David Moenning's Instablog

Thoughts From The Planes, Trains And Automobiles

Mon, 20 May 2013 12:20:28 -0400

Daily State of the Markets
Monday, May 20, 2013

Good Morning. One of the great things about being in Europe is the difference in time zones. Given that France and Italy are six hours ahead of New York and eight hours ahead of Denver, there was plenty of time each day to rest up, see some amazing sights, learn about history, and yet still have a moment or two to ponder the big picture of the stock market and the strategies we employ.

Unlike last year's Ireland adventure, where the markets were in turmoil and our trading systems required a great deal of attention, this year, the market gave me a break while my wife and I were exploring Nice, Eze, Cinque Terre, Santa Marghareta, Florence, San Gimignano, Sienna, and Bologna. In short, stocks went up every day but one while I was across the pond, which, again, allowed me some time to think.

While I had several big-picture epiphanies while on busses, planes, and trains (train travel is indeed a must-do experience in Europe), perhaps the biggest was the confirmation of my basic belief system about how best to manage money in the markets.

Take a look at the graph below. This is a monthly closing chart of the S&P 500 for the last 20+ years. In addition to some moving averages that I accidentally left in the chart when I copied it, I've added the approximate returns for each of the five major moves the market has experienced since 1993.

(click to enlarge)

What struck me is that while we spend SO much time talking about the day-to-day action, the indicators, the news, and what the central bankers of the world may or may not do next, getting the really big, really meaningful moves in the market right is really the key to success in this game.

Since about 1993 (I'm eyeballing the dates and levels here), the S&P 500 is up about 270% (The S&P went from about 450 to 1667). However, the ride has been anything but smooth as we've seen two MASSIVE bear markets since 2000 and two pretty good recovery bulls as well. But what jumps out at me here is that if one could have simply avoided at least a portion of the 47% decline that the "tech bubble bear" produced and the 56% dive associated with the "credit crisis," they would have been in much better shape.

Take a look at each of the major legs (+233%, -47%, +88%, -56%, and +150%) that took place over the last 20 years. Granted, it is IMPOSSIBLE to capture all of the up-moves and then avoid all of the down moves. However, in doing some math, it becomes quite clear that avoiding a decent chunk of the big declines is what the game is all about in the long run.

For example, if one were able to capture 70% of the gains that were available during the bull markets and then avoid 50% of the bear market declines, the returns would far exceed the buy-and-hold approach. If my calculator is correct, it looks like such a strategy would produce a total return of about +360%. And then if one could capture 70% of the upside and avoid 70% of the downside, the return is more like +523%, which is nearly double the 270% that the S&P itself gained during the period.

So, my thought here is simple. The trick to this game over the long haul is to get the big moves right. If you can stay on the right side of the big moves (such as the one that we're seeing right now), then the wiggles and giggles, and the day-to-day "stuff" will likely take care of itself.

On that note, it was enjoyable to come home after dinner each night while we were in Europe and see that our accounts had gained some ground almost every day because our Market Environment Models had told us that we need to be siding with the bulls right now. Like all moves, this one too will end at some point. But for now, we'll continue to enjoy the ride.

Looking for a disciplined approach to managing stock market risk on a daily basis? Check Out My "Daily Decision" System. Forget the fast money and the latest, greatest option trade. What investors need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets.

Turning to This Morning...

After Friday's joyride to the upside, it isn't surprising to see some sloppiness in the futures this morning. Asian markets were mostly higher while Europe is mixed and U.S. futures are currently pointing to a slightly lower open.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: +0.75%
- Hong Kong: +1.78%
- Japan: +1.47%
- France: +0.12%
- Germany: +0.36%
- Italy: -0.71%
- Spain: -0.63%
- London: -0.15%

Crude Oil Futures: -$0.55 to $95.47

Gold: -$10.20 to $1345.50

Dollar: higher against the yen, lower vs. euro and pound

10-Year Bond Yield: Currently trading at 1.946%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -2.82
- Dow Jones Industrial Average: -20
- NASDAQ Composite: -9.31

Thought For The Day...

You can't build a reputation on what you're going to do. -Henry Ford

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

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The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

The information contained in this report is provided by Ridge Publishing Co. Inc. (Ridge). One of the principals of Ridge, Mr. David Moenning, is also President and majority shareholder of Heritage Capital Management, Inc. (HCM) a Chicago-based money management firm. HCM is registered as an investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Ridge is a publisher and has not registered as an investment adviser. Neither HCM nor Ridge is registered as a broker-dealer.

Employees and affiliates of HCM and Ridge may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

What Separates The Pros From The Public

Thu, 02 May 2013 10:31:05 -0400

Daily State of the Markets
Thursday, May 2, 2013

Good Morning. I spent the better part of the last four days at NAAIM's (National Association of Active Investment Managers) annual "Uncommon Knowledge" conference, which was hosted in my hometown of Denver this year. While the conference agenda was chock full of strong presenters such as Keith McCullough of Hedgeye, Martin Pring, Tom McClellan, and Ian McAvity, the real benefit to attending a conference like this is getting to spend time chatting with more than 100 active money management professionals.

In case you're wondering, the term "active management" runs the gamut of everything from periodic reallocation of tactical and/or strategic investing strategies to trading in and out of various markets on a daily basis. In short, the managers at this conference engage in a wide variety of investment methodologies. However, the common thread is that ALL believe in doing something other than the old buy, cross your fingers and then hope approach. While we may disagree on whether a trend-following, black-box model, or mean reversion approach is better/smarter, one thing we all agree on is that buy-and-hope is an outdated concept - unless, of course, you are able to implement such a strategy when there is blood in the streets. But then again, isn't that too an "active" approach?

But I digress (as usual). While there is a contingent of managers within NAAIM that I would call "quants" who manage money based solely on the readings/rules of their mathematical systems, there are also a great many "active" managers who look to keep their clients in the right place at the right time using their experience and brains as a guide. And it was this crowd that I enjoyed talking to as the opinions on the outlook for the markets were all over the map.

I talked to advisors (a manager must be an RIA - Registered Investment Advisor - to be a member of NAAIM) who felt that the world was in sorry shape at the present time and that the piper would most certainly have to be paid at some point given the state of China, Europe, etc. What was interesting (well, to me anyway) is that some of these managers were younger and had only been in the business during the current secular bear market, while others were grizzly veterans who have seen it all since the 1970's. As such, I can't say that the folks I talked to were simply fighting the last war due to their frame of reference.

On the other side of the macro view, a smaller group of managers were borderline giddy about the outlook for the next couple of years. They cited the action on the chart, the Fed, BOJ, ECB, et al as well as the idea that the stock market tends to look forward and not back. Therefore, this group argued, if the market can find a way to not succumb to the "sell in May" season this year, stocks - specifically U.S. stocks - are the place to be.

While it isn't terribly surprising to have heard both bullish and bearish arguments from this crowd of investment professionals, the one thing that unites the crowd is the insistence on employing a risk management strategy. When asked, "What if you're wrong on your view?" the answer was universal. While the actual words chosen to offer a response varied, the overriding message was, "That's easy - we will follow our sell discipline and get the heck out of the way if things get nasty."

This is the message I will leave you with on this fine Thursday morning as I've got to pack a bag in a few minutes and start brushing up on my French (my goal is to not completely embarrass my wife in the restaurants this time around). While the approaches, strategies, methodologies, and time frames vary widely amongst the members of NAAIM, the common theme is the each and every manager has an exit strategy for their positions. And frankly, it is this one simple concept that separates the pros from the public.

While the public has a tendency to drink the Kool-Aid of the day being pushed by the financial media and their commission-based "advisors," most of the managers within the NAAIM organization get paid for "getting it right" when things go wrong. And this is why I so enjoy the gatherings because in short, I've found my people.

Publishing Note: My travel schedule continues to be full. Starting tomorrow, I will be traveling in Europe with my wife for two weeks. Then, the day after we return, I set off to fetch my youngest from college. So, I will be schedule-challenged for much of the next three weeks and will publish morning commentaries as time permits. However, rest assured that since vacation isn't a word in my vocabulary, I will be monitoring the markets on a daily basis.

Thought For The Day...

"He who walks straight rarely falls" -- Leonardo da Vinci

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

The Argument: Money Sloshing Around Vs. Macro Fears

Fri, 26 Apr 2013 08:56:10 -0400

Daily State of the Markets
Friday, April 26, 2013

Good Morning. In an effort to keep things brief and to the point (which is likely to be a serious challenge for me), let me say that the state of the market appears to be tenuous at the present time. In short, while the bulls appear to have the situation well in hand from the intermediate-term (3 weeks to 3 months) and longer-term (3 months to a year) perspectives, yesterday's late-day volatility raises some questions in my mind about the potential for future gains in the near-term.

Just when you thought our heroes in horns were about to embark on another journey into new-high-land, a headline out of Germany at about 2:00pm eastern gave the bears the opening they had been looking for. With the S&P perched right at its closing high at 1593, a report hit the wires that Germany's Bundesbank had issued an opinion for the country's high court opposing the OMT. (The OMT is the ECB's "bazooka" that could buy as many bonds as needed to stabilize the euro. Oh, and for the record, the OMT doesn't even exist yet.) With sell algos ever at the ready for such things, the news pushed the S&P down, down, down for the next 45 minutes. Thus, the question of the day appears to be if the Eurozone crisis can stay contained for long if Germany is not on board with the primary stabilizing factor.

But to be fair, we shouldn't blame the entire 9-point decline off the top on the Bundesbank. You see, more than four years after the credit crisis ended here in the U.S., Ben Bernanke said Thursday that things are not yet peachy keen in the banking system. The headline the received most of the attention was a line from a Bernanke speech in which the Fed Chairman said that vulnerabilities remain the financial system. While not exactly an earth-shattering statement, the algos remain back on high alert after the fake tweet this week and appeared to do their thing immediately after the quote hit the wires.

I know what you're thinking. First, this type of stuff with the algos creating intraday volatility in both directions goes on all the time. Second, the overall trend clearly favors the bulls. And thirdly, there is always something for the bears to worry about, right? However, my point is that for the second time in a week, the computers sent the market into a tailspin at the drop of a hat. And frankly, this type of action worries me a bit.

The bears can now argue that yesterday represented a "failure" at the old highs (the S&P hit its high water mark on 4/11), which is a clear negative according to the technical analysis textbooks. As such, a move below yesterday's low of 1579 would likely add fuel to this argument and bring in technical sellers. Remember, there are plenty of traders who are "riding the range" (buying the bottom of a trading range and selling the top) these days. And frankly, our Market Environment Models' signal to "reduce leverage" in our active risk manager programs at yesterday's close felt pretty good for specifically this reason.

On the other side of the court, the bulls will argue that the Japanese QE program is creating a boatload of new cash that is sloshing around the financial looking for a home. As one analyst wrote yesterday, overwhelming Japanese buying appears to be pushing up the prices of bonds, stocks, gold, silver, and even Apple. So, with the Japanese effectively doubling up on Ben Bernanke's QE efforts, there is indeed an awful lot of new capital being created these days.

The good news here is that if the "money sloshing around" argument is real, then any declines in the stock market should see folks implementing a BTFD (buy the freaking dip!) strategy. As such, any pullbacks in the market could very well wind up being short and shallow.

From my perch, the bottom line is this... The money sloshing around could easily cause traders to ignore the concerns about the state of the U.S. economy, the European debt crisis, and China's slowing economy. However, as they have displayed this week, the bears do have some additional weapons to work with. As such, I wouldn't be terribly surprised to see a trading range remain in place between 1540 and 1590 for a while longer.

Publishing Note: My travel schedule is about to get pretty nutty. First, I am first attending NAAIM's annual conference with meetings starting on Friday. Then I will be traveling in Europe with my wife for two weeks. And finally, the day after we return, I set off to fetch my youngest from college. So, I will be schedule-challenged for much of the next three and one-half weeks and will publish morning commentaries as time permits. However, rest assured that since vacation isn't a word in my vocabulary, I will be monitoring the markets on a daily basis.

Turning to This Morning...

The overseas markets are mostly red this morning as traders appear to be growing more cautious. The comment yesterday from Fed Chairman Bernanke about the risk still in the financial system got people's attention. In addition, the Bundesbank's opinion that it opposes the OMT has put concerns about the Eurozone crisis back on the table. And with Europe's markets down, the U.S. futures are following suit in the early going.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: -0.97%
- Hong Kong: +0.66%
- Japan: -0.30%
- France: -0.77%
- Germany: -0.24%
- Italy: -0.62%
- Spain: -1.05%
- London: -0.40%

Crude Oil Futures: -$0.38 to $93.26

Gold: +$1.70 to $1463.70

Dollar: higher against the yen and euro, lower vs. pound

10-Year Bond Yield: Currently trading at 1.701%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -2.94
- Dow Jones Industrial Average: -27
- NASDAQ Composite: -7.00

Thought For The Day...

If you don't like something, change it. If you can't change it, change your attitude. -Dr. Maya Angelou

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

Does The 'Hack Crash' Tell Us Anything?

Thu, 25 Apr 2013 08:28:20 -0400

Daily State of the Markets
Thursday, April 25, 2013

Good Morning. It is always interesting to see what captures people's opinion in this game. For example, Tuesday's "hack job" of AP's Twitter account produced a mini flash-crash in which the DJIA fell 145 points in about 120 seconds and then recovered 134 points in the ensuing 3 minutes. So, in just 300 seconds, the DJIA traveled 279 points. But since the source of the dance to the downside was identified instantly and then the event was reversed almost as quickly as it came, I really didn't give it much thought. The bottom line is this type stuff happens all the time (albeit on a smaller scale) to individual stocks. However, since this time the computers hit the DJIA and the emotions from the Boston Marathon bombings were still raw, the public can't seem to get enough of this story.

While most professionals in the game understand that there are lots and lots of algos combing through the news wires looking for combinations of words that will trigger buy and sell orders, apparently the public does not. It's actually fun to see these programs in action at times, as the computers grab words that don't necessarily go together correctly. But since the computers can read a wee bit faster than we humans can and they do seem to get "the story" right most of the time, this is a game that probably isn't going to go away just because somebody sent out a false tweet.

One of my colleagues (Ted Lundgren of Hg Capital Advisors, a firm that, by the way, runs some pretty nifty investment strategies) called me yesterday and asked me if I thought the "mini crash" meant anything from a market environment perspective. Ted's contention was that this was an event that could have, or perhaps even should have, shaken the confidence of investors. He suggested that while not on the same scale, the Flash Crash of May 6, 2010 might be used as a guide here. "If you look at the Flash Crash," he opined, "You'll see that it was part of a larger move lower. But on Tuesday, the market didn't miss a beat. So, doesn't that tell us something?"

I admitted that I hadn't considered Tuesday's event from that perspective as market participants largely ignored the move. But Ted's contention was interesting because of the fact that CNBC spent much of the day Wednesday talking about what I'm calling the "hack crash." And in terms of the media coverage, it was as if this type of thing had never happened before.

But I digress (yes, there is indeed a reason that I often refer to this column as a "meandering" morning market missive). The key point that was made to me was that the "hack crash" occurred and nobody really seemed to care (other than the financial news networks, that is). I was reminded that by the end of the day Tuesday, the market had moved to the high of the day and there was a fair amount of talk making the rounds about the potential for new highs. In other words, despite the deep-dive that had occurred earlier in the day, fear was most definitely not in the air.

I countered with the argument that there is a large number of trend-following algos these days pushing the indices around and that computers don't scare easily. After all, the trend is indeed an algo's best friend when the market is moving in one direction or the other for any length of time. But I will admit that my friend had a point.

You see, there wasn't any panic to speak of in the market on either Tuesday or Wednesday. People weren't fearful that stocks would fall out of bed again at any moment. And while the bears could be heard pushing their agenda (this day was no different from any other day in that regard), the concept of the market falling apart at the seams did not seem to dominate anyone's conversation. No, it appeared that the "hack crash" was all in a day's work and that the bulls were continuing to go about their business.

Speaking of the bull business, it looks like the word "accumulation" is definitely to be included in the description. Remember, despite all the worries about earnings, Europe, the rising wedgie-something-or-other chart formations, the defensive leadership, and the weak economic data, it does appear that stocks are still being accumulated here in the good ol' USofA. As such, it looks like it will take more than a "hack job" to take this market down. But, then again, today is another day, so stay tuned!

Turning to This Morning...

The majority of overseas markets sport green numbers this morning with the exceptions of Spain and Shanghai. The fact that the UK avoided a triple dip recession in Q1, a rebound in gold, and a steady flow of earnings appears to be keeping the mood upbeat on Wall Street prior to the open. Futures currently point to a gain of about 50 Dow points at the open.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: -0.87%
- Hong Kong: +0.98%
- Japan: +0.60%
- France: +0.18%
- Germany: +0.64%
- Italy: +0.49%
- Spain: -0.73%
- London: +0.10%

Crude Oil Futures: +$0.28 to $91.71

Gold: +$23.10 to $1446.80

Dollar: higher against the yen, lower vs. euro and pound

10-Year Bond Yield: Currently trading at 1.712%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +6.81
- Dow Jones Industrial Average: +51
- NASDAQ Composite: +9.68

Thought For The Day...

Challenge yourself to think positive ALL day today!

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

So Bad News Is Good News Again?

Wed, 24 Apr 2013 08:28:58 -0400

Daily State of the Markets
Wednesday, April 24, 2013

Good Morning. To be sure, there are times when the market's "logic" makes little sense to anyone not familiar with the way the game is played. Cutting to the chase, this would appear to be one of those times. Tuesday's rally, which took the S&P 500 back to within a positive tweet of its all-time high, was a pretty good example of this concept.

As I got to my desk at about 5:15 am Tuesday morning, I was expecting the worst. Before I had gone to bed, I had seen the report on China's HSBC Flash PMI. The report, which is designed to be a preliminary and/or independent read on the state of the country's manufacturing sector, had not only come in below expectations but had fallen from March's reading. And while the index reading was still above the "growth" line, there wasn't much room for error left in the number. As such, the Shanghai index had fallen -2.55% overnight. Ouch.

As I scanned my emails for updates on overnight data, I came across the preliminary PMI readings for the Eurozone, Germany, and France. In short, the readings weren't good... Eurozone: 46.5 vs. last month's 46.8. Germany: 47.9 vs. 49.0. France: 44.4 vs. 44.0. Okay, to be fair, the France number was actually a "beat." However, the problem in the report was Germany. You see, Germany is the strongest economy in the Eurozone and if they are starting to struggle, well...

Then there was Markit's Flash PMI for the U.S. manufacturing sector. And just like the vast majority of the other economic indicators that were not housing related, this one too missed the mark. April's Flash PMI was reported at 52.0, which was well below the consensus estimate of 54.2 and March's reading of 54.3. In fact, you have to go back to last September to find a lower reading. Ughh.

And while I didn't report on it, the Richmond Fed index also came in well below expectations. This seemed to match the decline in the Chicago Fed National Activity Index, the Philly Fed Index, the LEI, and the Empire Manufacturing Index for April. In case it isn't obvious, the point is that the vast majority of the recent data points have come in weaker than expected lately.

And if you will recall, it was a turn in the economic data that helped produce the severe stock market corrections that occurred in 2011 and again in 2012. And since the S&P's bounce off of important support over the past two days hadn't exactly been robust, one couldn't be blamed for expecting to see an ugly day on Wall Street yesterday.

Next, for some reason, the cover of the latest Barron's also zipped across my brain. My thinking was that the image of a grinning bull bounding around on a pogo stick was likely the icing on the cake for the bears and that we might see the advance of last two days erased in about 10 minutes.

So, what did stocks do yesterday in response to all that negative data? The Dow gained 152 points, of course! Sure, there was a 2-minute span Tuesday where the algos pulled all their bids and the Dow plunged 145 points in 120 seconds in response to the "hack job" tweet that said Obama had been injured in an explosion at the White House. But the dive was erased almost as quickly as it had arrived (it took 3 minutes for the Dow to recover after the drop) and before long, the bulls were back on track. Perfectly logical, right?

If you are relatively new to the game, this is called the "bad news is good news" environment where traders celebrate the idea that the ongoing spate of weak economic data means that nary a single central bank around the globe is likely to pull their QE punch bowls any time soon.

Another way to look at the situation is the recent weakness in Germany has increased the expectations that the ECB will cut rates at their next meeting. In addition, the latest macro developments across the pond have added to calls for a shift away from austerity and towards policies that stimulate growth in the Eurozone.

How did the European bourses react to the bad news yesterday, you ask? Not too bad, actually. The FTSE 100 was the laggard of the group and closed up +2.00%, while Germany's DAX gained +2.41%, Italy's MIB was up +2.93%, and France's CAC 40 soared +3.58%. As such, the bad news did indeed appear to be good news.

So, while today is another day and traders may very well decide to shift their computers' focus to the next shiny object, for now at least, it appears that bad news is good news again and that the concept of a Goldilocks economy is just fine for all that money sloshing around in the financial system these days.

Turning to This Morning...

The "bad news is good news" rally is continuing to some degree in Europe this morning as Germany's IFO Business Climate result confirmed yesterday's weaker than expected data. Here at home, earnings continue to be in focus. Procter & Gamble shares are sliding after it's earnings report, which may put some pressure on the "safety trade" here in the U.S. At this juncture, futures point to a flat-to-mixed open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: +1.53%
- Hong Kong: +1.73%
- Japan: +2.32%
- France: +0.77%
- Germany: +0.63%
- Italy: -0.71%
- Spain: +0.60%
- London: +0.26%

Crude Oil Futures: +$0.33 to $89.51

Gold: +$14.30 to $1423.10

Dollar: lower against the yen, euro and pound

10-Year Bond Yield: Currently trading at 1.717%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +2.17
- Dow Jones Industrial Average: +25
- NASDAQ Composite: -6.82

Thought For The Day...

"Poor is the pupil that does not surpass his master." -- Leonardo da Vinci

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

Thoughts On Gov't Debt And The Expected Bear In Bonds

Tue, 23 Apr 2013 08:31:10 -0400

Daily State of the Markets
Tuesday, April 23, 2013

Good Morning. Former Vice President Dick Cheney, who may be more famous for his hunting acumen (or lack thereof) than his economic policies, once told us that "deficits don't matter." The likely thinking was that running up deficits during times of need is okay because the good ol' USofA has always been able to "grow its way" out of difficulty. So, the Keynesian strategy employed by past administrations (both Democratic and Republican alike) has been to run up a deficit and assume that economic growth would take care of the problem down the road.

This approach is akin to a family where the primary breadwinner works on commission. Since the business of sales tends to be cyclical, the family may need to borrow on their credit cards or via a home equity loan in order to pay for their expenses when times are slow. And then the plan, of course, is to repay that debt when times are good again.

As you are likely aware, it's the latter part of this plan that Washington seems to have trouble with. Our lawmakers have no problem running up bills on the country credit card. However, paying down the debt (or even agreeing to talk about paying down the debt) is another story entirely. But since nations have been carrying huge debt loads for eons now, it's become a generally accepted concept. In other words, spend now and pay later (via the issuance of government debt) has been fine - as long as the country's total debt didn't exceed some percentage of its GDP.

The budget hawks contend that the debt being run up in Washington has now become a problem of monstrous proportions. Of course, those responsible for running up the debt counter with the idea that deficits are misunderstood and that the country will be able to grow its way out of the problem in the future.

Those in favor of running huge deficits also argue that since the amount of interest being paid on the outstanding debt is manageable, there isn't a problem - because, hey it's "affordable." Another argument being made is that the debt/deficit situation is actually improving. Statistics show that the U.S. government's income is actually rising (federal receipts rose 10% over the past 12 months) while spending is slowing (federal outlays fell -2.8% over the past year). And this was happening BEFORE the sequester cuts went into effect.

So, despite the fact that the Gross Federal Government Debt stood at an all-time high of $16.4 trillion at the end of 2012, we needn't worry, right? And according to data provided by the Federal Reserve, the Gross Interest Payments on Federal Debt has fallen to 8.8% of government spending, which is down from 20% in 1990, about 17% in 2000, and approximately 12% in 2007. Therefore, we must be on the right track, right?

While these may be good arguments for the idea of more government spending to try and stimulate the economy, the real story is that interest rates are at generational lows. Correspondingly, the average interest rate paid on government debt has also declined. Currently the interest paid as a percentage of government debt is about 2%. This is down dramatically from the 10% level seen in 1980 and less than half the average rate of 4.51% seen over the past 65 years.

The question here is what happens if the Fed succeeds and the economy improves? Logic dictates that interest rates would then rise. And if Bernanke gets his wish, the economy might finally get on a sustainable growth path at some point soon. But wouldn't this also mean that interest rates would move up toward more "normal" levels?

The point here is that if rates were to return to a more "normal" low level - as opposed to the artificially low levels caused by the Fed's ZIRP (zero interest rate policy), the government's payments on the outstanding debt would more than double. And even that number is probably very low due to the fact that the government is currently adding about $1 trillion a year in new debt.

Thus, at some point, the debt bomb currently being assembled in Washington might just go off. Given that the country currently pays about $331 billion in interest a year, if rates rise to 4.5% that amount would grow to something along the lines of $750 billion a year. So, assuming that Washington doesn't reduce spending, this means that the annual deficit would grow by about 40% when rates rise. Yikes.

What does this have to do with the markets, you ask? The simple fact here is that this country can't afford for rates to rise at the present time. In fact, almost no major country can afford for rates to rise right now. As such, it is probably a safe bet that the central bankers of the world are likely going to err on the side of low rates for as long as possible. Because, in short, a rise in rates could easily push most countries back into recession and we'd be soon looking for QE5, 6, or 7.

So, while rates are artificially low and the economy is expected to improve in the second half of the year (fingers crossed!), betting that rates will rise a lot in the coming months and that a vicious bear market in bonds will ensue may not be the lock that so many are calling for. Again, the bottom line is that nobody can afford higher rates. Thus, betting on the central bankers staying with their stimulus programs longer than expected may be the more pragmatic way to play.

Turning to This Morning...

Overnight markets were mixed as Asia fell on weak Flash PMI data in China. However, across the pond, investors are celebrating an improvement in Spanish bond yields and the idea that the recent data should encourage the ECB to cut rates at their next meeting. As a result, European bourses are up strong. Here at home, we continue to get a steady flow of earnings and there is some data after the bell this morning. But the bottom line is U.S. futures are following Europe higher at the present time and are pointing to a positive open.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: -2.35%
- Hong Kong: -1.08%
- Japan: -0.28%
- France: +2.30%
- Germany: +1.34%
- Italy: +2.39%
- Spain: +1.87%
- London: +1.12%

Crude Oil Futures: -$0.74 to $88.45

Gold: -$0.10 to $1421.10

Dollar: higher against the yen, euro and pound

10-Year Bond Yield: Currently trading at 1.667%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +3.20
- Dow Jones Industrial Average: +56
- NASDAQ Composite: +9.52

Thought For The Day...

The greatest glory in living lies not in never falling, but in rising every time we fall. -Nelson Mandela

Positions in stocks mentioned: none

Follow Me on Twitter: @StateDave

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.