The Great Unwinding?
Dan Burrows of Daily Finance writes So much for the Dow's 2009 high. Good news on jobs is bad news for stocks:
It was silly season on Wall Street Friday. November's unemployment figure -- still a dismal 10% and subject to revision -- came in stunningly better than expected and the markets immediately soared to fresh 2009 highs. The Dow Jones Industrial Average ($INDU) alone shot up as much as 150 points in early trading.
And then, at about 11 a.m. Eastern, everybody decided to sell. "I don't know what happened," says David Wyss, chief economist at Standard & Poor's. "Some of it was probably just profit taking, but anybody who believes in rational markets hasn't looked at them very long."
On a Teeter-Totter
The Dow spiked, plunged and eventually finished with a wee gain. Welcome to the wacky world of equities, where good news is bad news and bad news is good news. It seems traders -- as fidgety as chipmunks but with shorter attention spans -- suddenly and collectively realized that an improving jobs picture could make their cheap-dollar-fueled bubbles blow up much sooner than expected.
Here's how: Stocks, gold and oil have all ballooned on the so-called reflation trade. That's where central banks and governments around the globe keep interests rates low (in the U.S.'s case, essentially at zero), while simultaneously flooding the world economy with stimulus spending. All that cheap liquidity has to flow somewhere, and it's been pouring into pretty much any asset class you can think of.
Magnifying this effect is that the weak dollar has become the vehicle of choice for the international carry trade. That's where traders borrow cheap currency (until recently, the yen for 16 years) to purchase higher-yielding assets such as stocks, bonds, oil, gold and commodities in general. Profit is made by pocketing the difference. As the dollar rises, borrowers of greenbacks find themselves in a short squeeze, which forces them to sell those higher-yielding assets in order to buy outright the dollars they've borrowed.
Dollar's Surprise Move
So if the economy is stabilizing faster than forecast -- as today's jobs report at first seemed to suggest -- the chipmunks figured the Fed will have to raise rates sooner than they expected. Why is that bad? Stocks and bonds drop on rate hikes even in the best of times. But in this case, it would hurt even more because a rising dollar will make all the assets it has reflated -- equities, debt, gold, oil, etc. -- fall even harder.
Which is exactly what the chipmunks did to these asset classes Friday. The dollar jumped and everything predicated on it being weak fell. Who saw that coming? Apparently no one. As Dennis Gartman, author of the well-regarded investment newsletter bearing his name, said Friday, punters who played the jobs report got what's coming to them.
"Anyone, anywhere who chooses to make material 'bets' in the world of trading/investing predicated upon the outcome of [the unemployment] report deserves the sound thrashing that he or she shall likely receive," Gartman told clients, noting that these reports are "notorious for revisions of 30% to 60%...in either direction!"
If there is some weirdly good news about Friday's market action, it's that at least the dollar/securities correlation remained intact, unlike the previous spooky session. On Thursday, small cap stocks, financials and oil fell even as the dollar sunk, too, notes Keith McCullough, CEO of ResearchEdge, a New Haven, Conn., strategy and research firm.
Rates Staying Put
"Dollar down equals stocks and commodities down?" McCullough wrote Friday. "Yes, this is new," the former hedge fund manager says. "It's called unwinding the reflation trade," says McCullough -- a situation that does not bode well for our bubbles.
Also adding to Friday's market mishegoss was that even though the employment report was a pleasant surprise when benchmarked against economists' and market expectations, "the overall labor market backdrop remains extremely fragile," wrote David Rosenberg, chief economist and strategist and Canada's Gluskin Sheff. In other words, at least some of the chipmunks took the time to actually digest the data -- and they didn't like what they ate.
But getting back to the idea that the Fed might hike rates anytime soon? Well, that's just goofy. "The Fed will need to see sustainable unemployment trends before they'll raise rates," says S&P's Wyss. "And then if the fragile recovery started to fall apart, they would just drop them again."
The bottom line for retail investors is that one day in the market (or in Friday's case, 90 minutes) does not make a trend. Every day is but a single data point -- and some points are noisier than others.
There is nothing sinister about this price action. Anyone with minimum trading experience has seen it a million times. Stocks gap up, traders sell the news, gap is filled and we move forward and grind higher. People love conspiracy theories but they should first learn to read the tape and understand market dynamics. The rally of a lifetime still has legs to run.
Having said this, we are witnessing the unwinding of the global reflation trade. On Thursday, Bloomberg reported that European Central Bank President Jean-Claude Trichet is withdrawing stimulus measures faster than economists anticipated, clearing obstacles to higher interest rates next year:
The ECB’s decision yesterday to end long-term emergency loans and tighten the terms of its final 12-month tender will give greater traction to any rate increases in 2010 should policy makers deem them necessary.
“The ECB chose a quicker exit path,” said Laurent Bilke, a former ECB economist now at Nomura International Plc in London. “It’s very difficult not to think it’s the beginning of a tightening process.”
The move to tie the rate on the 12-month loans to the ECB’s key rate rather than setting a fixed rate of 1 percent means any increase in the benchmark will also affect banks’ funding costs. While Trichet said the move doesn’t signal the ECB intends to raise rates, some officials are concerned that leaving borrowing costs at a record low for too long will fuel asset bubbles and faster inflation.
Trichet spoke as Federal Reserve Chairman Ben S. Bernanke promised a “smooth” withdrawal of stimulus in the U.S. as the world’s two biggest economies pull out of recession.
Yesterday’s announcements “put the ECB in a position where it can choose to raise rates if it wants to further down the line,” said David Page, an economist at Investec Securities in London. “We’re penciling in a rate rise in the second half of next year.”
The risk for the ECB is that any indication it could raise rates sooner than the Fed may fuel further gains in the euro and undermine the region’s economic recovery.
Further gain in the euro will definitely undermine Euroland's recovery. The article went on to quote an ECB council member:
ECB council member Axel Weber said yesterday it’s a “balancing act” for central banks to withdraw stimulus measures without threatening their economic recoveries.
“We’ve made it clear that we’ll gradually withdraw unconventional measures in the future,” Weber, who is also head of Germany’s Bundesbank, told ARD television. “But that doesn’t mean that we won’t use the necessary caution. There’s no need to send a signal on interest rates at the moment.”
The pace of withdrawing non-standard operations is a balancing act for all central banks that engaged in quantitative easing. If they proceed too quickly and too aggressively, they risk creating another global recession.
What does the removal of global liquidity mean in terms of global macro moves? Bloomberg reports that BNP Paribas sees the US dollar rallying in 2010 as the Fed cuts liquidity:
The dollar’s decline is in its final stages, heralding a rally in the next two years, as the Federal Reserve scales back stimulus measures, BNP Paribas SA said.
“The Fed has sent signals that it will stop expanding its balance sheet from March onwards,” a team led by Hans-Guenter Redeker, London-based global head of currency strategy, wrote in a report dated today. “Hence, dollar liquidity growth will start to shrink starting in March.”
“Markets tend to be forward looking and extreme dollar short positioning indicates to us that the dollar turnaround could come earlier,” they wrote.
The greenback's rally is not just based on covering of extreme short positions. Going forward, the USD will rally because the relative fundamentals will favor US growth over other regions. I agree with Stéfane Marion, chief economist and strategist at National Bank Financial and one of the few who correctly foresaw US payroll surprise, the next few employment reports will surprise to the upside as companies redeploy their cash flows and start hiring again to position themselves for the recovery. This will lend further support to the US dollar.
Importantly, the drop in the US dollar allowed financial conditions to loosen as the US economy was trying to recover from a terrible recession. With interests rates at zero, the greenback's slide acted as an important buffer to further deterioration in economic conditions. Now that the economy is recovering, the greenback will reflect improving fundamentals.
So what does the global unwinding mean for other asset classes? Again, that all depends on how bold and how fast monetary authorities unwind all that stimulus they provided the financial system with.
In a recent comment, Reflation Trade or Recovery Trade?, Stéfane Marion and Pierre Lapointe of the National Bank Financial write that the "period between the end of recession and the first rate hike is a very profitable sweet spot" but they add that they "cannot exclude the possibility of short-term turbulence in equity markets" because the Fed will start removing liquidity.
On a sectoral basis, Mr. Lapointe recently shared his growth buys in 2010 with the FP Trading Desk:
For investors looking to take some risks in equities next year, the best bet is to keep it in North America, a new note from National Bank suggests.
"On a global basis, the sectors that are expected to show the best earnings growth in 2010 will not be the same as in 2009 ... consensus expects the strongest earnings improvements to be posted by the energy, materials, consumer discretionary and IT sectors," Pierre Lapointe, analyst with National Bank Financial Group, said in a note to clients.
And the best place for this is North America, with the U.S. having a 40% weighting and Canada 34% in these sectors.
Mr. Lapointe also expressed doubts about gold, which has been breaking price records on an almost daily basis in recent weeks.
"Since we think U.S. employment could start growing again soon and rates could start rising sooner than the market expects, we believe the U.S. dollar could gain support at the expense of bullion," he said.
[Warning: Solar stocks are not for the feint of heart as the sector is heavily manipulated by big hedge funds. I can tell you from personal experience that I endured swings of 40% or more in my portfolio but continued buying the dips and added to my long-term positions at very attractive levels.]
There are a few other sectors that show great promise. I continue to believe that in the investment environment we're heading in, you have to pick your spots, stay nimble and always remember that small is beautiful. Also, be very weary of those sharks on Wall Street spewing their nonsense, feeding off your insecurities.
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