Market Panic Time

* Yesterday someone turned the Panic sign on. Markets continued lower without any real catalyst, except the cumulative effects of headlines which many commentators have been saying will not amount to much. These are the same folks who thought the May 6th “Flash Crash” was not a worry, since the markets took back 2/3rd of that day’s losses as quickly as they occurred. As I have preached in this piece since the May 6th event, the fact that stock prices dropped so fast underscores the very weak foundation the recent stock market rally actually has been built upon. That weak foundation is now crumbling. Many commentators, who are typically bullish, are now talking about managing their long only portfolios within a correction. The stock market is back to the May 6th Flash Crash lows, as the attached pre-opening futures chart shows. So much for those dopes, who were quick to dismiss the May 6th price action.


It is also notable that in the midst of yesterday’s 4% sell-off, that the Euro currency staged a rally. There was some speculation that a Central Bank was intervening to buy Euros, but that was not confirmed. Instead, the rally in the euro might just have been a healthy dose of short covering. Nonetheless, a falling euro had been accompanied by a falling stock market over the last few weeks. The fact that stocks managed to continue lower despite a rising euro speaks to the underlying weakness of stocks.


The major beneficiary of the current stock market malaise has been a continued run to fixed income securities, with the 10 year treasury now about 80 bps below its recent high of 4%. As I pointed out a few weeks ago, the Barron’s big Money (Managers) Poll, taken in mid April, showed a 1% bullish view towards US debt securities. In fact, rates have fallen dramatically since that poll. It also turns out that the timing of the current rally is consistent with a seasonally bullish time period for bonds, which typically runs from the first week of May until the second week of June. I remain optimistic about the prospects for even lower US interest rates over this time period, through June 11th. From a chartist perspective, Fibonacci retracement projections point to the 2.80 to 3.00% area, which are 61.8% and 50% retracements. As the next chart on the attachment shows, there is also a cluster of trading activity between 2.8 and 3%, from February to March 2009, where yields paused, on their way to 4%. This cluster should likely act as a target for the current rally. 


Another beneficiary of the recent malaise has been the Yen and the dollar.  Some folks speculate that hedge funds, which were short the Yen and Dollar, were part of the short covering rally in both currencies. The third graph on the attachment shows the Euro/Yen cross rate, over-layed on a graph of the S&P 500. True to form, there is a pretty good (visual) correlation between the two instruments, although in the current environment, the Eur/Yen cross led the S&P lower. This is not going to be good for the Japanese export economy, as each 1 pt in the Eur/Yen cross means $7 billion of exports from Japan to the Euro-zone, according to sources. If you extrapolate the 20 Yen change which has occurred over the past 6 months, this means that Japan’s GDP will contract by $140 billion, or a few percent of total GDP. This cannot help the prospects for a recovery in the global economy.


What I noticed yesterday, is that the usually upbeat commentators are now sounding alarmist. To me, this is usually a reason to turn off the bear switch. But yesterday’s A/D (advance/decline) ratios were almost records, with reading of 3:497 in the S&P 500 (3 gainers to 497 losers) or 1:60 in the NYSE, and 0:30 in the DJIA. I track various indicators, but this is lower than I can remember, and suggests that the current sell-off should feed on itself. And as I suggested yesterday, there has been too much money leaving stocks to support the market. To me, this suggests that a bear market could be self-fulfilling. Which, by the way, says less about specific company prospects, but rather a collective posture to risk, and how big a multiple folks are willing to pay to buy a future revenue stream (corporate earnings). As I said yesterday, by the time this bear market plays itself out, I expect P/E multiples to be well below 10, which supports stock prices much lower valuations, along the lines of my 250-300 S&P target.


A reader writes in with the following question, in response to my S&P target:


“If your S&P target is 250-300, where does that put bond yields?”


Where rates are with a 250-300 S&P depends on the path the US takes to restructuring its debt. US rates (the 10 year) could easily go above 10% before there is some restructuring event, a moratorium on interest, or explicit backing with gold. Eventually rates will fall under a new debt regime. However, existing debt will need to be re-cast, or devalued in some fashion or another, which is a backhanded way of saying that rates will go dramatically higher, as a US debt crisis unfolds. 


Let me also tell you why there will be some sort of devaluation strategy if rates go dramatically higher. The external federal deficit, excluding the Social Security and Medicare trust funds, will total over $14 trillion, or the size of the GDP, in a couple of years. If US rates rise, then the cost of servicing the debt will make it impossible for the US (that’s us) to service the debt without dramatically throwing the economy into a depression, which in turn would make the debt service even more unlikely. Additionally, the negative feedback loop of higher rates on the fragile housing market will help insure a continuation of the Great Depression 2, in the US. 


Alan Ruskin, of RBS, wrote a very interesting piece which takes a glimpse into the future, should a US debt crisis arise, and what it might look like, as it pertains to variousdebt markets. Here is his summary, which was written over a week ago:


“Since I am not at all sanguine on US fiscal trends, and fear politicians will need to have their feet raked over the coals before behaving responsibly, a US sovereign crisis is among the fat tail risks that are worthy of serious consideration. Were Treasuries to slump like the 1970s, all hell would break lose, but what would this ‘hell’ look like? One special intrigue about a US debt crisis is that it would impact the world’s “risk free” benchmark. What happens when the US is no longer a refuge? Is the US treasury marketreally so large that there are no other assets that could accommodate a reverse flow out of Treasuries, or is there another dynamic at work? 


The US Treasury market is large, but by the size of global financial assets it is still surprisingly small. If we use end 2008 IMF data (because this data is complete and the last year will not have changed the big picture) US treasuries make up 25% of global public sector debt securities; 9.5% of public plus private sector debt securities; 7.5% of bank assets; and a modest 3.5% of all private & public sector debt plus equity plus bank assets. In other words there are plenty of other assets to own in the world. However, that would not help much if there was a run on US treasuries. The first problem is simply one of correlation. Almost all the above assets, private debt, bank assets and equities will be especially highly correlated with US Treasuries in a crisis. The second problem is that Treasuries, even if they stand at the epicenter of the crisis, are likely to be the low beta asset. The majority of the $220+ trillion in global bond, equity and bank assets would be leveraged off global growth and remain high beta relative to Treasuries, losing even more value were Treasuries to collapse. This probably also applies to many real assets in the short-term, especially those that are interest rate sensitive.


A Treasury collapse story presumably would very quickly evolve into too many risky assets chasing far too few ‘risk free’ assets. What are the risk free assets they would choose? Gold, the barbaric metal, would presumably feed handsomely off such sovereign risk savagery! But the total gold market is estimated to be only about $6.5 trillion, or smaller than the Treasury bond market, of which only a little over $5 trillion is in private hands. Worse still, the daily gold turnover is only 2% of major currencies! Such a slow churn, coupled with fixed supply, would drive prices parabolic, and the choice of buying gold would quickly start to feel like it did to the average Dutchman in the 17th century, when a single tulip rose to an average of 10 times annual income.


Foreign bond markets could provide an alternative, if tax revenues could hold up somewhere in the world, but all debt markets outside the G3 are tiny relative to global assets. For example even the German Bund market makes up less than 2% of global debt securities, and this is roughly three times all of Asia NIC public debt if you were looking for an emerging market ‘safe haven’. In a topsy-turvy world where the risk pyramid inverts, and the developing world risk converges further versus the developed world, emerging economy bonds, equities and bank assets still provided limited opportunities, making up a mere 14% of these same developed world assets.


The above clipped analysis tends to lead to an unlikely conclusion: One of the unique sources of Treasury value, is that as it goes down, it destroys more value in most substitutable assets than it loses itself, which perversely then provides some support! Put another way, one of the sources of Treasury ‘quality’ is precisely its ability to destroy value (quality) in competing assets! In the hierarchy of assets it makes a difference whether assets are dependent on other assets, or whether they lead other assets, as the Treasury market does. It is also doubtful whether another benchmark sits in the wings, for no other economy is big enough and has the global interconnectivity whereby changes in the long-term price of money reverberate around the world the way US treasuries do. Now a US Treasury crisis should also never have to extend to default, as long as the Fed is willing to buy US Treasury debt, and deliver the haircuts to investors through inflation rather than direct restructuring – which may be preferable for reputational interests. Unfortunately the inflation route is still desperately painful, not least because it drives up nominal yields and delivers the pain incrementally through bond and currency losses, rather than all up-front as a restructuring. Such bond losses are indicative of how a fiscal funding crisis quickly ends up as a monetary policy crisis, and a collapse in central bank control across the curve.


Although this all feels like jumping deep into the land of the hypothetical, the above scenario is not too far removed from the late 1970s period of stagflation. I have gone back a good deal further, to the start of the 20th century to see how assets coped with stagflation (a relatively rare phenomenon) which would be the likely backdrop to (or outcrop of) a US sovereign crisis. The conclusions are not pretty. As feared there have been very few places to hide outside commodities when US growth is very soft and inflation is above a 5% threshold. Sell equities, be a big seller of lower grade then AAA bonds and yes, buy FOOD commodities. Food commodities have been up as much as 30% y/y in years since 1900 when US per capita income was negative and inflation is above 5%, perhaps because these conditions are also accompanied by energy shocks or war, that are among the other darkest channels to financial blight.” (end of Alan Ruskin piece)


Before we face the rising rates and a possible US debt crisis, we are taking another swing at deflation, falling asset prices, and falling bond yields. The ebb and flow of inflationary factors and deflation will continue to dominate the landscape going forward, with a mix of inflation and deflation alternating their presence in the economy.