Nic Lenoir Has A Fever, And The Only Prescription Is More QE
From Nic Lenoir of ICAP
Today is absolutely key if the market is to turn anytime soon. Let me first summarize the global macro economic picture before we get into technical considerations. The economic cycle has turned as the effects of stimulus wane and the boost of inventory rebuilding abates. Regarding inventories in fact the expected contribution to GDP is expected to be negative in the next 2/3 quarters and Mr. Ore who runs ISM said that if recent inventory building was not fully voluntary we might have a very serious problem. ISM has rolled in the US, following Japan and Australia where it last printed 47. Sovereign credit spreads are hovering around the recent highs they made in peripheral Europe were default is pretty much a given at this point. Central banks are pretty much all with the notable exception of the ECB (which hiked in June 2008... no further questions your honor) intervening in the FX markets or launching additional/fresh quantitative easing programs in a devaluation race as demand is insufficient and exporters fight for a competitive advantage. Congress is voting laws to tax Chinese imports, and public relations between Japan and China are at rock bottom. Recently the entire mortgage foreclosure process in the US has come to a halt as it has come to light that most foreclosures were not backed by any documentation of ownership of the mortgage loans. There are talks about a potential moratorium on foreclosures. US states' CSD keep trading very wide and default is almost a given for a few states, including Illinois or California.
And all that is... great news because it all point towards more quantitative easing which should prop up asset prices. Well well, if this is not the dog chasing its tail. The argument has been made popular by David Tepper who voiced it the most clearly a couple weeks back on CNBC. I added the now familiar chart of global liquidity which shows how the prices of assets go up when global aggregate monetary base denominated in USD goes up. Here is my problem with this rationale: QE will not do anything for the underlying economy. First of all one can note that money flows more and more into gold, bonds, and sovereign markets, and out of US equities. Secondly because we have excess capacity and a dire need to repair consumers' balance sheets, there is no reason to expect massive capex from big business beyond the basic replacement cycle and the money that gets into the consumer's pocket via stimulus will either be a one-time boost to consumption in the case of the neediest, or a payment of credit balances otherwise. I could even say that in the best of cases it will go straight to savings if the recipient is lucky enough to be fat and debt free. Most of that cash will end up sitting on some financial institutions' balance sheet in no time, finding its way to Brazilian bonds or other higher yielding proposition. There is no demand for more money, and yields are not what is holding the real estate market from carrying our economy like it did from 2002 to 2007. Jobs will not come back because of excess capacity that can no longer be supplanted by credit. Instead, more QE will have the pervasive effect of debasing the USD, and bring about inflation which will no correspond to any improvement of the economy but more expensive commodities which will further hurt demand. Maybe this can be swept under the statistical rug with more CPI calculation modifications (an excellent job has been done by the governments to modify inflation reporting so that rates can be kept low, and the cost of education/healthcare/food/anything-else-you-need can grow between 6% and 10% a year), however I doubt it will be kept away from the pump long. Crude is threatening to break out higher and more USD debasement will only make things worse. This is because unlike Japan which has enjoyed a positive balance of payments thanks to her exporters and could therefore use quantitative easing for years without any major run on the Yen, the US has a negative balance of payments and the world will not tolerate QE if it is on its dime.
Here is what I think: everybody has priced in QE2 in November and in size (anything less than $500Bn here would be a major disappointment). USD has sold off aggressively irrespectively of the fact that other central banks like the bank of England and the bank of Japan have commited to more/new quantitative easing. Yet nothing has been delivered (little doubt is left since Ben Bernanke has sent his generals on the air to echo his desire to drop buckewts of liquidity from a helicopter) and questions whether purchasing US Treasuries is a good idea are popping up everywhere. The only buyers in the market base their reasoning on the fact that things are so bad (see macro assessment earlier) that liquidity will save us. I disagree.
If you are going to take a stab at this market, now is the time, and I will be very disciplined if price action proves me wrong. However, many signals show that we are at a key pivot. Early in September we had a Vix signal indicating a bottom in volatility for equities (see Vix chart). This low in volatility typically precedes a high in price for stock indices. So far this low/signal has not been invalidated. Then we set at the top of our agenda the task of trying to pick a top for US equities. Last week I finally pulled the triggered and committed to the 1,155/1,164 range for S&P futures. This is were I think bears are supposed to sell, and a close above 1,170 will be for me a signal that the melt up will carry on and 1,233/1,236 becomes the next sensible target. I have attached the 2-hour and daily chart that are pretty clear as to why this zone is a key pivot and should be a strong resistance. Another market I find of interest is crude, an its not so distant cousin USDCAD. Crude has been stuck in a range for a while as debasement has not eclipsed demand concerns. If we hold key resistance here it would be in my opinion a strong acknowledgement by the markets that QE is all fumes, and only gold or EM emerging markets will benefit from it as they unlike us can leverage the fresh liquidity. USDCAD similarly is testing a key support, and USDMXN looks very similar.
In summary, my base case scenario is that we are living a bad remake of 2008 when stocks could not re-take their highs in the summer but still rallied until late May despite obvious very troubling signs given by the economy (sounds familiar). At that stage bulls found a new holy grail: decoupling. Commodity and USD debasement hysteria ensued... but when reality set in all collapsed. I expect very much the same this time around. However periods of low volatility and delusion can last longer than one expects while realization is often sudden. I love the image of USSR which was the dangerous rival, a strong economic powerhouse, which when the wall fell instantaneously turned into a third world country in people's collective appreciation of the economic landscape (China... I see you). That is why if key resistances are breached on a market close, I will save some powder for the next time the technical picture aligns with my fundamental view of the economy which is not really getting any rosier.
Good luck trading,