Good Evening: The major U.S. stock market averages closed with smallish advances after trading in a narrow range for most of the day on Tuesday. Commodity prices joined equities by also churning and consolidating recent gains, leaving the real action to bonds and the dollar. While the former rose and the latter fell, the approach of summer might mark a good time to look back and reflect on how the capital markets have been acting (more precisely, interacting) during the two years since the collapse of two Bear Stearns mortgage-related hedge funds marked the beginning of what would become multiple crises. Interestingly, what was “all one big trade” in the run up to the crack up is essentially still one trade — right through June, 2009. Elevated correlation levels among many asset classes are still the rule, so let’s try to imagine the circumstances under which these relationships might start to break down.
Yesterday’s leap by Wall Street didn’t seem to possess its usual bullish coattails in overseas markets last night, and stock index futures were in hover mode as the opening bell in New York approached. Some modest early profit taking was erased as soon as the first piece of economic data hit the tape. Pending home sales were up 6.7% in April, well above consensus forecasts for the third time in as many months (see below). Those still looking for an imminent bottom in housing should try to recall that these sales levels are still very depressed and were flattered by both rising foreclosure sales and falling mortgage rates. The former may help the market clear some of the excess supply on the low end (high end home volumes are still very light), but the latter tailwind is disappearing as mortgage rates have spiked since April.
Still, it was a decent report, and the green shoots crowd was further encouraged when auto sales came in better than had been expected (see below). Again, a 9.9 mm annualized rate exhibits what a Doctor might call a “thready pulse”, but the level of sales is definitely an improvement when compared to April’s figures. Given the current legal status of both Chrysler and GM, it will be interesting to see which camp of analysts will be right — the ones who proclaim a turnaround in auto sales is now at hand, or the ones who claim the added sales came from the government and/or orphaned dealerships liquidating inventories ahead of their own Chapter 11 filings.
For his part, Treasury Secretary Geithner greeted this economic news warmly while in Beijing today. He’s all smiles these days, but remember last winter when he used to bark about the Chinese and their nefarious “currency manipulation”? His new role as lap dog won’t allow him to make such accusations, but I forgive him. A face to face meeting with one’s largest customer (in this case, for Treasury securities) has a way of doing that to even the most truculent salesman. And the Obama administration has little to fear from the unions about a China policy lacking either bark or bite. After all, didn’t the nice people working in the White House just hand over the lion’s share of Chrysler and GM to the UAW, leaving the hindmost for the creditors? Does it strike anyone as curious that the supposedly Communist Chinese are lecturing us about economics and the markets while we presumed capitalists extend a socialistic hand almost everywhere?
Such thoughts were lost on equity market participants today, and they kept stock prices in a steady range above unchanged for almost the entire session. It looked as if those wanting to take profits after the recent rally were almost perfectly balanced by those wanting to buy because they’ve been missing out. The employment data due out this week will likely move this situation out of equilibrium, but today every major average closed with gains between 0.2% and 1%. Only the bank stocks disappointed when the Fed pulled a fast one on them and changed the rules (again!) on TARP repayment (see below). Treasurys actually bounced after the beating they suffered yesterday, and yields on the long end of the curve fell 6 bps. The dollar retained the status reserved for it as global whipping boy by declining almost 1% during an otherwise tranquil day. And commodities snoozed right along with equities as the CRB index slipped mere 0.2%.
More than once during the 2003-2007 bull market, Bill Fleckenstein noted that the major asset classes were essentially “all one big trade”. His always excellent Rap (www.fleckensteincapital.com) pointed out back then that the overly generous Greenspan Fed was fostering a credit bubble, one that helped stocks go up, credit spreads to narrow, the dollar to fall, and commodities to rise. Anchored to the usually low fed funds rate on the short end of the curve, and recipient of large purchases by our foreign creditors on the long end, Treasurys went their own way during much of this period. Let’s just say, however, that it was hard to lose a lot of money in fixed income during this time frame.
Subprime mortgage paper was the first to run aground in early 2007, followed in June by Leveraged Loans and in July by High Yield bonds. Equities lost the plot for most of 2007, boldly and mistakenly setting all time highs in October. But they soon cracked, too, leaving only a falling dollar and rising commodities as markets that remained on their previous trends. Commodities finally buckled in July of 2008 and played an admirable brand of catch up ball as they weakened with equities last autumn. When all these markets went into panic mode after the collapse of Lehman last September, even the dollar was able to reverse by catching a surprisingly strong bid. Volatility in all markets soared. As 2008 wound down, each major asset class was running in the opposite direction of the trends they followed from 2003 to 2007. What credit had giveth, a credit crisis proceeded to taketh away.
After what can only be described as a depressing first 10 weeks, equities bottomed in mid March, followed quickly by Treasury yields. With stocks and interest rates rising, credit spreads began to narrow, the dollar resumed sinking and commodities went back to rising. The highly correlated panic reactions of last fall have now become less volatile, though no less highly correlated. These moves recall the Greenspan era, except this time it is Chairman Bernanke pushing a Quantitatively Easy monetary policy on the markets. Many investors believe the markets are signaling a return to economic health when it looks to me more like each asset class has become hostage to the credit backdrop. Whether melting down last fall or melting up this spring, it’s still “all just one trade”.
What will force these markets to stop resembling a band of junkies that are either on a high or in withdrawal? Once again, we turn to Bill Fleckenstein. He’s agnostic about stocks at the moment, but he senses some important stresses building up behind the scenes. In Bill’s opinion, the markets to watch are the dollar and long term Treasurys. To Bill, the precipitous fall in the dollar and dizzying rise in bond yields might mean the Fed has lost the control they deem so precious. If Bernanke and company let the flood of Treasury issuance take rates higher, then they lose the economy. If they scoop up all the Treasurys they can in order to prevent rates from rising, then they lose the dollar.
The risk, therefore, is a vicious circle that continually pits the Fed and its balance sheet against the global bond and currency markets. And, since even the mighty Fed can’t control world markets, U.S. stocks will likely then start to fall along with bond prices, instead of going in opposite directions as they have for most of the past year. Past an unknowable tipping point, the correlations so evident today will suddenly switch. If you think this is a tough investing climate, wait until you see what a funding crisis looks like. The only real winners in that environment will be the hardest assets of all — the precious metals. Please note that this is not my prediction of some inevitable, dark future; it is just one possible future. We can still do something to prevent such an outcome by becoming more responsible on the fiscal and monetary fronts. To paraphrase my friend, Rick Santelli: “Washington, are you listening?”
— Jack McHugh