Sunday, October 23, 2011

Listen to which market?

One of the tenets of technical analysis is, "Listen to the markets." When US equities broke out to the upside on Friday, many traders sat up and took notice. True, stocks also had a failed downside thrust when it violated resistance recently, but the current move certainly shows that the bulls have the upper hand.

But which market should traders listen to? The stock market which just staged an upside breakout? What about the bond market, which shows 10-year Italian-Bund spreads rising to challenge the 4% new high level, which signals rising systemic risk in Europe?

What about the message that economically sensitive Dr. Copper is sending?

My inner bull and bear debate
My inner bull tells me that to relax and it's time to get long risky asset for the following reasons:
  • 3Q Earnings Seasons has been coming in relatively strongly.
  • Most economic indicators for the US have been surprising to the upside.
  • Even if the economy were to weaken, the Fed is getting ready for QE3. Last week, a number of Fed officials have advocated more large scale MBS purchases. As well, the FOMC minutes of the latest meeting show that two members of the policy committee “said that current conditions and the outlook could justify stronger policy action.”
  • Stocks are reacting more strongly to good news from Europe than bad news, which is an indication that the market is ready to rise. The announcement last week that this weekend's meeting was not going to produce a definitive agreement and that a second meeting on Wednesday October 26 should have been terrible news and the markets should have cratered. While they did decline between 1% and 1.5% on the news, they rallied strongly when Merkozy stated that they would produce an "ambitious" rescue plan.
  • China is showing that she is standing by her banks in order to cushion any soft patches in the economy when a SWF indicated that it would buy more shares of the big four Chinese banks. The Economist interpreted the move as a form of confidence building:
These purchases were significant not for what they said about the banks, but for what they revealed about their owner. They signalled that China’s government will act, if necessary, to shore up the economy and the banks if a sharp slowdown takes hold. It purchased bank shares (on a far bigger scale) in September 2008, the first of a flurry of rescue measures, culminating in a big stimulus package two months later.

It all depends on Europe...
My inner bear points to the headline of Schaeffer's Research note which says it all: Despite technical feats, bulls remain at the mercy of Europe. Last week, I wrote about a framework for assessing a eurozone rescue plan and later tried to assess the probable eurozone Grand Plan, which was a form of best case analysis.

In brief, the eurozone's problem is a problem of excessive sovereign debt by a number of EU member states and much of the debt was stuffed inside eurozone banks. So trying to rescue either the banks or individual states becomes a circular problem. You can't take on more debt to rescue yourself. The money has to come from somewhere. The eurozone has three options:
  • Get more money internally from the strong states within the EU such as Germany;
  • Get more money externally, e.g. the US or BRIC countries; or
  • The ECB prints the money.
The Germans are currently balking at writing a big cheque to bail out their Greek cousins as they eye their Portuguese and Irish cousins standing outside the door. That's why I wrote that for any Grand Plan to succeed, both the EU's Grand Plan has to be credible AND the ECB has to cooperate and state that they will undertake to print sufficient amounts to reflate Greece and the other peripheral countries, whether that's €1 trillion or €5 trillion.

Right now, my inner bear says that the equity market is focusing on the EU Grand Plan. Most versions of the Grand Plan that have been floated are useful, but flawed in some degree, but the fact remains the ECB has to an about face and agree to quantitative easing on a massive scale. Moreover, my anecdotal sources tell me that the Europeans on the Continent see this crisis as a same old, same old crisis where the Eurocrats will work it all out in the end. A Goldman Sachs report (via ZH) confirms this view:
  • Investor sentiment and intraday market action remain focused on news flow and speculation regarding policy developments in Europe. Our meetings with clients in the US, UK, and continental Europe during the past two weeks revealed a clear delineation between the views of those located in Europe and those looking towards Europe. Investors continue to vote with their feet as evidenced by mutual fund outflows and smaller net equity futures positions since the end of July.
  • Investors “on the continent” are more composed about the direction and pace of policy decisions. Perhaps reflecting a home field advantage in understanding the region’s culture and politics, local investors are less anxious that periphery countries ultimately will receive support and less concerned about the day-to-day public conjecture. One worrying takeaway is that European politicians seem less sensitive to swings in asset prices and thus may be more tolerant of declines than in other regions of the world.
  • Investors outside Europe are far more worried about potential policy solutions and the cumulative impact of a drawn-out resolution. Clients in the UK and US were more negative than those in Europe particularly around the methodical nature of the debate. There is genuine concern among this group that growth, financial conditions and the total cost of resolution are negatively impacted each passing day. Outsiders are also acutely concerned about the impact of fiscal tightening in Italy, Spain and Greece will have on economic growth and place a higher probability on a break-up of the euro than “locals.”

In a numerous discussions with equity analysts and investors in North America, my inner bear would also say that the majority aren't aware of many of the issues surrounding the eurozone crisis and therefore they are inclined to react to the headlines, such as the circularity of trying to rescue yourself with more debt, whether it's through EFSF as a monoline insurer or any other scheme. In effect, the upside breakout by US equities is a fake-out, not the start of a true bull phase. That's also the message of the European bond markets, which is more used to pricing default risk, as they pushed the 10-year Italy-Bund spread to 4%.

A looming American recession?
The message from Dr. Copper and other commodity prices are also signaling a weak global economy. Unlike the breakout seen in equities, the chart of the CRB Index shown below indicates that the gap from late September was filled but commodities continue to show weakness. These are not signs of a reviving economy.

As for the better than expected economic numbers and reports from 3Q earnings, John Hussman recently defended the ECRI recession call:
From my perspective, Wall Street's "relief" about the economy, and its willingness to set aside recession concerns, is a mistake born of confusion between leading indicators and lagging ones. Leading evidence is not only clear, but on a statistical basis is essentially certain that the U.S. economy, and indeed, the global economy, faces an oncoming recession. As Lakshman Achuthan notes on the basis of ECRI's own (and historically reliable) set of indicators, "We've entered a vicious cycle, and it's too late: a recession can't be averted." Likewise, lagging evidence is largely clear that the economy was not yet in a recession as of, say, August or September. The error that investors are inviting here is to treat lagging indicators as if they are leading ones.

The simple fact is that the measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a "denial" phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007 (see Expecting A Recession ), the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high.
Tinfoil hat time?
I am inclined to tilt towards the views of my inner bear because inter-market analysis is not confirming the upside breakout, though I am listening to the message of my inner bull. There is, however, a far-out alternative hypothesis that could prove my inner bull right.
The European who are sanguine about this crisis are right. There is a Grand Plan that's already been decided by the eurocrats. Anecdotal evidence suggests that many German bureaucrats understand that the ultimate solution is to allow the ECB to go nuclear and print money like Helicopter Ben and having Mario Draghi at the head of the ECB gives them political cover to blame the Italian. The objections of the Old Guard, who will still remember the hyperinflation era of the Weimar Republic and will brook no discussion about any form of reflationary policy, will eventually be overcome. What you see in the news is just posturing by various parties playing to their own constituencies but the True Grand Plan will be revealed in the near future.
This is getting so far into tinfoil hat territory that I am not sure what to say.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Macro Rants said...

Cam -- you are essentially saying that ultimately the EU will fail. I agree with your analysis that the unelected Eurocrats are going to do as they please, voters be damned.

But the unstated subtext of that belief is that democracy in Europe is dead. The EU Treaty was never ratified by the majority of European voters, and the "Grand Plan" as you call it has no chance either.

Napoleon and Hitler must be so upset that they tried to conquer Europe by force, when all they had to do was hold secret meetings in Brussels and declare the citizens irrelevant.

I think you may be right about the Eurocrats -- but overriding Europe's citizenry is simply a precursor to yet another war.

Plus ca change, plus ca meme chose as the French like to say

Tiho said...

It sounds like you are toning down your super bearish outlook since August. Your article had "bullish" case scenarios for the first time... is that a is of mild capitulation here?

Definintly a different tone to what your articles were like in September. It's amazing what a 15% bear market rally does to sentiment.

Couple of more weeks of bulls frustrating bears like this and finally it might be time to short. By that time ever blogger will conclude thhe breakout above 1250 is real!