Archive for category: Investing

Away from the yen, the other focus in the currency markets was on the implosion we’re seeing in emerging market currencies.  The Indian rupee hit another all-time low vs. the dollar. The Brazilian real and South African rand hit four-year lows vs. the dollar, and even strong currencies like the Mexican peso got hit yesterday.

The reason for the weakness is this:  Since the Fed went to 0% interest rates and round after round of QE, investors have moved into higher-yielding emerging-market currencies over the past few years.  Well, now with the Fed potentially “tapering” and interest rates in the U.S. rising, investors are reversing the trade, as they no longer need to take the risk of being in emerging markets, as rates are rising here at home.

Emerging market debt has collapsed since May, and the decline is unnerving
equity investors.  This ETF needs to stabilize before we can sound an “all clear” in stocks.

Well, that’s causing the currencies of those emerging-market countries to drop as investors sell their bonds and reconvert those investments back into dollars.  Basically, “doomsayers” are saying the world’s major central banks, led by the Fed, have created a bubble in emerging-market credit, and now it’s popping.

The question I’m sure you’re asking right now is “Why the hell do I care about emerging-market credit?”  Well, you care because as these currencies and bonds plunge, it’s causing losses in the leveraged hedge funds that have put the trade on. That’s causing them to liquidate other holdings to cover the losses (like stocks and gold, for instance).

Point being, you should care for the same reason everyone should have cared when the mortgage-backed security markets started blowing up in ‘07, ‘08 and eventually led to the takedown of Bear, Lehman, etc.  I’m not saying it’s the same thing here at all—but it’s the leverage and the huge declines that are making people nervous.

So, while it’s not a disaster yet, this unwind out of emerging-market debt and currencies is having an effect on all asset classes.  It’s not anywhere near 1998-style proportions yet (the emerging market debt crisis), but it is unnerving investors, and weighing on other risk assets.  Bottom line is watch the PowerShares Emerging Markets Sovereign Debt ETF (PCY) and the iShares JPMorgan USD Emerging Bond Fund (EMB), the two emerging-market bond ETFs. Emerging-market bonds need to stabilize in order for equity markets to calm down a bit.

Bottom Line

Since the Fed “tapering” narrative began 3+ weeks ago, equity markets have basically been at the mercy of other markets (namely currencies and bonds), and that continued Tuesday.

The volatility in those markets is starting to unnerve investors, as watching major currencies and bonds gyrate around like penny stocks is a bit unsettling.

But so far, this is just part of an adjustment process that is to be expected as the market comes to terms with the prospects of higher interest rates going forward. Unless 1,600 is violated on the S&P 500, I don’t think that there’s any reason to materially reduce equity exposure at this point.

Continuing to focus on the clear trend of higher rates remains, in my opinion, a good place to slowly and methodically add exposure.  To that end, I do want to point out one ETF that rallied more than 1% yesterday and seems to be positioned to capitalize off this bond-market turmoil. The ProShares Short High Yield Bond Fund (SJB), the short junk-bond ETF, doesn’t trade with a lot of volume (90K shares yesterday) but it’s about the only way I know of for non-bond investors to get short exposure to the high-yield market, which is seeing a nasty sell-off as emerging-market debt and other high-yielding bonds get hit.

Shorting the high yield market has served as a good hedge against equity volatility,
and should continue to do so as long as currency and emerging market bond volatility weigh on stocks.

SJB is a volatile position and not for everyone. But if you’ve got some risk capital to put somewhere, it’s worth a look, as it should continue to benefit during this “adjustment period” and might serve as a good hedge. (It basically is acting like a short position on the market.)

“Bad” is Not “Good” Anymore.

Again, all this economic data coming with week is important because the world’s central banks are very, very data-dependent with regard to policy.  As the data goes, so will go markets.  But, and this is important: We are not in a “bad news is good for stocks” environment, especially here in the U.S.  Previously, markets have rallied because bad economic news meant more QE, which had been good for stock prices.  That is no longer true.  The market doesn’t want more stimulus and QE.  (That statement can be made globally, but it’s especially true here in the U.S.)  It is time for the domestic and global economy to turn for the better and for growth to re-engage.  That is the key to sustainably higher equity prices, and that’s why the data is important.

Despite the media reports, one thing that was not the reason for the strength in stocks yesterday was the weak ISM manufacturing PMI.  Again, bad economic news is not good for the market (as it has occasionally been in the past).  More QE isn’t the answer to a sustained rally from here—good economic growth is.  So, bad economic data this week is not good, regardless of the short term market reaction.

That said, the weak economic data yesterday was somewhat dismissed, but that’s mainly because of the looming jobs report Friday, which is far and away the “most important” economic report from a WWFD standpoint (What Will the Fed Do).

Bottom line is nothing much changed yesterday despite continued volatility.  This market remains very resilient and certainly isn’t going to go straight down, and yesterday’s rally is consistent with the choppy trading we’ve seen lately.

To me one of the biggest things that continues to stick out to me is the unwillingness of money managers to at least partially lock in 14% year to date returns on the third day of June, because everyone is so “sure” the market will eventually march higher, and as a result are happy to stay long through any correction.  I continue to think that selectively booking some profits at these levels, while staying broadly long, makes sense from a common sense and contrarian standpoint.    

Economics

Last Week

Last week was obviously all about the Fed, as Chairman Ben Bernanke’s testimony and the Federal Open Market Committee minutes were taken as “hawkish” by the market, which led to the Wednesday reversal and the first down week for stocks in five.

While pundits will debate the minutiae, the real takeaway from the Fed last week was that, on the margin, it seems more apt to taper QE rather than extend it. We can also conclude that, generally, Fed presidents are becoming a bit uncomfortable with the current program.

But, and this is the key, while the Fed is cautiously optimistic about the economy, its members want to see the improvement have some staying power, as they have been “faked out” by this economy a few times over the past several years.  As a result, they will err on the side of leaving the current QE program in place longer than they would like.

There are two takeaways then:  First, based on what we saw last week, we should expect “tapering” of QE to begin sometime in the September-to-December time frame, if the data continue to show improvement in the economy.  The Fed meeting on Sept. 18 is the date we should all circle as the first meeting where QE could potentially be tapered.

Second, the Fed is extremely data-dependent—as the data goes, so too will their decisions on when (and if) to actually taper the QE program.  So, economic data, especially jobs and inflation, are more important than usual this summer.

This Week

Domestically it’s a pretty quiet week, with the highlights being the jobless claims on Thursday and the monthly Personal Income and Outlays report Friday.

Jobless claims dropped last week and reversed about half of the surge we saw two weeks ago. Despite the volatility, the four-week moving average is still at a pretty low level (340k).  But, it’ll be important for markets to see the downtrend in claims resume, as the labor market is obviously important to the Fed.

Personal income and outlays is important not because of the spending numbers in the report, but more so because of the Personal Consumption Expenditure (PCE) price index, which is the Fed’s preferred measure of inflation.  Inflation is running low, and that has some at the Fed nervous about removing accommodation.

St. Louis Fed President James Bullard has been especially vocal about wanting to see inflation rise before “tapering” QE.  So, the PCE price index is important because, if it remains low, that may push back the date “tapering” begins.

Internationally it’s the same thing—the most-important factors in the short term are whether the European Central Bank will become more-accommodative and whether the Bank of Japan will continue its massive accommodation, add to it or even reduce it if Japanese bond yields continue to rise at the current pace.

So, while it’s a quiet week generally, the European Union’s HICP numbers Thursday (HICP is their measure of inflation) are key because inflation there is too low. Lower inflation implies a higher likelihood that we’ll see the ECB become more-accommodative over the coming months.

In Japan there is a lot of data this week (it’s by far the busiest region) with retail sales, Consumer Price Index, household spending and industrial production all hitting the tape. This data will show whether “Abe-nomics” is having the desired effect. Given the volatility we saw in Japan last week (in both the equity and bond markets) this data now takes on even more significance.

Don’t ignore Japan—last week it was a major influence on markets, and has the potential for a repeat performance this week.

Remember, this is all about central banks—and Japan currently is the one throwing its weight around the most.  If that appears to be changing or it looks like there’s instability in the Japanese markets, this will weigh on U.S. and European shares.

 

After a strong rally over the past several weeks, WTI Crude has stalled, and on the charts looks like it may have put in another “lower high” in the $96/bbl. area.  Generally most of the smart people I know in the energy patch are bulls and expect $100 to be taken out before too long, and I’m in no position to argue with them—but that chart pattern would make me a bit nervous if I were an energy bull.  A  break of $98 is needed to re-affirm the bullish trend.

 

Generally speaking, I consider something in a bubble when it meets three criteria:  First, there has to be some “game-changing event” that occurs that alters people’s behavior.  Second, a buying frenzy develops that pushes normal asset allocation practices out the window and prices to unreasonable levels.  Third, the fundamentally weakest part of the market sees massive inflows of investment and typical risk/reward relationships are ignored as greed sets in.

It’s no secret I think we’re in a bond bubble:  The Fed crushing rates to 0% and starting QE was the game-changing event that altered people’s behavior (the first criteria).  Treasurys have seen massive inflows at the expense of other assets, and given the fundamentals are now (most would admit) overvalued (the second criteria).  Finally, junk bonds are being bought with both hands, and yesterday the average yield on junk bonds fell below 5% for the first time ever, as yield-starved investors throw money into low-rated companies in an effort to generate income (the third criteria).

Some will justify the low yields based on the fact that investment grade bonds yields are also very low, and the spread between the two isn’t compressing substantially.  But, it is compressing, and if we use our common sense, we can see that risk isn’t being accurately priced at these absolute yield levels in junk bonds (a triple B– company is still just as risky on a ratings basis as it was when junk yields were higher).

Bubbles are all about the suspension of the proper pricing of risk—and I believe we’re seeing it in the junk market.    I’m not saying that junk bonds yields trading below 5% is akin to subprime loans trading where they were in the heights of the real estate bubble, but I’m just pointing out that, in my mind, all the criteria of a bubble have now been met by the bond market.

I don’t know when it’ll pop any better than anyone else—I just think it’s worth pointing out that the warning signs here are getting louder, and the “smart” money is quieting moving towards the door.  Food for thought.