Toro's Running of the Bulls Market Blog

Seventh Best September in 82 Years on Weak Economic Data

If September were to end today, September 2010 would go down as the seventh best September for the S&P 500 since 1928.  A mere three days into the month, the S&P 500 has risen 5.26%.  On only six other occasions – 1939 (start of World War II) +14.4%; 1950 (price/earnings ratio of 6.9x) +5.6%; 1954 +8.3%; 1996 +5.4%; 1997 (near resolution of the Asian Contagion) +5.32%; and 1998 (bailout of Long-Term Capital Management) +6.2% – has the market done better in September.

Near-term trading is all about newsflow and expectations. The past week offers evidence of this maxim up in spades.

The market soared this week not because the economic news was good.  It was not.  It was mediocre at best.  The market soared because it was not as bad as thought.  Jamming shorts into an illiquid market pushed the indices into the upper end of their four-month trading range.

The market was exceedingly pessimistic going into the month, with all sorts of chatter about a double dip.  Four pieces of data mattered, three of which caused the market to take off like a scalded cat and one that was ignored.

On Wednesday, the August ISM Manufacturing index handily beat expectations.  Perma-bear David Rosenberg detailed concerns about the ISM print, but the market would have none of it as the S&P 500 rose 3% and the Russell 2000 4% on Wednesday.

On Thursday, pending home sales unexpectedly rose 5.2% in July whereas economists were expecting a decline.  Sales declined 2.8% in June and a whopping 29.9% in May after the expiration of the homebuyers’ tax credit.  Whether or not the increase in home sales is a dead cat bounce remains to be seen, but for the moment, the market interpreted the data as the consumer having a pulse.

Friday was the jobs report.  Nonfarm payrolls in August declined 54,000, half of expectations.  Private payrolls rose 67,000, beating expectations of +40,000.  Perhaps more importantly, there were substantial upward revisions, with July revised from -131,000 to -54,000, and June from -221,000 to -175,000.

Interestingly, manufacturing jobs declined by 27,000, even though the jobs component of the ISM survey increased.  Prior to the release, David Rosenberg questioned the jobs component of the ISM, noting inconsistencies in the data.

An increase of 67,000 was the eighth consecutive month of positive private job creation.  However, job creation is still weak.  The prior seven months were; July +107k, June +61k, May +51k, April +241k, March +158k, February +62k, and January +16k.  Private job creation has been positive but August was below the year's average of +99k.  Over the past four months, private sector job growth has average +72k.  Private job growth has decelerated.

This is consistent with the claims data.  Initial jobless claims last week were 475k, above the 2010 average of 465k. The average of initial claims for August was 486k, the highest monthly average this year.  

According to the ISM non-manufacturing index, employment may even be contracting.  The broad index came in lower than expected at 51.5, signaling continued but slowing expansion.  (A reading above 50 implies expansion. A reading below 50 implies contraction.)  However, it was the lowest reading since January.  Given that the market went ga-ga over the ISM manufacturing index and ignored the services index, it should be noted that services are a much bigger part of the economy than manufacturing.

What was more interesting were the components of the index.  Business activity, new orders and order backlog all declined, while employment and new export orders were in outright contraction.  The reading for employment was 48.2, indicating that employment is falling in the services sector of the economy.  Also, inventory sentiment rose, indicating that managers think their inventories are too high.

Net net, the news releases were better than expected but weak in the absolute.  However, in a market where expectations were clearly negative, incrementally positive news can jam the market higher, especially when everyone is at the beach (except of course the machines that run the market, which never go to the beach).

The question now is whether or not the market can break through the fast approaching resistance levels.  My guess is that Tuesday will be up day, as Mutual Fund Monday is deferred because of the long weekend, pushing the market towards the upper end of the trading range.  I think the real test will come later in the week and into the following week as volume comes back into the market.  If volume does not come back into the market, be concerned, even if the market goes up.

The market is a discounting mechanism.  Perhaps the market action of the last three days is signaling that the economy is going to get stronger.  But the economy is going to have to show strength soon.  The data thus far has been weak, consistent with an anemic economy and a market in a trading range. 

 

Economic Theory Useless for Real Economy

We have the biggest economic crisis in 80 years, yet most economists were admittedly clueless about the cause of the crisis. 

Should economists and policy makers have identified the housing market bubble before it burst? The answer is most likely no, says the Federal Reserve Bank of Boston, because economic theory was not up to the challenge.

“Economic theory provides little guidance as to what should be the ‘correct’ level of asset prices — including housing prices,” the new paper published by the bank says. It was written by economists Kristopher Gerardi, Christopher Foote and Paul Willen.

“While optimistic forecasts held by many market participants in 2005 turned out to be inaccurate” those projections were not “unreasonable” given what was understood about the economy and housing market dynamics in the years before housing prices crashed and helped create one of the worst economic downturns in generations. ...

In other words, they did not understand much about the economy nor the housing market.

The paper notes economists were clearly not of one mind about the implications of rising housing prices. Some saw them as consistent with economic fundamentals, and driven by factors like the need for shelter to house a growing population, a favored explanation of central bankers themselves during those years. Others simply punted, offering no view.

Then there were those with negative views, many of whom have been sharply critical of the economics profession, and of policy makers.

“The pessimistic case was a distinctly minority view, especially among professional economists,” the paper observed. “The small number of economists who argued forcefully for a bubble often did so years before the housing market peak, and thus lost a fair amount of credibility” in the process. Others called a bubble with “arguments fundamentally at odds with the data” that became available after the fact, the economists write.

The fact that a small number of economists who saw this coming but lost credibility because the peak was still some time away says more about the economics profession than it does about those who saw the crisis coming but were early. 

That paper notes that for the most part, regardless of the view economists held on housing, the science of economics wasn’t really even equipped to deal with the issue. “Academic research available in 2006 was basically inconclusive and could not convincingly support or refute any hypothesis about the future path of asset prices.” That meant anyone could argue anything. [Emphasis added]

Yes, anyone could make any argument and no one had any idea if they were right or wrong.  That is quite the "science," isn't it?

Of course, not all economic theory is useless.  However, as a profession which attempts to add value through forecasting, it fails at the most critical times, which is tantamount to a meteorologist who consistently forecasts sunny skies with the occasional rain but is unable to see the hurricane coming.

All Quantitative Easing, All the Time

Earnings have been good this quarter, but earnings are not the primary driver of the recent stock market strength.  If earnings were driving the market higher, one would expect interest rates to firm.  But that is not happening as rates have collapsed and the dollar gets whacked every day.

What would cause stocks to rise, bonds to rise (and concurrently interest rates to fall) and the dollar to fall?  That would be quantitative easing (QE).

There is anticipation in front of the Fed meeting on Tuesday that the Federal Reserve will announce further quantitative easing to counter-act the deflation that is seeping its way into the economy. 

The first round of quantitative easing ended in March after the Fed finished purchasing over a trillion dollars of mortgages and government bonds.  Since then, a mere four months later, the economy is threatening to dip back into recession.

Economists are forecasting economic growth of 2.5-3% this year.  I think that will be wrong.  A favorite economic index of mine is constructed by a money manager who uses 22 leading and concurrent economic indicators.  It was remarkably prescient at predicting both the Great Recession and the subsequent recovery.  Today, it is in contraction mode, implying negative growth in the second half of the year.

I am loathe to rely on one sole indicator to make investment decisions. However, the Fed is also worried about the economy slipping back into recession, hence the noise about the need for further quantitative easing.

The effects of quantitative easing on asset prices is as follows.  The central bank purchases securities from banks (or the market), injecting cash into the financial system.  Cash earns nothing, so banks and investors turn around and use that cash to buy something else, bidding up asset prices.  Hopefully, for the Fed, interest rates fall and asset prices rise. 

In the last round of quantitative easing, the Fed primarily bought mortgages.  This time, the Fed is primarily going to buy – allegedly – government debt.  This explains, at least in part, why interest rates are collapsing and stocks are rising – the market is anticipating that the cash injections will lead to higher prices.  If deflationary fears were driving the market, stocks should also be falling.  But they are not.  At least not yet.

The dollar goes down every day because QE is the monetization of government debt, which is inherently inflationary.  The goal of the Fed is to create enough inflation to counter the forces of deflation in the economy.  However, that inflation also bleeds into asset markets.

It would certainly surprise me if the Fed did nothing.  Currently, the political environment is leaning heavily towards deflation.  Governments in Europe are talking about reducing budget deficits while it appears that the Republicans are poised to make significant gains in the November elections.  If the Fed opts not to being a new round of QE, I would expect a sharp correction in asset prices.

Of course, another round of QE is enormously bullish for gold.  Gold is correcting as fears about European sovereign default dissipate.  Investors have been comforted by the actions of European governments to address the Greek situation, the increased focus on budget deficits, and the so-called stress tests for European banks.  However, deflation is enormously bearish for the European financial system, which is in worse shape than the financial system in America.  I am afraid that the Extend-and-Pretend policies of the European governments are merely kicking the can down the road.  Ultimately, I believe European governments will also act to counter deflation.  If ultimately deflation wins out, gold is going down, but I am betting on the guys with the printing presses.  I have no exposure to gold at the moment but am watching carefully for entry points.

I am currently 80% in cash, my highest allocation ever, and my equity exposure is completely hedged out. (As regular readers of this blog know, I can change my mind in a heart-beat and get aggressively long or short tomorrow, and I won't tell you about it.)  Over the near term, it appears to me that the market wants to go higher.  Chart formations suggest such and the typical intra-day trading pattern over the past two weeks has been the market trading strong into the close, which is bullish.  However, volume is on fumes – Monday was the lightest volume day of the year – and the machines are pushing markets around as correlations between different asset markets are at or near all-time highs.  Thus, I remain on the sidelines, watching and waiting.

The Coming Hyperinflation?

The one word you won't find on Running of the Bulls is "hyperinflation," at least as it pertains to the United States.

I have seen "hyperinflation" used to describe the inflation of the 1970s, but I do not consider 7%-9% inflation to be "hyperinflation."  Instead, hyperinflation is what has happened in Zimbabwe or Latin America during the 1980s or the Weimer Republic.

And I do not believe hyperinflation is coming to America. 

But that doesn't mean I can't be wrong.  And an article in The Daily Telegraph last week sketches historical analogies to the current situation in the United States.

Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot).

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck.

People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

In other words, the Fed's balance sheet is not just the kindling, but also the gas-soaked rags on top of the kindling in the drought-ridden forest with seeping methane coming up from the ground.  It will take little for the forest to alight if the population suddenly changes it's attitude towards the currency.

The rest of the article is well worth the read.

What the Future Holds

This is an excellent post from China Financial Markets.  The abridged version is

1. The euro will not survive in its current form.
2. This crisis rivals the Great Depression but is more like The Long Depression of 1873.
3. The European crisis will be accompanied by a trade shock which will bring about a significant contraction.
4. The recovery in countries affected by the crisis will not begin until their debt is written off.
5. This will go on for many years.

China – Rising Costs, Lower Returns

I am seeing all sorts of commentary regarding the de-pegging of the RMB to the dollar as being positive for risk assets.  And it is, long-term.

Over the long-term, a floating Chinese currency is enormously positive as it will help alleviate the enormous imbalances in the world economy.  Simply put, the imbalances are that the US consumes too much and China produces too much, which has led to an unstable build-up of foreign currency reserves in China.  China must consume more and the US must produce more.  A rebalancing of the Chinese currency will help do both by making imported goods into China cheaper while making exported Chinese goods more expensive, leading to lower growth in Chinese currency reserves.  But over the short and intermediate term, this could produce headwinds for US stocks.

There will be pressures on businesses other than a rising Chinese currency, however.  Labor costs are rising in China, which means labour costs will start rising again in the developed world.  Because Chinese labour costs are rising, offshoring will become less ubiquitous and profitability will fall.

I believe that we are witnessing an inflection point in the construct of the global economy that could have enormous ramifications for how the spoils are divided up between capital and labour.  Over the past decade, those spoils have accrued primarily to capital whereas labour has lived off crumbs.  I believe that we are shifting to a more equitable distribution of wealth. And though I doubt we will see a reverse of the past decade such that all the gains accrue to labour and capital gets little, the gains will be more evenly distributed.

More to labour, less to capital

The biggest benefactors of the opening of China over the past decade have been the owners of capital.  The opening of China has shifted global cost curves down.  Companies have been able to shift productive capacity overseas, which has increased profitability and returns on equity.  Many measures of corporate health during the 00s hit either all-time highs or multi-decade highs – profit margins soared, return on equities skyrocketed, profits as a percentage of GDP exploded, etc.

Labour, on the other hand, experienced stagnant income growth, at least in the developed nations.  Productive capacity shifted offshore, pressuring wages.  Consumption growth was often financed by debt and home equity extraction, not by growth in income.

Even in China, which has seen enormous gains accrue to labour over the past decade, there is widespread discontent amongst the have-nots as income disparities have raised significantly over the past 10 years.  There have been several high profile reports coming out of China lately about worker discontent at plants and factories.  Workers have gone on strike and have received significant wage gains.

Wages are going to rise in China relative to capital as Beijing attempts to create more internal consumer demand within the country to rebalance the economy and to keep the social peace.

This cannot be overstated enough – if the cost structures of global corporations are rising, as accelerating wages in China and a higher RMB implies, there will be headwinds for corporate profitability growth, and gains to the owners of capital will be lower.

Rising costs in China will mean fewer options for corporations to lower costs by moving production offshore.  Costs for corporations are going to rise at the expense of profitability as companies pay their employees more domestically.  Profit margins are going to fall, return on equities will be lower and the percentage of profits to GDP will decline.  Good for labour, bad for capital.

Over the long-term, the developments in China are extremely positive as they assist in the rebalancing the enormous imbalances in the global economy.  Over the short and intermediate-term, however, they will slow aggregate profitability growth.

Less demand for dollars

Perhaps the most destabilizing imbalance is the enormous amount of currency reserves held by the People’s Bank of China.  Over the past decade, the Chinese currency peg has kept interest rates in the United States lower than they otherwise would have been.  To keep the RMB low, the PBOC purchased US dollars and used those dollars to buy US debt, primarily Treasury and agency bonds.  This demand for US government bonds kept a lid on interest rates.

A rising RMB means there will be less imperative for the PBOC to buy US bonds to keep the RMB low.  Less demand for US bonds will mean higher interest rates.  Higher interest rates means lower valuations for risk assets, which means lower returns for equities.

Less liquidity

The downward shift in global cost curves kept interest rates low as the opening of China was deflationary.  Central banks don’t like deflation, they like price stability.  To counter deflation, central banks created money, which is inflationary.  The money supply grew at a faster rate than economic growth. 

Much of this liquidity found its way into asset prices, particularly real estate prices but also commodities, credit and other more esoteric assets such as wine and sports teams.  A rising cost structure in China will reduce deflation, which means there will be less money creation to counteract deflation, thus less liquidity.  Less liquidity will mean less fuel for assets.  Less demand for assets will mean lower returns for risk assets.

The end game

The effects of a rebalancing Chinese economy towards more consumption will mean lower aggregate profitability growth, higher interest rates and less liquidity in the financial system, all of which are negatives for stocks over the intermediate-term.  This does not mean that stocks are going to fall but it does mean that returns to equities will probably be substandard.  Over the long-term, the effects will be positive as they will strengthen an unhealthy global system.

Of course, over the intermediate-term, there will be winners and losers.  Obviously, corporations selling to the burgeoning Chinese consumer will benefit.  However, companies that relied on offshoring are going to see lower profitability.  Profit margins are likely to be lower over the next decade than the past decade as less offshoring will mean less pressure on wage growth in the developed world.  This will alleviate (though not eliminate) the pressure on the American consumer caused by deleveraging, thus benefiting the American consumer.

I believe this shift in trend will occur over the next 10 years, and will happen slowly and subtly.  The opening of China has been and will continue to be one of the most significant economic events of the past 100 years.  However, the composition of wealth distribution caused by the opening of China is changing, I believe, which is going to have a significant effect on asset returns.

 

ECRI Index Heads Down

From FT Alphaville.

Conference Board's Leading Indicators Highest Ever

This is from earlier in the week, but it explains why the market goes up every day.

A gauge of the U.S. economy's prospects rose more strongly than expected to a record high in March, pointing to a steady economic recovery, a private research group said on Monday.

The Conference Board said its index of leading economic indicators increased 1.4 percent, rising for the 12th straight month, after an upwardly revised 0.4 percent gain in February. ...

This graph comes from Bonddad.

Bonddad makes a very cogent argument about how retail sales leads sales growth, and how job growth is going to be stronger than expected since retail sales adjusted for inflation have been strong.  Its worth the read.

China's Currency Peg and Bubbles

The global economy is characterized by enormous imbalances, particularly the $2 trillion or so in reserves parked at the People’s Bank of China.  This build-up of reserves is one culprit of the asset-driven economy.

Make no mistake, our problems are not because of China.  Our problems are because of ourselves.  But China’s currency peg has dramatically exacerbated the problems of the global economy.

The past decade has been characterized by two of the most deflationary forces of our time – the Internet and the inclusion of China as a major player in the global economy.  The Internet is deflationary because of dis-intermediation – it cuts out the middleman, lowering costs for consumers.  The opening of China is deflationary because its wages are low, effectively lowering the global cost curve for corporations.

In a balanced economy, these deflationary forces should have caused prices to fall.  However, prices did not fall.  The Federal Reserve would not allow that to happen.  To keep prices from falling, the Fed injected money into the economy to keep prices stable.  That money had to go somewhere, and it went into asset markets.

China supplied us with cheap goods and ran a massive trade surplus.  The yuan should have risen against the dollar, but the Chinese government would not allow that to happen, and China built up a ridiculous amount of reserves.  Had the yuan risen, Chinese labor would not have been so cheap, and the deflationary forces emanating from China would have been less.  With less deflation, less money would have been created and less liquidity would have flowed into asset markets.

With trillions of dollars in reserves, China had to put that money somewhere.  Much of China's reserves were recycled back into the US Treasury market, increasing demand for Treasuries which lowered interest rates.  Lower interest rates allowed people to finance purchases of assets cheaply – from homes to CDOs  – fueling the housing bubble.  Had China not pegged its currency to the dollar, it would have had fewer dollars to recycle into the US bond market, demand for bonds would have been less and interest rates would have been higher. Had interest rates been higher (and the Fed could have kept rates higher regardless of what China did) then there would have been no housing bubble, or at least the housing bubble would not have grown as large as it did. 

(This criticism can also be labeled at Japan and other Asian countries whose economies were geared towards exports to the American consumer.  They too ran up enormous currency reserves.)

Over the long run, a floating yuan is good for the global economy.  It will clear out many of the destabilizing structural imbalances.  It is good for China as well.  A rising yuan will increase consumer spending in China as imports become cheaper, re-balancing the Chinese economy away from its heavy (and unhealthy) reliance on exports and capital spending.

In the near and intermediate-term, however, it is bad for our asset markets.  A rising yuan means less demand for Treasuries, which means higher interest rates, which means less support for asset markets such as stocks, bonds and housing.   In our asset-driven economy, less liquidity is bad for our markets.

In the long-run, a floating yuan is positive for the US economy.  Our heavy reliance on asset markets is unhealthy.  Less trading things and more making things is ultimately good for America.

Cluelessness at the Very Top of Government

From Michael Burry, who ran Scion Capital and successfully foresaw the collapse of the housing bubble, in  The New York Times.

I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions. A week ago I learned the answer when Al Hunt of Bloomberg Television, who had read Michael Lewis’s book, “The Big Short,” which includes the story of my predictions, asked Mr. Greenspan directly. The former Fed chairman responded that my insights had been a “statistical illusion.” Perhaps, he suggested, I was just a supremely lucky flipper of coins.

Mr. Greenspan said that he sat through innumerable meetings at the Fed with crack economists, and not one of them warned of the problems that were to come. By Mr. Greenspan’s logic, anyone who might have foreseen the housing bubble would have been invited into the ivory tower, so if all those who were there did not hear it, then no one could have said it.

As a nation, we cannot afford to live with Mr. Greenspan’s way of thinking. The truth is, he should have seen what was coming and offered a sober, apolitical warning. Everyone would have listened; when he talked about the economy, the world hung on every single word.

Unfortunately, he did not give good advice. In February 2004, a few months before the Fed formally ended a remarkable streak of interest-rate cuts, Mr. Greenspan told Americans that they would be missing out if they failed to take advantage of cost-saving adjustable-rate mortgages. And he suggested to the banks that “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”

Within a year lenders made interest-only adjustable-rate mortgages readily available to subprime borrowers. And within 18 months lenders offered subprime borrowers so-called pay-option adjustable-rate mortgages, which allowed borrowers to make partial monthly payments and have the remainder added to the loan balance (much like payments on a credit card).

Observing these trends in April 2005, Mr. Greenspan trumpeted the expansion of the subprime mortgage market. “Where once more-marginal applicants would simply have been denied credit,” he said, “lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.”

Yet the tide was about to turn. By December 2005, subprime mortgages that had been issued just six months earlier were already showing atypically high delinquency rates. (It’s worth noting that even though most of these mortgages had a low two-year teaser rate, the borrowers still had early difficulty making payments.)

The market for subprime mortgages and the derivatives thereof would not begin its spectacular collapse until roughly two years after Mr. Greenspan’s speech. But the signs were all there in 2005, when a bursting of the bubble would have had far less dire consequences, and when the government could have acted to minimize the fallout.

Instead, our leaders in Washington either willfully or ignorantly aided and abetted the bubble. And even when the full extent of the financial crisis became painfully clear early in 2007, the Federal Reserve chairman, the Treasury secretary, the president and senior members of Congress repeatedly underestimated the severity of the problem, ultimately leaving themselves with only one policy tool — the epic and unfair taxpayer-financed bailouts. Now, in exchange for that extra year or two of consumer bliss we all enjoyed, our children and our children’s children will suffer terrible financial consequences.

And today, the people who run the Fed have no idea, or appear to have no idea, that they are recreating the the conditions for yet another asset bubble.

Find that bubble, ride it for all its worth, then short the hell out of it when it breaks, as it inevitably will.

Then, in five or ten years, listen to Bernanke et. al. explain that no one could have seen the bubble coming.  Count your money and amaze at the intellectual bankruptcy of those who are clueless.