A Bad Week For Risk

Includes: SPY
by: Acting Man

Global Downturn Confirmed

Official Final PMI data released late last week essentially confirmed the weak "flash" data. In the case of China one must keep in mind that the HSBC flash PMI is weighted toward private industry, whereas the official data contain sate owned enterprises as well, so the disparity between the "flash" data and the official data is greater than elsewhere.

A quick overview with links to the reports (except for China, these are all pdf files):

JPM 'Global manufacturing PMI' – still slightly positive at 50.6, but down from 51.4 in April at its lowest level in five months.

China's manufacturing PMI at a much lower than expected 50.4, down from 53.3 in April and missing expectations of a 51.5 reading.

UK manufacturing PMI at 45.9 down from 50.2 in April (!), slumping to a three year low.

Australia's manufacturing PMI at 42.4, down from 43.9 in April – the lowest since September 2011, whereby output actually dropped to the lowest level since June 2009.

South Korean manufacturing PMI at 51, one of the better showings, but still the lowest of the now only four months old expansion period.

HSBC's Brazil manufacturing PMI unchanged from April at 49.3, in a so far mild contraction.

German manufacturing PMI at 45.2, down from 46.2 in April and in its 11th month of contraction, posting the 'sharpest deterioration in operating conditions since June 2009' according to Markit.

Euro Area manufacturing PMI at 45.1, down from 45.9 in April and the lowest since mid 2009 – as he 'core' catches up with the peripherals.

This barrage of bad news was 'crowned' by a U.S. payrolls report issued on Friday that was so bad that David Rosenberg of Gluskin Sheff was moved to remark: “Even the good news in this report was bad”.

This remark was specifically in connection with the seeming sole bright spot, the household survey, the increase of which was entirely due to a rise in part-time employment, while full time employment retreated sharply.

As always, a comprehensive overview and analysis of the payrolls disaster can be found at Mish's site, we would only like to add an observation recently made by Albert Edwards of Societe Generale. Edwards pointed out that it is worth considering what the official 'U3' unemployment rate would look like if the labor force participation rate were still near its levels of 2001 in the region of 67%: It would stand at 12.8% instead of the 8.3% which are currently reported. Moreover, the rate of unemployment would have barely declined during the current 'recovery' had the participation rate remained constant!

Instead of 12.5 million people currently registered as unemployed, there would be 20.75 million.

There are numerous explanations regarding the decline in the participation rate, but the great bulk of it is due to people who have 'dropped out' of the labor force because they are deemed to have 'given up' looking for work.

This raises however an interesting question: if they are not unemployed, what exactly are they? This statistical legerdemain seems to serve no rational purpose safe perhaps deception.

In any case, the financial markets for the most part were not happy to be confronted with these large helpings of gloom, and stock markets world-wide remained under great pressure, further indicating that the primary trend has probably turned down. Hitherto somewhat better performing stock markets like the DAX and the S&P 500 were especially hard hit on Friday, with the SPX undercutting the 200 day moving average and revisiting a zone of lateral support that most bulls have probably not expected to see again so soon.

Unfortunately for the bulls, there were as of yet scant signs of the kind of panic volume and determined surge in the VIX that were evident near the lows of August and October last year.

(Click charts to enlarge)

The S&P 500 plunges, but the signs of panic usually seen at durable lows were absent

This is of course not to say that a short-term low could not be near – it is certainly possible. Arguably, a five wave initial move lower may be close to completion. However, as we have noted last week, when 'oversold' markets fail to bounce, then they often want to go even lower until signs of outright panic become visible.

The main argument in favor a relief bounce is that the US treasury bond market has basically gone bonkers in light of all these developments and is now in a rare overbought condition (and seasonal turns in this market often happen in June to boot).

Another sign that a short term turn in market fortunes may be near is that Spain's battered stock market actually fell only very little on Friday, after briefly attempting to peek into positive territory.

The 10-year note's RSI is above 80 now – not a condition that is encountered very often

In this context we would like to note that our very long-standing prediction, namely that the 10 year note yield would eventually fall to the 1942 low at 1.5% was finally fulfilled on Friday (we have held to this opinion for quite some time). This has prompted a friend send us this in recognition:

Apparently this means we must host the next neighborhood potluck. This term was first mentioned in medieval England and is actually not connected to the ancient Indian tradition of Potlatch, in spite of the similarities not only of the terms but the traditions.

A side note: market historians apparently differ on the exact level and even the precise timing of the previous all time low of the 10 year note yield. The estimates range from 0.98% to 1.67%, the timing varies between 1942, 1946 and even 1949 (yields were near their lows throughout the period). We believe 1942 is the right year, and with 1.5 in between these estimates we will stick with it. So, quite remarkably, the 10 year note yield has now fallen below the lowest level seen during the Great Depression.

A market that used the data release as the trigger for doing what we suspected it would soon do was gold. As noted in recent updates, the gold stocks had begun to act markedly better in spite of a failure of the gold price to improve. On Friday, gold made up for lost time – rising by almost $80 from intra-day low to intra-day high. It is actually normal for gold and gold stocks to rise when economic confidence declines and fall when it increases. In recent years this was not always obvious, but as we have remarked on several occasions, the positive correlation between the S&P 500 index and the XAU/HUI has certainly broken down since last summer – which is as it should be. This does not mean that a negative correlation should be observable from day-to-day, but certainly over the medium to longer term.

Gold was one of the few markets to react positively on Friday

Ironically, this happened as various observers began talking about 'gold's identity crisis' (since it appeared to act as though it were a 'risk asset' rather than a 'safe haven' asset of late). On Friday it became a 'safe haven' asset again in something of a hurry.

Germany's DAX index was whacked for 3.42% on Friday, an uncommonly big decline. We have previously remarked on the divergence between European markets and the S&P 500 at the highs in March/April – the opposite of the divergence seen at the lows last year

A close-up of Spain's IBEX over the past month. The daily candles on Thursday and Friday look like a potential short term bottoming attempt (confirmation is still required of course)

Charts by: StockCharts.com