Destiny is Fickle

Destiny is a fickle mistress, making the S&P 500 Index wait for it's date with new all time highs.  It appears we will be getting that correction everyone was talking about first.  Since closing at 1,530 on February 19th, the S&P 500 has shed 42 points, almost 3%, to close yesterday at 1,487.85. 



Source: StockCharts.com

Last week worries that the Fed might tighten sooner than expected started the pullback.  The European Commission's change in its 2013 economic forecast from a little growth to a slight contraction added to it.  Monday's deadlocked election results in Italy put the hammer down.  The Italian election results were exceptionally jarring as initial reports indicated Bersani's Democratic Party would have a majority in both houses of parliament enabling it to continue the prior government's austerity and reform efforts.   After it became clear that was not the case, the S&P 500 sold off strongly. 

The protest vote against austerity, brought eurozone breakup worries back to the forefront.  The effect was clearly seen in the Italian bond market.  Bonds were hit hard with ten year yields rising over 30 basis points to 4.85%.  Given the deadlocked results, pundits are predicting new elections in the next couple of months.

Source: Bloomberg.com

In the US, the sequester is due to start on Friday, forcing approximately $85 billion in cuts to discretionary spending.  We also have the potential for a US government shutdown on March 27, when funding for this fiscal year expires.  With GDP growth trending a bit under 2% a year lately, the combination of  the revised fiscal cliff tax hikes and spending cuts, the sequester cuts and rising gasoline prices have whittled away at our margin of safety regarding growth.  It would take less and less of an exogenous shock to tip the economy over into recession.  With these storm clouds on the horizon, review your investment plan and expect more volatility ahead. 

Gasoline Prices WTF?

Previously, I have mentioned rising gasoline prices both here and on LinkedIn.  It is now a story on the major news outlets and you are probably painfully aware of it.  The chart below shows this year's price increase compared to the last two years.  You can see we are already fast approaching the peak prices of the prior two years.

Source: AAA.com

Since we are still below the prior peaks, if you were wondering why it feels so bad, the chart below may help put things in perspective:

Source: Global Macro Monitor

Except for 2008 (which was no picnic with over $4 a gallon gasoline), this is the highest estimated percentage of mean household income we have spent on gasoline since the early 1980's.  If you are wondering why this is happening, it is a combination of things.  Below is a chart of what makes up the price at the pump:



Source: US Energy Information Administration

As you can see, two thirds of the price is based on crude oil.  Both global benchmark crude oil prices (North Sea Brent and West Texas Intermediate) have moved up since December, explaining much, but not all of the increase in gasoline prices.

Some of it is because inventories have been constrained due to lingering effects from Superstorm Sandy.  The rest comes from the smallest percentage piece, the refining part.  Over the last few years, approximately 1 million barrels of refining capacity on the East Coast and St. Croix has been shut down.  In addition, this January Hess announced plans to close its Port Reading NJ refinery.  (More pieces on this are here and here.)  This is on top of seasonal refinery shutdowns to switch over to summer blend gasoline, which is happening earlier than usual.  This has combined to start off the usual increase into the summer driving season in February instead of March.  If the experts are right, the price should top off around the same level as the last two years, just a lot sooner.

 

 

 

President's Day Update

I hope everyone had a good weekend and is enjoying the added day of market respite this President's Day.  Last week was mixed on the economic front.  On the plus side, housing inventory and unemployment claims both dropped in the US.  On the negative side, so did industrial production.  The big news was the return of M&A on a big scale, with Warren Buffett's Berkshire Hathaway taking Heinz private and American and US Airways coming together to form the world's largest airline.  For all of that, the S&P 500 Index was roughly flat for the week.

Looking ahead, this holiday shortened week has some interesting data points.

Tuesday:      German ZEW Survey         
Wednesday: US Housing Starts, PPI and Fed minutes, German and French CPI, Chinese Flash PMI
Thursday:    US Jobless Claims and CPI
Friday:         German GDP and IFO Survey
Sunday:       Italian elections

The two German surveys should give us insights into the state of that economy, as should the Chinese Flash PMI.  Here in the US, housing starts, Fed minutes and jobless claims will draw alot of attention.  With the Italian 10 year yield down 12 basis points (bps) YTD and spreads 45 bps tighter versus German bunds through Friday, the markets seem to anticipate at worst a neutral result to Sunday's Italian election, but we will need to see.  On Monday, the European markets did appear to get uneasy about the probable election results.  As they say, that is why they play the game.  

While the G-20 declared that they will refrain from competitive devaluation, there does seem to be a distinct benefit to a lower currency for ones stock market.



Both the UK and Japanese markets with their falling currencies are doing about ten percentage points better than Brazil with its strengthening currency, the real.  On Monday, with a seeming all clear from the G-20, the trend continued.  In Asia, the Nikkei was up over 2% as the yen fell to almost 94 to 1$US.  In South America, the Brazilian stock market (the Bovespa) fell another 50bps as the real rose against the dollar. 


On another front, correlations between various risk based asset classes have been coming down indicating some differentiation between them, as opposed to a blind risk on/risk off trading environment.  The chart below shows the trailing 24 month correlations between various asset classes as of 2/17/13 as represented by ETF's.  The red cells show high positive correlation.

Source: AssetCorrelation.com

The chart below shows the one month trailing asset correlations:



Source: AssetCorrelations.com

You can see how the dark red area has shrunk significantly, with even Emerging Market (EEM) correlations falling under 0.7 to the Real Estate indexes and the US stock market indexes.  While we are still subject to headline risk (Sequester, Italian elections, etc.) this is a healthy development as it indicates investors are differentiating more on the basis of each asset class' underlying fundamentals, rather than on the latest headlines.

Mid Week topic update

US and the Liquidity Wave

Despite all of the concerns, the S&P 500 Index (1,519 close 2/12/13) continues on its seeming date with destiny at its all time high of 1,576. 

Source: StockCharts.com



The liquidity wave continues to push the market higher.  In addition, there are some signals that there may be a structural shift in risk taking going on.  This would support the wave further than many expect.  On the negative side we have the usual cast of suspects, including slowing earnings growth, higher taxes, higher gasoline prices etc.  To these we should add the austerity risk; that the federal budget deficit has never fallen as fast as it is now without a coincident recession.  We never said riding this big wave would be easy. 

Japan

About a month ago, I mentioned that the Japanese stock market was up about 22% from November 14th.  After a short consolidation period, it has continued its upward trend and is now up about 31% from November 14th.

Source:StockCharts.com

A good part of this gain has been based on the drop in the yen. 

Source: Yahoo Finance

With the yen dropping against the dollar, it is important to hedge this out.  The Wisdom Tree Japan Hedged Equity Fund (DXJ) is one way to do this.  Comparing the returns for the DXJ and the iShares MSCI Japan Index Fund (EWJ) which is unhedged can illustrate how important this is.

Source: StockCharts.com

While the two track different indexes, DXJ was able to approximately double EWJ's return because it hedged out the currency depreciation.  For another way to see the effects of the yen on click here. 

On top of this, the Japanese government is now taking a page out of the Fed's playbook and specifically targeting asset prices.  This past weekend, Japan's Economic Minister Akira Amari said:

“It will be important to show our mettle and see the Nikkei reach the 13,000 mark by the end of the fiscal year (March 31),”
 

This is about another 15% from current levels and a full 50% from it November 14th close.  That would be quite the move in four and a half months.  Yet another fun wave to ride.

Pre Mardi Gras Weekend Update

Pitchers and catchers were officially supposed to report today for the Cubs, Indians, Rockies and Red Sox.  For many it is the start of a new season.  The Super Bowl is over and now on to baseball (with a little thing called March Madness in there too).  In the Chinese calendar, it is the start of the new year (Snake).  The markets seem to be turning towards a new season also.  Year to date, stock markets are generally up and Treasury bond prices are down.  The Fed seems to be succeeding in pushing investors out on the risk curve as funds are flowing into equities and out of money markets for the first time in years. 

 

While the S&P500 Index managed to eek out a small gain on the back of some positive economic news, most major international markets were down for the week.  European stock markets, and the euro, dropped after ECB President Mario Draghi said the exchange rate was important for growth.  Corruption allegations against Spain's Prime Minister Rajoy and the possibility of a hung parliament in Italy also fueled the downdraft. 

 

This coming week is a slow one:

 

• Tuesday - State of the Union address, UK PPI, CPI
• Wednesday - US retail sales and EMU industrial production
• Thursday - French, German and Italian GDP
• Friday - US industrial production

With earnings growth minimal, the recent rise in the market has been accomplished through increasing valuations.  The S&P 500 Index is approaching the upper end of its recent valuation range on a P/E basis, while the Price to Sales ratio is approaching pre crash 2008 levels.  Market confidence remains high even as the US average gasoline price has reached $3.54 a gallon and is over $4.00 a gallon in parts of Southern California.  While the fiscal cliff was avoided, most consumers are facing a decrease in take home pay as the temporary 2% reduction in Social Security taxes of the last two years expired.  In addition, many expect that the mandatory sequester cuts will now take place on March first, further slowing the economy.  While these factors should not push the economy into recession, they should also not be a valuation expanding event.  At the very least, they're definitely not helping the situation.

 

So why is the US market rising?  That would be the wave of liquidity we mentioned in Anecdotes vs the Fed.  This is an exhilarating and dangerous ride that can last longer than you think.  It can also crash down very hard on the unskilled and unwary.  So know what your plan is and in the meantime, don't fight the Fed and as they say in New Orleans:

Laissez Les Bons Temps Rouler*

 

*Let the good times roll



Note: The original post had the wrong week's international data announcements.  This is now corrected.  I apologize for the mistake.

Bond Prices: What Has Gone Up Must Come Down

Yesterday, the Congressional Budget Office came out with its budget and economic forecast through 2023.  In it, they project that the ten year US Treasury Bond will average a 5% yield in 2017, compared to 2% today.  This is only four years away.  With many investors holding bonds for their safety, I wanted to illustrate what would happen to bonds if that projection was accurate.  I looked at both a current ten year Treasury bond and a fourteen year bond that would be a ten year bond in 2017.  According to the Wall Street Journal, as of the close of business on 2/15/13, these were priced as follows:

Maturity	Price	Coupon	YTM
8/15/2023	140.08459	6.250%	2.007%
2/15/2027	149.14204	6.625%	2.461%

In early 2017, the 6.625% bond maturing on 2/15/2027 will be a ten year bond.  If it were to yield 5% at that point, it would be worth 112 for over a 24% drop in principal value.  Fortunately, some of that loss would be offset by interest income, so the total return would be roughly -6.7% over the next four years, or -1.7% a year.   In four years, the 2023 bond will be roughly a six year bond. If the yield curve stays approximately the same shape, we could assume it would yield around 4.12% and trade at 112. This would be a 20% drop in value in the principal. 

 

 

The other thing to keep in mind, is that the premium price on these bonds will naturally diminish (or amortize) as it approaches maturity, when it will be redeemed at par (100). If the ten year rate were to stay at 2%, the value of the 2027 bond would still decrease, but to only 141, or a 5% loss.  Similarly if yields on a six year bond were to stay at 1.12%, the 2023 bond would still drop around 6% in value as the premium amortizes. 

Investment grade corporate bonds with their higher yields offer a bit more protection in this regard.  However, the spreads over US Treasuries are between one and two percent depending upon maturity.  The cushion is not that large, given the current low rate environment.    If spreads stay stable, they will suffer losses as well. 

 

Alot of money has flowed into bond funds over the last few years. It will be interesting to see how those investors react if under either scenario.   




Note: This post was updated 2/13/13 with revised data.  The original prices under both scenarios were incorrect due to a data entry error.  The revised data shows a slightly smaller principal loss (24% vs 27% and >20% vs 20%) under the baseline scenario and a small principal loss under the unchanged rate scenario (5% vs 16% and 6% vs 8%).  The main implications are unchanged. 

Quick Pre Super Bowl Weekend Update

It was generally a good week in terms of economic reports.  While fourth quarter GDP came in slightly negative, much of it was due to inventory destocking probably associated with fiscal cliff uncertainty.  In contrast, the Case Shiller Home Price Index, ISM Manufacturing Index and Construction Spending all rose.  And while fewer jobs than expected were created in January, this was cancelled out by strong upward revisions to prior months data.  All this positive information helped power the S&P 500 further upward to close at 1,513 and the Dow Jones Industrial Average at 14,009. 

 

Source:Yahoo Finance

This stock market strength has not been confined to the US as can be seen in the chart below.  Both the London  and Tokyo markets are doing even better than either the S&P 500 or the Dow Jones Industrials.  

 

 

 

The flip side of all this good economic news was the rising yield on the ten year US Treasury Bond.  It closed over 2% for the first time in almost a year, which was 25 basis points higher than the start of the year.  This rise in yields was equal to over a 3% point loss in value. 



Source: Yahoo Finance

This week in the US, we get factory orders on Monday and chain store sales on Thursday.  Thursday is also a big day internationally, with German Retail Sales, Unemployment and CPI, Japanese Household Spending and Unemployment and Chinese PMI. 

With all of this data coming out, combined with the tremendous wave of liquidity continuing to spew from central banks around the world and the US indexes approaching their highs, it should be an interesting week.  Time to brush up on your surfing skills.

Source: BBC.com