Chart Update

 

Asia “Not Helped” by Chinese Data, Fed Officials Back-Pedaling

We wanted to see if there were any signs of concern in the mainstream financial press over the recent market decline (which is still small in terms of the major indexes, although this can no longer be claimed of the “average stock”).

We would characterize the mood as one of “mild concern” – generally it seems to be held that the decline is just another of the periodic (and ever smaller) corrections we have seen over the past few years. It is noteworthy though that the recent decline is referred to as a “growth scare”. For instance, Reuters reports on overnight weakness in Asian markets – which actually didn’t entail any overly big moves:

 

“Asian stocks stumbled to seven-month lows on Monday, while crude oil prices were pinned near a four-year trough as promising trade numbers out of China failed to cheer a market still worried about faltering global growth.

MSCI’s broadest index of Asia-Pacific shares outside Japan fell 0.8 percent, extending last week’s 1.1 percent drop. Mainland Chinese stocks skidded 1.1 percent and Hong Kong’s Hang Seng shed 0.7 percent. Australia’s S&P/ASX 200 index and South Korea’s KOSPI both slipped 0.6 percent. Tokyo’s Nikkei was spared the pain for now thanks to a public holiday in Japan. The declines in Asian markets came after U.S. stocks skidded 1.2 percent on Friday and Wall Street’s fear gauge, the CBOE Volatility Index, jumped to a near two-year high.”

 

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Market Reaction to Payrolls Data

Payrolls and unemployment reports should normally be regarded to be among the least useful economic data, as they are lagging indicators of the economy. Insofar the recent improvement in employment data only confirms what has already happened: economic activity has increased (note that this tells us nothing about the quality of said activity). It tells us absolutely nothing about the future.

The reason why the markets tend to react strongly to these data is mainly the Federal Reserve’s nonsensical “dual mandate”. Enacted in the heyday of Keynesianism, the mandate is based on the belief that both prices and employment can be successfully centrally planned by manipulating interest rates.

 

1-Employment dataCumulative non-farm payrolls, initial unemployment claims and the U3 unemployment rate (which excludes about half of the people who are actually unemployed). If we had asserted a few years ago that the Federal Funds rate would be at zero with the unemployment rate at 5.9%, we’d have been declared insane – click to enlarge.

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The Many Errors of His Ways …

An editorial by well-known leftist economist Joseph Stiglitz has recently been published in the Guardian, entitledAusterity has been an utter disaster for the euro zone”.

Before we are taking a closer look at it, we want to stress that we also believe that the EU’s approach to economic policy is worth criticizing in many respects. Just because we believe that Mr. Stiglitz is essentially an economic crank doesn’t mean that we disagree with every criticism of the so-called “austerity” policy as pursued by the EU. Below are several excerpts from his article with our comments interspersed.

 

“If the facts don’t fit the theory, change the theory,” goes the old adage. But too often it is easier to keep the theory and change the facts – or so German chancellor Angela Merkel and other pro-austerity European leaders appear to believe. Though facts keep staring them in the face, they continue to deny reality.”

 

The “old adage” is actually a well-known bonmot by J.M. Keynes – curiously, Stiglitz doesn’t mention that. Although it has merit with respect to the natural sciences, it does not apply to economic theory, which is a science of human action and not a study of inanimate objects without volition. Theorems of economics cannot be proved or disproved with “empirical data”. We do e.g. not need empirical data to prove the truth of the theorem of marginal utility, or to create a price or value theory, or to prove the truth of the law of association, etc.,etc..

All of these economic laws have been discovered by inner reflection and the process of logical deduction. They are only “empirical” in a Thomist or Aristotelian sense (for a detailed explanation of this point of view, we refer readers to Rothbard’s monograph In Defense of Extreme Apriorism -pdf).

To put it differently: one can use economic theory to explain the facts of economic history, but one cannot use economic history to argue for or against points of economic theory. If we look at economic statistics, we see that every slice of history is slightly different, as the contingent data, which are always extremely complex and varied, are different in every case. And yet, the same economic laws have time and place-invariantly operated in every instance and will continue to do so for all eternity, or at least as long as there are human beings who can act with purpose. Stiglitz continues:

 

Austerity has failed.But its defenders are willing to claim victory on the basis of the weakest possible evidence: the economy is no longer collapsing, so austerity must be working! But if that is the benchmark, we could say that jumping off a cliff is the best way to get down from a mountain; after all, the descent has been stopped.

But every downturn comes to an end. Success should not be measured by the fact that recovery eventually occurs, but by how quickly it takes hold and how extensive the damage caused by the slump.

Viewed in these terms, austerity has been an utter and unmitigated disaster, which has become increasingly apparent as European Union economies once again face stagnation, if not a triple-dip recession, with unemployment persisting at record highs and per capita real (inflation-adjusted) GDP in many countries remaining below pre-recession levels. In even the best-performing economies, such as Germany, growth since the 2008 crisis has been so slow that, in any other circumstance, it would be rated as dismal.

The most afflicted countries are in a depression. There is no other word to describe an economy like that of Spain or Greece, where nearly one in four people – and more than 50% of young people – cannot find work.

 

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Greek Government Worried About Its Survival

Antonis Samaras has a problem: just as the relatively tough austerity medicine Greece was forced to take seems to be beginning to bear some fruit (Greece is the one euro area country where nominal government spending has indeed declined significantly), his shaky coalition government may soon be stumbling over the country’s upcoming presidential election. The problem in a nutshell is that if Samaras fails to get his presidential candidate elected, new parliamentary elections would be triggered – and according to current polls, the coalition would lose against SYRIZA.

 

1-greece-government-spendingGreek government spending has declined significantly in nominal terms (though not as a percentage of GDP, as GDP has declined a lot) – click to enlarge.

 

SYRIZA as readers may recall, once was a smallish coalition of tiny left-wing parties to the left of the social democrats that didn’t really have a lot of electoral support. After the financial crisis and the bankruptcy of the Greek government, it quickly became the country’s largest party. SYRIZA is anti-bailout, whereby we are not quite sure what this stance actually entails. Presumably, a SYRIZA victory would mean a Greek exit from the euro, as Greece’s creditors would have to accept the country’s bankruptcy, and its banking system would lose the ECB’s support (since it would be instantly bankrupt, and hence no longer eligible to receive ECB funding). Moreover, tearing up the agreements with the “troika” would definitely lead to Greece being made into a pariah, so as to discourage others from following suit.

 

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Downturn in High Yield Bonds Continues

On Thursday the stock market had a down day that was actually not very remarkable in terms of its extent – it was only remarkable because even such relatively middling down days have become rare these days. Another thing that made it remarkable is that there was no “obvious” trigger for the selling, which started right out of the gate.

However, as we have previously discussed, market internals have weakened all year long (see “Market Internals Are Weakening” for a recent update) and most recently we have pointed out a number of divergences that have occurred, including the long term downshift in the ratio of HYG to the SPX (see this chart). High yield debt has recently continued to weaken, after a rebound rally that appears to have failed at a lower high. Along with this event, an attempt by treasury yields to break higher seems to have failed as well:

 

1-HYGHYG (a high yield bond ETF) suffers its biggest correction in a long time, and treasury note yields turn lower again (admittedly this may turn out to be just a brief pullback in t-note yields) – click to enlarge.

 

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Mark Hulbert on the HGNSI

As an addendum to Dan Popescu’s article on the state of gold sentiment, we want to show an update of the indicators we follow. Coincidendally, Mark Hulbert has also just published an update on his HGNSI measure (Hulbert Gold Newsletter Sentiment Index). The Index measures the percentage newsletter writers recommend to allocate to gold-related investments on average – either on the long or the short side. As it turns out, the current level of the HGNSI stands at nearly minus 47%, which happens to be the second-highest bearish sentiment expression in 30 years (the highest was recorded in June 2013).

 

Mark Hulbert notes:

 

“[...] the average recommended gold market exposure level among a subset of short-term gold market timers tracked by the Hulbert Financial Digest (as measured by the Hulbert Gold Newsletter Sentiment Index, or HGNSI). This average currently stands at minus 46.9%, which means that the average short-term gold timer is now allocating nearly half his clients’ gold-oriented portfolios to going short.

That is an aggressively bearish posture, which is unlikely to be profitable according to contrarian analysis.

There’s been only one time in the past 30 years when the HGNSI got any lower than it is today. That came in June 2013, when the HGNSI fell to minus 56.7%. As you can see from the accompanying chart, gold soon — within a matter of a couple weeks — began a rally that, by late August, had tacked more than $200 on to the price of an ounce of gold.

Notice that gold’s 2013 summer rally didn’t begin immediately after the HGNSI dropped to the levels we’re seeing today. That’s hardly a criticism, of course, since no trading system can pick the market’s turning points with pinpoint accuracy. Nevertheless, according to the econometric tests to which I have subjected the 30 years’ worth of my sentiment data, the gold market performs appreciably better following low HGNSI readings rather than it does high ones. Contrarian analysis hasn’t always worked, needless to say, but it’s more successful than it is a failure.”

 

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Gold Stocks Reach New High Relative to Gold

As we have mentioned in previous updates on the gold sector, few things are more important for its likely future performance than how gold stocks are performing relative to gold. The action in the stock market this year is in many ways increasingly reminiscent of the final phase of the technology bubble of the late 1990s. Concurrently, the recent action in gold, silver and gold stocks is also exhibiting similarities to the lows that were made at the time.

To elaborate a bit on this: the action in the stock market and the fundamental backdrop are of course only similar to the 1999/2000 period in certain respects; no two historical periods are ever completely similar. From a technical perspective, the parallels are the following: relative weakness in small cap stocks, an increasingly narrow advance driven by fewer and fewer stocks during each new rally leg over recent months, new all time highs in the Rydex bull/bear asset ratio and a noticeable increase in volatility in the ratio, multiple intra-market divergences over recent months with strength focused on the tech sector, and extremely lop-sided bullish sentiment readings in both positioning and survey data over recent months.

Fundamentally, the main similarity is a tightening of policy by the Fed. Note here that even though the Federal Funds rate remains pegged at the 0-0.25% corridor (and due to the mass of excess reserved held by banks effectively trades just below 0.1%), the so-called “tapering” of QE still amounts to a tightening of monetary policy. However, while the Fed has reduced its monetization activities, commercial banks have stepped up their inflationary lending. As a result, y/y money supply growth (TMS-2) has oscillated around the 8% mark since mid 2013. This is still quite brisk, and as such is a fundamental datum that can be considered as supportive for the market. Note though that it represents a sharp slowdown from the peak growth rates recorded in 2010 (approx. 17%) and 2011 (approx. 16%) and that the willingness of banks to continue to expand credit greatly depends on the economy's performance (there is a feedback loop between the two).

 

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The Nature of the Latest Rally Leg

Keeping in mind that a number of important historical market peaks have been recorded in late August/early September, here is a brief look at how the most recent rally leg stacks up in terms of its internals. It can definitely be stated that the technical condition of the market has weakened further (the same happened already on the preceding rally leg, but it has become even more pronounced now).

Specifically, it can be seen that the market is carried higher by fewer and fewer stocks. The underperformance of the small cap vs. the big cap sector has continued, but that is not the only evidence of narrowing we have.

Whenever a stock market rally becomes narrower, it essentially conveys the information that market liquidity is becoming less ample. There is no longer enough additional liquidity entering the market to enable the tide to lift all boats concurrently. Given the fact that most indexes are capitalization-weighted, their performance can easily mask underlying deterioration. It makes therefore sense to keep an eye on the market's innards.

Small caps on average sport higher valuations than big caps, and generally need more plentiful liquidity to rally. Moreover, they tend to be more economically sensitive, as smaller companies are likely to largely depend on the performance of the domestic economy.

 

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Derivatives and the Credit Bubble

In principle, there is absolutely nothing wrong with derivatives. They serve a valuable function, by transferring risk from those who don't want to be exposed to it to those who are willing to take risk on in their stead for a fee. However, since the adoption of the pure fiat money system, credit growth has literally gone “parabolic” all over the world. This growth in outstanding credit has been spurred on by interest rates that have been declining for more than three decades.

Larger and larger borrowings have become feasible as the cost of credit has fallen, and this has in turn spawned an unprecedented boom in financial engineering.

When critics mentioned in the past that this had created systemic dangers, their  objections were always waved away with two main arguments: firstly, the amount of net derivatives exposure is only a fraction of the outstanding gross amounts, as so many contracts are netted out (i.e., things are not as bad as they look). Secondly, the system had proven resilient whenever financial system stresses occurred. Perhaps not as resilient as it seemed, considering that these crises as a rule required heavy central bank interventions and/or bailouts in various shapes and forms. Would the system have been as resilient if those had not occurred? We have some doubts with regard to that.

 

total_derivativesSince the crisis, derivatives growth has stalled, but the notional amount has returned to its record highs as of the end of 2013 – click to enlarge.

 

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Loans to the Private Sector Keep Declining, Money Supply Growth Slows

We want to briefly update the most important credit and monetary data of the euro area, which we last briefly discussed in March (see: “Overview of Recent Monetary Trends”, which focused however more on the US than on Europe).

In spite of the ECB cutting interest rates to the bone and offering new “targeted long term refinancing operations” to banks (see “European Credit Dirigisme” for background information), neither lending to the private sector nor money supply growth have so far picked up in the euro area as a whole (there are of course differences between the individual member nations).

Generally we would regard this as a positive development, insofar as it should help to minimize capital malinvestment. Unfortunately, we can infer from the fact that money supply growth remains in positive territory, that lending to the private sector has been replaced with lending to governments, so the economy continues to be exposed to the burden of deficit spending by governments. This is probably not particularly surprising, but we would be remiss not to mention it.

Below we show three charts, consumer credit, loans to non-financial corporations and the euro area's true money supply (currency plus demand deposits). The red lines show the absolute numbers in millions of euro, the blue lines show the annual rate of change in percent.

 

chart-1-Euro area consumer credit

Consumer credit has taken a dive, and the slump has recently slightly accelerated again – click to enlarge.

 

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The Default is a Minor Problem – Argentina's Real Problem is Something Else Entirely

By now it is well known that Argentina has been declared in default by the major credit rating agencies. This has happened in spite of the Argentine government actually depositing the interest payment intended for those creditors who have grudgingly accepted the post 2001 default restructuring because they thought they had no other choice. After all, they couldn't very well invade Argentina and sell its government assets. That is the problem with lending to governments: they not only assuredly waste the money they borrow, but when push comes to shove, creditors often find themselves left out in the cold.

However, the so-called “hold-outs” –  a group of investors that didn't accept the terms of the debt restructuring – have continued to fight the Argentine government in court to get restitution, and have won several cases. At one point, they even had an Argentinian warship confiscated in a Ghanaian port.  The latest court case won by the hold-outs has led to the current impasse and subsequent default.

 

“Standard & Poor’s declared Argentina in default after the government missed a deadline for paying interest on $13 billion of restructured bonds.

The South American country failed to get the $539 million payment to bondholders after a U.S. judge ruled that the money couldn’t be distributed unless a group of hedge funds holding defaulted debt also got paid. Argentina, in default for the second time in 13 years, has about $200 billion in foreign-currency debt, including $30 billion of restructured bonds, according to S&P.

Argentina and the hedge funds, led by billionaire Paul Singer’s Elliott Management Corp., failed to reach agreement in talks today in New York, according to the court-appointed mediator in the case, Daniel Pollack. In a press conference after the talks ended, Argentine Economy Minister Axel Kicillof described the group of creditors as “vulture funds” and said the country wouldn’t sign an accord under “extortion.”

“The full consequences of default are not predictable, but they certainly are not positive,” Pollack wrote in an e-mailed statement. “Default is not a mere ‘technical’ condition, but rather a real and painful event that will hurt real people.”

Kicillof, speaking at the Argentine consulate in New York, told reporters that the holdouts rebuffed all settlement offers and refused requests for a stay of the court ruling. He said Argentina couldn’t pay the $1.5 billion owed to the hedge funds because doing so would trigger clauses requiring the country to offer similar terms to other bondholders.”

 

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A Bad Hair Day for Stocks

About one month ago we wrote two updates on market sentiment in close succession, one of which included a money supply update as well (see: “Boundless Optimism in the Stock Market” and “Market Sentiment and Money Supply Update” for details). On this occasion we pointed to an unusual spike in the OEX put/call ratio, commenting:

 

“[...] if a warning signal is legitimate, it usually has a certain lead time (two to four weeks). It is impossible to tell in advance whether it warns merely of a run-of-the-mill correction or of something worse”

 

This is still applicable of course, and we can now state that the lead time was indeed approximately four weeks in this case.  Apart from the past few days of trading, the market at first continued to levitate, teflon-like, unimpressed by any and all possibly worrisome data points. Wednesday's GDP data release, while superficially strong, owed 1.7% of its 4% annualized growth rate to inventory building, so it was probably widely discounted as another so-so report. The release of the Chicago PMI , which tumbled to a one year low in its biggest monthly drop since October 2008, immediately contradicted the happy GDP data anyway. Initial jobless claims rose fairly sharply from one small number to another small number, and are only worth mentioning because the stock market tends to be inversely correlated with them in the the long term.

As so often, it is difficult to identify what actually triggered the sudden selling squall, because lots of things appeared to be happening at once, or at least in very close succession.

Among these is the attempt to pressure Russia into abandoning the Eastern Ukrainian rebels by means of sanctions, so that Kiev can slaughter them more leisurely, and above all, more cheaply. Unfortunately, and predictably, the sanctions toll is already hitting Europe, especially Germany – see this graphic we recently posted. Things keep getting worse, as listed companies are beginning to post earnings disappointments they blame on the sanctions.

The problem is not only that there is already a highly visible economic toll, but in spite of the fact that Russia's economy is under a great deal of pressure as well, Putin remains equally predictably completely intransigent and is now threatening to use the economic levers Russia has at its disposal. According to press reports, he intends to use WTO rules to push these measures through (such as altering the prices on long term gas contracts).

As we have previously remarked in this context, sanctions are just bad for business. They never harm their real targets, namely the political ruling elite of the targeted  country. Quite on the contrary, Putin has experienced a big surge in domestic popularity.

 

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John Hussman's Latest Comments on the Bubble

In his newest weekly column, John Hussman talks about a feature of the current echo bubble era that we believe will turn out to be an extremely important one. Readers of this site know of course that we have frequently sung from the same hymn sheet, but it is a topic the significance of which cannot be stressed enough.  After briefly recapping the history of the housing bubble and the ensuing credit crisis, Hussman writes:

 

“Now, as we observed in periods like 1973-74, 1987, and 2000-2002, severe equity market losses do not necessarily produce credit crises in themselves. The holder of the security takes the loss, and that’s about it. There may be some economic effects from reduced spending and investment, but there is no need for systemic consequences. In contrast, the 2007-2009 episode turned into a profound credit crisis because the owners of the vulnerable securities – banks and Wall Street institutions – had highly leveraged exposure to them, so losing even a moderate percentage of their total assets was enough to wipe out their capital and make those institutions insolvent or nearly-so.

At present, the major risk to economic stability is not that the stock market is strenuously overvalued, but that so much low-quality debt has been issued, and so many of the assets that support that debt are based on either equities, or corporate profits that rely on record profit margins to be sustained permanently. In short, equity losses are just losses, even if prices fall in half. But credit strains can produce a chain of bankruptcies when the holders are each highly leveraged. That risk has not been removed from the economy by recent Fed policies. If anything, it is being amplified by the day as the volume of low quality credit issuance has again spun out of control.

 

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China's 'Eco' Ghost Town

Back in 2006, Hu Jintao was excited when he visited Caofeidian, the “the world’s first fully realized eco-city”, built on land reclaimed from the sea. Since construction began in 2003, it has devoured the princely sum of $100 billion, most of it provided by banks. One million resident were once supposed to live there. It is a ghost town today, sporting only a few thousand inhabitants. Practically no-one has ever stayed in the city, and the buildings are already deteriorating. In fact, many of the buildings have been left half-finished, as credit eventually ran out.

The Guardian has posted a number of haunting pictures of this monument to massive capital malinvestment.

As the Guardian notes:

 

The ‘eco-city’ was made possible through huge bank loans. Once it was half-built, these loans were halted and many projects suspended due to the rising cost of raw materials and a lack of government support.”

 

A few of the pictures are reproduced below:

 

bridge to nowhereThe city's obligatory bridge to nowhere – only the ten pylons have been erected, then the project had to be abandoned.

(Photo credit: Gilles Sabrie)

 

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Bond Yields Can Only Go Higher, Right?

There is a big warning sign out there that is widely ignored, so we thought we will briefly comment on it. Treasury note yields have trended lower since the beginning of the year – against widespread expectations that yields would surely rise (because of the “recovery”).

So what has happened to these expectations since then? This is actually truly astonishing. Below is are two charts showing where speculators stand – the hedger position in 10 year t-note futures and the Rydex bond bull ratio (which shows what percentage of all Rydex assets invested in bond funds is bullishly positioned).

In brief: speculators are fighting the trend in treasuries tooth and nail. This is a sign that the trend is likely to intensify. Why would it do so? One reason we can think of is that there will be a wobble in the current complacency about risk (which is becoming more absurd by the day – some of the data we recently posted with respect to positioning and sentiment have become even more extreme).

 

TNXThe 10-year t-note yield – click to enlarge.

 

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