Priming The Pumps Again

By: Michael Ashton | Mon, Sep 5, 2011
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The stock market, which was recently dubbed "insanely cheap" by a number of observers, is in the process of getting even-more-insanely cheap.

In any event there is little debate that it is getting cheaper. Whether or not the market is cheap is a different question. There is a natural tendency - it's called the 'recency effect' - for human beings to place greater weight on things which have happened recently than on things which happened long ago, even if the ones which happened less-recently should also carry a great weight. This is why, when the Internet bubble unwound and many stocks lost 80-90%, brokers were calling you all the way down to persuade you to buy Lucent or CMGI, or some other dog at 20%, 40%, or 60% off. "It's very cheap! CMGI traded at $150 just three months ago, now it's $50!" (Note: I looked it up because I was curious. CMGI, which is now "ModusLink Global Solutions Inc" (MLNK), trades at 3.84 versus a split-adjusted high over $1500).

So when people say that stocks look "cheap," I think in many cases that what they mean is that they are cheaper. And indeed they are. The S&P at 1174 is definitely cheaper than at 1350. But the landscape has also changed, the risks have evolved, and investors' alternatives have changed.

Let's look at the ways the landscape has changed, just since Friday.

(1) Nonfarm Payrolls was weak. It wasn't an unmitigated disaster, but it was pretty bad. Payrolls printed exactly zero. You can add 45k back to 'correct' for striking Verizon workers, but downward revisions to the prior two months were 25% more than that, so it's no salvation. Almost as much of a concern were the decline in hourly earnings (-0.1% versus +0.2% expected) and the average workweek (down 0.1 hour), the combination of which implies weak income growth. The Unemployment Rate stayed at 9.1%, which is something of a triumph - but a hollow triumph given the rest of the number.

(2) "IMF Said To Oppose Push for Greek Collateral in Potential Snag" (Bloomberg) - So, if the Greeks post collateral to satisfy Finland, then the IMF will get antsy because it "would deny the IMF priority creditor status and violate Greek bondholders' rights." If the Greeks don't post collateral, then Finland will likely prevent unanimity in a rescue ... which can potentially block a rescue of Greece.

(3) "Lenders suspend Greek bail-out talks." (Financial Times) It seems that somehow Greece is missing its budget targets. This is nearly as surprising as the news that PETA thinks "fur is murder." Greece's official shortfall is only $1.7bln, which is peanuts compared to what is at risk, but there is eventually a straw that breaks the camel's back. In this case, the EU, IMF, and ECB walked out of talks about the next tranche of the Greek bailout. I suspect that Greece will call their bluff and these entities will cave in, but - one never knows. To be sure, I have always thought the Greek "rescue" had approximately zero chance of success, but I am surprised this is happening so quickly. The Greek 2-year yield is now at 44.5%, up 249bps today, and the 10y is at a new high of 17.60% (up 69bps today). The bonds are trading essentially recovery value only - pricing in a virtual certainty of default.

(4) The party of German Chancellor Angela Merkel, who has continued to do just enough to help the EU hold together despite her protests, lost an election this weekend. Merkel's party has now lost all six elections held in Germany this year. The elite in Europe still want Europe at any cost, but the proletariat does not. The problem for the elite is that at some point, they must answer to the proletariat and they are beginning to be rather ticked off at being ignored.

And the markets aren't really happy about it either. If Germany begins to waver, the whole edifice gets shaky. Today Italian 10-year yields are up 29bps to 5.54% (see Chart), and Spain's are +12bps to 5.21%. Remember that the ECB moved in to push these yields down below 5% several weeks ago. Apparently, they got tired of running interference, or began to see the writing on the wall that they're not going to be able to buy allthe bonds, or are concerned about the fact that some people - I confess no direct understanding of the issues - are saying the ECB bond purchases were illegal to begin with. I don't really get that, but the chart below speaks volumes. Investors - including a lot of banks - are plainly saying "Game On!"


Seems like the ECB bid isn't there any more!

The equity markets are obviously not enjoying the combination of weak growth, election losses, missed austerity targets, and balky creditors. The Euro Stoxx 50 fell 5.1% today, and recorded what was easily its lowest close of the year although the spike lows from last month are still holding for now (see Chart).

Stoxx50
Euro Stoxx 50 is looking ugly. This is the year's low close.

The S&P equity futures at this writing - they were open today - are down 24 points (2%), off the lows for the session (when they were down 30 points). And now you see why Friday's trading session saw no bounce: there was a great deal of weekend risk, and wise traders were aware that there was a lot that could go on over the three-day weekend...most of it bad. And we still have another overnight session to go before the stock exchange opens tomorrow. My worry is that there have been a lot of people waiting for the sign to hit the exits, figuring they could get out in time if the crisis was not over yet, and the exits are just not that wide. Hopefully I am wrong about that.

We may well be in the 'next phase' of the crisis, and this time the world's legislatures and central banks face the specter of disaster without any dry powder. Citigroup and Goldman expect the Bank of England to re-start QE (that's Quantiative Easing; Queen Elizabeth does not need re-starting) as early as this week. The odds of some kind of QE at this month's Fed meeting certainly rise proportionally to any fall in equity markets as well. The Swiss National Bank is already flooding their economy with Francs to push its value down, and the ECB is busy buying bonds without a lot of concern for sterilizing the purchases. The monetary pumps have not yet blown a fuse and soon will be pumping for all they are worth.

But deflation is no longer the threat, and all this money can do is change the price level. Obama will present a jobs package, and other legislatures may come forth with new stimulus, but most politicians of solvent countries are now starting to understand that the choice of whether to stay a solvent country or become one of the insolvent starts now. Even those who still believe in Keynesian pump-priming are aware that they will need to face the voters, as Merkel has done with little success so far. I am not sure what can be done, other than the obvious, and I don't think the elites are yet ready to sunder the Euro and default the Greeks (and Irish and Italians and Spanish and Portuguese). Eventually, that possibility will get a much wider hearing than it is currently getting.

While all of this makes inflation that much more inevitable, it is challenging to think about shorting bonds into the teeth of a crisis. The window for a selloff is closed for now. September 6th also marks the beginning of the strongest seasonal period of the year for fixed-income in the US. Over the last thirty years, 10-year yields have fallen in the 30 days following September 6th an amazing 23 times, and the average yield decline is 16bps (note that includes the selloffs as well as the rallies). The chart below shows that the tendency persists to a 60-day window, where yields have fallen in 20 of the last 30 years by an average of 22bps. I think the next good chance to sell bonds strategically may not come until late October or early November, when big supply into declining year-end liquidity could make for a big year-end bond market selloff. But that's not today's trade. Today's trade is bracing for stocks to drop below last month's lows, potentially violently.

10-Year Yields
This chart shows both the average 60-day change in 10-year yields,
and the frequency of falling yields, over the last 30 years.

Tuesday's data is the ISM Non-Manufacturing index (Consensus: 51.0 from 52.7). Ignore it - only Europe matters right now.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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