It Won’t Go Down Forever


The worst possible thing that could happen to the stock market right now is a rapid bounce. A strong bounce would show that investors still don’t “get it” and are thinking the stock market is seriously undervalued and a quick buck can be made. In many ways, a quick bounce that would set up a worse decline later would be more damaging than another, bigger washout tomorrow that cleaned out everyone who was buying for a trade.

I covered the last of my put options this morning, and if the market trades lower tomorrow I will be buying. I will not be buying very much, because I don’t see the market as cheap. According to the model I use, the 10-year expected real return for stocks based on the current valuation is around 3.35%. That’s still pretty weak, except for the fact that real returns available other markets are even worse (10-year TIPS yield 0.15%). But at 3.35% real per annum, I’m not taking all the risk for no return as I was only a couple of weeks ago. Again, I will not be buying very much. I will probably buy one third of the allocation I consider personally neutral.

But there’s no hurry, and I may wait if the market looks like it has no bottom to it. I am acutely aware that the S&P fell 6.7% today, on higher volume still, two days after falling 4.8%. And any student of history will be acutely aware that the 20% stock market crash in 1987 didn’t come completely out of the blue but rather happened after the S&P had first fallen 3%, 2.4%, and 5.2% in the days before Black Monday. And the cumulative fall from the high, prior to the crash, was 14%. Right now, the S&P is down 16.9% from its high. I seriously doubt history will repeat that event, but I would be silly to be aggressively lifting offers while others still doubt less than I do.

And if I buy and there’s a quick bounce, I will probably sell. These valuations are not “attractive” in any historical sense of the word, especially with inflation coming. I believe we will get lower equity prices still, although not necessarily right away.

By the same token, I will not be rushing to sell bonds, although when this crisis has the first whiff of having passed, I will. Bonds are not only at levels not seen since the 2008 crisis, they are also at yields below the bottom of the long term bull market yield chart (see Chart – note this is on a monthly-close basis so technically there has been no violation yet) – even though I have long thought bonds had begun the next bear market. As I will argue below, there is nothing to suggest that bond yields have an equilibrium value anywhere near here, when inflation is heading higher and likely to accelerate. I continue to advocate commodity index positions as well, for similar reasons. They have less of an advantage today over equities than they did a few weeks ago, but with real yields this low commodities have historically been strong performers.

Long-term, logarithmic channel in 10-year note yields (monthly). Note last point is today.

Now, that’s what I have to say about strategy. I’ve put it first in this comment even though I usually leave it for last, because I suspect many readers may want to cut to the chase. But I guess the overriding message should be: be patient. This has been coming for a long time, and there is a lot of bearish work to do. At the same time, don’t crawl into a shell. Lower prices are great for long-term investors with cash. It’s okay to average in. You want to participate in the future growth of the economy, if you can do it at a fair price. If you’re a day trader? Well, buckle your seat belt, I guess. There is lots of volatility to come.

And that’s because this has only just begun.

Let’s be clear: the equity market selloff had nothing to do with the downgrade of the US credit rating. Bonds themselves rallied. The credit rating cut is not going to affect any haircuts, it seems – at least, various authorities that enforce haircuts (such as the FDIC) have come out and said as much. That was the big immediate risk from the downgrade. There are others, which I’ll mention later, but the market was not reacting to them.

This is somewhat tongue-in-cheek: Treasury Secretary Geithner told the Obama Administration over the weekend that he decided to stay on. Considering he is easily the worst Treasury Secretary since Paul O’Neill (the first secretary under George W Bush; he served two blessedly short years), that cannot be good for the market. As I said, that’s a little tongue-in-cheek. But just a little.

The troubles in Europe remain far more important to the market. Rumors have started to swirl about just which banks will fail. I don’t know which will fail. Maybe none of them will fail. (But many of them are insolvent, and we already knew that.) Meanwhile, it cannot build confidence, although it was meant to, that the ECB bought massive quantities of Italian and Spanish government bonds today, causing yields to fall on the order of 80bps. Nice trading, guys. When someone lifts every offer in sight rather than wait to see where the market clears, it’s not an economic buy. And it’s a sign of weakness. If there was real commitment behind the buying, the ECB would buy all the bonds offered at 6% (for example), then move the bid to 5.95% and buy all the bonds there, and so on – taking the time to make sure that the selling pressure at that level was exhausted first. By making a sloppy purchase, they’re trying to intimidate shorts. That almost never works. If you watch the equity tape, and you see the market go from 1100.20-.30 to 1101 bid with nothing trading in between, and then rapidly move up to 1103, it either means that someone entered a large market order stupidly or someone said “buy two thousand and make it sloppy.” Usually, the market comes back to test the buyer’s resolve. And I think that will happen this time, because putting the yields down doesn’t solve the fundamental problems that got the yields up in the first place.

And there is a more-fundamental question here to be asked of the ECB. If we’re not supposed to worry about Italy and Spain, why are you worried about Italy and Spain?

Commodities got smoked, with energy markets off 4-6%, Grains -2.4%, Livestock -1.2%, Softs -2.3%, and Industrial Metals -3.3%. Note that in each case, you’d still have rather held commodities than stocks! And, thanks to the sterling performance of the precious metals (+3.6%), the DJ-UBS Commodity index fell only 2%.

There’s clearly fear, and some optimistic bulls who bought on Friday were clearly being flushed today. I think this qualifies as panic (which doesn’t mean it is over, but that is a precondition to it being over). And at this hour, S&P futures are down another 26 points. A triple-digit S&P is not all that far away.

Tomorrow is the FOMC meeting, and not a moment too soon. I have held for some time that no QE3 was coming, and on the basis of the economy I think that’s the right read. However, the importance that Bernanke has attributed to the stock market’s level does make one wonder. But consider that the last two weeks’ trading, while it increases the calls in some quarters for QE3, also helps demonstrate the uselessness of QE2. The chart below demonstrates quite clearly that QE2 had essentially no lasting effecton stock market prices.

QE2 did basically nothing for equity prices. QED.

At the same time, commodity indices are still up 18-19% since the end of August (albeit roughly unchanged from November 12th). So QE2 either pushed prices higher, or had no lasting effect, on commodities prices too.

That proposition sounds amazing, until you remember that most of QE2 is still sitting in bank reserves and only a little bit has made it into transactional money, until recently. It isn’t supposed to affect anything while it is sitting in reserves, except bank funding ratios. This is why, if the Fed does anything – and let’s face it, if they do nothing the market will puke – I think the most aggressive action they are likely to take would be to eliminate the payment of Interest On Excess Reserves (IOER). Frankly, I’d advocate making it negative, but reducing it to get QE2 actually into circulation would be a reasonable first step. This is not to say that I am confident the Fed won’t announce another trillion in bond buys – only that such an announcement would be stupid.

Now, let’s talk about inflation. Commodities have recently suffered on growth concerns. TIPS are doing very well, though that’s partly because they are US government bonds. If the Fed wishes, they can talk themselves into believing that the slow growth we are experiencing could press inflation lower. It certainly will have that effect with headline inflation because of the decline in energy prices. It won’t affect core inflation, but the Fed models suggest it will (of course, the augmented Phillips Curve model and other models like the “threshold” model discussed here in a recent New York Fed piece http://www.newyorkfed.org/research/current_issues/ci17-3.pdf also predict that core should still be declining, so they’ve sort of seriously failed, but…) In any event, if the Fed wants to figure out how to ease, they’re not going to let core inflation below 2% impede them, regardless of whether it is currently rising or not. I will be interested to hear their new ideas.

But whether or not the Fed pursues QE3 or some other form of liquidity provision, it is now obvious that every other central bank will be adding liquidity. And the currency wars are about to begin. Here’s why: all politicians know the Keynesian equation C+I+G+(X-M). They all “know” that if they’re going to cut government spending (G) through austerity, then they must increase net exports (X-M). To do that, each country needs to weaken its currency, which is why Trichet last week made the comment about how a strong US dollar was in the world’s (except the US) best interest. The currency wars are going to have to happen. Now, economists should know that C+I+G+(X-M) is a static equilibrium for a single country, and not a prescription for the world’s nations collectively. Since my X is your M, global GDP is C+I+G. (And, frankly, that also is not a prescription since this period’s G affects future periods C+I, but let’s not worry about that wrinkle). However, and this is key, politicians are not re-elected by the world, and central bankers do not serve the world. They’re re-elected locally (or appointed, in the case of central bankers), and we’re going to have currency/devaluation wars.

And that means global inflation is going to be going up further. The way one weakens one’s currency is to print a lot of it, so there are plenty of Euros (for example) relative to dollars. Or yen. But the best way to fight back is for the producers of dollars, or yen, or whatever to print more of their currency, and so on. The only winners here are debtors and commodities producers.

Is it the only way out? Must we have currency wars? Of course not; I just think it is the most-likely future path over the next year or two. And I could well be wrong. But inflation is already rising and I don’t see it stopping; and this is the reason I’ll look to finally sell bonds soon.

Now, while we’re still worrying about Europe, and the FOMC, and currency wars, there are some concerns related to the US credit downgrade that we need to keep in mind. Yes, no one will sell US Treasuries because of the downgrade. But Fannie Mae and Freddie Mac were downgraded by S&P today, since they were only AAA because of the government’s backing. This is actually defensible, since there is no law saying the Treasury must backstop these entities. Will investors sell agency paper that is no longer AAA? What about munis, which will also presumably have trouble maintaining top ratings higher than the sovereign rating? That’s where you could get some pretty ugly performance.

Ironically, that would be salutary for Treasuries themselves, since the obvious trade is from agencies back into Treasuries. What else are you going to buy? Bank paper?

There are worse times ahead – for the global economy. The 2008 crisis was not allowed to serve its function by purging the imbalances, and now there is further purging to come. But the good news for domestic investors is that US banks are relatively less-exposed than they were prior to 2008. The global financial markets are interconnected, to be sure, but the banking system is now adequately liquefied (if not necessarily adequately capitalized for an event of this magnitude), and the Federal Reserve if nothing else learned in 2008 what sorts of policies actually help and which do not. Just as soldiers are readier for their second battle than for their first, the Fed is more-prepared to do something useful if the crisis starts lapping more seriously here (and I don’t mean stocks going down, I mean financial stability). There isn’t a lot of market-related competence at the Fed, but even they learn. We have a period of slow growth and inflation ahead of us, but I don’t think the financial system is seriously at risk this time.

Still, if you are a CFO and your company has credit lines that are not guaranteed, consider drawing them down. Paying a little bit of interest to preserve that liquidity beats the heck out of seeing them pulled in a repeat of 2008, right?

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  1. USIKPA
    August 9, 2011 at 1:30 am

    Thank you for this comprehensive macro review.

    I guess S&P’s downgrade easily shaved off (and more) whatever risk premium reduction had been so painfully achieved for the world economies with the QE2 implementation…. Risk re-pricing!

    I am a long term investor with cash, as you write above. I am looking at freshly issued Composite Leading Indicators for June by OECD. Europe’s reversal has been confirmed. USA and China’s economies are on their way down as well. We ought to be going through the recession now.

    Unless BB does something fundamentally stupid again, I fear we are on the brink of commodities’ fundamental purge. Do you agree?

    Thank you

    • August 9, 2011 at 5:04 am

      I really don’t worry about commodities going down very much. Historically, commodities tend to do well when real interest rates are low, as they are now. As long as the central banks keep on printing, and especially as M2 keeps booming, I’m not going to be dropping away from my commodities exposure. If I am right, then paper currency is about to get very weak compared to hard stuff.

  2. August 9, 2011 at 3:00 am

    Dropping the rate on excess reserves seems pretty scary to me. I’m not going to go to the FRED and look it up but the reserves are well over $1.6 trillion from memory. Do you really want that circulating around? How is inflation going to be looking then?

    One qualifier is that this money would be unlikely to be lent to people, since banks can already lend to credit worthy borrowers if they want to — the problem is lack of credit worthy borrowers at a given lending rate. This money is sitting in reserves because their are no suitable borrowers. So it is unclear to me what the banks would actually do with this money in the absence of being able to lend it.

    Also

    C+I+G+(X-M) is just an accounting expression — for the national accounts.

    Likewise (X-M) = (T-G) + (S-I) is another way of writing the national accounting equation.

    This says that if a country is running a current account deficit then the net of the government sector, T-G, and private sector, S-I, must be in deficit. It follows that if a government runs a balanced budget, while the country runs a current account deficit, the private sector must, by way of accounting, be in deficit.

    So just as one country’s M is another country’s X, a government’s deficit is the private sectors surplus (if the current account were zero) — which serves to illustrate the madness of a balanced budget proposal.

    • August 9, 2011 at 5:10 am

      Well, I really don’t want all those reserves circulating…but if the Fed is going to do a QE3 it seems silly not to get QE2 finished off, right?

      I think that banks would definitely lend if you penalized the rate sufficiently. By keeping IOER high, you’re forcing the cutoff of “credit-worthy borrower” higher because the price of a substitute (riskless reserves) is higher. Lower the price of a substitute, and you’ll see more lending at any given rate.

      The internal vs external accounting equivalence is important, and I’m glad you brought it up. We have to be careful not to read into it a certain causality, though, such as “if the external account goes into deficit then it will cause more domestic savings.” It might just as well be that when G drops, exports rise or imports fall. Both would preserve the equality. Taken to the extreme, your opposition to a balanced budget amendment would read as “no point doing anything, because it’s all got to balance.” This is true in a static equilibrium, but in a dynamic equilibrium where next period’s investment is related to this period’s government spending, all forms of current spending may not be created equal. At least, THAT is the main contention of the balanced budget people.

      • August 9, 2011 at 4:08 pm

        Good point about the extra margin. I agree it would/should increase loans on that basis. It would be interesting to see by how much. For example is their data on how much they decreased when the IOER was brought in?

        True, re: causation. If G drops then I’d expect imports to almost certainly fall, so the CAD will shrink, but lets face facts, despite all the policy regimes for decades the USA runs CADs. Even 2009 when the economy was on life support there was a CAD (with shrinking imports). So the way I look at it is that proponents of a balanced budget should explain by what mechanism additional policy measures will eliminate the CAD. If you accept that a CAD is more than likely to exist, then, without even knowing the causation, you can conclude that the private sector will be hammered by a balanced budget, since at the end of each and every time increment it is in deficit.

  3. August 9, 2011 at 6:31 pm

    Very fair points!

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