Mauldin: The Endgame Is Here, and We're In Deep Trouble

I came away from Maine, and meeting with some of the most astute economists in the world, with a series of impressions that will be the core of this week's letter. On Friday night, S&P downgraded US debt, and of course I need to comment on that. But as we talked the next two days and into the nights, I came increasingly to the opinion that this is indeed the Beginning of the Endgame. I must admit it has come about faster than I thought. But that is the nature of these things. And so, with no "but first," let's jump right in.

The Big Bang Moment

I think it relevant to start off by quoting from my book Endgame, where I quote in turn from what I think is the most important book of the last decade, This Time is Different: Eight Centuries of Financial Folly, by Ken Rogoff and Carmen Reinhart. I truly urge you to read it. The book is consciously designed so you can read the first chapter and the last five and get the thrust of the work. You can order it from Amazon.com. (The Kindle edition is only $9.99 and makes a perfect companion to my book Endgame [shameless plug].) Quoting from my book:
"We are going to look at several quotes from [This Time is Different], as well as an extensive interview [the authors] graciously granted. We have also taken the great liberty of mixing paragraphs from various chapters that we feel are important. Please note that all the emphasis is our editorial license. Let's start by looking at part of their conclusion, which we think eloquently sums up the problems we face:
"'The lesson of history, then, is that even as institutions and policy makers improve, there will always be a temptation to stretch the limits. Just as an individual can go bankrupt no matter how rich she starts out, a financial system can collapse under the pressure of greed, politics, and profits no matter how well regulated it seems to be. Technology has changed, the height of humans has changed, and fashions have changed.
'Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant. No careful reader of Friedman and Schwartz will be surprised by this lesson about the ability of governments to mismanage financial markets, a key theme of their analysis.
'As for financial markets, we have come full circle to the concept of financial fragility in economies with massive indebtedness. All too often, periods of heavy borrowing can take place
in a bubble and last for a surprisingly long time. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.
'This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success and say, as their predecessors have for centuries, "This time is different."'
[Back to my voice] "Sadly, the lesson is not a happy one. There are no good endings once you start down a deleveraging path. As I have been writing for several years, much of the entire developed world is now faced with choosing from among several bad choices, some being worse than others."
And this is key. Read it twice (at least!):
"'Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence—especially in cases in which large short-term debts need to be rolled over
continuously—is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! — confidence collapses, lenders disappear, and a crisis hits.
'Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained—or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.'"

Bang, Indeed!

When the subprime crisis started, we were told by numerous authorities (including Ben Bernanke) that the problems would be "contained." But by 2006 it was clear to anyone who studied the toxic instruments that the losses would be in the hundreds of billions. I estimated $400 billion, which just goes to show that I'm an optimist. That crisis spread to banks all over Europe and then back to the US. Authorities used every bullet in their guns, every legal means and –well let's be charitable, perhaps they pushed the rules a bit – to try and stem the tide. And then we had a "Lehman moment" and all at once the markets seemingly froze. It was "Bang!"
My sense is that the S&P downgrade is like that moment when we were told things would be contained. In and of itself, the downgrade is not that important. What did we learn that we did not already know? The US is headed for a financial crisis if they do not get the deficit under control? This is news?
But I think it forces S&P to take a very hard look at France, whose loss of AAA would bring into doubt the whole EFSF mechanism. And Spain and Italy must come under scrutiny if S&P's move in the US is not to be seen as politically motivated. The main result of the downgrade may not be here in the US but in Europe, where there are already issues. A series of downgrades (which are warranted if the US one was) would be traumatic.
My London partner Niels Jensen penned this observation:
"If France is downgraded, a number of French banks will almost certainly be downgraded, following which other European banks will face the same destiny. Such a scenario has the potential to cause calamity across Europe. The 90 European banks which recently went through the (so-called) stress test organized by the European Banking Authority need to roll a total of €5.4 trillion1 (!) of debt over the next 24 months. A massive amount even during the best of times. Probably undoable during times of stress.
"As Ambrose Evans-Pritchard, in consultation with Willem Buiter of Citigroup, pointed out in the Daily Telegraph over the weekend:
" '... the issue is not how long Italy and Spain can ride out the storm in bond markets. There would be a banking and insurance crisis long before sovereign defaults came into play, simply because the fall in bond prices on the secondary market is causing carnage to bank books (among other transmission mechanisms).'
"With its downgrade of U.S. sovereign debt, Standard and Poors has started a chain of events which can only make things worse in an already crisis-hit eurozone. For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment."
My latest trip to Europe and discussions with friends in Maine, plus my reading, simply reinforces my sense that we are seeing Europe unravel, or at the very least come to a very important crossroads where they must make a fateful decision. And let's make no mistake, this is a demon of a problem of their own making. Monetary union without fiscal union will not work in a world where there are so many cultures and different traditions. But how does that work? How do you exorcise that demon?
Which leads me to a sidebar. Michael Lewis is one of the greatest writers of our time. He is just brilliant. He has a piece in the latest Vanity Fair on Germany and the crisis in Europe. It is rather long (about 15 pages in a Word doc) and makes some rather interesting (if odd) scatological references, trying to explain the German world view, so if you are of a delicate mindset, perhaps you should confine yourself to the few paragraphs I quote here. But I do suggest you set aside some time to read the entire piece. (You can read the whole thing at http://www.vanityfair.com/business/features/2011/09/europe-201109.) Here is the editor's intro to the piece:

"It's the Economy, Dummkopf!"

"With Greece and Ireland in economic shreds, while Portugal, Spain, and perhaps even Italy head south, only one nation can save Europe from financial Armageddon: a highly reluctant Germany. The ironies—like the fact that bankers from Düsseldorf were the ultimate patsies in Wall Street's con game—pile up quickly as Michael Lewis investigates German attitudes toward money, excrement, and the country's Nazi past, all of which help explain its peculiar new status."
And from the middle of the piece, these insights:
"Greeks are still refusing to pay their taxes, in other words. But it is only one of many Greek sins. 'They are also having a problem with the structural reform. Their labor market is changing—but not as fast as it needs to,' he continues. 'Due to the developments in the last 10 years, a similar job in Germany pays 55,000 euros. In Greece it is 70,000.' To get around pay restraints in the calendar year the Greek government simply paid employees a 13th and even 14th monthly salary—months that didn't exist. 'There needs to be a change of the relationship between people and the government,' he continues. 'It is not a task that can be done in three months. You need time.' He couldn't put it more bluntly: if the Greeks and the Germans are to coexist in a currency union, the Greeks need to change who they are.
"This is unlikely to happen soon enough to matter. The Greeks not only have massive debts but are still running big deficits. Trapped by an artificially strong currency, they cannot turn these deficits into surpluses, even if they do everything that outsiders ask them to do. Their exports, priced in euros, remain expensive. The German government wants the Greeks to slash the size of their government, but that will also slow economic growth and reduce tax revenues. And so one of two things must happen. Either Germans must agree to a new system in which they would be fiscally integrated with other European countries as Indiana is integrated with Mississippi: the tax dollars of ordinary Germans would go into a common coffer and be used to pay for the lifestyle of ordinary Greeks. Or the Greeks (and probably, eventually, every non-German) must introduce 'structural reform,' a euphemism for magically and radically transforming themselves into a people as efficient and productive as the Germans. The first solution is pleasant for Greeks but painful for Germans. The second solution is pleasant for Germans but painful, even suicidal, for Greeks.
"The only economically plausible scenario is that Germans, with a bit of help from a rapidly shrinking population of solvent European countries, suck it up, work harder, and pay for everyone else. But what is economically plausible appears to be politically unacceptable. The German people all know at least one fact about the euro: that before they agreed to trade in their deutsche marks their leaders promised them, explicitly, they would never be required to bail out other countries. That rule was created with the founding of the European Central Bank (E.C.B.)--and was violated a year ago. The German public is every day more upset by the violation--so upset that Chancellor Angela Merkel, who has a reputation for reading the public mood, hasn't even bothered to try to go before the German people to persuade them that it might be in their interests to help the Greeks.
"That is why Europe's money problems feel not just problematic but intractable. It's why Greeks are now mailing bombs to Merkel, and thugs in Berlin are hurling stones through the window of the Greek consulate. And it's why European leaders have done nothing but delay the inevitable reckoning, by scrambling every few months to find cash to plug the ever growing economic holes in Greece and Ireland and Portugal and praying that even bigger and more alarming holes in Spain, Italy, and even France refrain from revealing themselves.
Until now the European Central Bank, in Frankfurt, has been the main source of this cash. The E.C.B. was designed to behave with the same discipline as the German Bundesbank, but it has morphed into something very different. Since the start of the financial crisis it has bought, outright, something like $80 billion of Greek and Irish and Portuguese government bonds, and lent another $450 billion or so to various European governments and European banks, accepting virtually any collateral, including Greek government bonds.
"But the E.C.B. has a rule--and the Germans think the rule very important--that they cannot accept as collateral bonds classified by the U.S. ratings agencies as in default. Given that they once had a rule against buying bonds outright in the open market, and another rule against government bailouts, it's a little odd that they have gotten so hung up on this technicality. But they have. If Greece defaults on its debt, the E.C.B. will not only lose a pile on its holdings of Greek bonds but must return the bonds to the European banks, and the European banks must fork over $450 billion in cash. The E.C.B. itself might face insolvency, which would mean turning for funds to its solvent member governments, led by Germany. (The senior official at the Bundesbank told me they already have thought about how to deal with the request. 'We have 3,400 tons of gold,' he said. 'We are the only country that has not sold its original allotment from the [late 1940s]. So we are covered to some extent.') The bigger problem with a Greek default is that it might well force other European countries and their banks into default. At the very least it would create panic and confusion in the market for both sovereign and bank debt, at a time when a lot of banks and at least two big European debt-ridden countries, Italy and Spain, cannot afford panic and confusion.
"At the bottom of this unholy mess, from the point of view of the German Finance Ministry, is the unwillingness, or inability, of the Greeks to change their behavior.
"That was what the currency union always implied: entire peoples had to change their ways of life. Conceived as a tool for integrating Germany into Europe, and preventing Germans from dominating others, it has become the opposite. For better or for worse, the Germans now own Europe. If the rest of Europe is to continue to enjoy the benefits of what is essentially a German currency, they need to become more German. And so, once again, all sorts of people who would rather not think about what it means to be 'German' are compelled to do so."

The Long and Winding Road to Crisis

As I will show below, the US (indeed much of the world) is on the edge of yet another recession. It will not take much to push us into one, just a small shock, like say a banking crisis in Europe, alluded to by Lewis and something I have been writing about for a year.
That being said, the apparent willingness of the Germans to come up with creative ideas (and to get the French to go along) to fund the various nations in crisis, in order to avoid technical defaults, is somewhat amazing. And if there was an election today and the socialists and Greens won in Germany, they would be even more open to the idea of a eurobond, to be somehow guaranteed by member countries. The current EFSF can deal with Greece, Ireland, and Portugal until maybe 2013, and the next version will be large enough to deal with Spain, unless of course the Eurozone elites decide to call it quits, which is something they have not shown the slightest hint of doing. What is more likely is that we lurch from crisis to crisis, with each crisis somehow being averted by throwing more money at it, until the debt of the AAA guarantors like France (and to a lesser extent Italy) starts to be called into question by the markets.
Remember, the demographics of Spain and Italy are horrendous, soon to be on a level with Japan. The government portion of GDP in France is already 53% (not a typo!) and is only going to get worse as aging Boomers have been promised monster benefits that simply cannot be provided without Greek-level austerities. Their future numbers are worse than those of the US.
This can go on for a long time, or it can end in a Bang! moment this year. That is the nature of the lesson from Rogoff and Reinhart. Look at Japan. They took what were functionally insolvent banks and kept them going for decades. Where there is a political will there can be a way … but there will be an Endgame. That is also the lesson we learn from history. Japan will not be able to stave off a crisis of major proportions forever. Neither will Europe, unless they all become Germans in their national accounting.

Are We Already in Recession?

My friend Barry Ritholtz posted the above question today, and wrote:
"Bloomberg reported today that " Consumer Sentiment Plunged to Three-Decade Low." That sent me scurrying to find some charts, and I ended up liking the two from UBS strategist Andy Lees, at bottom.
"The first one is an overlay the University of Michigan consumer confidence index vs the Conference Board's data. The second chart shows the long term history of the Conference Board data. At an implied level of 43.37 we would be in recession now; not only that but a deep recession.
"As the charts show, the ABC index has diverged from the Conference Board data for some time now. The correlation between consumer confidence and recession might not hold this time - although that would be the first split for 40 plus years. There is also an implication from this data series that we are already in recession. Given yesterday's data showing both imports and exports falling, we may have an implied Q2 GDP revised lower by 0.8% to 0.5% annualized growth - putting Q2 into the negative category.
"Hence, it is not unfeasible that we could be the verge of recession."


And that brings me to a chart I asked Rich Yamarone (chief econ type at Bloomberg) to update for me. Again, it is about the horrific consumer confidence number that came in today, but this time it is correlated with GDP. As you can see, there is a close correlation. With GDP growth of less than 1% for the last six months, asking if we are close to or already in a recession is not a question without merit. And either way, this does not bode well for the long-term direction of stocks and corporate earnings. Consumer confidence is really saying that a recession is in the cards. Maybe it is just weariness with the political malaise (which would be understandable), but we should pay attention.

And while I won't print the chart again, every time year-over-year GDP growth falls below 2%, we end up in a recession. It is now 1.6%. Past performance is not indicative of future recessions, but the trend is not in our favor.

So What Can We Do?

The economy is getting weaker. What can we do? The short answer is, sadly, not much. There were some in Maine who argued for more fiscal stimulus, but I think there is little political will for another major stimulus program. The last one got us up to 3% GDP growth before we fell back, and all we got was a major debt bill and a higher level of government spending. I fully get that lowering government spending will have negative short-term effects, but we are at the point in the Endgame where we must bite the bullet.
And fiscal policy is becoming a drag on the entire Eurozone, as well as Great Britain. Austerity may be warranted, but is has consequences.
What about QE3? Let's look at how that last move turned out. We ended up with more money on the Fed's balance sheet and higher commodity prices. The NFIB survey I cited last week showed there was no great demand on the part of small business for loans. 91% had what they needed. What they want are sales and customers! The trade data yesterday showed exports fell by over $2.3 billion last month. That suggests a slowing world economy. Which is borne out by numerous other indicators.
One has to applaud the Chinese for allowing their currency to rise by a significant (for them) amount this week, as almost every other government (including Switzerland) wants a weaker currency. Everyone can't devalue at the same time, just as everyone cannot export their way out of this crisis. Someone has to buy!
In short, there are no easy solutions. We have just about used up all our "rabbits in the hat" as far as fiscal and monetary policy are concerned. We now need to focus on what we can do to get out of the way of the private sector, so it can find ways to create new businesses and jobs. And that means figuring out how to get money to new businesses, because that is where net new jobs come from. But that takes time – and is a subject for another letter, as it is time to hit the send button.

Consumer Crashfidence; Lowest in 30 Years!

from Bloomberg:

Confidence among U.S. consumers plunged in August to the lowest level since May 1980, adding to concern that weak employment gains and volatility in the stock market will prompt households to retrench.
The Thomson Reuters/University of Michigan preliminary index of consumer sentiment slumped to 54.9 from 63.7 the prior month. The gauge was projected to decline to 62, according to the median forecast in a Bloomberg News survey.

from Tony Pallotta of Macrostory.com via Zero Hedge:


And that my friends is the nail in the economic "recovery." August consumer sentiment was just reported at 54.9 from 63.7 in July. This is the lowest level since May 1980. The chart below shows the correlation with sentiment and the consumer component of GDP which is about 70% of the economy and why I say the "recovery" is over.
In Q2 the consumer component of GDP was 0.07% from 1.46% in Q1. Based on historical correlations and today's sentiment data the Q3 consumer component will contract much further in the (2%) range. This will bleed into the fixed investment and inventory components of GDP causing further contraction.

But stocks are moderately higher.

The Infamous Death Cross Rears Its Ugly Head

Ironically, the stock market indicators I use have just turned bullish again. If tomorrow's stocks take out today's highs, the new bull market will be confirmed. The death cross, however, consists of the crossing of the 50-day (light blue on this chart) and 200-day (pink on this chart) simple moving averages. It is almost certain to occur unless the stock market moves about 800 points higher tomorrow. It's going to be interesting!

Commodities: Risk ON!

Corn -- near limit up, despite that it is near the highest price since the commodity bubble of 2008. Other grains all substantially higher today!

Crude oil -- up $4 today

There is NO Risk Today!

It's a "Risk On" Day!

Chancellor of the Exchequer, Rt Hon George Osborne MP: It's the Debt, Stupid!

Perilous times, but on Wall Street, hubris rules the day!

Excerpt from the Chancellor of the Exchequer of the UK:
There has been the weak economic data from the US and the historic downgrade of that country’s credit rating.
And the crisis of confidence in the ability of Eurozone countries to pay their debts has spread from the periphery to major economies like Italy and Spain.
But these events did not come out of the blue.
They all have the same root cause.
Debt.
In particular, a massive overhang of debt from a decade-long boom when economic growth was based on unsustainable household borrowing, unrealistic house prices, dangerously high banking leverage, and a failure of governments to put their public finances in order.
Unfortunately, the UK was perhaps the most eager participant in this boom, with the most indebted households, the biggest housing bubble, the most over-leveraged banks and the largest budget deficit of them all.
History teaches us that recovery from this sort of debt-driven, financial balance-sheet recession was always going to be choppy and difficult.
And we warned that would be the case.  
But the whole world now realises that the huge overhang of debt means that the recovery will take longer and be harder than had been hoped.
Markets are waking up to this fact.
That is what makes this the most dangerous time for the global economy since 2008.
I think we should be realistic about that. 
I think we should set our expectations accordingly.

Europe Dips, But Wall Street Flips

This has become a recurring event. The debt overhang in Europe is killing global economic growth, but Wall St is still oblivious. Markets are tanking in China, Brazil, India, and Japan, but Wall St is still trying to have a Pollyanna Party.

Reversal to Trend

We have now reverted back to the downward trend (on the daily charts -- not shown). Dow is down about 400 points for the day.

Powerful Rally Ensues

Gold Hits $1800

Euro Battered On News of France Debt Downgrade

Euro

Dollar

Dow Down 450, Seeks to Form Bottom

New Gold Record $1784

Turmoil and Tumult!

Selling resumes, but the bottom may be in for the day. Down is down 400 points today thus far.

...And the Bulls Battle Back

This is too much volatility for my blood. I'm going to sit and wait until the market becomes more stable.

...And Then Stocks Fall Off a Cliff

The Downtrend Resumes: Stocks Give Back Half Yesterday's Gains

S&P down 35 points. What a world!

Gold Back to Record Highs ($1780/oz.)

Dow Dumps 300

Rule 48 Invoked This Morning

Here is the statement from the NYSE:

Today, New York Stock Exchange has invoked Rule 48, which provides the exchange with the ability to suspend the requirement to disseminate price indications and obtain floor-official approval prior to the opening when extremely high market-wide volatility could cause floor-wide delays in opening of securities on the exchange.

Rule 48 is intended to be invoked only in those situations where the potential for extreme market volatility would likely impair floor-wide operations at the exchange by impeding the fair and orderly opening of securities. Accordingly, the rule sets forth a number of factors to be considered before declaring such a condition, including:

Volatility during the previous day’s trading session;

Trading in foreign markets before the open;

Substantial activity in the futures market before the open;

The volume of pre-opening indications of interest;

Evidence of pre-opening significant order imbalances across the market;

Government announcements;

News and corporate events; and,

Any such other market conditions that could impact floor-wide trading conditions.

Goldman Reinterpretation of Fedspeak Sparks Unprecedented Stock Rally

The no-QE2 speak of the Fed was interpreted by Goldman as nearly unlimited QE coming, and the S&P 500 rallied nearly 70 points. Unbelievable!

"Bubbles" Disappoints! No QE3! Wall Street Throws a Tantrum!

Wall Street is throwing a temper tantrum! After being up 200 points today, stocks just hit the flat line!

Ron Paul Speaks Plain Truth About Debt Downgrade!

“We were downgraded because of years of reckless spending, not because concerned Americans demanded we get our finances in order. The Washington establishment has spent us into near default and now a downgrade, and here they are again trying to escape responsibility for their negligence in handling the economy.” -- Congressman Ron Paul

Data? What Data?

Apparently, G7 finance ministers have had enough of tumbling stock markets. Despite continues abysmal data, they began aggressively intervening into the financial markets last night, determined to prop up the sagging stock markets.  After all, news is so, well, passe! We have printed prosperity now!

from Zero Hedge:

The only economic data point of the day is a disappointment as non-farm productivity drops 0.3% on consensus of -0.9%, although we once again get an unprecedented revision from the BLS whose data can no longer be trusted for anything, as Q1 productivity was cut by whopping 2.4% from 1.8% to -0.6%! This is the first consecutive quarterly drop since 3Q, 4Q 2008. Net, this is very disappointing data and means that the economic slow down is far more broad than previously expected. And, not at all surprisingly, we get the same thing with labor costs rising 2.2% on consensus of 2.4%. The kicker yet again is in the revision, which speaks for itself: from 4.8% to 0.7% in Q1. US economic reporting is rapidly becoming a bigger joke than the Chinese Department of Truth.

Market? What Free Market?

from Zero Hedge:

Anyone just waking up and noticing futures trading just barely below the closing print may get the impression that things are fine. They are not. Here is what has happened overnight as the global central planning cartel does everything in its power to prevent the global market rout, which has so far wiped out $7.8 trillion in market value around the world, from morphing into the catalyst that ends the status quo. To wit: ECB resumes buying Italian and Spanish bonds (UniCredit says the bank is losing a “game of chicken” with lawmakers by not holding out for budget cuts and higher taxes, and may eventually need to print money), the G-20 is prepared to take joint measures to stem a global crisis, Brazilian Finance Minister Guido Mantega said. Greece’s securities regulator banned all short-selling on the Athens exchange for two months starting today. Taiwan’s government bought stocks yesterday and this morning through four funds it controls. South Korea’s regulator asked pension funds, brokerages and asset-management companies to step up efforts to stabilize the market. South Korea also bans short selling for three months starting August 10. And lastly, rumors of an emergency Fed announcement are ripe. So... after all this global cartel intervention, is it any wonder that futures staged a near vertical move up overnight?

No Holding Gold Back As the Metal Reaches Another New High! Up $65 So Far Today!

We've already reached another new high above $1781!

S&P 500 Futures Rally 70 Points, Then Fizzle and Go Red Again

That was some rally, no doubt taking out many shorts, but alas, the fundamental weakness in the world economy bears sway, and stocks are negative again. That was a powerful rally, suggesting that Wall Street perceives that the market is oversold, but the continuing weak data make it difficult to sustain any rally.

The Fed is likely to announce a new program of monetary inflation today or tomorrow. If they announce it today, it will be a sign of how urgently "Bubbles" Bernanke perceives the crisis to be. Even if they wait until tomorrow, it is still a sign of desperation.

Ultimately and eventually, they will collapse the entire financial system in their irresponsible hubris. Bernanke himself has stated that his policies are "unprecedented measures"; in other words, he hasn't the slightest idea what effect they will have in this complex and interconnected world. But like a foolishly arrogant teenager with a chemistry set, he won't stop until he blows up the neighborhood. That is his destiny!

Trouble this way comes! Big trouble!

The Gold Rush Continues to $1773 per Ounce

Stocks Continue Weak in Evening Trading

Volume was heavy, and the Dow was down another 320 points. The Fed board is meeting tomorrow and Wednesday, so the market is anticipating more Fed action.

David Rosenberg Suggests We Shouldn't Worry! I'm Worried Anyway!

WHILE YOU WERE SLEEPING

As we had suggested in recent weeks, a U.S. downgrade was going to likely be more negative for the equity market than Treasuries, and that is exactly how the week is starting off. The reason is that history shows that downgrades light a fire under policymakers and the belt-tightening budget cuts ensue, taking a big chunk out of demand growth and hence profits. It is not just the United States — the problem of excessive debt is global, from China to Brazil to many parts of Europe. And let’s not forget the Canadian consumer.
If we are seeing any big rally today, it is in Italian and Spanish bonds following the ECB announcement that it will go into the secondary market and buy the debt of these countries en masse (en masse indeed because the estimates we have seen suggest that roughly 800 billion euros of Italian and Spanish bonds have to be absorbed to alleviate upward pressure on their bond yields — that is about double the entire 440 billion euro capacity for the European Financial Stability Facility (EFSF) and would imply a radical expansion of the ECB balance sheet, which is actually barely supported by 80 billion euros of Greek, Irish and Portuguese bonds since the spring of 2010). Today’s FT suggests that German Chancellor Angela Merkel is supportive of this expanded bond buying program by the ECB.
We also had an emergency G7 conference call and press statement that policymakers will do all they can to mitigate gyrations in the marketplace. So for investors, our fate is very much tied up in the prospect that government bureaucrats and politicians manage to get ahead of this latest version of the global debt crisis.
We had a nice two-year rally in risk assets and something close to an economic recovery, but as we had warned, it was built on sticks and straw, not bricks. This isn’t much different than the financial engineering in the 2002-07 cycle that gave off the appearance of prosperity.
Gold is also rallying hard as it becomes oh-so-painfully evident, now with the ECB joining the fray, that debt monetization by the monetary authorities globally is going to be part and parcel of the solution to this leg of the crisis. Expect gold to go much, much higher as well —just to get back to prior highs in inflation- adjusted terms would mean a test of $2,300; and normalizing by world money supply points to $3,000 an ounce.
That bullion is testing new highs today with oil getting crunched as global growth forecasts come down is testament to the view that the yellow metal is trading less as a commodity over time and more sensitively as a currency unit — a classic store of value that is as correlated with deflation as it is with inflation (and we have written on this file many times over the years).
The run-up in gold today is occurring even with the U.S. dollar consolidating. The euro is also quite stable but the data are not that lucky to start off the week — French business confidence fell to a 20-month low in July. Elsewhere, we saw job ads in Australia tumble 0.7% in July, which bodes poorly for upcoming employment figures.
For FX investors, there are few alternatives left —the U.S. has lost loses its across-the-board coveted AAA status (though the other rating agencies haven’t yet followed S&P’s footsteps); the ECB is allowing its balance sheet to blow out as it adds risky debt to its cache of bonds; the safe-haven yen and Swiss franc have been undercut by FX intervention; the rapid slide in the Asian stock marketsis pointing to much softer growth ahead in the region as the fight against inflation catches up with the real economy; and the resource currencies are getting hit by this most recent downdraft in the commodity complex (the Aussie dollar is down for eight straight days and the loonie is trading even closer toward parity). Copper is heading for its steepest monthly decline since December 2008 and crude oil is flirting near eight-month lows.
The stock market is now deeply oversold on a technical basis and while down sharply on the open it is how the S&P 500 and the other major averages close that will tell the tale over the near-term. The market has absorbed a lot of bad news of late. To be sure, the damage has been done and Dow Theory advocates will point to the transports confirming the breakdown in the industrials. And the transports sliding along with the oil price, which last happened like this in 2008, is indeed an ominous economic signpost. For those of us looking for capitulation data points, it sure didn’t surface in the op-ed section of today’s WSJ — Burton Malkiel titles his piece Don’t Panic About the Stock Market. Actually, that is exactly what is going to be needed to put a conclusive bottom to the stock market. Let’s wait for the VIX to age into the mid-40s.
Also don’t put too much faith in a payroll number that will be revised many times over; the contraction in Household employment, especially in full-time employment, is critical. Roughly $5.4 trillion in global equity values have vanished in the past two weeks and so one would expect to see all those high- flying, high-end retailers to give it up on the chin here.
While the focus is on the U.S. and Europe, we can’t help but note that the MSCI Asia-Pac index is down a huge 2.4% today and coming off five consecutive losing sessions — and this was the engine for global growth in the world economy and S&P profits for the past two years. Gonzo.
On the economic front, much damage has been done here as well. The OECD leading indicator fell to 102.2 in June — the lowest since November 2010 — from 102.5 and is down now for three months running and the declines were broad based across the G7 and emerging Asia.
As for the downgrade, keep in mind that this is a split rating, there is nothing to suggest that Moody’s or Fitch will follow suit (note both of these agencies re- affirmed America’s triple-A status and Fitch has already clearly stated that it will make a decision only after it has had time to assess the results from the coming debt commission). S&P has a different methodology and places a lot of emphasis on ‘political’ factors; and the fact that it did make a $2 trillion error from a mistaken assumption on future expenditure growth also detracts somewhat from the downgrade move.
Moreover, the U.S. can print its own money and certainly has the wherewithal to pay its debts so the downgrade is more symbolic than real. Perhaps there is a silver lining in all this as there was in Canada back in 1994. But default risks are no different today than they were last Friday morning, and the Treasury had already said repeatedly that bondholders would be made whole even if there was to be a government shutdown.
Now the question, in the name of consistency, is whether France is next — is it really AAA with the U.S. at AA+? Does that make any sense? But if France was ever to see a cut, then the EFSF no longer works as planned since the facility’s AAA rating is critically dependant on France and Germany obviously maintaining their pristine rankings. Or what about an Italian downgrade? Does it deserve to be A+? A1? That would likely be a market-mover as well and cannot be ruled out. This downgrading process cannot possibly stop at the U.S.
All that said, the Fed already said last week that banks will not have to put up any capital against this newly rated U.S. government debt. This is one ranking out of three. This also only applies to long-term U.S. debt, which is dwindling relative to the total pie of Treasuries outstanding. Most funds use an average of all the ratings so there will be no need for any major, or even minor, institutional investor repositioning. For all intents and purposes, the world is most likely going to still be treating the U.S. as a triple-A credit.
I see on my screens that Treasuries are AAA rated for all Barclay’s indices. And if you look at the history, whether it be Japan, Canada or Australia, you can see that domestic bond markets pay far more attention to the domestic economic and inflation environment than they do to the downgrade. It’s early days yet, but so far the Treasury market is doing exactly that (though a key test comes this week as the U.S. government auctions a total of $72 billion of new debt — the first sizeable sale since the debt ceiling was raised last week).
Throughout this round of turmoil, corporate bonds have hung in remarkably well. Spreads have widened a touch as they do tend to be directional with respect to where Treasury yields are heading, but average interest rates in the credit space have actually fallen to historically low levels. This is the benefit of hoarding cash on corporate balance sheets.
For CEOs, coming out of the last brutal cycle it has been all about survival in this post-credit bubble bust deleveraging cycle and the aftershocks we see occurring today. For bond holders, it is all about being made whole in terms of coupon receipts and principal repayment, and what makes corporate debt different than equities is that the former is a contractual obligation. In a world where not even cash is cost-less, as Bank of New York Mellon recently indicated, high quality bonds retain alluring risk-reward attributes.

ARE WE THERE YET?

Last two week’s 10% drubbing in the stock market was the worst performance since the depths of the bear market in late 2008 and early 2009 when the U.S. banks were being priced for insolvency. Now the major problem are the European banks and their sovereign debt exposures — and not just banks in the Eurozone periphery but those in core Europe as well, including France where there were reports of escalating liquidity problems.
The S&P 500 is technically oversold but except for day-traders, that obscures the point of the market having hit an inflection point, something that actually happened quite a while ago. Remember, this is a stock market that hadn’t managed to make a new high in five months despite all the great corporate earnings results.
Everyone is now so tempted to compare and contrast what is happening now to last year’s double-dip scare in an attempt to time when to jump back into the market. A year ago it was about Greece, Portugal and Ireland— not Spain, Italy or even France. A year ago, it was all about ISM —this time around, the economic downdraft is much more pervasive with real consumer spending falling now for three months running. A year ago the slowdown was confined to the U.S. and now it is spreading (a year ago, the OECD leading indicator was not rolling over, as an example). Friday we saw German industrial production decline 1.1% in June (consensus was +0.1%) and Italy showed a 0.6% slide. The Reserve Bank of Australia just cut its 2011 growth outlook to 2% from 3.5% and the markets there have begun to price in multiple rate cuts.
This is not a replay of mid-2010. The global economy is slowing down much faster than was the case then and the problems surrounding sovereign government debt are far more acute. While the Fed may be forced at some point into more easing action, there is more reason to be skeptical of any success now than before. And fiscal austerity is now the policy watchword in Washington whereas the largesse last fall after the midterm elections played a key role in stimulating the economy, at least for a short while, and risk appetite as well.
Everyone is trying to call a bottom now (which is never the hallmark of a panic low) and is what you would like to see to start dipping a few toes back into the market. The term “buying opportunity” is posted in so many circles, and what is interesting is that you never ever hear the term “selling opportunity” on Wall Street. It just doesn’t exist in the industry parlance —not even around peaks! Be that as it may, the market will find a bottom at some point, therefore it is worthwhile to identify and assess what could be trigger points. In my view, the five basic factors include the (i) technicals, (ii) valuation, (iii) fund flows, (iv) sentiment and (v) the good ol’ fundamentals. Also have a look at what other catalysts could be lurking around the corner.
1. Technicals
Looking at classic Fibonacci retracements (from last summer’s lows to the recent May high), the S&P 500 has already pierced the 38.2% retracement level, which was 1,233. The next key is 50% which implies 1,191 — almost where we are now. A complete reversal, which is 61.8%, points to very critical technical support around the 1,150 area. That is also very much in line with Walter Murphy’s trendline work that shows key support in a 1,168-1,179 band. One problem is that there is pervasive belief, even among bears, that this will be the final resting point. It may end up being just a short-term resting point depending on how the economy evolves.
2. Valuation
Valuation is never a very good timing device but is a useful barometer nonetheless to assess if you are buying low enough. Forward P/E’s right now are irrelevant because the analysts have yet to take down their estimates so the multiples are inflated. But if you are looking at really cheap markets, then consider that Germany and France are now trading at 8x forward multiples and China is at 10x. As for the S&P 500, the best that can be said is the market is not expensive and the dividend yield is starting to approximate the yield on the 10-year U.S. Treasury note.
If I am still not enthralled with equities as an asset class, it is not really the valuation metrics that have me unnerved as much as where we are in the business cycle and how fast recession risks are rising and what that will mean for earnings revisions going forward, which the equity market is very responsive to. For equities, it is not so much the valuation metrics that have me unnerved as much as where we are in the business cycle and how fast recession risks are rising – and what that may mean for earnings revisions going forward, which the equity market is very responsive to. To be sure, the Q2 earnings season had been stellar, but the lack of guidance —two-thirds of reporting companies did not provide any — points to reduced visibility.
When the goal posts are widened over the economic outlook (recall that the Fed just cut its economic projections a few weeks back) that augurs for a lower fair- value P/E multiple. The market may be less-cheap than it appears. According to research cited in the FT, nearly 70% of the few (76) that have provided guidance have reduced it, and in the most cyclical names as well (Tyco, Illinois Tool Works, Netflix, Texas Instruments).
3. Fund Flows
It was just a few weeks ago that we had Ben Bernanke hint at QE3 and the market soared. Then we had the EU rescue announcement and the market soared. Many a pundit was calling for new cycle highs. The problem here, much like with sentiment, is that the vast majority of the public was riding the bull market past the springtime highs.
For example, institutional portfolio managers who run aggressive growth capital appreciation strategies entered into this new bear market fully invested — just a 3.1% cash ratio, which is historically very low and at least at the lows of last summer. Back in early 2007, they had raised that figure to 3.6% and in early 2009 they had boosted liquidity to 5.2%— now that is capitulation and also provides a source of potential buying power.
The hurdle is that with retail investors in redemption mode, fund managers are going to be forced to liquidate their positions to raise cash. This is a clear fund- flow risk for the market over the near-term.
4. Sentiment
While so many like to look at the price action as a sign of capitulation this is not the place to look. You have to look at the surveys. The Market Vane survey of equity market sentiment right now is at 59%. Is that negative? At last summer’s lows it got as low as 42% and in March 2009 was 38%.
The Investor’s Intelligence survey right now is at 46.3% bulls and 24.7% bears; again, at last summer’s market bottom, the number of bears outnumbered the bulls by eight percentage points. At last count, the bulls outrank the bears by 22 percentage points. Where is the panic button? When you see that, then it may be time to get back in.
Even the VIX index, while touching 32, is nowhere near the 45 levels prevailing last year when at least you could point to a degree of capitulation and fear. We are not there yet, but keeping a close eye on these and other measures. Note as well that even though the economists have cut their GDP numbers, no equity strategist on Wall Street has cut price targets for year-end; they remain steadfastly at 1,400 on the S&P 500, which would be an 18% rebound from here.
5. Fundamentals
We have been saying for some time that recession risks are on the rise; in fact, we think it is a virtual lock by next year. In a market correction during a period of economic growth, brief market pullbacks of 10% or 15% are common. But in a recession, corporate earnings and the equity market both typically go down between 25% and 35% — these are averages —which would then mean a test, and possible break, of the 2010 lows (below 1,000). An $80 EPS profile for next year and a trough 12x multiple would yield a similar result.
Now, keep in mind that is not a forecast as much as an observation of what the past has taught us. The sectors that outperform are the classic defensives such as Utilities, Health Care, Staples and Telecom. The sectors to avoid would be Industrials, Technology, Consumer Discretionary and Financials. I would suggest that hedge funds that go long the defensives and short the cyclicals will do very well in this environment, along with a handful of high-quality bonds and continued exposure to gold, even though it does look overextended on a near- term basis.

CONFIDENCE SURVEYS RATIFIES RECESSION CALL

The just released IBD/TIPP poll came in at 35.8 in August, a 13.5% slide with all the subcomponents weakening dramatically, prompting the president of TIPP to conclude that “the weak confidence data strongly suggest that the economy has fallen into recession, driven by continued high unemployment, under- employment and low confidence in the government’s ability to improve the economy”.
This was the weakest reading on record, going back to 2001. The ‘six-month outlook’ subindex sagged 20% to 31.7, undercutting the December 2007 low (the first month of the last recession). Nearly 30% of respondents reported having someone in their household who is unemployed —the highest ever and well above July’s 24% showing.
Fully 45% of folks with just a high-school diploma cannot find a full-time job, and that metric is disturbingly elevated at 25% for college grads.
It would seem that the biggest casualty from all this angst is President Obama’s election prospects. For more on this file, have a look at page 2 of the FT — Obama’s Hopes for Re-Election Take a Knock.

THE NEEDLE AND THE DAMAGE DONE

The Dow finished last week with a slide of nearly 700 points, the worst drubbing since the worst of the financial crisis in October 2008. The blue-chips are down 10.7% from the 2011 peak and is now down for the year as well. The S&P 500 suffered its third loss in the past four weeks and is off around 12% from the nearby highs.
Yes, the market is near-term oversold but the fact that the decline last week took place on one of the largest volume periods of the year — 8.62 billion shares on the NYSE on Friday alone — is a sure sign that the ‘buy the dips’ mantra that was part and parcel of the two-year recovery that ended last April has morphed into a ‘sell the rally’ environment. The VIX has soared to 32, but true capitulation occurs closer to the 45 level. Stay tuned.
Fund flows are clearly a negative for equities. Retail investors are pulling around $10 billion per week out of mutual funds and another $5 billion from ETFs, according to TrimTabs.com. It is not just the market weakness but the wild intra- day swings in prices are equally a turnoff for people who like to sleep at night.
This is at a time when portfolio managers are running with extremely thin cash ratio levels. Corporate insiders are also selling at a rate that is 10x larger than insider buying levels. And the demand for cash is so massive that the Bank of New York Mellon is now going to be charging clients to hold onto deposits (i.e. akin to negative interest rates). Dip your toes into any risk asset right now and understand that you are not entering into anything remotely resembling a normal market environment. Dysfunctional is more like it. Treasury bill yields are close to 0%.
The problem that remains is the excessive global debt burdens that were never redressed by the Great Recession. Sure the U.S. banks took writedowns and cleaned up their balance sheets, but the problem of toxic assets and home price deflation have not disappeared. Governments around the world allowed debt- strapped private entities to ride off their AAA credit ratings and now that support is gone. Private sector largesse (banks and households) was replaced with taxpayer supported debt. The total debt pie relative to GDP has simply continued to spiral up to new and now seemingly unsustainable heights. Now the U.S. has hit the wall.
Those hoping and praying for a Chinese solution do not realize how debt- burdened even the second largest economy in the world is today — total banking sector credit in China relative to GDP is now 150% (180% when off balance sheet items are included). This is a 30 percentage point surge from 2008 levels (see No Plan B Exists if Growth in China Cracks on page B16 of the weekend FT).

IMPLICATIONS OF THE DEBT DOWNGRADE

Please, let’s not hyperventilate over this. S&P had already said they were going to do this. Who doesn’t know that the debt reduction package was on the light side? And it’s really a split rating since Fitch and Moody’s already reaffirmed the AAA status two weeks ago. If it is material, it is the impact on the repo market and this could lead to a tightening in financial market conditions.
The White House plans to get Congress to extend unemployment insurance benefits and expand payroll tax relief are now going to be kyboshed. The big news is that the screws have been tightened on the fiscal stimulus front. So on net, the downgrade is a deflationary event and as such is not negative but positive for the bond market. History shows that every time a AAA country gets downgraded, the budgetary belt is tightened and yields decline every time.
WHO’S AAA?
We thought it apropos to provide a list of who is left that is ranked AAA by all the major rating agencies ... the list is dwindling:
·Australia
·Austria
·Canada
·Denmark
·Finland
·France
·Germany
·Isle of Man
·Luxembourg
·Netherlands
·New Zealand
·Norway
·Singapore
·Sweden
·Switzerland
·United Kingdom

LAST WORD ON EMPLOYMENT DATA

It was akin to a student bracing for an F on his report card and getting a D instead. It was overall a poor report and while not pointing to a recession at this very moment, the pattern of the erosion in the pace of job creation is so obvious that if past is prescient, the downturn is only three to eight months away.
No change in aggregate hours worked so far for Q3 is not consistent with 2%+ growth, let alone 3%. Auto production may add 0.5 of a percentage point to GDP, but will not be enough to offset the ongoing sluggishness in aggregate demand. The Household survey is actually pointing towards economic contraction and when a mere 55% of working-age adults are holding onto full-time jobs — a record low — as was the case in July, you know you are talking about a very sick labour market.

COMMENT ON PROFITS

So much for 75% of companies beating their Q2 EPS estimates. Talk about a lagging indicator in any event. But now we are on the cusp of seeing earnings revisions head to the downside — the bottom-up consensus EPS estimates for Q3 have been trimmed to +15.8% (YoY) from +16.7% a month ago and while not a big haircut, at the margin, this is the onset of a new direction. Also note that of the companies providing any guidance, nearly 70% have been to the downside.
No doubt the bulls see the market as cheap especially when assessing the S&P 500 earnings yield to the prevailing level of bond yields, but valuation is a very poor timing device. Truth be told, the stock market never even hit prior trough multiples back in March 2009 — go back and look at where the P/E ratios bottomed out in the mid-1970s, early 1980s and early 1990s and you will get a sense of what I mean.
The Shiller P/E (at 20.2x) has now managed to compress back to the 50-year mean (19.5x) so perhaps the market is fairly valued now after this latest corrective phase, but it isn’t yet clear if it is cheap enough just yet to jump back in (have a look at Stocks are Cheaper, but They Aren’t Cheap on page B1 of the weekend WSJ).
This is not the summer of 2010 all over again either, as the economic deterioration is far more entrenched globally and across GDP sectors. There is now more reason to be skeptical of any lasting success from Fed interventions, and sovereign credit strains are far more acute. Recession risks are on the rise and if that is becoming more of a base-case scenario, then next year we could be talking about $70 or $80 EPS, not $113. Even if you want to slap a 15x multiple on that (more likely 10x or 12x) because you are clinging to the view that this market deserves a higher P/E given ultra low interest rates, the case for being long equities is very weak.
Moreover, as Ben Stein famously said, “anything that cannot last forever, by definition, will not”. We cannot help but think of profit margins and how in this tepid two-year economic expansion all the spoils went to capital over labour. This process may be coming to an end, which is key since the consensus has penned in new higher highs for margins for the coming year. See As Corporate Profits Rise, Workers’ Income Declines by the always reliable Floyd Norris on page B3 of the Saturday NYT.

IS 35 THE NEW 50?

We were reading Barron’s and came across this:
“Last week, Strategas raised the odds of a recession in 2012 to 35% from 20%”.
And then we saw on page A5 of the weekend WSJ ...
“He [Paul Kasriel of Northern Trust] now puts the odds of the economy entering a recession at 35%, up from 15% at the start of last month”.
The question here is what is magical about 35%. If the economy slips into recession these pundits will then say they called for it? Or if it doesn’t, they will say that their base-case never was for a contraction in any event? We think a recession at this point is a virtual lock — as close to a sure thing as there could be. But 35% doesn’t really say a whole lot except perhaps, at the margin, the risks are rising and investors should be adjusting either all or a growing part of their portfolio to this increasing probability.

WHAT’S THE FED TO DO OR SAY THIS WEEK?

It may be a good time to dust off Bernanke’s July 13 semi-annual Monetary Policy Report to Congress; the playbook is quite clear as to what the next steps are and look for some lip service paid to them in the press statement this week.
The passage below from Bernanke has not been receiving more airplay — which is a little surprising:
Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

CREDIT JUMPS — NOT GOOD NEWS AT ALL

Consumer credit soared $15.5 billion in June, three times as much as projected and the biggest monthly gain since August 2007. That this was the same month that consumer confidence slid to an eight-month low strongly suggests that credit was not being tapped for spending as much as to meet the unpaid bills. In fact, if you look back at the last three recessions, they are actually touched off by “get-by” behaviour like this.

Stocks Plastered 633 Points!

This was a disaster today. Stocks are down 1100 points in the last three days! Today was the sixth largest drop in Dow history! One can only wonder what the Fed will do tomorrow and Wednesday!

Selloff Resumes

Dow is down over 600 points and still falling!

Rally Time on Wall Street

I don't know if this is solid buying, or short-covering, but we have now erased about half the day's losses!

Dow Collapses 500 Points -- 2nd Time in Three Days!

We should get a bounce soon! 500 points will bring some bulls to draw another (temporary) line in the sand.

Magical Number: 1720

That's the price gold has reached and the number of points the Dow has fallen since July 22!

New Lows In Bloodbath After Obama Speaks

Dow down 385 points now! The Charlatan in Chief has only made it worse!

Three Scenarios of the Relationship Between the Dollar and the Stock Market

by Charles Hugh Smith from the Of Two Minds blog:


The Stock Market and the Dollar: There Are Only Three Possibilities
With stocks and the dollar on a see-saw, there are only three possibilities to choose from.
Since the stock market is in the news (perhaps as a result of trillions of dollars/euros/yen/yuan/quatloos having suddenly vanished from millions of accounts), it seems timely to examine the key correlation between stocks and the U.S. dollar. As I have often noted here, this "big picture" correlation is a simple see-saw: when the dollar is scraping bottom, stocks are at their highs, and when the dollar is up then stocks are tanking.
At the risk of alienating chart-averse readers, I've marked up the charts of the S&P 500 (SPX) and the U.S. dollar index (DXY).
For those who aren't going to look at the charts, what they suggest is that there are really only three possibilities in play:
A. Stocks go up and the dollar drops to new lows
B. Stocks fall and the dollar rises significantly, a pattern that has repeated several times since 2007
C. The see-saw breaks and stocks and the USD rise or fall together.
The key to the relationship between stock valuations and the dollar is corporate profits. When the dollar declines, then U.S. global corporations' overseas earnings--now roughly 60% of total profits for many big global corporations--expand as if by magic when stated in dollars.
When the euro and the dollar were equal back in the early 2000s, then 100 euros of profit was $100 when stated in dollars. When the euro rose to $1.60, then the same 100 euros of profit earned by the U.S. corporation in Europe became a stupendous $160 in profit when stated in dollars.
This explains why the Fed has been so keen to trash the dollar: it magically increases corporate profits and thus drives stocks higher. The mainstream financial media's explanation for the weak-dollar policy is that the Fed is anxious to increase exports, but this is a sideshow; exports make up less than 9% of the U.S. GDP. The real action is in corporate profits, which thanks to the weak dollar are near all-time highs of almost 14% of the entire GDP.
So those picking #3, the see-saw breaks and the dollar and stocks rise or fall in parallel, have to explain why this dynamic has broken down, and describe the new dynamic which has caused the USD and SPX to rise or fall as one.
Those picking #1, that stocks are about to rebound and the dollar will plunge to new lows, have to explain what force will drive stocks higher and weaken the dollar. The easy answer is the Fed will launch a "monetary easing" a.k.a. QE3 to goose risk assets, including stocks.
Perhaps this will do the trick, but just on a purely technical basis, the stock market has a number of arrows in its back, and nobody knows just yet if any of them are poisoned:


There are a lot of arrows in the back of the market. One of the biggest is declining volume; if volume is the weapon of the Bull, then declining volume has a distinctly bearish implication. One of the basic tenets of technical analysis is support/resistance: key levels (often round numbers like 1,200 or 12,000) become important when stocks bounce off them (support) or are unable to punch through them (resistance). When stocks break support, then that line becomes resistance when stocks try to rise. If stocks break through resistance, then that line become support should markets decline.
When key support levels are decisively broken, huge damage is done to the market, even if the actual point drop appears modest. The SPX broke a key support level just above the pyschological line at 1,200. This has provided strong support/resistance going back to 2008, so it's meaningful.
In the typical course of things, the SPX will attempt to break above that resistance on a rebound off the strong support offered by the 200-week moving average, a level it almost kissed last week.
But there are a lot of other arrows which suggest that will be difficult. Chartists like to draw trendlines, and if we trace out all the trendlines from the 2009 bottom, we get a fan of broken trendlines. This suggests a weakening major trend.
Then there's those three indicators arrows firmly planted in the market's back; RSI (relative strength), MACD (moving average convergence-divergence) and stochastics are all diverging from the rally--all have been declining as the SPX traced out a classic three-peak "head and shoulders" topping pattern over the past few months.
If we look at RSI, we see it is not yet oversold. We also see that when things get ugly, as they did in late 2008, the RSI can actually climb out of being oversold even while the market is in a freefall. When markets are falling, RSI can remain low for months.
MACD offers a very simple window into stock trends: MACD above the neutral line, Bullish, MACD below the neutral line, Bearish. MACD is heading straight for the neutral line and if it crashes through it, it is a distinctly negative indicator.
Stochastics can stumble along an oversold bottom for months, too, so there is little evidence here of an impending rally.
There is strong support around the 1,050 mark, but the market sliced through this like a hot knife through butter back in 2008 before finding some solid ground around 900. When that failed, 666 marked the final trough.
Maybe the SPX recovers the 1,220 level, maybe not. Nobody knows how many of the arrows in its back are poisoned. We'll just have to watch support/resistance.
Those picking #2, a rise in the dollar and a corresponding drop in stocks, have to explain how the dollar can survive the poisoned chalice proffered by the Federal Reserve. The Fed's entire game plan boils down to driving the dollar down by whatever means are necessary. Many observers see the Fed as all-powerful, irresistable, with god-like powers to move markets.
But as I have noted here many times, the Fed's mighty armament is revealed as a BB gun when compared to the foreign exchange markets ($2-3 trillion traded daily), the global risk trade ($30-$100 trillion, depending on what markets you include), and global debt denominated in dollars (in the trillions).
Thus the Fed's power is not the infamous printing press, but the belief of market players that the Fed can single-handedly reverse markets. On a large enough scale, the Fed does have some leverage; for example, the Fed played some $18 trillion into global markets to save the day in 2008.
It is my contention that the Fed's political capital and credibility--the "magic" of omnipotence--have both sunk below critical thresholds (Don't Fight Bet On The Fed August 5, 2011) and that the law of diminishing returns has emasculated the market-moving value of QE3, 4, 5, etc.: each infusion to goose the risk trade does less than the previous prop job.
The timeline of manipulation has also compressed: the Fed's "save" in 2007 lasted a year, the order-of-magnitude greater "save" in 2008-9 bought perhaps a year and a half, and QE2 boosted risk assets for less than a year. If QE3 is smaller than QE2, then its effects will be entirely transitory--weeks, perhaps only days or even hours.
Dollar Bears are assuming the USD will crash through support to new lows. That is certainly one possibility--but it can only happen if stocks rise (choice #1) or the see-saw breaks (#3).



The indicators are exhibiting positive divergence, i.e. slowly rising even as price declines or noodles around a narrow trading range. The USD has traced a classic pennant or flag "wedge" of lower highs and higher lows. This compression of price action often leads to a big move up or down. Those betting on the Fed's omnipotence to crush the dollar to new lows have to overlook the positive divergence and the previous pattern of the dollar rising dramatically when the risk trade unravels. Those betting the dollar will repeat that pattern have an easier case to make technically.
From a fundamental view, the DXY index is on a see-saw with the Euro, as the DXY is composed of a basket of six currencies dominated by the Euro (Euro 57.6%, Yen 13.6%, Sterling 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2%, and Swiss Franc 3.6%).
Thus those betting on the DXY hitting new lows are implicitly betting on a recovery of the Euro. THose betting on major dollar bounce are betting that the Euro is in deeper trouble than the U.S. dollar.
There is no crystal ball that foretells the future; when it comes to forecasting the future, we have only charts, judgment, intuition and probabilities.

Market Meltdown!

True Market Mayhem!

The S&P 500 is down about 38 points. The Dow has been down around 300 points thus far, but is showing a minor bounce at the moment.

Bill Gross Speaks the Truth On the U.S. Debt Crisis

from Zero Hedge:

After all the hollow rhetoric and scapegoating over the past few days about S&Ps "treasonous act" from Friday, we were delighted to finally hear one person say the truth. "I have been criticizing them and Moody's and Fitch for a long time. Moody's and Fitch are on the "S" list. I think S&P finally demonstrated some spin. S&P finally got it right. They spoke to a dysfunctional political system and deficits as far as the eye can see. They are enforcing some discipline. My hat is off to them." The person in question: PIMCO's Bill Gross, who says what everyone is thinking but afraid to say it for fear it would insult our oh so sensitive, and so incompetent, administration. Because if criticizing S&P over being far too late to the subprime party is justified, at least they have the guts (unlike those tapeworms from Moody's) to finally step against the tide of conventional sycophantic wisdom and tell everyone even a modest part of the whole truth. If that is not the first step toward penitence, then nothing is. And yes, America's real credit rating at the current level of deficit accumulation most certainly does not begin with the letter A, or B or even C for that matter. Because what America is doing is heading straight for default, however not by officially filing in the Southern District of New York, but by terminally hobbling its own currency in hopes of stimulating rampant inflation thereby cutting its debt load through devaluation. A sad side effect of that of course is the wipe out of its own middle class as well. But all is fair in love and preserving the wealth of the status quo.