $10 billion New York-based multistrategy hedge fund led by Goldman Sachs alum Richard Perry, is making a $1 billion bet against investment-grade corporate bonds, according to The Wall Street Journal. The report didn't specify which companies, but it said the fund's short bet included owners of commercial real estate and telecom companies. 
  • Another well-known hedge fund manager, Kyle Bass who runs Dallas-based Hayman Capital, recently revealed he is shorting shares of a real estate investment trust (REIT) operated by United Development Funding (UDF), accusing it of orchestrating a $1 billion “Ponzi-like scheme.” Shares tanked by more than 30% recently.
  • Wolf Richter wrote a comment on Naked Capitalism, What the Heck is Going on in The Stock Market?, looking at several recent blow-ups. I would add that shares of Tesla (TSLA) are down close to 40% this year.
  • In a post on Monday, Mark Dow at Behavioral Macro outlined the simple, but elegant and persuasive theory about why oil prices have been driven so low and why they remain there today. According to Dow, the supply pressures won’t stop until debt-financed production becomes equity-financed production
  • Yields on Japan's benchmark 10-year government bond fell below zero for the first time, as investors clamored for safe-haven assets in the wake of a global market rout. Meanwhile Bloomberg reports that the probability of negative U.S. rates is on the rise.
  • The new negative normal and the increasing likelihood that ultra low rates are here to stay spell big trouble for big banks. Moreover, President Obama just signed a bill to double the budget for Wall Street regulators, which will effectively turn banks into highly regulated utilities incapable of taking any risks. Add to this the risk of contagion from European banks because of Deutsche's big unknowns (shares of this bank are now trading below 2008 lows), and you have the recipe for a full-blown global banking crisis
  • Worse still, central banks are the only game in town, and they've been eerily quiet. Some claptraps on CNBC (like Steve Liesman) think the Fed should take Friday's jobs report as a good sign to keep raising rates. Meanwhile, the Dow has lost more than 600 points since Friday, signalling a pronounced slowdown in U.S. economic activity ahead (economists like Liesman should learn that stocks are a leading, not lagging, indicator of economic activity).
But it's not all doom and gloom in these scaredy cat markets:
  • According to Bespoke Investment Group, when investors get this scared, stocks rally. As of Monday's close the S&P 500 dividend yield was 2.38 percent, which was 0.63 percentage point higher than the 10-year U.S. Teasury note yield at 1.75 percent. This was the widest spread between the two instruments since July 2012. "In other words, treasuries, which offer no upside from their face value, paid an investor less to own them than an asset class that has historically generated capital appreciation at an annualized high single-digit percentage rate. For this to happen, either investor expectations for long-term equity returns must have changed, or investors were really scared." — Bespoke Investment Group wrote in a note to clients Tuesday.
  • Share buyback might save this market. Early indications are that 2016 buybacks are "on pace to be one of the fastest starts on record," David Kostin, chief U.S. equity strategist at Goldman Sachs, said in a note his team sent to clients over the weekend. Announcements so far have totaled $63 billion barely a month into the year, and Kostin thinks that's just the beginning." Companies have generally expressed a continued commitment to buybacks, holding the view that market weakness is a reason to increase, rather than taper, their repurchases," he said. Of course, the downside is companies have lost billions buying back their own stock.
  • Former long-term bear Mike Mayo, research analyst at CLSA Americas, turned bull recently after 17 years. He told CNBC on Monday that U.S. banks are more resilient than they were before. The analyst claims that while bank earnings were soft, they have strong balance sheets. Mayo said that even if investors were to charge off loans from energy companies and emerging markets debt, the balance sheets would remain strong. He added that concerns that have spilled over from European banks are overdone. 
  • What else? Keep you eye on the mighty greenback. The dollar index slipped to a 4-month low today, which tells you traders are betting the Fed will sit tight and save China in the nick of time. As the greenback weakens, it loosens financial conditions and firms up commodity prices which will help ease the pricking of the global debt bubble.
  • According to Bloomberg, wagers on the price of crude climbed to the highest since the U.S. Commodity Futures Trading Commission began tracking the data in 2006. Speculators’ combined short and long positions in West Texas Intermediate crude, the U.S. benchmark, rose to 497,280 futures and options contracts in the week ended Feb. 2. “This is a reflection of a lot of conviction on both sides,” said John Kilduff, a partner at Again Capital LLC, a New York-based hedge fund that focuses on energy. “We’re seeing a battle royal between those who think a bottom has been put in and those who think we have lower to go.”
I don't know if oil prices are at an interim low or if they will drift lower, but there is a "battle royal" going on there and in the stock market where high beta stocks are getting flushed for safe, dividend stocks (a classic RISK OFF flight to safety).

But I agree with GMO's Jeremy Grantham who recently stated while the stock market sell-off makes him nervous, he fears the big crash is coming later:
Jeremy Grantham is surprisingly bullish!

In his latest quarterly outlook, Grantham, cofounder and chief investment officer at GMO, outlines his views on the markets and the economy.

And in somewhat of a contrast to his recent commentary, sees the oil crash as a big tailwind for the economy and doesn't think the stock market, though it is expensive and potentially heading into a bear market, is going to crash.

"Looking to 2016, we can agree that uncertainties are above average," Grantham writes.

"But I think the global economy and the U.S. in particular will do better than the bears believe it will because they appear to underestimate the slow-burning but huge positive of much-reduced resource prices in the U.S. and the availability of capacity both in labor and machinery."

Grantham adds (emphasis ours):
As always, though, prudent investors should ignore historical niceties like these and invest according to GMO’s rather depressing 7-year forecast. The U.S. equity market, although not in bubble territory, is very overpriced (+50% to 60%) and the outlook for fixed income is dismal.

At current asset prices no pension fund requirements can be met. Thus, we should welcome a major market break that will leave us with more reasonable investment growth potential for the longer term, but I suspect that we will have to wait patiently for such a major decline.

The ability of the market to hurt eager bears some more is probably not exhausted. I still believe that, with the help of the Fed and its allies, the U.S. market will rally once again to become a fully-fledged bubble before it breaks. That is, after all, the logical outcome of a Fed policy that stimulates and overestimates some more until, finally, some strut in the complicated economic structure snaps. Good luck in 2016.
OK, so maybe not bullish, per se, but Grantham is definitely sounding the alarm on not sounding the alarm on a stock market bubble and resulting crash.
Stocks

Over the last 18 months, stocks are basically flat in what has been by far the most difficult period for investors since the financial crisis.

And this period has really been defined by three things: a crash in oil prices, a continued and relentless slowing of the Chinese economy, and a change in Federal Reserve policy.

On top of all this is the decline in profit margins, which Grantham has called the "most mean-reverting series in finance," implying that the long period of elevated margins we've seen from American corporations is most certainly going to come an end. And soon.

Profit margins are near record highs, and Grantham expects them to fall.

In Grantham's view the Fed holding off on raising rates all the way until December 2015 staved off what could have been a really disastrous year for stocks given the weakness in oil prices and anxiety over China's economy.

And continued assistance from the Fed is likely to send stocks higher, or at least stabilize them somewhat.

The question, then, is whether this sends stocks into a "blow-off-top" where, as Grantham outlines, you'd expect to see a two-standard-deviation event with stocks rocketing higher and the S&P 500 heading to 2,300 before the big crash.

"I must admit to feeling nervous for this year’s equity outlook in the U.S," Grantham writes. "But I am not entirely convinced. Sure, we can have a regular bear market. That is always the case. But the BIG ONE? I doubt it."
Oil

In addition to not being (overly) concerned with the prospects of a new stock market crash, Grantham also thinks we're about to see the good side of the oil crash that has been a long-awaited part of the US economic narrative in the last year.

"The largest hits from the major oil company responses are behind us, although at $30/barrel (and maybe less) there will be some further retrenchment," Grantham writes.

He adds: "And now comes the matching response from us, the consumers. Everything we buy has cheaper input costs. The major item of gasoline purchases is a steady jolt of encouragement. Heating bills are also much lower. Could there be a better financial input than this to the group that has been hurting for 30 years — the median wage earner? Not easily."

This is good!

Everything, it seems, is getting cheaper, and according to the latest data out of the BLS released Friday, our paychecks are getting bigger as average hourly wages grew 2.5% over last year in January, roughly matching the largest increase of the current economic cycle (December's gains were revised higher to show annual growth of 2.7%.)

But Grantham goes a step beyond the standard, "Low oil means more spending for consumers" line of thinking (which is why he's one our favorite market thinkers to track).

Grantham further argues that increasing commodity prices, as much as anything else, have been and will be factors ahead of recessions.

Because while 2008 was all about the crash in housing and the stress at major banks, the rapid rise in oil prices and other commodities stressed consumers as much as anything else, in Grantham's view.

And just as this rise was overlooked eight years ago, the crash in prices and the delayed — but positive — feedback to consumers and the economy has been forgotten by the market.

But the benefits are coming. Now.

"Market opinion now, though, impressed with the early negatives that it should have expected and because the offsetting stimulus effect is delayed and weakened initially by some understandable increases in savings, is doing the opposite," Grantham writes.

"[The market] is underrating what will very likely become an important economic tailwind for the next several quarters. Reflecting current opinion, Luke Kawa, a writer for Bloomberg reviewing the oil situation claims, 'One of the biggest surprises in economics has been how the world responded to a period of lower energy prices.' Well, the economic world is easily surprised."

Read Grantham 's full note here »
Is Jeremy Grantham right? Is the market underestimating the stimulative effects of lower energy prices? Maybe or maybe the market is rightfully worried that lower energy prices reflect the coming deflation tsunami.

But I agree with Grantham, the Big Crash that everyone is fretting about isn't coming anytime soon. This is all nonsense that blogs like Zero Hedge love propagating. Sure, some sectors like energy (XLE), Metals & Mining (XME) have crashed and will remain in a bear market for a very long time.

And other high-flyers like small (XBI) and large (IBB) biotechs are getting massacred in these RISK OFF markets but once things calm down, biotech shares will resume their secular bull market and make new highs.

That's what I'm trading on. Maybe I'll be wrong, maybe I'll be right, but either way I'm putting my money where my mouth is and will trade these gut wrenching biotech swings.

Apart from biotech, however, I think investors can seize opportunities in other sectors and have written on this here. The bloodbath in stocks may not be over because of the factors I discussed above, least of which are hedge fund redemptions, but the algos can switch gears in a millisecond and in these markets, so you better be very careful managing your risk whether you're long or short.

Below, while everyone is trying to figure out "who’s to blame for the market turmoil?", Grant Peterkin, senior fixed income portfolio manager at Lombard Odier Investment Managers, discusses what he thinks is setting off “alarm bells” in global markets right now.

Second, Larry McDonald, Societe Generale, weighs in on comments made by Deutsche Bank CEO as he disputed financial stability worries and states his bet on banks.

Lastly, former OMB Director David Stockman talks commodities with his view of long-term cheap oil from the economic slowdown in China and a monetary collapse due to negative interest rates. He speaks on "Bloomberg ‹GO›." I agree with some things, like oil prices will stay low for a long time as demand from China slows, but his call of a "monetary collapse" is too dark and basically means the end of capitalism as we know it.

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