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.
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.
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.
Consumer credit has taken a dive, and the slump has recently slightly accelerated again – click to enlarge.
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.”
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.
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.
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:
The city's obligatory bridge to nowhere – only the ten pylons have been erected, then the project had to be abandoned.
(Photo credit: Gilles Sabrie)
Europe's Cage is Rattled a Bit
The little disturbance in Portugal's banking landscape hasn't been entirely overcome yet. New management has been installed at Banco Espirito Santo, but the problem is that the bank apparently sits on quite a few dubious assets, and the new management cannot wish them away. BES appears to have sunk a lot of money into former Portuguese colony Angola, and these loans are the subject of growing concern. On Tuesday, the stock of BES collapsed to a new low, but the losses have been recovered in Wednesday's trading session.
In parallel with the still growing worries about BES, Germany's ZEW institute issued its economic confidence indicator, which showed the 7th monthly decline in a row. Wasn't there supposed to be a recovery?
A few excerpts from a Reuters summary:
“European stocks and the euro fell on Tuesday after shares in Portugal's biggest listed bank hit a record low, while a plunge in German economic sentiment pushed up borrowing costs for some peripheral euro zone countries.
Global stock markets have recently been supported by dovish policy measures from major central banks and signs that economies are recovering, though worries persist over the pace of growth in Europe and the health of the region's banks.
The banking sector was a sharp underperformer, with Portugal's Banco Espirito Santo slumping 17.5 percent to a fresh record low. Traders blamed concerns over the bank's Angolan loan portfolio and the sale of a stake at a low price by the bank's founding family on Monday.
"The key takeaway is that the banking sector globally continues to struggle despite time having been bought, and policy being tremendously supportive," said Jeremy Batstone-Carr, head of private client research at Charles Stanley.
"The sector feels like a minefield."
Portuguese Banking Group's Woes Deepen
When we wrote about the troubles at Banco Espirito Santo yesterday (our post was written before European markets opened) information was still fairly scant. However, on the very same day the situation continued to escalate. Here is an excerpt from the WSJ providing further details:
Shares in the troubled Portuguese lender have been under pressure since May, when the bank disclosed that an audit ordered by Bank of Portugal into Espírito Santo International SA, the conglomerate that indirectly holds a stake in the bank, had found Espírito Santo International was in a "serious financial condition" and had uncovered accounting irregularities. But the declines mounted drastically Thursday after investors learned Espírito Santo International had delayed coupon payments relating to some short-term debt securities.
Switzerland-based Banque Privee Espírito Santo SA, which is owned by Espírito Santo Financial Group, said in an emailed statement Wednesday that Espírito Santo International has delayed the repayment of short-term debt sold to some of its clients. It said the repayment is the sole responsibility of the conglomerate. The conglomerate declined to offer a separate comment.
The bank's stock dropped more than 17% before trading in its shares was suspended. Trading in Banco Espirito Santo's controlling shareholder, Espirito Santo Financial Group SA, listed in Luxembourg and Lisbon, was also suspended earlier Thursday. The Portuguese markets regulator banned short selling, or betting against, Banco Espirito Santo shares in Friday's session.
Breaking From the Wedge
France is currently Europe's “sick man”, not least due to the destructive economic policies pursued by its socialist government. Halfhearted attempts at reform have so far not achieved any notable change, precisely because they are going nowhere near far enough. President Hollande seems to be waiting for the recovery in the rest of Europe to bail him out. His willingness to look beyond leftist dogma and display political courage seems rather limited, which we have always attributed to his fear of being challenged from elements even further to the left, both in his own party and outside of it. However, it is probably more than that: he is a true believer, and is suffering from the delusion that governments can suspend economic laws by fiat. This delusion is of course shared by central planners all across the so-called capitalist world, but it is especially pronounced in his case.
A friend just pointed out to us that France's stock market suddenly looks rather wobbly. French stocks rallied strongly along with other European stock markets once fears over the sovereign debt crisis receded. As we have discussed previously in these pages, year-on-year true money supply growth in the euro area surged strongly from its late 2011 low near 1%, to a high slightly above 8% in early 2013, and has since then begun to decline noticeably again (see our assessment of Europe's tepid economic recovery from mid May: Europe’s Recovery is Stuck in the Mud. A chart of the euro area's true money supply and its annualized growth rate can be seen here). The money supply growth rate is still fairly high at present, but the trend is down and one cannot tell in advance what level will be the threshold that triggers the next bust. However, it would certainly make sense if France's stock market were to lead other European markets at the turning point.
There is a chance that such a turning point may have arrived. Of course, this isn't the first time European stocks are correcting since their uptrend started, and one can never be certain whether short term moves really have significance for the larger degree trend. France's stock market is acting worse in the recent correction than other European markets, but we thank that may well be because it is leading them.
The character of the recent correction seems different from that of previous short term downturns, even though its extent is not yet unusual. Contrary to previous dips, the market has put in a second lower high on the daily chart. The move has moreover clearly violated the lower boundary of the preceding wedge-like advance. The last rebound attempt didn't even manage to move the CAC-40 index back to the broken trend line for a “good-bye kiss”, which we believe is a strong sign that something is amiss.
Excessive Optimism, but Money Supply Growth Rate Remains High
We recently remarked on the astonishing levels of optimism currently visible in the stock market. The present phase of excessive optimism has lasted for quite a long time already and has recently begun to once again approach the all time records seen in several indicators at the end of 2013. As we already mentioned on occasion of the last update, there is at least one 'good' reason for traders to be optimistic, and that is the fact that many charts of individual stocks and sectors look bullish (there have been a number of noteworthy break-outs lately, as one would expect).
However, the problem with good-looking charts is that they only look good until they don't anymore, so one has to keep an eye on market sentiment and the money supply. In summary the situation is that the market's underlying technical condition (apart from being overbought) still looks positive, sentiment is at absolute nosebleed levels and giving us a big warning sign, and money supply growth remains strong enough to continue to lend support to the market. The caveat to the latter remark is that y/y money supply growth has halved from its peak, and we cannot know with certainty where the 'bust threshold' will turn out to be this time.
First a chart from sentimentrader, the “smart/dumb money confidence spread” – which measures differences in market exposures of the two classes of traders. The definition essentially regards anti-cyclical market participants as 'smart' and pro-cyclical traders as 'dumb'. This doesn't mean that the former are always right – in fact, they very often aren't right for long stretches of time. However, they will as a rule be right at extremes.
Cruising for a Bruising
The BIS has published its annual report, which as usual contains numerous quite candid observations about the global credit and asset bubble. The entire report is 246 pages long, so it takes a while to go through it all. Here is a comment from the report that doesn't really tell us anything new, but represents a good summary of what the brewing problem consists of:
“Highly accommodative monetary policies in the advanced economies played a key role in lifting the valuations of risk assets throughout 2013 and the first half of 2014. Low interest rates and subdued volatility encouraged market participants to take positions in the riskier part of the investment spectrum. Corporate and sovereign spreads in advanced economies drifted to post-crisis lows, even in countries mired in recession. Buoyant issuance of lower-rated debt met with strong demand, and equity markets reached new highs. Some asset valuations showed signs of decoupling from fundamentals, and volatility in many asset classes approached historical lows.”
Central banks got what they wanted – investors are acting as if there were no longer any risk. This is seemingly confirmed by certain data points like ultra-low default rates in junk bonds, but it must be remembered that these low default rates are themselves a direct result of yield chasing and the tsunami of central-bank created money that is crashing ashore in various asset markets. If any Tom, Dick and Harry regardless of his creditworthiness can get refinancing at absurdly low rates anytime he wants, then why should he default?
The problem is of course than many of the bubble activities that are receiving funding today at ridiculous rates would likely never get funded in an unhampered market economy, or would only be able to compete for funding at prohibitively high interest rates.
The entire situation is therefore solely a result of ultra-loose monetary policies. Has the perpetuum mobile finally been invented by our esteemed central planners? We rather doubt it – something, somewhere, will go wrong. The longer it takes for this to happen, the worse the denouement will be.
In its most recent monetary policy announcement, the ECB council introduced a new type of long term financing instrument, the so-called “TLTRO”, short for “targeted long term refinancing operation”. The reason is that the ECB has noticed that in the wake of its frantic – and ultimately successful – attempts to dissuade the market from punishing what are de facto bankrupt governments (there are only very few governments left in the world that are not in actuality bankrupt entities relying on a Ponzi finance scheme), lending to the private sector has plunged.
Let us recall the events surrounding the crisis. Beginning with Greece, Portugal and Ireland, it was suddenly realized that a number of governments in the euro area were actually on the brink of insolvency. The reasons were varied: in Greece, an inept and corrupt political and bureaucratic apparatus had for many years lied about the true state of the government's finances. Everybody in Brussels knew of course that they had been lying. After all, they were already lying when they joined the euro, and a number of economists and a handful of conscientious Brussels bureaucrats alerted the European commission to this fact. It was decided to simply get rid of these critics by firing them, so as to proceed with a cover-up. However, this scheme obviously unraveled with the advent of the crisis. In Ireland, the government had made the mistake – under pressure from various European institutions – to bail out its overextended and insolvent banks and in the process bankrupted itself.
From these humble beginnings (“the problem is well contained” was the widely heard refrain at the time), the crisis began to flower and soon included a few rather large, and partly “too big to bail” candidates, like Spain and Italy.
In the course of all this it was also discovered that Europe's fractionally reserved banking system – surprise! – had flagrantly overtraded its capital and was completely insolvent as well. “Luckily” though, we have a fiat money system and a central bank, which means that the losses of banks and governments can be “painlessly” shifted onto the backs of savers and wealth generators in the economy via the printing press. After all, the US Federal Reserve had already shown the way (as had incidentally Japan some time earlier already).
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