Review of World Economics

A weak China ISM number along with some negative reactions out of the emerging markets - caused from the winding down of QE - spooked the US stock market and triggered two strong DOWN days. Time will tell if the pullback turns into a full fledged correction, which is usually classified as a decline of 10% or more. It's never a matter of "if" we'll have a pull-back or correction, but "when" we'll have one, and doing our best to avoid them. Moreover, once a pullback or correction begins, we leverage our data to predict how deep it will be before finding support. Even after watching charts each week, it's still very difficult to predict when a sudden sell-off will hit and what will trigger it.

Prior to last Thursday and Friday's sell-off, just about all of the data was pointing to a market that would most likely continue to trade sideways and choppy as investors digest earnings data, and await remarks from this Wed's FOMC meeting. Moreover, valuation of stocks were fairly, but fully valued at 15.4 times earnings, the macro economic data was relatively strong, market breadth was holding steady, and Q4 corporate earnings results were okay.

Additionally, prior to last week's sell-off, the relatively strong fundamental and technical data told us that if we did have a pull-back there was a reasonable probability that the major indices would find support at a major support level near or just below the 50 day SMA. The status quo over the last 15 months was that every pullback was shallow, declining 2% to 4%, stocks would find support near or just below the 50 day SMA, bounce, and then continue to trend higher. So, is this pullback going to be the same? Or will it be different this time and turn into a full fledged correction?

When asking the question "is this pullback going to be different this time and turn into a deeper correction?", we need to ask ourselves "what is different today as compared to early last week before the sell-off?".

One thing that is different as compared to last week before the sell-off is that the Fed is tapering bond purchases by $10 billion after each Fed meeting, with the goal of winding down QE by the end of 2014.

A second thing that is different from last week is that the China ISM index showed that China is at risk of contracting. This is a new data point that definitely spooked the markets and provided a reason to book some profits.

A third thing that is different is that the retailers (XRT) were weakening over the last few weeks.

The final thing that is different this week versus early last week is that cash has been flowing out of the Emerging Markets over the last 6 weeks - caused from the winding down of QE - and this now is impacting foreign currencies.

Let's address each change mentioned above: 

1. The FED tapering QE is definitely a big deal and could keep the markets on edge; pullbacks will probably be deeper now since QE is winding down eliminating the artificial floor that has supported stocks for the last 15 months; 
2. If China's economy is truly slowing down and Chinese officials aren't able to address it this could ripple around the world; with this said, all slowdowns in China are "by design", and Chinese officials are constantly modulating growth to keep inflation under control; also the ISM index is highly overrated, it's not that accurate, and it's been under 50 many times over the last few years; 
3. Retailers (XRT) has been rolling over and if it doesn't find support soon it could be a problem for the entire market, because consumer spending drives 2/3rds of the US economy; on the positive, the last retail report was rather strong; 
4. Cash flowing out of the emerging markets and causing currency issues could continue to spook the markets and possibly help drive the major indices lower; on the positive, most emerging markets, other than China, don't really influence/impact the fundamentals of the US economy, such as consumer spending, which represents 2/3rds of the US economy.

In summary from our analysis above, the artificial floor propping up stocks will soon be eliminated from the termination of QE, so the market will begin to behave in a more "normal" fashion. i.e. when we have sell-offs, volatility will spike higher, most major indexes could pierce down through the 50 day SMA before finding support, and some indexes could pullback to the 200 day SMA. Thus, there is a higher probability that this current pull-back could turn into a full-fledged correction and drive the major indices down to the 200 day SMA, so we need to be prepared for this.

A poor China ISM number and volatile currency fluctuations in some emerging markets, like Argentina, spooked the US markets and triggered a sell-off. Because the Fed is now tapering QE, there is a reasonable probability that the major indices will pull back farther, possibly down to the 200 day SMAs before this correction is over. Earnings season is picking up steam and the results so far are okay. Investors/traders are now waiting to hear from Janet Yellen, the new Fed Chief, on her plans with QE and the pace of the taper. On the positive for Janet Yellen, she is dovish and the stock market likes this. For specific sectors, financials (XLF), consumer discretionary (XLY), industrials (XLI), transports (IYT), semiconductor (SOX), and the equal weight tech stocks (MTK), the UP trends are under pressure. 

On the negative, retailers (XRT) has weakened a lot over the last few weeks. Most of the charts around the globe are looking okay, so globally the coast is clear for the next few weeks, but we need to monitor them closely. Back to the US, oil and gasoline prices have been low over the last few months, which has boosted consumer spending and this is constructive for equities.  The bond indicators are pointing to a stock market that will be under pressure for the next few weeks. The macroeconomic data over the last 90 days has been good, other than the bad non-farm payrolls report a 3 weeks ago. The S&P 500 forward looking P/E multiple is 15.1, which is above the 10 year average of 14.0, but currently it's not classified as excessive. The market breadth indicators recently weakened after last week's sell-off, pointing to a market that will most likely trade sideways to lower over the next one to two weeks.

Prediction of where the stock market is heading over the next one to two weeks: The stock market will most likely trade choppy on higher volatility, and eventually pull back farther until the Dow touches 15,700 or 15,500, which is just above the 200 day SMA. As mentioned above in our analysis of "what is different today as compared to early last week", this sell-off could turn into a full-fledged correction since the Fed is now tapering QE. In the short-term, the market is bearish, and it could correct as much as 10%; for the long-term, the market is still in a confirmed UP trend, and most likely money managers will start to buy stocks once the Dow gets near 15,700, and the SPX gets near 1760.

Author: Chris Davies

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Global Markets Nervous, Investors Still Calm

Stock markets around the world show signs of building anxiety these days. Japan’s Nikkei 225 had its first 6% daily loss in its 63-year history. Actually, this happened twice this year. China's GDP growth has slowed to under 8% and its stock market has declined sharply, along with many emerging markets. Europe is still in recession as the U.S. tries to recover - its still muddling along with a GDP growth rate at 1.8%. Despite a sluggish economy, the U.S. stock market continues in a bullish trend higher and risk seems to be contained, at least for now.

Volatility
As we discussed previously, a measure by the CBOE of the Volatility Index (VIX) is an indication of the level of risk present in the U.S. stock market. From January 2007 until the present time, the has averaged 23.6. On November 20, 2008, the VIX peaked at 80.9, the exact day the S&P 500 reached a temporary bottom... temporary because it hit a post-crisis low on March 9, 2009. In the past three years the VIX has had three major spikes. The first was on May 20, 2010, when it reached 45.8; the second was on August 8, 2011, when it hit 48.0, while the third was on October 11, 2011, when it topped 45.5. Each time, the stock market was falling. In fact, the correlation between the VIX and the S&P 500 for the period January 5, 2004 until the present is -0.59, indicating a strong negative correlation. [Previously, we mentioned in this blog a structured product that takes advantage of this type of trading.] Recently the VIX rose to as high as only 20.5, but has fallen back to 16.9 as of June 27th. Therefore, for now at least, it appears to be calm.

Stocks
Even though the stock market has been trending higher there is an active fight between bulls and bears to decide how much equity growth is due to Fed policy and how much is due to fundamentals. With the near meltdown of the global economy in 2008, stocks fell hard and fast. Possibly, stocks had fallen so far that the rise over the past four years is neither excessive nor alarming. Everyone, however, seems now to agree that the world is in uncharted monetary policy waters as central bankers continually expand their balance sheets. How will these 'Lords of Liquidity' unwind their QE programs without causing severe disruption to the financial markets?

Bonds
Predicting the timing for any US Fed policy reversal has been a legitimate debate, in large part because US employment gains lag and global risks, including China’s economic slowing, persist. A huge surprise came with the velocity of the spike in interest rates recently. Yields on benchmark 10-year US Treasury notes crossed above 2.6% in late June, surging from 1.6% as recently as May. Besides just interest rate risk, we see the risks of leverage (closed-end funds) and bond-market liquidity. Eventually the bond market will lose a big customer when the US Federal Reserve stops slows its quantitative easing. We fully expect some disorder in the corporate-bond market for the next three to six months. Credit and credit spreads will continue to be vulnerable.

Summary
Consumers and businesses learned a great lesson in 2008: excessive debt can bring the house down when bubbles eventually burst. As a result, I suspect they will be more cautious about returning to the same behavior that led to the crisis. However, the profit motive is a strong one and leverage is still a drug of choice for most investors. This could prove to be an interesting ride!

Author: Chris Davies

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The ECB, QE3, and Gold

Recently, European Central Bank (ECB) President Mario Draghi endorsed an open-ended bond-buying program of troubled European sovereign debt.  This decisive monetary move was solidified after German courts confirmed the country’s support of the ECB’s unusually active program.  Businesses and investors in the Eurozone have welcomed the program, viewing it as a sign that the leaders of the bloc will support the debt ridden member states.  Earlier in the summer investors and commentators feared both that Greece could leave the Euro and that burgeoning debt crises in Italy and Spain would exert too much political and economic pressure upon the currency zone for it to remain robust and intact.

            Less than two weeks after the ECB announced its bond-buying program, the United States Federal Reserve announced a much anticipated third round of quantitative easing.  The central bank plans to purchase $40bn of mortgage-backed securities a month until as late as mid-2015.  While the policy has been the target of innumerable critics, Fed officials hope that monetary aid to the real estate market will reverberate throughout the economy, stimulating credit and economic output. 

            The immediate consequence of these two announcements is that the global investment environment is quite different than it was three weeks ago.  Sovereign yield curves are falling and flattening, equity markets are up, and rating agency Egan-Jones downgraded the credit rating of the United States.  Put/Call ratios fell sharply after the announcement and commodity values have increased.  As time progresses and the initial scramble for position after the dual announcements relaxes, many analysts are expecting that real growth in equity markets will persist.  

           

            The long-term consequences of central bank monetary stimulus are harder to gauge.  Critics of the ECB and Fed point out threat of inflation that comes from a third round of monetary stimulus in the US.  It is not uncommon for critics to pair the inflationary pressure of this year’s drought and consequent reduced crop yields with credit expansion to project a burst of high inflation at some future point. 

            The hyperinflationists have been decrying every Fed and ECB move since 2007, predicting hyperinflation after QE1, QE2, and Operation Twist.  While non-CPI categories of consumption such as food and fuel have indeed risen more than the official inflation figure, the data has failed to support any of the inflation hawks’ forebodings.  Investors interested in both the rising price of gold and gold as a hedge against inflation should understand the macro economic situation in which such an investment would occur. 

            Gold has reliably risen in response to money supply expansion since the financial crisis began nearly five years ago.  This should not be unexpected.  There is a strong correlation between the price of gold and the size of the money supply for the most basic of economic reasons i.e. as more dollars chase the same amount of gold, the amount of dollars required to purchase a fixed amount of gold rises.  Theoretically, this pattern should hold throughout the economy, with all goods rising proportionally in price to the increase in the money supply.  In the long run, this seems to be empirically accurate.  In the medium and short run, however, gold has risen faster than the CPI and has risen more closely proportional to bank credit expansion.  Why is this?

            The two major reasons are that the price of gold is pushed upward because of its status as a safe haven, inflation hedge, and store of value.  In other words, investors alter their behavior in response to monetary policy in a way that consumers do not.  Consumers do not respond to stimulus by purchasing more automobiles or groceries as an investment.  The effect of stimulus may be that lower interest rates will drive consumers to purchase a new car.  Car prices will rise because of this but the time frame for this rise will presumably take months or years while the rise in gold can take days or hours.  With regards to food inflation, this comes about after monetary stimulus after credit has expanded throughout the economy through loans, raising quantity demand for food at previous prices and thus driving up food prices. 

            This temporal structure is what concerns the hyperinflationists.  Such a catastrophe is possible but seems to be a very remote possibility.  A few investors may be purchasing gold in anticipation of bedlam but apocalyptic fears are hardly a robust enough sentiment to motivate portfolio investment.  This expectation, however inaccurate it may be, does raise a critic point about gold value after stimulus.  

Gold Price: Aug. 21-Sep.24 (2012)

*QE3 announcement leaked Sep. 12

We understand how gold rises in response to an expansion of the money supply for purely economic reasons.  We have also explained the rise of gold because of behavioral modifications that investors make in response to stimulus.  These reasons are multifarious and can include, naming only two, fears of inflation and negative sentiment by investors prompted by further monetary action.  A third key component of price level can generally be considered the speculative component.  Anticipating the first two reasons for a rise in price, investors buy gold products deliberately in order to earn a return buying low and selling high. 

With the implications for gold of the Fed and ECB’s further stimulus in mind, what should investors who are interested in or have already invested in gold do?  Such an answer is obviously dependent upon one’s own financial goals.  For investors who remain uncomfortable with the economic outlook of the Eurozone and United States, gold can serve as the timeless safe haven it has always been.  For investors willing to take some risk, returns can be generated both from the vacillations in gold’s value and/or its potential long term sustained rise. 

Return can be generated from long term rise in value and via price vacillation 

To evaluate the risk and potential reward of gold investment in a time of monetary stimulus, an experienced financial advisor is indispensable.  A variety of gold products are available and their efficacy varies by end sought.  AVC Advisory team members can help investors fit their gold strategy within a portfolio that is sensitive to investors’ overall financial goals. 

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QE and LTRO in Eurozone

Quantitative easing (QE) seems like a magic remedy whereby central bankers conjure up money out of thin air and use it to purchase assets. Such activity has the capacity to transfer toxic debt, stimulate demand for risk assets, devalue currencies – thus deflating debt – and maintaining low interest rates on government securities.

The European Central Bank’s (ECB) restrictive mandate does not allow it to print money (as opposed to countries' central banks) for any other purpose than lending, so QE is out of the question. Mario Draghi, President of the ECB, can therefore be said to have demonstrated the new resolve of the central bank under his leadership in unveiling his longer-term refinancing operation (LTRO) program within 8 weeks of taking office.

As we have seen in the case of Hong Kong in 1998 and Switzerland in 2011, decisive central bank intervention sends a message to the markets that there is a willingness to do whatever is necessary to achieve something that is worth fighting for.

Conversely, earlier ECB bond purchases were an indication of the weak resolve which caused the markets to gorge on negativity. LTRO delivered an infusion of liquidity at a critical time. Without it, a lot of otherwise solvent banks would have remained in a perilous position. However, structural issues remain and need to be addressed while the support of central bank liquidity is in place. Otherwise LTRO will simply prove a case of throwing good money after bad.

LTRO: An ingenious spin on QE

Source: Bank of England for illustrative purposes only.

LTRO ingeniously makes use of the Basel II accounting rules which allow sovereign nations in the European Economic Area a zero interest rate lending facility. Consequently, the ECB can lend unlimited quantities of funding to European banks, at a nominal interest rate, in the knowledge that there is more than one incentive for these banks to purchase government debt.

Firstly, banks can make easy profits from capturing the differential between the interest charged on the borrowed money and the yield in the government debt. Secondly, they can bolster their balance sheets from a regulatory perspective. Moreover, in buying sovereign debt the banks help achieve one of the critical aims of QE in maintaining low borrowing costs for indebted governments.

LTRO has also provided a timely boost to banks in their attempts to raise capital to satisfy an increasingly penal regulatory agenda. The launch of the program came just four days before the deadline for banks to submit plans for raising the cash needed to maintain capital adequacy levels.

More treatment is needed

Nevertheless, a boost in liquidity, like most pharmaceutical drugs, only works effectively in conjunction with complementary measures.  This contrasts with the example set by the US in March 2009, which used the Fed inspired rally to launch gazillions of equity.

At the national level, the rescaling of the Spanish budget deficit is challenging the resolve that is required for markets to believe in the planned reforms. The central bankers will be again solicited to control the markets, testing the government’s resolve. This is a perilous exercise at the best of times which is likely to be exacerbated by electoral and sporting distractions this summer!

In terms of further LTRO usage, most Spanish debt raised has been bought by domestic banks, and cross border confidence has not been boosted for long. Indeed, a variety of sources suggest that foreigners have used this window to divest from Spanish government bonds, and the domestic banks have been left mopping up the inventory, albeit with an attractive carry.

There is also increasing evidence that most of the monies from the LTRO have been spent or earmarked, more quickly than the markets thought, and we will soon need the next measure to prevent rates rising excessively in the periphery. As the private sector has already used a lot of its purchasing power, central bankers will soon, in spite of their reluctance, find themselves needing to buy government debt in the secondary market.

How they do it and what it leads to is important. There is a variety of tools they can use, from securities market programs (SMP) to a relaxation of ‘haircuts’. They can also allow Spanish banks to issue government guaranteed debt, essentially creating ECB eligible collateral, similar to what Italian banks have been able to do. SMPs were stopped after the LTRO, but can be reactivated, possibly sooner rather than later, as the markets need to understand the central banks are committed to preventing rates from spiralling out of control.

This summer has the added volatility of important and undecided elections, as well as distractions from football to the Olympics, that increase the risks of spikes on low volumes. Market interventions will need to be more stringent as a consequence.

Theoretically, there are few limits to what the ECB can do. They will likely test the market limits, as investors look through temporary fixes, and political limits, in respect of how much money the ECB can effectively create. This will test the resolve of politicians and central bankers from the north.

Author: Chris Davies

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