For the past two years I have been firmly in the bear camp and the greatest risk I face is becoming a perma-bear and missing the turn in the markets. Thus, to overcome becoming too bearish I browse the data looking for signs of stabilization and a possible turning point in the markets and economy, and have recently found some signs of stabilization that a major bottom is forming. However, while I see signs of a bottom there are still some current developments that prevent me from becoming bullish currently, and I still can’t shake the secular head winds that I see facing the economy and markets for years to come.
Current Positive Developments
One particular development that caught my eye last week was a chart that appeared on CalculatedRiskblog.com, which showed that the drag from residential fixed investment on real GDP was beginning to weaken, which has been a hallmark of previous economic recoveries. While residential fixed investment typically leads the economy, equipment and software expenditures act as a coincident indicator as they usually bottom at the conclusion to a recession and nonresidential fixed investment serves as a lagging indicator. The chart that was shown on Calculated Risk was recreated and provided below, which shows the typically cycle of the three series over the last few decades. So far it does indeed appear that residential fixed investment has bottomed in terms of the magnitude of its negative impact on real GDP growth, though equipment and software expenditures are still collapsing and nonresidential real estate is just beginning to roll over.
Source: BEA (Hat Tip: CalculatedRiskblog.com)
On the technical front, we are beginning to see signs of divergence within equities as the various sector correlations to the S&P 500 are beginning to decline. During panic sell offs and deleveraging, investors and wealth managers hit the sell button regardless of what they were selling, dumping anything they can in a mad dash for cash. The last quarter of 2008 is a perfect case in point, where the correlation between the various S&P 500 sectors with the S&P 500 was virtually one, indicating a nearly perfectly positive relationship. However, at market bottoms the new market leaders begin to emerge and outperform the broad markets as they become less correlated with the market.
To illustrate this point I have provided below a figure of the S&P 500 with the average S&P 500 sector correlation, which is shown inverted in the figure for directional similarity. As seen below, after the 1990 bear market the average sector correlation quickly dropped below 0.90 and ultimately bottomed near 0.65 as the market rolled over in 1994 during the mid-cycle slow down. Late in 1994 the average sector correlation peaked (bottomed in figure) and then began to fall as various sectors began to dance to their own tune.
As deleveraging can lead to a higher correlation among the S&P 500 sectors, so too can reflation. For example, the money supply exploded upwards in the latter half of the 1990s, as did margin credit, which helped drive all ten sectors higher. This is what occurred after the average sector correlation bottomed in early 1996 and then rose (declined in figure) into 1998 as the money supply and margin credit expanded rapidly. Accompanying the bottom in 1998 was a decline in the sector correlation that ultimately drove the correlation down to 0.45 in early 2001.
Source: Bloomberg
While the S&P 500 peaked in the middle of 2000 many sectors continued higher as the technology sector was the main factor in driving the S&P 500 due to their overweighting. As the economy slipped into recession all ten sectors rolled over and the average sector correlation rose for several years before peaking in 2003, signifying the bottom was in. Moving on to the present, the average sector correlation began to increase in early 2007 and its bottom in early 2008 was during the January low in the markets. The correlation then declined until September of last year, which then saw a wave of deleveraging that drove down nearly all assets as correlations were driven higher.
Currently, the average sector correlation is stabilizing after reaching the highest levels in more than a decade, indicating that the ten S&P 500 sectors may begin to distinguish themselves from the broad market. A significant decline in the correlation would be needed to confirm that a bottom was likely in and is still missing, with current developments simply pointing to stabilization.
Another positive development that supports the above analysis that various sectors, and individual stocks for that matter, may be starting to distinguish themselves is that the number of new lows on the NYSE is beginning to contract with each new low in the markets. This is another hallmark of a market that is forming a bottom as fewer and fewer stocks are driven to new lows with the broad indices. This is seen below as the peak percentage of NYSE issues hitting new lows occurred at the October 10th lows, with a lower percentage hitting new lows at the November market lows, and the current new low has seen an even smaller number of NYSE issues making new lows.
Source: Bloomberg
The setup above was also seen during the 2002-2003 market bottom that witnessed a peak in NYSE issues making new lows in the middle of 2002, a lower peak later in the year, and then a significantly smaller percentage hitting new lows in early 2003.
Source: Bloomberg
This general setup was also witnessed during the 1998 correction that saw the retest of the September 1998 lows occur with a smaller percentage of stocks hitting new lows as many were significantly above their prior lows during the markets retest.
Source: Bloomberg
One last example is seen below during the 1990 market sell off as each successive low in the markets was associated with fewer and fewer issues making new lows as market breadth improved.
Source: Bloomberg
Negative Developments
While there are some positive developments present in the market, there is one development that has me greatly concerned, and that is the risk coming out of Eastern Europe. As many newsletter writers have pointed out, Eastern European countries are experiencing severe stress as their economies topple and stock markets plunge; and there is a risk of an Eastern European currency crisis that could be even more severe than the Asian Currency Crisis that occurred in 1997-1998. For a more in depth analysis of the situation in Europe, particularly Eastern Europe, please read the March newsletter from Niels C. Jensen of Absolute Return Partners LLP (“Europe on the Ropes”), with excerpts provided below as well as the following graphic from The Wall Street Journal (emphasis added).
So, with that in mind, let’s take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don’t read any further. What is about to come, will make your heart sink…
The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn’t anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking…
According to the latest estimates from BIS, Eastern European countries currently borrow ,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About 0 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about 0 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%3.
On the 11th February the Daily Telegraph’s Brussels correspondent Bruno Waterfield wrote an article under the header: “European banks may need £16.3 trillion bail out, EC document warns.” In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union’s finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article’s header was changed to “European bank bail-out could push EU into crisis” and two paragraphs had mysteriously disappeared. Here they are:
“European Commission officials have estimated that “impaired assets” may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the ‘trading book’ total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.
In addition, so-called ‘available for sale instruments’ worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion.”
Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don’t know and I probably never will. But one thing is certain. If the EU Commission’s estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well…
The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis. Given this outlook, do you really want to be long euros?
Hopefully after reading the above comments from Mr. Jensen you can see how precarious the situation is in Europe. A major crisis in the region would reverberate across the globe just as the Asian Currency Crisis did last decade. Currently the currencies of the countries in the EMEA (Emerging Markets & East Asia), which contain most of the Eastern European countries, are rapidly depreciating relative to the US dollar. This can be seen below in my equal-weighted EMEA USD Index that shows that the countries in EMEA have seen their currencies depreciate more than 50% relative to the dollar in just a matter of a few months, with as of yet unknown consequences.
Source: Bloomberg
The depreciation of EMEA currencies relative to the USD is on the order of magnitude seen during the Asian Currency Crisis, with my Asian Equal-Weighted USD Index below showing that the US dollar's purchasing power rose more than 400% relative to Asian currencies as they were unable to maintain their currency pegs. What is disturbing is that we may also have an Asian Currency Crisis II on our hands as Asian currencies have lost nearly 40% of their value relative to the USD as it appears that they are again unable to maintain their currency pegs. Imagine the fallout that would occur if an Eastern European currency and Asian currency crisis occurred simultaneously. No wonder Mr. Jensen warned his readers that what they read may make their hearts sink!
Source: Bloomberg
Supporting the notion that we are in a far more precarious position than the Asian Currency Crisis in the 1990s is my Foreign Currency Market Stress Index, which is displaying more than twice the stress level that occurred during the Asian Currency Crisis. We are currently off the lows seen at the end of 2008, though we are beginning to roll over with my non-USD Currency Stress Index showing more stress than my more diversified Foreign Currency Market Stress Index that includes various USD foreign exchange rate stress levels. My USD/Foreign Currency (FX) Stress Index continues to improve off the 2008 lows, highlighting that the volatility in the currency markets is greatest between non USD currency pairs.
Source: Bloomberg
Source: Bloomberg
Source: Bloomberg
Another development I have been following that was looking bullish is now turning negative. My Stock-Bond ratio broke to new lows recently and the models bond allocation (lower clip) was progressively allocating more and more to stocks which is bullish, though this positive divergence with the ratio has marginally broken its recent uptrend and is on the verge of a more significant break as equities underperform bonds, not what is seen at market bottoms.
Source: Bloomberg
With the above being said, we are significantly overdue for some type of rally. The S&P 500 is nearly as oversold as it was back in November of last year when measuring distance between the S&P 500 and its 200 day moving average (200-DMA), when the S&P 500 was 39.6% below its 200-DMA on November 20th. With the S&P 500 35.1% below its 200-DMA we should begin to see the markets work off its oversold condition as the S&P 500 is nearly as oversold as it was during the Great Depression
Source: Bloomberg
Source: Bloomberg
While we are overdue for a rally we still aren’t seeing sentiment levels that are characteristic of bottoms. This can be seen when looking at the put/call ratio which isn’t showing widespread fear as the markets appear to be more complacent than struck with abject fear. As seen below, the CBOE total options put/call ratio stands near levels that at best could be called neutral, and at worst could be called relatively overbought. More significant bottoms are seen when the ratio climbs above 1.05, with current levels still below 1.0.
Source: StockCharts.com
What we are likely to see is the market rally today and tomorrow, rallying back up to the November lows and then fall from there possibly late in the trading day on Thursday or Friday, with the February jobs report a likely catalyst to kill the current short-term rally. There really isn’t any support near the 700 level as it marks more of a psychological level than a real price support, with the next level of support coming in at around 660, which is roughly the 61.8% Fibonacci retracement of the entire 1982-2007 secular bull market. At the 660 level we would likely see the put/call ratio at much higher levels with selling being closer to an exhaustion level than what is currently seen.
Source: StockCharts.com
I will remain bearish until I see more improvement in my US Financial Stress Index (FSI) reflected in market prices. The hallmark for a bear market is that once it reaches oversold territory it stays there, while bull markets are characterized by being more in an overbought condition. What has me greatly concerned and causes me to lean towards further market deterioration is that my US FSI has improved markedly from the October panic lows and yet the S&P 500 has nothing to show for it as it has made new lows. While the various financial markets have come back from the brink of collapse during October of last year as measured by the US FSI, all that the S&P 500 could muster was a churning sideways movement, which is incredibly anemic to say the least.
A major step that would turn me more bullish would be to see the US FSI break its current downtrend that has been in place since 2007 and a move back to neutral territory would make the picture even more constructive. However, until then the burden of proof lays on the shoulders of the bulls as we continue to remain in a bear market until proven otherwise. In the words of Saturday Night Live, “Daaaaaa Bears.”
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