Morgan Stanley’s piece on Treasuries Priced for Perfection…for Now! is pretty bearish. The basic gist is that while the ten-year represents fair value today, because inflation expectations have become unanchored, Morgan Stanley expects the yield to rise from 3.3% to 5.5%. That’s a disaster of 1994 proportions. Obviously, given some of my recent comments, this is not what I expect to happen, but be well aware of the risk; in this economic environment, it would be fatal.

Here’s an excerpt of what Manoj Pradhan had to say (emphasis added):

Fed Chairman Bernanke’s speech on Monday could not have been better tailored to keep bond markets happy. The commitment to keep policy rates "exceptionally low" for an "extended period" and the benign outlook for inflation were both very well received by bond markets, as well as other risky assets… Our proprietary model, MS FAYRE, shows a current fair value of 3.3% for the US 10-year Treasury yield – bang in line with actual yields…

Priced for perfection… MS FAYRE generates its fair value estimate using the real fed funds rate, 1-year ahead CPI inflation expectations from the SPF conducted by the Philadelphia Fed and the 5-year rolling standard deviation of inflation as a proxy for inflation volatility (for more details on the MS FAYRE model, see Fairy Tales of the US Bond Market, July 26, 2006). With the fed funds rate at 12.5bp, core PCE inflation tracking at 1.3% and the 4Q09 number for 1-year ahead CPI inflation expectations from the SPF coming in at 1.6%, MS FAYRE produces a fair value of 3.3% for 10-year bond yields, which is exactly where the 10-year yield is now (interested readers should contact us for a user-friendly spreadsheet for simulating the FAYRE model). Forward-looking bond markets thus seem to be pricing in altogether too rosy a scenario for the foreseeable future.

…for now: With actual bond yields bang in line with our fundamental fair value estimate, investors seem to be receiving no compensation for macroeconomic or fiscal risks..

Our forecasts look for bond yields to rise in 2010: Our US economics team expects bond yields to rise to 5.5% by the end of 2010 – an increase of 220bp that outstrips the 137bp increase in the fed funds rate expected over the same horizon (see Don’t Fear the Double-Dip, October 6, 2009). Our US interest rate strategy colleagues suggest that this bear steepening of the curve in 2010 may well be preceded by slightly lower 10-year yields in 2009 (see Liquidity Aplenty but Rising Sensitivity to Rates, October 22, 2009)…

Inflation expectations don’t seem to be anchored… The SPF measure of long-term CPI inflation expectations in the US has indeed remained stable, as claimed, since the median expectations have held steady for nearly a decade now. However…

…our conversations with clients also suggest a split into two fairly distinct camps. A smaller set of clients are bearish on the economic outlook and believe that inflation will be extremely low or even be outright negative for the next few years. The rest believe that inflation risks, and probably inflation itself, will rise within a year or so as the recovery becomes sustainable. The important point here is that it is difficult to find investors who believe that inflation over the medium-to-long run will be precisely in line with central bank targets. Both pieces of evidence do not support the argument that inflation expectations are anchored.

Obviously, Morgan Stanley is bullish on the economy because they are talking about a bear steepener across the Treasury curve. Their thinking on Treasuries is one reason you see Barack Obama talking about reeling in deficit spending. He obviously believes that an increase in interest rates would trigger a double dip recession.

My thinking goes more to bull flatteners where the two-year – ten-year spread decreases as expectations of a fed rate hike are countered by weak economic fundamentals.  This dichotomy points out some very real risks in the bond market right now.

Bill Gross his on the record expecting Treasuries to rally because he is cautious on the economic environment.

Gross has been talking about a “new normal” of deleveraging, deglobalization and reregulation. In his view, this means weak consumer demand counterbalanced only by heavier government intervention, leading to slow growth for the foreseeable future (See my post ‘Gross: The new normal for “the next 10 years and maybe even the next 20 years”’).  In essence, he sees a scenario that is bullish for bonds (especially longer duration types like the 10-year and the 30-year) but not particularly bullish for shares.

But we know that Gross loves to talk his book and he made billions from the Fannie/Freddie bailout doing so.  You have to make your own call here. It’s Morgan Stanley on one side of the trade and Pimco on the other.

Realistically, if rates spike to 5.5%, it would be a blood bath for insurers, and probably for pension funds (and hence municipalities as well). Mortgage rates would skyrocket and this would stop any housing recovery dead in its tracks. That sounds like double dip and depression to me; this is not an early 1990s economic environment. 

Ironically, 5.5% rates would sow the seeds of future 3.3% rates or lower. If you hold – and do not sell at the bottom – I don’t see how this induces a capital loss.

Related posts:

• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• Morgan Stanley sees U.K. downturn worse than Great Depression
• Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds
• Another take on the treasuries bubble
• Bill Gross: Fed on hold through 2010

Below is a CNBC video with Meredith Whitney in which she joins Nouriel Roubini on the doom and gloom parade.  Over the summer, both Whitney and Roubini were fairly optimistic. In June I said:

Think of the consensus forecast as an anchor which restricts the outlook of any individual forecaster afraid of failing unconventionally.

In Roubini’s case – and this logic also applies to media darlings like Meredith Whitney – it does NOT pay to up the ante.  What Faber is saying is that they have already benefitted from the bold and unconventional contrarian market call they initially made.  There is little payoff and much risk from continuing on that path.

To wit, Whitney upgraded Goldman Sachs to a buy and by July she almost sounded bullish. But, things are vastly different now. The banking index is up some 136 percent, with many stocks doubling and tripling. Some are up nine times. This is way over the top.

In her interview with Maria Bartiromo, Whitney gives ample reason to expect significant headwinds in the financial services industry and the economy more generally. While I am less certain that we are presently seeing a secular move to consumer deleveraging yet as evidenced by recent retail sales and current account deficit numbers, there is no doubt that credit lines to small businesses and consumers have been cut as Whitney details. 

I have also been getting much gloomier about the prospect of a sustainable recovery as a result.

With fiscal belt-tightening on the agenda at states and municipalities and, now, federally, I expect a double dip in 2011 – a view Whitney shares.

The key question in financial services?

Maria Bartiromo: Do you think that the sector is adequately capitalized today?

Meredith Whitney: No way.

Maria Bartiromo: No way?

Meredith Whitney: No way.

She is bearish on bank stocks generally. As for relative value trades, Whitney says the trade was large cap banks over regionals until now. However, she says now is the time to reduce weight in large cap banks as the outperformance due to government backstops may be about to disappear.

A lot more in the video below. The interview with Whitney runs 11:47.

Related posts:

• Bill Miller and Meredith Whitney: The Bull and the Bear
• Meredith Whitney: “I would diversify out of financials here”
• Meredith Whitney seems onboard with the fake recovery
• Meredith Whitney: more bearish than ever, but…
• Is Meredith Whitney bullish now?

From Bloomberg:

Confidence among U.S. consumers unexpectedly dropped in November as the loss of jobs threatened to undermine the biggest part of the economy.

The Reuters/University of Michigan preliminary sentiment index decreased to a three-month low of 66 from 70.6 in October…

Rising joblessness puts the economy at risk of slipping into a vicious circle of firings and declines in consumer spending that will limit the emerging recovery.

I don’t pay as much attention to consumer confidence as I do to some other economic data because I have yet to see enough statistically significant correlations between confidence and future economic paths.  However, I do realize there is a connection having recently posited the following about a term I coined unemployment rate illusion:

behavior changes in accordance with the nominal numbers used as economic signposts in an economy…

The parallel of money illusion to unemployment rate illusion is that a higher posted rate of unemployment can have a serious negative impact on consumer confidence and personal consumption (think balance sheet recession). All else being equal, higher unemployment rates mean lower confidence and consumption…

• If people see 12-13% in 2010, they will be floored, angry, and looking for someone to blame. As Democrats control Washington, they will get the lion’s share of the blame and lose big time in 2010.
• Making matters worse, this is the kind of shock that causes people to put their checkbooks away and go home for the night a.k.a sending us into a double dip recession.

So I am concerned that we are going to se a relapse. (Note: I have moved from seeing a double dip recession as a 1/3 chance to a base case scenario). My optimism about recovery is now fading.

Unfortunately, similar downbeat confidence numbers are also coming from the Conference Board index which unexpectedly fell in October:

The Consumer Confidence Index, released by The Conference Board, sank unexpectedly to 47.7 in October — its second-lowest reading since May.

Forecasters predicted a higher reading of 53.1. A reading above 90 means the economy is on solid footing. Above 100 signals strong growth.

The index has seesawed since reaching a historic low of 25.3 in February and climbed to 53.4 in September.

The connection to markets comes again via David Rosenberg from this past October 29th who I seem to be quoting a lot recently. In reference to the Conference Board numbers, Rosenberg said (highlighting added):

So many people are deluding themselves that we have some sort of durable recovery on our hands and yet consumer confidence, at 47.7 in October, is unbelievable — the lowest this every got in the 2001 recession, which included the 9-11 terrorist attacks, was 84.9. Think about that for a second. If the equity market is catching on to the view that we could be in for some slowing in the data, then a significant correction after a 60% surge is very likely. This is a time to be raising cash if you haven’t done so already — valuation, technicals, fund flows and fundamentals at this juncture are all near-term obstacles.

Related posts:

• Consumers ‘do believe in the green shoot story’
• Unemployment rate illusion
• The slow but inexorable decline of jobless claims
• A note on government statistics and unemployment
• Data on past consumer deleveraging during recessions

I have really started to dislike municipal bonds as an asset class. They have seen a huge rally along with almost every other financial asset but the underlying fundamentals are weak because of financial distress at states and municipalities.

Last week, I wrote a first piece on this topic, based on some work by Philip Greenspun and Fred Sheehan. I also just wrote a piece about Ambac Financial’s likely bankruptcy, which will impact this market because of Ambac’s municipal bond guarantees. But, a Barron’s piece about Jim Chanos of Kynikos called “Short Seller: Dump Munis” piqued my interest and precipitated this particular article.

Chanos is bearish

The Barron’s piece by Tom Sullivan said:

James Chanos, the famed short seller who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market — in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron’s staffer Susan Witty, adding that he wouldn’t touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It’s not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It’s all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state’s bonds will likely lose their federal tax exemption, he adds.

Sullivan went on to use New York and New Jersey as other examples of what is amiss for state bonds.

Revenue shortfalls

A New York Times article which I linked to this morning makes the situation in New York plain, ending with this:

The comptroller’s office numbers are more pessimistic than those from Mr. Paterson’s budget office. They project that the deficit for the remainder of the current fiscal year stands at $4.1 billion, with deficits of $7.8 billion and $15.7 billion in the succeeding years.

Mr. Ravitch, who helped steer New York City through its financial crisis in the 1970s, said, “The numbers are real and my own personal view is that they’re going to get worse.”

New York and New Jersey are suffering the same problems that California suffered, namely a huge fall in income and property tax revenue. This is true all over the country in places as far apart as Oklahoma, Hawaii, Texas, and Georgia.

Assets falling, liabilities ballooning

But, it’s not just about revenues versus outlays – the income statement. It’s also about assets and liabilities – the balance sheet. recently I spoke to Peter Schweich, a retired vice president of Boston University and founder of Boston University Academy, who had done some research on municipalities in Massachusetts and he explained that his research indicated that municipalities had seen a 30% fall in investment portfolio values during the credit crisis (much obviously gained back since). Even worse, he pointed me to enormous looming liabilities not reflected on balance sheet or considered by the ratings agencies.  In a recent Forbes article, he wrote:

While municipalities are able to raise property taxes to cover current salaries, not without considerable pain to the taxpayer, few of them, if any, are prepared for the future financial demands of their grossly underfunded or completely unfunded Other Post Employment Benefits (OPEB) obligation. OPEB obligations are primarily associated with health benefits for retirees.

In 2006, the Federal Reserve Bank of Chicago held a pension conference. In a short note, it reported that a "back of the envelope guess" for OPEB was $700 billion and that "other estimates suggest that OPEB exposure could range from five to 10 times current outlays for retiree health care."…

Cambridge, Mass., now known to most Americans as the city where a homeowner can be arrested for "breaking into" his own home, serves as a good example of the overwhelming burden residential and business property owners across the country are about to confront. Current and future Cambridge residents are now facing a completely unfunded OPEB obligation of $602 million. That figure, alone, is nearly one-and-a-half half times greater than the city’s entire 2009 budget. In addition, like most municipalities, the recent economic downturn has resulted in a significant loss to Cambridge’s regular pension fund: a 28.6% loss in 2008 in the amount of $225 million.

In addition, Cambridge has an unfunded liability for its regular pension fund (distinct from the OPEB fund) to the tune of nearly $70 million, and, of course, Cambridge also carries bond obligations, as do many municipalities. The Cambridge bond obligation exceeds $300 million. This means Cambridge, with approximately 75,000 permanent non-university student residents, one municipal employee for every 22 residents, and 22,000 taxable parcels, has current financial liabilities of nearly $1.2 billion…

Not surprisingly, the Cambridge city manager boasts of Cambridge’s financial stability each year in the introductory letter to his submitted budget. To bolster his claim, he proudly points to the Triple A bond ratings that Cambridge holds from Moody’s, Fitch and S&P. Cambridge, therefore, has 75,000 residents, 22,000 taxable parcels, $1.2 billion in financial liabilities–and a Triple A bond rating from Moody’s, S&P and Fitch.

These are circumstances that are being repeated across the United States. Expect scandals involving alleged improprieties to mount when financial distress hits. One notable example in the news is San Diego, where the top pension administrator is exiting after last year’s over 25% loss and where the fund is also being buffeted by two separate scandals: a conflict of interest scandal and a scandal where overtime pay was counted toward the formula in firefighters’ pension overtime. San Diego was also in the news a few years back because of a separate scandal where an alleged special pension benefit for the fire chief was under attack. See also San Diego’s Pension Scandal for Dummies from 2005, which details the conflict of interest case to that date.

Ratings agency problems

Then there are the rating agencies. Remember the whistleblower scandal from last month? It was all about municipal bonds and the Moody’s allegedly putting their revenue generating relationship with municipalities ahead of the rating function. If you recall, it was exactly this conflict of interest which led to Arthur Andersen’s downfall in the Enron scandal.

This is what Reuters said about the Moody’s whisteblower scandal last month:

Two former Moody’s executives — Scott McCleskey and Eric Kolchinsky — testified that senior managers were willing to silence employees who raised concerns about the ratings process or compliance efforts.

McCleskey said that while he was the head of compliance at Moody’s, he voiced concerns that the firm was not properly monitoring ratings on municipal debt. McCleskey, who was dismissed by Moody’s in 2008, said he was instructed not to mention the issue in e-mails or writing.

Kolchinsky, a Moody’s managing director who was recently suspended by the firm, said senior managers pushed revenue over ratings quality and were willing to fire employees who disagreed.

The two whistleblowers were flanked by Moody’s current chief credit officer, Richard Cantor. Cantor sat impassively, staring straight ahead as his former colleagues described their concerns to the lawmakers.

In his testimony, Cantor said Moody’s had recently hired an independent law firm to review Kolchinsky’s allegations.

That was criticized as an empty gesture by Chairman Towns, who said the law firm had no deadline and would not produce a written report.

Kolchinsky told lawmakers that Moody’s compliance group was understaffed and lacked independence. He also alleged Moody’s knowingly issued misleading ratings on complex securities and that analysts were "bullied" by managers, who overrode their decisions to protect revenue.  Kolchinsky said he would soon meet with the SEC to discuss his charges. SEC officials said the regulator had contacted Kolchinsky about his concerns in March 2009.

McCleskey, meanwhile, sent the SEC a letter in March 2009 warning about Moody’s weak compliance department and ratings process. He said Moody’s management had ignored his warnings that the company failed to properly monitor municipal bond ratings.

The company also spurned his suggestion to erect a firewall between the compliance department and its revenue-generating units, he said.

No doubt, there are those who are still recommending munis because of their tax-free status, as a recent WSJ article demonstrated. But, the fundamentals are weak and getting worse – both in terms of the income statement and the balance sheet. These governments are soon to lose their guarantees from Ambac (and eventually MBIA despite hiving off the muni business). To my surprise, these governments are getting no federal government backstop as the California situation has demonstrated. And the Fed and Treasury are on record as saying they will not guarantee any municipal bonds. Finally, I question whether one should rely on the ratings these bonds have to make an informed investment decision. Even the junk-bond king Michael Milken, a credit analyst of note, is now warning that credit ratings are inflated.

Municipal bonds are a clear case of buyer beware.

Related posts:

• The coming collapse of the municipal bond market
• MBIA and Ambac sued by LA
• Ambac may file bankruptcy soon
• California starts issuing IOUs as bankruptcy nears
• State and local government weighed down by housing

Tilson is saying what I have been saying, namely that March saw an increased number of attractive buys, but most of these are now fully priced. As a result, he is selling equities – even building up his net short positions.

Unlike bear turned bull Richard Bernstein, Tilson says that after a huge 60%+ run up which saw a trebling or quintupling of some beaten up shares like Huntsman, you need to be cautious. Invest in high quality and low beta, he says – exactly the opposite of what Bernstein is now saying.

Despite some positive earnings reports from the likes of Toll Brothers, the sector he hates the most right now is home builders because of a 2-year inventory overhang.

Below Tilson talks to Bloomberg’s Carol Massar. The video runs just over 3 minutes.

Related posts:

• Whitney Tilson of T2 Partners, a new media darling, strikes a bullish tone
• Richard Bernstein: Once a huge market bear, now a bull
• Which homebuilder will go bankrupt next?
• Bernstein: What kind of recovery are we going to get?
• Are the markets set for a pullback?

The long-coming commercial real estate bust has arrived in the U.S. and elsewhere, a result of sky-high prices met by a severe downturn.  Prices could only work in a best-case economic scenario and large busts are now coming (see my posts on Stuyvesant Town and Capmark Financial).

This bust is certainly another major impediment to a sustained recovery – along with a host of other wild cards like unemployment, trade conflict, and oil prices. But, the most worrying aspect about the CRE market is the marks on the balance sheets of our capital-constrained banks, which do not reflect the level of distress evident in the marketplace. And since securitization plagues the CRE market, some analysts expect bankruptcy to be the only workout option for many troubled deals. You will recall, this problem with securitized assets is a dynamic which has also plagued residential real estate (see posts here and here).

The video below explains how this real estate bust is different and what it will mean for the U.S. economy and likely bank failures. (Sorry that it starts automatically. If the wrong video pops up, see the link below).

Related posts:

• Circuit City as canary in the coalmine for commercial real estate
• Commercial Real Estate bust
• Commercial real estate is next
• Commercial poperty ‘im Visier’
• Commercial real estate: down even more than residential

Christopher Wood, the well-noted market strategist at CLSA and writer of the classic Japan crash warning book “The Bubble Economy,” is now warning of a market correction in the West.  According to CNBC India, Wood believes that the markets’ extreme upward move is increasing the chances of a major correction.

Wood is still cautious. He says there is some initial indication of a technical breakdown in the US. "The US market will be vulnerable early next year the US market. If it becomes clear, after this inventory cycle, that consumption, employment is not really recovering, then the market will go down. You will then get renewed stimulus in the US and measures trying to generate growth. The key variable in the West is government policy." CLSA’s best case scenario is 1,200 on the S&P 500 by year-end, he added.

I agree with Wood that underlying economic demand may indeed be weak and all we may be seeing is an inventory and stimulus induced cyclical upturn (see my July post “ISM: Is this the mother of all inventory corrections?”). Of course, the worry is about the employment cycle not turning up before these measures’ positive effect wears off.  This is the question for 2010. If this happens, we get  a double dip and a huge market-sell off. Even if the employment situation starts to improve slowly while stimulus and the inventory cycle recede, this will lead to a muddle-through scenario, again inducing a correction. This is the heart of Van Hoisington and Lacy Hunt’s call about partial recoveries and stock market weakness.

For those of you who want to believe and want to load up on junk, there’s a clap for that too, via bear turned bull Richard Bernstein:

Richard Bernstein of Richard Bernstein Capital Management is a lot more bullish. "Right now, there is a blurring between the secular issues and the cyclical ones. There are people, including me, who are concerned about the secular issues, but we can’t ignore the fact that the economy is getting better, employment is improving. When that happens you will see a cyclical rebound."

Just in September, Bernstein was saying America “practically invites another catastrophe.” What happened to that guy? He better be right on his bullish turn or he is going to have a lot of egg all over his face.

Source

Chances of a deeper correction are rising: Chris Wood – CNBC TV18 India

Related posts:

• Whitney Tilson: "A pullback of some sort is likely"
• Richard Bernstein: Once a huge market bear, now a bull
• Bill Gross: Sell equities and buy Treasuries
• Marc Faber: “Monetary policy in the United States will stay expansionary”
• Partial recovery will mean new lows for stocks

Jeremy Grantham is out with his much anticipated Quarterly Letter and it’s a good one. “Just Deserts and Markets Being Silly Again” is a cutting, snarling, and sarcastic rejection of the prevailing V-shaped recovery bull market view.  But Grantham is far from ultra-bearish, giving a more nuanced and realistic assessment for the medium and longer-term.

He starts his letter with sarcastic allusion to Obama’s Nobel Prize, titling the section “Just Deserts.”

I can’t tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee’s sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn’t seem deserved. And then it occurred to me. Isn’t that the point these days: that rewards do not at all reflect our just deserts? Let’s review some of the more obvious examples.

But, he is just warming up, as he goes on to heap vitriol on 13 groups he feels are equally undeserving of rewards in a scathing condemnation of status quo ante in the economic and financial establishment.

They are:

1. Ben Bernanke
2. Larry Summers and Tim Geithner
3. Mortgage Brokers
4. Homebuilders
5. Over-spenders and under-savers
6. Too-big-to-fail banks
7. Over-bonused financial types
8. Overpaid large company CEOs
9. Stock holders of overleveraged Corporations
10. The U.S. Auto Industry
11. Over-vehicled America
12. Stock options
13. And, of course, Sir Alan Greenspan

This letter is a polemic against the financial elites of a ferocity the likes of which I have never seen from a major fund manager. I see it as a must-read.

As for the markets, he is not all doom and gloom.  But the point that certainly jumped out at me was this:

Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year.

Translation: the market is so overvalued now that you should expect pretty meager long-term returns in equities.  Does that mean a crash is right around the corner? Not necessarily – but a brutal correction is probably in the offing. Grantham says:

I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19). 

Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February.

The bottom line here is this: the market is significantly overvalued at present levels because of a technical rally super-charged by stimulus. This necessarily means lower returns over a longer-term horizon. The possibility of a major correction is high.

Update: the full letter with a lot more detail, market history and asset allocation recommendations is now linked below instead of embedded due to copyright restrictions.

One other thing: a GMO representative reminded me you that can register with their site and subscribe to the letter and receive it automatically as well.

Source

Jeremy Grantham’s 3Q 2009 letter – GMO website

(the link to the GMO splash page above will guide you to registration in order to view the letter – and to subscribe to future letters)

Related posts:

• More bullishness from Jeremy Grantham
• Jeremy Grantham: “Pull the trigger”
• Jeremy Grantham: “Keep telling yourself… you’re a long-term investor”
• Jeremy Grantham: “Many shares priced for… economic collapse”
• Jeremy Grantham: Overheating in China, speculative rallies and fair value

This photo from Yves Smith’s antidote du jour was too good to pass up. You can think of the cat as the recovery stalking its prey and the bear as, well, a bear. The cat looks pretty tame though. Let’s hope this bear doesn’t come right back down and maul it.

Related posts:

• How did economists get it so wrong (parody version)?
• News from around the web: 2009-07-23
• Links: 2009-06-20
• Household debt as an indicator of secular bull and bear markets
• CNBC denies culpability in Roubini as bull saga

In my last post, I presented you with a bunch of data on debt levels broken down by sector of the economy (see “A brief look at the Asset-Based Economy at economic turns”).  I found it interesting that a secular pattern seemed to be at play when looking at the household debt charts.

Notice the three areas boxed in red on the chart to the right.

The chart measures the differential between the year-on-year change in household debt and nominal GDP.

The three areas show three distinct periods of household debt accumulation.

1. 1951-1966. The first shows household debt changes generally outstripping nominal GDP by a wide but decreasing margin. This period coincided with a secular bull market in equities.
2. 1966-1982. This second period is more volatile, but with the overall numbers lower.  In general, debt was accumulated less rapidly compared to the growth in nominal GDP. And when recession hit in 1970, 1974 and 1980, it induced a retrenchment (at least relative to nominal GDP growth). This period coincided with a secular bear market in shares.
3. 1982-?. This last period shows an enormous increase in debt growth relative to GDP growth during the 1980s followed by minor retrenchment after the 1990-91 recession and strangely also in 1997 (could this be a butterfly effect to the Asian Crisis?). But after that it was off to the races right through the 2001 recession until mid-2007.  This period coincided with a secular bull market in equities.

The pattern seems to indicate that there is a relationship between debt build-up in the household sector and stock prices.  The build-up in debt relative to nominal GDP troughed in Q3 2008 at -0.4%. As of Q2 2009, the number was +1.2%.

I see this as evidence of the so-called Wealth Effect. The data suggest that the secular bear market may not have begun in 1998 or 2000 as I have generally believed. And they also suggest that, despite the recent rise in shares, a new secular bear market may have just started in 2007. I will be curious to see what the data look like for the second-half of 2009.

Source

Z1 Data Series – Federal Reserve

Related posts:

• Americans are not increasing savings
• A brief look at the Asset-Based Economy at economic turns
• Chart of the day: household debt vs. savings
• Consumer credit falls 4.4% from year ago levels
• Data on past consumer deleveraging during recessions

Below is a wide-ranging interview with Marc Faber over four videos on CNBC TV18 in India explaining view on inflation, currencies, commodities, stocks and more.

Asset-based economy. In general, he thinks we are in an inflationary environment, whereas I think that deleveraging is secular and means any inflation is only cyclical. But he shares my belief that zero interest rates induce money balances to move into consumption or into higher yielding assets. He believes this is a boon over the medium-term (if not the short-term or long-term) for financial assets, whether they be stocks, bonds, commodities, real estate or art. And it is something that will continue, he says. Faber believes Bernanke will be loath to raise rates aggressively given his prior statements and writings.

Currencies. Faber takes the view with which I agree that the Fed’s easy money policies after 1998 flooded the global economy, especially emerging economies with liquidity. This has led to asset bubbles.  Hong Kong residential real estate is one example he cites.  As a result, Faber thinks the U.S. dollar is no longer overvalued at present levels. A snapback rally for the dollar resulting from oversold levels would be bearish for asset markets. But, longer term, Faber thinks the dollar is weak.

Equities. There has been a huge rally everywhere.  He says he is not a buyer at these levels. However, as central banks are going to continue to print money, stocks could continue higher – but he would not bet on a blow off rally from these levels.

Commodities. Faber thinks zero rate levels makes it extremely difficult to value anything.  Pose the question: which would you rather own – the “US dollar at zero interest rates or a ton of gold or a ton of copper or a ton of crude oil?” Of course, commodities are supply constrained, whereas dollars are not, so there is a justification for buying them. But, he anticipates the commodity hoarding by China is about to end and that is bearish for industrial commodities as well as precious metals. As with other commodities, he thinks the huge run up in oil could induce a setback. Long run, he is an oil bull because of limited supply.

 Financial Crisis. He is disturbed by the fact that a crisis caused by excessive debt growth, especially as a result of Federal Reserve policy has been allowed to pass with the same players in control. He says enjoy the ride for now. Longer-term, this necessarily means the same bad policies will follow and it will lead to a system-wide financial collapse.

India. Faber is bullish longer-term. Short-term, there could be a correction. India is one of the best protected countries because of less vulnerability to the export sector. He also believes the Reserve Bank of India has one of the best monetary policies in the world – supervise the financial system closely, relatively tight, and mindful not just of core inflation but other price levels like asset prices.

(videos embedded below)

Related posts:

• Marc Faber says avoid financials and buy gold
• Marc Faber: "I don’t think that you’ll see gold below $1,000 per ounce probably ever"
• Marc Faber on CNBC: bearish on oil and India
• Marc Faber: I advise every American to hold his gold outside of the United States
• Marc Faber: “A huge move is coming in the dollar, in bonds and in equities” but…

This comes via TheStreet.com and Doug Kass, a noted market strategist:

Many strategists (both bullish and bearish) assume that a fair value P/E multiple — based on interest rates and inflation — rests at about 15.5 times. Averaging the 2009 and 2010 S&P consensus forecasts produces a melded $67.50 S&P EPS, a year-end target of 1045 and a mid-2010 S&P target of 1130 on an EPS of $73 a share — against the current S&P level of 1043.

Bearish strategists such as David Rosenberg (this weekend’s Barron’s interview) believe the current S&P level is discounting a 40% increase in 2010 earnings over 2009, but the consensus believes (above) that about 10% growth is being discounted.

Bearish strategists (again) like Rosie expect real GDP growth of about 1% to 2% next year, but the consensus now anticipates 3% to 3.5% growth in 2010.

The market’s P/E multiple is up by 5.5 points, or more than 40%, since equities bottomed in early March. So, even for the bullish strategists, the phase in which expanding price-to-earnings multiples contribute to the market’s advance is largely over and future stock market gains will be dependent upon the achievability of a healthy growth in S&P operating earnings toward the consensus.

As Kass later points out, the anticipated earnings growth fuelling this rally must be predicated on continued leverage. The present multiple and earnings growth has come from cost-cutting which lowers employment and income – and, thus, aggregate demand in the absence of more leverage (See Tom Toles’ not-so-funny depiction of this via Prieur du Plessis).

According to Kass, other headwinds include poor commercial real estate fortunes, lower local government spending, and higher taxes. All of this makes the market rally seem more bear market rally than secular bull.

And I can think of no secular bull markets that began with a 40% surge in earnings multiples.

More here.

Related posts:

• Rosenberg: Market rally is just multiple expansion
• Getting bearish again
• Overbought?
• Rosenberg: Still a bear market rally
• Avoid consumer stocks

So we started September in an ugly way. With the markets down 2% across the board, and oil and bond yields also falling.  Forgive me for thinking this is a bad sign, but selling on good news doesn’t sound very bullish.

  And the ISM data definitely was bullish. Production 61.9 – Yay! New orders 64.9 – Hurrah! What’s not to like? But the Dow was down 185 points – Boo!  What gives? 

Well, for one, bank shares were decimated (see the sea of red in the chart to the right?). But, there’s more to it than that; Wal-mart was the only stock to rise in the Dow. For the S&P, we had breadth of 16-1 for decliners to advancers.  This was a broad-based selloff – and one that took place with the backdrop of positive economic data from manufacturing and housing.

To me, that is a very worrying sign. Now, obviously I expect a market correction (see posts here and here). But, I neither expect nor want a crash (I do think this is a possibility, however, given how far stocks have run without a correction).

It is now September, the month of market jitters,  and the financial services industry is headed back from their long slumber.  Things get serious in September. Let’s hope they don’t get too serious or Paul Tudor Jones is looking like a financial prophet yet again.

Related posts:

• Wood warns of correction, says “key variable in the West is government policy”
• Are the markets set for a pullback?
• Richard Bernstein: Once a huge market bear, now a bull
• Major selloff coming?
• Jeremy Grantham: The market is 25% overvalued; 15% correction coming

You have probably noticed a change in tone at Credit Writedowns since about June, but a lot more in the past month or so. Once mildly bullish due to the deeply oversold levels this Spring, I have become increasingly alarmed at the unjustified strength of the recent market rally.

My most recent post explaining my concern, “Major selloff coming?” kind of gives you the timeline. I really would like to be bullish, but I have major issues with this rally on both a technical and fundamental basis:

Technicals

1. The technicals all point to stock markets in the U.S., Europe and Emerging Markets as being overbought. This has been the case for at least two months now. As the market continues up without a pullback, you have to be concerned that any pullback will be violent.
2. There has been an enormous multiple expansion, which is usually what occurs in the middle to latter stages of a secular bull market, not in the beginning of one. It certainly makes one think this is a bear market rally and not a secular bull move.
3. I have said that the massive liquidity dumped into the system is not going to fuel inflation when capacity levels are at historic lows in the U.S.  There is absolutely no pricing power, either for businesses or workers. But, all that money is going somewhere eventually. Right now, it looks like it’s going into asset prices. Liquidity is seeking return.

Fundamentals

1. If you look at the deflationary pressures, they are almost all still at work: poor employment markets, producer price inflation at record low levels (Germany down 7.8% through July y-o-y for example), overcapacity in Europe, China and Asia, back breaking debt levels, etc, etc.
2. But, then, where is the demand?  It’s not there. The consumer is not going to be jumping in here. A lot of the uptick in the economy is inventory-related, not consumption-driven.  So either former exporters, government or business will have to pick up the slack.
3. And let’s not forget my favourite whipping boy, the financial sector. In the U.S., there are a lot of toxic assets on balance sheets, while leverage and equity capital ratios are still poor.  That speaks to the need for continued deleveraging and low loan growth in the financial services sector.

So while a snap-back rally was inevitable given how oversold things had become in March, this rally has been a bit over the top.  I am not alone in this assessment.  The Wall Street Journal has pointed to Jeremy Grantham and a few other March bulls who are now speaking in more cautious tones.

…Jeremy Grantham, penned a note on March 10 entitled "Reinvesting When Terrified" that encouraged investors to buy, suggesting stocks were 30% undervalued.

Since then, the market has roared ahead, without stopping for a correction of 10% or more. Standard & Poor’s 500-share index ended last week at 1026.13, up nearly 52% from its 12½-year low on March 9 and its highest close since Oct. 6. The Dow Jones Industrial Average is at 9505.96, up 45% since its March low.

Now, the chairman of Boston asset-management firm GMO and his colleagues say the S&P 500 has zoomed right past what they consider fair value of about 880, based on earnings estimates and historical price-to-earnings ratios.

Notice the part about not having had a correction, which I see as a contrarian indicator.  Back in May, Grantham said a leap up to 950 and then a sideways move between 950 and 1050 on the S&P meant the market was modestly overpriced.  That is not a sell signal. This is where we are right now. But, at 1026, we are dangerously close to breaking out of that range to the upside – which would be a sell signal.

With the City and Wall Street ready to return to full speed soon, we will get a better taste of what is to come due to higher trading volumes.  But, for now, I am mildly bearish on shares.

Related posts:

• Rosenberg: Market rally is just multiple expansion
• Kass: Bearish on equities
• Are the markets set for a pullback?
• Overbought?
• Jeremy Grantham: The market is 25% overvalued; 15% correction coming

Jeremy Grantham is out again with a very important investment strategy piece entitled “Boring Fair Price!”  He leads off by talking about how markets went from extremely overvalued a year ago to cheap back to a state which he considers fair value.  But, he sees the recent rally as a speculative rally which is a response to the savage beating markets took late last year and this past Winter.

Waiting for Markets to be Silly Again A year is certainly a long time in markets, and so is a quarter. A year ago, equities globally – and everything else for that matter – were very overpriced, particularly if they were risky. A quarter ago, in mid March, prices everywhere were cheap. Now they have all – or almost all – converged for a few unusual moments at fair value. A year ago, it was very easy to know what to be: a risk avoider. It was not so easy reinvesting when terrified, but most of us knew that we should have been doing more. But today? It’s difficult to be inspired at fair value. Since early March, the market has had the type of strong speculative rally that often follows extreme declines. The danger of a breathtaking rally is that it leaves those few investors who raised considerable cash waiting for a pullback and psychologically invested in the case for a new bear market leg. This was covered in our mid- March posting, “Reinvesting When Terrified.”…

I tried to make the point that such a rally had absolutely nothing to do with the logic. of long-term fundamentals, but was merely a response to great stimulus and great implied promises. Well, this time once again, enough risk takers were found to get the job done, and the market rose to 950, with presumably at least a decent shot (say, 50/50) at rising over 1000 in the next two to three quarters.

This is my tack as well as I explained in a June post Market manipulation, short-covering rallies and cyclical bulls.  Just because the fundamentals do not support a rally, doesn’t mean it can’t happen. Momentum, stimulus, moral hazard, technicals, you name it – they can all be factors causing a market to bounce significantly despite poor fundamentals.  And these speculative moves can certainly continue for much longer than a fundamental bear with a short position can withstand.  But, now it is looking like the market may have surged beyond what is even sustainable in the short-run.  What to do?  Grantham gives his perspective.  I have linked some of the points he makes to previous posts of mine that make the same arguments.

Plan C: What to do if the Market Overruns

Given our view that we are in for seven lean years in which the market will be looking for an excuse to be cheap, we recommend taking some risk units off the table, including becoming underweight in equities – between 1000 and 1100 on the S&P, if it gets there this year. Around 880 you should continue to move slowly to fair value, twiddle your thumbs, and wait to see what happens. Boring! Otherwise, it is time to focus on the lesser issues: which types of equities are cheaper or more expensive than the market. This leads us back once again to the bet on quality stocks.

The Quality Bet

The easy winner of the cheapest equity sub-category contest is still high quality U.S. blue chips. They were really trashed on a relative basis by the second quarter rally in junk. I understand a rally in junk after the record decline, but this was excessive and based apparently on unrealistic hopes for a strong, sustained economic recovery. Such a recovery seems most unlikely, whereas a temporary, weaker recovery appeared very likely three months ago as the substantial size of the stimulus package was revealed. The latter scenario still seems probable. Our original estimate for the timing of some economic recovery to occur late this year or early next year still stands. Without an unexpectedly strong improvement in the economy, it is hard to see high quality stocks losing much more ground, given their extreme value gap over junky stocks – more than an 11 percentage point spread per year on our seven-year forecast!

My synopsis: expect a weak recovery of uneven quality late this year or early next year.  That means you want to be overweight value and not reach for yield or risk as these asset classes are overvalued on a relative basis.  This is the same advice from Richard Bernstein, the astute market strategist formerly at Merrill Lynch.  Now when looking across global equities for shares to buy, emerging markets come to mind.  And Grantham is generally pretty bullish here.  However, a key note of caution comes on China.

My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors. On the other hand, the strong longer-term case that I outlined in “The Emerging Emerging Bubble” 15 months ago seems intact. I suggested then that emerging equities would sell within five years or so at a distinct P/E premium to celebrate their obviously superior GDP growth compared with that of an aging developed world. Emerging market equities are already selling at a modest premium to EAFE and the higher quality half of the U.S. equity market. Being pro-emerging yet anti-China is a dilemma for us; we are working to resolve it. Meanwhile, emerging equities, like most risky asset components, are moderately overpriced. We in asset allocation may, however, push our luck in emerging – particularly ex-China emerging – using inertia to reduce our current modest overweight. If we do this, it will be out of respect for the high probability that emerging equities will sustain and increase their overpriced level relative to the rest of the world.

Translation: Emerging markets have rallied way too much.  China is looking dangerous in particular.  However, we are holding positions ex China and not yet selling as these markets still may outperform.

Bottom line for me: this is NOT a bull market, and as such asset allocation decisions are fraught with risk. Running with a buy and hold strategy in this environment may not be the best strategy. Grantham has a ton more to say and it is a very good read.  I do suggest you read the entirety of his piece, which is linked below as well as being available here.

Jgletter All 2q09

Source

GMO Quarterly Letter July 2009 (PDF) – Jeremy Grantham

Related posts:

• More bullishness from Jeremy Grantham
• The mega Jeremy Grantham interview on how durable the rally will be
• Jeremy Grantham: The market is 25% overvalued; 15% correction coming
• Jeremy Grantham: “Keep telling yourself… you’re a long-term investor”
• Market manipulation, short-covering rallies and cyclical bulls

Here’s a nice clip from Stephen Roach from last week asking “where’s the demand?” 

His thesis is pretty simple:  we have an inventory-induced upturn that might actually show positive GDP growth in the U.S. for Q3, what I have termed the mother of all inventory corrections.  But, that’s it.  Underneath this is no discernible pickup in demand anywhere globally.  Add in a still massive number of writedowns to be taken by banks globally (at least $2 trillion by Roach’s estimate) and you can see that there are a lot of economic headwinds here.

My favorite part of this video is where the presenter says: “Stephen, you sound pretty bearish. Are you not a believer at all in that green sh**ts theory?”

The video runs 7:32 and covers a wide range of topics from inventories and consumer demand to China and systemic risk in finance.

In regards to markets, he makes the telling statement: “liquidity is seeking return,” suggesting that the market uptick since March is merely a liquidity-driven bear market rally.  This is something I have been suggesting as well.  See posts Is quantitative easing really inflationary? and Does Ben Bernanke blow bubbles too? for more.  The thing is these rallies can go higher and can last longer than most market participants would expect.

Related posts:

• Stephen Roach and Jim Grant: Video of credit crisis thoughts
• Stephen Roach sees a W-shaped recovery for China
• Stephen Roach: Downturn in Asia less severe, but recovery later
• Stephen Roach is still bearish, no recovery until 2010
• Quote of the day: Stephen Roach

This comes via David Rosenberg of Gluskin Sheff.

The week that was
After four weeks of decline with a total loss of 7.0%, the equity market turned in a like-sized gain this past week re-igniting the bulls. With tech leading the way, the Nasdaq has managed to rally to a nine-month high. The desire to be bullish is so intense that the business media totally misinterpreted what both Nouriel Roubini (who has not, in fact, changed his cautious or bearish stance) and Meredith Whitney (she likes Goldman but that seems to be about it in the financial space) had to say last week. Meanwhile, long-standing bullish strategist Jim Paulsen is featured prominently on this week’s Barron’s (he sees 3.5% GDP growth in the U.S.). This will not win us a popularity contest to be sure, but everything we see around us smacks of a bear market rally. Real bear markets never ever end with price-to-book, price-to-earnings, dividend yields, real corporate bond yields or sentiment readings at the level they have been for most of this year.

Earning less impressive than meets the eye
There was tremendous enthusiasm last week, but it could be all the good news we get for a while. We’re not sure that others are going to be reporting similar results as Goldman, JPMorgan, IBM and Intel mustered up last week (the banks received much of their profit growth from trading revenues — not a part of the business most investors pay a very high multiple for). What is very clear is that we have a very long lineup of companies who are still making their numbers (or not) but doing so through cost-cutting and are still missing their sales estimates.

I agree we are seeing a bear market rally.  How long this continues is another question that is hard to answer at this point.  But, I would note that earnings pre-announcements and surprises have been much more favorable this quarter than in recent quarters, suggesting the news cycle is going to continue to boost shares.

More from Rosenberg here.

Related posts:

• Rosenberg: Market rally is just multiple expansion
• Kass: Bearish on equities
• Rosenberg thinks U.S. market may Test March lows
• An amazing market rally. What’s next?
• Are the markets set for a pullback?

Marc Faber was quoted in June as saying he expects a major move in financial markets, but is unclear which directions markets will turn.  His statements suggest to me he could be advising clients to go long volatility in anticipation of market turbulence.  This would usually be accomplished by buying options in high beta assets which one believes are underpriced.

Moneycontrol.com reports.

Investment Guru Marc Faber said he sees a huge breakout from the narrow trading range soon. “I think the summer is shaping up nicely. The grave is out, we had a huge rally. We now have a narrow trading range but we will get a big breakout.” He added that the S&P could hit 970-1020.

“I have turned kind of neutral recently because I think we are at that trading range. The big move, a huge move is coming in the dollar, bonds and in equities. But I am not yet sure clearly on what side it will be.”

However, today CNBC is reporting that Faber remains a long-term bear irrespective of his short-term views. An article on their site called “Ultimate Crisis Is Still Coming: Marc Faber” says:

We haven’t seen the last of the crisis despite all talk about green shoots, and the surge in markets was caused by nothing more than the excess liquidity coming from central banks, Marc Faber, author of the Gloom, Boom and Doom Report, told CNBC Friday.

"If you pump money into the system and you create large fiscal deficits, you create volatility," Faber said.

"We’ve seen an intermediate low in March, we’ll rally for a year or so or maybe 18 months… the ultimate crisis will happen much later, and the ultimate crisis would clean the system," he added.

Asked when this would be, he said he could not forecast a precise timing: "it may be 5 years time, 10 years time, but that’s not the last crisis."

Translation: Don’t underestimate the power of printing money. This combined with government intervention into the market will most definitely keep markets from crashing over the near term. In fact, markets may rise for a longer period than bears now expect. The real question is what will be the likely longer-term implications of this money printing.

In my view, it distorts price signals, causing people to lever up, reach for yield and take on more risk.  Whether those bets pay off is now largely determined by how successful government actions are in arresting deflationary forces over the short-term.  That makes this market extremely difficult to call and also extremely volatile, hence Faber’s talk about a big move in either direction.

On other fronts, I see Faber as a bit extreme. Always the small government-minded Libertarian, he goes on to suggest firing half of government employees in the world as a solution.  He says, “Why does California have these problems? It’s not that there are too many teachers in California but the education department is very bloated.”

Whether you agree or not, he is always entertaining.

The video of Marc Faber’s more bullish statement from June is below.

Source

Mkt to break out either way, stay on sideline… – Moneycontrol.com

Related posts:

• Marc Faber on CNBC: bearish on oil and India
• Marc Faber says avoid financials and buy gold
• Marc Faber: “it’s very tough for a forecaster who was ultra-bearish to stay bearish”
• Marc Faber: Dr. Doom goes bullish
• Marc Faber: “Monetary policy in the United States will stay expansionary”

I have introduced the concept of a technical recovery to describe the anticipated weak recovery period that lies ahead.  Van Hoisington and Lacy Hunt have a different term to remember: Partial recovery.  They see the potential that a partial recovery will end this business cycle, and that’s not bullish for stocks:

Recessions end when the National Bureau of Economic Research (NBER), the official arbiter of such matters, says they end. But sometimes economic conditions suggest that the NBER miscalculated. Economic recovery occurs when these four indicators turn higher at about the same time. If the NBER’s cycle turning dates are aligned with these four indicators they have validity. Regardless of the NBER’s opinion, if the four indicators are not rising, a normal recovery will not occur. This seemingly esoteric point has important implications for the stock market.

In all the recessions from 1967 to 1999, the NBER aligns its recession ending dates very well with the unified recovery in income, production, employment and sales. However, for the 2000-2001 recession the NBER call date for the recovery did not line up with these four coincident indicators. Although the recession officially ended in November 2001, employment and income had not turned higher. In fact, they did not trough until March and August 2003 recording lags of 16 and 21 months, respectively. Thus, the economy was only in a partial recovery, a situation that had huge stock market implications.

The S&P 500 Stock Price Index troughed prior to the end of all the NBER defined recessions from 1967 through 1999, in concert with the four key economic variables. However, in 2001 the S&P bottomed 15 months after the end of the NBER defined recession yet one and six months before the cyclical troughs in income and employment, respectively. In other words, stock prices anticipated the complete, not partial, recovery of these pillars of economic growth. Although all four of these indicators are still falling, the critical event for the financial markets will be when all four finally turn higher. If a complete recovery of these four variables is still far in the future, then the current gains in the stock market cannot be sustained, just as rallies were not sustained in 2001.

More here.

Related posts:

• Discerning a real from a fake, technical, statistical, or partial recovery
• Technical recovery won’t feel like a recovery to most
• Personal income and recessions since 1929
• Unemployment numbers still point to partial recovery
• Philly Fed survey points to manufacturing rebound

David Rosenberg is out with a bearish piece on equities today (I hop that doesn’t surprise you).  He sees the market as still overvalued at these levels. The key, he say is that most of the rally has been built on multiple expansion and not earnings growth. Here is what he says (emphasis added)

We heard at the market lows in March 2009 that the stock market had sunk to Armageddon levels. We have often thought about that because we can certainly understand that at the 2.0% lows on the 10-year Treasury note yield, we had gone to a place we had not seen in over five decades. Also, with Baa spreads north of 600bps, we could see that corporate bonds had moved to levels not seen in seven decades as well.

But this notion that we had moved to Armageddon lows in equities does not seem to hold water. After all, the forward P/E multiple on the S&P 500 at the lows was 11.7x. That was not a multi-decade low or some massive standard-deviation figure — we were actually lower than that at the October 1990 lows when the multiple was 10.5x and frankly, coming off the 1987 collapse, the forward P/E had compressed to 9.8x. As it now stands, the multiple is back very close to where it was at the October 2007 market high, when the multiple had expanded to 15.0x. The range on the forward P/E over the last quarter-century is between 9.8x and 21.8x (excluding the tech bubble), so at 14.5x currently, it is hardly the case that this market can be viewed as a bargain.

On a trailing earnings basis, the P/E multiple has actually widened, from 17.0x at the lows to 23.3x currently, a huge multiple expansion. At this stage of the 2003 recovery, the multiple hardly expanded at all, earnings were driving the rebound; coming off the October 1990 lows, the multiple expansion four months into the rally was closer to 2x and the powerful surge in the post-1982 recovery saw a 3x multiple point expansion at this juncture — not 6x!

Back in November 2007, just as the recession was about to take hold, John Mauldin commented that 80% of the stock price appreciation in the 1980s and 1990s bull market came from multiple expansion (also see his May 2006 piece with research from Jeremy Grantham on this).  So, obviously, multiple expansion is part and parcel of the psychology of secular bull markets.  However, Rosenberg’s piece reveals that all secular bull markets in the U.S. for which data is available have started from price-earnings multiples that are much lower than we are seeing at present.  Translation: this is not a secular bull market.

What we have seen since March is a bear market rally, nothing more.

Source

Multiple-Led Market May Meander – David Rosenberg

Related posts:

• Kass: Bearish on equities
• Rosenberg: Still a bear market rally
• Rosenberg thinks U.S. market may Test March lows
• Getting bearish again
• Overbought?

This morning, stock markets are down in Asia and Europe.  And Futures show a likely decline in the U.S.

What’s happening?  I think we are seeing the March rally hitting the wall as the technical recovery everyone is anticipating looks to come later and to be less robust. As a result, commodities are selling off horribly.  Crude has traded under $65 and is down over 3%.

For me, Alcoa’s Wednesday report will give a good sign of how robust the economy is as basic material stocks should do well in an upturn.  In a post in late May Consumers ‘do believe in the green shoot story’, I indicated that June and early July would be key for this overbought market.

Let’s remember that confidence does not translate into consumption, especially as most of the uptick here was in consumer expectations.  Nevertheless, this has grabbed the market’s attention and U.S. stocks are up well over 2% as I write this.  If you were wondering whether the powerful market rally from March has legs, this should come as proof that it does.  The S&P 500 is now above its 20-day average trendline again.

I should caution that an uptick in expectations of this magnitude has a dark side.  If the economic data disappoint in June, we could see a sharp selloff.  That makes the June data and the early July earnings reports very crucial data points.

And I still believe this is true.  The June economic data was not nearly as good as market experts expected and the market has sold off as a result.  he employment data last week was truly dreadful.  If we get poor earnings here in July, this bear market rally is going to get cut down to size.

Key sectors to watch are financials and basic materials.

Sources

Commodity Futures – Bloomberg
CNN Money Pre-Market Data – CNN Money

Related posts:

• Dow 4,000 still in the cards?
• Kass: Bearish on equities
• Rosenberg: Market rally is just multiple expansion
• Are the markets set for a pullback?
• Getting bearish again

I love this guy. If you are looking for a guy who is super bearish on the U.S., then David Tice is your man.  He sees unemployment at 15%, stocks well down from present levels and a serious Depression with a Capital-D in the offing.  In short, he’s talking about a financial and economic catastrophe.  Obviously, I don’t see things quite as starkly based on my previous comments. Nevertheless, he is refreshing to watch. Very entertaining.

Below is a recent clip from 2 Jul 2009 that I caught of him spinning his doomsday tale on Bloomberg.  I liked it so much I decided to post several videos of him from earlier appearances on Bloomberg which are below the first video.  He makes a lot of sense if you watch them in chronological order from bottom to top.

Enjoy.

12 May 2009

17 Apr 2009

05 Feb 2009

25 Aug 2008

9 Jul 2008

16 Apr 2008

06 Feb 2008

20 Nov 2007

Related posts:

• Marc Faber: “it’s very tough for a forecaster who was ultra-bearish to stay bearish”
• Getting bearish again
• A conversation about Prop. 8 with David Boies on Charlie Rose
• Stephen Roach is still bearish, no recovery until 2010
• Why I am bearish on the U.S. Dollar

Yesterday, I wrote “Some think this is a secular bull – a view I am not discussing in this post.  Others see this as a cyclical bull-market a.k.a bear market rally  I would put Jeremy Grantham in this category.  I would also put myself here, although I do think short-covering has made this rally dangerously over-bought.”  Apparently, I am not the only one who thinks this market is way over the top here.  David Rosenberg has issued a missive saying similar things with some robust statistical support.

Going back to 1950, not once has the S&P 500 managed to surge more than 40% in advance of the recession ending. I think mostly everyone would agree that while the recession may be in its final stages, it is not over just yet.

On average, the S&P 500 rallies 20% from the lows to the end of the recession. I realize that the comeback is that we hit an egregious low, but we always do in bear markets. I am just talking about what the ‘norm’ is, in terms of rallies that typify the late stage of the recession in the real economy. So, it would not be untoward to see a 20% correction just to mean revert this rally from the lows, assuming that this is all about hopes of the recession coming to an end. Yes, that would be 750-plus. As an aside, Sam Stovall from Standard & Poor’s stated in the Sunday NYT that 800 on the S&P index is an inevitable retest point.

Again, back to 1950, by the time the S&P 500 was up 42% from a bear market low (as is now the case), not only was the economy not in recession at that point, but it was typically nine months into recovery mode. So even if the consensus is correct that the recession ends by September, the market right now is trading where it would ordinarily be in May 2010. What are we going to do for an encore?

Clearly, this is a case of caveat emptor.

Related posts:

• Rosenberg: Market rally is just multiple expansion
• Chart of the day: bear market history
• Chart of the day: Dow 1928-1932
• Market manipulation, short-covering rallies and cyclical bulls
• Getting bearish again

Nearly a month ago, back on May 5th, I highlighted some testimony by Federal Reserve Chairman Ben Bernanke before congress in a post labelled, “Bernanke expects recovery later this year“.  In his testimony, Bernanke used the phrase ‘Scylla and Charybdis’ to describe the Federal Reserve’s policy challenge regarding deflationary and inflationary forces.  I would like to highlight this characterization because I believe it goes to the core of the debate as to how the global economy and asset markets will fare over the next 5-10 years.  In my view (and apparently in Bernanke’s), both inflationary forces and deflationary forces will be at work for some time to come. This will present policy makers with a problem as the reflation trade comes good, and the resulting policy responses will have serious implications on the medium term outlook for the economy and asset markets.

Deflationary forces

The problem is this: we have just witnessed one of the most serious asset bubbles in history. In fact, I would call the great housing bubble an ‘echo bubble’ that was merely a continuation of the bubble forces that created the technology bubble of the late 1990s.  So, the world saw asset price inflation of the most severe kind for over a decade – from the mid 1990s when Alan Greenspan first voiced concern about ‘irrational exuberance”’ to 2007 when the housing bubble imploded.  What results from the implosion of such a significant bubble is deflation.

Actually, more crisply put, what results is ‘the D-process,’ an outcome highlighted by Ray Dalio of Bridgewater Associates (see my post “A conversation with Bridgewater Associates’ Ray Dalio” for more detail).  This process involves the three D’s of deleveraging, deflation and depression (outlined in my post “We are in depression“).

Richard Koo goes further in his book “The Holy Grail of Macro Economics.”  Here, he argues that the unwind of great bubbles suffers from what he labels a ‘balance sheet recession.’  In essence, companies go from maximizing profits, as they had done in normal times, to a post-bubble concern of reducing debt. Regardless of how much priming of the pump monetary authorities do, the psychology of debt reduction will limit the effectiveness of monetary policy as a policy tool.

In my view, the catalyst for this change of psychology is the ‘debt revulsion’ that ushers in the panic phase of an asset bubble collapse.  (Charles Kindleberger highlights the various stages of a bubble and its implosion in his seminal book “Manias, Panics and Crashes”). In this particular bubble, debt revulsion began post-Lehman Brothers.  What we have seen, therefore, is a reduction in leverage and debt as the most leveraged players have gone to the wall.  But, more than that, the household sector has gotten religion about debt reduction as the savings rate has increased dramatically since Lehman. In fact, I would argue that companies learned their lesson about debt from the aftermath of the tech bubble.  It is the household sector in the U.S. (and the U.K.) which is heavily indebted. Therefore, if the psychology of a balance sheet recession does take form, it will be the household sector leading the charge.

In sum, the psychology after a major bubble is very different than the psychology before its collapse.  The post-bubble emphasis becomes debt reduction and savings, making monetary policy ineffective, not because financial institutions are unwilling lenders but because companies and individuals are unwilling borrowers. These are forces to be reckoned with for some to come.

Inflationary forces

Meanwhile, inflation is going to be a problem too.  Why?  Two principle reasons come to mind: commodity prices and money supply. Now, just yesterday in my most recent post “Kasriel: ‘greater risk for the global economy…is inflation’,” I highlighted Paul Kasriel’s view that there are several inflationary forces, both secular and cyclical which will impinge upon the economy. I want to bear down on just the two forces of commodity prices and money supply.

First, let’s look at money supply.  The Federal Reserve and other central banks have been pumping a lot of money into the financial system in an attempt to add reserves to the system and to take on the intermediation role the wider banking system normally serves.  Nevertheless, this money is not being lent out and excess reserves are piling up at the Federal Reserve.  Last April, there were only $1.8 billion in excess reserves i.e. reserves against which loans were not being made. According to figures just released by the Fed on May 28th, this April that figure has soared to $824.4 billion, a surge of 447 times in one year. If you want to know what is wrong with the American economy, you should start here.

But, what happens when the economy returns to an environment in which those excess reserves start to be lent out?  Inflation.  And this is an inflation that will not be so easy to control because the Federal Reserve has embarked on a policy of ‘qualitative easing’ by buying up non-treasury assets, transforming its balance sheet from one dominated by treasury assets to one in which Treasury assets are in the minority.  So, as the Fed has intervened and bloated its balance sheet, an increasing amount of the assets it has with which to withdraw the excess liquidity in the system is hard to sell.

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet.  Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline.  Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices.  But, Copper is near a seven-month high. Oil is near a seven-month high.  And all of the agricultural and industrial commodities are taking off again.  As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces.  This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

Scylla and Charybdis

So, how do I see this push and pull of deflationary and inflationary forces playing out?  There are two outcomes I am looking for.

Outcome Number One

• No policy traction. This is a sluggish muddle-through Japanese scenario where the Richard Koo thesis of the balance sheet recession comes into play. You would see an output gap and below-trend growth for an extended period. Most pundits would say it is the lack of lending that is creating the problem.  However, what if it is the lack of borrowing which is at fault?  Then, we are going to see no traction from monetary policy.

Outcome Number Two

• Start-Stop economy. I believe Bernanke would prefer this outcome. This is one in which the Federal Reserve allows the economy to recover by keeping interest rates low.  The result is a rise in inflation. We could see inflation rising to 3 percent inflation and then to 5 to 7 and 10 percent. An example would be animal spirits coming back in 2010. And leading to 3 percent inflation followed by 7 percent including $100 oil and then interest rate hikes and another recession at which point the deleveraging begins again in earnest. Followed by more easing and on it goes. But, of course, the problem with outcome two is it is unstable and that it invites an aggressive policy response which risks situation one as an ultimate outcome.

Neither of these scenarios is one in which asset markets are likely to benefit, one reason I see the latest uptick in share prices as nothing more than a bear market rally.

Sources
H.3 Aggregate Reserves of Depository Institutions and the Monetary Base, current release – U.S. Federal Reserve website
H.4.1 Factors Affecting Reserve Balances, current release – U.S. Federal Reserve website
Copper Falls From 7-Month High on Speculation Gains Too Rapid – Bloomberg.com
Soybeans Advances to 8-Month High, Corn Gains to 7-Month Peak – Bloomberg.com
Oil Falls From Seven-Month High on Signs OPEC Output Climbing – Bloomberg.com

Related posts:

• Is quantitative easing really inflationary?
• The next crisis is already under way
• Debtflation
• Morgan Stanley warns of a new inflationary period
• Plosser: The Fed must stop qualitative easing

There has been a lot of chatter in the markets about why U.S. equities continue to rally.  Three distinct viewpoints have surfaced, two of which are bearish and one which is bullish.  Let me share those theories with you.

1. Market Manipulation aka. the Plunge Protection Team

In this storyline, someone (probably the famed Plunge Protection Team) is manipulating the market to push it higher.  Michael Panzner pointed out this view last Friday in a post called “Manipulation, Anyone? Now, Michael’s site is called Financial Armageddon, so you know he’s bearish and the post reflects this.

Coming as it did on the last day of the week at the end of a month, some might find the action that took place near today’s close to be rather interesting.

From 3:54:28 pm to 4:00:02 pm, S&P 500 e-mini futures rallied 17.25 points on approximate volume of 356,300 contracts, or 19.3% of the total turnover from 9:30 a.m. until futures finished trading at 4:15 p.m.

Hmmm. Manipulation, anyone?

2. Short-covering rally

But, while Panzner thinks outright manipulation is to blame, he is not alone in seeing this upward move as suspicious.  Others point to technical factors as responsible for why the market(s) is rallying (It is not just the U.S. – as I write this the Dax has rallied 4% AND the S&P 500 is up over 2%).  Yves Smith pointed out a post over at the Market Ticker which sees short covering as very much a factor in Friday’s late-day rally.

What does this all mean?  A few things:

1. The stops up there are gone.  They were potential rocket fuel for next week and the propellant to take us to – and potentially through – the 200DMA on the cash.
2. A bunch of someones had a lot of contracts that were short taken out on them.  Those nearly 250,000 E-mini contracts did change hands, and odds are a very large percentage of them constituted stop-loss orders on contracts sold short from when we were up toward 933 a few weeks ago.  Those traders are going to be quite pissed off, but that’s the risk of the game.

Next week is very likely to be extraordinarily violent, especially Monday.  /ZN (10 year Treasury futures) has seen an insane drop in open interest over the last few weeks.  This little game undoubtedly severely damaged open interest in the E-Mini /ES contract.

Thin markets are dangerous markets.  While the E-Mini still is very liquid, the removal of these stops from the order book leaves the door open for both little resistance if the market decides to move higher early next week, and also provides the potential for irritated shorts to re-establish their positions short, driving the market lower.  Those who wound up long during that little ramp job are likely to be rather nervous as well.

For my part I shorted that spike.  Not large, and I am fully prepared to hedge it Sunday evening if necessary or just take it down, as there is every possibility, this close to the 200MA, that we will at least hit it on the cash, and blowing through it on volume and continuing higher cannot be ruled out.

I will note, however, that the last time we saw this sort of dislocation activity start up into the close it it too began with these sorts of “rocket shot” moves higher – and once the shorts were all blown out by having their stops run, the market essentially pancaked.

Look sharp – the sharks are in the water and you taste good.

For those of you who need a translation of what this means, I would say this: someone who was short had to liquidate a very large position due to a margin call and this forced the market up.  In fact, many people believe (Meredith Whitney included) that much of the recent rally has nothing to do with fundamentals and is a short-covering rally plain and simple. Even so, it is a powerful rally nonetheless, and the shorts are getting killed.

3. Bull-Market/Secular Bear Market Rally

Then there is the bullish view.  This view sees the market rally as a real bull market based on the potential for economic recovery sometime in the second half of 2009. Some think this is a secular bull – a view I am not discussing in this post.  Others see this as a cyclical bull-market a.k.a bear market rally  I would put Jeremy Grantham in this category.  I would also put myself here, although I do think short-covering has made this rally dangerously over-bought.  Paul Kedrosky recently made the bear market rally story very well in an interview with Tech Ticker’s Aaron Task (see the attached video as well).

Kedrosky thinks the S&P could approach 1100 by year-end, which would translate into the Dow well above 10,000.

Nonetheless, he believes it’s a bear market rally and unlikely to continue into 2010 as the market to get hit by fears of a “double-dip” recession.

How long the rally last is dependent on how long authorities can prop up the economy artificially.  Remember the huge rally from 2002-2007 that took the Dow and S&P to new highs?  That was a very long bear market rally.  So, it is not altogether clear where the market is headed over the medium term. In my view, the U.S.market is going to eventually re-test its 2009 lows (which are 14 year lows when adjusted for inflation).

For now, there are enough doubters about how ‘real’ this rally is to provide road kill for the uptrend, making the kick up that much more powerful.  Witness today’s breathtaking surge to the upside. When and whether systemic weakness re-asserts itself is another question altogether.  For now, the bulls have gained hold.

Related posts:

• Overbought?
• Rosenberg thinks U.S. market may Test March lows
• Jim Chanos: “It’s a bear market rally”
• Random musings on the market direction
• Is the short covering rally over?