Romeo Fayette's  Instablog

When I charted the Real Dividend Yield of the S&P 500, I was looking for volatile moves (>1 std deviation of the trailing 24 month average) as precursors to index gyrations.  In sitting with money managers or executives to discuss fundementals, I'm always inquisitive about free cash flow, "I see the free cash flow, but what are you doing with it?"  From an investor's perspective, free cash flow is useless unless a firm is investing it in some way.  Substantially idle FCF makes me question why a firm is publicly traded?  Dividends, acquisitions, restructurings, and share buybacks are all bastions for FCF.  (This should piss off some GS shareholders, who earn a 1.40% div yield on top of 2.18% FCF yield.  The cash is all reserved for the GS prop desk, the hub of the biggest publicly traded hedge fund on the NYSE.)
So, anywho, the chart...

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I wanted to throw up a quick post as markets are moving today and there's a lot of news to take in.
In compiling a lot of recent headlines, I'm getting the inclination that markets are poised to derisk by the end of this quarter.  I was working through an article about CALPERS, who released a memo yesterday--something to the effect of reducing High Yield allocations with PIMCO and Alliance Bernstein:

Because the significant rally in corporate credit is most likely done, reducing exposure to AB... is justified.
Staff is reducing exposure to PIMCO... but recommends renewing the contract and allocating more assets to PIMCO in the future when risk aversion is expected to produce alpha in the high yield market.

That's about $450mm (redemption from Alliance Bernstein) plus $100mm (from PIMCO) worth of HY that'll be fishing for a bid... a drop of water in the ocean, but a worthwhile note nonetheless.
I compound that with the following slew of spread-widening considerations:

1. The Fed has now ceased it's Permanant Open Market Operations (POMO) in purchasing Treasuries.
2. The Fed's balance sheet has started shrinking after repeatedly finding its upward limit.
3. The US trade deficit [get this] widened in the past month.  By virtue of commodity price appreciation, a weak US Dollar actually managed to offset the expected increase in October exports with costly imports (esp. oil and raw materials).  With the USD carry-trade fully inflated AND political tempers flaring, the USD's dive should find temporary reprive.  [As an aside, imports picked up because industry tried to make a return in October, hence the oil and raw material inflows.  Are we now stuck in purgatory, between a Stock Market that needs a weak USD to move and an Economy that needs imports to operate?  Interesting to see how this plays out... could it be the impetus Alternative Energy is looking for?]

There's a more lot at work to add to that mix (feel free to use the Comments section as a forum for more discussion), but like I said, this is a quick note. Now, while none of those tidbits are direct hits upon HY fixed income and other risky assets, you have to understand the mechanics of what's happened in this broad rally...

Namely, liquidity gushed into the economy.  The rally started with a pursuit of quality, which had already been the vogue trade since Lehman's collapse.  A persistent, relentless stream of liquidity had an excess of capital chasing a dearth of quality.  In the deflationary environment we were in, capital had to be allocated out of (floating rate) cash instruments to avoid negative-interest erosion, so the rally in quality spilled over into riskier and riskier assets:

You can see the decoupling of Investment Grade and High Yield in October 2008 after LEH.  After that period of decoupling, spreads have narrowed (as evidenced in the rally since March)--in true form to the generally accepted "9 month lag on monetary policy" and the steep increases to the M2 Money Stock between LEH & March.  The even more dramatic spillout into even riskier grades (Equities) is manifest in the chart below:

Considering the aforementioned policy lag, I count out 8-9 months from December 08 on the M2 curve (where we see a flattening in the first liquidity ramp-up) and the rally in Equities stalls.  Couting out from the March pinnacle of M2 would indicate that another stall should be in store for this coming December.  [You may also note that--without a lag--any flat period of M2 stagnation is coupled with Equity gains... particularly echoed in the period from March to present.  I wonder if liquidity is being redirected into securities? <sarcasm.]
With everyone and their brother putting up good numbers this year, there's a strong case for a spread-widening derisking through the end of 2009.

I had a discussion with a strategist at PIMCO last week.  He quite animatedly emphasized that Dow 10,000 is not a rally.  Dow 10,000, he said, is a correction.  We overshot on the way down to 6500, and now you’re about to see the real rally.  I counter that losses are amplified in a leveraged environment.  Fear and illiquidity made small contributions to overshooting, but fundamentally Dow 6500 wasn’t an unhinged outlier.

What happened thenceforth (6500-10,000) was the displacement of levered losses by government stimulus and liquidity injections.  So, I suppose I agree with the PIMCO strategist's first point.  The problem henceforth (at Dow 10,000) is all that liquidity isn’t performing.  It’s sitting in bank vaults as capital reserves.  There’s no return on that capital.  It’s not working its way into the real economy to promote growth.  We know what the steep hike to Dow 10,000 looks like.  Watch how it’s echoed by a steep hike in M2.  Only thing is, we’re seeing a decoupling as M2 has started to tail off from its March highs:

So there's all this stimulus out there, and it seems to me like it's met by diminishing returns.  So I charted recent M2 against M1 to see what the relationship is looking like:

Looks like every $1 of M1 has reared an average of $2.83 M2 since October 2007.  So I compared that to histroical norms:

Since 1959, we've seen an average of $4.74 M2 reared from every $1 M1.  But, the data are higher correlated in the near term.
Since 1985, that number (M2:M1) clocks in at $6.04.
Since 1993, it registers a whopping $9.29.
Compare those numbers to the past 3 years' at $2.83.  Stunning.  Now, we have to be fair and give monetary policy its 9-month grace period... but we've been easing since Sept 2007; we've been ZIRP since Dec 2008.
This is why it's so important for the Fed to report M3!  All arrows are pointing to deflation, but we're still in this balance between de- and in-flation.  How is that possible with the Money Supply's impotence and liquidity sitting in bank vaults?  Simply put: the cheapened dollar has been funding the global carry trade.  Speculators are borrowing USD at low rates, investing in foreign currencies at higher rates.  There's a glut of eurodollars floating around the globe, under short-selling pressure and beyond the jurisdiction of the Fed.  That's a variable that M2 doesn't account for, which is why someone better be tracking M3.
We've all heard this "carry-trade" chatter already.  Most of us are waiting for the maturity these ST USD borrowings, because it should bring a rush of demand for USDs in short covering.  I worry, however, that once the rush happens, a lot of unaccounted-for, external M3 will onboard in narrower classifications (M2/M1), and we could see serious hyperinflation.
I've noticed two powers at work during our zero-interest-rate-policy onset:

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In the wake of China's release of their 3q GDP update today, I had to bring my first-glance reaction to the table.  Here's the meat, from Clusterstock:

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You have to play the game, but remember to keep your eye on the ball: as we've smoothly entered this earnings season, broad index plays are a bit inadvisable.  There's the usual tango between earnings reports and future guidance, profits and revenues; but it's getting so hard to figure out which datum is leading the dance and which is following.  How heavily are investors weighing profits, as the economy's thirsting for revenue growth to affirm a recovery?

I posted an article a couple of weeks ago that discussed the Investor's Cycle of Psychology:

The rally gained steam through short covering, earnings surprises, government interventions.  Now, the "late-to-the-party" money is piling into riskier securities to catch what profits remain[?].  We're accelerating from Caution to Confidence as popular Bears turn Bull, CNBC celebrates, and analysts come out targeting Dow 10,500.  We'll probably see another jump up to Enthusiasm as consumerless Inventories are rebuilt to pad GDP.  We can quickly gap up to Greed/Conviction when banks report loan growth, whilst Obama & Bernanke light a cigar.  The USD will have reached support in advance of that day, and Fed Funds rate futures will price a 60-something percent chance of a hike.  Then we'll realize that we've just churned our economy after devaluing it... 

Keeping us grounded, a friendly reminder I saw from Clusterstock last night:

What you’re watching now is a bull market on government spending. What you should be watching is the real report card:
• Inflation : There is $50T in unfunded liabilities on the country’s balance sheet. If the USA played by corporate America’s accounting rules, we’d be bankrupt. The laws of gravity still apply. We will experience significant inflation within 3 years.
• Job Growth : Since the start of the recession in December 2007, we’ve lost 7.6 million jobs. Millions more have stopped looking for work. The analysts keep saying this downward trend will stop. But it hasn’t.
• Innovation : The credit contraction makes it harder for entrepreneurs and small businesses to invest in growth. This segment of the economy is where a rebound will start. Don’t watch the Dow, watch small business credit (contracting) and patents filed (contracting).
• Education : The important word in “Gross Domestic Product” is product. We must have highly skilled knowledge workers to compete against other economic innovators. A third of high school students aren’t graduating. This is the HR pipeline??

...add to that list the CRE minefield.  Also note that m/m (or even y/y) growth or deceleration in the decline of macro statistics don't represent a turnaround, but merely a bottoming.  It's like exponential decay, wherein a value continuously declines at a rate proportional to its value.  Yeah, it's slowing, but it's still not good.

We've got to keep our eye on the ball here: look at nominal price and revenue levels from 2006/07; look at real high water marks; look around you at the 25-50% off retail sales everywhere!

This past January, Martin Armstrong put out a great piece, "The Coming Great Depression- Why the Government Is Powerless." (If you know anything about Armstrong's background, he's a pretty contemptuous crook... er, bankster.  But his economic analyses are gems nonetheless.)

The stock market by no means predicts the economy... the stock market drop may signal a recession, but the collapse in debt signals a Depression...
The bubble burst in 2000 and there was a moderate investment recession into 2002, but there was no appreciable decline... The real concentration of capital that created the [2007] bubble top, took place in the debt markets.

There are some sweeping generalizations elsewhere therein, but his data-less arguments to support his thesis are pretty interesting conversation topics.

For example, he accuses Volker's Fed of violating usury interest rate ceilings in the 1980s when it pushed rates above 10%.  As a result, we've needed more subsequent debt at lower interest rates just to keep yesteryear's debt performing.  Says Armstrong:

...the lifiting of usury to fight inflation back in the 1980 has resulted in usury now being so high, a larger portion of income of the common worker is spent on interest, not buying goods and services that even create jobs.

I'm a huge opponent of the disinflationary policy we've seen since the 1980's.  If soaring debt-to-GDP or debt-to-income don't exemplify an over-mature economy fueled by deficit, let's take a look at some other data--with Armstrong's abstract as a backdrop.  From BLS's latest release:

So Consumer Spending is 70% of our GDP.  That chart shows the total expenditures and the percent change y/y 2006-08.  You can see what the commodity bubble in '08 did to Food expenditures.  You can also see housing's proportional share of consumption.  Let me stretch out some of that data over a longer timeframe:

You can see what's happened to commodity intensive products like Food & Gasoline throughout the so-called "supercycle."  You can see what's happened to government subsidized [manipulated?] components like Owned dwellings.

By contrast, note that Apparel expenditures lagged severely, relatively stagnating over the past 20 years in nominal terms.  The US government hasn't interevened there, probably because of Apparel's diminutive notional contribution to GDP. There's also the rise of globalization nagging dometic retailers.

Point is: the US has done little to generate real growth where there hasn't been exogenous intervention.  The government pursuades each facet when it hits a wall.  Housing sputters, subsidize it.  Transportation dies on the vine, nationalize it.  Healthcare's next.