Market Warning Signs, Trading Momentum, And You

Includes: DIA, EWG, QQQ, SPY, VGK
by: Kevin Flynn, CFA

The Federal Reserve's Beige Book came out Wednesday, and as an exercise, we went back to the Federal Reserve's Beige Book from July of 2007. It's instructive on a couple of counts. Then, as now, the economy was expanding, yet the growth was qualified with the adjectives "modest" and "moderate." Indeed, the language of the reports is similar enough in some respects that at times I had to double-check which one I had just read.

There were differences, naturally. For example, residential real estate reported continued softening in the summer of 2007, compared to the "generally...improving" tenor of August 2012 (though 2007 homebuilding activity was nevertheless higher than today). Employment gains were heartier in 2007 than now, and commodity pricing pressure was referred to often, though many of the latter are in fact higher today. The overarching similarity between the two is a mixed economy, with softening here and there.

The fact that the July 2007 report came about five months before the economy sank into recession certainly doesn't mean that we are destined to follow the same path. The points of interest are that the 2007 market was able to keep rallying into October based more on its own momentum and hopes of Fed rate cuts than any thoughts about the slowing economy; and that the Beige Book has very limited predictive value.

Looking back at that period, a key marker missed by most was the August implosion of two Bear Stearns hedge funds structured as leveraged mortgage-credit investment vehicles. Such funds had been barn-burners in the wake of the tech wreck and 1% interest rates, helping to attract rivers of investment money into mortgage paper. Most dismissed the blow-up as just another hedge fund accident, missing the significance of much of the funds' paper becoming either illiquid or tradable only at a significant loss. Credit markets had become frothy to the point of ridiculous in the spring, and people had cognitive dissonance about the possibility of declines following a peak. There was considerable complacency.

Going by the current put-call ratio, the stock market has become seriously complacent again, ignoring the real economy in favor of dreams about central bank easing. The U.S. is slowing, in case you didn't know - the upward revision to second quarter GDP seems to us to mostly set the table for another quarter-to-quarter decline.

Looking at recent data for durable goods, wholesale sales, retail sales (which declined in real terms in July, regardless of what the seasonal adjustment printed) and the recent sharp decline in consumer confidence (which tends to lead the stock market), it's hard to see how we're going to do as well in the third quarter. Trucking volumes, a good leading indicator, are down, the key categories of business investment and personal consumption are running slower, and the modest bump from residential investment is likely to be more than offset by the decline in trade.

The ticking time bomb this time around isn't the U.S. or its housing bubble, but Europe. The $64 question, of course, is whether or not it's inevitable that the latter will go off too. Without making any bets on whether or not European Central Bank (ECB) President Mario Draghi is able to pull off a bond-buying program that the markets (and several governments) crave, we would say that it is, and that neither China nor the United States will escape the collateral damage.

The Federal Reserve began lowering interest rates in September of 2007 and was later ultra-aggressive in the wake of the Lehman bankruptcy, but monetary policy can't simply wave off recessions with a flourish of the wizard's wand. While it may be possible for the ECB to start buying bonds and lower the cost of government financing, if any country were to start using the proceeds for expanding government expenditures, not only would the program halt immediately, but the very cohesion of the EU would be called into question.

Spain and Greece cannot exit their recessions while continuing to cut government spending. Yet it was government spending and a Spanish housing bubble that financed most of their growth, and the credit available to do so then isn't available now. A structural adjustment is in order, and at some point, the affected countries will crumble, just as the financial sector slowly crumbled in 2007-2008 before ending in collapse.

Recent GDP data for both Spain and Greece have come in worse than expected, and Spain has had the unhappy fortune of learning that its performance in both 2010 and 2011 was worse than previously estimated. Japan is starting to tank, the Hungarian recession is worsening, Denmark is contracting more than expected and the Chinese economy is fading fast. Global trade has fallen precipitously in the shadow of the European drama, taking economies with it (first the importers, then the exporters) and yet market prices carry on as if very little is amiss.

In August of 2010, Ben Bernanke's speech about quantitative easing launched a booming rally in equities that ran into the end of the year. The second round of quantitative easing that was rolled out in November of 2011 did nothing for the U.S. domestic markets - it wasn't until after Thanksgiving that equities began to move for their usual year-end rally, one that got its vital impetus this time around from the ECB's announcement of the Long-Term Refinancing Operation (LTRO).

Here in August 2012, we have had something of a gossamer rally in anticipation of more easing from both central banks. Yet the opinion is fairly widespread that the market impact of any operation is already baked into prices, and that another round of LTRO or ECB bond-buying will accomplish nothing on its own but another postponement of the day of reckoning. Two groups are not participating - the smart money and the dumb money.

The so-called smart money, as represented by the typical hedge fund, is comfortably lagging the prices represented by the indices, because they can see the size of the potential crash and are aware that the risk of the same is more likely than not. The so-called dumb money, or retail investor, doesn't believe in the stock market much at all and has figured it all out - just buy bonds. As fund prices approach "get-even" levels (i.e., pre-crash), they are pulling the money out in buckets to buy the one thing that goes up: bonds. Shades of 1999.

If that doesn't make you want to lighten up on your SPY, VGK or EWG, consider a common thread to 2000, 2007 and today: the fear of selling. After being left behind in 2011 by an implausible last month and even more implausible last five days that miraculously turned a losing year into a winner, mutual fund managers bought with both hands in the first quarter. Hedge fund managers have never quite believed in the whole thing, but now they are left with only four months in the year and are still behind in the performance race.

What keeps traders in is the chance of running the meter ever higher before it breaks, and the "sure-thing" bet of central bank liquidity. What keeps the hedge fund out is the hard data of a fading global economy and fading corporate profits. So what do you do? Bet on an October top or a September fade? Post-election bounce/meltdown/chaos, or another December performance run for the goalposts? It's enough to drive a money manager crazy.

Had August seen a decent back-and-fill in prices, we'd feel a lot better about this market near-term. As it is, the short-term risks now seem quite elevated. We can't say for sure which scenario is going to pay off, but we do know that the global economy is going to get worse before it gets better. That bill is going to come due and this time isn't different, so if you can't stomach the big drawdown, better plan accordingly. A corollary of the old saw that "bulls make money, bears make money, but pigs get slaughtered" is that some get out early, some get out late, but nobody ever gets out just in time.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.