Market Update 05.10

I'm a little late this week, but with the benefit of Monday's session, I think we have some added evidence for the beginning of a multi-month decline. The character of this latest selloff has a different feel than either the July or October selloffs. I would venture to guess that if I asked people a month ago that we'd have an unemployment rate of 9.7% and GDP growth of 5.7% (annualized), the stock market would be squeezing shorts into oblivion and trudging yet higher toward the heavens.

Not so. Apparently, good news only mattes when, well, when it matters. If the stock market goes down, then the good news doesn't matter and something else does. Got it? Right. Perhaps it is best to pay greater attention to the bigger fundamental picture and what the market does, rather than the monthly or weekly data. People decide what stocks are worth based on their emotions. And their emotions appear to be directed by something other than the monthly data. The best explanation I have found for this phenomenon is that people merely take their emotive cues from each other - oscillating between optimism and pessimism.

Right now, everyone feels panicky about the situation in Greece, Portugal and Spain. But these problems are not new. They've been problems for a good 5 years now. The difference is that people are now paying attention to them. But I am sensing a great deal of complacency about the nature of this decline. Most sound completely certain that it is only a minor correction. And this gives me greater reason to believe that a far larger decline is upon us. See the chart below where a survey of 140 newsletter writers shows quite a decline in bullish sentiment, yet a far smaller increase in bearish sentiment. Notice how the two typically inversely correlate perfectly. But this time, we see a very strong resistance to the idea of becoming outright bearish.

(Data as of last Tues)


Elliott Wave patterns have been extremely compelling on the way down. This is in contrast with the October selloff, where one had to stretch to count 5 waves down and when it rallied, it rallied very compellingly. The bounces on this selloff have been weak and overlapping. The implication is that a 3rd of a 3rd wave down is just beginning. Support resides in the 940-980 range. This count from Daneric's Elliott Wave Blog looks like the most probable from my perspective.



The Euro/Yen cross has been a reliable indicator for risk aversion over the past few years. While I feel that trend will break at some point, it still bears watching.



Gold needs to hold the 200 day EMA to avoid significant technical damage. I think a test of the April lows at $865 is a best case scenario.



The weekly chart of oil is not looking pretty. I've pointed out the bunched up moving averages before, and they usually portend a major move in one direction or another. I still think we see new lows for oil as speculators unwind their positions. A sustained break of $70 would be very bearish.




Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Themes For 2010 - 6 - Final Thoughts

Last month, I ran a series of pieces detailing my outlook for credit markets, the economy, asset markets, and government interventions in them.

The overarching theme was that a secular shift had occurred in 2007 toward the reduction of debt and leverage within our economies. 2008 was the point of recognition. In 2009, we experienced a barrage of "fix-its." Most of these programs were designed to either conceal the actual problem, transfer the obligations to others, and to otherwise re-instill confidence in asset price valuations. The natural tendency for market participants to fluctuate between pessimism and optimism resulted in the perception that these programs had worked and that "normalcy" had returned.

But our concept of "normal" had been skewed by the previous secular shift, which was anything but normal. Its duration of over 3 decades was sufficient to eliminate the memories of how a normal economy actually functions. Indebtedness had replaced the role of savings; speculation the role of investment; consumption the role of production.

A number of factors enabled this shift: the fall of Soviet Russia, globalization, productivity enhancing technological advancements, booming demographics, and most importantly, the implicit and explicit government guarantees doled out to the financial services industry.

A number of those factors have reached their points of maximum impact. Others are already reversing. The first baby boomers began retiring in 2007. The impact of this will increasingly show its effects on markets as they liquidate their assets to pay for their retirements. Globalization grew to the point that the social ramifications of its imbalances will force a retrenchment. The cyclical nature of international trade is well documented. And technological progress, while it will always continue, has not experienced the type of long-term investment necessary to garner returns seen in the 90's and 00's.

The only constant is change. But while most are afraid of change, I prefer to embrace it. Every decade sees enormous secular shifts in our markets, yet most analysts, pundits and economists spend a majority of their time trying to figure out how we can avoid, or blunt the effects of such shifts. It is an exercise in futility. I don't expect to be able to alter people's irrational fear of change. I can only point to it in hopes that some can capitalize on it early.

I will reprint the conclusions from the previous installments in this series.

Part 2 - Credit Markets

On the whole, credit markets have not recovered. In fact, in many areas credit quality has continued to deteriorate unabated. A pending supply of low grade mortgage recasts, along with an overhanging inventory of underwater mortgages will likely force a continuing deterioration in loan performance and further house price declines. Despite accounting shenanigans that allow banks to value their assets at whatever they like, banks' lending ability remains constrained, while the ability and willingness to borrow is also under pressure. The overall amount of debt outstanding is also constraining the economy's ability to lend its way out of the recession. Even with historically low rates, the high level of debt gives us a servicing ratio that constrains our ability to invest in productive capacity.

Part 3 - The Economy

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.

Part 4 - Government

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.

Part 5 - Asset Markets

Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

With all that in mind, I'll proceed to my "Themes for 2010." The normal qualifications are required. Some of these themes will be correct, others will be laughably false. Such is the nature of prediction in a dynamic system. Many of these themes are very long-term in their nature. While pressures may build, many may not necessarily "peak" in their effects until many years down the road. For example, this will be the third year that I have highlighted the stresses in state and municipal governments. I have not necessarily been wrong in the past two years, as the problems have continually grown in both their size and realization in the mainstream. Indeed, it will likely take many more years for a long-term solution to be found. Such is the case with much of the below.

- a resumption in the trend toward deleveraging and falling prices for most liquid assets (stocks, commodities and corporate bonds)
- a consequent rise in the US Dollar Index, perhaps very substantially so as credit contracts
- decreasing global trade and a continuation in protectionist measures, primarily directed toward China
- outright collapse of China's bubble-economy as foreign capital flees. Chinese officials blame everyone but themselves
- movement toward surplus for America's trade deficit
- sovereign debt concerns roil Europe, the Middle East and perhaps even Japan
- state and municipal debt concerns accelerate, pitting unions and pensioners vs. everyone else
- another leg down in North American real estate prices - especially Canada's largest markets
- growing dissent within the Obama Administration as populist anger disables government's favourable treatment of the FIRE industry ahead of midterm elections
- falling salaries for sports stars and actors/entertainers as discretionary spending wanes on event tickets
- relative bright spots will include South America (specifically Brazil, Chile, Colombia and Peru) and personal wireless devices.
- the US manufacturing industry begins a revitalization

Regardless of what happens, I wish my readers a prosperous 2010!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Must Read Articles 05.10

If you're wondering what all the hubbub is about Greece, Portugal and Spain, I've grouped together a set of articles that explain the situation lucidly. Like most of the world's economic problems, it can be summed up by the simple phrase "there's too much debt." But in Europe, individual governments are restrained from printing money to temporarily relieve the stress. The only other cited cure is for public and union workers to take massive pay cuts in order to regain competitiveness. Socialist-leaning governments in these countries are not treating that like a legitimate option and appear to be losing control. They've now resorted to blaming their problems on "speculators." Euro-skeptics have always said this would eventually prove to be the undoing of the Euro. Right now they're being proven correct in spades.

While most of the focus lies on government debt, please remember that private banks in this region are even more susceptible. Credit default swaps (CDS) on Portuguese banks, for example, are up 30% today. That's no small potatoes. And Europe's banking system is just as systemically intertwined as is America's. If Club Med banks start going down, the big northern banks will likely follow.

The only actual solution to this problem is the only one everybody seems to agree is "not a solution." Debt repudiation.

Spanish Canary in the European Coal Mine (Rolfe Winkler)

If PIIGS Could Fly (Neils Jensen, Absolute Return Partners via Credit Writedowns and John Mauldin)

Should Germany Bail Out Club Med or Leave the euro Altogether? (Ambrose Evans-Pritchard)

Funds Flee Greece As Germany Warns of "Fatal" Eurozone Crisis (Ambrose Evans-Pritchard)

And now for some other issues:

Demand For Loans Weakens Again in Fed Senior Loan Survey (Mish)

It is easy to blame banks for not lending money to people who "need" it. President Obama does it all the time. But the problem is not that banks won't lend, it's that there's nobody willing to borrow that is remotely credit-worthy.

Saving, Asset Price Inflation and Debt Induced Deflation (Michael Hudson, via mannfm11)

Hudson follows a similar train of thought as Steve Keen. Neither are Austrians. They both maintain that Keynes was misinterpreted and combined with destructive "equilibrium based" theories. This is the most compelling of non-Classical Liberal theories I have come across.

On Depreciation, Malinvestment and GDP as a Gross Number (Ed Harrison)

All things I like to talk about. GDP is calculated based on aggregate spending data. Not all of that spending is worthwhile and beneficial. In fact, some of it is downright harmful. Eventually, that must be realized. The process of realization is otherwise known as "recession."


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.