Saturday, May 22, 2010

The Commodities Crash No One Noticed

WITH ALL THE ATTENTION FOCUSED on the so-called flash crash of May 6, there's been a nearly silent crash in commodities.
From copper to crude oil to corn, prices have been tumbling for the better part of a month. The Thomson Reuters/Jefferies CRB index hit a seven-month low, dropping 2% Monday, which brought its loss to nearly 10% in the past month.
The commodities decline has been overshadowed by news of the European debt crisis, the oil-spill disaster in the Gulf of Mexico and the flash crash which caused a thousand points of fright in the Dow Jones Industrials a couple of weeks ago. But the slide in commodities has been picking up speed in the last week and, anomalously, has come against the backdrop of soaring gold, which hit a record price in dollars of $1,249 an ounce last week.
The proximate factor driving down commodities has been the rise in the dollar. "A strong dollar, all things being equal, equates to a weak commodity market. It has always been thus; it shall always be thus," writes Dennis Gartman, editor of the Gartman Letter, which is the first read in the morning for traders and investors around the globe.
In particular, Dr. Copper is looking sickly. "The metal with a PhD in economics," so named for its sensitivity to the global economy, is down more than 20% in the past month. headlined its chart of the day "Now This Is a Deflationary Collapse," which seemed no exaggeration as copper plunged 6.4% Monday.
Copper's slide joined other disquieting signs of slower global growth. Monday, the Shanghai Composite Index plunged over 5%, putting China's stock market into bear territory at more than 20% below its peak last year.
Meantime, the Empire State Manufacturing Index fell much more sharply than expected, to 19.1 in May from 31.9 in April. That indicates a sharp deceleration but continued positive growth. Weak features of the survey were new orders and shipments, according to the report from the Federal Reserve Bank of New York.
Crude oil also fell sharply Monday, by $1.53, or 2.1%, to settle at $70.08 a barrel for the active June futures contract. That's a five-month low and down sharply from the mid-$80 range in early April and counter to the usual seasonal pattern of peaking out with the beginning of the summer driving season that kicks off with Memorial Day.
Gartman also notes that grains and soybeans with "huge crops" being planted with heavy rains in the Midwest. "Rain makes grain…one of the oldest and best trading 'rules' we know of," he says.
But the plunge in commodities while gold is rallying indicates the decline is even more severe when measured in terms of gold -- what its fans call real money (as opposed to paper fiat currency.)
For instance, Gartman points out just a few weeks ago it took 13.85 barrels of crude oil to buy an ounce of gold. Now it cost 17.5 barrels of crude to buy that same ounce of gold. "In other words, crude oil has fallen just a bit more than 25% in value in gold terms in only three weeks…a not immaterial sum in anyone's estimation."
Traditionally, rising gold prices have pointed to higher commodity prices. Similarly, rising gold also has been associated to an increase in bond yields as well as a falling dollar.
In the last month, those historic relationships have been turned on their ear. The yield on the Treasury benchmark 10-year note has fallen more than a half percentage point, to 3.48% Monday, in tandem with commodities, even as gold broke out above $1,100 to $1,225 Monday. Meantime, the U.S. Dollar Index, which measures the greenback against a basket of six major currencies, hit a 13-month high Monday after a gain of 7% in the past month.
Clearly, the Dollar Index's strength is the mirror image of the collapse of the euro as the result of the European debt crisis. That's driven the world's capital in the safe havens of the dollar, and by extension, Treasury securities, as well as gold. And the dollar strength translates into commodity weakness.
That simplistic explanation leaves out the broader subtext of the debt deflation resulting from the austerity measures being enacted in Europe along with the impact of the multiple monetary tightening measures in China. In the U.S., meanwhile, the maximum effect from last year's fiscal and monetary stimuli may have been felt; tax hikes loom for next year and the Fed continues to mull how to shrink its balance sheet.
In the context of the deflationary impulses now being felt in the world's economy, the flight from commodities such as copper makes sense -- even as investors seek the haven of gold.

Leading Indicator Reaches 35-Week Low

A measure of future U.S. economic growth fell to a 35-week low in the latest week, indicating a slowing of the recovery, a research group said on Friday.
The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index slumped to 127.3 for the week ended May 14 from 132.0 the previous week.
That was the lowest level since Sept. 11, 2009, when it stood at 127.0. The index’s annualized growth rate fell to a 43-week low of 9.0 percent from 12.2 percent a week ago. That’s the lowestlevel since July 17, 2009, when it stood at 8 percent.
“With WLI growth sinking further to a 43-week low, U.S. economic growth is set to start easing in fairly short order,” said Lakshman Achuthan, managing director of ECRI.

It's More Than Just Fear

Today marked a new phase in investors’ understanding of the EU crisis. Although the Euro itself recovered a bit, investors realized that Europe’s problems could spread to the U.S. and impede or stop its economic recovery. This would possibly mean that the 14-month market rebound in U.S. stocks may not have been justified. The possibility is more than just a fear, but a realistic assessment of a dire situation. Even if the EU and the Euro survive, all of the member governments, including the relatively stronger ones, would have to undertake severe spending cuts and pay down debt to rectify their budgets. These actions would lead to a long and serious economic slump that would most likely spread across the globe.
The crisis is also reminding investors that we have undergone two 50% plus market declines in the same decade and that the S&P 500 today closed at same level it first reached over 12 years ago in mid-March 1998. The two major declines are a reminder to traders of the benefits of getting out relatively early, while the lack of progress over 12 years make long-term investors wonder what they doing in the market. For those who didn’t get out on time at the tops in early 2000 and late 2007, the bell is ringing for a third time.
The potential impact of the European crisis on the American economy and markets is not just Comstock’s opinion. In testimony before a Congressional committee yesterday, Fed Governor Daniel Tarullo stated that sovereign debt problems in “peripheral” Europe could spill over and cause problems throughout Europe that, in turn, could be transmitted to global financial markets. This, he said, could cause banks and other financial institutions to pull back on lending as they did following the Lehman bankruptcy. “The result could be another source of risk to the U.S. recovery in an environment of still-fragile balance sheets and considerable slack”.
The Fed’s minutes of its last meeting, released this week, indicated that the economy was not doing quite as well as advertised, even before the impact of Europe’s problems. Attributing the recent increases in consumer spending to temporary factors and a lowered savings rate, they concluded that it was unlikely that consumer spending would be the major factor in driving economic growth. They added that the housing market appeared to have flattened despite major government support and that both sales and starts had stalled at depressed levels. They also saw the possibility of increased foreclosures adding to already bloated inventories of vacant homes, threatening a downside risk to prices. The minutes mentioned that commercial real estate continued to fall as a result of deteriorating fundamentals, while bank lending was declining and credit remained tight.
Other recent economic releases were also not encouraging. The Mortgage Bankers Association (MBA) reported a record 4.63% of mortgages in foreclosure in the first quarter with combined foreclosures and delinquencies amounting to 14% of all mortgages. We note that this is before an expected surge of new defaults and foreclosures as a result of foreclosures being delayed due to attempted workouts and the pending increase of adjustable-rate mortgages due for reset in coming months. In addition applications for new mortgages for home purchases plunged in the week following the expiration of the latest home buyers’ tax credit. It was also reported today that initial weekly claims for unemployment insurance unexpectedly jumped to 470,000. While one week doesn’t necessarily mean anything, we note that claims have now been flat since year-end, indicating that the labor market still remains weak.
We would be remiss if we didn’t mention increasing concern about China as a negative market factor. The Chinese housing market has been booming, and the authorities have been slowly tightening monetary policy. In the first quarter the nation reported its first trade deficit since 2004. If the Chinese economy slows down at the same time that Europe is dealing with its crisis the U.S. and global economy will stall. This is already being reflected in a sudden decline in commodity prices on anticipation of a drop in Chinese purchases. We’ll have more on this topic in subsequent comments.
In our view the 14-month rally since March 2009 is over and a major decline is underway. The recent decline has been extreme in the short-term, and some sharp rallies are likely. However, we believe that none of these rallies will hold and that the eventual market bottom will be far lower than today’s level.

Price Follows Sentiment

With price action getting downright nasty, thought we might try to put it into the context of recent history.
SP500 index price versus NYSE volume 400x243 GETTING TO THE BOTTOM
When Lehman’s officially waved the flag on 15 September 2008, with the market already well below its highs, it was the catalyst for the wholesale dumping of stock – whether it was leveraged equities or otherwise.  We can see that volumes remained elevated from that time until after the market had finally bottomed.
Risk appetite index3 400x233 GETTING TO THE BOTTOM   WHERE 
Our risk appetite index peaked on 20 October 2008 and thereafter returned to more relaxed levels even as the equities markets continued to fall.  This was simply a function of risk pricing (credit spreads and equities implied volatility) starting to contract from the crisis levels of mid-October.  Remember that when the equities market bottomed on 6 March 2009, the VIX closed at 49.33 (currently 45.79) and the Aaa-Baa spread was 280 bps (currently 113 bps).
So what can we extrapolate from this?
1) I have the selloff starting from the time that Goldman’s was indicted.    Up until that then financials had been viewed as untouchable.  While pinning the sell-off on a single event is just silly – I think that this action by the US government is indicative of the forced march of government’s globally into the private sector.  This trend should lead to an increase in risk premiums.
2) I’m marking the acceleration event as being the failure of the Greek rescue package.  From the moment it was announced, the EUR has been pummeled relentlessly, the carry trade began its descent into chaos and commodities have nose-dived.  Risk spreads have pushed out very quickly from the placidity that prevailed in April – but are not yet comparable to those that prevailed in the furnace of Sep/Oct 2008.
3) While we may not have a replay of the volumes that prevailed during late 2008/early 2009 – as leverage has been taken out of the equities markets – it’d be fair to assume that we have not seen the sustained selling that would signal the panic is upon us.
4) Time should be on the side of buyers of equities.  When sentiment turns this radically in such a small space of time, we can expect the aftershocks to ripple through asset prices for some time.  Watch for government actions to manage markets.  While it took 6 months from the time the Fed started its QE program for the market to bottom last time, think we have a better idea of how this mechanism might work.
5) The real worry for the Australian market is China.  It’s sharemarket has been trading lower for longer (see here).  A loss of confidence on this front would see the unravelling of the commodity longs that dominate the global demand and supply balance.  If you are long Australian commodity producers, you must be expecting the Chinese government to stump up with another $500 bn – and soon.
Shanghai Stock Exchange 400x326 GETTING TO THE BOTTOM   WHERE 
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Counter-Party Risk Increasing

Due to the European debt crisis, counterparty risk is increasing as banks are reluctant to lend to each other, which is remiscient of the bank freeze at the beginning of the fiancial crisis of 2008. The LIBOR-OIS spread which is a gauge of banks willingness to lend, widened 2 basis points today to a spread of 26. Despite the unveiling of the near one trillion dollar Stabilization Fund last week, it continues to drift higher.  The spread has now increased 20 basis points from the most recent low achieved on March 15.

As mentioned last week here at Bondsquawk, the spread inched higher from 13 basis points in late July 2007 to 19 basis points the following week. As market conditions deteriorated, the widening accelerated. By late August, the spread widened to 73 basis points and the route was on. During the height of the financial crisis which is marked by the fall of Lehman Brothers, the spread reached a high of 364 basis points by October of 2008. While it remains to be seen if this will turn into another credit crunch as we have warned several days ago and as Bank of America’s Jeff Rosenberg had suggested earlier today, today’s action is certainly a growing concern and deserves further monitoring.

U.S. Dollar As Indicator of Deflationary Collapse

If the chart below doesn’t grab your attention then few things will. In my opinion, the performance of the dollar is the surest evidence of the kind of environment we’re currently in. The surging dollar is a clear sign that inflation is not the concern of global investors. This is almost a sure sign that deflation is once again gripping the global economy and should be setting off red flags for equity investors around the world.
The recent action in the dollar is eerily reminiscent of the peak worries in the credit crisis when deflation appeared to be taking a death grip on the global economy and demand for dollars was extremely high. The recent 16% rally in the dollar is a sign that investors are once again worried about the continuing problem of debt around the world and they’re reaching for the safety of the world’s reserve currency – the dollar. As asset prices decline and bond yields collapse this is a clear sign that inflation is not the near-term concern, but rather that the debt based deflationary trends continue to dominate global economic trends.
This is exactly the kind of market action we saw leading up to Lehman Brothers. In 2008 the dollar rallied as signs of deflation began to sprout up. This was an instant red flag for anyone who understood the deflationary forces at work (and a total surprise for the inflationistas). The dollar ultimately rallied 26% from peak to trough. Coincidentally, the dollar had rallied 16% from trough to peak just prior to the Lehman collapse when the dollar surge accelerated.
Of course, the inflationistas will argue that gold is rising in anticipation of inflation. In my opinion, this is incorrect. First of all, if inflation were a major global concern the Goldman Sachs Commodity Index wouldn’t be almost 65% off its all-time high and just 33% above its 2009 low. Second, and perhaps most importantly, bond yields around the globe wouldn’t be plummeting if there were rampant inflationary fears. For a much more detailed analysis on the reasons why inflation is not a near-term concern please see here.
As for the gold rally, I think it’s clear gold is rallying in anticipation of its potential to become a future reserve currency. The potential demise of the Euro has become a rally cry for inflationistas who don’t understand that the Euro is in fact another single currency system (like the gold standard) which is destined to fail. In the near-term, the rise in gold is likely justified as fear mongering and misguided governments increase demand for the yellow metal. Ultimately, I believe investors will realize that there is little to no inflation in the global economy and that the non-convertible floating exchange systems (such as the USD and JPY) are fundamentally different from the flawed currency system in place in Europe.
Debt deflation continues to plague the global economy. Thus far, policymakers have been unable to fend off this wretched beast and I attribute this largely to the widespread misconceptions regarding our monetary systems. This extends to the very highest levels of government and the misconceptions regarding the EMU, the Euro and the vast differences in their monetary system have only exacerbated the problems and are likely to further worsen the global deflationary threat. The ignorance on display here borders on criminal in my opinion as governments impose harsh injustices on their citizens due entirely to their own lack of understanding.
I’ve mentioned repeatedly over the course of the last 18 months that government responses to the credit crisis were misguided and unlikely to resolve the structural problems. I’ve also mentioned that this was something I have sincerely hoped I would be wrong about as the consequences have the potential to be enormously destructive. Unfortunately, the policy responses have been so tragically misguided that I now believe the global economy is on the cusp of a potential double dip. And as Richard Koo says, the second dip has the potential to be far worse than the first because investor confidence is shattered (which is clearly the case on the back of the recent market crash). Policymakers are doing little to rectify confidence and have in fact, through their ignorance of the way in which our monetary system actually functions, only increased the global risks in the economy. The dollar is the surest sign of the lack of faith in the policy response and an enormous red flag for risk markets. Allocate accordingly.
PS - There is a video going around called “Melt-up” and it is receiving a HUGE amount of attention on the internet. It is regarding the recent melt-up in stocks and how the U.S. is about to enter an inflationary spiral and a currency collapse. I would recommend to the good readers here at TPC to ignore this video. It is 100% factually incorrect (well, more like 75%) and full of the same fear mongering misconceptions that fuel the asset destroying portfolio strategies of well known inflationistas (we all know the names). Videos like these are based on the same misconceptions regarding the monetary system that have actually led to the current debacle. Positioning yourself for hyperinflation and a U.S. dollar collapse has been a recipe for disaster and will continue to be a recipe for disaster as debt deflation remains the single greatest risk to the global economy.

Lessons Learned and Not Learned

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major fin-ancial institution even to have a ROE goal is to court disaster.

17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

18. When a government official says a problem has been “contained,” pay no attention.

19. The government – the ultimate short- term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.

20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3. There is no amount of bad news that the markets cannot see past.

4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5. Excess capacity in people, machines, or property will be quickly absorbed.

6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

9. The government can indefinitely control both short-term and long-term interest rates.

10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)

Buffett and Soros Are Selling

"...recent SEC filings by the likes of Warren Buffett, George Soros, and other large investors who must report changes in holdings, showing they sold large amounts of stock from their portfolios in the first quarter."

Sy Harding,

''Next time we have a slowdown, or a recession. America has shot its wad. Ben Bernanke can't keep printing money - the world is going to run out of trees at the rate he's printing money.'' - Jim Rogers

Friday, May 21, 2010

8 Months' Gains Lost for Stocks

Wow! Amazing graphic! We're back to September 2009 again! Note that we are below the 200-day moving average, and at February's low. We are also at the low May6th when the infamous 1,000-point Dow drop occurred.

"Experience is not what happens to you; it's what you do with what happens to you." - Aldous Huxley

Mass Lay-Offs Rise Unexpectedly

(Reuters) - The number of mass layoffs by U.S. employers rose in April led by manufacturers who shed workers even as the economy began to recover.
The Labor Department said the number of mass layoff events -- defined as job cuts involving at least 50 people from a single employer -- increased by 228 to 1,856 as employers shed 200,870 jobs on a seasonally adjusted basis.
The number of mass layoffs in the manufacturing sector totaled 448 resulting in 63,616 initial jobless benefit claims, the department said. That was more than 24,000 higher than the previous month, but well below the 125,000 initial jobless claims in the manufacturing sector a year ago.


Stocks are up 100 points so far today!

Thursday, May 20, 2010

"Put Your Helmets On! Bail Out and Head for Cover!"

May 20 (Bloomberg) -- A weeklong rout in stocks deepened, with U.S. benchmark indexes losing the most in more than a year, as reports cast doubts about the strength of the economic recovery and European leaders struggled to contain the region’s debt crisis. Commodities plunged and Treasuries soared.
The Standard & Poor’s 500 Index plunged 3.9 percent to 1,071.59 at 4 p.m. in New York, its biggest drop since April 2009. The Stoxx Europe 600 Index lost 2.2 percent and the S&P GSCI Index of commodities tumbled to the lowest since October. The losses accelerated even as the euro rallied as much as 1.5 percent to $1.2598 after earlier flirting with a four-year low. Ten-year Treasury yields sank to the lowest level of the year, down 15 basis points at 3.22 percent. The yen rallied against all 16 major counterparts.
Tomorrow’s expiration of U.S. stock options and progress on a financial-reform bill may have added to volatility after U.S. jobless claims unexpectedly increased to 471,000 last week and the Conference Board’s index of leading economic indicators posted a surprise drop of 0.1 percent. The slide came a day before the German parliament votes on the country’s share of a $1 trillion bailout to halt a worsening sovereign debt crisis.
“Put your helmets on if you are long risk here,” Nicolas Lenoir, chief market strategist at ICAP Futures LLC in Jersey City, New Jersey, said in a note to clients before markets opened today. “A lot of stops have been triggered when the S&P future crossed 1,100 and anybody still long will probably have to bail out and head for cover.”
S&P 500 Correction
Gauges of financial, industrial and commodity companies tumbled more than 4.4 percent each to lead declines in all 10 of the S&P 500’s main industry groups. Bank of America Corp., Alcoa Inc. and General Electric Co. dropped more than 5.7 percent as all 30 stocks in the Dow Jones Industrial Average fell, dragging the gauge down 376.36 points, or 3.6 percent, to 10,068.01 for its biggest tumble since March 5, 2009. Both the S&P 500 and Dow closed at their lowest levels since Feb. 10.
Today’s plunge in stocks came as the Securities and Exchange Commission continues its autopsy of the chain reaction of selling that briefly erased $1 trillion in stock value on May 6. Kentucky Republican Senator Jim Bunning and Virginia Democrat Mark Warner today said at a committee hearing that they were concerned the so-called flash crash could be repeated.
‘Question of Confidence’
“It’s a question of confidence,” said Jack Ablin, chief investment officer at Chicago-based Harris Private Bank, which oversees $55 billion. The almost 1000-point decline in the Dow average on May 6 “not only rattled the confidence of investors, but everyday policymakers are digging in and not giving us answers as to what’s causing this problem.”
At 1,071.59, the S&P 500 is 24 percent below its level 10 years ago, just after the peak of the Internet bubble. The index is 17 percent below its level on May 18, 2001, and 3 percent above its closing price on the first trading day after the Sept. 11, 2001, terrorism attacks.
Stock futures extended declines before exchanges opened in New York after the S&P 500’s June futures contract slipped below its average price over the past 200 days, a level watched by technical analysts as an inflection point that may trigger deeper losses. The S&P 500 itself closed below its 200-day moving average today for the first time since July 2009.
The drop below the level may not necessarily signal more losses to come, according to Harrison, New York-based Bespoke Investment Group LLC. On the previous occasions when it closed below the 200-day moving average after having stayed above it for at least 100 days on a closing basis, the S&P 500 “has actually done well” in the following months, according to a Bespoke note yesterday, with positive returns one, three and six months later.
Economy Watch
Today’s rout came as initial jobless claims rose by 25,000 to 471,000 in the week ended May 15, exceeding the median forecast of economists surveyed by Bloomberg News and the highest level in a month, Labor Department figures showed. Losses accelerated in the regular session after the Conference Board’s index of leading economic indicators unexpectedly slumped 0.1 percent.
The S&P 500 has plunged about 12 percent from a 19-month high on April 23, a retreat surpassing 10 percent typically known as a correction. The index has pared its rally from a 12- year low in March 2009 to 59 percent. The Nasdaq Composite Index today joined the Dow Jones Industrial Average and S&P 500 in erasing its 2010 advance.
‘Corrective Territory’
“We are clearly in corrective territory,” Robert Doll, who helps oversee $3.36 trillion as vice chairman and chief equity strategist at New York-based BlackRock Inc., said in a Bloomberg Television interview. “Europe has to stabilize, we need further evidence of cyclical improvement here in the U.S. and a little less volatility. When we get those things, we believe the cyclical bull market will resume.”
The Chicago Board Options Exchange Volatility Index, the benchmark gauge of U.S. stock options known as the VIX, jumped 30 percent to 45.79, its highest level since March 20, 2009. The gauge usually goes up as stocks fall on rising demand for options to protect against further losses. U.S. May options expire tomorrow.
“It adds to the pressure,” Stephen Lieber, chief investment officer of Alpine Woods Capital Investors LLC, which manages more than $7 billion from Purchase, New York, said of options expiration. “People are particularly nervous about the outlook of Europe.”
Naked-Short Ban
Stocks plunged yesterday as German Chancellor Angela Merkel’s unilateral effort to control what she called “destructive” markets rattled investors. The German ban on some bearish bets against financial companies and government bonds wasn’t replicated in other European states and European Central Bank council member Nout Wellink said Germany should have consulted other countries before introducing the ban.
The S&P 500 Financials Index tumbled 4.7 percent today, with Bank of America Corp., Wells Fargo & Co. and JPMorgan Chase & Co. pacing declines among all 79 companies.
President Barack Obama said the financial regulation overhaul moving through Congress will help the economy and protect consumers by bringing greater accountability to Wall Street.
The “hordes of lobbyists” from financial firms have failed to block the legislation, which will bring “sensible” rules to the market place, Obama said at the White House after the Senate voted 60-40 to clear the way for a final vote on the legislation. The measure would create a consumer financial- protection bureau at the Federal Reserve, overhaul rules for hedge funds and derivatives, and create a mechanism for dissolving failed firms whose collapse would roil the economy.
European Stocks
Only 30 of 600 stocks rose in Europe’s Stoxx 600. Yesterday’s 3 percent plunge left the benchmark gauge trading at less than 15 times its companies’ reported earnings, near the lowest level since December 2008. National Grid Plc, the operator of the U.K.’s power and gas networks, slumped 7 percent in London after announcing a 3.2 billion-pound ($4.6 billion) rights issue. SABMiller Plc, the world’s second-largest brewer, tumbled 6 percent as earnings missed estimates.
The MSCI Emerging Markets Index fell 3.1 percent as China’s Shanghai Composite Index slipped 1.2 percent, Russia’s Micex Index dropped 4.3 percent and Turkey’s ISE National 100 Index lost 4.4 percent. Dubai’s DFM General Index climbed 0.4 percent after creditors of Dubai World agreed to restructure $23.5 billion of liabilities as the state-owned holding company seeks to resolve a debt crisis that roiled global markets last year.
‘Unchartered Waters’
The global slide in equities may worsen and inflows to Treasuries will increase amid concern that Europe’s debt crisis will derail global growth, said Mohamed A. El-Erian, chief executive officer of Pacific Investment Management Co.
“This is not a typical retracement,” El-Erian, 51, whose firm runs the world’s biggest bond fund, wrote in an e-mail. “We are in uncharted waters on account of several issues, including what is going on in Europe and other important structural regime changes. In economic terms, European developments are unambiguously bad for global growth.”
The 10-year Treasury yield touched 3.2 percent today, the lowest level since Dec. 1. Yields on British, French and German 10-year bonds lost at least eight basis points, while Italy’s and Spain’s rose at least five basis points.
The benchmark U.S. Treasury note’s yield may drop to 2.5 percent as investors lose confidence in some European nations’ ability to repay their debts, Royal Bank of Scotland Group Plc said.
‘Political Risk’
“It’s difficult trading Treasuries right now because we are trading almost solely on European political risk,” said Donald Ellenberger, who oversees about $6 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh. “I do think that it’s safe to say that a lot of people have underestimated how far down yields could fall from a problem that started in a relatively tiny country.”
The euro erased earlier losses against the dollar amid speculation the Swiss National Bank sought to support the franc drove traders to theorize that the European Central Bank may do the same for the shared currency. The euro rose against all 16 major counterparts except the yen, gaining more than 3 percent against the Canadian dollar, the South Korean won, Brazil’s real and the Australian dollar.
Germany Vote on Bailout
Volker Kauder, who heads Chancellor Angela Merkel’s Christian Democratic alliance in parliament, said the almost $1 trillion emergency lending package for indebted European nations should be approved when it goes to a vote tomorrow. The three parties in Merkel’s coalition, which together have 332 of the 622 seats in the lower house of parliament, conducted a trial vote today, Kauder told reporters in Berlin. Seven lawmakers voted against and two abstained, giving the required majority to approve the bill, he said.
Crude oil tumbled 2.7 percent to $68.01 a barrel in New York and touched $64.24, the lowest level since July, as stocks fell and the euro weakened.
The cost to protect against defaults on U.S. corporate bonds rose to the highest since May 6, trading in a benchmark credit derivatives index shows. The Markit CDX North America Investment Grade Index Series 14, which investors use to hedge against losses on corporate debt or speculate on creditworthiness, increased 11 basis points to a mid-price of 124.5 basis points.

Fed Official Warns of Risk to U.S. of European Bailout

WASHINGTON (AP) -- Europe's debt crisis poses serious risks to the unfolding economic recoveries in the United States and around the globe, a Federal Reserve official said Thursday.
Federal Reserve Governor Daniel Tarullo, in remarks to a House subcommittee, said the timing of Europe's problems on the heels of the global financial crisis is a "potentially serious setback."
If the crisis were to crimp lending and the flow of credit globally, triggering more financial turmoil, that would endanger both the U.S. and global recoveries, he said.
"Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests it is not out of the question," said Tarullo.
As he testified, Wall Street took another nosedive on European debt fears. The Dow Jones industrial average was down 376 points when the market closed.
In a worst case scenario, financial turmoil "could lead to a replay of the freezing up of financial markets that we witnessed in 2008," he said. That contributed to the worst global recession since the 1930s.
For now, Tarullo said there are good reasons to believe U.S. banks and financial institutions can withstand some fallout from European financial difficulties.
In the past year, the Fed has pressed the biggest U.S. banks to raise additional capital, giving them a stronger cushion against potential losses in the future. The direct effect on U.S. banks of losses stemming from exposure to overextended governments in Greece, Portugal, Spain, Ireland and Italy "would be small," he said.
Almost all of the U.S. exposure is held by 10 large bank holding companies, Tarullo said. Their balance sheet exposure of $60 billion accounts for only 9 percent of the core capital that regulators value the most, known as Tier 1 capital. He didn't identify those banks.
However, if problems were to spread more broadly through Europe, U.S. banks would face larger losses as the value of traded assets dropped and loan delinquencies mounted. U.S. money market mutual funds and other institutions, which hold a large amount of commercial paper and certificates of deposit issued by European banks, would likely also be affected, he said. Commercial paper is an important short-term financing mechanism companies rely on to pay for salaries and supplies. It practically dried up during 2008 financial crisis.
Tarullo said a moderate economic slowdown across Europe would slow export growth, weighing on the U.S. economy "by a discernible, but modest extent." However, a deep contraction in economic activity in Europe -- along with severe financial problems -- "would have the potential to stall the recovery of the entire global economy."
To contain the European crisis, the Fed on May 9 agreed to supply European central banks -- and the Bank of Japan -- with much-in-demand dollars in return for foreign currencies. The "swap" arrangements were aimed at easing short-term financing strains.
European banks need dollars to lend to companies across the continent. European companies that have operations in the U.S. pay their employees in dollars and buy raw materials with the U.S. currency. Also, oil and other commodities are priced in dollars around the world.
Under the swap program, Tarullo said the European Central Bank will repay a $9.2 billion loan to the Fed on Thursday. Tarullo said the ECB requested a new $1 billion loan and the Bank of Japan wanted $200 million. That makes $1.2 billion outstanding under the swap program. Federal Reserve filings haven't yet been updated to reflect the new figures, a Fed spokeswoman said.
Tarullo said the Fed isn't considering taking other relief actions.
However, a growing number of economists now believe that the Fed will keep interest rates at record lows well into next year, or possibly into 2012, to help protect the United States from fallout due to the European crisis.

Stock Market 370-Point Sell-Off!

from the Wall Street Journal:

The stock market posted its steepest drop since the anxious days of early 2009, as worries that Europe's debt crisis would weigh heavily on global growth sent investors fleeing out of risky assets.
The declines accelerated late in the session, leaving both the Dow Jones Industrial Average and the Standard & Poor's 500 off more than 10% from their recent highs, the traditional Wall Street definition of a correction.
In the current plunge, some participants are worried that there could be further losses, that perhaps the bull run itself has crested. For many investors, Europe's recent struggles have conjured fears akin to those that resulted from the late-2008 meltdown of Lehman Brothers Holdings, which roiled the U.S. financial system.
"No matter how we slice all the chart data, there's no reason for anyone to have any exposure to the long side of the stock market here," said Walter Zimmerman, chief technical analyst at United-ICAP. "We have a serious unfolding debt crisis in Europe that very much looks capable of heading to a wave of sovereign-debt defaults."

The Dow slid 376.36 points, or 3.6%, to end down 10068.01, off 10.2% from its 2010 high and its biggest point drop since Feb. 10, 2009. The S&P fell 3.9% to end at 1071.59, down 12% from its high, its biggest point drop since Jan. 20, 2009. Every Dow component was down and only three stocks gained in the S&P.
The Nasdaq Composite Index, which first moved into correction territory on May 7, has moved back and forth above the 10%-down threshold since. But it is now back below the mark after plunging 4.1% on Thursday to end at 2204.01, off 12.9% from its 2010 high.
Shares of industrial and commodity-producing companies led the decline as worries mounted that Europe's debt woes and a possible slowdown of growth in China will sap global demand. Other markets around the world, from the Australian dollar to metals, tumbled as investors shed riskier assets in favor of safer bets such as U.S. Treasurys.
The dollar managed a 1% improvement against the euro, which traded late in New York at $1.2511 following a volatile series of moves throughout the day. But analysts believe the outlook for the common currency remains bleak measured over the longer haul, off 14.4% so far this year versus the dollar, including a heavy dose of selling since the European Union announced a $1 trillion bailout for its most heavily indebted members.
"With the euro weaker, you're going to have an impact on earnings," for big U.S. multinational companies that have become increasingly reliant on overseas revenue the last few years, said Bernie Williams, assistant vice president and portfolio manager at USAA Investment Management. "Everybody's assuming the worst."
Jitters over Europe persisted as unions went on strike in Greece and investors fretted that trading regulations like those introduced this week in Germany could be adopted in other countries.
The Dow's leading decliners included Alcoa, which dropped 6%, Caterpillar, which fell 4.5%, and Boeing, which slid 4.9%. Financials also weakened as new trading restrictions in Europe and the U.S. Senate's debate over financial legislation continued. Hartford Financial Services slid 7%, while American International Group fell 6.8% and Citigroup slid 4.7%.
Composite trading in New York Stock Exchange-listed companies hit 8.6 billion shares, well above the daily average for 2010.
"A lot of people who have held throughout the bull market are selling right now," said Jim Bianco, president of Bianco Research in Chicago. "That's why the bulls are viewing this as a big problem."
Executives of several major prime brokerages said they expected more margin calls Thursday than normal, but demands for managers to post cash as a result of losses weren't reaching crisis levels and the calls are expected to be met.
Reflecting the market's heightened unease, the CBOE Volatility Index jumped to its highest point since April 2009, posting an intraday high above 46 before pulling back slightly. The measure ended with a 29.6% daily gain, closing at 45.79.
Commodity markets also saw heavy selling with crude futures at one point plunging to their lowest point since July due to demand concerns before rebounding. Nearby futures ended down $1.86 at $68.01 a barrel in New York.
New data added to the worries about the U.S. economy with an unexpected surge in initial claims for jobless benefits.

Roubini: Stocks to Fall 20% MORE!

Stocks are likely to continue their aggressive decline and shed another 20 percent in value as the world economy weakens, economist Nouriel Roubini told CNBC.
As the market slides into correction territory, Roubini said weakness in euro zone countries and a slowdown in the US and other developed countries will make things even more difficult for investors in the months ahead.

"There are some parts of the global economy that are now at the risk of a double-dip recession," said Roubini, head of Roubini Global Economics. "From here on I see things getting worse."
Prices in both stocks and commodities are likely to take a hit, and investors may only be safe in cash and other safe havens. Roubini said investors also can use options to hedge against future market risk that he said is sure to come as conditions weaken in the US, Japan, China and through much of Europe.
That will lave little room for growth both in economic measures and in most investment classes, Roubini said.
"There is that risk because the problems on the macro level are first in the euro zone. Then in China there is evidence of economic slowdown...Japan is in trouble and US economic growth is going to slow down," he said. "There is also regulatory risk because we don't know how financial reform is going to occur."
Investors then should focus on buying debt from countries that are solid economically.
"Apart from cash I would invest in short-term government bonds of countries that don't have a serious debt problem, countries like Germany and maybe Canada, a few other advanced economies that from a fiscal point of view are sounder than the weaker economies," he said.
As for Europe, he called fixing the debt problems in Greece and other troubled nations "mission impossible" and said tough decisions will need to be made.
"What needs to be done is clear. We need to raise taxes and cut spending. Otherwise we're going to get a fiscal train wreck," he said. "It's going to take years of sacrifices."

Dollar Decline

If the Dollar closes at this level, it will be a sell signal for me if there is follow-through tomorrow.

3 minute chart

15 minute chart

Stocks Dive Through Support, Dow Loses 300 Points

We have now broken through May 7th low and the 200-day moving average. We're in correction territory! Note, however, the divergence in volume, which has turned bullish.

"The best way to destroy the capitalist system is to debauch the currency."

"The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."
-- John Maynard Keynes, Economist, Fabian Socialist

Jobs Report Hits Just As Stocks are Plunging

Stock futures were already down. Now, they're dropping even more!

WASHINGTON (MarketWatch) -- The number of people applying for unemployment benefits shot up 25,000 in the latest week, government data showed Thursday, indicating continued weakness in the U.S. job market.
Initial jobless claims rose to 471,000 in the week ended May 15, the highest level in a month, according to the Labor Department. About one-third of the increase occurred in financially stressed California.
Economists surveyed by MarketWatch predicted initial claims would drop on the week, falling to a seasonally adjusted 440,000 from last week's reading of 446,000.
A Labor Department official said there were no unusual factors to explain the increase.
The four-week average of initial claims -- a better gauge of employment trends than the volatile weekly number -- also rose, up by 3,000 to 453,500. Read the full government report.
While they've fallen 25% from 12 months ago, initial claims are now 3.6% higher compared with the end of 2009 in a reflection of the scarcity of new jobs. Most economists say claims need to fall below 400,000 to signify accelerating job creation.

Sovereign Debt Storm Hits Nations

from Alistair Barr at Marketwatch:

SAN FRANCISCO (MarketWatch) -- The financial crisis never really went away.
The debt mountain that brought down some of the world's biggest banks and dragged the international financial system to the brink of disaster has simply shifted to governments. Now it's threatening countries around the globe -- and, if left unchecked, could rip the very fabric of Europe's economic system and wreck economic recoveries in the U.S., China and Latin America.
The impact on markets has been severe. The euro has slumped more than 12% against the dollar since the sovereign-debt crisis flared in southern Europe. Gold has marched to new highs as investors seek a safe haven and, perhaps most alarming, it is now more expensive to buy insurance against national default than it is to insure against corporate failure.
"The sovereign-debt crisis spun out of control in the past week, and we see no easy way to resolve it," said Madeline Schnapp, director of macroeconomic research at TrimTabs Investment Research.
Some investors and analysts are increasingly concerned that governments may be no more capable of repaying their debts than the banks and insurance companies they saved. And, they warn, if a major country comes close to default, it could trigger a financial meltdown that would eclipse the panic that followed the bankruptcy of Lehman Brothers in 2008.
The world has seen sovereign debt crises before. Latin America, Africa and Asia have all experienced upheavals sparked by excessive debt. These crises were all accompanied by stunted economic growth, inflation and weak stock market returns, which make it even harder to pay off debts. As investors and government officials ponder the current state of affairs, they see ominous signs that the developed world may be facing a similarly bleak future.
"The problem of the western world is that we have too much debt," said Daniel Arbess, who manages the Xerion investment strategy at Perella Weinberg Partners. "Rather than reducing our debt, we've been moving it from one balance sheet to another."
"All we're doing is shifting chairs on the deck of the Titanic," he added.

Europe's bailout

Some governments have started to respond to market pressure, with the U.K. pledging billions of pounds in spending cuts this week. Spain and Portugal also unveiled austerity measures. But the problem is so big that investors remain wary. Check out Portugal's plans.
Stock markets plunged and credit markets shuddered last week on concern Greece and other indebted European countries like Portugal and Spain might default. See the story on market impact.
"What's happened on a corporate level is now happening on a national level. The first nation to experience this is Greece, but other nations will, too," Schnapp said.
To stop Greece's debt troubles turning into a run on the euro and a global stock market rout, the European Union unveiled an unprecedented package of almost $1 trillion in emergency loans, stabilization funds and International Monetary Fund support on Sunday.
In the days that followed, the European Central Bank bought the government debt of Greece and other countries on the periphery of the region's single-currency zone, such as Portugal, Spain, Italy and Ireland, investors said. Such a drastic step has been shunned by the ECB until now. Read about the market response on Monday.
"Temporarily the crisis in terms of liquidity has been averted, but the underlying problem hasn't gone away," Schnapp added. "Giant debt and expenditures by governments are still there."
TrimTabs cut its recommendation on U.S. equities to neutral from fully bullish on Sunday, in the wake of the European bailout.


The sovereign crisis has been brewing for months.
For much of the financial crisis, investors worried about financial institutions defaulting, rather than sovereign nations. But that pattern has been upended.
In early February, the cost of insuring against a sovereign default in Western Europe exceeded the price of similar protection against default by North American investment-grade companies. That was the first time this had happened, according to data compiled by Markit from the credit derivatives market.

The move "symbolizes how credit risk has been transformed from corporate to sovereign risk, as the solution to the financial and economic crisis was government intervention," Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, wrote in a note to investors at the time.
Since then, the cost of insuring against sovereign default in Western Europe has climbed further, hitting a record of 169 basis points on May 7.
The European bailout pushed that down to 120 basis points on Tuesday. But that's still more expensive than default protection on North American corporate debt which cost 100 basis points on Tuesday. (In the credit derivatives market, 100 basis points means it costs $100,000 a year to buy default protection on $10 million of debt for five years).


Market Edge: Debt Crisis Enters Second Phase

The global debt crisis is in its second stage as governments deal with the debt absorbed from the private sector, and record gold prices have been reflecting these worries, according to SCM Advisors strategist Max Bublitz. Laura Mandaro reports.
While much of the concern has focused on Western Europe, unsustainable government debt is a global problem. And it is developed world governments that are accumulating the biggest debts, not emerging market countries -- a big change from previous sovereign crises.
"Looking beyond the immediate crisis in Europe, I am particularly worried about the next stage involving the U.S., the U.K. and Japan," Xerion's Arbess said.
Debt to GDP ratios in the world's advanced economies will top 100% in 2014, 35 percentage points higher than where they stood before the financial crisis, the IMF estimated last month.
Three percentage points of this increase came from government bailouts of financial institutions, while 3.5 percentage points was from fiscal stimulus. Another four percentage points has been driven by higher interest on government debt and 9 points came from revenue lost from the global recession, according to the IMF.
"Public finances in the majority of advanced industrial countries are in a worse state today than at any time since the industrial revolution, except for wartime episodes and their immediate aftermath," Willem Buiter, chief economist at Citigroup Inc. (NYSE:C) and former member of the Bank of England's Monetary Policy Committee, wrote in a recent note on sovereign risk.
Even though the current epicenter of the crisis is focused on the euro zone, the overall fiscal position of the single currency area is stronger than that of the U.S., the U.K. and Japan, he noted.
"Unless there is a radical change of course by those in charge of fiscal policy in the U.S., Japan and the U.K., these countries' sovereigns too will, sooner (in the case of the U.K.) or later (in the case of Japan and the U.S.) be at risk of being tested by the markets," Buiter said.
Ultimately, these countries face the risk of being "denied access to new and roll-over funding, that is, of being faced with a 'sudden stop,'" he warned.

Economic drag

Once government debt levels approach 100% of GDP, things can get tricky.
That's because a lot of a country's income from taxes and other sources has to be spent on interest payments.
John Brynjolfsson, chief investment officer at global macro hedge fund firm Armored Wolf LLC, illustrated the point with a simple example. With debt at 100% of GDP, interest rates at 3% and real economic growth of 3%, all the extra income collected by a country would be used to pay interest on its debt.
If a lot of government debt is owned by foreigners, like the U.S., the money leaves the country rather than being invested in more productive ways. This dents economic growth.
A study published this year by economists Carmen Reinhart and Ken Rogoff found that, over the past two centuries, government debt in excess of 90% of GDP produced economic growth of 1.7% a year on average. That was less than half the growth rate of countries with debt below 30% of GDP.
"Most lenders realize that once growth disappears, there's little reason to lend more," Brynjolfsson said. "That's because new lending is just going towards paying off old debt, not investment in productive activities."


The U.S. government has spent more than $1 trillion bailing out financial institutions like American International Group (NYSE:AIG) and rolling out fiscal stimulus programs to bolster the flagging economy.
In 2009, the government took in about $2.1 trillion in taxes and other revenue and spent more than $3 trillion, according to TrimTabs' Schnapp. The gap, or deficit, is made up by borrowing more money through sales of Treasury bonds and notes.
In coming years, U.S. government debt will exceed 100% of GDP, according to economists at Exane BNP Paribas and elsewhere.
In the next 20 years, if fiscal policies aren't changed, U.S. debt to GDP will exceed 150%, putting the country in the same league as Greece and Portugal, according to recent research led by Stephen Cecchetti, head of the Monetary and Economic Department at the Bank for International Settlements in Switzerland.
And the official data don't tell the whole story, Buiter says.
Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) have been the responsibility of the U.S. government since the mortgage giants were placed into conservatorship by the Federal Housing Finance Agency during the financial crisis in 2008, he noted.
Fannie and Freddie's liabilities at the end of last year's third quarter were almost $1.8 trillion, according to Buiter. This equals 13% of U.S. GDP and should be included in measurements of the country's general government debt, he added.


The U.K. government committed 850 billion pounds ($1.25 trillion) to bailing out banks including Royal Bank of Scotland (LONDON:UK:RBS) and Lloyds Banking Group (LONDON:UK:LLOY) and providing guarantees and insurance to the sector, according to the country's National Audit Office.
The U.K.'s debt to GDP ratio will soon reach 100% and could top 200% in the next two decades if fiscal policies aren't changed, according to Cecchetti's research.
The country's new coalition government, which came to power this week, called for 6 billion pounds in spending cuts starting this fiscal year. Bank of England Governor Mervyn King applauded the plan.
"We are still halfway through the world's worst financial crisis ever," King warned. It's "imperative that our own fiscal problems are dealt with sooner rather than later." Read about his comments.


Japan's government debt to GDP, at over 200%, already dwarfs the U.S. and the U.K., a hangover from its own financial crisis at the end of the 1980s.
"The perfect example of sovereign risk that is contained today but could be dramatic in the future is Japan," Pierre-Olivier Beffy, chief economist at Exane BNP Paribas, wrote in a recent note to investors.
Such high debt levels aren't a problem now because Japanese people save so much and invest a lot of that money in the country's bonds. Financial institutions in the country are also big buyers.
With more than 90% of all Japanese government debt purchased domestically, interest payments get funneled back into the country, helping to support economic growth.
However, Japan's population is getting a lot older. At some point, savers may stop buying government bonds and start spending their money in retirement. If that happens, the government may be forced to pay higher interest rates when it borrows.
Rates on 10-year Japanese government bonds are below 1.4%. So, despite huge debt, interest payments aren't too cumbersome. But if rates climb, that would change with painful consequences.
"Japan, as an economy, has never admitted its mistakes. Twenty years ago they transferred the bad private assets to the public balance sheet, while nominal GDP has gone nowhere for 20 years," Kyle Bass, managing partner at global macro hedge fund firm Hayman Capital, said during an April industry roundtable run by Opalesque Ltd.
"When your biggest holders turn into sellers overnight, what do you do? You have to finance yourself at G7 rates," he added. "If they borrow where Germany borrows at a bit over 3%, they are out of business."
Bass is betting on higher Japanese interest rates, similar to positions that other hedge fund firms including David Einhorn's Greenlight Capital and John Paulson's Paulson & Co. have put on. Read about Einhorn's views.

'Final chapter'

How will all this debt be repaid? Brynjolfsson discusses the three main alternatives.
Developed nations could generate strong productivity gains, while rising exports from their pharmaceutical, technology and financial-services industries could generate better-than-expected income. Combined with "frugality, sacrifice and good fortune," there could be enough money to repay debts, he explained. This may include lower government spending and higher taxes.
Countries could also default, either because they can't pay or won't, Brynjolfsson said. In this scenario, lenders would likely agree to a reduction, or haircut, on the amount of money they're owed -- either voluntarily or after courts impose a settlement.
A third outcome may be inflation, Brynjolfsson said. Sovereign debts would be honored but would be repaid in currency that's worth a lot less than when the debt was sold.
"The sovereign debt problems encountered by most advanced industrial countries are the logical final chapter of a classic 'pass the baby' (aka 'hot potato') game of excessive sectoral debt or leverage," Buiter said.
"First excessively indebted households passed part of their debt back to their creditors - the banks. Then the banks, excessively leveraged and at risk of default, passed part of their debt to the sovereign," he explained. "Finally, the now overly indebted sovereign is passing the debt back to the households, through higher taxes, lower public spending, the risk of default or the threat of monetization and inflation."


Brynjolfsson and other investors are in the inflation camp.
One tell-tale sign of potential inflation is that the U.S. Treasury Department is trying to extend the average maturity of its debt from about 48 months to roughly 84 months, Brynjolfsson said.
"That makes me a little uncomfortable and suspicious," he added.
With lots of short term debt, it's hard to inflate the debt away. That's because interest rates should rise quickly to adjust for higher inflation expectations and investors will charge a higher rate when it comes time to refinance the bonds.
But the longer the maturity of government debt, the easier it is for inflation to kick in before bonds need to be refinanced, Brynjolfsson explained.
Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) Chairman Warren Buffett said this month that he's bearish about the ability of all currencies to hold their value over time because of massive deficits being run up by governments in the wake of the financial crisis.
The U.S. will never default on its debt because the dollar is the world's reserve currency. But the country may print more dollars to repay with devalued currency, he suggested. Check out Buffett's take on currencies and inflation.
The ECB's actions this week added to inflation concerns. The bank has been in the market buying the government debt of Greece and other indebted European countries, according to Brynjolfsson.
Some investors worry this amounts to so-called quantitative easing that could devalue the euro and produce inflation. The ECB says it plans to neutralize the effects of government bond purchases by selling other assets, limiting growth of the money supply.
Xerion's Arbess sees "a round of devaluations of a lot of different currencies."
"That will be accompanied by inflation in the price of non-renewable assets like gold, other precious metals and industrial commodities," he said. "People start to hold on to things that they think will retain value."

Wednesday, May 19, 2010

Stocks Reach Key Levels

Stocks have reached key support levels today and over the past few days.

This first chart shows the support levels from the market bottom on May 7th on the 4-hour chart. We have held that support level thus far today.

In this second chart showing the daily period, we see that stocks bounced down off the 50-day moving average resistance level (light blue line), and stocks have thus far held above support on the 200-day moving average (magenta/pink line).

Obama, Please Start Listening to Your Adviser

May 19 (Bloomberg) -- Former Federal Reserve Chairman Paul Volcker, a top outside adviser to President Barack Obama, said time is “growing short” for the U.S. to address problems ranging from its budget deficit to Social Security obligations.
“We better get started,” the 82-year-old former central banker said in a speech yesterday in Stanford, California. “Today’s concerns may soon become tomorrow’s existential crises.”
Volcker, speaking hours after the euro fell to a four-year low against the dollar, said Europe demonstrates for the U.S. the hazards of “uncontrolled borrowing.” The European currency slid below $1.22 for the first time since April 2006 as a ban by German authorities on certain bearish investments fueled concern the region’s sovereign debt woes will worsen.
“Little has happened to allay my concerns” raised five years ago that “dangerous and intractable” problems were rising in the U.S., said Volcker, chairman of the president’s Economic Recovery Advisory Board.
“Intractable not just because of the combination of complicated issues, but because there seemed to be so little willingness or capacity to do much about it,” he said during a dinner at the Stanford Institute for Economic Policy Research.
Volcker said in an interview yesterday it will take “years” to restore economic balance in Europe following the debt crisis. European Central Bank President Jean-Claude Trichet has been “particularly effective in maintaining the credibility of the euro,” he told Tom Keene on Bloomberg Radio.
Sense of Urgency
“In the United States, we don’t seem to me to share the same sense of urgency” as countries such as Ireland, Volcker said in his speech. “The time we have is growing short” and “there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs.”
The Obama administration is forecasting a record annual budget deficit of $1.6 trillion. The shortfall is projected to be $10 trillion over the next 10 years, with interest payments on the debt forecast to quadruple to more than $900 billion annually.
Sovereign debt is becoming an issue “most pointedly in the euro zone” and is “potentially of concern among some of our own states,” Volcker said.
Speaking to reporters before the speech, Volcker sought to clarify remarks he made earlier this month about the possibility of “a potential disintegration of the euro.”
“I didn’t want to suggest, at the moment, Europe was disintegrating,” he said. “They’re fighting very hard, they’re providing a lot of support but it is a challenge for Europe.”
Euro Drops
The euro fell to as low as $1.2144, the weakest since April 17, 2006, before trading at $1.2219 as of 2:25 p.m. in Tokyo from $1.2202 late yesterday in New York.
Europe’s woes are unlikely to derail the U.S. economy, which is undergoing a “subnormal” recovery, Volcker said in response to audience questions. The U.S. has reached its limit on corporate and income taxes, and there isn’t an “easy way” to raise more revenue under the current system, he said, calling a carbon tax “an interesting thing to do.”
In addition, Volcker said the U.S. must rebuild its mortgage market from “the ground up” and higher capital requirements alone won’t be enough to prevent the next crisis.
“Any thoughts that participants in the financial community might have had that conditions were returning to normal should by now be shattered,” he said. “We are left with some very large questions: questions of understanding what happened, questions of what to do about it, and ultimately questions of political possibilities.”

Richard Russell: Batten the Hatches and Sell Everything!

Richard Russell, the famous writer of the Dow Theory Letters, has a chilling line in today's note:

Do your friends a favor. Tell them to "batten down the hatches" because there's a HARD RAIN coming. Tell them to get out of debt and sell anything they can sell (and don't need) in order to get liquid. Tell them that Richard Russell says that by the end of this year they won't recognize the country. They'll retort, "How the dickens does Russell know -- who told him?" Tell them the stock market told him.
That's pretty intense!
Update: By popular demand, here's more on what he sees in the market. The gist is that the markets recent gyrations are telling him that the economy is in trouble:
And I ask myself, "Am I seeing things? The April 26 high for the Dow
was 11205.03. The Dow is selling as write at 10557 down 648 points
from its April high. If business is even better than expected, then
why is the Dow down over 600 points? And why, if there were 674 new
highs on the NYSE on April 26, were there only 20 new highs on Friday,
May 14? And if my PTI was 6133 on April 26, why is it down 17 points
since its April high?

The fact is that I've been seeing deterioration in the stock market
ever since early-April, and this in the face of improving business
. The D-J Industrial Average is composed of 30 internationally
known top-quality blue-chip stocks. These are 30 of "America's biggest
companies." If Barron's is so bullish on the future of America's
biggest companies, then why isn't the Dow advancing to new highs?

Clearly something is wrong. But what could it be? Much as I love
Barron's, I trust the stock market more. If I read the stock market
correctly, it's telling me that there is a surprise ahead. And that
surprise will be a reversal to the downside for the economy, plus a
collection of other troubles ahead

About Dow Theory -- First, we saw the recent April highs in the
Averages. Then we saw a plunge in both Averages to their May 7 lows --
Industrials to 10380.43, Transports to 4298.12, next a short rally. If
ahead, the two Averages turn down and violate their May 7 lows, that
would be the clincher. Such action would signal the certain resumption
of the primary bear market.

Just as for years I asked, cajoled, insisted, threatened, demanded,
that my subscribers buy gold, I am now insisting, demanding, begging
my subscribers to get OUT of stocks (including C and BYD, but not
including golds) and get into cash or gold (bullion if possible). If
the two Averages violate their May 7 lows, I see a major crash as the
outcome. Pul - leeze, get out of stocks now, and I don't give a damn
whether you have paper losses or paper profits!

Crash Chatter Takes Over

Here a Swan, there a Swan, everywhere a Black Swan...
Newsletter writers, hedge fund managers, journalists, bloggers, technicians, fundamental analysts, economists and strategists are joining the crash camp left and right.  Not the bear camp...the crash camp.
I've been running around Manhattan all day taking care of business, meeting clients etc.  After scanning today's articles and blog posts, I can honestly say that I've never heard more chatter about an imminent market crash, all at once, in my life.  It's like the May 6th Flash Crash got everyone in the mood to talk cataclysm all of a sudden.
I'm not one of those guys who takes everything as a contrarian signal.  I abhor knee-jerk contrarianism.  Samuel Lord once said "Do not choose to be wrong for the sake of being different," and I think that's kind of apropos here.
As avowed contrarian Dougie Kass likes to remind us, the crowd usually outsmarts the remnant when herd mentality takes over.  So what is the herd hearing/ seeing?

* First of all, the macro guys are disturbed by the Euro Zone's crisis and its ripple effect/ contagion risk.  This isn't new but it is more pervasive.  And the possibility of a China collapse scares the hell out of almost everyone.
* The technicians and Dow Theorists are grossed out and have dusted off all the 1937 charts again.  Specifically, they are looking at the highly distinct pattern of a big drop (May 6th) followed by a failed rally (euro bailout day's 4% gap open) followed by another fast sell-off.  Richard Russell's latest missive, in which he tells us that we won't recognize America by year's end, will make you want to kill yourself.
* Equity analysts are all pointing to year-over-year comps which will start getting harder now.  They may feel OK about the "E" but they're shaky about the "P" - will the tax hikes and regulatory headwinds we now face really allow for a high-teens multiple on whatever the earnings turn out to be?
* Bond guys are freaking out about sovereign stuff, obviously.  We've transferred corporate risks onto government balance sheets with bailouts, the Piper still awaits his payment in many cases.
* Eddie Elfenbein posted the results of a CNBC poll yesterday in which 40% of respondents predicted a 50% haircut for the Dow.  Seriously, almost half the respondents predicted Dow 5000 by the end of this year.
* The hedgies are vocally bearish again as well.  Seth Klarman's got some cautious commentary out today and Jeremy Grantham's "sell everything" stuff is being quoted everywhere.  Raoul Pal put out a newsletter this week with a 2 day-to-2 week crash prediction.
We're not talking garden variety bearishness here.  We're talking about ubiquitous crash predictions.  My comment is that I've never seen so much certainty in so many places of a coming crash.  Will it be self-fulfilling or are we talking major contrarian signal?
Worth noting no matter what.