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Tuesday, January 26, 2010

For Neil

Neil thought the recent drop in markets had a lot to do with the Volcker issue - the perception by investors that there is a limit to US stimulus. But I don't think so - the problem is that investors have been buoyed by the hope of unrealistic growth globally, and now reality is beginning to impinge upon those great expectations.

First, Japan - its credit rating was just cut. Second, more news about China restricting loans.

This current phase started last year, and I'd date it from Dubai's default. But there continue to be nasty little reality checks, like Greece's problems, Japan's contracting nominal GDP, Singapore's most recent results, etc. And the drizzle of these things continues, which is curbing exuberance, and causing people to question their assumptions.

The idea that China was ever going to make up, in the near future, for drops in US and European consumption of oil was odd, to say the least.

But now if we step back and consider our own situation, Japan's dilemma ought to make us rethink some of our economic assumptions. There is a limit to government borrowing, especially when the demographics of your population are unfavorable. We are nearing those limits and can't afford to get there.

M_O_M, thanks for the info. I'm willing to be argued out of my thesis, and divining the factors driving market participants is always an angels-on-the-head-of-a-pin exercies. That said, these fundamental data have been around for quite some time. It was, at the very best, never more than a 50/50 bet that the government could inflate enough to keep the economy going without causing some kind of catastrophe.

I agree that these are the fundamental factors driving things, but why did they not drive the markets before last Wednesday?
Neil - they did. Look at treasury yields. It's been a slow build.
OK, now I'm a little confused. If I'm reading the data correctly, Treasury rates did rise with inflation expectations since last year, but Treasury rates have fallen with the market since last week.

The latter is consistent with non-inflationary or deflationary expectations, and consistent with the fundamental expectations you mention in your post, but the former is not. Or am I misunderstanding something?
Look at the 2 year YIELDS for 2009 here.

Look at the summer rates. Then look at what happened in November - yields fell down into the high sixties! That was during the Dubai default flap.

Then there was Greece, etc. I think things are improving, but risk awareness is returning largely because there are safer options.

When there are risk concerns people buy T-bills, prices go up, yields come down.

Of course, when the Fed does raise rates, you get whacked - but not as bad as if you stake your future on junk bonds from Chinese property companies.

2 year yield started 2009 at 88 bps, and more than one year later, Jan 26th, 2010, 87 bps.
BTW, thanks for indulging me here. This is a help to understanding where the markets are headed between now and this fall, even if we have to agree to disagree.

I see what you're talking about on the short end of the Treasury curve, but what about this chart of the S&P? And the longer-term Treasuries show similar trends.

It's pretty clear that something has been a drag on equities since last November, as you say, but what happened on the 20th? It seems pretty plausible that the Massachusetts election and the President's reaction to it forced some kind of re-evaluation on the part of market participants.

I think an awful lot of the money driving equities has been foreign-held dollars. It looks to me like something caused a re-evaluation of relative risks to their holdings.
Oh - I see your point.

Yes, I think it had an impact on stocks, but earnings - especially the earnings of banks - are a big driver too.

I would not be surprised at all if some investors weren't raising an eyebrow and thinking that some of the free money party were over. But the Chinese moves also are very, very big. People just thought that somehow China could pick up all the slack, and a lot of commodity hope and joy is seeping out of the markets as we speak.

Everything seems to me as if we are readjusting to a more rational basis, and that is going to have a lot of impact on the market.

Try graphing S&P 500 3 month against Exxon, Alcoa and Bank of America in turn and think about it. Both commodities and financials are losing any bling components; after this a lot of pricing will change back to the good old fashioned type of thing, where they are expected to make money.

Then do the same against AMD, Autozone, Amazon, and Sears.
OK, now THAT's interesting.

The first group of companies shows the pattern you noticed--the "bling" gradually going out of the bubble, so to speak.

The second group of companies shows something closer to the effect that I noticed--a sharper change in the tone of the market away from equities.

Hmmm, I'll have to think about this. Which market segments are showing which pattern...?

I do agree that when all is said and done, we're going to go back to the old cash-flow-based investment models. I suspect that dividends will play a bigger role in valuation, as well, and the tax codes will change to reflect that.
The first group was profiting from the bling - after all, aluminum, oil, financials. They reversed.

The second group is more related to the real economy, and look at the breakout on Sears and AMD. That's related to slowly, painfully increasing retail sales and inventory clearance.

That's why I'm arguing that we are seeing market patterns that represent a reversion to a cynical, but somewhat hopeful, reality.

Our goal should be to nurture the real side of things. Forget trying to support house prices and rescue GMAC. They'll have to align with the economy.

As we discuss this our betters are plotting to destroy this hopeful turn....
And Neil, if you take the staggeringly low 2-yr yields along with those two stock charts, the forecast is for a VERY slow recovery with danger ahead. The yield curve has straightened out nicely, but near term money demand (through 2 years) seems to be forecast as abnormally low. At the very least, we're looking at a period in which the larger companies are not planning to invest very much, nor to borrow.

Looking at T-Bill yields now vs the beginning of last year shows a forecast for an increase in money demand (or inflation) at 3-5 years, but the six month yield is about half of what it was in the beginning of 2009, and the two year has not moved.

T-bill yields are telling us that there is a very strong possibility of a second half dip. Domestic nonfinancial commercial paper is slightly more sanguine (level up from the 2009 low), but does not forecast any strong move up either. We do not need to discuss bank lending because people may be rolling over, but they aren't looking for much in the way of new.

So I would not be too frisky buying right now.
That's good analysis on the Treasury curve. I think this leg down in equities is about the markets adjusting to the "new normal", whatever that turns out to be. I'll have to watch the relative price changes going forward. If your understanding is correct, we should see "real economy" sectors outperforming here, yes?

I really have no idea where the bottom is for this particular move, though. I think I want to see some real panic again before trying to buy, though.

On the broader topic: I agree, the story of the next ten years is the balance of trade going back to positive--whether we do it the easy way, or the hard way. We're going to be making a lot more of what we consume, whether it's because we make more, or consume less.
Remember, the American consumer, whether through apathy or action, chose the fools we have had running Washington over the last 30 years. Bet on us taking the hard way to a positive trade balance.
Caterpillar got whacked today. They think China will pull them out.


Call me skeptical. I think the Caterpillar has finally become the moth.
Just for the sake of completeness, there's another bump in the road coming up at the end of this year, as well. The sunset of the Bush Administration tax cuts.

Cap gains go back to 25%, estate tax to 50%, top income tax rates to 39% if I remember correctly, and dividends go back to being fully double-taxed.

All that implicitly lowers the value of equities come Jan 1, 2011.
In a very long column in the Asia Times Online, Julian Delasantellis dissects the hypocrisy and fallacy of Main Street. He makes the devastating observation that the only real location of Main Street is in a California town called Disneyland.


Very much by design, visitors to Disney-themed amusement parks share a common introductory sensory experience. After passing through the gates, they emerge in the middle of what is called "Main Street, Disneyland", a block-long depiction of life in an American small town from around the start of the 20th century.

Since just about no one now has much memory of what life was actually like in a small American town at the dawn of the 20th century, the experience of the town has developed into something originating from others' memories (in particular, Walt Disney's memories) of what these places were like, and, more critically now, fantasies of what life was like. Thus, a traveler through a Main Street, Disneyland, will see a block of small businesses, non-franchised storefronts containing such establishments as a barbershop, an ice-cream parlor and an "Emporium" general store selling Disney souvenirs.
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