The past week saw a massive rally in risk asset prices. Since the bottom on October 4th, the S&P 500 is up 14%, the Nasdaq 100 up 16%, Brent and WTI crude up 16%, and copper up 15%. To be sure, risk asset prices experienced their strongest rally since the rally off of the March 2009 lows.
However, in the same time period, the CRB RIND rallied only 1.1%. The following charts show the CRB RIND and the GSCI Index.
Chart courtesy of The 10/14 Commodity Analyst Newsletter -
Chart courtesy of The 10/14 Commodity Analyst Newsletter -
As can be seen, the GSCI Index has experienced the same massive rally as all risk assets, whereas the CRB RIND has barely responded. This is of particular interest to us, as this would seem to suggest that speculators are getting ahead of actual commodity demand.
To illustrate this, the following charts show the percentage changes on the CRB RIND and the GSCI Index for September and month to date October.
As can be seen, in September, the CRB RIND fell 5.67% while the GSCI Index fell 8.85%. This makes sense as speculative moves tend to be more exaggerated. However, so far in October, the GSCI Index is already up 8% while the CRB RIND is only up 0.63%. While the CRB RIND may be stabilizing, it seems that the GSCI's advance is largely betting on the future, pricing in a robust increase in commodity demand which may or may not materialize. In our opinion, not only will this increase not materialize, but we will see a continued dropoff in demand for commodities.
Despite what risk asset prices and news headlines tell us, the situation in Europe is far from resolved. The reason why Merkel and Sarkozy can only announce that they will have a plan at some point in the future, and that they are pushing back meetings, is because there is no mutually palatable solution.
At this point, the major European powers are at odds over the use of the EFSF. As we commented on last week, France would prefer to use the EFSF immediately to recapitalize their banks due to their absolutely massive PIIGS debt exposure while Germany would prefer to use the EFSF only as a measure of last resort. Given the bailout's already high level of unpopularity in Germany, Germany will most likely prevail in this battle. This will be the next major leg down in the European crisis, as France's AAA credit rating will almost certainly get downgraded as they backstop the liabilities of their 3 largest banks.
To give an idea of the magnitude of this backstop, France just backstopped 36.5% of Dexia's short-term liabilities, which comes out to about 30 billion euros. Between the 3 of them, Soc Gen (SCFLF.PK), BNP and Credit Agricole (OTCPK:CRARF) have 1.7 TRILLION euros of short-term borrowings (980 billion for BNP, 598 billion for Soc Gen, 153 billion for Credit Agricole). France's total public debt outstanding is just under 1.6 trillion euros currently. Even if France only has to backstop one of these banks, their effective debt would absolutely skyrocket, leading to an assured downgrade of their credit rating, and sending French government bonds into freefall.
Another huge problem that developed this week was the admission that Europe is now seeking a 50% haircut for private Greek bondholders. We won't bother commenting on the inherent problem for Greece that this private haircut really doesn't help them that much, as UBS has already published a great piece on it. However, what no one is really talking about is what effect this haircut will have on the other PIIGS countries. With Ireland and Portugal suffering through their own austerity and debt crises, how exactly could the EU offer such a generous debt reduction for Greece but then tell Ireland it must continue to pay 100% of its debt? These other peripheral countries will expect some sort of haircut if Greece gets such a sweetened deal. Taking PIIGS debt ex-Italy, there is about 1.4 trillion euros of debt. Applying a conservative 25% haircut, that is 350 billion euros of losses that must be taken on the debt. Furthermore, even if the debt is probably already trading around that level, banks have not marked it to market because of accounting rules, while a haircut event would force that inevitability. Such a scenario would trigger massive insolvencies in Europe and a complete collapse of their banking industry.
The basic problem in Europe has not changed, and that is that their sovereigns are massively overleveraged. There are only 2 ways to solve a sovereign debt problem: either let the sovereign go bankrupt, or print currency to pay back the debt. Europe has taken the tiniest of baby steps towards printing to pay the debt, but they must move much, much faster. The most likely catalyst towards Europe accepting such a currency-deflating event will be a renewed market crisis in which the market completely stops funding the French banking system or even the German banking system. In our opinion, we are very close to this watershed event.
Once Europe accepts their eventual fate and enacts a European version of the TARP, markets could calm and we could move forward. However, this option is not even on the table right now for Europe, as they perceive everything to be ok with the markets. It will likely take a significant and violent deepening of the crisis before Europe can gather the popular support they need to proceed with these Draconian measures.
On the other side of the Atlantic, the U.S. needs massive fiscal and monetary stimulus before things can improve in this country. However, the Republicans will continue to hold this hostage, as a failing economy actually benefits their political cause by being able to blame all our woes on Obama. The republicans have been able to convince the population that monetary and fiscal stimulus is somehow hurting them, a truly amazing feat. Until things get very bad, the population will not support further accommodative measures from the government, at which point they will beg for them.
It is our opinion that significant pain is yet necessary to galvanize support around what needs to be done in both Europe and the U.S. The population in both continents does not support the measures necessary to get U.S. out of the current debacle, but they will once things get bad enough. In this vein, we expect fiscal stimulus and QE3 from the U.S., but only after things get so bad that the population is left clamoring for them. We expect a massively deflationary period followed by yet another bazooka of government intervention being fired to inflate our economy.
Obviously, our view is highly bearish for U.S. stocks as it is all risk assets. We view 900-950 as a reasonable target as to how far we could fall during this current bear market. While this week saw a massive rally, such retracements are the hallmark of a bear market.
The following chart shows late 2008 with its bear market rallies.
As can be seen, the index experienced 3 quick rallies of 20% each during an otherwise brutal bear market. Because so little confidence is in the market, the situation lends itself to massive moves either way, even though the general direction remains down. The most important concept of bear market trading is to be sure to be able to stay in the trade to reap the eventual rewards of the downward trend.
The chart above shows the weekly move in the S&P 500 index along with its volume. As can be seen, volume on the S&P 500 was at its lowest point since the shortened Labor Day week even though prices moved magnificently. This is usually a red flag, as it signals a lack of conviction and a lack of participants. More likely than organic buying emerging is that market makers and short sellers are completely unwilling to be sellers here due to the headline risk of temporary bullish developments coming out of Europe. This lack of liquidity has sellers increasing their asking prices while buyers continue to pay up. However, it appears that the large money has stayed out, unwilling to pay ever higher prices for assets that cost between 10-20% less just 1 week ago.
While the stock market is fairly attractively priced based on a simple P/E ratio, we believe this may not be telling the whole story. The following chart shows the S&P 500 in orange, trailing 12 month earnings per share on the S&P 500 in white, and total U.S. public debt outstanding in green.
As can be seen, the response to the last 2 recessions has been to sharply increase the trajectory of government debt. From a Keynesian point of view, this makes alot of sense, in that government needs to step in and stimulate to create the demand that is gone from the private sector. However, the current Congress and administration has made it clear that cutting government debt is a priority, not increasing it. Also, the Fed has made clear their aversion towards increasing the Fed's balance sheet. With both fiscal and monetary stimulus off the table at this point, what will be the engine to pick the U.S. back up in case of a growth hiccup?
Furthermore, the increase in earnings during this bull market has been astounding. Since the bottom, earnings have increased at an annualized rate of 54% during this current bull market. The last 2 bull markets saw EPS increase at an average rate of around 15%. With profit margins hovering near all-time highs, it doesn't seem like there is going to be much of a catalyst to power EPS, and the stock market, higher.
U.S. consumers remain tapped out, and are busy rebuilding their balance sheets in the face of persistently high unemployment. With very little job security and stagnant or falling real wages, the U.S. consumer cannot be counted on as the next major driver of global demand. With the U.S. consumer comprising 70% of U.S. GDP, this is a very large problem.
While our analysis applies to all risk assets, the stock market tends to be the most leading of them. The same analysis could be applied to realize that crude oil, copper and any other industrial commodity is due for a precipitous fall.
We recommend short positions in U.S. stocks. S&P 500 futures can be sold at 1219.25. In order to keep risk contained, one could place a buy stop at 1250 to get out of the trade if stocks do continue rallying.
Along the same lines, we recommend short positions in Brent crude. With Brent crude trading at $112.23/barrel, this price will prove far too high when looking back 6 months to 1 year from now. The Saudis have already claimed the market is not oversupplied and will not cut their production. With the Saudis lofty social agenda, they need Brent to stay above $90/barrel to fund their social projects. That makes $90/barrel a very reasonable target for Brent's depreciation.
We continue to be highly bearish on the precious metals complex. Gold and especially silver could see quite a ways of downside in the coming economic environment. As risk asset markets rally, gold and silver rally as well, but at a smaller magnitude of the increase. On the other side, as risk asset markets fall, gold and silver will fall a greater magnitude of the decline.
Gold essentially has a ceiling on prices, as rising risk asset prices signal increasing inflation, but also exponentially decreased chances of further monetary easing. While risk assets fall, gold will experience the devastating effects of deflationary expectations. When viewed in this light, gold has a low ceiling and much lower floor.
Silver is even worse in that industrial demand will clearly be falling in the coming environment. If investment demand falls as well due to gold prices stagnating, silver could easily see $20-25/ounce before the year is out.
We recommend shorting both gold and silver futures at the price of 1683 and 32.2, respectively. Buy stops on gold could be placed at 1700 and 33 on silver, although one should do so carefully because these metals are extremely volatile.