March 25, 2013

The S&P500 managed to lose only 0.24% last week. Volatility crept higher, suggesting that concerns against greater losses were being priced in. Volume, as has been typical over the last two years, was very low and trending lower (ie. the first quarter’s volume was notably lower  than volume in the first quarter of 2012). And this flies in the face of everyone on mainstream media touting how the small retail investor was ‘coming back’ to the stock market and ‘rotating’ out of bonds. If that were true, then equity volumes would be rising, not shrinking. And more importantly, the disappearing volumes imply that the recent price gains have been built on a foundation of quick-sand, and that any  disturbance to the upward momentum, whether it’s Cyprus or anything else, could lead to a quick and vicious sell-off.

In macro news, housing starts disappointed slightly. While the housing ‘recovery’ engineered by the Fed and the Treasury seems to be pushing prices up for now, it’s important to remember that this is not happening because the housing market is recovering organically, and when these government policies are pulled back, the US housing market will very likely begin to struggle once again. Initial jobless claims have been hovering near the mid-300 thousand range for several weeks. Existing home sales, while rising, missed expectations. The Philly Fed survey came in slightly better than expected, as did the leading indicators index, which being driven by the rise in stock prices is arguably a somewhat circular measure (stock prices up, so leading indicators up, so more stock price increases).

Technically, the US stock market continues to be extremely over-bullish and over-bought. History very strongly suggests that at these levels of over-bullishness, even the slightest disturbance could lead stock owners rushing to the exits to avoid losing the substantial paper gains achieved over the last several months. The problem is that history also suggests, strongly, that almost all investors who believe they’ll  be able to ‘get out’ before any real damage hits them are wrong……most will get caught in any severe pullback.

And speaking of pullbacks, it seems that—for now—Cyprus may not be the spark that triggers one. As of this writing, the island nation has apparently struck a deal that would presumably avoid a collapse of its banking system.

But at what cost?

Well for one, many depositors who hold more than 100,ooo euros will suffer massive confiscation of their money. Nobody even knows for sure what the haircut will be, but it mean a loss as high as 40% or even 50% of all balances above 100,000.

Another consequence is the imposition of capital controls, to try to prevent the thousands of depositors who have been burned, and who were almost burned, from withdrawing money from their Cyprus banks accounts. Cash withdrawals have already been restricted, and restrictions on large electronic transfers are sure to follow.

These developments have created a shockwave, not only for depositors in Cyprus banks but depositors in all euro-area periphery nations, also known as the PIIGS.

The psychological damage will be devastating. All of these depositors will rightfully ask, if this damage can happen in Cyprus, why can’t it happen in Spain, Italy, Portugal, etc.?

And the answer is that it most certainly can.

As a result, many will begin to quietly withdraw euros from their accounts in these periphery states, especially folks and businesses with balances above 100,000 euros.

This will most definitely lead to financial stress in the euro area banking system.

So while the future consequences remain to be seen, we can almost guarantee that they will not be good.

Cyprus…..a Market Tipping Point?

March 18, 2013

While the week ended on another Fed-inspired high note (the S&P rose 0.6%), the weekend began with a stunning development in Cyprus, a member of the euro. More on this below. US equity market volume was abysmal, as one would expect when retail participation is missing (ICI confirmed another weekly OUT-flow by retail investors from US stock markets).

Meanwhile, the US economic ‘recovery’ continues to struggle to gain any serious momentum. Although retail sales (ex-autos) rose more than expected, the actual ‘un-adjusted’ sales FELL, for the first time since 2010. Import prices rose more than expected; this hurts profits and GDP growth. Producer prices rose more than expected. Consumer prices also jumped more than expected; this affects the ability of consumers to buy more goods, which in turn, hits economic growth. The Empire State manufacturing survey rose less than predicted. And finally, consumer sentiment collapsed. In fact, it missed expectations by the greatest margin ever.

Technically, the S&P ended the week even more overbought and over-bullish than it was the week before. Being so stretched, the US equity markets have become extremely vulnerable to even the slightest excuse for a sell-off. And as the weekend began, Cyprus could develop into that slight excuse, and possibly much more.

What happened? Simple—the EU for the first time since the crisis began several years ago, has decided to impose LOSSES on bank depositors. Normally, bank equity holders and then bank bond holders take the brunt of banking writedowns, not bank depositors who understandably do not believe that they are speculating of even investing in a bank. Instead, they are simply storing or warehousing their money for safe-keeping, almost always giving up all chances of significant returns on their money, in exchange for the guarantee that their deposits will be safe.

To add to the insult, the Euro area offers (normally) a guarantee that all deposits, in Euro area banks, under 100,000 will be protected. Even worse, as late as Friday the day before the confiscation was announced, the government of Cyprus publicly insisted that depositors will be protected.

And then boom, the opposite happened.

What are the implications? Well, the most important implications will be in the rest of the Euro area, not Cyprus which is a tiny part of the entire project. The bottom line is that the Euro leaders are gambling with the entire Euro area financial system. If depositors in Spain , Greece, Italy, etc. begin to worry (and after this bombshell in Cyprus, why would they NOT worry?) that their deposits in their respective banks may also be at risk of confiscation, then they would naturally begin to pull money out of their banks.

This would trigger a bank run, not just on one bank, but on the entire Euro financial system. If this run gathers steam then not only would global equity markets plunge, but the entire Euro project would almost certainly blow up.

Cyprus could be a major tipping point, for markets and for the global financial system.

If Gold Falls, Buy It

March 11, 2013

The S&P 500 continued its march higher into bubble territory, rising 2.17% last week. Volume continued to shrink, meaning that this is a rising market that fewer and fewer ‘investors’ believe in or wish to participate in. Volatility dropped back down to the complacent levels seen in January and February, but not lower simply because VIX has historically never gone much lower.

Meanwhile, the US economy continues to muddle through. Although ISM services rose slightly more than predicted, factory orders contracted. International trade was worse than predicted, and this will have a direct—negative—impact on GDP growth. Initial jobless claims were slightly better than expected, but productivity and labor costs were not (ie. corporations are seeing unit labor costs surge and this will hurt future profitability). The big number of the week was the payrolls report, and it beat expectations by rising almost 240,000. And unemployment fell to 7.7%. But under the surface, the reality was much more ugly. The labor force participation rate fell; this means that while the headline unemployment rate looks better, than more and more discouraged unemployed people are simply giving up and leaving the workforce. Most importantly, the strong headlines ignored the quality of the jobs created. The reality is that about 500,000 part-time jobs were added in February, BUT at the same time about 250,000 full-time jobs were lost. The result is a net addition of about 250,000 jobs, but they were essentially all part-time jobs! Not good.

Technically, the S&P is, once again, extremely over-bought and overly bullish. As mentioned earlier, the US stock market is in a condition that resembles its condition in 1929, 1987, and 2007 (according to economist and money manager John Hussman). Does this mean that a crash is around the corner? Of course not, but it does mean that the US stock market is extremely vulnerable to a severe correction.

What about gold?

It’s fallen about 18% from peak prices reached in mid-2011. The good news is that it’s still in a bull market, 12 years after it began. And the most critical driver of rising gold prices—negative real interest rates engineered by the Fed—is still in place today and in the foreseeable future.

The bad news is that gold is vulnerable to more declines in the short to medium term. If the US equity markets do take a tumble, and if gold behaves in a way that echoes its movement in 2008 when US equities last suffered from a bad tumble, then gold could take another notable drop before resuming its long-term uptrend.

How far?

Well, gold fell about 35% in 2008, without breaking its uptrend. If the same 35% were applied to the most recent peak price (about $1920), then gold could fall to the mid-1200’s.

But again, even if gold were to fall into the $1,200’s remember that this would still NOT break its 12 year bull market!

What to do if it falls anywhere near these levels? Simple, buy it.

The Fed will not walk away from risk asset markets and the financial system. And the ONLY tool it has left to deploy is to push real interest rates even further into negative territory by printing more money. And this will inevitably be bullish for gold, in the long-term.


When the Music Stops……

March 4, 2013

The S&P500 inched up 0.17% last week on typically weak volume. Volatility went the other way; the VIX rose over 8%. Amazingly, the US equity markets suffered their worst losses of the year on Monday,   after getting spooked by the election results in Italy, but then spent the rest of the week brushing off that concern and any others that have been building up for months.

The US economy continues to struggle. One of the most important, but largely unknown, leading indicators of GDP growth fell substantially. The Chicago Fed National Activity index fell from a former 0.25 reading to a negative 0.32 reading. The Dallas Fed and the Kansas City Fed manufacturing surveys also disappointed. Durable goods orders missed; but durable goods ex-transportation beat expectations. Revised 4th quarter GDP also missed badly, coming in at only 0.1% instead of the hoped f or 0.5%. Initial jobless claims beat expectations, but un-adjusted claims still high. Personal spending met expectations, while personal income collapsed. That means that the personal savings rate sank as more and more Americans are scrambling to pay for essentials. While ISM manufacturing beat consensus estimates, construction spending fell the most in almost two years.

Technically, the S&P500 is weakening on the daily charts. While it is still severely overbought on both the daily and weekly resolutions, it appears to be losing momentum on a day-to-day basis. Breadth is also weakening. The percent of stocks above the 50 day and 150 day moving averages has started to turn down notably.

Back in early 2007, when many insightful financial experts were warning that the credit bubble, and the possibility of its bursting, could lead to deep financial market problems, several leading executives rejected the warnings by asserting that they had the wisdom to see and the agility to react to any troubles….if they were ever to hit.

The current CEO of Citigroup famously asserted that it the music is still playing, then we have no choice but to keep dancing. Surely, the experts at Citigroup were smart enough to know when the party was about to end, if it ever were to end at all, and then they could surely be quick enough to sneak out the back door  before the music stopped and chaos ensued.

Of course, Citigroup failed. It failed to see the Global Financial Crisis arrive in early August 2007, and it failed to react properly by not being able to ‘leave the party’ before getting ensnared in the ensuing financial collapse. For all intents and purposes, Citigroup failed as a financial institution, and the only reason its doors did not close was because the US taxpayer (directly through programs like TARP and indirectly through money printing programs courtesy of the Fed) kept in alive.

So why was the CEO’s assurance so blatantly false, especially in retrospect?

One reason is that it’s almost impossible to know for sure when a crisis will hit precisely. Almost all of the experts on Wall Street got it wrong. Citigroup was by no means alone.

But the more important reason is this—if everyone is buying and holding overpriced securities (the core component of the ‘dancing’ analogy), and even if everyone holding these securities knows that the music is about to stop, then WHO will everyone SELL to when the music stops.

By definition, when the music stops, all the marginal buyers will presumably also be aware that the party is over. WHY would they buy securities at artificially inflated bubble prices?

The obvious answer is that they wouldn’t.

Would new buyers step in and buy at any price? Of course, but that price is often 20%, 30% or even 40% LOWER than the price prevailing at the bubble peak.

And the higher the bubble prices keep climbing, then typically (as demonstrated countless times in history) the greater the subsequent discount must be to entice new buyers.

So if you continue to cheer on the rally, great. Enjoy the ride. But try not to forget that you will almost certainly not be able to sneak off the dance floor when the music stops.