Equity Markets

All you need to know.

We have previously eschewed the constant refrain of any and every talking head who pounds the table on adding to equity risk on the basis of 'low' interest rates - why wouldn't you earn the higher dividend? or how much lower can rates go? However, aside from the drawdown-risk and empirical failure of the stocks-bonds arguments, there are three very pressing reasons currently for reconsidering the status quo of bonds against equities. Volatility in equity markets has been considerably higher than bonds and even at elevated earnings yields, it is no surprise that risk-savvy investors prefer a 'safer' lower-vol yield. Furthermore, when compared to a long-run modeling of business cycle shifts in stocks and high yield credit markets, stocks remain notably expensive to the credit cycle. Simply put, corporate bonds are at best offering better value than stocks if your macro position is bullish (and are forced to put money to work) and at worst suggest being beta-hedged is the best idea (or market-neutral) or in Treasuries.

Last month, global equity markets fairly demanded that the ECB hurry up and print, through buying euro zone debt. Effete euro elites publicly demurred at first, insisting that unlike crass Anglo-Saxons, they didn’t let financial markets push them around. Shortly thereafter, to markets’ thrill, LTRO was launched, i.e. backdoor money printing, since any sentient investor realizes that the debt being bought by the ECB is effectively like a loan to a family member: One should only expect repayment if the recipient has a chance encounter with a winning lottery ticket. Market euphoria over this intensely desired outcome was briefly interrupted a week later, when investors had a look at the shockingly bloated ECB balance sheet, causing a Euro chart breakdown, with a concomitant breakout for the dollar. This now unremitting dollar strength will doubtless temper company outlooks due to be delivered in the next few weeks. Ironically, it is the most crowded trade of late, the Dow Dividend Darlings, whose earnings are likely to be singularly impacted by this newfound dollar strength, as at current rates the dollar is looking to be ~10% higher in H1/12 vs. H1/11.

The New Year has ushered in a new pattern for the market - or perhaps has clarified an old one. The last 3 days has seen European credit markets notably underperform equity markets but stage a significant rally around the equity close each day. This rally then flops into US markets. Today was no different from yesterday - EURUSD leaked lower (holding under 1.28 here) all through the European day session - the question is whether we will see the same stability we saw during yesterday's US afternoon session in FX which will enable the equity strength to hold. We suspect not given that broad risk assets (CONTEXT) has notably not participated in the equity markets pull higher so far. At the same time as Europe closed, with financials massively underperforming, US financials were breaking out as XLF went green and BofA broke above $6. Volumes are above yesterday but below Tuesday for this time of day - still notably low on a medium-term basis. TSYs have been very volatile this morning but European sovereigns have been on a one-way path wider all day - closing near their wides. Commodities are lower (USD strength) but Gold is holding up relatively best for now - well above $1600.

While the market continues to simply fret over when and where to start buying up risk in advance of inevitable printing by the US and European central banks, those of a slightly more contemplative constitution continue to wonder just what it is that has allowed the US to detach from the rest of the world for as long as it has - because decoupling, contrary to all hopes to the contrary, does not exist. And yet the lag has now endured for many more months than most thought possible. And making things even more complicated, the market which doesn't follow either the US nor European economy has decoupled from everything, breaking any traditional linkages when analyzing data, not to mention cause and effect. How does reconcile this ungodly mess? To help with the answer we turn to David Rosenberg who always seems to have the question on such topics. His answer - declining gas prices (kiss that goodbye with WTI at $103), and collapsing savings. What happens next: "in the absence of these dual effects — lower gas prices AND lower savings rates — we would have seen real PCE contract $125 billion or at a 3% annual rate since mid-2011 (looking at the monthly GDP estimates, there would have also been zero growth in the overall economy). Instead, real PCE managed to eke out a 2.7% annualized gain — but aided and abated by non-recurring items. Yes, employment growth has held up, but from an income standpoint, the advances in low paying retail and accommodation jobs have not compensated the losses in high paying financial sector and government employment." Indeed, one little noted tidbit in the monthly NFP data is that those who "find" jobs offset far better paying jobs in other sectors - as a simple example the carnage on Wall Street this year will be the worst since 2008. So quantity over quality, but when dealing with the government who cares. Finally, will the market continue to decouple from the HEADLINE driven economy, which in turn will decouple from everyone else? Not unless it can dodge many more bullets: "As was the case last year, the first quarter promises to be an interesting one from a macro standpoint. The U.S. economy has indeed been dodging bullets for a good year and a half now. It might not be October 26, 1881, but something tells me we have a gunfight at the O.K. Corral on our hands this quarter between Mr. Market and Mr. Data." Read on.

With Unicredit's stock down 14% and sovereign spreads continuing their decompression trend, European corporate and financial credit markets are tanking - dramatically underperforming European equity markets. Perhaps the credit market is much more acutely aware of the 'bumpy road' ahead in terms of supply and the heavy calendar of both sovereign and corporate issuance at a time when demand (away from Ponzi bonds) seems weak. Nowhere is that pressure more obvious than in French government debt spreads which have popped over 40% in the last week, ahead of tomorrow's huge issuance and redemptions.

Is idiosyncracy the substitute for a fledgling Sovereign Bond Market?  Including our recommendations for 2012

European credit and equity markets rallied today but there was considerable relative underperformance by the former (especially in financials). Sovereign spreads leaked wider all day and started to lose it more rapidly into the close. It looks like Senior versus Subordinated decompression trades were placed in the European afternoon (a bearish trade ion financials) and even with the ECB in the market, BTPs closed above 500bps over Bunds (just shy of 7% all-in yields). Broad risk assets also lost ground as Europe's bid eased off as Oil eased back off its best levels and FX carry came off its highs of the day. US Treasuries are rallying after trying to converge earlier and 2s10s30s is also dragging risk lower for now.

The ongoing squeeze in US equities, evident in the significant outperformance of the most-shorted-name indices from Goldman relative to market indices, continues to keep domestic wealth effects ticking along nicely while US credit and European equity and credit markets do not seem to have got the same memo. While this rally, seemingly predicated on the fact that Europe 'get's it' finally (and admittedly some talking head chatter about the number of earnings beats - which we argue is useless given previous discussions of the wholesale downgrading of expectations heading into earnings), the US equity market is the only market to have made new highs this week, is outperforming its credit peers in the US (which is simply ignorant given HY's relative cheapness if this was a risk-on buying spree), and most wonderfully - is hugely outperforming the European financials, European sovereigns, European IG and HY credit, and European equities. Did US equities become the new safe-haven play of the world? Perhaps this week, but we suspect that won't end well - at least from the experience of the last decade or so.

Uh... did a member of the status quo just tell the truth? "It is clear now that the Fed cannot bail equity markets out any more and any interest rate cuts by the ECB may not have much of an impact on markets" Cue panic? 

After clearly demonstrating that last year's flash crash was essentially a byproduct of massive quote stuffing-induced churn surge, which cascaded into a full blown liquidity collapse, coupled with the bulk of HFT "liquidity" providers simply turning their machines off and subsequently reverberating by ETF "amplifiers" to the n^th degree, last week Nanex released what is probably one of the most critical white papers on why in its pursuit of ever higher speed (or, at least speed that is physically capped by the theory of relativity at 300,000km/sec) to gain a frontrunning advantage over everyone else, courtesy of a massively two tiered market in which there is the collocated Ph.D. braintrust focused on millisecond trading (day trading is so 20th century), and then everyone else, the core premise of the "fair and efficient market" - the National Best Bid Or Offer, which is at the heart of Regulation NMS which in turn sets forth the guiding principles behind modern "capital markets" is now an anachronism and is being overrun on a daily basis as the fastest to the market gets to set just what their own NBBO is, in the process literally destroying the premise of market fairness and efficiency, as those who have the newest and shiniest toys are guaranteed to win, while everyone else fights for a fraction of the scraps. Said otherwise, steroids are forbidden in sports but when it comes to capital markets, they are very much accepted.

Notwithstanding persistent headwinds in the global economy, ranging from sovereign debt fears in Europe to double dip risks in the US, equity markets had their best September in over seventy years. This may be largely attributed to the expectation that in order to prop up a flagging recovery the US Federal Reserve will soon embark upon a second quantitative easing (QE) program, as further evidenced by recent US dollar weakness and gold reaching historical highs (in nominal terms). This expectation seems to be getting traction. According to a leading financial blog (1), Goldman Sachs recently sent a note to its clients stating that the Fed will announce $500 billion in asset purchases at the November 2-3 meeting. Even prominent hedge fund managers are publicly proclaiming that QE is a sure thing, and that this will put a floor under equity prices. But will the Fed implement a sizeable QE program over the near-term? And how much is actually needed to keep equity markets humming along?

Brandon Rowley over at Wall Street Cheat Sheet has penned a post conveniently summarizing some of the most critical market structure trends that we have been highlighting for the past year. In a market that is increasingly computerized, the only key benefit presented by the pro-algo lobby has been that liquidity has increased. And while that may indeed be the case for the 50 or so most traded stocks whose trading is dominated by HFTs, the trade offs have been a spike in the average quotes per minute over the past decade, a fake order depth which disappears on a moment's notice, a dramatic shift away from traditional marketplaces and to "gray" venues, and most importantly, a massive surge in the cancellation to execution ratio, which is currently at an all time high, with the Nasdaq seeing 30 cancels for every execution. With so much probing and poking by computers to test which bids and offers are real, it is a miracle we don't have flash crashes every single day, as the bulk of the liquidity, likely well over 90%, is a sham.

The title says it all...

Big picture I keep my long term target of 380 on the S&P 500. Broken record but I stick to my guns one this one. Short term we are still advising to be short but moving in on key supports. Fundamentally my view is that the inventory rebuilding/federal spending is absolutely not anything organic and sustainable we can build a long term growth outlook on. We have renewed balance sheet deflationary forces at work which have triggered a relapse of credit markets and this time sovereign debt is on the table too. There are measures that have been put in place in terms of liquidity but so far the impact on markets has been null with disruption in the funding markets still building up. At this point we think the solution will be for the Fed to step in and reactivate the liquidity facilities they let expire, but that will come only after a heavy political battle. Politicians are slowly finding out that maintaining artificially a market that is bankrupt in every possible way without printing money is quite tricky and they have not found the answer to that riddle yet. An overleveraged system supported by a structurally weak economy can only be maintained by a flooding of central bank liquidity combined with austerity. It will take a solid decade to get balance sheets in good health at the consumer/sovereign level without masive wave of defaults, pick your poison. - Nic Lenoir