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Waiting on QE3

“When the only tool you have is a hammer, every problem begins to resemble a nail.”
– Maslow’s Maxim

The market is gearing up for the announcement of another round of Quantitative Easing to be dubbed QE3, although one could argue that QE3 has already started with the opening of practically unlimited swap lines between the US and European Central Banks.

The signs that the Risk Markets need a kick to keep the party rolling are popping up around the globe:


GDP was a bit soggy in 4Q. There are plenty of reasons for disappointment:

  1. a bit too much inventory build,
  2. a worrying drop in the savings rate,
  3. lower 4Q earnings surprises and growth than 3Q numbers, and
  4. 1.5 – 2% GDP growth rate which means that US voters will go to the polls in November with around 8.5% unemployment.

To confirm the slow growth trend, the FED has made the unprecedented announcement that it will keep rates at current near-zero levels for the next three years. Team Obama may hope that the Republicans tear themselves apart in the primary season but that is no reason not to try a few more Keynesian and Monetarist kicks to the system to spruce up the economic backdrop for the autumn.


Asia typically greets the first day of trading after Chinese New Year with a rally, especially for a “Dragon Year”. However this year, only Taiwan managed to pull out a positive day on delayed reaction to strong Apple numbers. Hong Kong and Chinese investors parsed poor real estate sales results over the Chinese New Year Holiday and took the Hang Seng Index down towards the so recently breached 20k mark.


And not to be left out, Europe is preparing for another cycle of summits to solve the “Euro Crisis”.
Whatever solution bubbles up from the cauldron this time, it seems to be too late to save Greece from exiting the Eurozone. The real question now is whether the Eurozone can draw a line at Spain and Italy (Portugal appears to be the other acceptable casualty of the Euro Crisis). No matter what the politicians decide, recession (and worse) will haunt the Eurozone for most of 2012.

What is the System Saying?

The system can be described as somewhat lukewarm about risk assets with a definite preference for US listed equities. Top ratings for funds and ETFs are in the teens and for S&P 500, there are a few rating in the 30s and 40s. Given the extremely high likelihood of another round of government stimulus and Central Bank pump priming, one should wait for the next burst of bullish enthusiasm before taking profits.

January Effect

Traditionally in the US, January is a time for chasing small caps. The NASDAQ has outpaced the S&P 500 almost 7% to 4.6% so far this month. In Asia, some of the larger markets will close or be affected by the closures around the Chinese New Year Holiday. Since the New Year will be a Dragon Year, expect at least a few strong sessions when markets reopen.

What does this mean for riskier assets? A bullish forecast off the back of a January rally is a dangerous one. Right now, the positives and potential negatives suggest another volatile year.

Housing Stocks Come Back to Life

There is no doubt that the US is starting to rouse from the GFC imposed slumber. A Financial Crisis induced recession is harder to bounce back from than the more common inventory cycle recession. One consequence (amongst many) is that one traditional avenue of entrepreneurial capital (residential real estate) has not be readily available to finance new business start-ups because of falling housing prices and general bank reluctance to extend credit to the private sector. That deep freeze appears to be thawing a bit. The bellwethers of the US domestic housing market (ITB and XHB for ETFs, LOW, HD, PHM, and LEN for individual stocks) have turned up strongly. Will this be a “head fake” like the last time XHB surged from July 8th 2009 to April 23rd 2010 (+89%)? Perhaps, but with other positive “green shoots”, this surge (from October 4th 2011, +58%) may not reverse as dramatically as the last one. Given the sharp run-up and some good earnings reports, don’t be surprised if there is a correction in the coming weeks, though.

The housing sector bears watching. If entrepreneurs can unlock capital in residential housing, the Great American Job Creation Machine can crank back into gear (recent job report numbers are rounding errors compared to what they should be for a full blooded recovery).

Summer in Europe?

Unfortunately in our interconnected world, the troubles brewing in Europe still look likely to cause more heartburn in the next few months. There is little doubt that Europe has failed to sort out the sovereign debt crisis of its periphery to the satisfaction of financial markets. Credit agency downgrades only confirm what most market players have been saying for months…the sums do not add up. The next “final deal” will just be one of a series of “deals” that will see a series of painful writedowns for the banks. Bank Capital is being bolstered largely by clever accounting tricks these days. And with hedge funds buying up troubled sovereign debt and relatively cheap Credit Default Swaps, the prospect for an orderly “voluntary” haircut looks somewhat diminished. The rot is spreading from the periphery to the core and until the Germans are forced to make some hard political decisions, the rot will continue to spread inward.

So what is left for Europe? Very likely…devaluation.

In a rambling article for Bloomberg, two professors from MIT make the case that Italy is crucial to the Euro’s survival and that unlike most other European countries, Italy has a significant amount of trade outside the EU (55% of exports according to the authors). Given those two factors, a Euro trading at parity with the US dollar should help Northern Italian exporters boost exports enough to make a difference. And, since Italy boasts a massive and vulnerable bond market, any improvement should help to relieve pressure on the Euro’s long term survival as a common currency (ETF: FXE).

How will this play in the US and other emerging markets?

In the short term, it means that a summer holiday in Europe might be a great bargain. In the medium to longer term, a more competitive Europe could hamper any manufacturing renaissance in the US as a large swing in exchange rates allow German exporters to price more keenly than US Midwestern component makers (and makers of commercial aircraft). For China, the authorities in Beijing probably have enough fiscal and monetary firepower to overcome the negative effects of a Euro devaluation (the Eurozone is both a large customer and competitor of China).

One can only guess whether China will continue to diversify its foreign exchange holdings into Euros. Given the likelihood of a significantly lower exchange rate in the not too distant future, it would not be surprising to see the People’s Bank directing its traders towards other currencies for the time being. Given the massive size of the foreign exchange reserves and China’s desire to hold down domestic inflation, the US dollar is probably the only reasonable home for recycling the trade surplus (ETF: UUP).

Chinese Numbers

The market took great comfort in the 4Q GDP number (+8.9%) published an efficient 17 days after the end of the quarter (perhaps the BEA could pick up a few pointers). With a small improvement over the consensus of 8.7%, concerns of a weak Chinese economy have been banished from the 24 hour news cycle for the time being.

China GDP

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Baltic Dry Index

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

The Elephant Parade

Watching the market action over the last few months, I am reminded of the traditional circus of my youth. When the Ringling Brothers rolled into Madison Square Garden, the elephants would march in at the beginning of the show. Each elephant would hold the tail of the elephant in front with his or her trunk and they would parade around the main ring. When the ringmaster raised his hands, the elephants would lift their trunks, and consequently, the tails of the elephant in front. When the ringmaster lowered his hands, the trunks went down. Around and around it would go until the elephants found their places and started lifting clowns and circus girls into the air with their now unoccupied trunks.

Obviously the ponderous elephants today are the financial markets around the globe which have risen only after dramatic flourishes by the ringmasters (Central Bank worthies and European politicians). However, when these ringmasters let their arms down to prepare for the next flourish, the elephants have been dropping their trunks around the world. Without the ringmaster, market participants are not willing to step out of line and risk capital (note the repeated approaches to but few breaches of the 200 day moving average on the SPX). And this observation is not just a reminiscence of youth. Thanks to Bloomberg, it is not hard to plot the increasingly correlated nature of the main equity indices.

Correlations between the equities markets are tightening

Data Source: Bloomberg

I constructed this chart by taking the weekly correlation measurements at monthly intervals. At the far left it measures the correlation for 12 months (Dec 15 2010 – Dec 15 2011). The next point is from Jan 15 2011 – Dec 15 2011 (11 months) and so on until the last data point on the right which measures just the past month. The function on Bloomberg is CORR for the Correlation Matrix.

What do I think this means?

Although this is a non-standard “study” of the market, I think it demonstrates pretty clearly how dramatically the nature of the markets have changed over the year. What surprised me the most was how much GLD’s relationship with the SPX has shifted (much to the chagrin of gold bugs with 2000 price targets). I also looked at TLT as a proxy for treasuries and its correlation moved from -0.79 to -0.87 through the same period. I suspect that the “dead hand” of policy risk (both political and monetary) has stamped down the risk appetite amongst investors for any significant investment time horizon.

I think there are two key take-aways from these “observations”.

First, we need to watch for opportunities to sell puts and calls when the VIX is high because there are not the usual amount of “asset allocation” opportunities to make money. With little divergence to play for and markets that appear range bound in the medium term, clipping options premiums may not be a bad way to pass the time.

Second, we need to watch for the divergence. Although I have not done an exhaustive study, it makes sense that market convergence and divergence would happen in waves. As we saw in the 2008/9 period, the high correlation into the meltdown was matched by a divergence once the markets started to rally off the bottom. If history is any guide, a shift towards more divergence should spell the end of the current slog. At that point, we should see winners and losers emerging and asset class breakouts (hopefully to the upside). It will be a concurrent indicator at best but with the current lack of confidence, that may be a useful confirmation of a change in trend.

History Rhymes

As we pointed out in a previous post, the action on the S&P 500 reminds us of a similar period in May 2008. Investors tried to rally the market above its 200 day moving average (see faint red circle) and failed…leading eventually to a 40% drop.

S&P 500 in 2008

S&P500 in 2008

Source: Bloomberg

This year, we are faced with a similar pattern. There is good news in the S&P 500 (75% of the companies have exceeded expectations in 3Q numbers) and the US economy is still growing (albeit at a sluggish 2-3% pace). When this pattern appeared in 2008, the US economy was already in recession (started from December 2007, declared on December 1st 2008).

This time around, while there is a significant risk that the US economy is already tipping into recession (ECRI declared one in September), the two big issues dominating the market continue to be the European Sovereign Debt Crisis and the Political Gridlock in the US.

The Euro Crisis impacts the largest economic area in the world on a combined basis. Unfortunately, the central design flaw of the Euro (monetary union without fiscal union) has been exposed. There is too much sovereign debt in Europe and too much of it is owned by European banks which in turn have too little capital to absorb any losses. Germany is the only player with the economic and political clout to resolve the problem and it has yet to decide on which expensive resolution to adopt.

The US continues to struggle with political gridlock which in normal economic circumstances might not be such a problem. However, with such tepid consumer demand growth and a corporate sector keener to horde cash than invest in new projects and employees, the issue of the federal budget is causing deep anxiety amongst investors. For the middle of the road voter, who will once again swing the election next year, the choices are stark and surprisingly well understood. The Republican plan emphasizes spending cuts and will translate into an immediate reduction in GDP. The Democratic preference for stimulus spending financed with higher taxes will lead to a more gradual reduction in GDP but runs the risk of blowing out the deficit and attracting the negative attention of the bond market.

Neither outcome is particularly good for corporate profits and stock market performance. This is why we are seeing the October rally start to fade.

S&P 500…last six months.

S&P500 Today

Source: Bloomberg

What should investors do?

The System continues to favor short ETFs, short term US government paper and Gold. In other words, there is no underlying momentum in risk assets that should give one confidence at this time. The fate of the macro-economic foundations of half the globe’s GDP is in the hands of politicians who are faced with no easy choices and one of the leading forecasters of business cycles has called for a recession in the US.

We have often observed that the Bull Market slogans of the 80’s and 90’s (Buy and Hold…Buy the Dips) have served investors poorly since the dawn of the new millennium. At this juncture, we would remind investors of that observation continue to maintain a cautious investment stance.

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