10-24-2011 Market Commentary

By Eddie Katz Gluskin Sheff - We are hearing that many economists have backed off on their recession calls. Let's get one thing straight: There were no recession calls. Saying that the odds of recession have risen to 35% or 40% is actually saying that the base-case is a muddle-through scenario. The U.S. economy hit stall speed in the first half of the year and then got sideswiped by a 100 basis point tightening in overall financial conditions, which if history is prescient will start more noticeably affecting the real economy and hence corporate earnings late in the fourth quarter Gluskin Sheff - The Philly Fed Index surprised to the high side indeed in October, firming to +8.7 from -17.5 in September. This was well above the -9.4 reading that was widely expected, the first move to positive terrain since July and the highest print since last April. Even the forward-looking six-month expectations index ticked up to its best level since last April at 27.2 from 21.4. This didn't dovetail that well with what the Philly Fed told us in the Beige Book, but that was for September and this data-point was for October. Prior to this, the Philly Fed was negative in three of the prior four months, and it will be very important to keep an eye on this metric because in every recession in the past, it went down and stayed down through the opening months of the downturn. One should always challenge one's assumptions, and if the Philly Fed does not turn down again in the next few months, it will certainly call into question if the recession is coming as soon as we think. This is not a change of view — it is just something for us to be aware of. John Hussman - The measures that we use to identify recession risk tend to operate with a lead of a few months. Those few months are often critical, in the sense that the markets can often suffer deep and abrupt losses before coincident and lagging evidence demonstrates actual economic weakness. As a result, there is sometimes a "denial" phase between the point where the leading evidence locks onto a recession track, and the point where the coincident evidence confirms it. We saw exactly that sort of pattern prior to the last recession. While the recession evidence was in by November 2007, the economy enjoyed two additional months of payroll job growth, and new claims for unemployment trended higher in a choppy and indecisive way until well into 2008. Even after Bear Stearns failed in March 2008, the market briefly staged a rally that put it within about 10% of its bull market high. At present, the S&P 500 is again just 10% below the high it set before the recent market downturn began. In my view, the likelihood is very thin that the economy will avoid a recession, that Greece will avoid default, or that Europe will deal seamlessly with the financial strains of a banking system that is more than twice as leveraged as the U.S. banking system was before the 2008-2009 crisis. Gluskin Sheff - As for the “muddle-through” consensus view in the U.S., dare we say that the Conference Board's index of coincident economic indicators has formed a peak, which in the past signalled the end of the expansion with 100% accuracy (see more below) and that once the effects of the yield curve are adjusted for since it is irrelevant in a deleveraging cycle, the Conference Board's index of leading economic indicators actually peaked in August. In addition to that, let's deal with what we know. This has become an ongoing game of market ping-pong and the volatility since mid-summer is practically without precedent — and much more characteristic of a bear market than a bull market. The VIX index has now been north of the 30 mark in 56 of the past 57 sessions — 98% of the time. The Dow has moved intra-day by at least 100 points in 61 of the past 63 sessions — 97% of the time. And it has swung at least 200 points in 43 of the past 60, or 72% of the time. So you want an investment strategy? Well, through classic long-short relative value investing, you can actually take the intense volatility and turn it into a tradable asset class. It's called hedge funds that hedge. The Technical Take - I often get the feeling that traders and investors have put too great a trust in the monetary magic of the Federal Reserve. It's August, 2010. The SP500 is nearly 20% from its near term high. The economy is on the verge of a recession. Fed Chairman Bernanke announces a little program at the Jackson Hole conference that ultimately morphed into QE2. The markets bottomed and never looked back. Fast forward a year to August, 2011. The markets have suffered another devastating summer as prices on the major exchanges have fallen nearly 20% again, and in dramatic fashion. Back in August, 2010, there were favorable conditions for the equities markets to move higher. The Dollar was falling and bond yields were moving higher in approval. A recession was averted. But now a year later with another QE upon us, there is strength in the Dollar and Treasury bonds. A bullish Dollar is a headwind for equities, and falling Treasury yields are a sign of economic weakness as in recessions are deflationary. These are 2 very material and substantive differences for equities, and this is why October, 2011 is not like August, 2010. I don't know if the Fed can engineer another “recovery”. I know they will try, and I know investors will do their very best to believe in the Fed's abilities to make everything good. However, I cannot help but think that investors are going to the well just once too often. There are headwinds in the headlines out there. Is it the “wall of worry”? Maybe, but the equity markets need to reconcile with the growing headwinds presented in the Dollar and in Treasury bonds — both which remain bullish. JPMorgan - Investors are not positioned for a YE rally. The 13% rise in short interest (past 3 mos) is a 1 std-dev rise and historically has pointed to large moves (either direction) in next 12 months. Short interest historically has been a contrarian indicator and, at 4.1% of float, is the highest since March 2009. This along with Investors Intelligence % bears the week of 10/11 at 46% the highest since March '09 (47%) are further examples of a market not positioned for a rally. [Editor's note: We would argue that based on how markets have moved of late, the next 12 weeks (or dare I say days?) may see a “large move” (as referenced above) in a time period that is normally reserved for 12 months.] Barron's - The fact that we are struggling daily to hold above a level first reached nearly 13 years ago is both sobering and, viewed in the proper light, profoundly encouraging for true long-term investors. Henry McVey, Kohlberg Kravis Roberts' head of global macro and asset allocation, suggests in a new white paper that "we are finally returning to a time of 'stocks for the long run'….Anyone who believes in mean-reversion investing has to consider the current starting point for equities at least somewhat attractive." That doesn't make McVey a snorting bull; he thinks investors should accumulate stocks aggressively if the S&P 500 gets below 1050, and views around 1250 as "fair value." Jim Paulsen of Wells Capital was kind enough to calculate the 10-year forward return from all points in history when the market was flat or down over the prior 12 years. The result: a 7.2% annual gain, versus 4.7% for all other times, not including dividends. Conclusion – Angela Merkel & Nicholas Sarkozy. Every time we read an article this week that discussed why the markets moved one way or the other, those two names were mentioned. We think the volatility will continue at least until the European debt problem is completely solved. As Merrill Lynch so aptly put it this week, “Markets have high hopes for a solution, but sometimes a perfect solution can become the enemy of a good solution.” So we can try to distract ourselves with the daily task of monitoring earnings reports, but we don't foresee ourselves getting too comfortable with risk assets until the German people accept the fact that they are the backstop for the bad assets on European bank balance sheets…unless they want to see Lehman 2.0. Basically it's a lose-lose situation if you live in Deutschland. As for us Yankees, what we have gathered through this process is that German acceptance = unprecedented Euro money printing = asset inflation = Dow Jones up big! Not exactly how we want to make money, but we'll take it even if only for the time being. A couple weeks back (and about 10% ago) we said the S&P 500 should rally big up to about the 1,250 mark. Well, we're at the doorstep (1,238) and it's time to determine what's next. We don't advise you to trade on the following information, but if the Germans step up and the EFSF provides in excess of $2TN, the S&P 500 should break through our target and could make a move to the April highs of 1,368, although we do not believe this is the beginning of a new bull market…just an opportunity to lighten up on stocks. However, if the German's stick to their typically conservative ways and the Greeks continue to miss budget (thus infuriating the Germans) and Italian bond yields continue to march higher…then the S&P 500 will likely stall out at these levels and then….watch out below because, unfortunately, there could be a lot of room to fall. Guess which scenario keeps pushing us to do more diligence? Regards, eddie