Flight From Risk: Treasury Plummets To Record Low Yield As Gold Surges

Thursday, May 17th, 2012

Now its get­ting inter­est­ing. 30Y yields fell the most in 5 months today back to 5 month lows, 10Y yields crashed to all-time clos­ing lows, and Gold surged by its most in 4 months (and 2nd most in 7 months) as stocks started to accel­er­ate lower. Gold is unch on the week now as 30Y is –21bps and 10Y –14bps — incred­i­ble. Between the Philly Fed's con­fir­ma­tion of decel­er­a­tion in US macro data and Europe's increas­ingly crescendo-like implo­sion, is it any won­der that the decou­pling the­sis has given way to real­ity. S&P 500 e-mini futures repeated the early rally late fade pat­tern of the last 8 days but this time it was more aggres­sive as ES pushed towards 1300. CAT was a dog today account­ing for 25% of the Dow's losses and AAPL tum­bled fur­ther — head­ing towards a 20% retrace­ment off its highs. Finan­cials tum­bled fur­ther with Citi inch­ing very close to red YTD (and JPM falling rapidly). Credit mar­kets, which led the sell­off, con­tinue to slide but this time with equi­ties in sync. Equi­ties went out at their very lows of the day — at 3.5 month lows as VIX soared over 24% to close at its high­est in 5 months.

Is BTFD DOA?

30Y Trea­suries plunged but 10Y fell to record clos­ing low yields!!!

and Gold is back near unch of ther week as the PMs soared today...

Finan­cials are rapidly los­ing ground with Citi and JPM about to go red YTD...

Tags: 4 Months, 5 Months, 7 Months, Aapl, Confirmation, Credit Markets, Crescendo, Deceleration, Dow, Futures, Jpm, Losing Ground, Lows, Macro Data, Pms, Retracement, Selloff, Treasuries, Unch, Ytd
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Last Month a Disaster for Commodities

Tuesday, May 15th, 2012

I went to cir­cle back today to look at what has been among the weak­est areas of the mar­ket, and chart after chart came up in the com­mod­ity space.   Here is a chart of the per­for­mance of the futures in var­i­ous mar­kets (mostly com­modi­ties) over the past month (via Fin­viz) and it's a mess.  Iron­i­cally, nat­ural gas – the most hated com­mod­ity of most of the first quar­ter, was the stand­out.  Rever­sion to mean trade.   Coal is not listed, but that group looks as bad as solar stocks… ironic since the lat­ter was sup­posed to sup­plant the for­mer at some point.

There is an in depth story on the sec­tor in the WSJ today as well.

• Com­modi­ties fell to nearly two-year lows last week, mea­sured by a widely used bench­mark, prompt­ing investors to pon­der whether the mas­sive rally that began in 1999 may be faltering.
• China is cool­ing down at the same time the U.S. is strug­gling to heat up, cloud­ing the out­look for the world's two biggest con­sumers. And pro­duc­ers of some raw mate­ri­als have ramped up sup­plies enough to cre­ate at least tem­po­rary gluts, par­tic­u­larly if appetites falter.
• For more than a decade, invest­ing in com­modi­ties was prac­ti­cally a sure thing. Prices rose in nine of the 12 years start­ing in 1999. Even down years had expla­na­tions, such as the Sept. 11 attacks in 2001 and the global finan­cial cri­sis in 2008.
• On Fri­day, the Dow Jones–UBS Com­mod­ity Index, which tracks futures con­tracts for 20 basic goods, fell 1% to the low­est level since Sep­tem­ber 2010. U.S. crude oil, gold and cotton—all com­po­nents of the index—helped lead the way down, as each hit fresh lows for 2012. The index is down 4% this year after a 13% drop last year, putting it on track for the first con­sec­u­tive declines since 1997 and 1998.

Tags: Appetites, Commodities Prices, Commodity Index, Commodity Space, Crude Oil, Declines, Dow Jones, Futures Contracts, Global Financial Crisis, Gluts, Investing In Commodities, Lows, Massive Rally, Natural Gas, Raw Materials, Sept 11 Attacks, Standout, Sure Thing, Ubs, Wsj
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The Axis of Weeble (Tchir)

Thursday, May 10th, 2012

by Peter Tchir, TF Mar­ket Advisors

Wee­bles wob­ble, but they don’t fall down. Europe, and the Euro in par­tic­u­lar might fall, but right now they are close to the bot­tom of this cur­rent wob­ble and are about to start another upswing (seri­ously, as I kid, you could make a Wee­ble fall down, but it was hard).

Greece is a bas­ket case. It may or may not have a gov­ern­ment. The even­tual gov­ern­ment may or may not want to stay in the Euro. That is all true, but will take time. Greece will and should attempt to rene­go­ti­ate the bailout pack­age. Our analy­sis yes­ter­day might be a good place for Greece to start. The results of the rene­go­ti­a­tion will deter­mine the tim­ing and neces­sity of Greece leav­ing the Euro. Until the Greek’s have had time to attempt to rene­go­ti­ate and have actu­ally planned for an exit back to the Drachma they will not risk a hard default where they really don’t know the con­se­quences. So look for more hard-line head­lines but expect May pay­ments to go smoothly. I think the post PSI bonds, down a touch again today, offer good risk/reward opportunities.

Spain may be less of a bas­ket case than Greece, but it is a far big­ger bas­ket. Spain nation­al­ized Bankia, the 4^th largest bank. So far the mar­ket is react­ing pos­i­tively. I think that this will turn out to be a “head fake” over time. While encour­ag­ing that Spain was will­ing to act a lot is left uncer­tain. Is this even enough to fix Bankia? Prob­lem banks have a ten­dency to be big­ger money pits than any­one at first real­izes. Look for doubts to creep back in about the suc­cess of this recap­i­tal­iza­tion. Then there is the ques­tion of how many other banks need how much money? The fig­ure will be stag­ger­ing. That brings us to the last ques­tion, how will Spain get all the money? Spain will be back to test the lows, but with the IBEX index at 9 year lows, a lot has been priced in and these lit­tle actions should be enough to pro­vide a decent pop. I rec­om­mended long IBEX vs short DAX into the Euro­pean close yes­ter­day.

Ger­many has its own set of prob­lems. The peo­ple voted and made it clear that the bailout pro­grams Ger­many is cre­at­ing don’t sit well with the peo­ple. So Merkel can­not eas­ily back down and make things eas­ier for Greece or Spain (or Italy, or Por­tu­gal, or Ire­land, for that mat­ter). She has to talk tough, but there is no way she has gone this far and will let it fail eas­ily. She is likely to insist on the same level of bud­get cuts, but may be less con­cerned about the tim­ing. She has to pan­der to her base, so look for dis­rup­tive state­ments from Ger­many, but their bark will be worse than their bite. Behind the scenes she will be a lit­tle more con­cil­ia­tory and flexible.

France has been sur­pris­ingly quiet since the elec­tions. Mr. Hol­lande is not forced to embrace the poli­cies of Merkozy and is free to carve his own role in Europe. The French elec­tions seemed to have less to do with bailouts and more to do with a renewed focus on France and a push for growth. So while he has to spend more time on domes­tic issues than the pre­vi­ous gov­ern­ment, he also has the abil­ity to push the growth agenda through­out Europe. He can be a leader in a “new” Euro­pean plan, one focused on “growth”. Since “growth” is just code for spend­ing, most of the politi­cians will get behind him. The equity mar­kets love growth and are always happy to drown out the screams and protests of the fixed income mar­kets. The fail­ure of the “growth” agenda will become appar­ent and mar­kets will sell off, but that could take some time. For­tu­nately for the bond mar­ket and the sov­er­eign debt cri­sis, the fal­lacy of the “growth” argu­ment will become appar­ent before more debt has been issued to fund elab­o­rate spend­ing projects. It does con­tinue to amaze me that “aus­ter­ity” is so hated and not an option, when in spite of all the votes, and approvals, very lit­tle actual aus­ter­ity has occurred.

Job­less Claims have the poten­tial to move the mar­kets. To me, the revi­sion is key to how the mar­ket will respond. If we get another upward revi­sion to last week’s data, the mar­ket will show lit­tle enthu­si­asm for the num­ber unless it is below 350k. If we get 365k and even a small down­ward revi­sion to last week we could see a sig­nif­i­cant pop. That’s because the mar­ket largely ignored last week’s num­ber with so much else going on, and because after Fri­day, the “we have jobs” por­tion of the rally took a seri­ous beat­ing. If we get a 365k print will another upward revi­sion, expect the mar­ket to be rather blasé about it. I like being a lit­tle long U.S. risk com­ing into the num­ber, but will take my read more from the revi­sion than the data itself.

Credit is mixed this morn­ing, but by and large unchanged. Span­ish and Ital­ian bonds are trad­ing much bet­ter. There is still pres­sure on CDS, but even there I think it is less of a warn­ing sign than a mar­ket that is about to get squeezed badly. U.S. CDS is trad­ing a bit bet­ter with both IG18 and HY18 trad­ing frac­tion­ally tighter. Futures have man­aged to retrace back to almost ses­sion highs, and given how many peo­ple seemed to expect overnight prob­lems in Europe, expect buy­ing to con­tinue, espe­cially if job­less claims are good.

e-mail dis­tri­b­u­tion sign up link

E-mail: tchir@tfmarketadvisors.com

Twit­ter: @TFMkts

Tags: Axis, Bailout Package, Basket Case, Bonds, DAX, Doubts, Drachma, Last Question, Lows, Pits, Problem Banks, Psi, Recapitalization, Renegotiation, Risk Reward, Spain Money, Tendency, Tf, Upswing, Yest
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Warren Buffett Visits with CNBC

Monday, May 7th, 2012

Today is War­ren Buffet-palooza day on CNBC and I'd encour­age those who are new­bies (or vet­er­ans) to the mar­ket to take a lis­ten to his inter­views as he always has a lot of inter­est­ing things to say, even if he man­ages invest­ments in a way that is (nowa­days) con­trary to the major­ity.  CNBC videos can be found here, but I embed­ded his intro­duc­tory com­ments below.  You will actu­ally hear a lot of sim­i­lar thoughts on Europe and the U.S. sit­u­a­tions to what I have out­lined in recent interviews.

14 minute video – email read­ers will need to come to site

As for the mar­ket futures are down some this morn­ing, but well off the worst lev­els seen overnight as Span­ish and Ger­man mar­kets have turned green.   Despite a lot of hand wring­ing over Euro­pean elec­tions, the results in France were not a sur­prise to any­one and how a politi­cian gov­erns ver­sus how they cam­paign are two dif­fer­ent things… Greece is prob­a­bly more of a mess but we'll see how it all plays out.   Big­ger pic­ture, U.S. mar­kets – after fail­ing the fol­low through day sce­nario last week – remain under dis­tri­b­u­tion but are apt to snap back ral­lies within the con­text of said dis­tri­b­u­tion.  The S&P 500 did break through the lows of the past month at 1357 in the overnight ses­sion but have recov­ered to get back into "the box" of upper 1350s to low 1390s.  Things have become more herky jerky in mar­kets since early March, and it would be no sur­prise to see that con­tinue or accel­er­ate.  The largest bounces often hap­pen in downtrends.

Eco­nomic data is going to lighten up dra­mat­i­cally this week but a lot of Fed talk and the mar­ket should begin demand­ing assis­tance on every sell­off from here.  We know how this cycle works – the demand for paci­fiers should begin to hockey stock with each drop in equi­ties go for­ward.  Earn­ings sea­son is on its last legs, but some high pro­file names such as Price­line (PCLN) remain.  The next few weeks should focus on the demands for new rounds of cen­tral bankers assis­tance, and Europe.

Tags: Cnbc, Earnings Season, Economic Data, European Elections, Forward Earnings, German Markets, High Profile, Interesting Things, Introductory Comments, Last Legs, Lows, Market Futures, Overnight Session, Profile Names, Rallies, Selloff, Two Different Things, Video Email, Warren Buffet, Warren Buffett
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Commodities Trounced As Stocks Dead-Cat-Bounce

Thursday, May 3rd, 2012

For the third day in a row, the USD was bid from the Europe open to its close and drifted lower in the US after­noon. Today's limp lower in the USD this after­noon (with AUD and CAD strength while JPY was flat) pro­vided, along with some leak­ing higher in Trea­sury yields, sup­port for a mod­est risk-on lev­i­ta­tion in stocks as the S&P 500 tried and failed to get back to unch after falling below yesterday's lows (well below the pre-ISM lev­els) early in the day. Credit, equity, and Trea­sury mar­kets were remark­ably in sync today — which is unusual given recent dis­lo­ca­tions and cor­re­la­tion across asset classes in gen­eral picked up. Gold (and the rest of the com­mod­ity com­plex) traded pretty much in sync with the USD all day, leav­ing Sil­ver down 2% on the week and WTI back under $106 but still +0.4% on the week — but Gold –0.5% (in sync with USD's 0.5% gain this week) was the best per­former of a bad bunch today. VIX gen­er­ally traded in sync with stocks aside from an odd gap lower right at the close. Trea­suries ended the day 2-3bps lower in yield (a few bps off their best lev­els though) leav­ing the entire com­plex mod­estly lower in yield for week (aside from 2Y which is +0.4bps). Broad risk assets ebbed a lit­tle into the close even as stocks bounced off VWAP for one last push but vol­ume leaked away as we ral­lied (as normal).

The USD has been bid through­out the Euro­pean ses­sions this week and then drifted lower after the EU close...

Stocks and Trea­suries (blue and red) were in almost per­fect sync today as were com­modi­ties (gold below) and the USD (green) — though the lat­ter appear to be lag­ging the hope in stocks still. Gold held in bet­ter than Sil­ver, Cop­per, and Oil though today...

HYG remains cheap (stocks remain rich) but after stocks (blue) caught back up with credit's dis­ap­point­ment (red arrow) they all traded very much in sync today...

The high cor­re­la­tion (lower right quad­rant below) is most evi­dent in our cross-asset class mod­els...

Upper left shows the SPY-Arb model (which tracks the behav­ior of an ETF bas­ket of credit/rates/vol — HYG/TLT/VXX — rel­a­tive to Stocks — SPY) was extremely highly cor­re­lated today (only small devi­a­tions between them — mid­dle left). Upper right shows the CONTEXT model (our cross-asset class proxy for risk sen­ti­ment) which was extremely highly cor­re­lated (unlike in recent days) but came apart a lit­tle into the close as risk assets in gen­eral slid lower rel­a­tive to stocks (right mid­dle orange oval).

VIX rose to almost our credit/equity model's fair-value early on and then slid lower all day (lower left) with an odd gap down and refill at the close.

Today was a bet­ter vol­ume day (as Europe was back) but the vol­ume ebbed as we rose in the after­noon. After yesterday's one-month high in aver­age trade size, and today's re-correlating action across asset classes we sus­pect hope for QE has faded a lit­tle and this was a dead-cat-bounce in stocks but with ECB tomor­row and NFP on Fri­day, any­thing goes.

Charts: Bloomberg and Cap­i­tal Context

Bonus Chart: Gold out­per­formed (though fell — match­ing USD's gains) as Cop­per dropped hard­est in the day...

Tags: asset class, Asset Classes, Bps, Cheap Stocks, Class Models, Correlation, Dead Cat Bounce, Dislocations, Hyg, Ism, Levitation, Lows, Quadrant, Red Arrow, Silver Copper, Third Day, Treasuries, Treasury Markets, Treasury Yields, Wti
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Being Prudent is Boring … but Prudent

Wednesday, April 25th, 2012

Even in a down­trend since late March, the mar­ket is not mak­ing it easy for those await­ing this pull­back.  Sell­ing bouts are met with over­sold bounces quite quickly, and the action is not con­sis­tent in one direc­tion for that many days in a row.  The S&P is back above the key 1370 level this morn­ing, after break­ing the key 1370 level yes­ter­day.  And since it's key that is lead­ing to a lot of chop­pi­ness.  But big­ger pic­ture we con­tinue to see a mar­ket under dis­tri­b­u­tion, and what appears to be a 'head and shoul­ders' for­ma­tion being cre­ated on the senior indexes.  If you are unfa­mil­iar with the term, please google it.

Yes­ter­day I men­tioned we had two key points of sup­port – that was last week's lows of 1365 and the pre­vi­ous week's lows of 1357.  Both came into play yes­ter­day as the mar­ket ulti­mately bounced just above the lat­ter level and fin­ished just above the for­mer level.   If 1357 were to break, the next key level is 1340.  But for now, as noted – the buy­ers keep push­ing the mar­ket back above 1370 on each dip.  How­ever each rally is on light vol­ume, while each sell­ing bout is on heavy – hence all the dis­tri­b­u­tion days.

I'd also point out that we are hav­ing a sec­tor rota­tion under the sur­face even as the major indexes are down less than 5%.   Just about the entire momen­tum growth stock uni­verse is tak­ing turns get­ting hit.  And some of it is very ran­dom – take Ulta Salon (ULTA) today.  I can­not find any news, so unless some­thing pops up later today I have to assume some big boys are liq­ui­dat­ing as vol­ume is huge.  But this is exactly the type of action that can rip away a lot of your money as you search for 'rel­a­tive strength' – pile in, wait­ing for a bounce day like today, only to be punched in the face.

Today we popped a bit in the broader mar­ket on some hous­ing data but in the big pic­ture that data remains quite weak… I think it was more of an excuse to sim­ply get an over­sold bounce going.  Yesterday's gap (137.87) has not yet been filled but we saw the gap down post Good Fri­day took about a week and a half to be filled and then some chop, and then back down.   So no one should be sur­prised to see a run to fill this gap later today or tomor­row morn­ing (with Apple's bless­ing).  At this point with a long series of dis­tri­b­u­tion days in the mar­ket we need to see a true change of char­ac­ter to feel like these moves up are any­thing but head fakes and frus­trat­ing moments for the bears.

Obvi­ously key events are Apple earn­ings tonight and FOMC Meet­ing and Bernanke quar­terly update Thurs­day.  But Europe has not gone away, even though the mar­ket some days act like it after their mar­kets close.  I don't think the path is much dif­fer­ent than it has been repeat­edly the past few years – things will down­grade, peo­ple will sit on their hands until it gets really bad, then peo­ple will panic as the sit­u­a­tion wors­ens, and then Ger­many or the cen­tral bank will step in to kick the can.  Mar­kets will surge on the kick the can for how­ever long that can stays in the air.  We'll rinse, wash, and repeat  - until we do it again.  It's Ground­hog Day as their sys­tem is bro­ken due to lack of auton­omy for each coun­try or the abil­ity to print their way out of messes ala UK, Japan, USA.  See Ice­land for an exam­ple – they defaulted on much of their debt, deval­ued their cur­rency like mad and are back to growth.  You never hear about them any­more since they had the inde­pen­dence to do such things.

Tags: Amp, Big Boys, Big Picture, Bounce, Bounces, Bouts, Choppiness, Day Like Today, Excuse, Google, Growth Stock, Head And Shoulders, Indexes, Light Volume, Lows, Momentum, Pullback, Rally, Relative Strength, Sector Rotation
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WSJ's Hilsenrath: Fed Will Stay Pat

Tuesday, April 24th, 2012

Before we get to Fed talk in the early action we've obvi­ously seen the S&P 500 break through 1370 (with vigor), and last week's lows of 1365s. The pre­vi­ous week's surge down to 1357 is the next key level. Now of course with sharp sell­offs there can be large reflex­ive bounces along the way – we saw that last Tues­day when the mar­ket sky­rock­eted on the back of Apple, but all that led to was more choppy action the rest of the week and then today's smack to the face. So unless one's timetable is mea­sured in hours it's a mar­ket com­plex­ion one does not want to be deal­ing with much.

Off to Fed speak… as long time read­ers know the Fed has its spe­cial lit­tle birdies in the media that it likes to speak to us through, and Jon Hilsen­rath is among the most promi­nent. Not sur­pris­ingly Jon says the Fed will stay pat at this meet­ing – I believe the key one shall be mid June as Oper­a­tion Twist fin­ishes up, and they need a replace­ment pro­gram. Any good cor­rec­tion in the mar­ket will also help as the Fed now believes their trans­mis­sion pol­icy for Fed can largely come through the tran­si­tory "wealth effect" of the stock mar­ket – even if that ben­e­fit accrues to a rel­a­tively small por­tion of soci­ety. [Nov 10, 2010: Who Will Any Form of Inter­me­di­ate Term Wealth Effect Really Help? Not the Masses] On that end, we're prob­a­bly half way to the point Ben will feel he must step in to make sure the "free" mar­ket goes up.

• If the Fed expects eco­nomic growth to slow, infla­tion to fall, or unem­ploy­ment to stall at high lev­els or rise, it will be inclined to do more to sup­port growth with new pro­grams to reduce inter­est rates. If it sees the oppo­site, the con­ver­sa­tion turns toward rein­ing in credit. The chang­ing fore­cast will be one of the most impor­tant top­ics of dis­cus­sion at the cen­tral bank's pol­icy meet­ing Tues­day and Wednes­day, when offi­cials will update their quar­terly eco­nomic projections.
• It's pos­si­ble to hand­i­cap the Fed's chang­ing fore­cast in part because offi­cials are becom­ing open about it. And the out­look doesn't look like it's shift­ing in a way that would sup­port new ini­tia­tives to boost eco­nomic growth. The new fore­casts could project a lit­tle more infla­tion in 2012 than the Fed fore­cast in Jan­u­ary, thanks in part to a recent rise in gaso­line prices. It could also project a lit­tle less unem­ploy­ment for 2012, thanks to recent declines in the job­less rate.
• But with many offi­cials still doubt­ful about the dura­bil­ity of the recov­ery and expect­ing infla­tion to recede, the broader view at the Fed seems likely to favor stick­ing to their plan to keep rates low until late 2014.
• Taken alto­gether, the econ­omy doesn't seem to be break­ing in a way right now that would cause the Fed to shift the stance it laid out in Jan­u­ary. Investors expect­ing a sig­nal of an early rise in rates are likely to be dis­ap­pointed. And those expect­ing a new bond buy­ing pro­gram are likely to be dis­ap­pointed too. The Fed is on hold until its fore­cast shifts more clearly.

Tags: Amp, Bounces, Complexion, Economic Growth, Economic Projections, inflation, interest rates, Last Tuesday, Little Birdies, Lows, Rest Of The Week, Selloffs, Small Portion, Stock Market, Time Readers, Timetable, Unemployment, Vigor, Wealth Effect, Wsj
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Bracing for Bondageddon

Friday, April 20th, 2012

April 18, 2012

"Bondaged­don" now?

Dire warn­ings about the com­ing col­lapse of the US bond mar­ket have grown in fre­quency and vol­ume over the past two years. Some of these warn­ings have come from very promi­nent voices: War­ren Buf­fett was quoted say­ing that bonds are "dan­ger­ous" and "should come with a warn­ing label," while Pro­fes­sor Bur­ton Malkiel of Prince­ton sug­gested in aWall Street Jour­nal edi­to­r­ial that bonds are no longer appro­pri­ate for "pru­dent" investors.

We believe warn­ings like these are dan­ger­ous and impru­dent because they may lead investors to aban­don diver­si­fied port­fo­lios and unwit­tingly take more risk. Let's put the sit­u­a­tion into per­spec­tive: Bond yields have been falling for more than 30 years. The 1.8% low in 10-year US Trea­sury yields reached at the end of Jan­u­ary may be the low­est level we see for a while. How­ever, the "spike" in rates from those lows has been pretty modest.

Ten-Year US Trea­sury Yields Trend Steadily Downward

Source: Bloomberg, as of March 29, 2012.

In our view, cur­rent eco­nomic con­di­tions don't point to a risk of a sig­nif­i­cant increase in rates in the near term. Although the US econ­omy has shown signs of stronger growth, Europe has tipped into reces­sion and lead­ing indi­ca­tors for some major emerging-market economies such as China and Brazil are slow­ing. As a result, cen­tral banks around the globe have been low­er­ing inter­est rates. Infla­tion pres­sures have actu­ally eased since late last year despite the recent rise in energy prices. Finally, we see longer-term demo­graph­ics point­ing to ris­ing demand for fixed income as the pop­u­la­tion ages.

OECD Com­pos­ite Lead­ing Indi­ca­tors for US, Europe, Brazil and China

Source: The Organ­i­sa­tion for Eco­nomic Co-operation and Devel­op­ment, an orga­ni­za­tion that mon­i­tors events in its mem­ber coun­tries, as well as oth­ers, and makes reg­u­lar pro­jec­tions of short– and medium-term eco­nomic devel­op­ments. Y-axis rep­re­sents OECD com­pos­ite lead­ing indicator.

Nonethe­less, there's clearly less upside than down­side poten­tial in bond prices over­all. We think that some of the forces dri­ving bond yields lower in the past few years, such as fears of defla­tion and the risks in the global bank­ing sec­tor, have begun to abate. With the US econ­omy seem­ingly on the mend and yields low rel­a­tive to infla­tion, bond val­u­a­tions look stretched. Once the eco­nomic expan­sion is estab­lished, the Fed­eral Reserve will likely begin to raise inter­est rates, prob­a­bly in 2013 or 2014. How­ever, longer-term bond yields have his­tor­i­cally moved higher six to nine months before the Fed raises short-term rates for the first time in a cycle.

Don't panic—strategize

Despite headline-grabbing warn­ings, we believe the risk of ris­ing rates is no rea­son to panic or aban­don the bond mar­ket. Bonds can serve an impor­tant func­tion in your port­fo­lio: They help gen­er­ate income and pro­vide diver­si­fi­ca­tion from stocks. These attrib­utes have been impor­tant fac­tors in help­ing sta­bi­lize port­fo­lios over the past decade, while stock prices have been volatile.

In addi­tion, the bond mar­ket is large and var­ied. There's no sin­gle bond in the bond mar­ket, any more than there's one sin­gle stock in the stock mar­ket. The types of bonds or bond mutual funds you hold can make a big dif­fer­ence in the way your port­fo­lio per­forms when inter­est rates rise. More­over, you'll only real­ize a loss on an indi­vid­ual bond if you sell it or if the issuer defaults. Even in bond funds, the net asset value of the fund will likely decline if rates rise, but the fund man­ager may be rein­vest­ing in higher-yielding bonds, so the income received may rise even though the net asset value is declining.

First, do the math

A first step is to assess the impact a rise in rates may have on your bond port­fo­lio. "Dura­tion" is a term used to mea­sure a bond's sen­si­tiv­ity to changes in inter­est rates. The con­cept is sim­i­lar to matu­rity, in that longer-term bonds usu­ally have longer dura­tions and tend to be more volatile than shorter-maturity bonds. In gen­eral, the longer the dura­tion of a bond, the more its mar­ket value is going to fluc­tu­ate with the interest-rate cycle.

Although dura­tion is a com­pli­cated con­cept, the most impor­tant part to remem­ber is fairly straightforward—it rep­re­sents the per­cent­age change in a bond's price give a 1% rise or fall in inter­est rates. For exam­ple, if you own a 10-year bond with a five-year dura­tion and inter­est rates decline 1%, you should expect it to gain 5% of its value. The oppo­site is also true: A 1% increase in inter­est rates will mean an expected 5% decline in the value of a bond with five-year duration.

What if Rates Rise?

Source: Bar­clays US Aggre­gate Bond Index, as of March 9, 2012. Illus­tra­tion assumes the Bar­clays US Aggre­gate Bond Index mod­i­fied adjusted dura­tion of 4.97 years, semi­an­nual com­pound­ing, rein­vest­ment of coupons at pre­vail­ing inter­est rates and a rate shift imme­di­ately after pur­chase. Num­bers may not add up due to round­ing. For illus­tra­tive pur­poses only.

In our hypo­thet­i­cal exam­ple, we assume inter­est rates sud­denly jump from 2.5% to 4.0%. If you were unlucky enough to buy a five-year-duration bond yield­ing 2.5% just before rates rose to 4.0%, it would imme­di­ately decline in value. How­ever, if you con­tinue to hold it and rein­vest the inter­est, then the total return (income plus price) would be in pos­i­tive ter­ri­tory after two years. The exam­ple is purely hypo­thet­i­cal and sim­pli­fied, and assumes that rates stay flat for four years after the rise in the first year—but it illus­trates one poten­tial path of a bondholder's return in the event of a jump in inter­est rates.

Most bond funds will pro­vide an esti­mate of the fund's aver­age dura­tion in their reports to investors. For indi­vid­ual bonds or port­fo­lios of indi­vid­ual bonds, you can esti­mate dura­tion by adding up the yearly income pay­ments, giv­ing greater weight to the pay­ments made sooner rather than later, and then divid­ing the pay­ment total by the bond price. Your Schwab rep­re­sen­ta­tive can also help find a bond's duration.

Sec­ond, con­sider var­i­ous strategies

1. Reduce the dura­tion of your bond port­fo­lio. If you're hold­ing long-term bonds that have appre­ci­ated in value, it might be time to real­ize some gains on those hold­ings. Although you'll no longer receive the income from those bonds, it's rea­son­able to reduce dura­tion to a level where you're com­fort­able with the poten­tial impact on your portfolio.

We're fans of bond lad­ders because they’re designed to pro­vide income and flex­i­bil­ity. Lad­ders spread out matu­ri­ties of bonds over time. Shorter-term bonds on the lower rungs of the lad­der should gen­er­ally be less volatile and pro­vide cash for near-term needs or for rein­vest­ment. Income gen­er­ated from the longer-term bonds on the higher rungs of the lad­der can be rein­vested and com­pounded or con­sumed, depend­ing on your needs. Bond lad­ders can com­prise any type of bond—municipal, cor­po­rate or Treasury—or a mix of var­i­ous types.

2. Con­sider higher-coupon bonds. All else being equal, bonds that pay higher coupons (cur­rent income) are less volatile than bonds with lower coupons. Higher-coupon bonds gen­er­ate more cur­rent cash flow that can be rein­vested in a rising-rate envi­ron­ment. Money received today is worth more than money received later. Con­se­quently, bonds that gen­er­ate more cash flow up front tend to have higher prices and be less volatile than those for which the cash flow is paid out at a lower rate over time. Not sur­pris­ingly, bonds with higher cur­rent coupons may trade at a pre­mium to their par value when rates are low and decline less than lower-coupon bonds when rates rise.

Higher-Coupon Bonds Less Sen­si­tive Than Lower-Coupon Bonds

Source: Bloomberg, Schwab Cen­ter for Finan­cial Research. The illus­tra­tion above is for two 10-year Trea­suries: a "sea­soned" older Trea­sury issued when rates were higher with a 5% coupon; and one issued with a 2% coupon closer to the mar­ket rate today. The bond with a 5% coupon is sell­ing at a pre­mium com­pared to the bond with the 2% coupon that is pric­ing at par. The chart assumes a 1% and 2% increase in the 10-year inter­est rate. Illus­tra­tion assumes semi­an­nual inter­est pay­ment and an imme­di­ate change in inter­est rates after pur­chase. For illus­tra­tive pur­poses only.

3. Decide on the amount of credit risk you're will­ing to take. Credit risk refers to the risk of default—the chance that you won't get your money back. One way to try to earn more income with­out tak­ing more dura­tion risk is to take more credit risk. Investment-grade cor­po­rate bonds (those rated BBB or above) usu­ally yield more than Trea­suries. How­ever, credit qual­ity varies depend­ing on the sec­tor and the issuer. More­over, if inter­est rates rise, the value of these bonds will most likely decline as well.

Sub-investment-grade (or "high yield") bonds have tended to out­per­form other sec­tors of the bond mar­ket when rates rise, because inter­est rates tend to rise when the econ­omy is get­ting stronger and eco­nomic growth is gen­er­ally pos­i­tive for com­pa­nies that issue high-yield bonds. With stronger eco­nomic growth, con­di­tions for improv­ing their earn­ings and cash flow are bet­ter, which in turn may mean they have an eas­ier time pay­ing inter­est on their bonds. In addi­tion, high-yield bonds tend to have shorter matu­ri­ties than other types of bonds and higher coupon rates. The off­set­ting fac­tor is that high-yield issuers are less cred­it­wor­thy, so the risk of default is higher than with other types of cor­po­rate bonds.

4. Diver­sify glob­ally. Inter­na­tional bonds can also help pro­vide diver­si­fi­ca­tion in a fixed income port­fo­lio, because eco­nomic cycles aren't always in sync around the world. Inter­na­tional bond funds may or may not hedge the cur­rency risk in own­ing for­eign bonds. Either way, allo­cat­ing some por­tion of a port­fo­lio to non-US bonds has his­tor­i­cally demon­strated diver­si­fi­ca­tion benefits.

5. Other types of bonds. Alter­na­tive bond struc­tures such as floating-rate bonds or con­vert­ible bonds may make sense in a rising-rate envi­ron­ment. Coupon rates for floating-rate bonds are usu­ally set to move up and down with an index, such as the Lon­don Inter­bank Offer Rate (LIBOR). Indi­vid­ual investors usu­ally get access to floating-rate bonds through mutual funds. How­ever, floating-rate bonds may come with greater credit risk than tra­di­tional cor­po­rate bonds, so it's wise to be cau­tious. In addi­tion, many mutual funds use lever­age in an attempt to boost returns, and if short-term rates rise, the lever­age can reduce the fund's returns.

Con­vert­ible bonds are hybrids that com­bine char­ac­ter­is­tics of fixed income and stocks: They pay reg­u­lar inter­est but can be con­verted to equity shares at cer­tain price lev­els. Con­vert­ible bonds have his­tor­i­cally tended to out­per­form tra­di­tional fixed-rate bonds in a grow­ing econ­omy with ris­ing inter­est rates, but they can be volatile and less liq­uid than other sec­tors of the bond market.

Pre­ferred secu­ri­ties are also fre­quently con­sid­ered hybrids of debt and equity because they have char­ac­ter­is­tics of both. There are many types of pre­ferred secu­ri­ties: Some are very close to bonds because they pay inter­est rather than div­i­dends and have set matu­rity dates, while oth­ers are more like stock in that they pay div­i­dends and are "per­pet­ual," with no set matu­rity date. While yields tend to be higher for pre­ferreds than tra­di­tional bonds, the risks are higher as well. If the issu­ing com­pany needs cap­i­tal, the div­i­dend can be cut or elim­i­nated. Due to their long dura­tion and credit risk, these secu­ri­ties gen­er­ally tend to be more volatile than bonds.

Avoid Bondaged­don

You can't con­trol inter­est rates, but you can con­trol what's in your port­fo­lio. We believe it's pru­dent to make sure your port­fo­lio isn't over-allocated to bonds—especially long-term bonds. How­ever, we believe it would be ill-advised to ignore the poten­tial ben­e­fits of diver­si­fi­ca­tion and income gen­er­a­tion that bonds can pro­vide in an over­all port­fo­lio. The types of bonds or bond funds you hold should be based on your own needs and cir­cum­stances, rather than try­ing to time the interest-rate cycle. A fixed income port­fo­lio should be con­structed with the goal of match­ing your income stream with your needs over time, keep­ing in mind how much risk you're will­ing to tolerate.

Impor­tant Disclosures

Tags: asset class, Bloomberg, Bond Holdings, Bond Portfolios, Bond Yields, Burton Malkiel, Coupon Bonds, Diversified Portfolios, Emerging Market Economies, Fixed Income, Interest Rate Risk, Leading Indicators, Lows, Professor Burton, Prudent Investors, Us Bond Market, Us Treasury Yields, Wall Street Journal, Wall Street Journal Editorial, Warren Buffett
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To "V" or Not to "V"

Friday, April 13th, 2012

Mar­ket par­tic­i­pants have been struck with the con­sis­tency of a type of rally the past 3–4 years, that is the "V" shaped rally.  Once a rar­ity it has become the rule.  No one is sure exactly why it is – per­haps momen­tum based, com­puter dri­ven, liq­uid­ity fed envi­ron­ments are the cul­prit but what­ever the rea­son they are not some­thing that hap­pens one out of ten times, but now nine out of ten times.  A mar­ket that stops going down, turns on a dime, and furi­ously "V" shapes up with­out let­ting those left behind in.  So the ques­tion of the day across the land is, are we begin­ning to embark on another?

Yes­ter­day morn­ing I wrote about the "the most impor­tant line in finan­cial mar­kets" – that is the line con­nect­ing the lows of the dips from Octo­ber 2011 til April 2012.  That level had been breached Tues­day, and typ­i­cally a mar­ket will come back to test that area before mov­ing on to do what it nor­mally does.  Now, I had no thought that this level would be tested in 2 mar­ket ses­sions, but that goes back to para­graph 1 – there is no mid­dle ground in mar­kets any­more … either the world is going to end, or every­thing is hunky dory.  I said the approx­i­mate level of this area is 1385–1390 on the S&P 500, and we fin­ished at 1387 yes­ter­day.  (again I had no incli­na­tion we'd see that level so quickly)

So now the ques­tion is – to V or not to V? Was yes­ter­day day 2 in yet another once rare V shaped rally?  Or will things revert to a more tra­di­tional type of action and after this over­sold bounce are we look­ing at a more seri­ous cor­rec­tion in the days and weeks to come?  Bulls will wish for a break through this 1385–1390 level and then a clear of 1400 and hold­ing it, to make a charge at highs from last week at 1420ish.  Bears will want to see a break of the 50 day mov­ing aver­age at 1376 and ris­ing sharply every day.

Tags: Approximate Level, Bulls, Consistency, Culprit, Dips, Financial Markets, Inclination, Left Behind, liquidity, Lows, Market Participants, Market Sessions, Momentum, Moving Average, Nine Out Of Ten Times, Question Of The Day, Rally, Rarity, Turns On A Dime, Yesterday Morning
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Time to Exit Emerging Markets? (Koesterich)

Thursday, April 12th, 2012

“Is it time to sell emerg­ing mar­ket equi­ties?” That’s what many investors are won­der­ing given that emerg­ing mar­ket stocks are up sig­nif­i­cantly since fall lows and have mod­estly out­per­formed devel­oped mar­kets year to date.

Despite emerg­ing mar­kets’ strong recent per­for­mance, I believe there are two major rea­sons why investors should still con­sider over­weight­ing select coun­tries rel­a­tive to their weight in the MSCI ACWI benchmark.

Cheap Val­u­a­tions: First, and most impor­tantly, emerg­ing mar­kets remain cheap com­pared both to their own his­tory and to devel­oped mar­kets. Cur­rently, the MSCI Emerg­ing Mar­ket Index is trad­ing for around 12x earn­ings. As the chart below indi­cates, this is a sig­nif­i­cant dis­count to the index’s long-term aver­age mul­ti­ple of 16.

The cur­rent val­u­a­tion of roughly12x earn­ings is also a 22% dis­count to where the MSCI World Index is trad­ing. And his­tor­i­cally, when emerg­ing mar­ket stocks have been at a 20% or more dis­count to devel­oped mar­ket equi­ties, they have sig­nif­i­cantly out­per­formed over the next year.

Falling Infla­tion: A sec­ond fac­tor sup­port­ing emerg­ing mar­ket equi­ties is that infla­tion con­tin­ues to decline in most emerg­ing mar­kets, India being a notice­able excep­tion. For instance, over the past nine months, infla­tion in China has fallen from 6.5% to roughly half that level, while infla­tion in Brazil has decel­er­ated to around 5% from 7.5%. Lower infla­tion should pro­vide for some mul­ti­ple expan­sion in emerg­ing mar­ket stocks.

How­ever, since not all emerg­ing mar­kets cur­rently look attrac­tive, I con­tinue to advo­cate over­weight­ing only cer­tain areas through a regional and coun­try implementation.

In par­tic­u­lar, I like Latin Amer­ica, Brazil, China and Rus­sia, and I pre­fer to access these mar­kets through the iShares MSCI Emerg­ing Mar­kets Latin Amer­ica Index Fund (NASDAQGM: EEML), the iShares S&P Latin Amer­ica 40 Index Fund (NYSEARCA: ILF), the iShares MSCI Brazil Index Fund (NYSEARCA: EWZ), the iShares MSCI China Index Fund (NYSEARCA: MCHI) and the iShares MSCI Rus­sia Capped Index Fund (NYSEARCA: ERUS).

Mean­while, investors look­ing for a lower risk alter­na­tive for access­ing emerg­ing mar­kets may want to also con­sider the iShares MSCI Emerg­ing Mar­kets Min­i­mum Volatil­ity Index Fund (NYSEARCA: EEMV).

Source: Bloomberg

The author is long EWZ and ERUS

Invest­ing involves risk, includ­ing pos­si­ble loss of prin­ci­pal. Past per­for­mance does not guar­an­tee future results.

In addi­tion to the nor­mal risks asso­ci­ated with invest­ing, inter­na­tional invest­ments may involve risk of cap­i­tal loss from unfa­vor­able fluc­tu­a­tion in cur­rency val­ues, from dif­fer­ences in gen­er­ally accepted account­ing prin­ci­ples or from eco­nomic or polit­i­cal insta­bil­ity in other nations. Emerg­ing mar­kets involve height­ened risks related to the same fac­tors as well as increased volatil­ity and lower trad­ing vol­ume. Secu­ri­ties focus­ing on a sin­gle coun­try may be sub­ject to higher volatility.

Tags: America Index, Amp, Brazil Index, Earnings, Emerging Market Stocks, Emerging Markets, Ewz, Index Fund, Inflation In China, Ishares Msci Brazil, Latin America, Lows, Msci Acwi, Msci Emerging Market, Msci Emerging Market Index, Msci World Index, Nasdaqgm, Nine Months, Valuations, Year To Date
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The Most Important Line in Financial Markets Today

Thursday, April 12th, 2012

(note: face­tious finan­cial web­site hyper­bole intended)

Yes­ter­day began the "obvi­ous" over­sold bounce.  By obvi­ous I sim­ply mean it was due after a pretty hec­tic sell­off, but with the poor close Tues­day it was not nec­es­sar­ily obvi­ous that it would begin in the overnight futures ses­sion.  A neg­a­tive open yes­ter­day would have cre­ated a low risk 'trade' – unfor­tu­nately the mar­ket did not give that oppor­tu­nity.  This morn­ing futures con­tinue the bounce.

Day one of the move up was not enough to get the S&P 500 through the very obvi­ous 50 day mov­ing aver­age, around 1373.  But even if regained, the more impor­tant line is the mega trend­line cre­ated from con­nect­ing the lows of the move from early Octo­ber.  It is dif­fi­cult to put an exact num­ber on it, because if you change the angle by a degree or two you get a dif­fer­ent out­come but let's call it 1385-1390ish. But the key thing to note is Monday's sell­ing took the index to that sup­port, and Tuesday's sell­ing broke through it.  Now for the bulls to con­tinue their 2012 party – after this over­sold bounce fin­ishes – this level needs to be recap­tured.  To be safe let's say it's impor­tant to get back over 1400 and stay there.

Please note, the DJIA has a very sim­i­lar setup but the index for­merly known as NASDAQ and now goes by NASDAPPLE has not bro­ken this trend line.  The Rus­sell 2000, on the other hand, is just a big mess.

As for the next 24 hours – key reports from Google (GOOG) tonight, JPMor­gan (JPM) and Wells Fargo (WFC) tomor­row morn­ing, with Chi­nese GDP overnight.  So the mar­ket most likely will gap one way or the other tomor­row morn­ing as well.  Janet Yellen's speech last night was not quite as overtly "free money-ish" as I assumed it would be.

EDIT 8:32 AM – weekly claims in rel­a­tively poor at 380,000 but it is get­ting blamed on the Easter holiday.

EDIT 8:45 AM – the weekly claims data has taken some steam out of the mar­ket as futures are back to flat.

Tags: DJIA, Easter Holiday, Exact Number, Facetious, Financial Markets, Free Money, Google, Hyperbole, Janet Yellen, Jpm, Lows, Moving Average, Nasdaq, Russell 2000, Selloff, Tomorrow Morning, Trend Line, Trendline, Wells Fargo, Wfc
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Is the Fed Promoting Recovery or Desperation? (Hussman)

Monday, April 9th, 2012

On Fri­day, the Depart­ment of Labor reported that March non-farm pay­rolls increased by 120,000, falling well short of con­sen­sus expec­ta­tions in excess of 200,000. For our part, we con­tinue to expect a dete­ri­o­ra­tion in observ­able eco­nomic vari­ables, with weak­ness that emerges grad­u­ally and then accel­er­ates toward mid-year. On the pay­roll front, our present expec­ta­tion is that April job cre­ation will dete­ri­o­rate toward zero or neg­a­tive levels.

Imme­di­ately after the pay­roll num­ber was released, CNBC shot out a news story titled "Dis­ap­point­ing Jobs Report Revives Talk of Fed Eas­ing." Of course it does, because this remains a mar­ket depen­dent on sugar. And with lit­tle doubt the Fed will even­tu­ally deliver it — per­haps fol­low­ing a mar­ket plunge of 25% or more — but with lit­tle doubt nonethe­less, because like the indul­gent par­ent of a spoiled tod­dler, the FOMC can't stand to see Wall Street throw a tantrum with­out reach­ing for a lollipop.

If the Fed indeed steps in with an addi­tional round of QE, a few dis­tinc­tions may be help­ful. First, regard­less of Fed actions, and even in the past few years, the mar­ket has invari­ably suf­fered sig­nif­i­cant losses fol­low­ing the emer­gence of the "over­val­ued, over­bought, over­bull­ish, rising-yields" syn­drome that we presently observe. In con­trast, the main win­dow where it has not paid to "fight the Fed," so to speak, has been the period com­ing off of over­sold lows. That's pri­mar­ily the win­dow where finan­cials, cycli­cals, mate­ri­als, and garbage stocks with highly lever­aged bal­ance sheets have out­per­formed. Regard­less of the fact that QE has had no durable eco­nomic ben­e­fits (more on that below), and does lit­tle but to repeat­edly lay fresh wall­pa­per over the rot­ting edi­fice that is the global bank­ing sys­tem, the main effect of QE has been to pro­vide tem­po­rary sup­port for the most spec­u­la­tive cor­ners of the finan­cial mar­ket after they have been pummeled.

Strate­gi­cally, then, we con­cede that there is some lat­i­tude to ease back on defen­sive­ness between the point where QE induces an early improve­ment in mar­ket inter­nals and an upturn in var­i­ous trend-following indi­ca­tors (com­ing off of a pre­vi­ously over­sold con­di­tion), and the point where an "over­val­ued, over­bought, over­bull­ish, rising-yields" syn­drome is estab­lished. But once that syn­drome is estab­lished, it is unwise to ignore it, and a defen­sive stance becomes essen­tial (as we saw sep­a­rately in 2010 and 2011, not to men­tion at most major mar­ket tops over his­tory). Mean­while, it is unwise to believe that addi­tional rounds of QE will do much to help the econ­omy in any event, as its pri­mary effect is merely to drive investors into spec­u­la­tive invest­ments by starv­ing them of safer yields.

There is a very well-defined the­o­ret­i­cal and empir­i­cal rela­tion­ship between the mon­e­tary base and tar­gets like short-term inter­est rates and mon­e­tary veloc­ity (see Six­teen Cents: Push­ing the Unsta­ble Lim­its of Mon­e­tary Pol­icy), but investors should note that the response of the stock mar­ket and other finan­cial assets to quan­ti­ta­tive eas­ing is far more based on super­sti­tion than on struc­ture. We can observe, for exam­ple, that drown­ing the finan­cial mar­kets in zero-interest assets has tended to lower the yields (and there­fore raise the prices) of higher-risk, longer-duration assets, but that response is depen­dent on a cer­tain form of myopia. Specif­i­cally, investors either have to assume that they can safely spec­u­late until some par­tic­u­lar date arrives on the cal­en­dar and they can all take their prof­its simul­ta­ne­ously, or they have to ignore the ten­dency for low prospec­tive long-term returns to go hand in hand with quite neg­a­tive prospec­tive intermediate-term returns. For that rea­son, any "QE indi­ca­tor" we might develop (as sev­eral peo­ple have requested) would likely be spu­ri­ous and not very robust going for­ward, even though one might be back-fitted to the data. A bet­ter approach, as noted above, is to take a sig­nal from mar­ket action and trend-following mea­sures, but emphat­i­cally to also impose sev­eral alter­nate exit cri­te­ria — includ­ing for exam­ple a dete­ri­o­ra­tion of those mea­sures, or the estab­lish­ment of an over­val­ued, over­bought, over­bull­ish, rising-yields syn­drome. I remain con­vinced that investors who sim­ply have blind faith that QE is reli­ably bull­ish in and of itself, or can be trusted to limit losses, will have their heads handed to them.

How QE "works"

Keep in mind that the U.S. bank­ing sys­tem has tril­lions of dol­lars sit­ting in idle deposits with the Fed already. Quan­ti­ta­tive eas­ing sim­ply does not relieve any con­straint that is bind­ing on the econ­omy. Rather, QE is a method by which the Fed hoards longer-duration, higher-yielding secu­ri­ties like U.S. Trea­sury bonds and replaces them with cash that bears zero inter­est. At every moment in time, some­body has to hold that paper. The only way for the holder to seek a higher return is to trade it for a more spec­u­la­tive asset, in which case who­ever sells the spec­u­la­tive asset then has to hold the cash. The process stops when all spec­u­la­tive assets are finally priced so richly and pre­car­i­ously that the peo­ple hold­ing the cash have no fur­ther incen­tive to chase the spec­u­la­tive assets, and are sim­ply will­ing to hold idle, zero-interest cash balances.

Why does the Fed want this? Sim­ple. Chair­man Bernanke believes that by cre­at­ing a bub­ble in spec­u­la­tive assets, peo­ple will "feel" wealth­ier and keep con­sum­ing — regard­less of the fact that real incomes are stag­nant and debt bur­dens are already intol­er­a­ble, and despite the fact that there is extremely weak evi­dence for any such "wealth effect" in the his­tor­i­cal record. Undoubt­edly, it would be dif­fi­cult for Bernanke to refrain from these reck­less poli­cies when every­one is cry­ing "do some­thing!" But the will­ing­ness to tol­er­ate short-term crit­i­cism in the inter­est of long-term ben­e­fit is part of what sep­a­rates lead­er­ship from cowardice.

Given the bub­bling con­cerns among var­i­ous FOMC mem­bers about infla­tion risk, the next round of QE is likely to be "ster­il­ized." Essen­tially, the Fed would buy Trea­sury bonds from banks, and would pay for them with newly cre­ated cash, but the Fed would then bor­row those funds back from banks, hold­ing them as idle deposits with the Fed­eral Reserve. By def­i­n­i­tion, the addi­tional "liq­uid­ity" cre­ated by a ster­il­ized round of QE would not be avail­able for new lend­ing (as if there aren't enough idle reserves in the bank­ing sys­tem already). So again, the main goal is to increase the out­stand­ing stock of zero– and low-interest assets in the econ­omy, in order to lower the yields and increase the prices of more spec­u­la­tive investments.

Now, if you think care­fully about this, you'll rec­og­nize that the U.S. gov­ern­ment is still run­ning a deficit of more than 8% of GDP, so the Trea­sury will have to issue more than a tril­lion dol­lars of new debt in the com­ing year any­way. Given that banks already hold tril­lions of dol­lars in idle bal­ances, the Trea­sury could have the iden­ti­cal effect of an addi­tional round of QE sim­ply by issu­ing a larger por­tion of the new debt as very short-term T-bills, which also yield next to noth­ing. So why bother doing this as "quan­ti­ta­tive eas­ing" when the Trea­sury could just change the matu­rity pro­file of the new debt all by itself?

Well, for one, the Trea­sury secu­ri­ties are issued on the open mar­ket. The Fed typ­i­cally pre-announces which issues it will buy, allow­ing the banks that act as pri­mary deal­ers to essen­tially front-run: buy­ing the newly issued debt from the Trea­sury in expec­ta­tion of get­ting a higher price from the Fed. So doing all of this as QE has the ben­e­fit of hand­ing the banks a nice trad­ing profit. Sec­ond, the Fed has an awful lot of Trea­sury debt on its bal­ance sheet, which is lever­aged about 50-to-1 against its own cap­i­tal. By pur­chas­ing Trea­sury secu­ri­ties and cre­at­ing zero-interest cash (or low-interest reserves), the Fed essen­tially earns a spread that can cover any short­fall it might expe­ri­ence if it is ever forced to unwind its posi­tion and sell any of those secu­ri­ties at a loss. It's true that if the Fed earns any sur­plus inter­est, it has to go back to the Trea­sury, but the sur­plus ren­dered back to the Trea­sury is only what remains after a night on the town in the Fed's bal­ance sheet.

Finally, the rea­son for doing QE through the Fed (rather than sim­ply chang­ing the matu­rity pro­file of the new Trea­sury debt) is that Wall Street — at least — believes that the Emperor is actu­ally wear­ing clothes. Despite the fact that the main effect of QE is to boost spec­u­la­tion and release brief bursts of pent-up demand, both which imme­di­ately soften when the poli­cies are sus­pended, this recur­ring pat­tern is still unclear to many investors and ana­lysts. As long as that delu­sion per­sists, we can expect the Fed to peri­od­i­cally exploit it.

Ignore that the side-effect of this delu­sion is the mis­al­lo­ca­tion of cap­i­tal toward spec­u­la­tive assets in the belief that the Fed has set a "put option" under the mar­kets. For­get that sav­ings are dis­cour­aged, bad lend­ing deci­sions are res­cued, incen­tives and eco­nomic sig­nals are dis­torted, and the accu­mu­la­tion of pro­duc­tive cap­i­tal is dis­abled. We have the most cre­ative, entre­pre­neur­ial nation on the planet, but our pol­icy mak­ers are intent on pre­vent­ing debt restruc­tur­ing and mis­al­lo­cat­ing scarce cap­i­tal. As a result, they con­tinue to com­pro­mise long-term growth in favor of tem­po­rary bouts of short-term speculation.

What about recent employ­ment gains?

But wait. How can we say that quan­ti­ta­tive eas­ing has such weak effects on the econ­omy when we've clearly enjoyed a sig­nif­i­cant amount of job cre­ation since mid-2009? Isn't that clear evi­dence that Fed pol­icy is working?

Well, that depends on what one means by "working."

Last week, we observed "Real income declined month-over-month in the lat­est report, which is very much at odds with the job cre­ation fig­ures unless that job cre­ation reflects extra­or­di­nar­ily low-paying jobs. Real dis­pos­able income growth has now dropped to just 0.3% year-over-year, which is lower than the rate that is typ­i­cally observed even in reces­sions." It wasn't quite clear what was going on until I read a com­ment by David Rosen­berg, who noted that much of the recent growth in pay­rolls has been in "55 years and over" cohort. Sud­denly, 2 and 2 became 4.

If you dig into the pay­roll data, the pic­ture that emerges is breath­tak­ing. Since the reces­sion "ended" in June 2009, total non-farm pay­rolls in the U.S. have grown by 1.84 mil­lion jobs. How­ever, if we look at work­ers 55 years of age and over, we find that employ­ment in that group has increased by 2.96 mil­lion jobs. In con­trast, employ­ment among work­ers under age 55 has actu­ally con­tracted by 1.12 mil­lion jobs. Even over the past year, the vast major­ity of job cre­ation has been in the 55-and-over group, while employ­ment has been slug­gish for all other work­ers, and has already turned down.

For most of his­tory prior to the late-1990's, employ­ment growth in the 55-and-over cohort was a fairly small and sta­ble seg­ment of total employ­ment growth. Undoubt­edly, part of the recent increase has sim­ply been a change in the clas­si­fi­ca­tion of exist­ing work­ers as they've aged (1945 + 55 = 2000, so the we would have expected to see some grad­ual bulge in this bracket since 2000 due to aging baby boomers). But the shift is too large to be explained sim­ply by reclas­si­fi­ca­tion. Some­thing more trou­bling has been underway.

Begin­ning first with Alan Greenspan, and then with Ben Bernanke, the Fed has increas­ingly pur­sued poli­cies of sup­press­ing inter­est rates, even dri­ving real inter­est rates to neg­a­tive lev­els after infla­tion. Com­bine this with the burst­ing of two Fed-enabled (if not Fed-induced) bub­bles — one in stocks and one in hous­ing, and the over-55 cohort has suf­fered an assault on its finan­cial secu­rity: a dif­fi­cult tri­fecta that includes the loss of inter­est income, the loss of port­fo­lio value, and the loss of home equity. All of these have com­bined to pro­voke a delay in retire­ment plans and a need for these indi­vid­u­als to re-enter the labor force.

In short, what we've observed in the employ­ment fig­ures is not recov­ery, but des­per­a­tion. Hav­ing starved savers of inter­est income, and hav­ing repeat­edly sub­jected investors to Fed-induced finan­cial bub­bles that cre­ate volatil­ity with­out durable returns, the Fed has suc­cess­fully pro­voked job growth of the oblig­a­tory, low-wage vari­ety. Over the past year, the major­ity of this growth has been in the 55-and-over cohort, while growth has turned down among other work­ers. Mean­while, over­all labor force par­tic­i­pa­tion con­tin­ues to fall as dis­cour­aged work­ers leave the labor force entirely, which is the pri­mary rea­son the unem­ploy­ment rate has declined. All of this reflects not health, but despair, and explains why real dis­pos­able income has grown by only 0.3% over the past year.

Eco­nomic Notes

It's impor­tant to rec­og­nize that our con­cerns about the stock mar­ket here are inde­pen­dent of our eco­nomic con­cerns, in that the "Angry Army of Aunt Min­nies" we've recently observed are asso­ci­ated with very neg­a­tive aver­age mar­ket out­comes regard­less of eco­nomic con­di­tions. Even in the past few years, the emer­gence of these con­di­tions has invari­ably been fol­lowed by declines that have wiped out all of the inter­ven­ing gains since the ear­li­est sig­nal was observed.

As noted above, even in the event of another round of quan­ti­ta­tive eas­ing, the par­tic­u­lar win­dow to ease back on a defen­sive posi­tion would be between the point where QE induces an improve­ment in mar­ket inter­nals and an upturn in var­i­ous trend-following indi­ca­tors (com­ing off of a pre­vi­ously over­sold con­di­tion), and the point where an "over­val­ued, over­bought, over­bull­ish, rising-yields" syn­drome is estab­lished. To ignore the syn­dromes we observe at present, in the hope that the hope of QE will be suf­fi­cient to limit mar­ket risk, is a strat­egy that would not have been suc­cess­ful even in recent years.

Still, though our present mar­ket con­cerns are inde­pen­dent of eco­nomic con­cerns, they are also rein­forced by those eco­nomic con­cerns. We've reviewed var­i­ous lines of evi­dence, from lead­ing indi­ca­tors to "unob­served com­po­nents mod­els," and I con­tinue to view the com­ing weeks as a likely mine­field of eco­nomic dis­ap­point­ments. The issue here remains the dis­tinc­tion between lead­ing, coin­ci­dent and lag­ging mea­sures of the econ­omy. As I've noted before, a ten­dency toward pos­i­tive eco­nomic sur­prises over this period would improve the under­ly­ing eco­nomic state that we infer from observ­able data, but here and now, the most lead­ing com­po­nents remain clearly neg­a­tive. The con­cerns are also clearly com­pounded by the uni­form dete­ri­o­ra­tion in eco­nomic mea­sures in Europe, China and India, among other regions. The charts below con­vey the gen­eral situation.

Over the week­end, the New York Times pub­lished a good arti­cle (Some Dreary Fore­casts from Recov­ery Skep­tics) that sum­ma­rized the con­cerns of a num­ber of eco­nomic observers, plac­ing Lak­sh­man Achuthan of the ECRI and me into the clas­si­fi­ca­tion of "perma-bears." Actu­ally, with respect to the econ­omy, I'm pleased to be in good com­pany, and don't greatly object to the "perma-bear" label in that I con­tinue to believe major under­ly­ing eco­nomic prob­lems have merely been kicked down the road and remain unre­solved (pri­mar­ily an over­hang of unser­vice­able debt, which con­tin­ues to need restruc­tur­ing, and which will leave the global econ­omy prone to recur­ring crises until that happens).

I also peri­od­i­cally get the "perma-bear" label with respect to my views on the finan­cial mar­kets. While I do believe that stocks have been gen­er­ally over­val­ued since the late-1990's (a view that is sup­ported by the pre­dictably dis­mal over­all total returns on stocks since that time), I do think that some observers mis­clas­sify the 2009-early 2010 period as being a reflec­tion of our stan­dard invest­ment strat­egy instead of what it was — a period when we sus­pended risk tak­ing until we were con­fi­dent that we had ade­quately stress-tested our meth­ods against Depression-era data. That may seem like a dis­tinc­tion with­out a dif­fer­ence, but the dif­fer­ence is that for most peri­ods since 2000, our present invest­ment meth­ods would do very lit­tle dif­fer­ently than we actu­ally did in prac­tice (though there are of course a few mod­er­ate dif­fer­ences due to var­i­ous refine­ments and ongo­ing research). The 2009-early 2010 period is dis­tinct in that it is not at all indica­tive of the hedge posi­tion that can be expected of our strat­egy in future mar­ket cycles, even under iden­ti­cal con­di­tions and evi­dence. The fact that we removed about 70% of our hedges in 2002 (when our pro­jec­tion for 10-year S&P 500 total returns was not much more com­pelling than what it is today), should be some evi­dence of that.

Finan­cial mar­kets fluc­tu­ate, and prospec­tive returns change. We will undoubt­edly have ample oppor­tu­ni­ties to accept finan­cial risk in expec­ta­tion of rea­son­able returns, and if his­tory is any guide, those oppor­tu­ni­ties will emerge well before our eco­nomic prob­lems are behind us. What con­cerns me here is the refusal of investors to even rec­og­nize those prob­lems; the army of hos­tile syn­dromes we observe in both finan­cial and eco­nomic data; the blind faith that sim­ply chang­ing the mix of Trea­sury debt and bank reserves can pro­duce growth and put a floor under spec­u­la­tive assets; the near-complete denial of ongo­ing debt strains; and heav­ily bull­ish sen­ti­ment that Investors Intel­li­gence cor­rectly notes is now in "ter­ri­tory asso­ci­ated with mar­ket tops."

Mar­ket Climate

As of last week, the Mar­ket Cli­mate for stocks remained char­ac­ter­ized by a hos­tile "over­val­ued, over­bought, over­bull­ish, rising-yields" syn­drome, and a vari­ety of other hos­tile syn­dromes that I've reviewed in recent com­ments. Strate­gic Growth and Strate­gic Inter­na­tional Fund remain tightly hedged here. Strate­gic Div­i­dend Value has a hedge equal to about 50% of the value of its hold­ings — its most hedged stance. Strate­gic Total Return con­tin­ues to have a dura­tion of just under 3 years, and a small per­cent of assets in util­ity shares and for­eign cur­ren­cies. We raised our expo­sure in pre­cious met­als shares to just over 4% on last week's price weak­ness, but there too, our stance remains decid­edly con­ser­v­a­tive at present.

—

Tags: Balance Sheets, Banking System, Cnbc, Consensus Expectations, Cyclicals, Department Of Labor, Desperation, Economic Benefits, Economic Variables, Edifice, Fomc, Global Banking, Hussman, Job Creation, Lollipop, Lows, Market Plunge, Non Farm Payrolls, Payroll Number, Qe, Tantrum
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The Economy and Bond Market Radar (April 9, 2012)

Sunday, April 8th, 2012

The Econ­omy and Bond Mar­ket Radar (April 9, 2012)

Trea­sury yields changed lit­tle this week, but the gen­eral direc­tion was down as global eco­nomic data was weaker than gen­er­ally expected. Euro­pean con­cerns resur­faced this week as 10-year Span­ish gov­ern­ment bond yields spiked to the high­est level this year on tepid demand at this week’s auc­tion. Spain has become the focus in the mar­kets with a dif­fi­cult bud­get sit­u­a­tion and already high unem­ploy­ment. This is a reminder that many of the dif­fi­cul­ties fac­ing the mar­kets have not been resolved and are likely to sur­face again as we move through the year.

Strengths

• The ISM Man­u­fac­tur­ing Index rose in March and was ahead of expec­ta­tions, indi­cat­ing con­tin­u­ing eco­nomic expan­sion in the man­u­fac­tur­ing area.
• The non-Manufacturing ISM Index fell in March, but remains well into expan­sion mode.
• The four-week aver­age for the weekly ini­tial job­less claims con­tin­ues to make new lows and is viewed as a pos­i­tive lead­ing indi­ca­tor for the over­all economy.

Weak­nesses

• Global man­u­fac­tur­ing data dis­ap­pointed as euro­zone PMI remained weak and con­tin­ued to indi­cate con­trac­tion in manufacturing.
• Con­struc­tion spend­ing fell 1.1 per­cent in Feb­ru­ary even as weather was con­ducive to growth.
• Euro­zone retail sales fell 0.1 per­cent in Feb­ru­ary as aus­ter­ity and high unem­ploy­ment take their toll.

Oppor­tu­ni­ties

• Over the past cou­ple of weeks, bonds have staged as investors reassessed the global growth out­look. That trend appears likely to con­tinue as long as China is com­fort­able with slower growth.

Threats

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing, led by Europe, may raise the prospect of a reap­pear­ance of higher infla­tion going forward.

Tags: Austerity, Bond Market, Budget Situation, China, Contraction, Economic Data, Economic Expansion, European Concerns, Expansion Mode, Gasoline Prices, Global Growth, Government Bond, Growth Outlook, Initial Jobless Claims, Ism Index, Ism Manufacturing Index, Leading Indicator, Lows, Market Radar, Spanish Government, Treasury Yields
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S&P500: At Major Resistance

Tuesday, April 3rd, 2012

by Guy Lerner, The Tech­ni­cal Take

March 30, 2012

Prices have risen rather dra­mat­i­cally over the past 6 months, and many an ana­lyst have extrap­o­lated the recent price gains into the future sug­gest­ing that the bull mar­ket train is about to leave the sta­tion.  And oh if you don’t jump on now….well you will regret it.

But I say not so fast.  There is no great hurry to jump on that equity train.  Why?  Prices are at resis­tance lev­els, which means there should be some sell­ing.  There will also be some buy­ing as the those late to the party will want to get on that bull mar­ket express.  But I don’t see any great urgency.

Fig­ure 1 is a monthly chart of the S&P 500 (sym­bol: $INX).  The orange trend line is drawn from the March, 2009 lows .  The break of that trend line (red down arrow) occurred back in August, 2011.  Prices rebounded and have man­aged to retrace those losses, but cur­rently prices are stymied by that ris­ing trend line (black down arrow).  This ris­ing trend line (the orange one) will con­tinue to be a big­ger and big­ger hur­dle as it is likely to rise faster than prices, which have def­i­nitely flat­tened out over the past cou­ple of months.  The ris­ing pur­ple trend line is likely to come into play some­time in the future, and maybe it and price will meet up around 1225 SP500.

Fig­ure 1. SP500/ monthly

Fig­ure 2 is a weekly chart of the S&P Depos­i­tory Receipts (sym­bol: SPY).  A nice trend chan­nel is drawn and prices are at the top of that trend chan­nel.  Of course, how prices got to this point is note­wor­thy in that they have gone up for the entire quar­ter on poor vol­ume and breadth.  In other words, with prices at resis­tance and a poor foun­da­tion under­neath, I can eas­ily see that this is not a launch­ing pad for a new bull mar­ket.  I sus­pect we will get a pull back to at least the mid­dle chan­nel line some­where between SP500 1300 to 1350.

Fig­ure 2. SPY/ weekly

Tags: Amp, Arrow, Breadth, Depository Receipts, Figure 1, Guy Lerner, Hurdle, Hurry, Launching Pad, Losses, Lows, Market Express, Nbsp, P500, Poor Foundation, Poor Volume, Resistance Levels, Trend Channel, Trend Line, Urgency
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David Rosenberg: The Record Quarter

Tuesday, April 3rd, 2012

from David Rosen­berg, Gluskin Sheff

What a quar­ter! The Dow up 8% and enjoy­ing a record quar­ter in terms of points — 994 of them to be exact and in per­cent terms, now just 7% off attain­ing a new all-time high. The S&P 500 surged 12% (and 3.1% for March; 28% from the Octo­ber 2011 lows), which was the best per­for­mance since 1998. It seems so strange to draw com­par­isons to 1998, which was the infancy of the Inter­net rev­o­lu­tion; a period of fis­cal sta­bil­ity, 5% risk-free rates, sus­tained 4% real growth in the econ­omy, strong hous­ing mar­kets, polit­i­cal sta­bil­ity, sub-5% unem­ploy­ment, a sta­ble and pre­dictable cen­tral bank.

And look at the com­po­si­tion of the rally. Apple soared 48% and accounted for nearly 20% of the appre­ci­a­tion in the S&P 500 (it now makes up 3% of the 200 largest hedge fund port­fo­lios — three times as much as any other name; 4% of the S&P 500 mar­ket cap; and 11% of the Nas­daq). Not since Microsoft in 1999 was one stock this dom­i­nant, though the val­u­a­tions are not com­pa­ra­ble (MSFT then was trad­ing with a 70x P/E multiple).

But out­side of Apple, what led the rally were the low-quality names that got so beat up last year, such as Bank of Amer­ica bounc­ing 72% (it was the Dow's worst per­former in 2011; finan­cials in aggre­gate rose 22%). Sears Hold­ings have sky­rock­eted 108% this year even though the com­pany doesn't expect to make money this year or next.

What does that tell you? What it says is that this bull run was really more about pric­ing out a pos­si­ble finan­cial dis­as­ter com­ing out of Europe than any­thing that could really be described as pos­i­tive on the global macro­eco­nomic front. Low– qual­ity stocks in the S&P 500 out­per­formed high-quality stocks in Q1 by 500 basis points and high-beta stocks within the Rus­sell 1000 out­per­formed low– beta by 900bps. On a global scale, what has been a poorer place to put cap­i­tal to work than Japan? And yet the Nikkei posted a rip­ping 19% advance in Q1, the best start to any year since the pre-bubble-burst times of 1988. Emerg­ing mar­kets are up 13% year-to-date. Greece ral­lied 7% in Q1 — that also tells you some­thing about this rally. It's called a dead-cat bounce. Mean­while, the stodgy sec­tors that worked so well last year are bid­ing their time — util­i­ties so far in 2012 are down 3%, tele­com is flat, and sta­ples are up a mere 5%.

Most investors can dig back to 2000 if they really try. It was not uncom­mon for typ­i­cally risk-averse investors such as retirees to be insis­tent that at least half of their port­fo­lios con­sisted of Microsoft, Intel, Cisco and Dell. Each of these stocks had gone par­a­bolic and none of them paid div­i­dends, which was a good thing because that left them with all those earn­ings to plow back into the busi­ness. If you needed to buy gro­ceries, you could just sell a few shares for cash flow.

My how things have changed. Today, "div­i­dend pay­ing stocks" are all the focus of atten­tion — not to men­tion fund flows. Indeed, what is still so fas­ci­nat­ing is how the pri­vate client sec­tor sim­ply refuses to drink from the Fed liq­uid­ity spiked punch bowl, hav­ing been burnt by two cen­tral bank-induced bub­bles sep­a­rated less than a decade apart. Investors con­tinue to use stock price appre­ci­a­tion as an oppor­tu­nity to rebal­ance and diver­sify rather than chase per­for­mance — pulling $15.6 bil­lion from U.S. equity mutual funds so far this year while tax­able bond funds have seen net inflows amount­ing to $59 billion.

The lack of any real sig­nif­i­cant back-up in bond yields sug­gests that the asset allo­ca­tors have been idle as well.

It would then seem as though this is a mar­ket being dri­ven by traders. Then again, it has been a very trad­able rally, just as the post-QE1 and post-QE2 jumps were. Ditto for the cur­rent post-LTRO rally. But liq­uid­ity is not an anti­dote for fun­da­men­tals. And a mar­ket that lacks breadth, par­tic­i­pa­tion and vol­ume is not gen­er­ally one you can rely on for sus­tained strength, notwith­stand­ing the ter­rific first quar­ter that risky assets deliv­ered. We lived through this exactly a year ago.

Mean­while, we have real estate defla­tion rear­ing its ugly head in China, a spread­ing Euro­pean reces­sion (for all the talk of Ger­man resilience, retail sales vol­umes sank 1.1% in Feb­ru­ary and have con­tracted now in four of the past five months), acute debt prob­lems in Por­tu­gal and Spain (there is already talk in Greece about the need for a third bailout), and the U.S. data have been com­ing out rather mixed (it should have enjoyed a much big­ger bounce than it did in recent months from the extremely warm weather — it was the fourth warmest win­ter since 1896; 15% warmer than usual.

In Chicago, it was the warmest March ever and sec­ond balmi­est March on record in New York City. For the lat­ter, it was 9 degrees above nor­mal and would have lined up in the top 10 for any April!). That the employ­ment, hous­ing and spend­ing data weren't even stronger than what they showed — likely lit­tle bet­ter than a 2% pace for Q1 real GDP — is the real story beneath the story. The fact that the 10-year note yield stopped at 2.4% and has since ral­lied 20 basis points instead of mak­ing the expected tech­ni­cal chal­lenge of 2.65% sug­gests that the bond mar­ket crowd may be fig­ur­ing out what this means for the Q2 land­scape as the weather skew to the data subsides.

U.S. DATA ON SHAKY GROUND
Yes, yes, U.S. per­sonal spend­ing jumped an above-expected 0.8% in Feb­ru­ary, above the 0.6% increase that was gen­er­ally expected and the largest monthly gain since August 2009 when the shoots were green. But if truth be told, this as we would say in mar­ket par­lance, was a "low mul­ti­ple" increase. The rea­son? Per­sonal incomes were soft and that is what counts most — income fun­da­men­tals remain dis­mal. Not only did income come in soft at +0.2% (half what was expected) but not even enough to cover the cost of liv­ing, but Jan­u­ary and Feb­ru­ary were both revised lower. Real dis­pos­able income also declined 0.1% — the third decrease in the past four months and on a per capita basis is down 0.4% YoY, a far cry from the +2% trend of a year ago. The econ­omy is build­ing momen­tum. Right.

Let's just say that had the sav­ings rate stayed the same in Feb­ru­ary, nom­i­nal con­sumer spend­ing growth would have come in at a puny +0.2% and guess what? Real PCE would have been –0.1%. Thanks for com­ing out. As we said, a "low qual­ity" spend­ing per­for­mance, absent the income fun­da­men­tals, there is no sustainability.

Then we got yet another spotty regional man­u­fac­tur­ing index in the form of the Chicago PMI (the national fig­ure comes out today). It came in below expec­ta­tions at 62.2 for March (con­sen­sus was 63.0) — a 1.8 point drop from the pre­vi­ous month, and the third decline in the past four months. New orders slid from 69.2 to 63.3 — the largest one month drop since last May and the low­est level since Octo­ber (this is now the fifth man­u­fac­tur­ing sur­vey to show a drop in new orders). If not for the inven­to­ries, which jumped from 49.6 to 57.4 — the sharpest run-up since Decem­ber 2010 and the high­est lev­els since last Sep­tem­ber — the head­line decline would have been much worse. And in a sign­post of how cor­po­rate exec­u­tives (or the Human Resource depart­ments in any event) are respond­ing to neg­a­tive pro­duc­tiv­ity growth, the employ­ment index dropped from 64.2 to 56.3— largest drop since April 2008 and it has fallen in two of the past three months.

Then we got the Uni­ver­sity of Michi­gan con­sumer sen­ti­ment index which was revised higher for March to 76.2 from 74.3 in the pre­lim­i­nary read­ing — this the high­est level since Feb­ru­ary 2011. What was inter­est­ing were the details beneath the sur­face, such as auto buy­ing plans being revised down from 123 to 122 — first decline in three months; and buy­ing con­di­tions for large house­hold items being revised lower from 127 to 125— a four-month low.

Finally, the best Canada could muster up was a 0.1% gain in real GDP for Jan­u­ary. At least it was pos­i­tive — but barely. It reveals an econ­omy that right now is uneven and sput­ter­ing. It's a good thing there was a solid hand­off from the tail-end of Q4, as that is what is keep­ing Q1 GDP esti­mates close to a 2% annual rate. If there is a piece of infor­ma­tion that Cana­dian dol­lar bulls can put in their back pocket it is that man­u­fac­tur­ing out­put, even with the loonie at par, man­aged to post a solid 0.7% advance — fac­tory out­put up now for five months run­ning. Now that is impressive.

Copy­right © Gluskin Sheff

Tags: Bank Of America, Basis Points, Bull Run, Canadian, Canadian Market, China, David Rosenberg, Financial Disaster, Fiscal Stability, Fund Portfolios, Global Scale, Gluskin Sheff, Hedge Fund, Internet Revolution, Low Quality, Lows, Msft, Nasdaq, Political Stability, Quality Names, Quality Stocks, Record Quarter, Sears Holdings
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Scratching My Head Till it Bleeds & The 5 classes of Corporate Bonds

Tuesday, March 27th, 2012

by Peter Tchir, TF Mar­ket Advisors

The mar­ket has ral­lied more than 2% since the lows on Fri­day morn­ing.  The rally has been almost exclu­sively cen­tral bank and gov­ern­ment driven.

On Fri­day the rally started with rumors of ECB bond pur­chases, it con­tin­ued Mon­day morn­ing with Merkel soft­en­ing her stance on how much Ger­many is will­ing to risk, and momen­tum accel­er­ated to a crescendo once Bernanke made it clear that not only is QE not off the table, but he is dying to do more QE ASAP.

Equi­ties seem to have com­pletely accepted that cen­tral banks and gov­ern­ments can only be good for the mar­ket.  That is what has me scratch­ing my head so hard.  Does noth­ing other than cen­tral bank pol­icy make a dif­fer­ence?  Any­one who nailed the eco­nomic data last week has to feel like an idiot. The Chi­nese land­ing ques­tion has not been answered, but there is grow­ing evi­dence that it could be the hard sort.  The Euro­pean econ­omy dete­ri­o­rated and some of the weaker coun­tries did the worst – Spain as a not so shin­ing exam­ple.  Hous­ing data in the US missed across the board, and gen­er­ally the data was weak.  Yet here we are, back to new highs in equities.

So it is true that flood­ing the world with money has helped stocks, there have also been peri­ods where stocks did poorly in spite of all these pro­grams being in place.  Are we now sup­posed to believe that we can never go down again while cen­tral bankers are at work? That doesn’t match with his­tory, yet yes­ter­day seems to have con­vinced many that the only direc­tion for stocks is up with Ben­draghi in charge.  The S&P is trad­ing at 14.7x earn­ings.  Maybe not over­val­ued, but also hard to argue that they are extremely cheap – espe­cially with eco­nomic indi­ca­tors not only a lit­tle weaker than expected, but show­ing signs that a lot of the strong data early this year truly was a func­tion of weather, and rather than being able to jump­start the econ­omy, merely pulled activ­ity for­ward and we are now see­ing the impact of that.

While equi­ties and com­modi­ties (except for nat­ural gas) knew exactly what to do with the Ben’s state­ment, trea­suries had more dif­fi­culty fig­ur­ing it out. They seemed to be left scratch­ing their heads and were torn between the desire to rally on the back of more gov­ern­ment sup­port, or sell­ing off as part of a “risk on” rally.  Trea­suries seem to be caught in no man’s land.  Fed pur­chases keep them arti­fi­cially low, but with any poten­tial for sta­bil­ity in the world, any signs of infla­tion, and a stock mar­ket this high, it is hard to be an “investor” in trea­suries here.  There is real fear that you do not want to be the one left hold­ing trea­suries once the QE game is over.  It is a bit sur­pris­ing that Ben wasn’t able to do more for trea­suries yes­ter­day.  The long bond is actu­ally 2 bps higher than it was on Friday.

Cor­po­rate bonds were okay.  Not as enthu­si­as­tic as stocks and com­modi­ties, but more excited by the prospects of addi­tional QE than trea­suries.  On the credit ETF side, it looks like most of the appre­ci­a­tion went into increas­ing the pre­mium as the NAV didn’t move as quickly.

Mort­gages should do best on any QE as it seems that will be the pri­mary ben­e­fi­ciary.  In the mean­time, cor­po­rate bonds seem to be 5 dis­tinct assets classes:

Invest­ment Grade Cor­po­rate: These are already trad­ing tight, but should have lit­tle volatil­ity.  I would want to own them on a hedged basis, if at all.  Noth­ing wrong with the bonds, but lit­tle upside left.

Finan­cial Bonds: Bonds issued by banks still have the most spread and best chance of appre­ci­a­tion.  They also clearly have the most risk.  I pre­fer bonds of the biggest Euro­pean banks (DB and SG), but would want to avoid or be short the banks that have used LTRO the most aggressively.

“Short Dated” HY Bonds: There are a lot of high coupon hy bonds trad­ing to call dates within the next two years.  Nor­mally these offer lim­ited upside, but it might be worth buy­ing some.  Retail investors seem to have their eyes on these bonds, and there is now at least one ETF specif­i­cally tar­get­ing these bonds.  There isn’t much value here, but retail is likely to drive these bonds up a cou­ple points higher than insti­tu­tional investors ever would – espe­cially with the econ­omy being sta­ble.  Decent carry and real chance that retail chases these bonds higher than they should be.

“Story Credit” HY Bonds: These have ral­lied but still have some poten­tial.  It really is a “close your eyes” and hope for the best at this stage as the down­side is prob­a­bly greater than the upside, but if you truly believe in QE and its abil­ity to make things good, you are sup­posed to close your eyes and buy these.  Not a strat­egy I like right now as I believe that in spite of (or because of) all the gov­ern­ment and cen­tral bank inter­ven­tion we are a long way from hav­ing resolved anything.

“high qual­ity non-callable” HY Bonds: These are poten­tially the most dan­ger­ous.  These are typ­i­cally BB com­pa­nies with bonds that have good call pro­tec­tion for at least 5 years.  Spreads are rel­a­tively tight, though have room to move tighter, but in spite of many arti­cles say­ing that HY doesn’t move with rates, these will.  We are in a pretty unique sit­u­a­tion in the credit mar­kets.  Trea­sury yields are very low.  Spreads on these bonds are okay, and could tighten, but the yields are very low.  The abil­ity for this class of bonds to rally in a ris­ing rate envi­ron­ment is low.  On a spread basis, they could tighten as they should out­per­form trea­suries, but they can still go down on price.  They will be squeezed out by BBB bonds in a ris­ing rate envi­ron­ment.  The analy­sis of HY cor­re­la­tion to trea­suries that I have seen is too sim­plis­tic.  The first two cat­e­gories of hy bonds that I men­tion do not have much rate risk.  This cat­e­gory does.

Tags: 7x, Asap, Central Banks, Chinese Landing, Commodities, Commodity, Corporate Bonds, Crescendo, Economic Data, Economic Indicators, European Economy, Friday Morning, Lows, Match, Merkel, Momentum, Monday Morning, New Highs, Qe, Spite, Tf, Weather
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David Rosenberg: The Truth On Sideline Cash

Wednesday, March 21st, 2012

The money-on-the-sidelines argu­ment has reached deaf­en­ing and self-confirming as anchor­ing bias among any and every swollen long-only man­ager seems to have made them ignore the real­i­ties of the sit­u­a­tion. David Rosen­berg, of Gluskin Sheff to the res­cue with good old fash­ioned facts — as much as they might dis­ap­point the audi­ence. Bar­ton Biggs quote in the USA Today arti­cle points out how bull­ish he is and how cash lev­els are very high and "idled money is ready to be put to work". How­ever, as Rosie points out equity fund cash ratios are at a de min­imus 3.6%, the same level as in the fall of 2007 and near its low­est level ever. The time when cash was heavy and 'ample' was at the mar­ket lows in 2009 when the ratio was very close to 6%. Bond fund man­agers, it should be noted this includes the exu­ber­ant HY funds, are now sit­ting on less than 2% cash so if retail inflows con­tinue to sub­side as they did this week, buy­ing power could weaken over the near-term. What David points out that is more inter­est­ing per­haps is the con­verse of most people's con­trar­ian dumb money per­spec­tive — the house­hold sec­tor appears to have used the rally of the past three years, for the most part, to diver­sify out of the equity mar­ket (get­ting out at price lev­els they could only dream of see­ing again). As we have pointed out again and again, the retail investor has been a net redeemer in equity funds for nine-months run­ning and has been rebal­anc­ing since the March 2009 lows in a clearly demo­graphic shift towards income strate­gies as the mem­ory of two burst­ing bub­bles within seven years is seared into most pri­vate investors' minds.

Tags: Article Points, Bond Fund, Bursting Bubbles, David Rosenberg, Demographic Shift, Dumb Money, Equity Fund, Equity Funds, Fund Managers, Household Sector, Hy, Income Strategies, Lows, Private Investors, Redeemer, Retail Investor, Sheff, Sideline, Sidelines, Usa Today
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Do High Yield Bonds Know Something Stocks Don't?

Monday, March 19th, 2012

 
As the S&P 500 reaches new multi-year highs and VIX touches multi-year lows, there is one rather large and risk-appetite-proxying mar­ket out there that is not as excited. The high-yield bond mar­ket has seen record in-flows drop­ping off recently and for the last four-to-six weeks high-yield spreads, yields, and bond prices have been very flat as stocks have surged ahead. Despite US earn­ings yields at near-record highs rel­a­tive to high-yield bond yields, we see lit­tle pick-up in LBO chat­ter sug­gest­ing a notable pref­er­ence for higher-quality junk credit (and/or lack of belief in sus­tain­abil­ity of earn­ings yields) and the recent 'dra­matic' out­per­for­mance in invest­ment grade credit is a notable up-in-quality rota­tion (as well as early spread-compression reac­tion to Trea­sury weak­ness recently) that strongly sug­gests less risk appetite among real money man­agers (given how 'cheap' high-yield appears across asset classes). Lastly, the ratio of HY bond prices to VIX is near its extreme once again, some­thing we saw occur before the risk flares of 2010 and 2011 sur­round­ing the end of the Fed's QE ses­sions.

The S&P 500 (Blue line) has stormed higher from its Octo­ber lows and extended gains recently despite sig­nals that QE3 may not be so immi­nent. Invest­ment grade credit (dark red) has pushed higher with it as size and qual­ity was pre­ferred (and the last week or so of out­per­for­mance likely reflects the ini­tial spread com­pres­sion impact as Trea­suries blew higher in yield but cor­po­rates remained bid from safety up-in-quality rota­tions). What is most clear is the HYG (green line) and HY (red line) have flat-lined in the last 4–6 weeks while stocks have accel­er­ated. We have seen this pat­tern before and the old saw that 'credit antic­i­pates and equity con­firms' has been extremely use­ful a num­ber of times over the past few years.

Here is the mar­ket moves head­ing into the end of QE2...obvi­ously HY became anx­ious first and proved cor­rect once again...

There are plenty of tech­ni­cal rea­sons for why HY may be strug­gling includ­ing neg­a­tive con­vex­ity at such low yields but the slow­ing flows and rel­a­tive decom­pres­sion far out­weighs the stick­i­ness of bond prices and their calla­bil­ity here.

Fur­ther­more, the ratio of HY bond prices to VIX has soared to record 'risky' highs strongly sug­gest­ing that either VIX is set to rise notably, high-yield bond prices are set to fall notably or both and these extremes have tended to occur in the lead ups to notable risk flares (around Fed implicit eas­ing periods).

While not per­fectly fun­gi­ble, VIX and HY rep­re­sent risk pre­mia for extreme down­side pro­tec­tion and there is clearly a major dis­con­nect. Using longer-dated Volatil­ity we get a bet­ter more real­is­tic per­spec­tive between the two mar­kets — once again con­firm­ing that short-dated enthu­si­asm is at extreme lev­els as even with mod­est rises in VIX we see the term struc­ture steep­en­ing today.

Charts: Bloomberg

Tags: Asset Classes, Bond Market, Bond Prices, Bond Yields, Earnings Yields, Flares, High Yield Bond, High Yield Bonds, Investment Grade, Junk Credit, Lbo, Lows, Money Managers, Outperformance, Qe, Qe2, Record Highs, Red Line, Risk Appetite, Treasuries
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The "Great Bond Selloff" of 2012

Thursday, March 15th, 2012

There has been a lot of talk since Tues­day after­noon of the "great bond sell­off"…  this started post FOMC meet­ing and sup­pos­edly was due to the Fed's "upgrade" of the econ­omy in the state­ment.  The same upgrade that will do lit­tle to stop them from con­tin­u­ing a new round of eas­ing once Oper­a­tion Twist is over.  But it has a bunch of peo­ple in a huff.

Short term the move is rel­a­tively dra­matic for such a large and deep mar­ket.  I will use iShares Bar­clays 20+ Year Trea­sury Bond (TLT) ETF to demon­strate but there are any num­ber of matu­ri­ties I could use; this is just a widely used instru­ment so a good exam­ple.   Look­ing at a 4 month chart, a big change appears afoot.

How­ever, if we pull the chart back some to say 8 months, we sim­ply see the price has moved to the end of a longer term range.  Indeed, this ETF is not even at Octo­ber lows (remem­ber Octo­ber 2011 was one of the biggest up month's for equi­ties in many years), not to men­tion lev­els it was at last summer.

That said, it's a sharp move in the span of a few days and since U.S. Trea­suries yield so lit­tle the losses on the under­ly­ing can wipe out gains from inter­est very quickly.  On the flip side, Trea­suries were gen­er­ally an incred­i­bly lucra­tive asset class in 2011 return­ing far in excess of equi­ties.  So for now, it sim­ply looks like a give back, and not the "burst­ing of a bond bub­ble" as many are screaming.

Tags: asset class, Barclays, Economy, Few Days, Flip Side, Huff, Losses, Lot, Lows, Maturities, People, Selloff, Sharp, Span, Term Range, Tlt, Treasuries, Tuesday Afternoon, Year Treasury Bond
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Understanding the New Price of Oil (Martenson)

Wednesday, March 14th, 2012

by Gre­gor Mac­don­ald via Chris Marten­son

Under­stand­ing The New Price Of Oil

In the Spring of 2011, when Libyan oil pro­duc­tion — over 1 mil­lion bar­rels a day (mpd) — was sud­denly taken offline, the world received its first real-time test of the global pric­ing sys­tem for oil since the crash lows of 2009.

Oil prices, already at the $85 level for WTIC, bolted above $100, and even­tu­ally hit a high near $115 over the fol­low­ing two months.

More impor­tantly, how­ever, is that — save for a brief eight week period in the autumn — oil prices have stub­bornly remained over the $85 pre-Libya level ever since. Even as the debt cri­sis in Europe has flared.

As usual, the main­stream view on the world’s abil­ity to make up for the loss has been wrong. How could the removal of “only” 1.3% of total global pro­duc­tion affect the oil price in any pro­longed way?, was the uni­ver­sal view of “experts.”

Answer­ing that ques­tion requires that we mod­ern­ize, effec­tively, our under­stand­ing of how oil's numer­ous price dis­cov­ery mech­a­nisms now oper­ate. The past decade has seen a num­ber of enor­mous shifts, not only in sup­ply and demand, but in mar­ket per­cep­tions about spare capac­ity. All these were very much at play last year.

And, they are at play right now as oil prices rise once again as the global econ­omy tries to strengthen.

The Sub­or­di­na­tion of Cushing

Through the dom­i­nant force of its own demand, the US econ­omy largely con­trolled the oil price for many decades. For years, it was com­mon prac­tice there­fore to gauge world demand through the weekly updates to oil stor­age at Cush­ing, Okla­homa as well as total oil stor­age in the United States. If the US was demand­ing more oil from the global mar­ket, and thus either not adding to oil inven­to­ries or draw­ing them down, then a sig­nal was given, point­ing to future oil price strength.

But this dynamic began to break down com­ing into 2005–2007. That was the period when US oil demand — because of ris­ing prices — began its cur­rent decline. Now that US oil demand is down over 12% from its mid-decade peak, the fluc­tu­a­tion of oil inven­to­ries in the US no longer drive prices.

The chart below shows that US inven­to­ries have been on an upward trend since 2005, and are now near decadal highs above 300 mil­lion bar­rels even though oil prices are back above $100:

What we're now see­ing is that US inven­to­ries and US demand are now sub­or­di­nate to numer­ous other fac­tors, rang­ing from emerg­ing mar­ket demand, to mar­ket per­cep­tion of spare capacity.

Lessons of Libya

A use­ful fact learned dur­ing last year's Libyan civil war is that Saudi Ara­bia does not nec­es­sar­ily posses the 2–3 mbpd of spare capac­ity which most have assumed for years. More­over, Saudi Ara­bia ceded the posi­tion of top world oil pro­ducer to Rus­sia over 5 years ago in 2006. Indeed, Saudi Ara­bia made no pro­duc­tion response to the loss of Libyan oil last spring. Pro­duc­ing near 9 mbpd, it was only by June that Saudi pro­duc­tion was lifted by 600 thou­sand bar­rels a day (kbpd). That is a hefty pro­duc­tion increase to be sure, but it raised ques­tions as to how quickly spare capac­ity in the world can be brought online.

By the time Saudi Ara­bia had lifted pro­duc­tion, the OECD coun­tries led by the IEA in Paris had already decided to release oil from offi­cial inven­to­ries. But this, too, did lit­tle to calm oil prices — and as I pointed out last June, only cre­ated fur­ther prob­lems. In The Dark Side of the OECD Oil Inven­tory Release, I explained that, by low­er­ing OECD inven­to­ries, the mar­ket would cor­rectly deduce that safety buffers had been reduced fur­ther. Com­bined with the Saudi increase in pro­duc­tion, this only reduced spare capac­ity further.

The result was even stronger prices as WTIC ran back to $100 (until all global mar­kets floun­dered on a flare-up in the EU finan­cial cri­sis). Indeed, it is no longer US inven­to­ries of crude oil but the fluc­tu­a­tions in the emer­gency cush­ion of all inven­to­ries in the OECD (of which the US is part) that is now the more impor­tant fac­tor in oil prices:

The loss of Libyan pro­duc­tion caused a dra­matic draw­down of OECD total oil stocks, which were already in a down­ward trend start­ing the pre­vi­ous sum­mer in 2010. OECD inven­to­ries fell on both an absolute basis and on a com­par­a­tive basis to the trail­ing 5 Year Aver­age as the above chart shows. Tak­ing these inven­to­ries from a high of 2800 mb to 2600 mb only 6 months later, com­bined with unrest across the entire Mid­dle East, was more than enough sup­port to boost WTIC oil prices from $85 to above $100 last spring. Addi­tion­ally, as we can see in the chart, the decline in OECD oil inven­to­ries was main­tained into the end of 2011.

These are impor­tant con­di­tions to con­sider when try­ing to under­stand how oil prices now, in early 2012, are once again on the rise.

The Decline of Spare Pro­duc­tion Capacity

The lat­est global pro­duc­tion data shows that Saudi Ara­bia was pro­duc­ing 9.4 mbpd on aver­age dur­ing 2011, an increase of 500 kbpd over 2010. To accom­plish this, The Saudis had to increase pro­duc­tion from 9 mbpd in 1H 2011 to 9.8 mbpd dur­ing 2H of 2011. But para­dox­i­cally, this pro­duc­tion increase has only made the global oil mar­ket even tighter, as spare capac­ity shrinks further.

Let's recall that nearly 60% of global oil sup­ply comes from out­side of OPEC from coun­tries like the US, Canada, Brazil, Mex­ico, China, Aus­tralia, and the big producer—Russia. There is no spare capac­ity in this non-OPEC group­ing and there hasn’t been for years. Sure, there is oil to be devel­oped in non-OPEC coun­tries; but that is not pro­duc­tion capac­ity (mean­ing it is not sup­ply that can be brought online quickly).

More­over, Rus­sia, the coun­try that single-handedly saved non-OPEC pro­duc­tion from going into steep decline, mas­sively increased its con­tri­bu­tion to world sup­ply in 2002. But in the past two years, it has seen its pro­duc­tion growth taper off and flat­ten, to just shy of 10 mbpd.

That leaves the oil mar­ket, tasked with the job of pric­ing, to fig­ure out the ongo­ing mys­tery that is the "true" spare pro­duc­tion capac­ity in OPEC. That it took 4–5 months for Saudi Ara­bia to increase pro­duc­tion is a con­cern. Such delays should seri­ously give pause to those ana­lysts who’ve regur­gi­tated the belief over years that Saudi has 2–3 mbpd that can be brought on quickly.

Although EIA Wash­ing­ton cur­rently judges OPEC spare capac­ity to be higher than dur­ing the lows of 2003–2008, it's his­toric fig­ures show that spare capac­ity has been declin­ing since a 2009 high.

More­over, the fail­ure of non-OPEC pro­duc­tion to increase within last decade counts as a true sur­prise to the global oil mar­ket. The faith in non-OPEC sup­ply over the last decade helped to keep prices sub­dued, until that faith was shat­tered by 2007's wild spike.

The prob­lem now is that the oil mar­ket has been re-educated. Faith in the non-OPEC coun­tries' abil­ity to increase sup­ply is no more. Mean­while, the great decel­er­a­tion in Russ­ian oil sup­ply growth, has spooked the mar­ket. Com­bined, a mar­ket with 74 mbpd of pro­duc­tion and a the­o­ret­i­cal spare capac­ity of 3 mbpd sim­ply cre­ates too much uncertainty.

And con­sider this: the amount of total spare capac­ity is now equal to the 3 mbpd of demand that’s been taken offline in Europe, Japan, and the United States over the past 7 years, as oil prices have risen from $40 to the $100 level. Thus the oil mar­ket has quite cor­rectly rationed sup­ply, at higher prices. If prices were to fall to $50 or $60, the world’s lost demand could be rebuilt rather quickly.

Killing dis­cre­tionary demand is now the proper func­tion of the oil mar­ket in an age of flat sup­ply growth.

Quan­ti­ta­tive Eas­ing and Granger Causality

We should also remem­ber that the global econ­omy would be mired in a text­book defla­tion­ary depres­sion were it not for the con­tin­ual and gar­gan­tuan US$ tril­lions that have been pro­vided by cen­tral banks since 2008.

Early 2009 saw oil prices slip briefly below $40. But, of course, that's the price level appro­pri­ate to a world dur­ing an indus­trial crash — with reduced ship­ping, halted economies, and dis­lo­cated con­sumer demand. The world can have those prices again, if it chooses. But it must also be will­ing to accept a global reces­sion to achieve such low oil prices.

Thus, there is a mis­con­cep­tion that cur­rency debase­ment is the main dri­ver of oil prices. How­ever, given the new sup­ply real­i­ties, that sim­ply isn't true any longer.

The chart below is help­ful in explain­ing why. There is no ques­tion that com­ing out of 2000, the decline of the US Dol­lar as expressed by the USD Index was a true com­po­nent of the ris­ing oil price. Dur­ing that period, as the USD was falling, global oil sup­ply was still increas­ing. The descent of the US Dol­lar was unques­tion­ably part of the repric­ing process, as the USD Index fell from a high of 120.00 in 2002 to 80.00 in 2005:

But see how the most fero­cious part of oil’s price advance started to unfold after 2005, when, as the USD con­tin­ued falling, the global sup­ply of oil stopped grow­ing.

If we think of this com­pre­hen­sively, we have to con­clude that the debase­ment of cur­ren­cies is no longer the pri­mary fac­tor in the price of oil on a val­u­a­tion basis. Rather, it is that quan­ti­ta­tive eas­ing pre­vents a defla­tion­ary indus­trial col­lapse, thus keep­ing the global econ­omy alive and able to con­sume more energy.

We can there­fore say that in our post-credit bub­ble col­lapse era, and with global oil sup­ply now flat, that quan­ti­ta­tive eas­ing causes higher oil prices (through Granger causal­ity). It keeps economies from col­laps­ing (for now) and thus brings demand up against very tight sup­ply. As we can see from the chart above, the USD Index has for 3 years now been bounc­ing off the bot­tom it first reached in 2008. In a way, this is help­ful because it brings to light the new dom­i­nant fac­tor in global oil prices: supply.

Sup­ply is now Primary

Sup­ply, and the recog­ni­tion of sup­ply, are now the dom­i­nant fac­tor in the oil price. A point so obvi­ous, it hardly seems worth mak­ing. How­ever, the devel­oped world is still largely oper­at­ing on the clas­si­cal eco­nomic view that higher prices will make new oil resources available.

That is true. But, it’s just not true in the way most anticipate.

While higher prices have brought on new sup­ply, these resources have been slow to develop, are more dif­fi­cult to extract, and gen­er­ally flow at lower rates of pro­duc­tion. As the older oil fields of the world decline, the price of oil must reflect the eco­nom­ics of this new tranche of oil resources. There are no vast, new sup­plies of oil that will come online in 2013, 2014, and 2015 at the scale to negate exist­ing global declines.

Dur­ing the entire time that global oil sup­ply has been held at a ceil­ing of 74 mbpd, since 2005, a lot of new pro­duc­tion in the Amer­i­cas and Africa espe­cially has come online. But it has not not enough to increase total world sup­ply. And the price of oil has finally started to price in that new reality.

Here Comes Volatil­ity in Oil Prices

The pric­ing dynamic dis­cussed above is accen­tu­ated by the cri­sis cycle: the repet­i­tive oscil­la­tion between acute and chronic phases of the ongo­ing debt cri­sis, mit­i­gated by cen­tral bank refla­tion­ary policies.

In Part II: Get Ready for Oil Price Volatil­ity to Kill the 'Recov­ery', we fore­cast how today's pro­tractly high recent oil prices are already send­ing a sig­nal that a new hit to global demand is underway.

Gen­er­ally, it appears that the oil price is mak­ing its move too early in the year — which will likely serve as a sucker punch to the frag­ile world econ­omy — thus mak­ing spec­tac­u­larly high prices before year end less likely, and a sharp mar­ket cor­rec­tion and return to eco­nomic reces­sion more so.

Investors will be wise to take pru­dent pre­cau­tions before this nasty wake-up call arrives.

Click here to access Part II of this report (free exec­u­tive sum­mary; enroll­ment required for full access).

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