11-28-2011 Market Commentary

By Eddie Katz

CitiFX - A domestic economic recovery looks far from sustained/robust…As long as unemployment stays high the housing market is likely to struggle…As long as housing continues to struggle credit conditions are likely to remain tight…As long as housing continues to struggle and credit conditions remain tight consumers are not likely to gain confidence…As long as consumers are not confident the Equity market will likely continue to remain under pressure…As long as housing continues to struggle, credit conditions remain tight, consumers are not confident and the Equity market will remain under pressure the Fed has only one mandate - Employment. No inflation dynamic at this point will push them to tighten.

At best it may make them reticent to head towards QE3 and instead may prompt “Operation twist 2” where they will try and drive the whole yield curve into negative real yields. This backdrop together with the “European crisis” remains the “perfect storm” to see flatter curves and lower long term yields in the U.S. Ultimately we still believe that this dual dynamic can give us a 10 year yield at 1.25%; a 30 year yield at 2% or lower and an equity market that sets a lower low close to 1,000 (S&P 500) in the coming weeks/months. [S&P 500 = 1158.67 as of 11/25]

JPMorgan - Equity markets have fallen 4% this week, on the heels of a 4% decline in the prior week and 100 pts in total as Europe worsens (Germany’s poor auction on 11/23 did not help) and the US Supercommittee was unable to come to an agreement. Investors are understandably disappointed (disgusted, really), prompting many to question how a YE December rally is possible. After all, equity markets thrive on “visibility,” and the political turmoil and Europe result in wide possible outcomes. That said, December seasonals are strong. Since 1900, the US economy has been in expansion 79 of those years, and December was an up month for 84% of those. Thus, we should not rule out a rally. [Editor’s note – While an 84% likelihood of a market rally is enticing, you’ll have to excuse us for not considering this investment decision in a vacuum of “past December performances”. We kind of think it’s important to recognize the issues of the Supercommittee and much more importantly, Europe.]

Gluskin Sheff - We know the bond bears are a frustrated lot and recall fondly the Grant’s conference in the spring of 2010 when the prevalent view was that the 10- year U.S. note yield was going to be heading to 5%. Here we are, nearly two years down the road, and the yield is sub-2% and below 3% at the long end. Long-dated zero coupon bonds have been stellar performers. Income- generating assets in general have been great investments. The reason is because we are still caught in a post-bubble period of consumer frugality that has unleashed powerful secular deflationary forces in the U.S. consumer space. For real life evidence, just go to the front page of USA Today and have a look at the article titled It’s Black Friday No More: Now it’s Freebie Friday. We know that there are still many people out there who “only see inflation” — maybe they should spend less time at the spa and the high-end jewellery stores and more time where the masses spend their money, like J.C. Penney (NYSE: JCP), Sears (NASDAQ: SHLD) and Old Navy. In a deflationary environment, it is critical to focus on the segments of the economy that do have pricing power.

Food remains a bullish secular theme in this respect — and we highly recommend a read of Turkey Prices Are Taking Flight. Supplies are very tight and as a result, wholesale turkey prices have soared 26% this year on the East Coast. There is little doubt that globally, food demand is outstripping supply. This is not just due to population growth but also to shifting dietary patterns abroad, and this is happening in real time. This also explains why it is that fertilizer, grains and farm incomes remain in a full-fledged secular bull market.

James Capital - We have heard many people comparing the yield on dividend paying stocks with the yield on bonds. This comparison is dangerous because the total return (interest plus or minus capital gains) on stocks and bonds have been vastly different. Historically, stocks have had more downside risk than bonds and this is especially true when market valuations are high as they are now. The worst year for large stocks going back to 1926 was in 1931 with a total return of -43%. The worst year for long term treasury bonds was in 2009 with a total return of -19%. Currently the dividend yield on the S&P 500 is about 2% while historically the average dividend yield has been about 4%. The yield on long term US Treasury bonds is around 3%. Historically it has averaged a yield of about 5.5%. Hypothetically, the S&P 500 would have to decline by about 50% to get back to its average, while the long term US Treasury bond would only have to decline about 36%. Even with interest rates at historically low levels, bonds would seem to have less downside compared to stocks.

John Mauldin - If the ECB does not backstop the banks and Italian and Spanish debt, the Eurozone will fall into a deflationary debt spiral. The large majority of European banks (even in core countries) are basically insolvent. They simply hold too much sovereign debt of all types, at leverages approaching 40 to 1. They have this debt on their books at face value. Even a write-down of 10% wipes out most of their capital. It would be an unmitigated disaster. Look at Dexia. Only a few weeks before it was nationalized by the French and Belgians, the regulators were telling us the bank was well-financed. And then Bang! In a matter of a few weeks, it had to be taken over by the governments. Note please that these are the same regulators that said European banks only needed about €3 billion this summer, and recently that has been raised to €100 billion. They have no clue what mark to market means, but the market does. Bank financing dries up quickly and there is a default moment. Maybe the only real purpose of European bank regulators is to make US regulators look conservative and prudent. Allowing banks and sovereign governments to default at the scale we are talking about means Europe would be plunged into a depression. And that of course means the value of the euro would plummet.

Conclusion – We attempted to take the week off for the holiday…but it’s hard to just stick your head in the sand when markets are down more than 4% for the week. What we did do with some of our downtime (interesting lives we have) is read various commentaries on the ECB and the likelihood that they turn on the Euro printing press. We would classify our research as anything but a legal interpretation, but it seems pretty apparent that the ECB cannot get involved in a massive bailout scheme of Club Med governments (and ultimately countless European financial institutions) without a complete overhaul of the EU equivalent of a Constitution. Of course, there is probably some “out” clause that we aren’t privy too so if you would like to base your pro-risk investment thesis on the Europeans finding that clause…go right ahead. [Post Script: We are now reading that the IMF might bailout Italy to the tune of $600 BN. Noteworthy is that the U.S. “donates” about 17% of all IMF funds.] 

If there was any silver lining this week it’s that volume was extremely light, however, on Wednesday there was an auspicious selloff in the last 5 minutes of the day which would appear to be those fancy MIT algorithmic trading programs jumping over one another in search for the exit. This type of activity doesn’t exactly give us the warm and fuzzies as it provides shades of May 6, 2010 (aka THE flash crash). Our commentary is starting to make us feel like the days when we had a full head of hair. Rinse and repeat. Leave these markets for the skilled day-traders (aka NOT us). Long-term investors need to focus on income and capital preservation. 

Regards,

eddie