5 Anomalies in the Current U.S. Markets

If there's any lesson to be learned from Hollywood's fictional aliens, it's that they deserve to be treated with caution. If an alien wants to have you for dinner aboard his flying saucer, make sure you find out first whether you'll be the guest or the main course.

So today, while Newsweek speculates on the existence of extraterrestrial life and movie-goers enjoy films like District 9, we find ourselves shaking hands with another form of alien, while planning our escape route at the same time.

The alien in question is today's stock market, which seems so totally unlike any other in history that it may as well have beamed down from Mars. It's a UFO: an Unidentified Financial Obstacle.

Fortunately, the evidence still supports our long-term view that the emerging markets will outgrow the U.S. economy, eventually dominating the world. The investment implications remain clear: You should make money by owning commodities and companies expanding into these strong-growth markets. However, over the near-term we are forced to contend with strangeness that renders the market difficult to predict...

5 Signs of Alien Life on Wall Street

We can count off at least five anomalies that make today's market unlike any we've ever seen on planet earth.

1) First, glancing at my Bloomberg screen this morning, I am struck by the current T-bill yield. Despite all the talk of recovery and green shoots, T-bills only yield 0.14% today. Yields haven't been this low since the Great Depression. Moreover, in the Depression we were experiencing deflation, while today we have (admittedly low) inflation. Never before have we had such low yields in an inflationary environment. In fact, even in the Depression the discount rate was around 2%, whereas today it is practically zero.

2) Second, we see today a complete lack of discrimination between high-growth and low-growth stocks. Since 1990 at least, the market has valued high-growth stocks at a higher PEG ratio than low-growth stocks. Yet today, the PEG ratio of low-growth stocks is identical to that of the high-growth stocks.

Investors have always believed correctly that share values will grow along with earnings. So, even though fast-growing stocks are slightly riskier, they traded at a premium. But that faith seems strangely absent now.

3) The third anomaly today is the remarkable correlation between all assets. It's odd enough to see oil prices moving higher along with stocks. The fact that all commodities seem to be on the same bandwagon is even stranger. Even the raw industrial indices that exclude oil and speculation are moving in step with stocks and closer to all-time highs than either stocks or oil.

We've mentioned before why this cannot persist. Higher prices for oil and other commodities will eventually drive up business expenses, depressing profits and share prices. High (over 80 percent) year-over-year increases in oil have always been deadly to the market and usually signal economic decline. (Only in 1987 did we avoid recession, though we still had a market crash.)

Why too should gold prices be so strong when stocks are rising? Generally, if stocks are doing well, investors trade gold for equities, on the grounds that equities provide higher dividends and growth. Gold becomes popular when stock returns decline and people want safety. There's simply no logic to today's correlations.

4) The fourth anomaly is that the recent huge rally occurred on the back of consistently low volume. For comparison, I recall a period in August 1982 when the market moved steadily down on low volume. One of the averages fell for seven consecutive days. Then, after some positive forecasts by economists, the market exploded upwards on record-high volume. Throughout the ensuing rally, volume remained above average. That move made sense. Prices were driven up by scores of investors snapping up shares.

Today's rally on low volume makes little sense. We've never seen a rally this strong, let along a major bottom, where so few hands participated.

5) Finally, we turn to the anomaly of the leading indicators. We've had a lot of talk of green shoots, green stalks, etc. Some of these economic improvements – such as “cash for clunkers,” inventory restocking, etc. - may be short-lived unless consumer spending picks up. True, if we set aside such speculation and look at the performance of leading economic indicators since at least 1960, we find there has been some improvement over the past four months.

Nonetheless, we have never in history emerged from a recession and experienced a real market rally on high volume without first seeing at least one month in which all the leading indicators gave positive readings. Nor have we had a real recovery and rally without first having a 6-month period in which 100% of the leading indicators showed positive gains.

This time around, the best showing we've had has been one month in which 70% of the indicators were positive (July '09). On a 6-month basis, our best score so far has been 85%. So today's green shoots are not nearly as green as they have been in the past.

If you think this is just a fluke, consider that one of the key leading economic indicators is the difference between 10-year T-Bond yields and the Fed funds rate. Today, the Fed funds rate is practically zero, so the difference effectively equals the Bond yield rate.

Normally, at this stage of the cycle, the higher 10-year yields go, the more bullish for the economy. But this key indicator (the difference between 10-year T-bill yields and the Fed funds rate) will not start rising again until 10-year yields start rising. But lately, bond yields have been falling.

Equally negative is the money supply picture. We've had a massive creation of monetary reserves. But over the past few months we've had virtually no growth in money supply – in fact the rate is less than zero for three months and about zero for six months.

Unless these two indicators pick up, we will remain in a totally alien landscape in which the rally won't make sense and a real recovery will be unlikely.

So what does a poor (or rich) investor do?

Be Cautious in the Face of the Unknown

Certainly, our long-term strategy remains unchanged. Worldwide growth will no longer be driven by the U.S. consumer. Consumer psychology in this country has changed. We are becoming more careful with our money and more inclined to save.

In the emerging markets, however, consumer sentiment is going the other way. The Chinese consumer may only be about 35% of China's economy, but he's stepping up to the counter and plopping his credit card down. This year, the Chinese will likely buy more cars than Americans, and more gasoline and other items too. Suddenly China has become an important importer in both Asia and even Europe.

As for the short-term, our first impulse is not to accept an invitation from an alien – at least not without being very cautious. We don't like this market.

Nonetheless, we recognize you may have an IRA in which a 100% cash position may not make much sense. We also don't want to be so cautious that we blow first contact with a friendly alien (i.e. a market that might transition into something more trustworthy).

So our first step is to carry a ton of protection, in the form of our barbell strategy. That means gold on one side along with a few inflation-resistant investments like Intel (INTC) and Chevron (CVX). On the other end, we have zero coupon bonds as protection against deflation – and gold too, which does well no matter what kind of turbulence we experience.

In between, we will stick with large companies with deep franchises and steady growth. These include Visa (V), Teva (TEVA), Schlumberger (SLB), Baxter (BAX), Microsoft (MSFT) and others with footprints around the world.

This is the best advice we can give you until the alien market proves itself to be of a friendly species.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.

Comments

[Larry House:]

Proper note of caution. Underweight equities and reduce size of positions. I don't like this market either, but I don't think one should be all cash and do nothing. I no longer like corporate bonds of any maturity as the prices have appreciated (lower yields) to the point of being uninteresting.

Aug 31 10:10 PM

[Dr. O:]

Stock prices, bond prices, commodity prices all moving higher. In general, there is too much paper money chasing too few assets. In particular, governments have agendas that require both low interest rates (to stabilize the housing markets and re-liquify bank balance sheets) and higher stock prices (gives banks access to capital and increase household wealth).

The fact that volume across many of these markets is anemic is a giveaway that higher prices are the result of direct manipulative intervention and not the result of investors snapping up shares.

Aug 31 10:29 PM

[jse17:]

The very astute Laszlo Birinyi wrote an interesting piece about one year back reviewing the efficacy of all of the primary market bottoming indicators. This rather comprehensive list included everyone’s darling indicator du jour at that time, the VIX. No surprise, none of the indicators were consistently accurate and in fact, were deemed relatively useless.

We search desperately for the key to unlock the answer. As others have noted, about the time the key is found, they change the lock! Now if only we could have Laszlo deliver the message in John Facenda’s voice.



On Aug 31 09:51 PM Tsy Fox wrote:

> While on the subject of questionable economic improvements, a few
> facts need to be brought to light regarding the track record of the
> Chicago PMI, which is at best a dubious economic indicator. At worst
> outright misleading !! On Sept 30th 2008, when the world's economies
> were moving into the economic collapse phase of the downcycle, the
> Chgo PMI issued the following report. "The Chicago Purchasing Managers
> report that the CHICAGO BUSINESS BAROMETER confirmed the August surge
> with a solid 58.1 reading, up from the 56.2 August 31st reading.
> Then the Chgo PMI proceeds to inexplicably drop to 36.2 in the October
> 31st reading. I find it very interesting that they did not report
> the collapse until after the S&P had collapsed to its 742 interim
> low. Call me conspiratorial but this smacks of market manipulation.
> Only a complete fool with a very short memory would ever trust any
> Purchasing Mgrs Index again.

Aug 31 10:29 PM

[LilBob:]

Sorry Doc, but the initial supposition upon which you base your succeeding arguments is inherently wrong. Global markets will not become powerhouses of economic growth because one of the side effects of globalization is an averaging out of incomes for working class peoples in all participating economies. As soon as any developing nation tries to approximate western standards of living, that nation will see investors flee to cheaper labor markets. The notion of developing nation-particularly Chinese-consumption becoming a buoy for existing capital markets is a fallacy. Declines in spending by developed world consumers will-in the long run-exceed increases in spending by developing world consumers.

Also, while the United States had the accumulated consumer capital of the WWII generation to sustain it through the early stages of out-sourcing, developing nations have no such resource, ergo there is nothing to sustain these nations financially once they start to experience capital flight.

Consumer spending in the developing world will never over-balance declines in spending in developed world markets.

Aug 31 10:59 PM

[schoolchildren:]

Last I checked lilBob, China had quite a pile of reserves - probably more than any country in the history of capitalism

Aug 31 11:02 PM

[LKofEnglish:]

as usual interesting commentary. correlation is of course terrifying to any trader because it screams "no anomalies." the typical reaction among "intelligent humans" is to presupose an "anonomlous situation" since high correlations among asset classes screams "anomolous" in and of itself. in other words "this shouldn't be happening" according to the forumulas. of course as has often been said, "dumb farmer, big potato." in case your wondering that guy's name is JR Simplot and his potato farm created Micron Technology and he's one of the richest men in the world. Go figure.

Aug 31 11:05 PM

[Donald Ingram:]

Why do we have an insiders selling to buying ratio of 30 to 1?
SINCE APRIL! No company or CEO/CFO wants to own their own shares? This market looks like a 'dump and run' mill to me. When volume is composed of the likes of AIG, CITI, FANNIE, FREDDIE etc. all trying to do each other out of 5 cents, while the HFT programs whirl away, I don't blame anyone for dumping and running!

Sep 01 02:12 AM

[Michael Del...:]

DI,

I agree that a disproportionate amount of the daily volume is in junk like AIG, Citi, Fannie, Freddie, etc. But this volume is not being generated by corporate officers "dumping and running". It is being generated by gunslingers and hedge funds who find opportunity in high volatility areas to make money both long and short (sometimes in the same day!). I sincerely hope that a very insignifificant portion of the volume is an average citizen investor who says to himself "AIG sure is cheap. I think I'll buy some for my 401(k) and hold it for a few years".

There are dozens of reasons why corporate officers would want to sell. Maybe they had stock options about to expire and needed to exercise them. Maybe they found that great house on the beach in Costa Rica and need a few million in cash. Maybe they just need to diversify. But there is only one reason why corporate officers will buy more of their stock on the open market. And they should know their company's future prospects better than anyone else. When you find a company like that, it's a gift.

Sep 01 06:31 PM

[Old Trader:]

Michael,

You're correct in saying that there numerous reasons for corporate insiders to sell having absolutely nothing to do with the market and/or the prospects for their firms, going forward.

Having said that, the fact this has been going on for some time, and the ratio of sellers compared to buyers is SO lopsided, is more than a bit troubling.


On Sep 01 06:31 PM Michael Delaney wrote:

> DI,
>
> I agree that a disproportionate amount of the daily volume is in
> junk like AIG, Citi, Fannie, Freddie, etc. But this volume is not
> being generated by corporate officers "dumping and running". It is
> being generated by gunslingers and hedge funds who find opportunity
> in high volatility areas to make money both long and short (sometimes
> in the same day!). I sincerely hope that a very insignifificant portion
> of the volume is an average citizen investor who says to himself
> "AIG sure is cheap. I think I'll buy some for my 401(k) and hold
> it for a few years".
>
> There are dozens of reasons why corporate officers would want to
> sell. Maybe they had stock options about to expire and needed to
> exercise them. Maybe they found that great house on the beach in
> Costa Rica and need a few million in cash. Maybe they just need to
> diversify. But there is only one reason why corporate officers will
> buy more of their stock on the open market. And they should know
> their company's future prospects better than anyone else. When you
> find a company like that, it's a gift.

Sep 01 08:38 PM

[Jake2:]

Up . . . . Don't bet your whatchmacallit on the thingamigig, however. You might lose it.

Sep 02 01:58 AM

[LilBob:]

On Aug 31 11:02 PM schoolchildren wrote:

> Last I checked lilBob, China had quite a pile of reserves - probably
> more than any country in the history of capitalism

Unfortunately those reserves are held by China's central bank which strictly controls the value of the Yuan and national wage-rates. The several trillion you're talking about will not be made available to the average consumer.

Sep 03 09:00 PM

[whidbey:]

The possibility of a further rally into the fall is real. After that there is a very high chance of either a long period of in determinant backing and filling,
OR a major Wave C down to maybe new lows. (about 60/40)

The unknowns that control any market are:

1. Jobs recovery and demand growth to at least a 3% GDP for Q3/4.
2. Resolution of the Congressional spending binge downward to match tax revenues
3. Focused action to help small businesses ramp up activities.
4. Prosecution of some of the miscreants in the banking world to assure honest business people and tax payers that the field is level.

Sep 04 09:07 PM