The Stock Market
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.
Political Troubles in Bulgaria
We have previously written about “Bulgaria's Strange Bank Run”, but is appears the saga is not quite over yet, so we are providing an update on the developments since then. Keep also the curious temporal synchronicity with the most recent developments in the South Stream saga in mind. We have wondered if there could be a connection between these events. We don't know obviously, and have as of yet not seen the possibility mentioned anywhere. It wouldn't surprise us though.
There have been extensive protests against the government of technocrat Plamen Oresharski in Sofia in 2013 that were originally triggered by the appointment of Bulgarian media mogul Delyan Peevski to the post of chief of the National Security Agency. The parliamentary debate on his nomination reportedly took a mere 15 minutes. The protests then forced the government to fire Peevsky from his post again a month later (officially, he withdrew voluntarily). However, the protests still continued thereafter.
Protests against the appointment of Peevsky as head of the State Agency of National Security began in Sofia in mid 2013. The demonstrations had been organized via Facebook. A number of academics declared themselves appalled at the anti-communist slant of the protests. For instance, the chairman of the Institute for Modern Politics, Borislav Tsekov, reportedly deplored the "primitive anti-communism" espoused by the protesters. However, there also were rumors that the usual suspect Western NGOs were behind the protests. The demonstrations curiously dwindled right after the government indicated it would greenlight the construction of a nuclear power plant by Westinghouse. This has subsequently indeed happened (see the preceding article on South Stream).
(Photo via Wikimedia Commons,
On The Nature of the Pullback
Why have stocks and high yield debt recently declined? The standard excuses trotted out by the financial press make very little sense. For instance, it is held that stocks have fallen due to rising geopolitical upheaval in Ukraine, Iraq and elsewhere (actually, the “elsewhere” situations, such as the falling apart of Libya are rarely mentioned, because they are overshadowed by the other two).
But this makes no sense when we consider that the market was perfectly happy to completely ignore both developments for months. Why should they matter now, if they haven't previously? There is only a kernel of truth in these assertions insofar as “bad news” from these conflicts can serve as short term triggers for market weakness on a daily or even hourly basis. However, there is a difference between a trigger and a “reason”.
As Zerohedge has pointed out, outflows from high yield debt ETFs are causing some indigestion, because the ETFs themselves are highly liquid, while the underlying debt is anything but. We have also briefly discussed this problem of bond market illiquidity in our recent comprehensive update on the junk debt bubble (see: “A Dangerous Boom in Unsound Corporate Debt” for details), however, we haven't brought it into context with ETFs.
Zerohedge is quite correct in pointing this relationship out – it is an added wrinkle complicating the situation. Why are corporate bonds illiquid? Because the biggest banks have withdrawn from proprietary trading and market making in these instruments due to various post-crisis regulations that have been imposed (such as the Dodd-Frank monstrosity).
Head Fake or More?
The Dow fell 139 points on Tuesday. Gold dropped $3 an ounce. It’s too early to know if this is just a head fake… or the start of a bear market.
Our old friend Mark Hulbert at the Hulbert Financial Digest thinks a bear market is developing. Citing the work of Hayes Martin of investment consulting firm Market Extremes, Hulbert says there are three indicators that never fail to predict a bear market:
“In fact, no bear market has occurred without these three signs flashing at the same time. Once they do, the average length of time to the beginning of a decline is about one month, according to Martin.
The first two of these three market indicators – an overabundance of bulls and overvaluation of stocks – have been present for several months. Back in December, for example, the percentage of advisers who described themselves as bullish rose above 60%, a level Investors Intelligence, an investment service, considers “danger territory.” Its latest reading, as of Wednesday, was 56%.
Also beginning late last year, the price-earnings ratio for the Russell 2000 index of smaller-cap stocks, after excluding negative earnings, rose to its highest level since the benchmark was created in 1984 – higher even than at the October 2007 bull-market high or the March 2000 top of the Internet bubble.
The third of Martin’s trio of bearish omens emerged just recently, which is why in late July he advised clients to sell stocks and hold cash. That’s when the fraction of stocks participating in the bull market, which already had been slipping, declined markedly.
One measure of this waning participation is the percentage of stocks trading above an average of their prices over the previous four weeks. Among stocks listed on the New York Stock Exchange, this proportion fell from 82% at the beginning of July to just 50% on the day the S&P 500 hit its all-time high.
It was one of “the sharpest breakdowns in market breadth that I’ve ever seen in so short a period of time,” Martin says.”
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.
Challenges and Extra Points
On Friday, the Dow fell 123 points. On Saturday, our youngest son, Edward, returned from Africa. He had escaped capture by a rebel army in the Democratic Republic of the Congo… walked 50 miles through the jungle… and eventually made his way to the US embassy in Kinshasa, where he was given a new passport.
Statues of the two symbolic beasts of finance, the bear and the bull, in front of the Frankfurt Stock Exchange
(Photo credit: Eva K.)
As to the Congo, Edward reported to his grandmother: “Rich country (in natural resources). Hard place to do business. The local people are nice. Until they decide to kill you.”
Grandmother: “Why would you want to do business there?”
Edward: “Because it’s there. It’s a challenge. It’s an adventure.”
Grandmother: “You don’t get extra points in life by doing things that are not worth doing.”
US stocks dropped on Thursday, after news broke that someone shot down a Malaysian passenger airplane over eastern Ukraine. Then came the report that Israel had ordered a ground assault on Gaza. The Dow lost 161 points. Gold shot up $17 an ounce.
This comes only days after the Princess of Peace, Janet Yellen, assured investors that most stocks were fairly priced. We don’t doubt that she was right. Prices are set by willing buyers and sellers, operating on the basis of what they know at the time.
What they knew on Wednesday was that Yellen had their backs. Thursday, they weren’t so sure. Friday’s another matter …
Looking for Value
Editor’s Note: At the Diary, we are big on value. Bill’s motto is “buy cheap.” And someone who knows where to find value in today’s generally overpriced markets is Dr. Steve Sjuggerud, editor of Stansberry & Associates True Wealth Systems.
If you think there is no value out there … think again.
In today’s edition – originally published in the June 30 issue of Daily Wealth – Steve reveals the system he uses to identify global value … and why the cheapest stocks in the world are outside the US.
What’s Cheap in the World Today? by Dr. Steve Sjuggerud, Editor, True Wealth Systems
You probably haven’t noticed, but boring government bonds are up double digits this year. US stocks continue to push to all-time highs as well. Even Europe is soaring to multi-year highs. Today, we’ve got uptrends around the globe. The big question is: after so many investments have run up so high, where is the value in the world today? Is there any left out there? In short, yes!
Let me show you exactly where the value is right now. There are dozens of ways to size up what’s cheap. One classic measure of value is the price-to-earnings (P/E) ratio. But like most value measures, it isn’t perfect on its own. To fix that problem, we built an in-house value indicator for a few dozen global markets. We call it the “True Wealth Systems (TWS) Value Composite Measure.”
These TWS Value Composite readings give us a simple way to see where the value really is in the world. And today, there is a clear winner. Let me show you what I mean by looking at a few major developed countries’ stock markets.
The table below shows each country’s historical premium or discount relative to its own history, based on our TWS Value Composite. In addition, it shows each market’s premium/discount to U.S. stocks – the benchmark for comparison for developed markets.
Controlling the Dice
“Untergang der Titanic”, conception by Willy Stöwer, 1912
Not much market action on Friday. With a VIX reading of just under 11, a remarkable tranquility has settled over the markets – like the calm seas in the North Atlantic when the Titanic set sail.
“Not even God Himself can sink this ship,” said its architect. In the event, it was sunk by an iceberg. God claimed no credit nor took any blame. We humans can never hope to know the truth. Even in science we never know whether something is true or not. All we know is when something isn’t true.
We test it. If it doesn’t work, we know the premise was false. We mock it and ridicule it. We tell the poor sap who believes it: Good luck with that! We know it won’t work. Even when something does work, we still don’t know the premise behind it is true.
“Here… I’ll prove that I can control the dice,” says a lunatic.
“I’ll throw them four times… and each time I’ll get snake eyes.”
He rolls the dice. If he fails to get snake eyes each time you know the premise was false. But what if he succeeds? Is it true that he can control the dice? Or is he just lucky? You don’t know.
An Overabundance of Confidence
When looking at the charts of individual stocks, we find many that “look good”. This is undoubtedly one of the market's main saving graces. The problem with this is of course that charts always “look good” until they suddenly don't anymore. Shortly before the crash of 1987, to name an extreme example, the charts of many stocks, as well as those of the indexes, also looked good. There was very little in the technical backdrop that indicated that things would change radically and go totally pear-shaped in the space of just one week. And yet, this is what happened. The only warning provided by the charts was that the market suddenly and inexplicably became extremely weak in the week prior to the actual crash day. It put in a lower high on that occasion, which by itself is also not an entirely reliable sign that things are about to go seriously awry.
We are only using this example to illustrate that there is sometimes more to the situation than just the message provided by the charts. Normally, charts will deteriorate slowly enough to provide plenty of warning that the technical underpinnings of the market are weakening – but this is not always the case (it did happen in late 2007/early 2008, but even at that time, the message was for 'mixed' for quite some time. For instance, the DJ transportation average made a new all time high in May of 2008).
Anyway, in order to gauge the market's temperament, or at least the effects of the most widely adopted belief system, we can also look at quantitative sentiment data, and since a few remarkable things have happened on that front lately, we are providing a brief update. As to the “belief system” adopted by most market participants, it is the sheer boundless faith in the machinations of central banks. We happen to think that relying on these bureaucrats is dangerous, regardless of the fact that is has obviously “worked” for a good while now. It is the modern-day variation of the “potent directors fallacy” – the belief that a handful of powerful people can actually stop the market from expressing itself in an untoward manner. There are countless historical examples that show this belief to be erroneous, with the 2008 dislocation being the most recent one.
We regularly look at put-call ratios and the like, and came across a rather remarkable combination of data last week. The equity put-call ratio declined to its lowest one day reading in several years last week, while almost concurrently, there was the biggest spike in the one-day reading of the OEX put-call ratio in at least 20 years (we cannot tell for sure if it was a record high, since we are only able to consult data going back two decades). At the same time, the VIX (which measures volatility premiums paid for SPX at and near the money front month options) has declined to below 11, which is roughly in line with the lowest values seen in 2007:
The Dumbest Plan Ever
We are still reeling. Yesterday, we reported that central banks are major buyers of stocks. Their policy of suppressing yields on bonds has pushed them to stretch for higher returns in the stock market.
A recent report by a central bank research and advisory group called the Official Monetary and Financial Institutions Forum (OMFIF) calculates that central banks around the world have lost out on $200-250 billion in interest income on their bond portfolios.
In other words, central banks are victims of their own depressed interest rates. Feeling the pinch, they move more and more of their portfolios into equities.
The OMFIF says “global public investors” – including central banks – have increased investments in equities “by at least $1 trillion in recent years.”
And we could still be in the early innings of the game. Private investors, deprived of a decent return on their savings, buy stocks. Corporations borrow from the banks to buyback their own stocks. Central banks also buy stocks. Stocks go up.
Seeing what a success they have made, they all buy more! Has any finer system ever been developed to manipulate the stock market? Has any dumber plan, more doomed to disaster, ever been devised?
Quarterly stock buybacks, via Factset – click to enlarge.
Nothing Bad Can Happen …
The Dow fell 21 points on Tuesday. Gold was flat. Around the world, stocks have been doing well. Even our top recommendation, beaten-down Russian stocks, are moving up fast. The Russian market rose 14% in May (leaving it still down about 9% for the year). Why?
Maybe world debt levels hitting mega highs has something to do with it. Over $100 trillion was the last estimate we saw. Meanwhile, why worry? Volatility is ultra low. The VIX measures investors’ worry levels by looking at implied volatility in the options market. The index just posted its lowest monthly close since 2007.
Investors are not fearful. And not necessarily greedy, either. They are just complacent, sure that nothing bad will happen.
The VIX is stuck in the 'nothing bad can happen' range – click to enlarge.
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