Still Believe in the Downside

During the 13 weeks ended last Friday, blue chips stocks had gained 38 percent, marking one of the sharpest stock market rises in history. Small cap stocks, as measured by the unweighted average of all stocks on the New York Stock Exchange, fared even better, gaining a whopping 84 percent in that same period with nary a pause. But for all the bullish stock market talk, the major averages have been unable to muster much in the way of a rally since the results of the banks stress test were released in early May.

The problem is that plenty of other things are rising as well, including bond yields and commodity prices. These latter two could scuttle a recovery. For instance, the 10-year Treasury that so many consumer loans key off of shot up more than a full percentage point during the past few weeks. And 30-year mortgage rates have risen to 5.5 percent. Although that’s still low by historical standards, we’ll see less refinancing and few new home purchases as a result.

Our banking sector is walking on egg shells as it is. The number of problem banks has risen to more than 300. And even though $75 billion in capital has been raised many of the so-called “healthy” banks are on the edge. Yet the Federal Deposit Insurance Corporation (FDIC) is essentially out of money, with only $13 billion in remaining reserves (although its line of credit was recently upped to $500 billion).

Because they’re in such sad shape, the major banks are reluctant to lend these days. And they’re going to be hard pressed to grow their earnings without greater lending. Yet existing loans, running the gamut from commercial loans to home mortgages to auto loans to credit cards continue to deteriorate.

Stocks have inched above their 200-day moving average, enough to increase investor confidence. At the same time, what would have been seen as bullish news just a few weeks ago, is beginning to be ignored. The banks repaying their TARP borrowings is just one example of this. With momentum slowing down, stocks overall will be more prone to setbacks.

One possible trigger for a big decline may have been pulled yesterday afternoon when Supreme Court Justice Ruth Bader Ginsburg put a temporary hold on the government’s unusual bankruptcy plan for Chrysler.

The government-brokered deal to sell the stub of Chrysler to Fiat is a complicated one, but at the heart of the matter is that it is using TARP money (intended for ailing banks) to fund the deal and, in giving the United Auto Workers union an equity stake in the company, the government gave precedence to unsecured creditors ahead of bond holders, who are secured creditors (and therefore higher up in the pecking order). Most of the bondholders were strong-armed into going along with the deal, but a couple of Indiana pension funds (not Wall Street fat cats, mind you) sued to prevent the government’s plan from going through. The matter quickly made its way though the appeals system.

In an unusual turn of events, President Obama, eager to put the matter to rest and limit the economic fallout, decreed that the Supreme Court had no right to rule on the deal (essentially circumventing the rule of law). The Supreme Court, or at least Justice Ginsburg acting as the Circuit Justice, had other ideas.

Ginsberg’s ruling gives her (or the entire Court should she defer to them) additional time to decide on if the sale should proceed as it’s currently structured. If the Court’s final ruling runs counter to the current plan, Chrysler may be forced into liquidation, throwing tens of thousands Chrysler employees out of work. That would inflict further pain on the weak economy.

Regardless of the outcome of the Chrysler situation, our work suggests that the stock market’s upside remains quite limited, while downside risk is considerable. Indeed, we still can’t rule out a test of the March lows. We just can’t say how quickly that decline will unfold: It could occur at any time, but it may take as long as October before we see any real selling pressure.

We’re still getting hammered in many of our trades, and we understand if you’re running short of patience with our recent bearish picks. But we’ll continue to risk your ire knowing just how fast and how far stocks could potentially fall.

Comments

[Bluechippie:]

Write to you congressman to pass a bill on using natural gas. US have lots of natural gas and I do not see why the inertia to get all this started.

Jun 10 09:02 AM

[Zachary Sch...:]

Rises in bond yields and commodity prices also correspond with rises in unemployment and an increased savings rate. Since GDP is still geared toward consumer spending (68% at last count), that's bad news for an economic recovery.

I share your concern over a potential decline in the market and while we may not see the fear levels of the mid 600's on the S&P - we should see investor confidence get hit. Consumer names may be the first to get hit as these names have rallied more sharply than peers and an emotional retail investor is more likely to liquidate these names.

Good article - enjoyed the insight - hang in there with your short picks,

Zach
zachstocks.com

Jun 10 09:03 AM

[David Roskoph:]

Steve you can join Linus and spend another Halloween waiting for the Great Pumpkin of a collapse while the rest of us enjoy a blossoming recovery. Not only is this a recovery, it's a renaissance with the seemy innards of our great nation being upgraded to mitigate the continuous destruction of the middle class through each fed-financed mal-invested bubble. Humbled are the once mighty UAW, gone is the notion that somehow, someway off-budget items will get financed, vanishing is the ruse of GSE's. Of course we're bankrupt, but the unrivaled value of our franchise continues to keep us on top despite our mortgage-backed dalliances.

Jun 10 09:16 AM

[basehitz:]

I echo above comments on yields and commodities relative to consumer impact.

Recently, consumer debt levels were vividly quantified (hat tip to Barry Ritholtz). Please consider the ramifications of this conbination on the hyped consumer recovery.

www.ritholtz.com/blog/.../

Jun 10 09:25 AM

[enigmaman:]

IM not getting this three month stycok market climb, I understand a certain amount of recovery was due to the overly bearish sentiment, panic but it seems irrational to have climed as high as it has in sucha short time, normally a forboden of a big decline, I said nomally but these are not nomal times and thats the problem. OUr economy is being restructured in record time, the affects on US business cannot be beneficial to anybody, here opr abroad, yet the marklet continues its climb. In 200 crash its was the market, tech bubble but the fundamental make up of our economy was changes very little , so to expect the economy to return to normalized growth rates was not unreansonable. We cant say the same about this economy by any means, verything is changing and fast, can anybody predict what normal is now, its being called the New Normal and what does that Translate into as it relates to S&P earnings?? But thje marklet rises as if the market is embracing the change as good, inevitable without knowing what tomorrow will bring. They say the market " Climbs a wall of Worry" but they also say the " Market doesnt like uncertanty" but Worry begets Uncertanty and Uncertanty begets Worry, I dont get it at all, its like Happy Days are Hear again, out with the Old Normal in with the New Normal, I just dont get it!

Jun 10 09:50 AM

[thiazole:]

Here is an interesting TIME article on this very topic taking the opposite view of this author.

www.time.com/time/busi...

Jun 10 10:13 AM

[Mad Hedge F...:]

Me too. The market has gotten so dead here that I have started watching Suzie Ormand to get trading ideas. So I’m not supposed to run large balances on my credit card? Who knew? A hedge fund friend told me that the market is now like watching a ball tossed in the air that is at the apogee of its move, just before the free fall begins. No news, with shrinking volume and volatility. General Motors (GM) isn’t a stock anymore, so all of the news flow there might as well be a History Channel documentary. You can only sell so many out of the money short dated calls on other stocks before bumping up against risk control parameters. Even if you do make money in these conditions, it is at the expense of a Maalox addiction to fight the multiple holes in your stomach. It’s not worth it. This is why I prefer to spend my summers mountain climbing or practicing my ballroom dancing. Please see my “Sell in May and Go Away” opus at (www.madhedgefundtrader...

Jun 10 10:39 AM

[Larry House:]

I agree with the tone of caution in the article. I don't want the market to go down as I don't short, but the fact is the market CAN go down and do so substantially. That has to figure into what decisions I make.

Jun 10 10:51 AM

[lex:]

great article. as soon as the PPT stops propping up the mkt...it will collapse.....there is no real buying...just shuffling of stocks around PPT and their concert parties. Bit like a poker table which usually sits 10 but now only has 3 players..all pros...trying to take each other's money and betting larger raising the pot size.....for a bull mkt to happen, all 10 seats have to be filled...i doubt retailers are coming back anytime soon

Jun 10 11:51 AM

[Alphameister:]

It is so much easier to posit a long-term bull market in emerging economies. Have hedged my US long positions in recent weeks because too many people have begun to anticipate a v-shaped economic recovery, but I don't see any realistic prospect of this market testing the March lows this year. Meanwhile, a Chinese stock market that had become more ridiculously oversold and undervalued than its US counterpart has been delivering superb rewards in deeply undervalued growth stocks that still hold the potential for further huge gains. I'd have left so much money on the table if I'd "sold in May and gone away." If ever there were an investment environment that calls for a global perspective, it is the one that prevails today.

Jun 10 11:56 AM

[woodsey:]

I'm scared, friends. But scared never held me back. I continue taking what I call prudent risks. "Sometimes you eat the bear; sometimes the bear eats you."

Jun 10 05:25 PM

[rufus black:]

Finally some said no to this president , and more importantly it came from left leaning Gingsberg. A green political shoot maybe? No rule of law and no America. The outcome of this confrontation should be a signal as to how much confidence can be placed in the markets.

Jun 10 06:32 PM

[schnickelfritz:]

This guy needs to learn how to use spell check.


On Jun 10 09:50 AM enigmaman wrote:

> IM not getting this three month stycok market climb, I understand
> a certain amount of recovery was due to the overly bearish sentiment,
> panic but it seems irrational to have climed as high as it has in
> sucha short time, normally a forboden of a big decline, I said nomally
> but these are not nomal times and thats the problem. OUr economy
> is being restructured in record time, the affects on US business
> cannot be beneficial to anybody, here opr abroad, yet the marklet
> continues its climb. In 200 crash its was the market, tech bubble
> but the fundamental make up of our economy was changes very little
> , so to expect the economy to return to normalized growth rates was
> not unreansonable. We cant say the same about this economy by any
> means, verything is changing and fast, can anybody predict what normal
> is now, its being called the New Normal and what does that Translate
> into as it relates to S&P earnings?? But thje marklet rises as
> if the market is embracing the change as good, inevitable without
> knowing what tomorrow will bring. They say the market " Climbs a
> wall of Worry" but they also say the " Market doesnt like uncertanty"
> but Worry begets Uncertanty and Uncertanty begets Worry, I dont get
> it at all, its like Happy Days are Hear again, out with the Old Normal
> in with the New Normal, I just dont get it!

Jun 10 09:17 PM

[FB5000:]

Dr. Leeb. Sorry to say but I fear you will continue to get hammered in your positions.The market will continue to drift up because the flood of money pumped in these past 6 months is working its way through the system. Saying we will retest the March low is as ludicrous as saying we will be hitting the all time high anytime soon. Both are in the realm of <5% probability events. Very unlikely. Expect a continuing rise in US equities over the next 12 months. That upward sloping yield curve is a thing of beauty and presages recovery. It also means inflation and higher short term rates but that is a 2010 - 2011 problem. Expect financials to continue to run - why because they are at historic lows and can borrow for nothing and lend to good credits at a handy margin. Anyone who is looking for money now knows that it can be got - at a price - less competition and cheap raw materials will work their magic on bank balance sheets. Earnings will be speactucular. How can they not? Yes, there will be defaults and some banks will fail - so what - it is all priced in - but the vast majority of loans are good and continue to pay. Armageddon has been averted - so don't bet on that scenario. Emerging markets are a nice place to be - commodities too and non US treasuries might be worth a look but the US market is the widest and deepest on the planet and pretty soon all that cash that is earning negative real returns will start to flow into it - we are already seeing asset values increasing at the margins - witness oil, gold, etc. Emerging markets etc. - as the dominoes fall the cash has to flow toward the big kahuna.

Lather, Rinse, Repeat.

Jun 14 01:56 PM