Market Outlook: It's Awfully Quiet Out There...Much Too Quiet

The markets will chop sideways forever, I wrote early in January.

Above: Bank of America (BAC) Option Implied Volatility, click to enlarge, (from ivolatility.com)

Volatility has collapsed back to pre-Lehman levels. Starting on April 27 I began warning of a volatility implosion, which now has run its course (click to enlarge).

Too many things can go wrong at this point.

1) The real estate rally is aborting, judging by the price of structured products. The Markit Indices for commercial mortgage backed securities (CMBS) are a pretty good indication of loss expectations. The single-A tranche is interesting, because it carries 15%-20% of loss protection, and in turn protects the AAA and AA tranches. It is something of a levered bet on survival of cash flows. It had a big rally a few weeks ago followed by a recent letdown (click to enlarge):

SIngle A Tranches of Commercial Mortgage Backed Securities Indices (Markit)

The same pattern applies to structured securities backed by subprime mortgages and other consumer assets. The one area in which prices have been robust is in collateralized loan obligations backed by high-yield loans. That’s a small and relatively technical market.

All this suggests that there simply isn’t any real improvement at the base of the economy. Mortgage rates have backed up along with the Treasury market and the Federal Reserve clearly is unwilling to buy mortgages indefinitely to support the market. The market for inflation hedges showed the Fed the instruments of torture. Along with asset prices, the bank rally has fizzled. Banks are doing nothing and have nowhere to go, which is why the implied volatility on bank options has fallen so far.

It is interesting that the commodity rally has stalled out: the rise in bond yields (and the very premature anticipation of an eventual Fed rate hike) sent a chill whiff of deflation back across the markets. The markets appear stalled, with nowhere to go.

That can’t be good.

In the long term, I expect Asian equities to outperform American equities, but the long term can be very long indeed: governance in Asia remains extremely uncertain. Nonetheless I am very slowly and carefully buying Asian equities, looking for individual names that have the potential to become great international companies (or great international companies now trading too cheaply). I also am looking for long-term commodity plays, with an emphasis on agriculture.

Still, I expect that the next move in markets will be down. The Obama adminstration’s “sugar high” (as Robert Zoellick characterized it) surely is not doing much for the consumer. US households paid down nearly $30 billion of consumer credit during April and May, an unprecedented reversion to savings. To finance a $1.8 trillion deficit without monetizing Treasury debt, the US can import (maybe) about $300 billion a year in capital to the Treasury market (all time high was $400 billion and there is pushback from the Chinese and others). It needs about $1.5 trillion in domestic purchases, or about 10% of GDP. That’s a pretty high savings rate, and it presumes that NOTHING gets financed apart from the Treasury deficit. The Fed, to be sure, can monetize a few hundred billion of Treasuries or mortgages, but not much more — the markets have already caught on to the sleight-of-hand.

I haven’t changed my view since the beginning January: the stock market will chop sideways forever.

I’ve been a big advocate of the credit rally all year — that’s a falling-volatility play, of course — but I am taking profits in some of my credit portfolio.

Comments

[Vanni]

I fully agree with your outlook!

2009 Jun 10 03:05 AM

[Jasper M]

Oh, that single A chart is One UGly Chart!
But I think your data does not support your conclusion. Periods of extreme complacency tend to precede big impulsive moves. And the complacency is certainly there - I am picking up puts for Pennies. NObody seems to believe that there will be any new casualties among economy's larger players.

I think that is a very, very bad bet. Can the largest players in the financial industry, and most of Detroit, turn into perpetual basket-cases, zombies dancing to political tunes, producing according to government will, not customer demand, and all that NOT affect the rest of the economy? I doubt that. I doubt it a lot.

This market could chop out through the fall, but at some point, interest rates are going to start choking EVERYthing.

2009 Jun 10 03:31 AM

[William Montague]

The market is so quiet that the DOW and S&P can move up 100-200 points with very little volume. There are so many people waiting on the sidelines for the next dip in what many expected to be the 'W' recession. The only problem is that government intervention has saved the 'W' for the time being as it provides capital in its plentiful 'acronym' programs.

As time goes by investors are getting bored and putting money back into the stock markets, there is only so long you can wait on the sidelines. Is all this creating a new artificial saccharin high?

None of the core problems have been solved, high unemployment, MBS, bankruptcys, defaulting home owners, credit card debt, CRE debt.

But JPM, MS and GS are allright and paying back there part of the $68B, as for the other trillions sitting out there in 'la la land', who knows?

2009 Jun 10 05:47 AM

[fireball]

i am simply playing the bounces as political favors are paid. this is the easiest money i have ever removed from the markets. yesterday i took my double+ on gm. if it falls hard again i'll take it again. the profits go to metals in the hand or to an investment out of (taxing politicians) harms way. ay least as far out of the way as i know how to put it.
if the favored banks fall hard again i'll take more there.
this morning i read an article on the many businesses preparing to leave in anticipation of even more taxation and regulation.
my most optimistic view is a double bottom. i am trying to prepare for my most pessimistic view. i expect something in between.

2009 Jun 10 08:47 AM

[doubleguns]

Fireball "this morning i read an article on the many businesses preparing to leave in anticipation of even more taxation and regulation"

I would love to read this article.

2009 Jun 10 10:26 AM

[Lilguy]

I'm almost with you on this one: I think the economy may well move sideways--or continue its decline at a slower pace--"forever" (OK--a long time), but I'm less sure that the stock market will. The market is too driven by psychological forces (especially massive media coverage) that undue its ability to be rational, whether its "irrational exuberance" or "irrational pessimism."

What has been weak about the economy--real estate, finance, employment, spending--continues to weaken notwithstanding the slew of USG and Fed actions. Moreover, these actions have added (& will continue to add) federal debt & budget deficits to the unresolved problems. The implication is a continuing slowdown in the economy with a significant risk of inflation--a double bad!

The market can see "green shoots" despite these economic realities, but even the President's unabashed "confidence" in the economy can not erase all reality in the marketplace. I expect that we will lose most of the recent substantial gains in the market over the summer as the reality becomes more obvious.

That said, we may see an economic uptick in 4Q as some of the benefits of the stimulus package and households show a willingness to loosen their purse strings for holiday spending. After that, I think we can expect more recession until at least mid-2010--and then a long, slow, uncertain semi-recovery spanning several years in which we will be constantly fighting inflation while sustaining growth. This is a "W" recession with a very weak right-hand side.

2009 Jun 10 11:07 AM

[Outside Observer]

"I also am looking for long-term commodity plays, with an emphasis on agriculture."

Why agriculture specifically?

2009 Jun 10 11:41 AM

[fireball]

doubleguns
the global guru-tax tea party 6/9/09. this is an ad letter. i rarely pay much attention to what they are selling but sometimes an opening article is pretty good here and there. better than the "media" at least.
one i think you might get a kick out of is "townhall spotlight", "millionaire patriot wants you armed". i think newsmax runs it too.
i also enjoy "the daily reckoning", "whiskey and gunpowder", and "the soveriegn society". one of the very best imho is "the daily bell". these are all just ad letters but they usually run some pretty good articles. i get a flood of them and just skip through looking for news.


On Jun 10 10:26 AM doubleguns wrote:

> Fireball "this morning i read an article on the many businesses preparing
> to leave in anticipation of even more taxation and regulation"<br/>
>
> I would love to read this article.

2009 Jun 10 11:56 AM

[doubleguns]

Thanks Fireball

2009 Jun 10 01:00 PM