Stock Market Bottoming Soon

By: Tony_Caldaro

Another choppy week in the US stock market that led to the fourth consecutive, albeit small, weekly loss. On the economic front positive reports outpaced negatives 8:5. On the negative side: durable goods orders, pending homes sales, the M1-multiplier, and the WLEI declined; while weekly Jobless claims rose. On the positive side: we had increases in new homes sales, the FHFA housing index, PCE prices, the monetary base and consumer sentiment. Remaining positive were Q1 GDP and personal income/spending.

For the week the SPX/DOW were -0.40%, and the NDX/NAZ were -0.45%. Asian markets lost 1.6% and European markets lost 0.6%. The DJ World index, however, gained 0.2% and the Commodity equity group gained 2.0%. Bonds were +0.8%, Crude gained 1.2%, Gold gained 1.6%, and the USD lost 1.0%. Next week: Chicago PMI, ISM , the Payrolls report and Case-Shiller.

LONG TERM: bull market

When we review the monthly and weekly charts we see very few signs of a potential market top. We have, however, posted a very low probability SPX bull market top count on the NDX daily chart. Other than this potential count we see very few market internals supporting this view. Our weekly chart continues to look like a bull market is unfolding.

Notice during bull markets, 2002-2007 and 2009-now, the MACD remains above the neutral line and the RSI spends most of the time in overbought condition. Then during a bear market both of these indicators reverse. Also observe how the last bull market started off quite simple and then extended into a complex Major wave 5. We may be experiencing the early signs of a wave extension in our current market.

We have been expecting this bull market to unfold in five Primary waves. Primary I consisted of five Major waves, and Primary II was a somewhat complex correction. Primary wave III started off simple enough with Major waves 1 and 2. Now it appears we may be experiencing a subdivision for Major wave 3, or a continuation of Major wave 2 in the form of an irregular correction. Either way, it’s still a bull market.

MEDIUM TERM: downtrend likely underway

The uptrend started off simple enough from the SPX 1249 March low. A rally to SPX 1339, a pullback to 1295, then another rally to 1371. The monday SPX 1371 was hit was the first trading day after the news of Osama bin Laden’s death. That week the risk trade appeared to wind down as both Silver and Crude tumbled. The stock market also started to weaken with a drop to SPX 1329. For the rest of the month the SPX has been drifting lower in choppy action. The decline thus far has been 4.3% (SPX 1371 to 1312).

The internal count for the March-May uptrend offers three possibilities. We have been using the above count since the uptrend began in March. If the market can avoid a downtrend confirmation next week it is still the working count.

The second and higher probability count is a five wave structure, with a small second wave and much larger fourth wave, completing Intermediate wave one. This SPX count is displayed on the DOW hourly/daily charts.

The third count suggests that the entire uptrend was a B wave of Major wave 2. And the C wave decline to end Major wave 2 is currently underway. This SPX alternate count is posted on the NAZ daily chart. Currently we prefer the five wave structure count, alternate #1.

SHORT TERM

Support for the SPX remains at 1313 and then 1303, with resistance at 1363 and then 1372. Short term momentum hit overbought during friday’s rally and ended around neutral. There is a high probability the SPX has been in a downtrend since the 1371 high. When the downtrend is confirmed we will switch the SPX internal count to alternate #1 posted on the DOW hourly/daily charts. The decline from the high appears to be unfolding in a double three.

The first decline was an ABC zigzag from SPX 1371 to 1319. Then we had a counter trend rally to SPX 1347. That was followed by a decline to SPX 1312 and a rally to 1335. We are counting this last activity as an A and B of the second ABC decline. We also note the first decline was 52 points (1371 to 1319). Should the second decline equal the first, and the SPX should bottom around 1295 = 1347 – 52.

After the first trading day of the month, the market has spent the rest of May trading between the 1313 and 1363 pivots. Naturally, a breakout to the upside would indicate the bull market is resuming, a breakdown the correction continues. Our short term count suggests there will be a retest of the 1313 pivot, plus the 1303 and 1291 pivots as well. Should the OEW 1291 pivot fail, then the SPX alternate #2 count would come into play. Best to your trading!

FOREIGN MARKETS

Asian markets were all lower on the week for net loss of 1.6%. China’s SSEC dropped 5.2% and all five indices are in confirmed downtrends.

European markets were mostly lower for a net loss of 0.6%. Three of the five indices we track are in downtrends.

The Commodity equity group were all higher on the week gaining 2.0%. All three are still in downtrends, but improving.

The downtrending DJ World index gained 0.2% on the week.

COMMODITIES

Bond prices continue to uptrend, +0.8% for the week, and rates downtrend. The 1YR is yielding 0.18%, suggesting no chance of a FED rate increase in the foreseeable future.

Crude is downtrending but gained 1.2% on the week. This looks like a B wave rally with $105, more or less, the upper limit. Support is between $85 and $93.

Gold, (+1.6%), is likely to confirm a downtrend soon, joining Silver and Platinum. It held support quite well during the selloff in commodities. Yet, it has been unable to generate the upside momentum needed to resume the uptrend.

The uptrending USD lost 1.0% on the week. We have resistance between 77 and 79 DXY.

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Euro Debt Crisis, Greece, Portugal, Spain Debts Are Unpayable

By: Bob_Chapman

We hope all of our appearances on Greek TV, radio and in the press have helped the educational process and to allow the Greeks to identify who the real culprits are, and what to do about it. It has just been over a year since this tragedy became reality, but we reported on Greece and Italy ten years ago. They both bent the rules to enter the euro zone. We knew then that Goldman Sachs and JPMorgan Chase were assisting them by creating credit default swaps. There were a few European journalist who reported on the issue, but the elitists control the media and few noticed that Greece and Italy were beyond bogus. 

The events of the past year remind us of the onslaught of the credit crisis, which unfortunately is still with us. What finally brought about trouble for Greece and other euro zone countries was the zero interest rate policy of the Fed and slightly higher rates by the EC. These policies encouraged speculation and caused problems that would have never happened otherwise. In addition, the stimulus measures by both banks were embarked upon to save the financial sectors and in that process promote speculation by the people who caused thee problems in the first place. That began with QE1 and stimulus 1, which we now recognize as our inflation drivers. Wait until QE2 and stimulus 2 appear next year. It will be very shocking.

Just to show you what a loser lower rates are just look at economic progress. There has been no recovery under either QE1 or QE2. Even 4.60% 30-year fixed rate mortgages have not encouraged people to buy homes. They are either broke or they don’t know whether they will be employed five-months or even one year from now, so how can they buy a house? Consumer spending is falling along with wages. The small gains you see are for the most part the result of higher inflation.

Growth moved from the fourth quarter of 2010 of 3.1% to 1.8% in the first quarter of 2011. We had forecast 2% to 2-1/2% growth for 2011. That is little to show for a minimum of $1.8 trillion spent in QE2 and stimulus 2. Without that we probably would have been at a minus 2%. Just think about that. Trillions of dollars spent with little results. Obviously such programs do not work very well. You would have thought the Fed would have found a better way after two such failures. They know what the solution is, but they won‘t put it into motion and that is to purge the system and face deflationary depression. That will happen whether they like it or not, but in the meantime the flipside is 10% inflation headed to 14% by yearend and another greater wave next year, and another in 2013. Unimpressive results is not the word for it. It has been a disaster and the Fed keeps right on doing it. As a result of the discounting of QE3 we wonder what the stock market has in store for us? We would think that a correction would be in the future. If that is so could that negatively affect the economy? Of course it could. All the good news coming, further stimulus by the Fed, will have been discounted. What does the Fed do for an encore? Create more money and credit – probably? Does that mean hyperinflation, of course it does. If the Fed stops the game is over. We are also seeing fewer results from additional stimulus. It is called the law of diminishing returns. In the meantime the dollar goes ever lower versus other currencies, but more importantly versus gold and silver.

If you can believe it, even though the Fed has provided financial flows and assisting speculative flows so Wall Street, banking and hedge funds can glean mega-profits, it still has not provided enough liquidity for additional GDP growth. The small and medium sized businesses have been shut out. The latter participants do not play those games, it is the propriety trading desks, hedge funds and the remainder of the leveraged speculating community that takes advantage of the excess liquidity and the Bernanke put of keeping bonds and stocks up artificially. The Fed and the others are sustaining this process. There are negatives for the Fed and their friends, higher commodity and gold and silver prices. The Fed and banks temporarily took care of that and haven’t quite finished their latest short-term foray in that sector. There are still fears as well regarding Greek debt fears and their CDS, Credit Default Swaps, and those of other euro zone members. They could still blow up in everyone’s faces in a partial if not total default, which is very likely. Banks are on the wrong side of this trade as well as the bond trade, not only with Greece, but with five other nations as well.

In the final analysis papering over the problem never works. The problems also reemerge with new additional problems. The combination of excessive speculation and liquidity and too big to fail is going to end badly, as it always has. De-leveraging will eventually rear its ugly head.

As we said, Greece and others could cause extensive bond and CDS problems and that is not only being reflected in a lower euro, but in higher Greek bond yields of 16-3/8% in their 10-year notes and 24-3/4% in two-year yields, and Portugal, Ireland and Spain are not far behind. The socialists just lost the latest election in Spain in a big way showing the public is fed up with the lies of government and the bankers. The euro is attempting to break $1.40 to the downside as a result of those election results and the Greek impasse. It is obvious that Greece cannot service its debt and reduce its deficit and the other deficient nations are in the same boat. The CDS marketplace would be severely disrupted if there were a sovereign debt default. That fear, of contagion, could be seen in higher rates in Spain, some .30%, the highest upward move this year. Greece, Ireland and Portugal have problems that can never be resolved and Spain, Italy and Belgium are not far behind.

Spain is implementing austerity, but that means like in recent weeks millions have demonstrated in 72 Spanish cities. The 17 autonomous regions have doubled their debt in the last 2-1/2 years. The socialists just did not know when to stop, now they are out of office. Spain is going down. There is no way they can sustain. That should bring the CDS situation front and center. It will also increase unemployment for those 18 to 35 to 40% or more. It is not surprising that half of the protestors were in that age group.

Greek PM George Papandreou, who secretly promised Europe’s elitists bankers that he would sell-off and or pledge Greek state assets, wants to sell stakes in Hellenic Telecommunications, Public Power Corp., Postbank, the ports of Piraeus and Thessaloniki and their local water company. All supposedly worth $70 billion. The bankers, of course, say they are worth far less. They want to buy them for 10% to 20% of what they are worth – so what else is new. The Cabinet went along with the giveaway, as expected, and without a whimper. The EU is demanding all the assets be sold off immediately, so the bankers can buy them as cheaply as possible. The threat by the bankers is if you do not sell and sell fast for a pittance, then we won’t fund loans of $42 billion over the next 2-1/2 to 3 years. If not funded it would be “re-profiled” another new euphemism for default and debt restructuring, or perhaps debt extension. 

Then there is the threat that the bankers, the ECB-European Central Bank for the Euro Zone, would refuse to supply the Greek banking system with any further liquidity. They would then admit their new word refilling would mean default. This would end with Greece leaving the euro zone and the euro and total default, the issuance of a new drachma at 50% of the value of the euro and perhaps even leaving the EU, the European Union. Jens Weidmann, the Bundesbank’s new president said no compromise on monetary stability and a correction back to normality and a full separation between monetary and fiscal policy. It is obvious to us that in spite of debt of $620 billion that Germany wants to cut Greece loose. The German voters said that in last month’s elections. The Germans should have accepted default for $0.50 on the dollar offered by the Greeks a year ago. Even if the Greeks sold $50 billion in assets it would be a drop in the bucket, when they cannot possibly pay off the remainder of the debt ever. This shows you how derelict the bankers and sovereign countries were in allowing this debt to be accumulated. In addition Goldman Sacks and JPMorgan Chase hid their problems, via credit default swaps and now these same banks and others want to loot the country.

Tuesday Jean-Claude Junker, chair of the euro zone finance ministers committee had to admit he lied about the secret meeting the bankers had concerning Greece. He is another who says Greece cannot pay its debt under its current debt burden. Both he, and Lorenzo Bini Smaghi, Member of the Executive Board of the European Central Bank, said that any partial or total default would put all of Europe and the euro in jeopardy. In fact, some of these apologists for banks, especially the Germans, have entertained having Germany control Greek budgets and collect taxes. That means you would have a financial SS running things not only in Greece, but also in Ireland and Portugal and eventually in Belgium, Spain and Italy.

It should be noted the ECB paid in capital $14 billion and they hold $183 billion in Greek debt. We would say the ECB is already insolvent. It could be the Ponzi scheme, much like that of the Fed’s will soon come to an end. Some believe that a 50% markdown is in store for Greek debt. That could have worked a year ago, but not low. It is 2/3’s or more of a write down. We can just imagine Greece, Portugal, Ireland, Belgium, Spain and Italy recapitalizing the ECB – forget it. This is why partial or full debt default are out of the question. Just to buy time the ECB will kick the can down the road as long as they can. Those six nations in trouble should all go back to their currencies, default by at least 2/3’s and leave the euro zone.

European bondholders with a 50% debt write off are offside $1.2 trillion for Greek, Portuguese and Irish debt. If we include Spain, Italy and Belgium the 50% write off is $846 billion. That should easily destroy the ECB and the euro zone. We predict that by October changes will have to be made not only in the EU and euro zone, but in the UK and US as well. The battle rages in the euro zone, EU, UK and in the US over overwhelming debt. The debts are all unpayable. This dance of debt could go on for 4 or 5 months. Even a temporary solution is not going to work. The debts are unpayable. Once the lending stops the bottom falls out. The same is true in the US.

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COMFORT IS RARELY REWARDED; MAVERICK RISK & FALSE BENCHMARKS

By JJ Abodeely

In Rob Arnott’s November 2010 piece, “The Glad Game” he asks investors to consider “Maverick Risk” as an important driver of investment outcomes:

There’s conventional volatility in returns, which introduces a risk of poor investment returns. There’s the asset/liability mismatch, which leads to a risk that we cannot cover our future obligations. And, there’s maverick risk, in which investors choose a different path than their peers, exposing them to criticism, especially when performance suffers. All three risks are hugely important. Yet, we typically focus our analytics on the first of these, simple volatility, and our behavior on the last of these, maverick risk.

The idea of “Maverick Risk” is an interesting one. We know that from a human behavioral standpoint, we are conditioned to think of being outside of the herd as “risky.” There is plenty of evolutionary logic behind this idea considering that humans have spent much of their existence as both predator and prey; there is safety in numbers. So as much as we modern humans know the value of “thinking outside the box” or “being contrarian” and as much as we value and revere those in society who are capable of going it alone or using creative or original thought– when it comes down to financial decisions, our lizard brains take over and we seek the safety of crowds. This is true for amateurs and professionals alike. This is well documented in the rapidly growing popular and academic literature on behavioral finance.

GMO takes the idea of “Career Risk” and relates it to idea that it can drive periods of over and undervaluation. As Ben Inker, the head of asset allocation at GMO was quoted as saying in a recent Advisor Perspectives article:

“The market tends to be priced in a way that if you want to try to outperform, you have to take a risk of looking like an idiot,” Inker said. To outperform, you have to deviate from your benchmark, and that increases the risk of underperformance and, in the extreme, looking like an idiot and getting fired. As a result, markets exhibit herd-like behavior, which in turn encourages momentum and other self-reinforcing behaviors, such as money flowing into whatever strategy has been doing well, Inker said. That merely ratchets up valuations within better-performing asset classes and sectors, he said, creating a self-fulfilling prophecy.

Of course this can not continue indefinitely. Eventually prices move far enough away from fair value and the risk/return trade off becomes so one-sided, that prices get pushed back towards fair value. Consider this chart from GMO.

The Way the Investment World Goes Around: They Were Managing Their Careers, Not Their Clients’ Risk

Rob Arnott suggests that by embracing Maverick Risk and deviating from the traditional 60/40 stock bond portfolio, one can add several percentage points a year to expected returns above and beyond the expected returns that are available from the valuation of traditional asset classes themselves. This is good to hear as broad equity and bond market indexes are priced to deliver very low single digit returns over the next 5-10 years, with a high likelihood of meaningful periods of negative returns. Consider my post, Expensive Markets Mean Low or Negative Prospective Returns.

The basic approaches that Arnott advocates for range from adding non-core asset classes such as emerging markets, high yield bonds, and “alternative” strategies to choosing fundamentally-weighted indexes (Research Affiliates Fundamental Index or RAFI is what they sell after all). Importantly, he advocates employing an active, dynamic, and contrarian approach to asset allocation, which presumably does not require investment in each of these asset classes or strategies at all times. It does however require that each of these asset classes and strategies are at a minimum, part of investors’ tool box, our universe of potential investments.

Research Affiliates’ Expected Returns for Various Allocations

GMO’s Inker agrees when it comes to power of truly active asset allocation to drive investment returns:

“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said. “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”

GMO knows what they are taking about when the say that it’s a tough thing to do and survive. Their refusal to chase expensive markets in the late 1990′s meant they lost half their assets under management. HALF. 50% of their assets, 50% of their revenues, gone. They were willing to embrace Maverick or Career risk and looked like idiots for doing so. That must have been a somewhat painful experience, but perhaps they were comforted by John Maynard Keynes:

…it is the long term investor…who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

Of course, the bubble burst, GMO saved/made their clients lots of money while most others were comfortably failing (read: losing money) the conventional way, and the assets came back and then some. In his piece, Arnott is quick to point out that

taking these steps is not comfortable. Comfort is rarely rewarded. Investors can move down the path toward this maverick portfolio, careful not to exceed their board’s or their client’s “comfort” threshold. This approach goes against human nature and invites second-guessing whenever it inevitably doesn’t work. Keynes’ oft-cited “reputation” quotation, in its more complete form, bears careful consideration.

This point bears further consideration. GMO clearly did exceed their client’s comfort threshold. That’s why so many left.

If we spend too much time as professional investors calibrating ourselves to our client’s comfort threshold there is significant risk that we will make sacrifices to our process, our investment discipline, and ultimately to our fiduciary duty of acting in our clients’ best interests. It’s not just a little ironic that the line between doing what is right for our clients and doing (or not doing) things that might make them fire us is a blurry one indeed.

Client-Manager Alignment

How do we deal with this paradox? For starters, there needs to be a high level of trust between clients and investment managers. This trust should be based on the obvious considerations like ethics and integrity, but also the more difficult ideal of alignment and understanding of the investment objectives and the process by which we are trying to meet those objectives. This requires open communication among other things.

Seth Klarman is unequivocal when he says “having great clients is the key to investment success.” For those unfamiliar with Klarman, his Baupost Group hedge fund gained an average of 17 percent annually from 2000-2010, a period in which the S&P 500 Index fell 1 percent annually. And while Baupost faced some criticism during the 1990s when the fund had a hard time keeping up with the raging and speculative bull market, the fund has returned 19 percent a year since it was started in 1982 (Klarman was 25 years old), even as it held more than 40 percent of its assets in cash at times. In an interview, he goes on to describe Baupost’s ideal client as having two characteristics:

1.) If we feel we have had a good year, they agree, regardless of relative performance
2.) When we call, asking them to consider adding new capital, they a.) appreciate the call and b.) add new capital

The second characteristic is important for Baupost because they often invest in illiquid securities or non-traded assets such as real estate. When prices are down, they want to have extra liquidity from clients in order to purchase more assets. Such was the case in 2008-2009 when Baupost doubled their assets under management to $22 billion after being closed to new investors for many years.

The subtext of point #1 is that Klarman’s clients know that his number one priority is to generate positive absolute returns regardless of the market’s direction. To put it another way, Klarman’s self-identified “key to investment success” is having clients who want what he is offering: a strategy that seeks out attractive returns for the risk that he is incurring without the expectation that he will outperform in every market environment. Indeed, he is clear that the returns they will generate are a function of the opportunity set presented by the market’s valuation and is not afraid to return capital to investors (whether they want it or not) as he did at the end of 2010 if the market is not offering abundant opportunity.

At a recent Grant’s Interest Rate Observer Conference, Klarman professed to “being surprised at how little cash we have.” 28% of the Baupost portfolio was held in cash. While 28% sounds like a large amount of cash (mutual funds currently hold 3.4% of their assets in cash) to most relative return investors– the expensive valuations present in the stock and bond markets have pushed an absolute return-oriented investor like Klarman to buy hotel properties in places like Charlotte, N.C. at a 7-9% cap rate, while keeping 28% of dry powder for an eventual return to attractive valuations in the public markets.

Bringing it all home: What’s your benchmark?

We should all strive to place less emphasis on the conventions of the day and seek to arrive at a fundamental understanding what really drives investment returns so that we can make smart decisions about where we put our money. We can not accomplish this however, without knowing what our future liabilities or objectives are and addressing as Arnott puts it, “the asset/liability mismatch, which leads to a risk that we cannot cover our future obligations.” For most individuals, these “future obligations” come in the form of a desire for lifestyle maintenance in retirement, the ability to leave a legacy, or give back to the world. These obligations tend to be absolute in nature– that is requiring a certain level of assets– independent of how much your neighbor is making on his portfolio or how much “the market” returned last year.

As Tom Brakke of the Research Puzzle put it:

Decisions large and small are off kilter because the looming shadow of benchmark risk overwhelms almost everything else… maybe they should consider a low volatility strategy, even if some “underperformance” in a bull market comes with it, since such a shortfall versus a benchmark is not really a risk that matters relative to other considerations… Many of the benchmarks are, in fact, false ones. I dare say that the S&P 500 is not a natural liability for many individuals or organizations to fund. Nor is some broader market portfolio. These are made-up constructs and should not be the prime guide for decision making. But the business of investing is tied to them, to its detriment and that of its clients (emphasis mine).

The bull market of the 1980s and 1990s provided the fuel for the relative return performance derby embraced by so many people and organizations today. In a consistently rising market, when nearly all returns are positive, the collective focus shifts towards relative returns and places undue importance of “false benchmarks” such as meeting or exceeding the S&P 500. The last 10 years has demonstrated the importance of remaining vigilant and keeping our eye on the true “natural” benchmark of earning absolute returns without being exposed to catastrophic of permanent losses of capital.

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Dollar Divergences

by Trader Craig

We have a definite positive divergence in the macdh for the US Dollar Index. A similar situation occurred in 2009 leading to a multi-month dollar rally. Even if we see a retest of the recent May low, the positive divergence is likely to remain, and the outcome will also likely be the same.

For those who might assume this means the stock market will necessarily decline, the argument is not so clear. While a negative correlation with the stock market has existed for some time, that has not always been the case. In fact, according to John Murphy, the normal relationship between the Dollar and stocks is a positive correlation. It may be that we will see an inversion of the recent negative correlation with a rise in the Dollar supporting a rise in stocks.

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The Bubble in Bubbles

By Barry Ritholtz

New York Magazine has this terrific bubble graphic, that is far prettier than it is informative.

Abnormal returns call it a “bubble in calling things bubbles;” That is a phrase I will take some credit for — I first used all the way back in April 2005 in BusinessWeek: A Bubble in Bubbles? (never it saw it before then anywhere else).

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click for ginormous graphic


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FDIC Bank Failures

By Barry Ritholtz

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