The 2Q10 GDP report came out and it was an eye opener for many people as it showed that the recession, depression, was deeper than most believed and things are surely not as rosy as we are being told. Aside from the inventory rebuild there is not much else going on, final sales are dead as a door nail and some firms, like Samsung, are reporting good earnings, but warning of weaker times ahead. I take the Samsung warning pretty seriously as they are a large or the largest supplier of electronics which had shown signs of strength recently. So when they say things may not be rosy in the near future I suspect that will apply to more than just TV sales.
What made the news cycle this week was a report by Fed President Bullard about the threat of a Japanese style deflation here in America. I am kind of shocked that people were caught so of guard by this news, about 10 economic data points already indicated this to be if not already occurring a very real near-term threat. I suspect we are in for some really tough times ahead and worse yet I suspect we will see the Fed start moving towards quantitative easing, again. As I have said, repeatedly, this will not do anything to boost economic demand as we must wait for the deleveraging cycle to be completed by the consumer before demand will return. Zero Hedge just wrote a piece about this tonight which illustrates exactly what I have been saying for a month now, but no one is listening. Here is what they said:
“In other words, all those who say QE2.0 will do nothing to stimulate the economy are correct, as all such a greenlighted action would encourage is the warehousing of yet more cash by banks.And since banks have no incremental incentives to lend it out, it doesn’t matter if the Fed’s liabilities are $2.5 trillion or $2.5 quadrillion. Instead of stimulating inflation, which is the end goal, all such an action would do is to create further doubts about the stability of the dollar, which in turn, as Ambrose Evans-Pritchard discussed, is a sure way to go to hyperinflation without first passing either Go, or inflation.”
They also indicate my thoughts exactly, we bypass money velocity inflation and go straight to dollar devaluation, i.e. currency crisis, hyperinflation. The irony is that you would only feel this pain on imported goods and we do consume 87% of what we produce domestically so it may take some time before any real currency devaluation hits home. Regardless, Bullard indicated along with prior reports by Ben Bernanke himself that QE is on the table. The question is what kind of QE, treasury purchases or other asset purchases? Also, how much, I bet $3-5T in total purchases, but who knows.
What we do know, compliments of David Rosenberg, is that Ben Bernanke said IF we hit a Japanese style deflation that the target rate on the 30 year treasury would be 2.5%. Rosenberg says that if we hit that rate, down from the current 4% yield, one would receive about a 30% rate of return. I think he is right and if one followed his recommendations of treasuries and gold, along with high yield stocks, you would have avoided much volatility this year and had nice returns. I am happy to say I bought 2’s and 5’s when the yield was 1.10% and well over 2% so I am happy. I suspect the rally in treasuries will continue and if QE happens, wow.
The trade of the century, although risky, would be to leverage a long position into the 20+ year treasury market, UBT (2X bull) or TMF (3X bull). IF Rosenberg and I are right and this happens, QE, deflation or a major selloff in equities, those positions would do very well. However, they are risky, they are leveraged ETF’s, but if you time it right I believe that you could do very well. I also believe that the bull market in bonds is in full force again, very similarly to the summer of 2008 I might add which adds a bit of mystery to the rally in treasuries. The mystery is, what is going on and is the bond market telling you that something really bad is coming?
A look at the chart above looks like there is something going on in the bond market. We broke above the 123/4 mark on the 30 year futures and now that is support. I believe it goes higher because of, at least, of deflationary pressures and, at worst, because of QE. However, while I am short-term bullish on treasuries I hate them long-term since it will be impossible for the U.S. to meet its long-term debt obligations which means they will default somehow in the future, in my opinion. I also believe, as stated earlier, that QE will wreck our currency maybe not now, but at some point in the near future which makes gold very attractive as well. If QE is announced treasuries will go nuts and so will gold. If one is levered into treasuries you could do well, if you want the risk.
What QE means for stocks, I do not know. I would think QE would be bad for stocks as it signals things are not good and the economy is weak, but we are living in bizzaro world where good news is fantastic and bad news is even better.
Initial claims came in at -457K this morning, this is not good, and last week’s figures were revised from -472K to 476K, really not good. This has little to do with the oil leak in the Gulf and anyone making that claim disqualifies themselves from the conversation. This has to do with a weak economy, pure and simple. We are entering a double dip recession and as the stimulus is pulled back it is going to get worse, much worse.
Your first warnings came from Best Buy and Fedex, but no one listened to what they had to say. Frankly, the real warnings were always in the weekly claims reports, but everyone dismissed them as a “lagging indicator” which is simply not true in a post credit collapse economy. If we were in a normal inventory recession I would agree that employment is a lagging indicator, but when the economy blows up because people cannot pay their bills, well, employment is a leading indicator. That is where economists missed the mark and failed to adjust their models, those that fail to change will go the way of the dinosaur, it is inevitable that natural selection weeds out the weak and that is what is happening now.
To top off the situation we did the worst thing possible, we tried to cure a debt problem with more debt. You cannot do that, it just doesn’t work. Take a look at Greek bonds, the 10 year is over 10% again, why? They have austerity measures in place. They have access to special funding, etc. yet their bonds are yielding over 10%. That is telling you there is no fix for the problem as the smart money is always, I cannot stress this enough, always in the credit markets. We have treasuries climbing with 2 year yields pushing .64%! Are you kidding me? This is not normal and while I bought when yields hit 1.10% on the 2 year, taking much flak from friends and family I might add, I figured the yield would drop to .77% or so, within the trading range, but they broke out. This is a sign that things are not as they seem and extreme caution is merited. Where treasury yields can go is the big question, certainly zero is not out of the question and negative yields have happened before, watch the credit markets.
Europe is a problem and will continue to be a problem, remember that the EU is China’s biggest market and the EU is responsible for 30% of the S&P 500’s earnings, not an issue for 2Q, but 3Q I would not be long in 3Q. Unemployment in the U.S. will climb higher, I am sad to report, especially as Europe deteriorates and much to Mr. Krugman’s chagrin forcing the EU members to increase their deficits is not a good idea. Their deficits are the problem and making them bigger will not solve their problems. Europe could lead to much higher unemployment in the U.S. and one has to remember that Europe did make the Depression much worse in America in the 1930’s as well, history does repeat itself.
To top it all off we do have the moratorium for drilling in the Gulf, it may get overturned again, but assume it will not. What does that mean? That means at least 10,000 jobs will be lost within the first few weeks. After that it could get worse as it creates a negative feed loop and the loss of one job means others will lose their jobs over time. From my lens the moratorium is insane. The leak is horrible, we all know that, but this is the first oil leak we have had in the region, ever, out of how many wells? Perhaps if the government puts a safety inspector on each rig that may solve the safety concerns, but that idea was rejected. Instead, let’s halt the entire industry and watch them all go to Mexico or Brazil instead so we can lose those jobs for years to come in the best case scenario or forever in the worst case scenario.
Employment is indicating things are mildly better, but merely stabilized at “less bad” which is not good overall. Housing, the release yesterday, solidified that we will have a double dip as housing is about 21% of GDP and we just saw the worst housing data since they started recording the data series. How much more evidence do we need to have? We also created false demand which means we had distorted housing data for the past year. How in the world are we supposed to know how far forward we pulled demand? Months? Years? This is the problem with Keynesian economics especially when it is used wrong, which we certainly did.
The bottom line is this, unemployment is going to grow outside of government rolls, period. Housing is going to go lower meaning GDP is going to be bad in the second half of this year, if not negative. The employment report, due out soon, will show more government jobs which will not be positive for the markets. The ISM surveys are rolling over. The leading indicators are pointing down, hard. Inflation is nil right now. Treasuries are telling you something big is going to happen. Europe is in major trouble. How you can believe the long only permabulls being paraded on the TV is beyond me. They get paid to have your money in their funds whether it goes up or down. I get nothing whether you invest or not. Frankly, the facts at this point are irrefutable.
The past 2 weeks we have seen the markets do things that simply do not seem natural from freefall flash crashes to intraday 300 point turn around rallies. However, there is one thing that is pretty clear, I would not buy this pull back. As David Rosenberg points out and a few other non-perma bull market strategists, not that there are many left, point out is that these wild swings are not normal in a bull market.
Think back to the market of late 1999 to the early 2000 and you will remember such swings, but do you remember how it ended? If you bought on those dips you never made your money back, ever if you bought the NASDAQ and you would have barely broke even in the S&P 500 if you sold at the peak in 2007. I think it is safe to assume that this market action is a sign of a sick overbought market trying to lure you in to buy one more time before it robs you blind, don’t do it. To be clear, I believe the broad market will move lower, I think 900 to 950 is not an unreasonable target, but we could move much lower than that. Before you say it, no the fundamentals are not so strong that we could not see the lows of last March, more on that in a minute.
I am not saying do not buy great individual companies, not at all, I am bearish on the market, but I like some individual names. I am bullish in the biotech area as there are tons of patents expiring in the next few years and you will see big pharma buy many of these names, but I also like big pharma too. Look at the yields and the rock bottom P/E’s, they are dirt cheap and you should look at some of these names, but biotech is not a prisoner to the business cycle, as long as it is well funded and near approval for a drug. I also like consumer staples that pay dividends, boring names, but they pay you to hold them and no matter what the economy is doing you will always need toilet paper and a toothbrush, I hope at least. I also still like high quality bonds and can make a case for treasuries right now, but use your own discretion, I would stay away from high yield, I sold mine a couple months ago.
Why do I think boring and income is the best model right now? Well, the market is going to correct even more than it already has, kind of a simple explanation. Income strategies, which I have been on the record for supporting since last year, makes sense because we are living in disinflationary, possibly deflationary, times where real yields are much higher than what we think. I am a long-term inflationist, come on look at all the money being printed and Obama wants to double exports in 5 years, you cannot do that with a strong dollar, but right now deflation is the name of the game and income makes sense. Deflation also means stocks need to be trading at much lower multiples than most people think and that is why I think this correction will potentially be much deeper than most people believe. Time will tell who is right about that.
The Fundamentals!
What about the fundamentals? Are they better than a year ago? Sure. Do they support a 20 P/E multiple on the S&P 500? Nope. Do you really think the housing data since the homeowner tax credit implementation was actually real data? No way. How about unemployment, do you believe temporary jobs are going to lead America to the next level of prosperity? Well, all the amazing job growth has been only in the temporary job area, let’s not forget that the actual employment report numbers are tinkered with via the birth/death model which added 188K jobs to last month’s employment report. For those of you who don’t know, the birth/death model are estimates the BLS uses to predict how many new business are started based on how many business died and population growth, it is fantasyland stuff basically.
What about corporate earnings? They have been good, but I do not believe they are sustainable. First, the stimulus is running out, that is a very important thing to remember moving forward. Second, a cool 30% of the S&P 500’s earnings come from Europe and up until lately U.S. companies enjoyed, globally, a weaker dollar which is over since the new sovereign debt issues are driving the value of the dollar higher. In technology a large percentage of earnings came from Asia and I do not believe that will continue much longer because of what is happening in Europe, Greece was a big deal indeed.
You see, Europe represents 20% of the worlds GDP and, believe it or not, China’s top importer is not the U.S. it is the EU. So, if the EU is going to have lower growth because of austerity measures, which they will, it will automatically be a drag on world GDP, but it will specifically hurt China. If China begins to slow down that is very bad news since China is “the recovery story of the world” or some other tag line the media gave it. In other words, China will be buying less from the U.S., exporting less to the EU and the EU will be buying less from the U.S. Also, China will be running, more than likely, trade deficits not surpluses which means they do not need to buy our debt. Can you see the problem now?
Greece is/was a big deal not on its own, but because it was locked in with the other PIIGS which were locked into the EU as a whole. It is all very bad news and no matter what CNBC says we are all still coupled with each other. It is the interlocking of the global economy, especially in the debt markets, that is the problem and there is no escaping it. I am afraid that even when governments guarantee debts that may not be enough anymore because, as the price of gold is proving, people are losing faith in money. Our whole system is based on faith and when that faith is damaged that is when problems get out of control and I believe we are just about at that point. The rumor yesterday was a .50% rate cut, how is that good for the Euro? If anything that would have brought it closer to parity to the USD. Printing another trillion just won’t calm markets because it means nothing. At this point I cannot see much of anything from Europe that will calm the markets.
The only things they can do is let the PIIGS default on their debt and kick them out of the EU, not necessarily in that order. Anything else will just prolong the problem and the printing press is the cause of the problem, not the solution.
The smart money is always in the bond market, mostly because it is institutional money instead of retail investors. Anyone watching the last 2 treasury auctions see something wrong, a major problem in fact. The auctions were duds, dare I say failures? The primary dealers are taking in a large swath of the last 2 auctions, this has actually been a trend over the last few weeks, and the direct bidders are now gone. Yields are perking up to levels not seen in months, something isn’t right.
Whether it is sovereign debt or the markets frothy valuation, the bond market is signaling trouble ahead. Yields are not increasing for any good reason other than there is no demand for the hundreds of billions the U.S. needs to raise to keep the lights on. Perhaps the market has had enough or the Chinese are just not buying because Krugman and Schumer called them currency manipulators, you never make your largest lender mad at you when you need to raise billions of dollars.
Either way you look at this there is a problem and I do not know what it is other than a general buyers strike. However, what scares me is that this is following some historical events. In the late 1970’s there was a huge treasury bubble and rapid inflation, this is no secret, which led to the dollar’s decline in value. This was no big deal until the treasury bubble burst in 1980 and the treasury market imploded. What happened was treasuries sold off and the primary dealers, still in bubble mode and required to suck in supply, began to buy when prices went lower. Their thought was this was a steal, it wasn’t. This happened for a few days and prices continued to decline to the point where the primary dealers were on the verge of failure.
This was a serious situation as the companies that raise money for the government, the primary dealers, were almost all gone because of massive losses, they bought on leverage of course. This led to Volcker doing what he is famous for and Carter issuing credit controls. No one talks about this, and I overly simplified the story, but it was perhaps the days that almost ended America. I am not saying this is happening now, but if the primary dealers have to bring in supply and the prices on treasuries keep dropping, this could be a major problem. Of course, everyone is too big to fail, but still.
While I do not know if this is a short-term problem or the beginning of bond buyers telling the U.S. to get its act together, I believe it is the vigilantes, I do know this has serious potential problems. We need to wait to see what happens over the next few weeks, but more ‘failed’ auctions may be a problem bigger than a worldwide embarrassment, but our lenders cutting up our credit card. This will lead to more quantitative easing and dollar destruction which would mean we would actually begin to see higher prices without money velocity, don’t think that can happen? It can and just might happen.
Most disturbing is that we are talking 5’s and 7’s that could not get placed, that is easy paper. I sure hope Washington is worried enough to take the national debt situation seriously after this week. If they do not we all could be in for a rude awakening very quickly.
The Fed just raised interest rates to .50-.75% on the discount window. What does this mean? Nothing. It is simply just a measure to shut people like me up and to encourage banks to go to the private markets for capital. Essentially, this was a populous encouraged move and will have a negative impact on equities, but do not concern yourself with this.
This hike will not hurt corporate bonds, but treasuries and equities, ouch! The bottom line is that the Fed is not selling its assets so, again, this is meaningless at best. If they raise rates above 1% then be worried, but other than that, who cares. Ben, apparently, has just had enough of the negative mean people like me. However, this could prove difficult for Treasury as they have to place so much paper on to the Street. It is also a move to “prove” that this statistical recovery is for real, which it is not. A meaningful rate hike would be well above 1%, don’t hold your breath for that anytime soon.
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