Banks not out of the woods despite the BAC deal

As the news of the Berkshire/Bank of America deal hit the tape, BAC rallied and so did the banking sector. I had written about the systemic risks that Mr. Market was indicating in the banking system, how does this BAC rescue change the picture?

The answer is, "Not very much."

Take a look at the relative performance of the BKX compared to the market. Notwithstanding the fact that the Buffett rescue was a sweetheart deal (not everyone can get a 6% coupon on preferred shares senior to the common, so that if everything blows up the common shareholders eat the loss first, plus Buffett gets common share warrants as a "sweetener"), the banks have rallied but remain in a relative downtrend. I would like to see the relative downtrend broken and, ideally, a rally above the relative support line (which has become resistance) broken in June.

The performance of the Regional Banks, which are less exposed to European sovereign risk,  tells the same story. This was a nice rally, to be sure. But it was not enough to change the picture of a banking sector that is deteriorating.

Let's see if Bernanke can ride to the rescue, but I am on record as stating that such a possibility is doubtful. Add to the equation the observation that corporate bonds spreads are starting to blow out, Mr. Market is telling us that the systemic risks are rising in the financial system. Until the banks can stage a significant follow-through on the rally on Thursday, I remain of the opinion that a Euro-disaster is still menacing the global financial system much in the same way that Irene is menacing the US east coast.

A stock market bottom at the end of this decade

There has been some buzz in the blogosphere about a paper published by researchers from the San Francisco Fed entitled Boomer Retirement: Headwinds for U.S. Equity Markets? In the paper, the authors concluded that, based on their demographic studies, "real stock prices are not expected to return to their 2010 level until 2027".

I had written about the effect of demographics on equity market returns before (see Wait 8 years for a new bull). I had referenced a paper by Geanakoplos et al entitled Demography and the long-term predictability of the stock market, where the authors related stock market returns and long-term P/Es. Reading between the lines, they forecast a 1982-style (my words, not theirs) market bottom about 2018.

What's the difference between the San Francisco Fed paper and the Geanakoplos paper?
 
The San Francisco Fed paper addresses that issue of methodology:

We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio.

By contrast, the Geanakoplos paper uses the M/Y ratio, or middle-aged to young ratio. The San Francisco Fed researchers justified their use of the M/O ratio this way:

We prefer our M/O ratio to the M/Y ratio of middle-age to young adults, age 20–29, studied by Geanakoplos et al. (2004). In our view, the saving and investment behavior of the old-age cohort is more relevant for asset prices than the behavior of young adults. Equity accumulation by young adults is low. To the extent they save, it is primarily for housing rather than for investment in the stock market. In contrast, individuals age 60–69 may shift their portfolios as their financial needs and attitudes toward risk change. Eligibility for Social Security pensions is also likely to play a first-order role in determining the life-cycle patterns of saving, especially for old-age individuals.

The results aren't all that different. Though many bloggers focused on the headline "real stock prices are not expected to return to their 2010 level until 2027", here is the full conclusion [emphasis added]:

The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. The subsequent recovery is quite slow. Indeed, real stock prices are not expected to return to their 2010 level until 2027. On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.

The San Francisco Fed researchers concluded that stock prices bottom in 2021, instead of 2018 as implied by the Geanakoplos paper. 2018? 2021? What's the difference? These kinds of estimate errors are to be expected in these kinds of long-term demographic studies. As they say, it's close enough for government work.
 
 
Range-bound markets until the end of the decade
These studies support my technical conclusion that we are likely to see volatile and range-bound stock markets until the end of the decade.

 

 
(Note that range-bound doesn't necessarily mean sideways or flat. Most recently, the SPX has been bounded by 666 on the downside and 1370 on the upside - which is quite a range.)
 
 
It's the valuation, stupid!
I recently came upon a better fundamental explanation of these mult-decade bull phases followed by multi-decade range-bound stock markets. The chart below from VectorGrader shows the market cap to GDP of US equities from 1950 (charts is theirs, the annotations are mine). Note how the bull phases coincided with expansion of the market cap to GDP ratio. The equity market then topped out and then became range-bound, which coincided with a corrective phase in the market cap to GDP ratio, until that "valuation" metric returned to more realistic levels.
 

Today, the market cap to GDP ratio has corrected some of its gains from the highs seen at the NASDAQ peak in 2000, but not entirely. If I were to eyeball the chart, a market bottom around the end of this decade is quite plausible and likely given the current rate of descent of that ratio.
 
 
An investment plan for a range-bound market
In July 2010, I wrote the following and I stand by my conclusions:

Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.


During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Asset Inflation-Deflation Timer model to capture the swings of a flat market.

Incidentally, the Timer Model is currently at a deflation reading, signaling a stance of maximum defensiveness. There is a new way of regularly accessing those model readings. I have been participating in the Ticker Sense blogger sentiment poll and the my "blogger opinion" is reflective of the model reading, where:


Bullish = Inflation
Neutral = Neutral
Bearish = Deflation

The poll is updated on a weekly basis and the results are released on Mondays.

The price of becoming Swedish

Europe seems to lurch from crisis to crisis and the time between them has shrunk dramatically from months to days. Where does it all end? (See this hilarious account of what's wrong with Europe).

To put the European sovereign debt problem into context, what we have is the case of a number of peripheral countries that have taken on too much debt. The question then becomes, who bears the pain of this situation? There are four principal solutions:

1. Default/restructuring - the banks first take most of the pain, which would result in a European banking crisis that threatens the stability of the global financial system.
2. The ECB goes nuclear with QE - The European Central Bank buys up peripheral debt on an un-sterilized basis to the tune of, pick a number, €1T? €2T? €3T? In this case, the euro tanks and inflation breaks out in the eurozone.
3. Political integration (in addition to economic integration) - National constitutions get changed and a central authority (Brussels?) assumes greater authority over the budgets and policies of individual EU member states. There is little or no political support for this solution and riots would likely break out all over Europe. The strong EU member states, mainly Germany, bears much of the pain for bailing out its partners.
4. One or more countries (Greece? Portugal? Spain? Germany?) leave the euro - There is no mechanism for leaving the euro. This amount to a form of succession. How do you unscramble an omelette? Widespread confusion and chaos would rule in the financial markets and such an event would likely spark a financial conflagration that spreads around the globe.

The least costly option, in my opinion, is option 1. Force the bank shareholders and bond holders to take the pain and at the same time nationalize the troubled banks, much like the Swedish approach to their banking crisis of 1991-2 (also see this description of the Swedish solution in the wake of the Lehman Crisis of 2008).



A Euro-TARP for a prepackaged banking crisis?
How much would a Swedish style bailout cost?

If the EU or its member states nationalized the banking system, the first cut estimate comes from the current market cap of the European banking sector, which is roughly €300 billion.

For a more conservative estimate, I considered Tier 1 capital, which includes preferred shares and subordinated debt in addition to common equity. I added up all of the Tier 1 capital of the eurozone banks (ex-UK, Norway and Sweden) shown in the European Banking Authority's stress test of 2010. That figure came to roughly €800 billion. Note that estimate is more conservative because the list of banks include banks which are not exchange-listed such the German Landesbanks. True, there is some problem with this data set. The banking balance sheets does date from December 2009 but I couldn't find the a more up to date table Tier 1 capital and the point of this exercise is not to be exact, but to get a ballpark figure. (If anyone has access to the Tier 1 capital figures from the 2011 stress test please contact me at cam at hbhinvestments dot com).

So the ballpark estimate for nationalization ranges from €300 billion to €800 billion. The bill could even be less. During Sweden's banking crisis, not all banks had to be nationalized and some found private solutions.

The price of such a rescue campaign is roughly equivalent to TARP, which is very do-able and affordable given the stakes involved. The question is whether the EU member states have the political will to run roughshod over the bankers and financiers to do it.

For now, there is little political will to do anything, which has led to an impasse. Regardless whether the political will is there, I believe it's the right solution. Here is how the Reformed Broker put it [emphasis added]:

After 40 years of pain avoidance, can we just rip off the f**kin' band-aid already? Enough with the asset price protection, it is the root cause of everything bad about the economy right now. Had we saved the banking system and said f**k the banks themselves, we'd be two thirds of the way out of this by now. Had we gone Swedish instead of Japanese and said the banks are now "Wards of the State" until cleaned up, then yes, we probably would have seen Dow 5000...but so what? Was stopping at Dow 6500 so much better? We would have had an unencumbered financial system at this point, one healthy enough to cope with a new leg down in housing, rather than the debt-ridden George Romero zombie film we find ourselves re-watching every quarter.

He was writing about the US economy and how the Fed and the Obama Administration should handle things, but the same comment applies to Europe as well.

Banking system like 2008? What about 1998 and LTCM?

Recently there has been some discussion about the stress showing up in the banking system. Cullen Roche at Pragmatic Capitalism pointed out that the CDS market in the selected European banks is showing higher levels of stress than 2008:

Don Fishbach pointed out that the average CDS level for US banks is higher than levels seen in March 2008, which is worse than the Bear Stearns peak but lower than the worse stress seen during the Lehman Crisis:

I wrote about this indicator in May 2011. My own indicator of the BKX relative the the market is now in freefall. There were two occasions in the past when this indicator was in freefall after breaking down through a relative support level. The first time was in 1998 just before the Russia Crisis took down Long Term Capital Management. The second occasion was more benign, as the stock market outperformed the banks during the 1999 run-up to the NASDAQ peak of March 2000.

Right now, we have the stock price of Bank of America in a waterfall decline and European banks teetering at the edge. If the real stress in the financial system lies with Europe, which I believe it is, then we have real trouble as the ECB and EU have shown that they are paralyzed and anything that Bernanke Fed announces Friday at Jackson Hole is likely to be a sideshow.

Stop buying gold stocks!

Here we go again. Gold has hit all-time highs again. As you can see from the chart below, bullion remains in a well-defined uptrend.

On the other hand, gold mining stocks performance is disappointing as the group is struggling with technical resistance and has underperformed gold (again). What happened to the story about a better leverage to the gold price?

I wrote about this before here. Gold stocks are underperforming because their cost of production is going up, which creates a headwind for earnings - a driver of stock price. Yes, the value of what they have in the ground has gone up, but so has the cost of what it costs to take it out of the ground.

I wrote the following in December 2009 and it has proven to be true:

Supposing that you had a crystal ball that told you the price of gold were to triple within two years. Given this piece of information, what should you buy in order to maximize your gain?


Buying gold by itself will give you a gain of 200%. Buying a two-year call on gold with a $600 strike will give you a projected gain of about 300%. If you change the strike to $900, the projected gain is about 550%.

If you buy gold stocks given its poor fundamentals of rising production costs and their resultant pattern of disappointing leverage, gains are likely to be 200% or less. An investor would be taking on more volatility risk but at the price of little or no incremental gain.

If you are a gold bull you should either buy GLD or physical bullion, not gold stocks.

Don't expect the Fed to throw another party

Last year, Ben Bernanke made a speech at Jackson Hole announcing the start of the Fed's QE2 program, which kicked off a stock market rally. (The Fed throws great parties, don't they?) This year, there seems to be a certain level of market expectation that we may see another Jackson Hole surprise.

Don't count on it.


Bullard's QE3 denial
First and foremost, James Bullard of the St. Louis Fed (an FOMC non-voter), who was one of the advocates of QE2 last year, clarified the FOMC statement that interest rates would stay low for another two years is not a signal for QE3 to start. Bloomberg reported that Bullard stated:

"The most likely outcome for the U.S. economy is still that the economy continues to grow at a moderate pace through the second half of the year,” Bullard said late yesterday in a telephone interview. “If the economy is substantially weaker than expected, we could take more action, especially if it was coupled with a renewed deflation risk.”

Second, the higher than expected PPI and CPI reports last week are not exactly comforting signals for Fed governors who are concerned about inflationary expectations.


The worst of all worlds
At the same time, we have signs of a decelerating economy. This long term chart of the ratio of coincidental to lagging indicators shows that the US economy is definitely in the danger zone.

...though this indicator did tick up this month:

Then we have the awful Philly Fed print last week. David Rosenberg showed this chart of his composite of the Philly Fed and University Michigan Sentiment Index. Need I say more?

In effect, we have the worst of both worlds - the combination of a slowing economy and a Fed showing reluctance to be more accommodative than they are today. On top of that, we have European banking system and sovereigns lurching from crisis to crisis. (What's the over/under these days the for number of days before another European "problem" erupts? 2 days? 3 days?)

In the absence of effective policy response, the intermediate term path of least resistance for stocks is down.

How cheap are stocks?

There have been a number of recent posts about stock valuation with the question of, "How cheap are stocks?"

I had posted about bullish data points, most notably from the news that Warren Buffett is buying stocks. Felix Salmon had blogbed about whether stocks are cheap compared to TIPS or corporate bonds. There was also this discussion based on the notion that stocks are cheap according to the Fed Model of earnings yield vs. bonds. I thought that I would do my own exercise of US equity valuation. I decided that rather than consider the forward P/E ratio favored by the Street, where the E tends to be optimistic and analysts can never call the turns in the economy, I focused on a trailing P/E based on actual as reported earnings.

Using the data from Standard and Poor's and a history of S+P 500 earnings and valuation, I found that with 94% of the companies reporting 2Q2011 results, "as reported" trailing 12 month earnings for the S+P 500 is $83.75.

How much can earnings fall in a recession?
The table below goes back to 1960 where were several recessionary episodes when earnings declined. These declines ranged between a low of 7% (for a mild recession such as we saw in 1990) and a high of 30.8%, with a 15% fall as a reasonable guide as to what a "typical" recession might look like. In all of these cases, except for the earnings decline that began in 2006, the peak-to-trough calculation were based on one-year changes in earnings. The first average shown in the table excludes the 2006-7 and 2006-8 years in order to avoid double and triple counting. The average earnings decline excluding the recessionary episode starting in 2006 came to -14.8%.

How bad could stocks get in a recession?
At the current level of roughly 1200, the trailing P/E ratio using "as reported earnings" is 14.3. If we were to apply that multiple to a 10%, 15% and 30% decline in earnings from current levels due to a recession, we would get targets of 1080 (-10% from current levels), 1020 (-15%) and 840 (-30%) respectively - a simple math calculation.

What about a market panic? When the market reached the devil's bottom of 666 in March 2009, it was trading at roughly 10 times trailing earnings. Applying that panic bottom earnings multiple of 10 to the 10%, 15% and 30% earnings decline scenarios would get us 750 (-37%), 710 (-41%) and 590 (-51%). In a worst case analysis, the market could therefore re-test its lows of 2009.


More optimistic assumptions
Wait a minute, you might say, stocks have already fallen from their peak. Is applying the current multiple of 14 times earnings realistic?

The market made its high in early May and the trailing earnings multiple then was 16.9. Applying a 10%, 15% and 30% decline in earnings using a peak multiple of 16.9, which is admittedly an optimistic assumption, gets us targets of 1270 (+6%), 1200 (0%) and 980 (-18%).


What's in the price?
Given these range of scenarios, my best guess is that US equities are currently discounting a slow growth environment, possibly a very mild recession such as the 1990 episode. A more typical recession is not in the price.

If you believe that a recession isn't in the cards, then stocks represent good to fair value. On the other hand, if you believe that there is a serious risk of a recession, then you should be more cautious in your equity allocation. Personally, I am tilting to the bearish side because of growing evidence of a global slowdown.

To look on the bright side, should the market panic and re-test the 2009 lows, that's a signal to back up the truck and get long.

Some bullish data points

After my recent posts, examples here and here, I have been accused of overly gloomy, bearish and even Apocalyptic.

Today, I would like to present a number of bullish data points as a change of pace. It's always useful to look at the other side of the story, in order to challenge your own viewpoint. We all suffer from confirmation bias, which is the tendency to find data points or news items that confirm our biases.


In brief, I would like to discuss each of the following points:

• Insiders are buying.
• Warren Buffett is buying.
• Sentiment is getting so bearish that it has reached the public consciousness, which is contrarian bullish.

Insider buying
Insiders are known to be smart investors. Even if they are not trading on material non-public information, which is against the law, their investment activity has on average beaten the market. So the market got very excited when TrimTabs reported last week that insiders were buying at the heaviest pace since May 2008.

Others have jumped on the story by reporting that insider buying activity was heaviest in financials, which is bullish for that sector.

Wait a minute - heaviest buying since May 2008? Wasn't May 2008 before the crash in stock prices? While this group has shown outperformance in the past, insider activity is not a perfect timing indicator and they can be early in their calls. Izabella Kaminsky at FT Alphaville highlighted TrimTab's warning about the less than perfect record of insiders:

But TrimTabs cautions that insiders are not infallible. Insiders were also buying heavily in late 2007 and early 2008, right before the financial crisis intensified.

Warren Buffett is buying
The Oracle of Omaha had been speaking bullishly about the economy and the market in early July. More recently, Fortune publish an interview with Buffett entitled Buffett: The lower stocks go, the more I buy. Firstly, Buffett observed that he sees no recession on the horizon from his read of Berkshire Hathaway's businesses:

Up until right now, all of our businesses have been coming back---even Europe isn't doing that badly---except for businesses relating to home construction which is on its rear end. [Importantly Buffett did say that if events continue like the last few weeks it will change things.] Business has been coming back steadily, even more than the mood of the public.

He went on to say that they are buying stocks and issuing Berkshire bonds in the process:

In the meantime, Buffett is looking to buy stocks -- oh, and apparently to sell Berkshire bonds too. Berkshire is reportedly taking advantage of record low rates and issuing bonds to raise dirt-cheap capital. For Buffett right now at least, this is not a time for fear. This is a time for action.

Are stocks really cheap on an absolute basis or are they just cheap relative to bonds? I don't pretend to be as smart an investor as Warren Buffett, but respected value investor Jeremy Grantham of GMO recently wrote that fair value on the S&P 500 is no more than 950.
 
There is a case to be made that bonds are expensive, especially after the Fed intervened to say that they would keep rates low for another two years (which would encourage a borrow-short-lend-long carry trade). Marc Faber agrees with this assessment:

I personally think the Treasury market (NYSE:TLT), the long-dated, are a bubble and it will be one of the worst investments for the longer term if you buy a 10-year, a 30-year U.S. Treasury so I’m a bit puzzled that Treasuries are now yielding, are essentially near record lows. I would rather sell Treasuries.

In that case, could Berkshire be issue cheap debt to buy stocks in order to arbitrage the difference in expected returns?


 
Consensus is getting too bearish
The final bullish data point that I have is the contrarian magazine cover indicator. Yesterday, I wrote about the risks in Europe, but look at this Time Magazine cover:
 

 
When the story gets to the popular mainstream press such as Time, is it time to buy?
 
My inner bear doesn`t have a good answer to that question, other to point to this technical analysis study from Goldman Sachs (ht: ZeroHedge) indicating that when the VIX spikes to the high 40`s, as it did last week, it usually either marks an intermediate term bottom or a sideways consolidation pattern in the market. The report, however, does cite the risks to Europe as part of their forecast.

Sentiment analysis seems to be the most compelling from the bullish viewpoint. Given the risks in the system, my best guess is that the market is likely to be choppy but move sideways after this oversold relief rally is complete.

Timer Model updates

A number of regular readers have asked me to update the readings on my Asset Inflation-Deflation Timer Model.

There is a new way of regularly accessing those model readings. I have been participating in the Ticker Sense blogger sentiment poll and the my "blogger opinion" is reflective of the model reading, where:

Bullish = Inflation
Neutral = Neutral
Bearish = Deflation

The poll is conducted weekly and the current reading is neutral.

Your move, Jean-Claude

Last week's FOMC statement read [emphasis added]:

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.  The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Note that they didn't exactly say that they would keep rates low until 2013, they just said that they "currently anticipate" that they would keep rates low until 2013, which means that they can change their minds at any time - but never mind that.

Moreover, they hinted at another round of quantitative easing:

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

As with last year, there could be another round of fireworks coming out of the Jackson Hole meetings this year when Bernanke is scheduled to speak on August 26.


Stresses are showing up in the financial system
I don't believe that the market volatility last week was the result of the credit downgrade of US debt. Instead, it represents signs of stress showing up in the financial system.

Where is the stress coming from?

I have been writing about the relative performance of the KBW Bank Index (BKX) relative to the market since May (see my original post here). Since then, the BKX has violated a major relative support level. Past violations have been signs of major systemic risk in the financial system coming to light. The first instance was the Russia Crisis in 1998 and the second was 2007 with the Subprime Crisis. Now it's happening all over again when relative support was broken in June. The recent selloff in the markets only intensified the underperformance and the sector remains in a major relative downtrend.

Interestingly, the performance of the Regional Banks have been much better. The KRX Regional Bank Index did not violate relative support until last week:

What to make of the difference between the BKX, which includes all of the big too-big-to-fail (TBTF) banks, and the KRX, which are regionals more focused on plain vanilla banking? The difference is global and investment banking exposure. The TBTF banks have it and the regionals don't, or have a lot less.

The logical conclusion is that the difference in performance in BKX and KRX performance are concerns over a European banking crisis, which the Fed will only play a secondary role in. True, the recent relative breakdown in the KRX is worrisome and likely reflects concerns over a the effects of a slowdown on an already fragile US economy (e.g., see this recent story indicating that 64% of Americans can't handle a $1,000 emergency expense), but it could be a false signal because of the incredible market volatility last week.

The biggest macro problem remains Europe.


Eurogeddon?
Consider what Ambrose Evans-Prichard wrote in the Telegraph under the headline Eurogeddon postponed again as ECB gains three weeks about the ECB announcement that it would buy Club Med debt in the open market:

Unless the ECB is willing to back up its new role as lender-of-last-resort with massive purchases of Italian and Spanish debt, it will inevitably be tested by markets. Weak hands will take advantage of rallies to offload holdings onto the ECB, i.e. onto eurozone taxpayers. Frankfurt will find itself underwater very quickly without a legal mandate or EU treaty authority.

The problem is the unfunded EFSF [emphasis added]:

RBS calculates that the ECB will have to buy roughly half the outstanding tradeable debt of the two countries to defend the line. RBS calculates €850bn. I would put it nearer €1 trillion.
This is currently impossible. The ECB is acting as a temporary back-stop until the revamped EFSF bail-out fund is ratified by all parliaments over coming months. The EFSF will then take the baton.

Yet as we all know, the EFSF has no money. The parliaments have not even ratified the earlier boost to €440bn. As of today, the fund has barely €80bn left after all the commitments to Greece, Ireland, and Portugal. It remains a fiction.

...and the EU (read: the Germans) are adamantly against forking more euros over to save the Club Med countries. Both the FT and the WSJ are indicating widespread discontent with Angela Merkel over the prospect of more bailouts. Though there was a report over the weekend that the German government no longer rules out euro bonds, it doesn't actually say that they would actually take that step, but consider the option. Moreover, any government that pursues such a policy in the face of widespread popular discontent risks its own tenure in power.


Will the ECB throw in the towel and "do QE"?
What about the ECB as a white knight?

Joseph Cotterill of FT Alphaville recently wrote about the ECB in action in their "rescue" efforts. For newbies, let me explain how the mechanism works. Supposing that the ECB were to buy Spanish or Italian debt. Where does the money come from? One option would be for the ECB to print it (because central banks can print money out of thin air), which is variously described as debt monetization or (horrors!) quantitative easing. If it doesn't want to engage in QE, then it has to issue debt into the market and that activity is termed "sterilization", or "sterilisation", as the Brits would have it.

Cotterill outlined the dual problem of moral hazard and sterlization facing the ECB [emphasis added]:

Key points:

• Italian government bonds outstanding: €1,597bn
• Spanish government bonds outstanding: €576bn
• ECB bond purchases outstanding: €74bn
• Daily turnover on Italy’s electronic bond market (MOT) in June: €13.5bn
• Typical size of a single ECB purchase: €25-100m
• Italy/Spain holders looking to get out at a good price: many

Eventually the ECB also supported Greece, Portugal and Ireland ‘on a massive scale’, holding up to 20 per cent of their respective total debt stocks. If the ECB went on to hold that much of Italy, it would hold about €320bn (Spain €115bn).

So we have a problem. Actually, two problems. Whether the ECB can sterilise Spanish and Italian bond-buying if they get to a large size, and whether that size will itself become the big liquidity threat to Italian or Spanish bond markets over time as supply is sucked out. Hanging over all of it is the Securities Markets Programme’s long-running tendency to give long investors who want to sell an exit route at a good price, rather than encouraging them to maintain exposure.

Paul Kedrosky pointed out the differences between the Fed and the ECB in graphical terms. Just look at their balance sheets shown below. While the Fed's balance sheet has exploded upwards due to their QE2 program, the ECB balance sheet has been flat:

The mechanism for a rescue in Europe has been the Troika, consisting of the EU, the ECB and the IMF. The IMF is unlikely to take the lead in any crisis unless it's called upon. What's left is the EU and the ECB. Given resistance of the German public to further bailouts, the most likely candidate is the ECB.

Will the ECB finally "do QE"? Over to you, Jean-Claude!

Given risks of a banking crisis in Europe, anything that Bernanke announces at Jackson Hole is likely to be a sideshow.

Dark Crosses everywhere

I reviewed many of the world's stock market charts this weekend and what I found were numerous Dark Crosses where the 50-day moving averaged and crossed under the 200 day-day moving average. These are ominous signs indicating the overall trend has turned south. In fact, most Dark Crosses had occurred in either June or July and US equities were one of the last markets to experience a Dark Cross. In fact, only one stock market, the Russian one, hadn't seen a Dark Cross marking a technical downtrend but it had experienced a pattern of broken support.

To start our tour around the world, let's start with the US market. This market only experienced its Dark Cross last week:

Across the Atlantic, the UK market saw a Dark Cross in mid-July:

On the Continent, the STOXX 50 saw its downtrend begin earlier in mid-June:

The Hong Kong market also began its technical downtrend in June:

...as did Shanghai:

The resource based market of Australia saw a Dark Cross in mid-June:

...and the Canadian market, another resource based market, followed in July:

The tour would be incomplete without a look at the other BRIC markets. Brazil had been in a serious downtrend, which began in March:

The Indian market saw a Dark Cross in March and now it has seen a break of a major technical support:

Russia, which has not technically seen a dark cross indicating a downtrend, has nevertheless broken down through a major technical support level:

In this age of rising market correlations, a preponderance of technical downtrends and violations of support levels can't be good news for the bulls. The weight of the evidence indicates that a bear market has begun.

Prepare your portfolios accordingly.

How to play an oversold relief rally

Wow! The Fed relief rally that began Tuesday evaporated on Wednesday like the morning dew.
I have learned from bitter experience that over-reliance on overbought/oversold models can be a route to the poorhouse. So here is a better way to use OBOS models to play an oversold bounce. Consider, for example, my favorite overbought/oversold model* (but this is applicable to any OBOS model such as the popular RSI indicator):

Oversold markets can get more oversold and overbought markets can get more overbought. In fact, my former Merrill Lynch colleague used the term "a good overbought" condition to describe an uptrending market or stock that rallied, paused and rallied again.

I have found that a better way to play an oversold bounce consist of the following:

1. Wait for the oversold condition;
2. Buy when the market exits the oversold condition.

While this method isn't perfect, it avoids much of the draw-downs that come from buying a panicky falling market or shorting an overexuberant bullish market.

Warning: This technique isn't for the faint of heart. But if you can stand the risk and want to play a rally here, then wait for the oversold condition to clear itself before entering the market on the long side. As I write this, ES futures are up about 1% so we have a shot that Thursday will be an up day, which would could prove to be the start of a relief rally that typically lasts 1-3 weeks.



* For traders who want to monitor the readings of this model on a daily basis, click on this link.

Big down days on the DJIA

CXO Advisory wrote about what happens after big down days on the S&P 500. Their study dates from January 1950 and they defined "a big down day as a decline of at least four standard deviations of the daily returns over the preceding four years (1,008 trading days)." They found 45 observations and concluded that:

• The average next-day return is 0.59% (but variability is high).
• 60% of next-day returns  (27 of 45) are positive.
• The average next-day return is fairly consistent for subsamples when the index is above and below its 200-day SMA.

CXO went on to warn that the results were very volatile and 45 days is a relative small sample upon which to reliably draw conclusions. So I repeated the study using data for the Dow Jones Industrials Average, pulled from Yahoo Finance. That data goes back to October 1, 1928 - though if you average four years' worth of data, you missed the Crash of 1929. Here are the results:

DJIA 4-Std Dev Big Down Days

Markets rallied the next day but fell back in a week

I found similar results, though the sample size was slightly larger at 59 (instead of 45). The next day return averaged 0.36%, which beat the average daily Dow daily return of 0.03% by 0.33%. There was an outlier of -22.6% during the Crash of 1987 which pulled down the average return. If we were to look at the median return, which is less sensitve to outliers, the median daily return on big down days was 0.43%, which was substantially ahead of the Dow daily return of 0.04%. 62.7% of the subsequent daily returns were up, ahead of the 52.2% figure for all Dow days from 1928. Next day returns were highly volatile and the standard deviation of daily returns after big down days was nearly four times the standard deviation of daily Dow returns for the entire sample.

CXO Advisory warned against looking at averages of subsequent one-week returns because of overlapping instances of big down days. The table reflects the first instance of a big down day in a five day period and subsequent big down day weekly returns were ignored.

Interestingly, while the markets rose for the next day for big down days, the one-week return was not so encouraging. In all cases, the average and median returns, as well as percentage of positive weeks, underperformed our control sample of the Dow returns for our entire study period.


Monday was not a 4-standard deviation day
Despite the market carnage yesterday, Monday did not qualify as a 4-standard deviation day. The measure actually came in at -3.48. So I repeated the exercise by defining big down days as 3-standard deviations under the 1008-trading day average:
 

DJIA 3-Std Dev Big Down Days

 
Here the sample size grew to 170 from 59. The results were similar but not as strong. The one day return outperformed but the one-week returns were mixed.

The New Yorker bottom?

Remember the market adage about the magazine cover indicator? When a popular magazine (not financial one such as the Wall Street Journal, Barrons or the Financial Times) writes about either the devastation of bear markets or the beauty of stocks, then it's a contrarian sign marking either a top (in the case of exuberance) or bottom (in the case of excessive bearishness).

I just came across the latest cover from the New Yorker and the lead commentary is entitled "How bad is it out there? The economy after the debt ceiling agreement":

There is no doubt that the markets are oversold. Does the New Yorker cover mark a bottom, even if it's a short or intermediate term bottom?

What's next?

Despite the G7 statement over the weekend hinting at coordinated intervention:

We are committed to taking coordinated action where needed, to ensuring liquidity, and to supporting financial market functioning, financial stability and economic growth.

...the markets are behaving badly as I write this. Asian markets are deeply in the red and ES futures are down over 2%. There is no doubt that markets are deeply oversold, but oversold markets can get more oversold.

Here are some signposts that I am watching for from Monday's market action to see if the market has put in a short-term bottom:

• Does the decline get arrested in Europe? Will ECB intervention occur and will that spark a relief rally?
• How do the financials behave relative to the market? European sovereign risk, as well as the fear of a US double-dip recession, are driving this rush to safety and the financials are one of the most vulnerable sectors of the market. Do the financials outperform or underperform the market Monday?
• How will the US stock market behave intraday? The markets will be buffeted, on one hand by panic and forced selling from margin calls and risk managers, and on the other hand by short-sellers covering shorts by the day's end just in case the Fed comes out with a market friendly statement on Tuesday. (See my comments here about my assessment of the likelihood of QE3).
• How does gold behave? As I write this, the gold price has screamed upwards in Tokyo and breached the $1700 mark. If this is truly a risk-off "margin clerk" market, then risky assets like gold, silver, copper and other commodity prices should get hit just as hard.

Buckle up. It's going to be a wild ride.

Yes to QE3, but not yet

Last week, it is dawning on Mr. Market that the US economy is starting to look weak. Last whis week, John Hussman was discussing the signposts for another economic slowdown. Moreover, ECRI was warning about double-dip concerns this summer (note that they are not calling for a double-dip recession, just rising concerns about a double-dip). In addition, three prominent former Fed officials, namely Brian Madigan, Vincent Reinhart and Donald Kohn, called for the Fed to take a second look for another round of bond buying.

In view of these worries about slowing growth, is the Fed likely to ride to the rescue with another round of quantitative easing?


QE3 Tripwires
Tim Duy, who is one of the better Fed watchers in the blogosphere, outlined the criteria for QE3 here. In Ben Bernanke's testimony to Congress on July 13, 2011, the following snippet from Bernanke's testimony got the markets all excited about the possibility of QE3 [emphasis added]:

On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally.

When economists say "on one hand", you have to see what they say "on the other hand" [emphasis added]:

On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy. Accordingly, the Committee has been giving careful consideration to the elements of its exit strategy, and, as reported in the minutes of the June FOMC meeting, it has reached a broad consensus about the sequence of steps that it expects to follow when the normalization of policy becomes appropriate. In brief, when economic conditions warrant, the Committee would begin the normalization process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve's balance sheet to begin shrinking. At the same time or sometime thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the federal funds rate target. From that point on, changing the level or range of the federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments.

Duy thinks that the criteria for QE3 are economic weakness and deflation risk:

Note the two conditions – persistent economic weakness coupled with deflation risks. The latter was a focus when the Fed initiated QE2, with the lack of such risks guaranteeing the Fed would cease asset purchases at the end of June. Bernanke made clear the focus on deflation in his most recent press conference.

 
Let's go to the tape
So what are the deflationary risks and, conversely, inflationary expectations? As they say in the sports shows, let's go the tape...
 
One of the Fed's most closely watched inflation indicators is Personal Consumption Expenditure, or PCE. The Dallas Fed publishes a trimmed mean PCE series, which is a measure of core PCE, or PCE without the volatile components. While one-month PCE did turn negative in the latest June release, note how trimmed mean PCE has been ticking up in the last few months at the 6 and 12 month level (circled). These figures are at best mixed and not friendly to the initiation of QE3.
 

 
In addition, Friday's Non-Farm Payroll came in ahead of expectations. Though the headline NFP jobs gain of 117K jobs still indicates a weak economy, it is not showing signs of deterioration (and deflation).
 
What about inflationary expectations? Don't forget one of the Fed's mandates is to control inflation. Tim Duy made the following comment after the jobs report Friday:

The implied inflation expectations from the TIPS market is 193bp and 225bp at the 5 and 10 year horizons, respectively. Still well above last summer's lows. The Fed has repeatedly argued they can't do anything about growth, but can fight deflation. But this doesn't appear to be a strong deflationary signal. This too argues against significantly policy shifts.

What about other market based indicators of inflationary expectations? Take a look at the price of gold. In July the yellow metal rallied about resistance at 1,500 and is in a solid uptrend. Is this what deflation looks like?

Despite the pain suffered by the financial markets, I don't believe that the Fed will ride to the rescue with a QE3 program in the immediate future. They will undoubtedly act - but later, when the damage is done to the markets and the economy.
 
Understand how Fed governors think. These people are mostly academics, charged with steering the most powerful central bank in the world. Academics are conservative by nature and want to wait for the evidence to come in before acting. After all, you don't want to over-reacting on minor blips in the data, do you?
 
 
The Greenspan Put vs. the Bernanke Put
Also put yourself in Bernanke's head. His academic reputation was built on the study of central bank action during the Great Depression. This is probably a little voice in his head telling over and over again, "Don't let another Great Depression happen on your watch." As a result, we have the Bernanke Put.
 
Contrast that with Alan Greenspan's background, who had more experience on the Street as a forecasting economist. His bio from Wikipedia states that before he went to the Federal Reserve, he had extensive real-world (as opposed to academic) experience:

During his economic studies at New York University, Greenspan worked under Eugene Banks, a managing director at the wall street investment bank Brown Brothers Harriman, working in the firms equity research department. From 1948 to 1953, Greenspan worked as an economic analyst at The National Industrial Conference Board, a business and industry oriented think-tank in New York City. From 1955 to 1987, when he was appointed as chairman of the Federal Reserve, Greenspan was chairman and president of Townsend-Greenspan & Co., Inc., an economic consulting firm in New York City, a 33-year stint interrupted only from 1974 to 1977 by his service as Chairman of the Council of Economic Advisers under President Gerald Ford.

In the summer of 1968, Greenspan agreed to serve Richard Nixon as his coordinator on domestic policy in the nomination campaign. Greenspan has also served as a corporate director for Aluminum Company of America (Alcoa); Automatic Data Processing, Inc.; Capital Cities/ABC, Inc.; General Foods, Inc.; J.P. Morgan & Co., Inc.; Morgan Guaranty Trust Company of New York; Mobil Corporation; and The Pittston Company. He was a director of the Council on Foreign Relations foreign policy organization between 1982 and 1988. He also served as a member of the influential Washington-based financial advisory body, the Group of Thirty in 1984.

Greenspan's approach as Fed Chairman was to stimulate whenever he saw signs of weakness - and he was far more market savvy than Bernanke. Therefore the Greenspan Fed tended to be more proactive and tended to get ahead of events. The Great Moderation was the result of the Greenspan Put - and those policies worked well, until they went overboard with the stimulus (and we are still paying the price for those policies).
 
In essence, that's the difference between the Greenspan and Bernanke Fed. The Greenspan Fed would be acting now with another round of QE as it had a history of getting ahead of market events. The Bernanke Fed is more cautious and will only act when the economic evidence is fully in - which likely means Q4 at the earliest.
 
I don't expect any form of QE to be announced this week. The most we can expect from the Fed is for them to moderate their language to hint that they are allowing for some signs of weakness (which they'll "monitor") and hint at another round of QE.

Reason over passion

The carnage in the markets on Thursday was truly breathtaking. By the time the European markets closed, it was clear that there was nowhere to hide in the US.

The broad based US stock market averages were down 4-5% on the day. "Defensive" sectors such as utilities, consumer staples and healthcare were down -3.3%, -3.2% and -4.0% respectively. While the returns of these sectors outperformed the averages, it was cold comfort to investors who lost 3-4% in a single day.

What about gold? Aren't we told by the gold bugs that it's the only "real money" and the only source of stability in a crisis? Oh, never mind...

In the words of Dennis Gartman, Thursday was the example of a "margin clerk market", where everything was liquidated to meet margin calls or to de-risk portfolios. The only green on my screen were bonds and bond ETFs.


Do you have a credible plan?
To be a successful investor, you must have a disciplined and credible plan and you must follow it during these periods of market turmoil. I have a plan and it's called the Asset Inflation Deflation Timer Model. I rely on it to be tactical in asset allocation and the Timer Model designed to make money in sustained bull markets (by buying risk) and sustained bear markets (by buying long-dated Treasuries).

To put the weakness into context, equities are down slightly over 10% on a peak-to-trough basis. Although short and dramatic, this recent bout of market weakness puts it into the category of a plain vanilla correction.

While I remain concerned about the risk of financial contagion in Europe and a double-dip recession in an already weakened US economy, I am relying on the discipline of the Timer Model to stabilize my portfolio during periods of extreme stress, e.g. a Russia or Tequila Crisis. Otherwise, I could be panicked into making self-defeating decisions at precisely the wrong time.

Do you have a credible plan and are you following it?

A different kind of NFP preview

The headline blared: JP Morgan warns of a even more disappointing NFP.

The Non-Farm Payroll number that gets released Friday will be watched closely by the markets for a clue as to the strength of the US economy. The problem is, the NFP figure is notoriously noisy.


Watching the employment and temp agency stocks
Instead of monitoring employment statistics, there is another real-time indicator of employment confidence that gets updated every day - that's the performance of the employment and temp agency stocks. So let's take a look at some of the relative performance of the stocks in this industry. The two biggest are MAN and RHI, with market capitalizations of about $3.7b apiece.

The price performance of MAN looks awful. It is obviously in a well-defined downtrend relative to the market.

RHI looks a bit more constructive. The stock rallied above the relative downtrend line, but relative price performance remains weak.

Analysis of this industry is hampered by a number of factors. There aren't a lot of publicly traded companies in the group and some of the stocks are moving on news, e.g. KFRC and SFN. Looking at some of the other smaller cap companies, KELYA remains in a relative downtrend.

...but TBI's relative chart looks like it may be stabilizing its recent trend of underperformance.

Overall, the relative returns of the stocks in the group can only be characterized as weak. Given these conditions, don't expect too much from the NFP release on Friday.

How much more downside from here?

Weakening PMI!

Italian-Bund spreads are blowing out!

Equity markets have been selling off, first on debt ceiling concerns, then worries over a weakening US economy and renewed financial pressures in Europe. For traders, the question has to be is it too late to get short?


Markets are very oversold
Despite these concerns, the markets are very oversold. My favorite overbought/oversold indicator is showing an oversold reading.

From past experience, a rally of this indicator over the 0.50 level after showing an oversold reading is good for an oversold bounce of 1-3 weeks. At the same time, the SPX is now at the bottom of a trading range, with the RSI showing an oversold reading.

Over at ZorTrades, his facetiously titled post We are crashing tomorrow confirms the oversold conditions that I also see and he is tactically calling for a short-term bounce:

We are 25% invested right now in $UDOW and $TNA- 75% CASH. We are not looking for new highs, or betting that QE3, 4, 5, or 6 is going to happen. We are looking for a dead cat bounce, one that could rally the indices 3-5%. This is just a trade, not a macro, micro, whatever call. Just a trade.

My inner trader is waiting for the signs of a rally before jumping on board the bull trade and he believes that, tactically speaking, downside risk is likely to be limited at these levels. My inner investor, on the other hand, has become very defensive and is wondering whether he should sell more of his holdings into strength and perhaps even short the market should it move to higher levels.

The US budget dilemma in context

Over the weekend I have heard a lot of talking heads expressing their opinion about the US debt ceiling and budget impasse. Some of the opinions have been wildly off base. In that context, I would like the put the US fiscal picture into a clearer context.


Dire straits
Last year, three BIS economist published a paper entitled The future of public debt: prospects and implications. The paper paints a terrifying prospect for the inhabitants of the US and for most of the developed world. The chart below shows the projected debt to GDP ratio of the US for the next 30 years. The red dotted line depicts the baseline scenario, which assumes that assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 OECD projected levels. The green line assumes budget cuts of 1% of GDP for five years starting in 2012. The blue line assumes deeper cuts to entitlement programs, e.g. pension benefits, etc. To put the Standard and Poor's demand of $4 trillion in deficit reduction over the next decade, that amounts to roughly 28% of current GDP, spread over 10 years.

How the Tea Party has dominated the conversation
There is no question that the yawning gap between government revenue and spending has to get closed in the long run. But how do you achieve that goal?
 
In the current debate, the Tea Party activists have dominated the conversation by adamantly insisting that government spending be cut, with no increases on the revenue, or tax, side and held the country's solvency and credit rating hostage in doing so. In many ways, they have won as even the Democrat dominated Senate plan has taken tax increases off the table.
 
Is a budget plan that relies purely on spending cuts realistic? Consider this chart from Ezra Klein showing the path of past budget deals. All of them relied on a combination of spending cuts and tax increases. Viewed in this context, the Obama plan of relying on revenue increase of just 17% of the savings looks positively draconian:

Klein wrote [emphasis added]:

As you can see on the graph, in each case, taxes were at least a third of the total, and in Reagan’s case, his massive tax cuts were followed by deficit-reduction deals that actually relied on tax increases. Today, tea party conservatives would be begging Sen. Jim DeMint to primary the Gipper.

The Free Exchange blog at The Economist comment that every successful rescue of a nation by the IMF has involved a combination of spending cuts and tax increases:

Put simply, no fiscal consolidation that the IMF has judged to be successful relied on public spending cuts for more than 83% of its impact. In successful fiscal consolidations, tax rises accounted for between 17% and 33% of deficit-reduction measures.

Unlike many European countries, the US has more room to raise taxes. Paul Kedrosky blogged that the tax burden in the US is one of lowest in the world, just between Chile and Turkey:

A noble experiment or a disaster in the making?
From the latest reports, it seems that the Tea Party has succeeded in dominating the agenda and Congress has resisted tax increases in coming up with a budget deal. Under the circumstances, the deal can charitably characterize as a "noble experiment" in fiscal policy.

Here is a great little interactive from the Washington Post, who would you pay?


Be careful about what you wish for
I wrote before about being careful about what you wish for. Consider this example of what is happening in Toronto as foreshadowing what happens when the no-government-is-good-government crowd wins power:

An round-the-clock meeting at Toronto city hall where more than 300 members of the public came to tell mayor Rob Ford which services to protect and which to cut ended just before 8 a.m. ET with all decisions on cost-cutting options put off until September.

The marathon meeting, held by the city’s executive committee and chaired by the mayor, heard from hundreds of union members, arts groups, social agencies and private citizens on the Rob Ford administration’s deliberations over cutting services to rein in a budget deficit. At just few minutes shy of 22-and-a-half hours it was the longest continuous meeting of either council or one of its committees since the modern megacity was created in 1998.

With the exception of two or three, the message the meeting heard from the public was the same: don’t cut anything.

Rob Ford won the mayoralty on a platform of "we are sick of out-of-control spending at City Hall and we are going to fix the problem".

The trouble with ideologues is when they attain power, they actually have to govern.