May 7, 2012

Extreme Divergence- the tell-tale heart of bi-polar capital markets on the brink

To say the performance of equities in April 2012 was all over the map would be putting it mildly. Many countries in the developed world such as Spain flirted with their 2009 lows while the US market averages flirted with new multi-year highs. Divergence is now a core theme and it’s not limited to equities. A month that saw the greatest amount of stock mutual fund redemptions since April 2000 (when stocks peaked) also extended a streak of eighteen consecutive weeks of positive net inflows into bond market funds. The preponderance of US retail investors have already cast their vote in 2012 for bonds over stocks and this accounts for the first of several extreme divergences we will explore today.

This trend of retail cash leaving stocks for bonds is enormous and cannot be overstated. It’s been a panacea to the debt markets and explains the mystery of why US Treasury bond yields are so close to all-time lows while the Dow Jones is close to all-time highs.  It’s all too clear that the retail investor is still spooked about the 2008-9 financial crisis and the extended decay seen in the labor and housing markets here in the US. This is tantamount to a shift in consumer preferences that is not fickle and not likely to reverse for many years.  Once consumers are shock tested as they were in 2008, new habits die hard, even if they may not be what may be best for them.

I would argue strongly today that this secular shift in allocation is quite untimely and unfortunate for those investors. It could cause a great degree of wealth destruction if interest rates rise even a little and that’s more than a remote possibility in the coming years. This development resembles the retail herd in 1999-2000 buying internet stocks at their peak when so many lost so much.  Then they were buying illusory valuations through greed  with internet stocks and now they are buying illusory safety in US Treasuries through fear but the outcome is likely to be the same. Fear and greed should never be the basis for asset allocation but often they are.  The reality of this 3-4 year gusher of capital from stocks to bonds coming from retail investors is very telling. These investors are now buying bonds at all-time historical highs but also at a point in time that corresponds to an all-time high in global aggregate outstanding debt. Bonds may look enticing but they are just a trap at these levels.

That the ten Year US Treasury yield is now well below 2% says much about the precarious state of the global financial system. Presently the Kondratieff Winter is taking hold in a big way in much of the world but few seem to notice. Many countries in Europe are now in the throes of a full blown depression including most notably Spain and Greece. Italy ,the UK and Portugal are not too far behind. And has anyone noticed the market averages in the BRIC countries of Brazil, Russia, India and China are approaching bear market territory?  The next and final phase of the global financial meltdown has already begun as the weight of the world’s debt is now crushing the weaker economies. Despite trillions of debt monetization by the ECB yields on the weak sisters of Europe are rising and now approaching a breaking point that will test investor confidence in the entire global financial system once again. But unlike 2008, that system now has an additional $14 trillion debt piled on by fiscal and monetary stimulus that has increased the chances of a contagion. One day I suspect it will be all too evident that long standing  ignorance of economic super-cycles hurts consumers, taxpayers, investors and nearly everyone.

The last time we faced such a turning point in global finance was 1980 when inflation threatened to cripple global trade. Unlike today, Fed Chairman Paul Volcker decided to raise interest rates to rid inflation even if it would bring about a recession, which it did. Just imagine that only thirty years ago the Dow Jones was below 1000 and interest rates were over 14%. K-Wave theory holds that it’s no accident these cycles began in lockstep ever since. Bonds have actually outperformed stocks since then because they are at all-time highs today while stocks peaked in the spring of 2000. We advance the idea here that understanding these divergences today can only best be done through the lens of long wave economic analysis. Despite the recent advances in the market averages in nominal terms we hope our readers will instead choose to see the bigger picture coming from such an extended outlook.

This outlook is supported I believe by the ultra light volume in this melt-up rally that I call out to be suspect. In fact it was reported this week that now over 84% of the total volume is comprise by High Frequency Traders (robots) whose investment horizon can be measured in seconds, not years as was the case only recently. This represents yet another divergence evident in our bi-polar capital markets in that there is no real price discovery today given that overall dollar volume in trading is prohibitively higher in the global FX and debt markets. In fact corporate, junk and sovereign debt issuances are both at all-time historical highs by wide margins. This is another sign of a market top as fools rush in to chase yield no matter how risky and its twin peer was the rash of internet IPO’s in 1999-2000 that proved to be awful for most of those investors.

Other signs of a market top are evident in measures of adulation. Look no further than the pending IPO of Facebook next week to mark a peak in IPO valuations for years to come. Facebook will soon go public with the highest initial valuation in history yet they don’t produce a single product. The adulation of Facebook and Apple Computer have reached epic proportions that are not sustainable. They are both fine companies but I believe AAPL is extremely over-owned and Facebook is extremely over-hyped.

Another divergence worth mentioning relates to the certain sectors that are crucial to the intermediate and longer term direction of these markets. The first relates to old school Dow Theory that asserts that bulls markets are only confirmed when the Dow Transports join the other market averages in making new highs. This key ingredient to the bull’s elixir has been missing all along and raises concern that the rally that seems OK may not be so broad based. Also the fact that the US stock market is the only global market not experiencing a crash or a significant correction is a divergence all its own. European stock markets are breaking hard to the downside and China and Brazil have been sinking for a very long time. Still too early to make a call on a hard landing in China and the Asian tiger economies but I suspect this will happen next year.

One divergence not being discussed in the mainstream financial press is the direction of sovereign bond yield in the US and Germany versus the rest of the world. Investors have increasingly flocked to German and US debt whose yields are near all-time lows. However yields in other countries that are perceived to be weak (Spain, Italy, etc) and even some not as weak (France) have all been rising for weeks and years for that matter.  One day soon I expect investors will wake up and see the folly in buying German and US debt at these levels. The US has more total debt than anyone by a wide margin and Germany is underwriting the failed Eurozone experiment.. Yet fools rush in and push yields on these shaky credits to such low levels that guarantee a negative real return. This is the madness seen in a Kondratieff Winter.

In past blogs I have outlined my case that the endgame of this winter is more likely to take shape  through a deflationary bust triggered by rising yields more than falling asset prices. To date the fallout from rising yields has only occurred in the weakest countries but evidence is mounting that yields will rise on debt in developing economies and even on the highest sovereign credits. In recent months it has been suggested that the US can manage just fine despite most of the world being in such bad shape. To this I would call out the fact that there has been a buyer’s strike on US Treasury debt by foreigners for several months now and this trend is likely to intensify in the coming months and years. US and German debt yields have nowhere to go but higher but today these bonds are levitating at historic highs. Call it the “greater fool” theory that has been the bedrock principle underlying every ponzi scheme in history.

Another divergence screaming to be heard is the awful performance of the single most important sector of any economy- the financials. To say that the performance of the financials has diverged from the broad market averages since 2009 is quite an understatement.  Today most investors along the risk continuum have all agreed on one thing- they won’t touch financials with a ten foot pole nor will they troll for flounder.  Financials are today the modern day pariahs and lepers and for good reason. They have in spades what investors hate the most- uncertainty squared to infinity with their some $700 trillion exposure to derivatives that are still not transparent to the civilized world.  What exactly is underneath those rocks? No one dares to know and no one will know for many years the level of their true risk exposure. Discussion about the return of so-called “normalization” is just a pipe dream not likely to come to pass until a radical reformation takes place in the financial markets. Normalization of the balance sheets of the Federal Reserve and the US Treasury will require nothing less than a complete renaissance in the finest form of that term. Such a transformation is unlikely to come about by itself. It is more likely to happen through the forces of creative destruction evident in late stage economic winters.

Topping it off is the odd price behavior in Apple Computer during the past two weeks. This juggernaut may have formed a blow-off top as investor sentiment in recent months has evolved from hope to greed to euphoria to delusion. But recently AAPL tanked nearly 100 points in just days before staging a huge rally on one day last week after their earnings were announced. Yet that rally has been summarily trounced ever since and those gains were taken back in a hurry. Despite all bluster to the contrary this price action is very troubling. Such a demonstrative reversal in AAPL is quite a travesty for bulls and if this holds it would represent the pinnacle of divergence given AAPl’s undisputed role as a market leader.

Of course other meaningful divergences strut in plain sight. After the DJ transports failed miserably to confirm the broader rally in February, the Russell 2000 index of small caps retraced considerably and sold off while the S&P, DJ and Nasdaq all made new multi-year highs this spring. Bears see this as very disconcerting that transports and growth stocks sell off in such a bullish environment. What’s happening now is that so many key areas have all peaked since mid-February but since they have not done so all at once the effect is lost upon most of the market. Don’t look now, but nearly every sector, index, or star performer has recently peaked (Nasdaq, S&P, DJ Transports, Russell 2000, Oil, AAPl, etc.) but in sort of a stealth way.  Others peaked long ago (China, Europe, the US financials, most commodities etc.). The last to fall is naturally the strongest of all- the DJIA. Just a few days ago the Dow Industrials just made new multi-year highs and those headlines have the effect of cloaking the underlying weakness.  In past bull rallies in 1983, 1991, 1995-99, and even in 2003-7 we saw all sectors participate. But today it’s much different as investors sense there is something askew but can’t point to the exact cause of their anxiety. Our readers know the source of this anxiety- trillions of debt that’s accrued over this Kondratieff cycle.

Early last week a familiar recurring theme emerged again to account for some of the rally in the equities markets. It the same old “bad is good” notion that asserts that bad news is cheered because it assures massive Fed and other central bank intervention that is sure to prop up the markets. But perhaps this so-called “Bernanke put” is already fully priced into the markets.  Although corporate profits are strong from our top firms, their market caps are based today entirely on the belief that consumer demand will continue to be as strong as it has been for the past 20-30 years. Since 2011, US consumers have tapped their savings to continue the spendthrift patterns that are seemingly invincible. This pattern of US consumption is deceiving and vulnerable to radical shifts in ideology. Today US consumers account for over 70% of our GDP but like their sovereign peers consumers are in the twilight of their reckless spending that won’t be able to keep pace as it has in the past.

The present state of the US and global economies are in a state of flux to put it mildly. The election results from Greece and France today present new challenges for the EU in preventing a contagion. Confidence is the Eurozone will be sorely tested in the coming days and weeks as the backlash against austerity has been renewed and now threatens the region like never before. The debate over austerity vs. growth is extremely complex for each country as the same medicine for one may not be the same for another. It is reasonable to expect that in the short to intermediate term only one thing will come from this- uncertainty.

The global economies and capital markets today can be seen as one giant see-saw. On one side rests the massive lead weight of trillions in aggregate global debt that is coupled by a derivatives market of some $700 trillion lacking transparency. On the other side are corporate profits that are now at record highs that have pushed the US stock markets near their historic nominal highs.  But are these profits now peaking? Haven’t corporate profits been the greatest recipient of the multi-decade expansion in credit that is unsustainable? If this is so then both corporate profits and our economic infrastructure are both in peril from the excesses brought about the greatest expansion of credit in world history. I would argue that this has not been priced into current valuations. Investors instead have come to the belief that nothing could imperil the mighty US economy or its capital markets.

The last time such a sentiment was abundant was in England in the spring of 1912 when London was the undisputed epicenter of global commerce and the British pound was the reserve currency of the world.  But in just a few short years Great Britain was a shadow of its former self. First the Titanic sunk, then they were mired in WW1, and with five years New York had replaced London as the financial center of the world. This was symbolized by virtue of the massive physical shift of gold bullion from London to the Federal Reserve in NY and that event marked the changing of the guard do to speak of NY and the US as the global leaders in capitalism. NY during that period that’s not so well know to today’s investors. I find it fitting that in the month marking the 100 year anniversary of the sinking of the Titanic we must ask ourselves if our own debt levels have put the US in jeopardy of losing that crown. Keeping it will require effective leadership and a dose of humility given the fiscal cliff and debt ceiling extension looming just over the horizon.

42 Responses to “Home”