The U.S. stock market closed out its worst week since the dark days following the collapse of Lehman Brothers, key commodity prices broke down, and Treasury bond yields plunged to lows few of us thought we would ever see. It was an eventful week indeed. Let’s break down the numbers.
Stocks: The S&P 500 and Dow Industrials dropped 6.5%, with most of the damage coming in the two days after the Fed meeting. Every S&P sector was in the red, with defensive sectors and tech holding up best, and materials, energy and industrials hammered, along with banks. The small cap Russell 2000 dropped 8.66%, while the large cap tech dominated NASDAQ 100 fell a more modest 4.3%. The selling had exhausted itself by Friday, when the market recovered slightly. Volume picked up during the week, but fell short of the massive levels of early August.
Losses on the Euronext 100, Bovespa, KOSPI and Sensex were very similar to the SPX in a global selloff. The CAC 40 (France), IBEX 30 (Spain) and Dow Jones Italy indexes are all approaching their March 2009 lows. In China there was an interesting divergence, as the Hong Kong based Hang Seng fell more than 9% while the Shanghai Composite was down less than 2%.
Bonds: Bond prices shot up as yields tumbled again after a one week reversal. The 10 year treasury yields is down 25 of the last 33 weeks, an amazing run. The benchmark yield fell nearly 13% this week alone, closing just above 1.8%. The long bond fell further on confirmation that the Fed will extend the maturities of its holdings, closing at an astonishing 2.87%. Investment grade corporate bond yields fell more modestly; high yield corporates sold off on risk aversion, but the pressure was much less that we saw on equities. By comparison they were a rock of stability. TIPs were little changed and munis found a bid.
Commodities: Commodities participated fully in the massive liquidation that hit the risk asset markets. The CRB Index fell 8.4% and has given back all of the gain since the announcement of QE2. Losses were widespread: WTI crude closed below $80, the Dow Jones grains index closed at a new year to date low, and copper plunged more than 15%. The precious metals were not spared: spot silver fell a stunning 23.5%, and both platinum and palladium closed at new year to date lows. Gold was best of the breed, falling a mere 8.4% on the week.
Currencies: After a small pullback the previous week, the U.S. dollar resumed its sharp advance, while the euro declined again amid deepening crisis. Yen, still a perceived safe haven, was flat on the week. Sterling was off 2%. The commodity producer currencies were generally down 5-6%. Both the Aussie and Canadian dollars fell below parity vs. the greenback, and like commodities, have given back much of their gains since the announcement of QE2.
Last week did not bring us a great deal of economic data. There wasn’t much to the FOMC, and nothing that was a surprise to the markets. Initial and continuing UE claims were not far off consensus. Most of the data was on housing and shows a market that is still bumping along the bottom - no longer deteriorating but not improving enough to move the needle. We did not learn anything that would change our outlook on growth or inflation.
Stocks: The stock market has seen a rough couple of months. We have been hearing reports of forced institutional liquidation again, for the first time since the post Lehman crisis, and ICI data show heavy rotation out of domestic equity funds and into fixed income. The commentary stream is predictably leaning bearish. Last weekend we were encouraged by the strength in tech stocks but the momentum was overwhelmed by selling. It should be fairly clear by now that the events in Europe, and to a lesser extent what is looking like a global growth deceleration and lowered earnings guidance, are dominating the markets.
In spite of all this pessimism, much of it quite well reasoned, we remain optimistic on equities and are beginning to see some attractive opportunities. Panic selling and forced liquidation make quality assets available at attractive prices. If you are a long term investor, this should be a larger concern than trying to call a bottom. We have a list of stocks, ETFs or funds that we like, and are still looking to open or add to positions now that they are on sale.
At the same time, we’re not going to try to catch any proverbial falling knives, so we will be looking at technical indicators to signal entry points. At this stage my read is that the broader indexes have re-rested and held the August lows, and the accumulation of volume suggests that the selling could be washed out. Thus even for traders with a shorter horizon, there is a good probability of a tradeable rally here with the market so far extended from the mean.
Bonds: Just as equities are stretched far from the mean on the downside, Treasury bonds are stretched far on the up side. My regular readers know that I have been a long term bond bull, and more recently have urged staying away from shorting them, but I am finally warming up to the idea. Another idea that I like even better is rotating out of Treasuries and into high yield.
In the last couple of weeks I have pointed out some technical divergences in Treasury yield charts. There is another, larger market inefficiency at play here. Who believes that sub 3% 30 year yields are a reasonable forward prospect? This essentially means accepting that long term growth and long term inflation prospects are moribund for a generation and more. I can buy that outlook perhaps for the next couple of years, but not 30. The way to take advantage of this market inefficiency is not however to be short bonds; being short anything has a carrying cost, and being short for very long periods is a non-starter. The way to take advantage is to be long growth assets instead.
The current yield on the iShares 20+ Year Treasury Fund (TLT) is an anemic 3.4% and subject to reinvestment risk - the yield could fall further in the near term as bond holdings mature and the proceeds are reinvested at current rates. There is also, in my opinion, considerable risk of capital deprecation in the long term as rates rise. As a result of the fall in equity share prices, such alternatives as the iShares Global 100 ETF (IOO), currently yielding 4.3%, the Dividend Yield ETF (DVY) yielding 3.9%, the SPDR Utilities ETF (XLU) yielding 4.1%, all offer more attractive yield on cost than TLT and its shorter maturity sibling IEF.
There is normally more risk with equities than with fixed income, but the current market dislocation has narrowed the long term forward risk spread by pushing share prices so far down and bond prices so far up. The dislocation could certainly get more extreme before it reverts to the mean so timing the entry as always demands careful consideration, but this is the type of infrequent opportunity that allows investors to “break the rules” and capture good returns in the long run. Each investor must consider their own risk tolerance and whether equities are appropriate.
Commodities: Commodities are now in worse condition than equities. Where equities have held a previous low, commodity selling is accelerating. However bargain hunting in this asset class is a slightly different proposition. As I often remind readers, many types of commodity positions have a carrying cost, or effectively negative yield, so they are not always appropriate long term holdings. This makes timing entry and exit even more crucial than with equities.
My previous articles have stated that I was looking for a level near 300 on the CRB Index to begin looking at long positions - so long as support developed. It is surprising how quickly we have gotten to that level. We still need to look for support; my suspicion is that we will get a short term bounce, but there is at least another 10% down from here. In the longer run, the macro case for commodities is fairly compelling, but I am willing to wait for a better entry point.
Currencies: With the U.S. dollar index rallying and commodities crashing, the commodity exporter currencies are coming under severe pressure. Growth is slowing everywhere, and policy makers seem to think that they can all export their way out of trouble - all of them at the same time. This leaves the U.S. as consumer of last resort, and a strong dollar suits everyone else just fine. Look for the trend to continue.