Monday, October 3, 2011

Too many bullets for stocks to dodge

Admit it. We are in a cyclical bear market. The stock market has too many bullets to dodge. Despite the ugly returns seen the 3Q, there is more downside potential from current levels. Here are the big macro risks that I remain concerned about:
  • Europe:  The market is still expecting either that Greek default will somehow be avoided or a TARP-like rescue of the banking system. Neither is going to happen. Add to the mix of a looming recession and you have the precursors of a market meltdown.
  • US: ECRI was out publicly with their recession call last week. As we approach 3Q Earnings Season, what happens when the equity markets start to price in a recession?
  • China: The fears of a hard landing are rising. As the markets move the consensus view of a soft landing to the possibility of a hard landing, it will put downward pressure on the price of risky assets.

A soft landing in Europe? Not!
I wrote last week to remember that the endgame is a Greek default. That is the bond market's consensus, but the stock market seems to hope against hope that there will be an orderly resolution of the crisis. I don't mean to pick on STRATFOR, but their analysis is one example of conventional thinking. STRATFOR believes that Greece needs to leave the eurozone, though that's not necessarily the consensus. What is consensus is what needs to happen afterwards:

And so to prepare for a Greek ejection, you have to prepare a fund that can handle three things more or less simultaneously. First, you need about 400 billion euro to firebreak Greece off from the rest of eurozone. Second, you need about 800 billion euro in order to prevent a wide-scale banking meltdown, because the day that Greece defaults on that debt, the day that it’s ejected from eurozone, there will be catastrophic banking collapses in Portugal, Italy, Spain and France, probably in that order.
In other words, the European authorities need to come up with funds (and a lot of it) to make bond holders whole. Otherwise we will be risking a banking catastrophe.

When analyzing Europe, it's important to remember these principles:
  1. Greece is going to default. It's just a question of when and how.
  2. The EU can't afford to bail out the peripheral countries. What makes you think that they can bail out their banking system?
In this week's commentary, John Hussman gave some perspective on the scale of the problem facing Europe if the authorities were to decide to make bondholders whole [emphasis added]:
As background, the EFSF represents a fiscal commitment of European countries to a fund intended to stabilize the European financial system. It is not, however, money that these governments have eagerly decided to simply flush down the toilet - the intent is to use it for stabilization, but also to get most of it back, as the overall commitment represents about 6% of the GDP of the European union. Notably, the total amount of Greek debt alone represents nearly 80% of the size of the EFSF, which would leave only 20% of the commitment available to other states if the EFSF was to buy it up, as some have suggested.
In other words, don't expect the EU or ECB to bail out the European banking system. They can't afford it.

Warren Buffett was interviewed on CNBC last Friday and he says that European banks shouldn't expect help from Berkshire. By contrast, he did buy into Bank of America. That's a signal of how deep in doo-doo the European banks are.

What's more, there is no one in charge in Europe. Leadership is sorely lacking. As the Economist points out, the European politicians' plan is to have a plan.  Attila Szalay-Berzeviczy, who is the current Head of Global Securities at Unicredit (speaking personally as the former head of the Hungarian Stock Exchange), wrote about the level of cognitive dissonance among Eurocrats (translated from Hungarian from Google Translate):
The American politicians, at least it has always been understood that the money and capital markets are efficient economic policy allies of the investor for the company are responsible for. In contrast, their counterparts in Europe, unfortunately, still do not understand the nature of markets, most of them think that the financial system, the ancient enemy, because it does not work the way it is dictated by their own political interests.
Even worse, there have been multiple forecasts of a European recession that begins in 4Q (see examples here and here). Such a slowdown is coming at an inopportune time when the financial system is especially fragile.
American investors start to price in a recession
Across the Atlantic in America, ECRI went public last week with their recession call which they provided clients with the previous week. They wrote:
ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down – before the Arab Spring and Japanese earthquake – to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not “soft landings.”
ECRI has had no false positives in their recession calls, though, as their detractors point out, they have been late on occasion.

In an interview with Bloomberg Television, Lakshman Achuthan used the word "wildfire" in characterizing the downturn in all of their indicators, which was "pronounced, pervasive and persistent". These are all hallmarks of recession. Moreover, their recession call was not based on events in Europe. "If there's an 'event'", Achuthan said, "I don't know where this is going to go."

What's the downside risk in US equities?
I wrote here back in August that US equities were trading at 14x trailing earnings, which appear to be reasonable value given level of 10-year Treasury yields. However, recessions have a nasty habit of taking earnings down 20-30%, which would mean that the market may not be so cheap anymore. By contrast, James Bianco thinks that earnings may be 20-40% too high if we were to encounter a recession.

If you were to apply a 10x stock market panic P/E multiple observed in 2008-9 to depressed earnings levels, US equities could very well revisit the lows seen in the bottom set in 2009. In that case, investors could have a very nasty surprise. I plan to keep a close eye on company guidance during 3Q Earnings Season. Unexpected negative guidance may the catalyst for another downdraft in equity prices.

No help from Helicopter Ben
The bulls can't expect any help in the near term from the Fed. I was of the opinion that, when things got bad enough, that the Fed would come to the bulls' rescue with QE3. Ben Bernanke gave a speech entitled Lessons from emerging market economies on the sources of sustained growth last week and gave a press conference afterwards. If the Fed were to move forward with further stimulus, that press conference would have been the perfect venue to signal such a move. Instead, we got the Fed-has-done-all-it-can-and-it's-up-to-fiscal-policy lecture:
“Monetary policy can do a lot, but monetary policy is not a panacea,” Bernanke said.

A Chinese hard landing?
As the American and European economies slow and prices of cyclically sensitive commodities such as copper tank, investors will no doubt start to wonder about the fate of China. As the chart below shows, should a global recession grip the world, then the copper price decline has much further to go (and the panic will grow).

With copper prices crashing, what are the implications of the Chinese copper collateral trade on the informal banking system? Already, we are seeing signs of credit stress among Chinese property developers.

Ambrose Evans-Pritchard, writing in the Telegraph, observes that the financial contagion from the West is already showing up on Chinese shores:
Contagion has spread to Chinese "Dim Sum" bonds issued in yuan on the offshore market in Hong Kong, where companies linked to China's property market and building sectors have taken a beating. Yields on Dim Sum bonds jumped by 105 basis points to 5.85pc in August, the worst month since the instruments were created.
China and other emerging market could face a credit crunch because of Europe's unfolding financial crisis [emphasis added]:
Most developing countries lack a proper bond market so firms rely on global finance to raise capital. Almost 80pc of the money come from European banks, which have lent $3.4 trillion to emerging markets. Part of the funding comes from US money markets – which have effectively pulled the plug on Europe. This adds a nasty twist to what is already a very twisted nexus.
BCA Research echoes Evans-Pritchard's concerns about the vulnerabilities of the emerging market economies to the problems in Europe [emphasis added]:
[S]ome developing nations have received massive inflows from G7 banks in general and European banks in particular. These inflows are at risk as European banks freeze their lending activity and repatriate capital. Brazil is the most vulnerable on this front as it has received US$485 billion in inflows from G7 banks, of which US$350 billion is from European institutions. Central and eastern European economies are the most at risk from Europe’s credit crisis, given the heavy involvement of European banks in the region and their trade links with the euro area. Meanwhile, the biggest impact on Asian emerging economies will be via global growth. The share of Chinese exports going to the EU is almost 20%. In fact, the EU is just as important a trade partner for Asia as the U.S., and a renewed contraction in Europe would pose a material risk to Asian exports.
While I am not necessarily in the camp that China will experience a hard landing this cycle, I am of the belief that as the economies of the West slow, investors will begin to price in the possibility of a Chinese hard landing. Already, I am seeing more and more hand-wringing articles and blog posts such as "Whither China?" and "China: The risks of a hard landing are growing".  David Cui, the Bank of America/Merrill Lynch China strategist, has also joined the bandwagon by producing a highly bearish report on China.

Don't say that you weren't warned.

What to do?
Under these circumstances, my inner investor is staying with the long Treasury bond trade, largely because the Asset Inflation-Deflation Timer Model has been signaling deflation for several weeks. He is also depending the Timer Model to maintain a stop-loss risk control discipline for the trade and to sound the all-clear signal to return to risky assets.

My inner trader, for once, is positioned in a similar way by staying long the USD/long Treasury safe haven play and waiting for a rally to short equities.
October is likely to be a good month for the bears.

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.


GE Smith said...

T-Bonds are going up, but basically for the same reason as Miami condos in 2007.

You can't claim there is any value in buying a 20+yr bond that yields less than CPI. Whether you admit it or not, you are betting on being able to sell your condo -- uh, T-bond -- to a bigger sucker just before the music stops.

Of course, a few people got lucky and sold their condos just at the peak. Most people got screwed.

This time will not be different

Bobster said...

why does Greece matter if its debt represents only 3% of the EU's total?

Why cant Bond holders take a hair cut? After all their investments are not guaranteed?

Tiho said...

I completely agree with Macro Rants. He seems to know what a value investor should be doing.

You do not invest in a 30 year bull market near the top, even if it goes up for another year.

Stocks were depressed from 1974 to 1982. Treasury Bonds were depressed in 1979 to 1982. Gold was depressed in 1999 to 2001. Today... Japanese equities are depressed. Since 2008 all the way to now, Nikkei 225 remains 80% below its nominal and inflation adjusted high...

That is what you should be recommending clients to do. But usually "retail investors" don't chase bears - they chase bulls. In this case Bond bulls!