Submitted by Rational Capitalist Speculator
Weekly Bull/Bear Recap: Thanksgiving Edition, 2011
Risk markets are losing their patience. The Eurozone situation is approaching a major climax. This is by far the most important story to follow in the coming days and weeks. U.S. Economic data has been quite encouraging and the economy remains muddling along. If Europe took care of business quickly, global stock markets would rally sharply. The S&P 500 could possibly make a run at the bull market highs. Unfortunately, there is a major ongoing political crisis in the region. There are 3 options.
The first option, which would entail a fiscal union and Eurobonds, seems to be out the window at this point. Merkel again rejected calls for Eurobonds and insisted on treaty changes as a first step. The probability that 17 parliaments could pass German requested amendments is quite low. As I have stated all along (section 2), I remain dubious on the hope that sovereign nations such as Greece, Spain, France, and Italy are willing and politically able to cede their sovereignty to what would clearly be a German-mandated supranational organization. It would be like WWII all over again, only this time perversely legal. There is little political appetite at this point. The second option entails the ECB monetizing the debt. My issue with the ECB printing, is that it would open a Pandora's box over the long-term. In my eyes, if the central bank were to print, it would represent a stealth and dangerous commitment to fiscal union without the consent of the governed. Liabilities would be shared. German-mandated austerity programs would continue and the recession would grow deeper. This environment would begin to create significant animosity amongst these nations, possibly ending in armed-conflict. This post drives my point home. No doubt that if they printed we'd see a powerful rally in risk markets and the bears would get run over. I would significantly pair back bearish winners and initiate a few more bullish positions in commodities. But, the solution would prove only to be ephemeral in my view.
The other increasingly significant problem is China. Recent manufacturing PMI data showed that the sector is contracting at its broadest pace in more than 30 months. Signs of falling housing prices are more widespread and public protests have intensified. To make matters worse, the political leadership in China doesn't seem to be loosening monetary policy as quickly as the bulls would like. They remain committed to tempering land prices. The chorus of "bank-crisis warnings" grows louder and export orders sank markedly in October. I'm paying keen attention to the charts at this point. Copper and the Shanghai Index have rolled over and are within striking distance of the their lows (the Shanghai Property Index is at its lows already). As I said here, if those markets break down, I think we'll follow. Remember that the global recovery hinges on China, thereby I see the country's stock market and copper as leading indicators.
Finally, it's important to keep an eye on geopolitical risks. Tempers have flared as of late and the situation is very tenuous in the Middle East. I believe that oil markets have been pricing in a risk premium from these developments. I remain surprised at how little it has been covered in the mainstream media though.
Like I said before, the bullish case is appealing. Valuations are very tempting for stocks. If analysts earnings estimates were correct, the market would already be discounting a mild recession. Furthermore, you have a U.S. economy that continues to chug along despite weakness in the global economy. I will admit, I'm quite surprised at its continued resiliency. The clear dichotomy between consumer confidence surveys and actual retail numbers remains intact. Consumer sentiment surveys are in recessionary territory, yet consumers keep spending. They are learning to live with these conditions it seems. Transportation metrics such as the American Trucking Association's Truck Tonnage Index and the American Association of Railroad's Weekly Rail Traffic Report show a manufacturing sector that remains in growth mode. Looking at the GDP data, we may be setting up for a renewed wave of inventory building. Companies are lean as jobless claims are near 390,000 (correlations between equity markets and jobless claims is very strong). The data keeps telling us that the recovery continues and in fact may be accelerating according to the Conference Board's U.S. Leading Indicator. China's Leading Indicator is flagging a soft-landing in China.
Overall, the bullish case exists and it's real. However, international macro headwinds are increasing in strength and are already proving to be too much for the recovery to bear. The S&P 500 just had its worst Thanksgiving week performance since the Great Depression. While the Bulls insist that exports to Europe comprise a relatively small portion of economic activity, I believe that increasing financial volatility, disruptions, and a major financial shock would effect the entire economy, not just the manufacturing sector. Banks would restrict lending and their balance sheet health would be questioned again (it's already happening). A Eurozone blowup would undoubtably sink the U.S. recovery. The ball's in Europe's court and they need to take action. If they act now, it may still be on time to avert a Chinese hard-landing. The bulls would end up as winners and risk assets would make a comeback. It has really all come down to this binary variable in the short-term. Government officials wanted Globalization, well they've got it.
Weekly Bull/Bear Recap
+ U.S. economic data remains a major thorn in the bear thesis. It proves that the economy is resistant to a European recession:
- The American Trucking Association’s Truck Tonnage Index reports its second straight gain, up 0.5% in October after a 1.5% rise the prior month. The American Association of Railroad’s weekly metric on rail traffic points to continued growth. The arteries of American commerce signal growth, not contraction.
- The manufacturing sector remains in growth mode and consumption will keep factory activity buoyed. The Richmond Fed manufacturing survey signals that contraction in the region has ended. Meanwhile, the Kansas city region reports that activity remains stable but that expectations remain solid. Growth in car sales is poised to continue, thus resulting in important segments of manufacturing having sustainable demand.
- Existing Home Sales for October unexpectedly rise, while stocks of unsold inventory retain their downward trajectory. The market is undergoing a secular bottom and sentiment is very bearish. Housing has no where to go but up.
- Strong income growth buoyed consumer spending and allowed for an uptick in the savings rate. As long as job growth continues, income growth will persist. With lower gas prices, consumer confidence will improve. So far, national gas prices have averaged 2% less than the prior month and 10% less than September.
- Finally, Deere & Co, an important economic bellwether for the agricultural industry, announces a profit beat and a bright outlook for 2012 on the back of strong foreign demand.
+ The World Bank says that China will head for a soft-landing. Aside from falling inflation (see page 2) and loosening monetary policy, Asian countries also have strong balance sheets and will be able to resort to fiscal stimulus to vaccinate their economies making them resistant to a potential West slowdown. According to the Conference Board, they might not even have to resort to such measures.
+ Profits continue to surprise to the upside. Only in the 1970s and 1980s did we see PE ratios this low when using NIPA (National Income and Product Accounts) profits as the “E” in P/E. Those periods turned out to be fantastic opportunities to buy stocks for the long-term investor.
+ Lakshman Achuthan looks like he’s about to get egg on his face. The rate of growth of the ECRI’s U.S. Leading Indicator has improved for the 3rd straight week. The index’s growth rate improved to -7.3% from an upwardly revised -7.8%. The index is beginning to signal a re-acceleration in U.S. economic growth.
- In Eurozone news, Banco de Valencia is nationalized and signals the first of many more to come in Europe. Belgium, which has not had a government for 18 months now, demands a renegotiation of the Dexia bailout. They demand that more of the weight be put on the French government. Their debt-rating is cut by S&P. A downgrade of France’s credit rating and a scrapping of the current form of the EFSF is practically inevitable. Ireland demands relief in the form of a reward for their sacrifice in bailing out investors in 2008. Greece scraps the orignal bailout with the EU and is now demanding larger haircuts. The core of Europe has officially been infected as Germany experiences a failed Bund auction. The Bundesbank had to step in and buy 65% of the planned sale due to little demand (is this monetization?). Belgian/German spreads hit new highs; Italy 10-yr yields are soundly above the 7% mark; Austria is finding itself on the edge of a banking crisis (which it will obviously bailout, thus resulting in one less AAA country); and Hungary turns hungry. European credit markets are paralyzed. The bulls plead for the ECB to print, however, If they did, then countries would need to become apostates of their sovereignties, that’s unlikely to happen. Preliminary Eurozone PMIs for manufacturing and services sectors continue to report contraction. Germany remains opposed to Eurobonds and ECB printing.
- The deficit committee finally announces the obvious and sets the stage for a feisty but futile attempt to expand the payroll tax and unemployment benefits. The fiscal contraction that would result would be the cherry on top for the recession in 2012. Furthermore another stress-test is in the cards for the banking sector. The scenarios they are using are downright ugly. This is another warning to the sound investor who “reads between the lines”.
- On the U.S. economic front, Q3 GDP is revised downward by 20% to 2.0% from 2.5%. An important leading indicator is pointing to further slowing in the coming months. Business Investment (Core Capital Goods: excluding transportation & defense) takes a sizable hit in the October Durable Good Orders report. It declined 1.8%, while last month’s reading of +2.4% is revised down to a gain of just 0.9%. From an earnings standpoint, guidance for the 4th quarter and 2012 disappoints.
- On the global economy front, China’s HSBC preliminary manufacturing gauge sinks to the lowest in 32 to months on the back of a renewed contraction in new orders. Copper is rolling over as well and is poised to take out its lows next week. These “leading-indicators” of the global recovery are flashing red. Meanwhile, Geopolitical tensions are heating up with a possible showdown in Syrian waters between the U.S. and Russia. Meanwhile, Iran/Israel’s furtive crisis keeps bubbling.
- Treasury yields are raising red flags as well. Yields are back near early October lows and dictate that equity markets have more to fall as they catch up with the asset class that has been right-on in diagnosing the Eurozone crisis. Capital floods U.S. Treasury auctions for the week, indicating a raised sense of fear. Taken together with copper prices and other poorly performing in Asian indices, it’s becoming clear that the global economy has stalled.