Big Picture:

  • Warning: The mini greedometer (tactical risk indicator) is displaying readings previously only seen when the S&P500 was within 5% of a secular (long term) top. The greedometer (strategic risk indicator) is approaching dangerous risk levels as well. There is very little upside and a great deal of downside to risk assets (stocks, junk bonds, commodities, REITs) at this time. A much more detailed view was presented in the private client letter.
  • My book is progressing and will be out in the second quarter. It will be called: Greedometer. Dow 5000 in 2013. Why no one saw it coming.

 

(This week’s letter is longer than we’ll see for a while as I spend less time on the economic letter and more on the book. There will be no change to the time/ effort spent on analysis and trading.)

A Primer: Why will stock markets crash in 2012-2013?

Recognizing that this note is meant for a wide audience -including some new folks that receive it via social media – it might be helpful to summarize the case for risk assets (stocks, high yield bonds, commodities, REITs) to crash. Longtime clients will know these points well …….

  • Earnings are going to head lower, and expectations of earnings will compress P/E multiples as investors lose faith in the “cult of equities”. Having been burned badly in 2000-2002, and 2007-2009, retail investors are now more apt to run for the lifeboats when markets breach intermediate-sized losses (say 25-30%).
  • S&P500 profit margins are at all-time highs (last week). As they mean revert, this puts downward pressure on earnings.
  • US Consumers have just stretched their credit / reduced savings again (4Q 2011). The consumer will sober-up very shortly when they realize their largest financial asset (their home) is a boat anchor. US home prices will continue to slide for 3-4 more years to re-balance supply with demand.
  • Over a century of US stock market data shows secular market bottoms have a P/E south of 10. 7-8 is more common. Slap an 8-handle on what is likely to be $75-80 in 2012 S&P500 earnings (as-reported, not operating), and $50-55 in 2013. (FYI: 2007 saw $66, 2008 $15, 2009 $51, 2010 $77, 2011 $89)
  • Stopping the S&P500 at 666 last time (March 2009) required mammoth fiscal and monetary ammunition that is not available now. So the 500s (my estimate) is the right ball-park.
  • 2012 sees a GDP headwind from budget cutting and tax raising in Europe. Recession.
  • 2013 sees a sobering US GDP headwind from fiscal reality finally coming home. Higher taxes and spending cuts — courtesy of the bond market. Recession.
  • Plus wildcards:
    • when does the European sovereign debt crisis finally implode via a Greek default initiated a credit crunch?  March?  June?
    • when does Japan’s mounting debt load cause it to dramatically increase the amount of int’l buyers for JGBs?  In so doing, doubling or tripling the debt burden. Causing Japan to print or default. Probably 2013.

 

In the US:

  • The latest US consumer sentiment report saw the highest readings since May last year — when the US stock market had just peaked for the year. Mind you, on an absolute basis, the reading remains at recessionary levels.
  • The latest sentiment indicator of US retail investors hit the least bearish point in seven years. There’s a contra-indicator for you. When retail investors are extremely bullish / extremely unbearish, the stock market is frothy and primed for a fall.
  • Manufacturing perked up 0.9% in December — the fastest pace in a while.
  • Citigroup reported disappointing results this week. Though results were even lower than expected despite earnings assistance from lowered loan loss reserves. It posted $0.38/share net income, falling short of recently lowered estimates of $0.49. In the spirit of highlighting the sandbagging that Wall St does, three weeks ago, there were analysts with net income estimates as high as $0.76 (2X what was posted!!!).
  • Goldman Sachs and Morgan Stanley reported disappointing results this week as expected. Due to more accounting tricks and a recently lowered expectation (sandbagging), their share prices held up well this week.
  • Builder confidence rose to the highest levels since June 2007. Wow. They’ve risen from depression levels almost up to average recession levels. The wind is going to be let out of the sails to this story in a few days. The next Case Shiller housing report (next week) will show US homes dropped 5% in price over the past year. And they’ll drop another 5-8% this winter to 2002 levels. (rinse and repeat…).
  • The latest inflation reading shows it gained 3% in 2011 -the highest in 4 years. Core inflation (ex food & energy) was up +2.2% over the past 12 months. Some view this data as alarming — and are buying TIPS. Indeed, this week saw the first ever TIPS auction with a negative yield. A guaranteed loss unless inflation goes higher than it currently is.
    • But dig into the data and you see that all of 2011′s inflation was during the first half. It was caused by our old friend QE2. The inflation rate was 1.5% in December 2010 -when QE2 was just getting started. By the end of QE2 in June, inflation had risen to 3.6%. It continued to rise marginally higher shortly thereafter, then rolled over. The last quarter saw inflation drop from nearly 4% to 3.0%. So in an era of stagnant wage growth, the Fed caused inflation to rise – and mortgage rates with it. Thanks for the help. Still think we’ll see a QE3?  Still want QE3?
  • 4Q 2011 Earnings season is well under way and the results are mixed. Of 59 companies reported so far, 29 beat lowered expectations, 20 fell short, and 10 met. So 49% of companies have managed to beat sandbagged/lowered expectations. That figure is usually well into the 60%s, and has average 70% for the previous year. Profit margins are at all-time highs. Mind you, retailers haven’t started reporting yet.
  • I’ll be watching to see how revenue is fairing (harder to manipulate than earnings). Plus, pay attention to the spread between operating vs as-reported earnings. As this widens over the course of the coming year, that’s a signal “earnings quality” is weakening. This means more tricks are being played to bury more bad stuff.  

 

South America:

  • Brazil: Protectionistas R Us. Last month Brazil implemented a 30% tax increase on cars sold with less than 65% local content. This was in keeping with a trend of other protectionist actions last year. These actions are aimed at China –its largest trading partner. Trade with China is up 17-fold since 2002. (you read that right). What Brazil needs is a way to depreciate its currency relative to China. Good luck with that. As the global economy softens this year, look for protectionism to spread.

 

In Europe:

  • The IMF is passing the hat and trying to raise another $ half trillion to save Europe. It has $387B available, and Europe says it can scrape together another $200B. $1T seems to be the target. And this is in addition to the EFSF and ESM. We’re closing in on $2T in bailout loans altogether. That’s in the right neighborhood. The US & UK are not interested in throwing good money after bad, so it is pretty much back to China they go. As I wrote over a year ago, China is going to play the trump card: removal of arms sanctions applied after the 1989 Tiananmen Square massacre.
  • Not content in merely lowering the ratings on sovereign bonds, S&P lowered the rating on the EFSF bailout fund. This came as no surprise. After all, there’s another bailout fund-the ESM scheduled for early arrival in 5 more months. Surely they can make the 250B euro remaining in the EFSF last until then?
  • More records! Commercial banks parked over 520B euro with the ECB — yet another all-time high in a string of highs. This means despite the ECB’s LTRO feed trough, banks still don’t trust each other. Hmmmm.
  • Greece:
    • Apparently, we’re close to an announcement that will see a 68% voluntary (no default, no CDS trigger) haircut to Greek bond holders. That should goose the risk-on trade. But it will be short lived because the bond holders with CDS protection were not likely part of the negotiations. Because they bought CDSs to indemnify them against default they will not accept a large haircut that does not trigger a CDS payout. Besides, 68% won’t be enough. It would buy more time for banks to build up their balance sheets and prepare for the real thing — an 80% haircut. I wonder what Portugal and Ireland are thinking about all this. And if Greece applies a collective action clause retroactively – thereby cramming a 68% haircut to all bond holders – there will be a nuclear winter in the CDS market. The unintended consequence will be bond buyers will demand higher interest rates since they no longer can count on CDS insurance against default. There’s a silver lining here for US banks. If CDS don’t have to pay-out, big US banks benefit as much as Greece does because large US banks are on the hook to pay-out on some of those CDS contracts. (but happens to the bank on the other side that was counting on that pay-out ?)
    • In the coming weeks we’ll get an update on Greece’s economy. The numbers will come up short again. Having seen its economy shrink 12.5% since the 2008 peak, it will be seen to have shrunk 6% last year. And it will shrink a similar amount this year as tax increases and budget cuts are ramped up. The debt : GDP will exceed 180% this year without a haircut. And the proposed haircut level will still leave Greece with a 120%+ debt:GDP that will continue worsening. Basically, Greece is in a death spiral. There’s no chance it can outgrow the interest on its debt. Assuming more good money after bad will continue to be thrown at it before the March debt repayment and probably again in June, Greece will hold an election in July. A mish-mash of parties will form a coalition Parliament, but won’t be able to pass any legislation involving spending cuts for fear of running amok of one of the coalition members. An unstable situation becomes more unstable.
  • Portugal. The 10-year note saw yields climb to 14% — the highest since Portugal joined the euro. If this does not reverse soon, it will be hard to argue against contagion spreading from Greece to Portugal.
  • Germany: December saw investor sentiment rose the most it ever has. Granted it rose from near-depressionary lows. But bear in mind that stock market tops always coincide with high investor sentiment readings. (sorry to burst the bubble) Egan Jones (a US ratings agency) lowered Germany’s sovereign rating 1 notch last week.
  • Italy: Looking forward to next week’s test: a large auction of 10-year notes.
  • Spain: Had a successful 10-year bond auction this week. The yield (interest rate) dropped 1.5%. A sigh of relief all over Europe. 

 

In Asia:

China:

  • Q4 2011 saw the first time since the Asian financial crisis of the late 1990s that Chinese foreign exchange reserves dropped. No panic button yet, but it is significant nonetheless.
  • Q4 2011 GDP grew at +8.9% — the slowest rate since summer 2009 — but more than anticipated. Slow down? What slow down? Not yet — at least not if we are to believe the data from China (always taken with grain of salt).
  • China’s central bank is likely to keep softening monetary policy to stop the GDP growth rate from dropping under 8% since that seems to be the threshold at which civil unrest ramps up.

Japan:

  • Last year, Japan had a trade deficit –its first in nearly half a century. By my estimates, Japan’s current account will follow into deficit within the next 2 years. Translation: Japan will become importers of cash like we are here in the US. With Japanese household savings rates dropping over the past 20 years to roughly 2%, corporations became buyers for Japanese government bonds (JGBs). That’s about to change because corporations have paid down their mammoth debts and rebuilt their balance sheets (it only took 20 years). Profits are being squeezed by the high-priced Yen, and taxes can only go up. So, where does this leave us ? There’s an explosive moment (failed bond auction) in Japan’s future. Foreign bond investors will not settle for the current JGB bond yield. A 1% rise in the cost of borrowing will double the cost of servicing Japan’s debt. And if you think interest rates will only rise 1%, I have a bridge to sell you.