Intervention Fails to Stop the Rot

Includes: BAC, EWI, EWP, FXE
by: Acting Man

Evidently the ECB followed through on its promise to intervene in Spain's and Italy's government bond markets, as these markets saw a strong bounce on Monday. Spain's 10-year yields dropped by nearly 0.9%, Italy's 10-year yields dropped a likewise very large 0.8% to 5.29%. To be sure, a yield of 5.29% is still uncomfortably high for Italy, but obviously a far cry from the levels above 6% seen last week and the distance to the point of no return level of 7% to 7.5% has now once again increased markedly. A 10-year yield above 7% is generally viewed as representing the first step to government insolvency in the euro area, based on the experience with the GIP (Greece, Ireland, Portugal) trio. Since Italy needs to refinance more than €500 billion over the next two years, a rise in yields to comparable levels would have soon posed a problem in terms of rising debt service costs.

So in the short term, the ECB's intervention must be regarded as a success, although it is hard to say how much of the move was due to the intervention and how much of it was motivated by a positive reception of Italy's latest plans to curb its deficit. These plans, as we noted yesterday, are short on detail and long on uncertainties, so in all likelihood the intervention played the bigger part. As far as that goes, we would note that similar interventions in the GIP bond markets did obviously not have any lasting effect, although they too helped bring yields down in the very short term. CDS on Spain and Italy likewise pulled back.

[Click all to enlarge]

Spain's 10-year yield falls a large 90 basis points on the ECB intervention.

Italy's 10-year yield comes in by almost 80 basis points following ECB intervention.

However, it was probably hoped by the authorities that this would help to stop the panic in the world's stock markets, a hope that turned out to be forlorn. Also, within the euro area and in the neighboring CEE nations, the crisis simply moved on to other targets.

We mentioned in yesterday's missive that at the time of writing, Asian markets had opened sharply lower along with GLOBEX trade in US stock futures. In European trading, stocks resumed their crash with losses ranging from 5.2% in Germany's DAX, 4.7% in France's CAC 40, 6% in Switzerland's SMI to a relatively mild 3.39% in the UK's FTSE.

When the wave of selling arrived in the Americas, it accelerated further, with the DJIA plunging 634 points, the sixth biggest point loss ever and at 5.5% certainly one of the bigger percentage losses as well. The already very oversold Bovespa plummeted by another 8.08% to a new low for the move, while Argentina's Merval index crashed by nearly 11%.

The free-fall continues – as we noted yesterday, volume was chunky, but in a true panic it would become more so. This is still the verdict as it were. Since there are no notable divergences, momentum remains strong and volume could grow even larger, the down wave could still continue before it finds a low. The above is a two-year chart, as one must now look back further to find any reasonable levels of lateral support.

The downtrend in the Bovespa accelerates further – note that the current level was last seen in July of 2009.

Looking for Reasons

It becomes more difficult to pin down a reason for the continued wave of selling now that the pressure has come off Italy's and Spain's bond markets. This leads us to conclude that the main motive behind the selling remains the growing fear or realization that the global economy is teetering on the edge of a synchronized recession, or has perhaps already entered one. This happens at a point in time when the firepower of the normally interventionist governments has been severely curtailed.

The downgrade of US treasury debt by Standard & Poors may not mean much per se – it certainly failed to faze the US government bond market – but it does mean that the illusion of recovery that can be temporarily bought with massive deficit spending and the associated debt monetization by the central bank will be somewhat harder to come by in the future.

Note here that we need to clearly differentiate between genuine sustainable economic growth – something that government intervention can only delay – and the artificial 'stimulus' that allows market participants to engage in what we would term the inflation trade.

However, there is also another, more technical reason behind the severity of the decline. As we have pointed out many times, before the decline in stocks began, the mutual fund cash-to-assets ratio stood at an all time low of 3.4%, NYSE margin debt had moved to its second highest level in history and the NYSE short interest ratio had dropped to a historically extremely low level. Also, the net speculative position in stock index futures had reached a record high in some futures contracts a short while ago.

As a result we believe that there was/is a wave of margin calls going out, with fairly little buying power left to slow down the decline, as there are not enough shorts to make a difference with their covering while mutual funds are tapped out.

We have also noted frequently that earlier this year, the smart money OEX put-call ratio gave its biggest sell signal ever. As we pointed out in this context, these traders are sometimes early, but that one should no underestimate the importance of the signal. On the other hand, speculation on more market upside in options more generally reached a never before seen extreme concurrently. As surprising as this may seem, we were not too far from this extreme as of the end of last week. This is to say, when considering all opening transactions in options and grouping them by whether they represent bullish or bearish activity (in other words, a more detailed look at options transactions than mere put-call ratios), option traders appeared to be rather bullish. This is demonstrated by the options speculation index published by sentimentrader depicted below.

An index that measures the ratio of all bullish vs. bearish opening transactions across the US option exchanges. This shows that the information from raw put-call ratios is not sufficient to get a clear picture of the level of fear in the market. This measure showed that speculation on a rising market was still rife as of last Friday.

Another Unperturbed Expert

Similar to the overview of various WS market strategist views by Bloomberg we discussed yesterday, the WSJ published an article by Burton Malkiel on Monday, along the very same lines. We should point out that we want to neither pick on the bullish WS strategists nor on Malkiel – we merely want to show our readers what the anecdotal sentiment backdrop looks like. Malkiel writes:

“The sky is falling! The sky is falling!" Chicken Little's admonition may strike many observers as particularly apt today. I disagree. This is not the market meltdown of 2008 all over again. And panic selling of U.S. common stocks will prove to be a very inappropriate response.

It may not be 2008 all over again, but clearly something bad is happening. Ironically, the article then relates the fundamental problems that one would normally expect to see listed in support of the exact opposite position:

The sharp decline in stock prices last week has renewed fears that the economy is headed for a double-dip recession. Economic growth has been reduced to stall speed, with gross domestic product rising at less than a 1% annual rate during the first half of 2011. Real consumer spending has been negative over the past two quarters. Just as a rider risks falling over when his bicycle slows sharply, so the economy is dangerously close to slipping into recession even before a real recovery has taken hold. And now Standard & Poor's has downgraded the U.S. credit rating, citing inadequate progress in Washington on long-run budgetary problems.

The headwinds restraining the economy are many. Consumers are still over-indebted and household finances are perilously balanced. House prices, after sharp price declines, threaten to fall further. The effect has been a big hit to households' net worth and has prevented any recovery in construction activity, which normally plays a big role in the early stages of any economic expansion. The unemployment rate is stuck above 9%, and even optimistic economic forecasters see little chance of a meaningful decline, even if a tepid economic recovery resumes in the second half.

Making matters worse, Europe has not really fixed its economic problems. Growth prospects there are gloomy.

All true, as far as we can tell. So people should not sell stocks why, exactly?

First, I believe that stocks today are cheap. Price/earnings multiples are just over 14 and forward P/E multiples, which use forecasted earnings, have shrunk to less than 12. These multiples are low relative to historical precedent and are especially low when considered in comparison to a 10-year Treasury yield of 2.5%. Dividend yields of 2.5% also compare favorably with 10-year Treasuries. Multiples do not look cheap relative to average 10-year earnings (the so-called Shiller P/E multiples), but today's earnings are so much higher than average earnings that a 10-year average is not a good estimate of today's corporate-earning capacity.

Well, here it is again. The "tocks are cheap" meme, complete with a reason why should blow off the Shiller p/e that tells us that stocks are actually, well, not really cheap. The fact that today's earnings are higher than average earnings is precisely the reason why the Shiller p/e should be consulted and not today's trailing p/e. Why should one rely on a statistical outlier? Malkiel continues:

Moreover, the structure of U.S. corporate earnings increasingly reflects economic activity abroad — including the rapidly growing emerging markets — rather than activity in the U.S. This is why corporate earnings have been growing so rapidly even though U.S. economic growth has been so tepid. For large U.S. multinational corporations, the continued growth in emerging markets will be the most important determinant of the future growth of corporate earnings. For many companies, what happens in China, India and Brazil is more important than the inability of Europe to get its house in order and the paralysis in the U.S. and Japan.

This enduring faith in the magical powers of emerging markets is likely to be shaken severely in the not-too-distant future. Has he looked at the charts of the stock markets of the countries he named? As far as we are aware, Brazil is on the verge of a private sector credit crisis, in China the manufacturing sector is close to contracting (or already contracting, depending on whom one believes), while a huge real estate bubble following in the wake of the world's biggest recent money supply and credit expansion hangs like the sword of Damocles over the country's head. India seems fundamentally far sounder, but like Brazil, it now sports an inverted yield curve, which means a recession can probably be expected (perhaps only a growth recession, but definitely a painful slowdown). So even if we accept that what happens in these countries is nowadays the most important economic variable for US based large cap multinationals, it is at present not a reason to buy stocks.

Malkiel of course then notes that while allegedly no-one can predict what the stock market will be doing, selling during times like these is usually a mistake – at least it will be revealed as one a few years down the road. He further remarks:

My advice for investors is to stay the course. No one has ever become rich by being a long-term bear on the fortunes of the United States, and I doubt that anyone will do so in the future.

As far as we're concerned, staying the course has been a mistake for 11 years running. It is important to realize that we have been in a secular bear market since the year 2000 when the Nasdaq topped out. Since then, t-bills have vastly outperformed the stock market – which is the yardstick by which one can determine that a secular bear market does indeed pertain. What investors should have done was use the rebound from the 2009 low to gradually sell the rally.

All of this is beside the point that something we said yesterday, namely that the probability of a short term rebound has increased is even more true today than it was yesterday. We acknowledged yesterday that there were some disturbing signs that indicated there could be even more crash-like behavior in store and offered this chart showing a range of possible paths. This is not something that can be forecast with any degree of certainty. All that is certain is that the more oversold the market becomes, the more likely a short term rebound becomes (usually a violent one followed by more downside action).

Similar to yesterday, Asian markets have crashed right out of the gate at the time we are writing this (for instance, the HSI in Hong Kong is down over 1,500 points at this very moment), so we can not rule out that yet another wave of selling gets transmitted around the world. Gold is trading at $1754 per ounce as we write these words, up another $35. Tomorrow, Helicopter Ben and his merry band of printers will be on tap with their attempt to rescue us, but there is a certain danger that whatever they have to offer will be considered as too halfhearted by the markets. This is of course simply unknowable at this stage. Should a short term reversal be in the cards, it will likely take the form of an early bout of selling that later in the day gets reversed, but we will cross that bridge when we get there.

Readers may recall that we wrote about a major smart money bet in put options on Bank of America (BAC) a while ago (in the charts section at the bottom of the article). It is worth revisiting BAC's chart. The option buyers were indeed smart, as the stock cratered by over 20% on Monday alone.

Bank of America – the banking crisis seems to be making a comeback globally. We know of an owner of 40,000 puts who must be very happy by now.

Note in this context that credit default swaps on US banks and brokers have suddenly begun to soar again, in a manner clearly reminiscent of 2008. Apparently this time it is at least in part a side-effect of the Standard & Poors ratings downgrade of US treasury debt. As Bloomberg reports:

The cost to protect against a default by U.S. banks soared by the most since the month Lehman Brothers Holdings Inc. failed after Standard & Poor’s cut the AAA rating on the government’s debt.

Credit-default swaps on Bank of America Corp., the nation’s biggest bank by assets, rose by the most on record and reached the highest since May 2009, while contracts tied to Morgan Stanley debt increased the most since September 2008. Swaps on insurers Hartford Financial Services Group Inc., MetLife Inc. and Prudential Financial Inc. rose, and a benchmark gauge of corporate credit risk climbed to the highest since July 2010.

The downgrade triggered investor concern that fallout could impair the health of banks that have been recovering from the worst financial crisis since the Great Depression two years ago. Investors including BlackRock’s Peter Fisher speculated S&P may be forced to lower its ratings on banks, while Morgan Stanley (NYSE:MS) said in a regulatory filing that market reaction from the government downgrade could have “a material adverse effect on our business, financial condition and liquidity.”

“This has never happened so I don’t think anybody really knows” the ultimate impact of the sovereign downgrade, said David Withrow, head of taxable fixed income at Fifth Third Asset Management. “It certainly could have an impact on the credit rating of banks, which could impact counterparty risk. What the level of impact is nobody really knows right now.”

This doesn't sound particularly comforting.

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