Pullback Time? There's No Better Predictor than Credit Spreads 21 comments
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Moves in the equity markets like the ones just experienced in the recent holiday-shortened week bring the statisticians out of the woodwork looking at the size of the moves, how fast they happened and where things stand in relation to the oft-cited benchmarks. The talking heads will be inundating you with that for most if not all of today and by doing so could well help the prophesy of a pullback become self-fulfilling.
I will spend only the space needed here discussing those things to lay the groundwork for bringing to light some hopefully not so often looked at information which will, also hopefully, allow you to come to your own conclusions as to where things might be headed.
The S&P has rallied 26.6% since closing on March 9th at 676.53 and the closely watched VIX has fallen 30.6% since its 52.65 close on March 2nd. At 1653 the NASDAQ’s 27.7% 5 week run is the best in its entire history while the Russell 2000 has gained 33.4% in the same time period. Banks, which every monkey’s uncle has said need to participate in any turnaround, are now up 80% from their lows according to Kopin Tan in Barron’s.
Andrew Burkly of Brown Brothers Harriman says the index numbers are now ahead of the moves in 1932, 1938, 1974, 1982 and 2002 which were all the start of new bull markets.
The numbers themselves are impressive but the acceleration of the move begs the question; where to from here? Probably a good time to have a look at the tea leaves.
Barry Knapp, a strategist at Barclays Capital, sees some questions of sustainability with financial stocks 26% above their 50 day moving averages, which he says, is the widest gap in two generations. On top of this, with 84% of all stocks are now above their 50DMA:
“To buy the equity market at these levels implies a degree of confidence in a sharp recovery that doesn’t seem to jibe with the available evidence”, is how Barry put it. Some, however, wonder whether Barry is including the easier mark to market rules the banks now have and the Fed’s quantitative easing actions in his “available evidence.”
Louise Yamada says,
“The bottom isn’t a place, it’s a process. The indexes, except for the NASDAQ, have been outperforming, but are still in a pattern of lower highs; each rally has met with selling into strength. The first step would be to get through the December peaks across the board. It is a bear-market rally until proven otherwise.”
The recent uptick in home sales and reduction in mortgage rates have been greeted with enthusiasm as was PHM’s promise to marry CTX (The next reality show is going to be the “Real Homebuilders of America”.) Ronald Temple, Lazard Asset Management’s co-director of research asks us to remember, however, that homes are among the planet’s slowest moving assets. With the jobless ranks continuing to grow and the banks being less than effusive in their lending he feels we could see another 22% - 27% to the downside from January’s levels.
The Fed’s quantitative easing once again comes into play here as Ben’s plan to buy $1TN in mortgage securities will apply downward pressure on mortgage rates. Given that each 1% decline in rates reduces monthly mortgage payments by 10% RT thinks that even at 4% there is another 16%-21%% lower to go in home prices. Ron doesn’t see home prices stabilizing this year but thinks with all the work the government is doing they “may decline at a slower pace.” Stocks won’t need to see a recovery in housing but only “smell one” to begin to recover he says.
The actual effectiveness of the Government’s quantitative easing is coming into question as the announcement to purchase $300BN of its own paper in the open market initially pushed the 10-year yield (a key rate in the mortgage market) down to 2.5% from 3%. That rate had since risen back to 2.93% as of Thursday.
One cause for this is that “the Treasury auctioned far more than the Fed bought back” last week as was observed by Gray Smith of Arbor Research. Exact numbers for the week come in at $59BN sold; $36.6BN bought. “This leads many to question what impact the necessity of funding massive projected 2009 and 2010 federal deficits will have on interest rates over the next six to nine months.” If you’re wondering where the bond vigilantes are you need only ask the little girl in front of the TV in “Poltergeist II”.
In the market, as in many areas of life, perception is, or at least can quickly become, reality (just ask the “Housewives”). The reality of which I speak here is that perceived by the 50 economic forecasters who contribute their thoughts to Blue Chip Economic Indicators, a Kansas City based business sentiment aggregator. The good news is that the group has stopped lowering their expectations. This is not the same as raising them but with “not as bad as expected” becoming the new “good” beggars can’t be choosers.
BCEI’s nifty fifty sees all of 2009’s contraction occurring in the first half of the year with real GDP falling at annual rates of 5.1% and 2.1% in the 1st and 2nd quarters respectively. Beyond that they see growth of 0.4% and 1.6% in the last two quarters of the year. A year out they see 4Q10 GDP growing at 2.7%. They expect unemployment to peak at 9.6% in 1Q10 but they don’t see an unemployment rate without a 9 handle for any part of next year.
The wealthy, who for these purposes will include investors with $500,000 or more in liquid assets, (how many of those are left?) are feeling rather upbeat at the moment according to TNS, a research firm that monitors these types of things. They say 79% of the previously defined “wealthy” expect improvements in their households’ overall financial situation in the net 6-months; that is up from 69% in October of last year. Ellen Sills-Levy, a senior vice president at TNS thinks “the market always responds worse to uncertainty than to anything definitive – positive or negative. These results show us that affluent Americans are beginning to sense a ‘shift’ in the markets.”
Where does this all bring us? Back to the one thing we monitor more closely than anything else at Market Strategies Mgmt., credit spreads.
Justin Lahart put a feather in my cap (without even knowing it) writing in the WSJ recently saying that “corporate bonds spreads have been far better at predicting where the economy is headed than anyone thought.” He cites the widening of spreads in the fall of 2007, even as the stock indexes made all time highs. The research Mr. Lahart cited also looked at a similar period in early 2000 which, as we all know, lead to similar results.
Spreads are not only good at detecting individual companies’ ability to service their debt but can also be the canary in the coal mine when disruptions occur in credit supply. Like when banks have so many toxic assets on their books that they can’t lend anymore, widening spreads which results in a contraction of expansion.
By now everyone has heard the soprano Meredith Whitney sing the aria “Insolvenza” from the new opera “Completa Rovina Finanziaria Globale” written by Nouriel Roubini. You haven’t?! Make sure you’re not the last on your block to do so or maybe you should just make sure you’re not the last one on your block!
The findings quoted by Justin are the work of Simon Gilchrist and Vladimir Yankov at Boston University and Egon Zakrajsek at the Federal Reserve. All of their work will be included in a paper due to be published in the Journal of Monetary Economics.
Until then, what you should know is that the model these gentlemen have developed predicts industrial production falling an additional 17% by the end of 2009 with 7.8MM more people out of work than the 5.1MM already unemployed.
Those are the tea leaves.
Enjoy the week.
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When credit is extended by banks and entities with no capital or very little capital, this produces two things: inflation and bankruptcies. Someone, somewhere, must have some sovereign wealth in order to fund credit to those who have no sovereign wealth.
What we are seeing is a zero interest rate system being run by governments that are the deepest in debt, on earth. The world's #1 and #2 economies [the US and Japan] are doing banking at near zero % interest while both are the biggest national debtors on earth.
We can see this situation is utterly unstable and impossible. Now that China is encouraging the creation of credit again, both the US and Japan will follow suit. But creating government debt at a mad rate so we can inflate an unbalanced economy is a doomed enterprise.
When the British and German empires clashed in 1914, the after effects lasted for nearly 100 years. Germany basically grew their empire by creating the European Union and Britain attached itself to the US empire.
Both Japan and the US are in a death spiral with each other. Japan has always run a closed economic system that locks out value-added imports while the US has totally open borders and won't protect anything here, at all, no matter what. When US buying of Japanese exports collapsed, Japan collapsed.
These dynamics can be detected in VIX data or credit spread data but those are thermometers which let us gage the fever. The ultimate problem here is much scarier than this article: throughout history, heavily armed empires always try to fix debt problems by going to war with the people who are their creditors.
The US could happily ignore non-nuclear creditors and basically force them to accept our terms. China has nukes.
Widening credit spreads are primarily due to two factors: Banks still see a lot of risk and have low capital reserves. That means that credit spreads will rise. Secondly the banks and other lenders see that the Federal government is on a spending spree, with the federal debt possibly doubling under the Obama administration, leading to as much as 50% total inflation (over the next few years) as a result of monetary expansion. So these widening spreads may be more due to factors we already know, and not because the economy will tank.
On the positive side, new housing starts are now below "replacement" by about 250,000 units per year. With a growing population and decreasing housing stock, People will either need to rent or buy those empty homes, double-up with relatives, or live in the streets. While an additional two million people living in the streets is possible, I doubt it will happen here. That will result in house prices firming, though there may still be some drops in prices in many areas.
However, I will admit that looking at inflation adjusted S&P averages over the past 100 years suggests that we have not yet reached the bottom of the current "long cycle" in stock prices. Look up "Kondrateif Cycle" for more information on the long cycle.
Not only that, I get the sense that Meridith Witney is becoming more nuanced in her predictions. For example, the first quarter may be an exception to her gloomy forecast, and not all banks are going under -- both a change from a month, or so, ago.
Second, your headline points to credit spreads, of which there are many (e.g. short, long, high yield, investment grade, mortgage, CDS, etc.). Since absolute yields are far lower, in general, than they were a year ago, I wonder if the context of this indicator could change.
I realize the bigger issue is the lack of functioning securitization markets, but lower yields overall should have SOME effect.
Third, you tell us the current state of the markets, except for credit spreads -- the point of your article.
Finally, you point to the model developed by the Fed researchers, but there is no context, like when the forecast was made (juried articles take a very long time to get published).
I'm long COY for this exact reason. I believe that the mark-to-fantasy now in effect will keep a few companies out of bankruptcy long enough to catch the positive wave when the recession ends.
After 8-12 months, I intend to sell this position, because I think there's a better than 50-50 chance the Fed's 'quantitative easing' will lead to extreme inflation.
Doug T.....The mutual fund guy
www.mutualfundwealth.com/
The ‘Dirty Little Secret’
What Geithner does not want the public to understand, his ‘dirty little secret’ is that the repeal of Glass-Steagall and the passage of the Commodity Futures Modernization Act in 2000 allowed the creation of a tiny handful of banks that would virtually monopolize key parts of the global ‘off-balance sheet’ or Over-The-Counter derivatives issuance.
Today five US banks according to data in the just-released Federal Office of Comptroller of the Currency’s Quarterly Report on Bank Trading and Derivatives Activity, hold 96% of all US bank derivatives positions in terms of nominal values, and an eye-popping 81% of the total net credit risk exposure in event of default.
The five are, in declining order of importance: JPMorgan Chase which holds a staggering $88 trillion in derivatives (€66 trillion!). Morgan Chase is followed by Bank of America with $38 trillion in derivatives, and Citibank with $32 trillion. Number four in the derivatives sweepstakes is Goldman Sachs with a ‘mere’ $30 trillion in derivatives. Number five, the merged Wells Fargo-Wachovia Bank, drops dramatically in size to $5 trillion. Number six, Britain’s HSBC Bank USA has $3.7 trillion.
After that the size of US bank exposure to these explosive off-balance-sheet unregulated derivative obligations falls off dramatically. Just to underscore the magnitude, trillion is written 1,000,000,000,000. Continuing to pour taxpayer money into these five banks without changing their operating system, is tantamount to treating an alcoholic with unlimited free booze.
The Government bailouts of AIG to over $180 billion to date has primarily gone to pay off AIG’s Credit Default Swap obligations to counterparty gamblers Goldman Sachs, Citibank, JP Morgan Chase, Bank of America, the banks who believe they are ‘too big to fail.’ In effect, these five institutions today believe they are so large that they can dictate the policy of the Federal Government. Some have called it a bankers’ coup d’etat. It definitely is not healthy.
The government has committed almost all the revenues of the federal government amounting to $2.381 trillion would be used to finance the bank bailout (1.45 trillion), the war ($739 billion) and interest payments on the public debt ($164 billion). In other words, no money would be left over for other categories of public expenditure.
This is a transfer or wealth pure and simple. It will enable these corporations to buy up major corporations for pennies on the dollar due to deflated stock prices that they created via the meltdown.. Beatuiful scam!
G
On Apr 13 11:37 AM conceptwizard wrote:
> When are people ever going to realize that the financial system is
> out of our control and in the control of the people who own it. What
> will happen is already going to happen. This is not a game of stats
> and chance but a very methodical well thought out, mutifaceted drain
> of weath fom the american people.
> The ‘Dirty Little Secret’
> What Geithner does not want the public to understand, his ‘dirty
> little secret’ is that the repeal of Glass-Steagall and the passage
> of the Commodity Futures Modernization Act in 2000 allowed the creation
> of a tiny handful of banks that would virtually monopolize key parts
> of the global ‘off-balance sheet’ or Over-The-Counter derivatives
> issuance.
> Today five US banks according to data in the just-released Federal
> Office of Comptroller of the Currency’s Quarterly Report on Bank
> Trading and Derivatives Activity, hold 96% of all US bank derivatives
> positions in terms of nominal values, and an eye-popping 81% of the
> total net credit risk exposure in event of default.
> The five are, in declining order of importance: JPMorgan Chase which
> holds a staggering $88 trillion in derivatives (€66 trillion!). Morgan
> Chase is followed by Bank of America with $38 trillion in derivatives,
> and Citibank with $32 trillion. Number four in the derivatives sweepstakes
> is Goldman Sachs with a ‘mere’ $30 trillion in derivatives. Number
> five, the merged Wells Fargo-Wachovia Bank, drops dramatically in
> size to $5 trillion. Number six, Britain’s HSBC Bank USA has $3.7
> trillion.
> After that the size of US bank exposure to these explosive off-balance-sheet
> unregulated derivative obligations falls off dramatically. Just to
> underscore the magnitude, trillion is written 1,000,000,000,000.
> Continuing to pour taxpayer money into these five banks without changing
> their operating system, is tantamount to treating an alcoholic with
> unlimited free booze.
> The Government bailouts of AIG to over $180 billion to date has primarily
> gone to pay off AIG’s Credit Default Swap obligations to counterparty
> gamblers Goldman Sachs, Citibank, JP Morgan Chase, Bank of America,
> the banks who believe they are ‘too big to fail.’ In effect, these
> five institutions today believe they are so large that they can dictate
> the policy of the Federal Government. Some have called it a bankers’
> coup d’etat. It definitely is not healthy.
> The government has committed almost all the revenues of the federal
> government amounting to $2.381 trillion would be used to finance
> the bank bailout (1.45 trillion), the war ($739 billion) and interest
> payments on the public debt ($164 billion). In other words, no money
> would be left over for other categories of public expenditure. <br/>This
> is a transfer or wealth pure and simple. It will enable these corporations
> to buy up major corporations for pennies on the dollar due to deflated
> stock prices that they created via the meltdown.. Beatuiful scam!
>
>
>
>
We have unending black holes in Fannie/Freddie, AIG, and now GM bankruptcy likely to cost $100B (additionally about $30B lost in GM bonds). US is in big trouble, ultimately the $ would crash, in the short term we see rallies in bonds, even in equities. The strength of equity rally is unbelievable – fools never learn.
The aggregate of industrial companies' yield spreads over Treasuries was 444 basis points last Thursday, below a record peak of more than 600 basis points in December, according to Merrill Lynch data.
But financial institutions' yield spreads over Treasuries were 804 basis points last Thursday, even higher than levels during investors' December flight out of riskier assets into safer havens such as Treasuries.
I'm only long oil and precious metals right now (ultimately other commodities will be good again). We'll see which one of us has more money left at the end of the game.
By the way, he does mention on his site his plan of using open web forums to post his BS in order to attract attention to his web site. so, this is all planned out to be as annoying as he can in order to get attention.
On Apr 14 01:55 PM History Buff 24/7 wrote:
> Cetin,
>
> I'm only long oil and precious metals right now (ultimately other
> commodities will be good again). We'll see which one of us has more
> money left at the end of the game.
Look at the unemployment numbers, and home price Shiller numbers - they are a much better indicator of where the economy is headed. It is headed in the wrong direction - deflationary big recession.