Saturday, May 29, 2010

More like a “W”, not “V” shaped recovery

A lot of data points that support that there is a W movement coming in the stock market that I spoke about a couple of days ago.


MARKET MUSINGS & DATA DECIPHERING from Gluskin Sheff at a Glance
Breakfast with Dave
Call it a nightmare. Asian markets closed down over 3% and are down to 10-
month lows and are now down 16% from the nearby highs of April 15.
Geopolitical concerns surrounding a rift between North and South Korea are
posing an added source of angst, as did Steve Ballmer’s surprisingly cautious
comments about China as a reliable end-market.
European bourse are rapidly following suit with all major sectors in the red at
this time (Spain’s stock market is now down 26% for the year – we suppose it
would be safe to call this a ‘bear run’ in Pamplona). There is a further huge
flight to safety and liquidity as the U.S. 5-year Treasury note yield is all the way
down to below 1.9% and the U.S. 10-year yield is seven basis points away from
breaking below 3% for the first time since April 27, 2009. And, there is still lots
of room to play catch-up seeing as the 10-year German bund yield has rallied all
the way down to a record low of 2.6%.
The Dow is also on its way — assuming the futures market is a tell-tale — towards
breaking back below 10,000 in a decisive manner for the first time since
February 8. And, the Canadian dollar has slipped below its fair-value estimate
for the first time in nearly five months as the greenback gains favour in this
sudden new era of risk aversion, which is in the process of clipping the
commodity complex at the current time. (The loonie is not alone — the Aussie
dollar is down 2% as well and down to 81 cents, the lowest in nine months).
Speaking of the commodity sector, we see that copper is down over 2% today
and oil down 4% — the former is now off almost 10% for the month and the
latter is on the precipice of slicing below $67/bbl (last there on August 17,
2009). Asia’s currencies are also selling off, including yuan forwards as a
Chinese revaluation has been taken off the table for the time being amidst all of
the global financial turmoil.
The euro is getting crushed after a brief respite last week — down to its lowest
level since November 2001 against the yen — in response to mounting concerns
over Spain’s banking system. Over the weekend, a savings bank in Spain
crippled by bad property loans was seized by government regulators – there is a
major push for consolidation to limit contagion risks. There is also growing
market chatter of the euro emerging as the new “funding currency” for global
carry trades (see page 24 of today’s FT and C2 of the WSJ for more on this file).

! More like a “W”, not “V”
shaped recovery

The banks led the rally off the March 2009 lows and now they are leading the
descent — strains underscored by the move up in three-month Libor to their
highest level since July 16 of last year. Investors may also be in the process of
adjusting future U.S. bank earnings power by roughly 20% based on what is
soon to transpire in terms of new regulations governing capital ratios, consumer
protection, derivatives trading as well as hedge funds/private equity
investments — see today’s Lex column on page 14 of the FT.
What is most ironic is that the world financial markets managed to hit this latest
inflection point just as the National Association of Business Economists (NBER)
lifted their GDP forecasts for this year and next — talk about a contrary indicator.
The U.S. government is so freaked out now about the prospect of a double-dip
that just a week after Timothy Geithner was crowing about how well the
economy was doing (aren’t payrolls rising — at least outside of the ADP survey?)
we had Larry Summers advising Congress yesterday that a new $200 billion
stimulus package (on top of the $787 billion earmarked from last year’s budgetbuster)is needed. Ironically, a month after Mr. Obama established a
commission to identify budget cuts in order to help shrink the deficit! You truly
cannot make this stuff up.
As we have warned time and again (i) this has been an overvalued equity market
for the past nine months and as such the rally needed to be handled either with
care or a large grain of salt regarding its sustainability; and, (ii) undervalued
markets do not behave the way this market has been behaving for the past
month. These types of brutal downdrafts coupled with intense volatility are
generally the hallmark of overvalued markets as we saw in 1990, 1998, 2000
and again in 2007. Undervalued markets tend to have more downside
protection, which is why we prefer to invest in them compared with overvalued
markets. However, we can certainly understand that human emotion has and
will test investor resolve and, just as fear gripped the market back in March
2009, greed came back into vogue at the highs just a little over a month ago.
We have the emails from our readership to attest to that!
In the meantime, we welcome the move in the markets for everything from the
Canadian dollar, to credit, to commodities, to equities back towards fair-value —
and also look forward to taking advantage of it, especially as the liquidation
continues.Speaking of credit, just a month after what can only be labeled as a frenetic pace of new-issue activity, risk premia in the high-yield space has done a
complete about-face as spreads in the junk bond space in a matter of a month
have moved out 150 bps in the most pronounced reversal since late-2007
meltdown. This is now forcing deals to be pulled back in rapid fashion — at last
count, a total of seven have been either withdrawn or postponed since April 29.
The banks led the rally off the March 2009 lows and now they are leading the descent
We welcome the move in the markets for everything from the Canadian dollar, to credit,to commodities, to equities back towards fair-value.
One of our primary themes has been deflation — say that at a time when
average wage offers to 2010 college graduates are 1.7% lower than they were
for the 2009 crew. In fact, wages paid out by private sector employers as a
share of total personal income just fell to a record-low 41.9%; it was almost 45%
when the recession began in late 2007. Never before, 16 months after a
recession began, has real income excluding government handouts been down
anywhere near $500 billion as is the case now.

One has to wonder aloud what it means to have the yield on the 5-year note
back below 2% following the most unbelievable experiment in monetary and
fiscal stimulus in recorded history. Perhaps what it means is that the
challenges and imbalances in the U.S. economy are more structural in nature
than they are merely cyclical. The fact that the DXY (U.S. dollar index) is
soaring this morning — challenging the recent highs — is merely testament to
how bad things are on a relative basis across the pond. Like Canada, the U.S.
is the proverbial one-eyed jack.
The only economic news that came out — Eurozone industrial orders, which were
up a resounding 5.2% in March, was double the consensus estimate and is
being treated as old news by Mr. Market. There is nothing major coming out of
the U.S. this week except for a variety of housing-related indicators (see more
below on yesterday’s synopsis of the April resale data) and the calendar in
Canada is extremely light — the focus will be on first-quarter bank earnings
beginning with the BMO tomorrow.

We see no shortage of market commentators claiming that investors should be
buying into this rapid selloff. Of course, these commentators never saw a
correction coming in any event. Our advice is to be patient and disciplined and
let the market do the talking.
We need two solid up-days in a row (a follow-through after a big bounce is vital)
with some major volume attached to show participation (October 18-19, 1990;
October 20-21, 1987; October 14-15, 1998; October 10-11, 2002; March 10-
11. 2009 — we can’t help but notice how October usually shows up as the
capitulation month!). This may be technical turnaround talk, but bottoms and
tops in the market are typically technical events, as history suggests. There is
not one general piece of data, sentiment indicator or government intervention
that rings the alarm bell at the peak or the trough. Again, it is best to let Mr.
Market do the talking. For example, anyone who was watching closely enough
could see a classic ‘neckline’ emerging in what was is hindsight a very clear
‘heads and shoulders’ pattern developing since late year (peak and trough
formation, as an aside, is a process and not an exact point in time). But we
should always be aware of ‘double tops’ forming — June and August of 1987;
January and June of 1990; April and July of 1998; March and September of
2000; July and October of 2007 all serve as classic examples.
The V-shaped recovery lasted two quarters — it’s now starting to look like a W.
After swinging wildly on the back of the massive fiscal and monetary stimulus
from -29.87% on December 5, 2008, to +28.54% on October 9, 2009, the ECRI
leading economic index (smoothed) has slumped all the way back down to 9.0%
in the May 14 week (down from 12.15% the week before in what was the
steepest one-week slide on record). At 9.0%, it is back to where it was last July
when the S&P 500 was hovering near the 900 mark. In the past 30 years, there
has only been one other time when the index fell this far over such a time span
and it was during the depths of despair in early 2009.
The downdraft in the market in recent weeks reflects the financial risk related to
the European debt crisis, the monetary tightening in China and the re-regulation of
the financial sector that is currently making its way through to Congress. The next
leg down in the equity market specifically and cyclical assets more generally is
economic risk. Equities went into this period of turbulence priced for peak
earnings in 2011 and with a tailwind of positive earnings revision and positive
guidance ratios from the corporate sector. If the ECRI and the Conference Board’s
own index of leading economic indicators, which dipped 0.1% in April, are
prescient, then they are portending a period of sub-par economic growth ahead
(the ECRI is pointing to 1½% real GDP growth in the second half of this year). As
the events of 2002 showed, more-than-fully valued markets do not need a doubledip
scenario to falter — a growth relapse can easily do the trick. It’s still time to be
defensive and too early in this correction to be picking the bottom.

The “V”-shaped recovery lasted two quarters — it’s now starting to look like a “W”
If the ECRI and the Conference Board’s own index of leading economic indicators are prescient, then they are portending a period of sub-par economic growth ahead

History can be a useful tool so we went back to the 1870s to see how severe
equity sell-offs can be during bull markets (as an aside, all the data can be found
on Robert Shiller’s website for free). While the 1987 correction was the most
severe (down more than 30%), we saw several instances where equities corrected
by at least 10%. In fact only two of eight times did the correction stop at 10%, with the average correction being 20%.
United States: S&P 500 Bull Market Correction Date Total Increase Date Total Correction
1877-1906 206% 1903 -26%
1921-29 385% 1923 -15%
1932-37 279% 1933 -25%
1949-68 662% 1956-67 -11%
1962 -21%
1970-73 57% 1971 -10%
1982-2000 1391% 1987 -33%
1998 -19%
Average -20%
Note: From 1877-1987, monthly averages of S&P 500 were used. From 1987 onwards, daily values were used.
Source: Haver Analytics, Robert Shiller, Gluskin Sheff

The April State Employment Report was released on Friday (yes, it lags the
national report by several weeks). While the national unemployment rate
inched up to 9.9% from 9.7%, most U.S. states saw unemployment rates stay
the same or move down slightly. Thirty-four states saw a decline in the
joblessness rate and 10 states were unchanged. This is actually a slight
improvement over the March tally where about 40% of states saw
improvements in the unemployment rate. While the improvement is
encouraging, bear in mind that more than one-third of states have
unemployment rates above 10%.
We saw yet another strong piece of Canadian data — March retail sales sailed by
analysts’ expectations, jumping 2.1% MoM versus consensus expectations for a
very modest 0.1% rise. Even stripping out autos (which jumped 3.6%) and
gasoline station receipts (+2.4%) “core” sales were up a very respectable 1.6%.
Furthermore, once we adjust for prices, retail sales were up 2.2%, capping off
a strong month of data (real manufacturing shipments up 1.7% and real
wholesale up 2.2%). Our in-house GDP tracking suggests that monthly GDP
could be 0.5% MoM in March, leaving the quarter at very respectable 6.0%
QoQ annualized rate, which would be better than the Bank of Canada’s own
lofty estimate of 5.8% and would beat the 5.0% Q4 result.
Yes, there wasn’t much to quibble about in the report (although we will note that
Stats Canada did note that warmer-than-expected weather may have boosted
some spending). The problem is that this is old news and it is very unlikely that
we will see a repeat performance in Q2 and beyond. Already, we have seen
some signs of slowing in Q2, especially in the housing market (resale home
sales slowed as the Q1 ended and single-family starts plunged in April).
While markets and most analysts continue to expect the Bank to start hiking
in June (the just-released Reuters poll found that all primary dealers expect a
25bps rate hike), the BoC is not just watching the domestic data flow (not only
were retail sales strong but Canadian CPI came in above expected too).
Global events are one of Governor Carney’s key downside risk and we now
place 60% odds that the Bank does not start hiking rates in June.
For all the talk of a boom in the art market, we see that even in this space,
deflation pressures are building. See page B9 of the weekend WSJ — all told,
art valuation declined 5% YoY in the first quarter of the year.
And at a time when underlying price trends have receded to below 1% for the
first time in four decades, one must contemplate the odds of outright deflation
after reading page B6 of today’s WSJ on the U.S. consumer spending outlook
(Retailers Temper Hopes for Recovery).

While markets and most analysts continue to expect the Bank to start hiking in
June, the BoC is not just watching the domestic data flow; global events are one of
Governor Carney’s key downside risk

Who would have thought that on a year-to-date basis, the S&P 500 would have
generated a 3% net loss and the Treasury market a net positive return of 4%
(nearly 7% for the 10-year note, 10% for the long bond and 16% for long-dated
zeros). Bonds do have more fun after all.
The rally in bonds is creating at least as much pain for the investment
community as the sell-off in equities. As of May 18, the Commodity Futures
Trading Commission (CFTC) data show that there are still a net speculative
SHORT positions in the 10-year T-note of 206,783 contracts (in the futures
and options market). In other words, the potential for a further significant
short-covering rally in U.S. Treasuries.
By way of comparison, there is a net speculative long position of 1,238 S&P
contracts, a net long position on oil totalling 134,863 contracts, a net long
position of 7,233 on copper, as well as 47,085 contracts on the Canadian dollar.
All of these are vulnerable to a further short squeeze. We are still long-term
bulls of gold, but even here near-term caution is advised considering that there
are a near-record 274,769 net speculative long positions in the yellow metal —
this has become a very crowded trade; better pricing points likely lie ahead.
1. The ECR weekly leading index growth rate peaked on October 9, 2009 (at
28.54%; now at 9.0%).
2. The Conference Board’s LEI peaked at 109.4 in March (109.3 in April).
3. ISM orders/inventory ratio peaked at 1.805 in August 2009 (1.33 in April).
4. University of Michigan consumer expectations peaked on September 2009
(at 73.5) – now at 65.3 in May.
5. The UofM index of big-ticket consumer purchases peaked in February-March
at 136; is down to 129 as of May.
6. Jobless claims bottomed at 442k on March 11. They had peaked at 651k
on March 28, 2009. But they are back at 471k, which is where they were
back on December 19, 2009 so the improvement has stalled out. Not only
that, but to keep 472k into perspective, claims were at 453k the week after
9/11 (and the economy back then was eight months into recession). Yes,
yes, employment has been rising of late; however, keep in mind that
nonfarm payrolls are in the index of coincident indicators; claims are in the
index of leading indicators. Please let’s not drive looking through the rear
7. Single-family building permits peaked at 542k (annual rate) in March (were
484k in April).
8. Mortgage purchase applications peaked on April 30th at 291.3 and now are
at a 13-year low of 192.1 even though mortgage rates have come down 20
basis points since the nearby high.
9. Auto production peaked at 7.8 million units (seasonally adjusted annual
rate) in January – was at 7.2 million in April.

The rally in bonds is creating at least as much pain for the investment community as the sell-off in equities
10. Electrical utility output was down 0.1% YoY as of May 15th. Could be
another early sign that the production revival is behind us.
Many in the past have used an ISM clock (while on Wall Street, I did the same
several years ago) but the problem is that the ISM is a perfect coincident
indicator. It leads nothing. But the ECRI leading index does look ahead six
months and is now pointing to GDP growth of little better than 1½% at an
annual rate through the second half of the year, which is anaemic enough to
regenerate ...
! A new peak in the unemployment rate (jobless claims have stopped falling
and at current levels are consistent with net job loss 75% of the time in the
! A new low in housing prices (see page 16 of the weekend FT — the venerable
Lex column — for true Bob Farrell-type mean reversion, U.S, home prices still
have downside risk of up to 40%!);
! And new concerns over consumer credit quality (we say this as we see the
S&P/Experian consumer credit default rate index hit a new high of 9.14% in
April — the proportion of credit card debt going bad is rising sharply and this is
not receiving the attention it should but is a yellow flag for consumer-oriented
lenders and businesses).
This is not necessarily a double dip scenario as much as a growth relapse -- as
we saw in 2002, still not exactly an ideal atmosphere for taking on long risk
The ECRI not only leads but is also more timely than the ISM since the data
are released weekly and the index covers the whole economy, not just
What we did was divided the ECRI into four different quadrants:
1. From the trough to zero (coming out of recession).
2. From zero to the peak (sweet spot of the cycle -- from the end of the
recession to the cycle peak in growth).
3. From the peak back to zero (past the peak in growth; economy slows but not
back in recession).
4. Zero back to the negative trough (heading back into recession).
5. From late 2008 to the fall of 2009, we were in stage 2. Since last October,
we have been in stage 3 and it looks like we could be here for a while.
In stage 3, historically, the S&P 500 has provided tiny positive returns
(average price appreciation of +1.3%). Tech, industrials and energy are the
top performing cyclicals and health care and staples are also outperforming
sectors in the more defensive area. This cyclical-defensive barbell works well
— basic materials, consumer discretionary, financials and utilities tend to lag
the most.

In the credit market, this is a period to be focusing on reducing duration and
scaling into quality -- Baa spreads tighten, on average, by 11bps but widen in
the high-yield space by an average of 13bps.
Nothing is to say that we will automatically revert to stage 4 just because we
are in stage 3 right now but we are only nine -percentage points away, even
with policy rates still close to 0%. Then again, this was a credit cycle, not a
rates cycle. It was credit that created the 2003-07 boom, and it was credit
that created the 2007-2008 bust. A 5.5% peak in the funds rate was hardly
the culprit, and we know that it was not a 0% rate in late 2008 that triggered
the 2009 renewal in economic activity and investor risk appetite but rather
the Fed’s massive expansion of its balance sheet and the government’s
willingness to push the fiscal deficit to record peace-time levels. In this sense,
any analysis that relies on the classic post-WWII recession-recovery experience
-- even this one -- has to be viewed in the context of a secular credit
contraction which began two years ago.
In stage 4, the S&P 500 on average declines 6.3% with eight of the 10 sectors
declining — a barbell of being long energy on the cyclical side and consumer
staples on the defensive side has worked well. Consumer cyclicals,
technology, industrials and financials are crushed in this segment of the ECRI
cycle; telecom, utilities and health care do not perform as well as staples but
are areas where at least you don’t typically get beaten up (for relative-return
folks). The CRB is down an average of 3% but gold and oil tend to be
supported by a weaker U.S. dollar. The yield on the 10-year note rallies an
average of almost 40bps; as with equities, corporate bonds are hurt in this
quadrant -- Baa spreads widen about 60bps and high-yield by close to 100bps.
We have to be mindful that this can very well be the next phase of the cycle
even without the Fed raising rates.
The ECRI bottomed this cycle a good four months before the equity market did
and for those folks that paid attention, like Jim Grant, kudos to them.
Because from the trough to zero — stage 1 — the equity market rallies on
average by 12% with all 10 sectors in the green column, led by tech, consumer
discretionary and basic materials. Energy, telecom and utilities tend to lag
behind. Financials are basically market performers. The government bond
market is still rallying in this segment and the curve is steepening — that along
with a slight softening in the U.S. dollar provides a positive liquidity backdrop,
which in turn is conducive to spread narrowing in the credit market (average
tightening of around 50bps in investment-grade and 200bps in junk).
The market really takes off once the ECRI crosses above the zero line on the
way to the peak, which is stage 2 or the “sweet spot”. In this phase, risktaking
works best with the S&P 500 rising 22% through this interval and every
sector is up double-digits in terms of average price gains. Financials, basic
materials, industrials, technology, and consumer discretionary typically
provide the greatest alpha in this most intensely pro-cyclical phase of the cycle
— utilities and telecom lag the most as does energy within the economicsensitive
space (energy tends to be a stage 3 and 4 outperformer). Again, the
credit market mirrors the positive backdrop in equities — Baa spreads come in
by more than 30bps and by nearly 170bps in the high-yield space.
U.S. existing home sales soared 7.6% in April to a seasonally adjusted annual
rate of 5.77 million units, above expectations. The surge was already
foreshadowed by the earlier release of the pending home sales figures and
entirely reflects the rush of activity ahead of the April 30th expiration of the
homebuyer tax credit ($8,000 for first time buyers who made up close to half
of the April sales tally (repeat buyers represented 36% of the pie last month --
they get a $6,500 tax credit). We already know what housing activity looked
like following the April 30th deadline with mortgage applications for new
purchases down to a 13-year low as of mid-May. Moreover, the one critical flyin-
the-ointment in April was the surge in supply — inventories climbed 11.5%
to their highest level since July 2009 (+12.8% for single-family homes to their
highest level since Nov/08) — and back up to 8.4 months' supply from 8.1
months in March. This excess supply casts a cloud over the outlook for home
prices in coming months.
As a sign of just how sick the housing market really is, almost all (that is nearly
100%) of the mortgages issued last quarter were insured by the government
under Fannie, Freddie and the FHA. In fact, FHA lending ($52.5 billion)
actually exceeded the combined volume of government-supported Fannie Mae
and Freddie Mac ($46 billion) in a home-lending market that's still a
"government-financed market," David Stevens, the agency's head, said today
at a conference in New York, citing research by consultant Potomac Partners.
"This is a market purely on life support, sustained by the federal government,"
he said at the Mortgage Bankers Association conference. "Having FHA do this
much volume is a sign of a very sick system." And you thought we were
bearish on the real estate backdrop.

And the strains are not limited to the single-family market. Defaults on
apartment-building mortgages held by U.S. banks climbed to a record 4.6
percent in the first quarter, doubling from a year ago. This already exceeds
the 3.4% S&L-induced peak seen in 1993.

The Chicago national activity index improved to +0.29 in April from +0.13 in
March — the best tally since December 2006 and the first back-to-back positive
readings since the opening months of 2007. The Chicago Fed suggests that we
concentrate on the three-month smoothed index, which went from -0.09 in
March to -0.03 in April — still underscoring a below-average pace of growth but
you still have to go back to February 2007 to see the last time that the index
was this “strong”.
Production and income are on an improving trend but we do see that the sales
component has slowed for two months in a row. Not only that, but the
consumption and housing segment actually fell to a three-month low and at -0.41
is actually still lower today than it was at the depths of the past five recessions One has to wonder what happens once the inventory
cycle runs its course and the production index stops proving support.

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