By Kevin M. Wilson
The markets have continued grinding upward over the last few weeks, but there are many signs of undue complacency on the part of investors. Markets are currently over-bought, over-bullish, and over-valued, a syndrome that is commonly associated with declines. In evaluating the markets, I’m reminded of the fatal complacency that must have prevailed in the pilot house of the Costa Concordia right before she hit the rocks off Giglio, Italy on Friday, January the 13th. Everything seemed fine, and then two hours later the 115,000 ton ship had rolled onto its side and foundered within a stone’s throw of the shore, leaving at least 16 dead and 18 missing. Markets have likewise decided that going close to the “rocks” (i.e., exhibiting extreme bullishness in a weakening global economy, with Greek default looming, and US earnings now falling) is not dangerous at all. However, market history and various technical indicators suggest that the markets are possibly in the process of topping, and are capable of rolling over into a correction of some type at any moment. For example, the amount of short interest on the S & P 500 was recently at a three-year low, indicating on a contrarian basis that it’s a very poor time to be long on equities, in terms of risk and reward. The put/call volume ratio topped 2:1 three weeks ago, which it has done just before all three of the most recent corrections. Also, the VIX or volatility index for the S & P 500 has fallen below 18 for the first time since July, which is again a contrarian indicator.
John Hussman (www.hussmanfunds.com) characterizes the current market as exhausted, and has warned that the situation for stocks, based on market history, is extremely hostile over the next few weeks. There is evidence that we are now in what might be called a “whipsaw trap,” meaning that after a breakdown such as we saw in late October, the new rally since then has set up a situation where the probable outcome going forward is a 25% market drop over the next few months. This is not set in stone, but it is highly likely. Other observers are equally cautious based on a variety of technical factors, as mentioned above. Other examples of the whipsaw trap and their associated market losses include November 1961 (-25%), August 1987 (-33%), July 1998 (-18%), August 2000 (-22%), March 2002 (-32%) and May 2008 (-43%). In view of this very hostile risk/reward environment, we are close to fully hedged in growth-oriented portfolios, and very defensive in more income-oriented portfolios. However, if new Federal Reserve or ECB interventions were to occur, we would be forced to drop our hedges and defensiveness and buy equities, since markets go for the bait each time it is offered. For now, we are in the process of gradually buying some small positions in cheaper stocks that still have substantial upside, but these are longer term holdings and we would probably buy more if in a correction they dropped off a bit.
The global economic situation is also deteriorating somewhat, as evidenced by the new recession in Europe, sharply slowing growth in China, and falling consumer spending and real income in the US. Unemployment in Europe is on average above 10%, and in Spain and Greece it is above 20%. The European recession is starting from an output gap (gap between trend GDP and actual GDP) of 9%, which suggests that this recession will be much deeper than markets think. Indeed, it will be curious if we do not have a global recession by year-end 2012. The Year-Over-Year GDP growth for the US through 4Q/2011 was just 1.5%; note that a decline to this level has always been associated with the onset of recessions, including the last ten in a row. Even more disconcerting is the report this week that electricity use in China dropped 7.5% in January, a huge drop that suggests a rapidly falling growth rate for Chinese GDP. Naturally, this would directly affect the rest of Asia and would probably cause great consternation in the markets, if they at some point bother to notice this little slice of reality.
The question of what is real is of course the problem at hand, especially in the light of questionable economic data such as we had in the US last week. For example, payrolls were reported to have grown by 243,000 last month, which would be good news if true (we need 125,000 added each month just to keep up with population growth). Unfortunately, this figure was arrived at using huge seasonal adjustments to the raw data, and payroll tax data indicate the opposite trend, i.e. payrolls went down. This confusion between data sets arises because the government insists (as it has for many years) on using outdated and highly unreliable employment data rather than real-time, verifiable hard evidence like tax payments. In any case, few market bulls care about what’s behind these numbers; they trade off headlines, not knowledge. Traders dominate now (courtesy of the government) and they rarely examine anything other than the current supply of cheap money from the largest central banks, which are determined to continue their push for speculation in the markets. They do this in the vain hope that something good for the economy will come of it, but I think the main thing that will happen is the continued punishment of prudent investors and rewarding of risk-taking with borrowed money.
Of course, we now have the strange situation where things are supposedly getting better, so further monetary easing is not needed in the US, and yet the markets continue to expect more money printing by the Fed and the ECB. They will get it on February 29th from the ECB because of the sovereign debt crisis in Europe. However, the Fed would have to have more “cause” than current data supports in order to justify starting another round of easing. This may slow markets down a bit in the very near term, but with the “Bernanke Put” permanently available to equity markets, it is hard to imagine them stalling out for very long. The US economy is still quite fragile of course, and if the Chinese economy slows dramatically, or the Euro-zone recession is very deep, or the Iranians/Syrians/Egyptians/Israelis start a war, Mr. Bernanke will get yet another chance to print money and play the hero, later this year.
Weekly Comments: Telltale Signs
By Kevin M. Wilson
The markets have reacted pretty tamely today to the news that Greece has once again been bailed out by the EU, the ECB, and the IMF. In part this muted reaction is due to the traditional market wisdom many players adhere to, which is to “buy the rumor, sell the news.” In part the market is exhausted after its recent rally. But a substantial part of this reaction is probably due to the fact that one of these three entities, which together are known as the so-called “Troika,” has leaked a confidential report to the Financial Times on the viability of Greece’s economy once the new bailout has been put into operation. The report notes that the Greek program may “remain accident-prone,” and the very deep recession in Greece, made much deeper by the Troika’s imposed austerity program, may “leave debt as high as 160% of GDP in 2020.” Since the putative goal of the bailout was to drop the debt/GDP ratio for Greece to 120% by 2020 (which is nevertheless entirely unsustainable even at this hypothetically reduced level), the Troika has in effect agreed to a deal that will not work. It seems clear that the bailout is really just another attempt to buy time to save Europe’s banks, at huge cost to taxpayers in the EU (and some cost to US taxpayers via the IMF), and with the risk of a financial catastrophe for the average Greek citizen. Indeed, very little of the bailout money ($224 billion) will go to the Greek government; instead, the majority of the money will go to cover the costs of giving private investors (banks, hedge funds) new 30-year bonds in a bond swap (53.5% “haircut”) negotiated as part of the deal.
There are many lines of evidence to support the notion that markets are exhausted and due for a pullback. For example, net Insider Selling has climbed dramatically in the last few weeks, to a recent high ratio of 16.1 x Insider Buying, suggesting that corporate insiders are selling in massive proportions. Another indicator of a top is that those insiders have to find someone to sell their shares to, and right on cue retail investors have shown up and are finally getting into the market (as usual, right at the top). Yet another potential indicator of a top is the fact that corporate buying has been slacking off substantially in recent weeks, according to TrimTabs (http://trimtabs.com) and this has been one of the main drivers of the markets in recent months. Markets are also over-bought, over-bullish, and over-valued, and bond yields have recently been rising, all of which in combination are strong indicators (according to John Hussman, www.hussmanfunds.com) of at least a short term market top. Additional well-known indicators include the Economic Surprise Indexes put out independently by Societe Generale and Citibank, which appear to have peaked, as they commonly do right before a top is made.
Those who would argue that the US economy is relatively strong and any dips should be bought have a point, but for the wrong reasons. The recently strong manufacturing and unemployment data have been interpreted as signs of economic strength, but both are coincident-to-lagging indicators and imply nothing about the future. Indeed, it is common to see both measures improving for months in a row right before a recession begins. Many forward-looking indicators around the world are signaling a substantial slowdown or even a global recession. No, the reason that one should possibly buy the dips in the present market is because the Federal Reserve, the ECB, and many other large central banks have been printing trillions to help head off the European crisis. This has only delayed the ultimate crisis, but in the meantime it has provided plenty of fresh fuel for the speculative portions of the markets. The ECB has printed about $2.50 trillion in just the last year, and the Federal Reserve has printed about $0.75 trillion in the same period of time. Overall, the top central banks have printed over $10 trillion since the troubles began in 2007. China, which many believe has no major economic problems, has actually printed over $3.00 trillion since 2007. Many also believe that China will be able to pull off a soft landing for its economy after fighting inflation last year, but their electricity consumption dropped 7.5% in January, and their lending activity is down sharply as well, so we will see if they can avoid a hard landing.
US markets are facing substantial headwinds in the coming months. There is the uncertainty associated with national elections, the risk of higher oil prices, the uncertainty involving Iran’s nuclear program, a recession in Europe, falling profit margins, and the European crisis, which is far from over. We should see a major sell-off along the way (springtime or sooner), but end the year on a more positive note as the global and US economies start to recover, barring unforeseen events.