At These Levels

This is what I wrote on August 10 in an e-mail to subscribers:

www.bloomberg.com

The S&P US Credit Speculative Grade Index, which measures the difference in yield between junk bonds and “no risk” Treasuries, has been climbed from 316.3 on May 11 to a current reading of 376.8. A similar climb during the March-May 2005 period turned out to be a false alarm. Still, I find it peculiar that during all rally attempts since June, the S&P US Credit Speculative Grade Index kept on climbing, indicating that bond investors don’t share the enthusiasm their equity brethren have tried to exhibit.

From a different perspective, in the spring and summer of 2004, when we had several notable stock selloffs, the same speculative-grade index declined, indicating that the selling in stocks was nothing more than a correction after a big run. The situation’s now reversed: The stock market is trying to rally while junk bond yields are rising.

There’s been a lot of selling into strength in the past week, and small caps and technology stocks have continued to underperform. Combined with the way junk bonds are acting, this says a lot about an institutional desire to take on risk. If the big money isn’t behaving as if the stock market has established a bottom, individual investors should sit tight and not take too many chances.

Now, I was bullish in August for tactical reasons (which was the right attitude) and not so bullish in September, again for tactical reasons (which was the wrong attitude). But here's the same chart, updated to the present day.

www.bloomberg.com

While the S&P 500 made a new high, so did junk bond spreads, which are trading at the highest levels for the year (389, and they look like they want to go higher). This is bizarre behavior. Just as junk bond spreads were falling in the summer of 2004, indicating that selling in the stock market was merely a correction, now they say this stock market rally is doomed (this isn't me saying it, it’s the S&P US Credit Speculative Grade Index; OK, it's my interpretation of that index).

And don't get me started on the core PCE inflation numbers this morning, which were at 11-year highs. Yes, the stock market can be irrational longer than anyone can be solvent, but this blog is not about day-to-day market timing. Some insight won't hurt that much.

On Monday I noted the following in some weekly commentary:

www.stockcharts.com

One big divergence that’s been bothering me the past month is the performance between some of the hottest emerging markets up until the May decline. If you look at Russia (in red in the chart above) and India (in blue), they’ve gone in completely different directions since the beginning of September. Russia is the quintessential resource market, and it’s easy to see that the correction in metals and energy will cause a correction in the stock market there. But that set of circumstances isn't peculiar to Russia; Brazil and many other Latin American markets are also considered derivative plays on natural resources.

It’s a notable occurrence when previously hot emerging markets begin to move in opposite directions. We’ll find out what it means shortly.

I saw an interesting discussion on the BRIC phenomenon that deals with this issue from an economist who's earned the "permabear" nickname. I say that beforehand for a reason.

The new home sales are out, up 4.1 percent in the last month. How can that be? Because the decline last month was much larger than reported then, this month new home sales are UP 4.1 percent from that much worse revised number (which we also got this morning). The year-over-year change is still down 17.15 percent, where last month's YOY change was down 25.83 percent.

www.bloomberg.com

I am sure this is a reason to push the Dow to a fresh all-time high. The chart of the 12-month rate of change in new home sales is above. Follow the blue line and roughly match the dates where the chart intersects it with the dates in this table. I am just reporting here, so please, do not shoot the messenger (no high hopes that won't happen).

I don't believe that the bond market cares one iota about inflation right now. As I write in this week's Global Viewpoints: "On Monday, the stock market, the bond market, the dollar and gold all moved higher without much rhyme or reason, because of this man. September hasn’t lived up to its bad reputation, leaving both stocks and bonds notably overbought. Which one is it: the slowing economy suggested by the bond market, clearly ignoring the inflation numbers, or the strong economy indicated by the stock market?"

John Hussman doesn't buy the "Goldilocks" story either, but I have to repeatedly remind myself that the market can be irrational longer than one can be solvent. I mean, repeatedly. We have new five-year recovery highs on the S&P 500. Please, keep that in mind when you read the following excerpts:

“Core” inflation is an interesting animal. The notion of “stripping out volatile components” isn't too objectionable, provided that deviations in those volatile components average out to zero over modest periods of time. But over the past 4 years, for example, the annualized inflation rate in the CPI has been 3.07%, while “core” inflation has averaged just 2.00%. The "core" figure is clearly doing more than just reducing volatility – it's leaving out components that have been in clear uptrends, and is therefore understating an index that's probably already understated due to factors like “hedonic” adjustments, “rental equivalent” housing costs, and the like.

The best we can say is that over the past two months, various inflation figures have been coming in a few pips below “consensus estimates.” That's good news as far as it goes, but with, for example, intermediate goods prices up 8.72% over the past year (though a smaller 5.94% annualized over the past two months), it's a far cry from a major reversal in inflation trends.

Also:

In the meantime, we have a combination of an inverted yield curve and Treasury bill yields narrowly above the rate of inflation. That pair of conditions has generally been associated with hard upward inflation pressures. Now that the weak Philly Fed report (as well as relentless weakness in the leading indicators) has thrown some cold water on the “growth” part of the “Goldilocks” thesis, the inflation side has become that much more interesting to monitor. My impression is that the whole theme – both the “resumed economic growth” and the “subsiding inflation” parts are wrong. Investors, both in stocks and in bonds, have impounded the Goldilocks thesis into prices, so there's a lot riding on the next couple of months of data.

The whole report is here.

He has done it again

A friend of mine was ecstatic about the gas price drop and asked me: "Are they doing that?" "Who is they?" I asked. "You know, for the elections," he replied.

I don't know if "they" are behind it; oil generally has negative seasonality going into the 4th quarter. But, clearly, my buddy and the public loves it, although for two days the market is getting hit on soft economic news and is ignoring the gas price fall. From UBS this morning:

INVESTOR OPTIMISM SURGES AS GAS PRICES FALL

UBS/Gallup Index of Investor Optimism at 74 – Its Highest Level Since March

Energy Price Concerns Decline Significantly

Real Estate Market Conditions Continue to Worry Investors

NEW YORK, September 25, 2006 – Investor optimism surged in September to 74, its highest level in five months, according to the UBS/Gallup Index of Investor Optimism. The 21 point increase from last month follows a downward trending in investor optimism since the beginning of 2006, which reached a low point of 53 in August. The Index is conducted monthly and had a baseline score of 124 when it was established in October 1996.

Much of the surge in optimism can be attributed to the sharp drop in investor concerns about energy prices. The percentage of investors who believe energy prices are hurting the investment climate “a lot” fell from 78 percent in August to 63 percent in September. This represents the lowest level of investor concern about energy costs since February 2005 when 56 percent of investors held this view and a sharp contrast to the 80 percent who felt this way in October of last year.

The fall in energy prices over the last month has also impacted investor expectations for future gas prices. In August, investors expected the average price of a gallon of regular gas to reach $3.30 in the next three months. In September, however, their expected average price for a gallon of gas three months from now is down to $2.76.

“This sharp rise in optimism demonstrates the significant degree to which high energy prices affect investor sentiment – both with regard to the potential impact upon growth as well as the threat of higher inflation. We therefore expect that lower energy prices will also positively influence consumer confidence,” said Mike Ryan, Head of UBS Wealth Management Research Americas. Investors seem to believe that the U.S. economy is headed towards a so-called “soft-landing.”

Fifty-one percent of investors describe current economic conditions as showing signs of an “economic slowdown” while 38 percent feel the economy is experiencing a “recovery” or an “economic expansion.” Only one in ten investors believes that the economy is in a recession.

Today I have only a chart of the Nasdaq Volatility Index (VXN), which is on the verge of the Mother of All Breakouts. To read up on what that means for stocks, see here. And the bonds are trading as if the economy’s growth rate will be cut in half, at least.

www.stockcharts.com

Jeff Matthews remembers what caused one of those volatility spikes back in 1998 and puts it in perspective. The FOMC lows on the S&P 500 and the Dow are now gone, which many times signifies a turning point, as suggested yesterday.

It's pointless to say anything before the Fed statement. I’ll try to get in a few words tonight after the close (or later). So far, it’s Yahoo against Oracle and the oil freefall is helping. But the market is terribly overbought and Fed statements have served as turning points in the past. Acceleration higher from current levels is doubtful in my view, but I've been early to look for a top by about 2 weeks. I still don’t trust this tape.

UPDATE 5.35 PM:

Nothing was decided today. The FOMC statement didn't change much and neither did Mr. Lacker’s opinion. Sometimes the real moves start the day after the Fed meeting, but again, how we get upward acceleration here is beyond me.

I have to say that John Hussman blows me away with his intricate spot-on discussions on market technicals. After all, the man has Ph.D. in economics and he was in academia before he became a money manager (and a good one at that). Market timing is extremely important. Most of the reading I do is probably 80 percent economics and fundamental market strategy, and it never ceases to amaze me how few smart people appreciate the art of market timing. Those things are not mutually excusive, you know.

I just got this from Merrill Lynch, obviously for PR reasons. The actual report is 31 pages long, but I won't post that here. I sure share many of their views, but I'm not sure I reach the same conclusion. One thing is sure: They have a lot of money behid that view. See for yourself:

U.S. DOWNTURN WON’T DERAIL WORLD ECONOMY

LONDON and NEW YORK, 18 September - A sharp slowdown in the U.S. economy in 2007 is unlikely to drag the rest of the global economy down with it, according to a research report by Merrill Lynch’s (NYSE: MER) global economic team. The good news is that there are strong sources of growth outside the U.S. that should prove resilient to a consumer-led U.S. slowdown.

Merrill Lynch economists expect U.S. GDP growth to slow to 1.9% in 2007 from 3.4% in 2006, but non-U.S. growth to decline by only half a percent (5.2% versus 5.7%). Behind this decoupling is higher non-U.S. domestic demand, a rise in intra-regional trade and supportive macroeconomic policies in many of the world’s economies. Although some countries appear very vulnerable to a U.S. slowdown, one in five is actually on course for faster GDP growth in 2007.

Asia, Japan and India appear well-placed to decouple from the U.S., though Taiwan, Hong Kong and Singapore are more likely to be impacted. European countries could feel the pinch, but rising domestic demand in the core countries should help the region weather the storm much better than in previous U.S. downturns. In the Americas, Canada will probably be hit, but Brazil is set to decouple.

2- Global Growth Beyond The U.S.

U.S. slowdown will be consumer-led

The much-vaunted housing market correction, which has finally hit the U.S. economy, has the potential to pull the U.S. to the brink of recession by early 2007. Judging by past experience, housing starts decline by 50% peak-to-trough and the correction lasts well over two years. This time around, the correction has the added twist that housing has become extremely overvalued – by 20% at least and perhaps as much as 40%. Merrill Lynch expects an outright decline in housing prices of about 5% next year.

The combination of the decline in home prices and the slowing in the growth of housing stock is expected to reduce housing wealth by more than U.S.$ 1 trillion in 2007. This, in turn, will likely mean that U.S. consumers will spend 1% less for most of next year and double that figure if house price falls are more severe. The only bright spot is business investment, which is set to be robust due to healthy profit margins, high productivity growth and strong corporate balance sheets.

Japan is global star...

I don’t know where Barry gets the time to make these excellent points, but if before rounding the annualized core CPI is 2.9 percent, that would put it at over 10-year highs (as high as early 1996).

www.bloomberg.com

Now, the bond market did like the news initially, but then sold off and ended down almost on the low tick of the day. Stocks lost the opening optimism, but ended up (many of them on the desired strikes as it is option expiration day). And we have PPI numbers next week…

www.stockcharts.com

Am I reading too much into this, or did, after all, the “punk” run out of bullets?

Well said. And about the CPI tomorrow at 8.30 am, this is where Dirty Harry would ask: "You've got to ask yourself one question: 'Do I feel lucky?'....Well? Do ya, punk?". I forget, but I don't think the "punk" made it.

CPI UPDATE 9/15:

The core rate (see chart) is at a fresh five-year high at 2.8 percent, above the fed's comfort level of 2-2.5 percent and clearly accelerating in 2006. That's a reason to celebrate? The market thinks so, for the moment anyway. I look forward to the close; the opening gap in the index futures has to hold for this to be a bullish day. Rule of thumb: Overbought breakouts don't work, but I can clearly see how oil is helping sentiment as it's dawn yet again. Talk about a relentless decline…

www.bloomberg.com

If true, as I heard this morning, it could explain why there were so few hurricanes. Here's a detailed account of what it means for the economy and here is Shell's CEO talking about oil prices. Shell is also big in liquefied natural gas and I recommend it for a model portfolio (it's up about 50 percent since recommended). No one argues the long-term bull market in energy – there is one – but you figure no war in Iran on top of an El Niño can make the correction in energy more extreme? Just askin'.

A reader referred to Ned Davis here and made some good points. Here is his recent take on the market.

For some bizarre reason, the bid prices on my streaming quotes are off by a lot. I wasn't surprised to see the market bounce off support--I was surprised to see how much it bounced. The futures on the major averages traded into the gap where they broke down last week. This is a patented futures traders' trick. If the market is illiquid, run it to fill gaps. You can see that on the SPY chart below (SPY volume correlates closely with futures volume).

www.stockcharts.com

As I said yesterday, the market has not broken down yet. I'd consider the breakdown kosher if yesterday's lows are taken out.

John Hussman has an excellent market commentary this week:

It's not unusual for people to magnify trivial differences when the stakes themselves are trivial. Call it a scarcity mentality. My impression is that this sort of mentality is present in the financial markets here.

Over the past two-and-a-half years, returns to both Treasury bonds and the S&P 500 have been well below-average. Interest rate levels are still muted despite wage pressures and other inflationary indications. With no persistent benefit from capital gains, fixed income investors have been stretching for yield, allowing risky corporate bonds to trade at nearly the same yields as default-free Treasuries. In effect, investors are taking higher risks precisely because the stakes are so low. Of course, the potential negative outcomes could substantially exceed the extra interest margin these investors are receiving, but it's historically been the nature of junk bond investors to stand around in smoky rooms until they actually see the fire.

From its intermediate peak on March 5, 2004, the S&P 500 has earned scarcely more than the 3-month Treasury bill yield (on any given day, the exact figure ranges between 2-3% annualized, depending on whether the market is at a short-term peak or trough). Yet every trivial advance to a temporary peak is hailed by analysts and floor reporters as if the stock market is “breaking out” and soaring without bounds. [Note: See yesterday's blog post]

Also:

The recent inflation data is another area in which investors are magnifying the trivial. For the most part, the excitement about “moderating inflation” in recent weeks has been based on the thinnest “positive” surprises, generally on the order of rounding error. Last week's upward revision in 2 nd quarter unit labor costs threw a bit of cold water on that excitement, as year-over-year figures exceeded 5%.

Given that initial disappointment in the “inflation is going away” thesis, Friday's CPI data will be interesting. (my emphasis).

Indeed it will. You should take notice, as bad CPI numbers will set off some real fireworks.