Dow Jones/ Market's thoughts

Market's thoughts
by Gianclaudio Torlizzi

I. Strategy
II. Credits
III. Liquidity, currencies & gold
IV. Commodities

I. Strategy
I received the following email yesterday morning: “So this is how it works…The US House passes a Health Care Bill. The dollar goes down. The market goes up and commodities follow…See how easy it is.” Here was my immediate response: “WARNING: Do not use your mind when investing….it can get in the way of making money.” An account in Chicago recently told me that her biggest mistake since March has been thinking too much about the structural problems facing the US economy. “All that seems to matter is that short-term rates are near zero,” she concluded. I agreed that for now it seems to be that simple.

Is it possible that the stock market rallied yesterday because Pelosi’s bill was so radical that investors figured that it has no chance of passing the Senate? Maybe. Or, perchance, investors were overjoyed by the communiqué issued on Saturday, November 7 by the G-20 finance ministers, who jointly pledged: “To restore the global economy and financial system to health, we agreed to maintain support for the recovery until it is assured.” (See link below.) They promised to work together on the “transition from crisis response to stronger, more sustainable and balanced growth, consistent with our goals of sustainable public finances; price stability; stable, efficient and resilient financial systems; employment creation; and poverty reduction.” In addition, they are committed “to develop further our strategies for managing the withdrawal from our extraordinary macroeconomic and financial support measures.” Gee, can the G-20 really do all that? I have my doubts, and I doubt that’s why the stock market rallied yesterday.

The S&P 500 has been up the last six sessions since Monday, November 2. So far this month, it is up 4.8%, after it fell 2.0% during October. Notwithstanding Pelosi’s triumph this weekend in the House, investors haven’t given up on Gridlock, which received a boost from the Republican wins in the gubernatorial elections in New Jersey and Virginia last Tuesday. Investors were also cheered by the November 4 FOMC statement. While the G-20 finance ministers may have agreed to prepare to unwind their stimulative policies, the Fed will keep the federal funds rate at zero for “an extended period.”

What about this past Friday’s ugly employment report? It increases the odds that the Fed won’t tighten in the foreseeable future. The market even ignored David Rosenberg’s latest grim prognostication for the labor market. He told Bloomberg yesterday that the unemployment rate is likely to rise to 13%. He quipped, “This is going to be the mother of all jobless recoveries.” I think that David is too pessimistic about the outlook for the jobless rate. If he is right, then it won’t be a jobless recovery. It will be a depression.

Meanwhile, there is no depression in earnings. Au contraire, there is a V-shape recovery underway in S&P 500 forward earnings. It is up 19.2% to $75.00 over the past 26 weeks since it bottomed during the week of May 8. In the previous recovery, which started during the week of February 14, 2003, it was up only 6.2% over the same period. This year, industry analysts underestimated earnings for the third quarter in a row. The current number for Q3 is $16.62, 11.9% better than the estimate at the end of September, just before the start of the latest earnings season. As a consequence of the positive surprises from Q1-Q3, and the resulting upturn in the Q4 estimate, the 2009 consensus estimate for S&P 500 operating earnings is up from a low of $56.48 during the week of May 22 to $61.55 as of last week. The 2010 and 2011 estimates are up to $77.09 and $93.71. So profits are now expected to rise 25.2% in 2010 and 21.6% in 2011.

While I am inclined to agree with David that the recovery is likely to be jobless, I’m not letting that distract me from the mother of all stock market rallies. The S&P 500 is up 64.1% from its March 6 intra-day low of 666, and 61.6% from the March 9 closing low. I am still predicting 1200 before the end of this year. My Da Vinci Code target is still 1332 by March 6, 2010--that’s double this year’s devilish low. To get there, I am assuming that the forward P/E will remain around 15 and that forward earnings will climb to $88.80 by the end of next year’s first quarter. That’s admittedly optimistic, but realistic if the global economy continues to recover.

II. CREDIT

Nouriel Roubini and David Rosenberg are quite a tag team. They both tend to be pessimistic. While David is alarmed about the mother of all jobless recoveries, Nouriel is warning us about the mother of all carry trades. That’s certainly a convenient explanation for the bears who missed the bull market so far. It also suggests that the bears won’t be surprised if the market goes still higher, but then it will surely all end badly with the mother of all bear markets when the latest bubble bursts. How depressing. Admittedly, I am inclined to be optimistic. In my view, much of the rally since March has been a relief rally reflecting that the worst case scenarios predicted by the bears didn’t unfold. Of course, their rejoinder is “just wait.”

Have carry traders been fueling the global bull market in assets so far this year? The notion that they have been borrowing at near-zero interest rates in the US to purchase stocks, commodities, and currencies around the world doesn’t jibe with the weak bank loan numbers in the US. However, carry traders don’t have to borrow from bankers. Wall Street’s trading desks have had access to cheap money raised by their firms in the capital markets with debt guaranteed by the FDIC, while the Fed has been keeping the left side of the yield curve nailed down at zero!

The biggest carry trade of them all may be going on between the asset and liability sides of bank balance sheets. Yields on bank deposits have dropped close to zero along with the federal funds rate. This provides a big windfall to the banks since loan rates remain well above zero. So far this year, the bankers have chosen to make their carry trade even less risky by letting their loan portfolios decline as loans come due, while purchasing Treasuries and Agencies instead. These securities have no credit risk compared to much riskier loans given that the unemployment rate is above 10%.

Fed officials know all this. In fact, they’ve enabled it in an effort to stabilize the banking system by providing the banks with the windfalls from their balance-sheet carry trade. This also explains why the Fed is extremely unlikely to tighten any time soon. Such a move would cause capital losses in the securities held by banks, thus wiping out their carry-trade gains.

* Senior Bank Loan Officers Survey: Are bankers tightening their loan standards? They didn’t again in October, according to the Fed’s quarterly survey. Percentages continued to fall from last year’s highs for both businesses and households. However, there isn’t much evidence that loans are getting easier to get either.

III. LIQUIDITY, CURRENCIES & GOLD: Don’t get me wrong, I don’t completely disagree with Nouriel and David. I share many of their concerns. This may all still end badly, as they predict. However, the mother of all relief rallies is likely to continue as the global economy continues to recover. While the mother of all global liquidity bubbles may be inflating asset prices, it is also reviving global economic activity.

The IMF’s monthly compilation of non-gold international reserves held by central banks rose to a record high of $7.68tn in August. It is up 8.3%, or $587bn, y/y. Not surprisingly both the level and the growth rate of international reserves tend to be highly correlated with their counterparts for global exports. They have diverged over the past year more so than in the past. That’s because exports went into a depression-like dive after Lehman and AIG failed in mid-September 2008, while central bankers scrambled to do “whatever it takes” to pump massive amounts of liquidity to keep the global economy afloat. So far, they have succeeded.

Since so much of the liquidity has been pumped by the US Treasury and the Federal Reserve, the dollar has weakened since early March. That’s what currencies do when the supply exceeds the demand. It would have been worse for the dollar but for massive purchases of US Treasuries by foreign central banks. Unless, they sterilize these purchases, they tend to increase foreign money supplies. This explains why the price of gold continues to set record highs. It is the safe haven for investors worrying about the adverse consequences of too much fiat money.

Let’s review the liquidity data through August:
(1) While the IMF data show that central banks held a record $7.7tn in non-gold international reserves at the end of the summer, US Treasury data show that foreign official institutions held $2.4tn, or 30.7%, in US Treasuries.
(2) US Treasuries held by foreign official institutions rose $415.2bn y/y, accounting for 70.7% of the increase in non-gold reserves.
(3) So foreign official institutions financed 23.8% of the increase in US publicly-held Treasury debt over the past year through August.
(4) Foreign official institutions accounted for 68.4% of US Treasuries held by all foreigners. That’s up from less than 50% at the start of the decade.
* Global Liquidity: Is the world awash in liquidity? Yes. International non-gold reserves held by all central banks climbed to a record high $7.68tn in August. Emerging nations held $4.84bn in international reserves, while advanced nations held $2.84tn, both new highs. All this liquidity has provided a huge shock absorber to cushion the impact of the global financial crisis.
* Currencies: Where’s the trade-weighted dollar headed? The path of least resistance is down. It’s 11.5% below the March 3 peak, losing ground to commodity currencies, such as the Australian dollar, Canadian dollar, Brazilian real, and Russian ruble as commodity prices surge. Rallies in these currencies had stalled along with commodity prices recently, but now most are rising again. The euro is rallying, up 19.4% from recent low earlier this year. The UK pound is 21.5% above its January 23 low, though moving sideways recently. The Japanese yen is back around 2008 highs. The Chinese yuan is in a flat trend vs. the greenback since mid-2008.

IV) COMMODITIES: Commodity prices are very sensitive. In the past, they were very sensitive indicators of global economic activity. I think they still provide the best real-time assessment of the global economy. However, over the past few years, these prices seem to have become increasingly decoupled from their own unique supply and demand fundamentals. Commodities have morphed into an asset class that tends to be driven by global liquidity. Of course, there are plenty of feedback loops. For example, ample liquidity can drive up commodity prices, thus increasing the incomes of commodity exporters. If they spend their windfalls on imports of manufactured goods, everyone prospers. Prosperity, in turn, increases the demand for commodities.

During the summer of 2008, commodity prices soared led by energy and grain commodities. Then they crashed during the fall. They mostly bottomed at the end of last year, and have recovered by a third or more. What does this tell us about the global economy? It dodged the depression bullet, and it is recovering. To assess the accuracy of commodity prices as economic indicators, we really need to keep track of other indicators, such as industrial production and exports. They are confirming the recovery, but provide a mixed picture. In other words, we are in-between a bust and a boom. This is also the message of the Baltic Dry Freight Index, which has recovered at a lackluster and somewhat erratic pace since the beginning of the year.

* Baltic Dry Freight Index: A recovery in world trade? That’s what industrial commodity prices are predicting. The CRB Raw Industrials Spot Price Index, which is one of our favorite indicators of global economic activity, has rebounded this year. It’s 41% above its early December 2008 low, and only 15% below its record high in mid-May 2008, turning up again after a brief lull. Copper futures are on steep uptrend, with the price more than doubling since its late-December bottom. The Baltic Dry Index (BDI) coincides with the trend and volatility of commodity prices. It is climbing again after dropping sharply during Q3. It rose for the sixth straight week last week, up 57% over the six-week span. It added to that gain yesterday, hitting its highest level since July 29, on strong demand for iron-ore carriers to the Far East, mostly China. In a sign the global economy is emerging from its downturn, the value and volume of world trade are up from 2009 lows. Commodity prices are predicting further upside through the end of the year.
* Industrial Spot Prices: More to go for rally in industrial commodity prices? Yes, if global industrial production continues to strengthen and the dollar continues to weaken. Industrial prices soared from mid-2007 to mid-2008, and then crashed during the second half of last year. The CRB all commodities spot price index is up 32% from recent low; raw industrials spot price index is up 41%. The metals sub-component of the CRB raw industrials has increased 82% from its low in late December. All have resumed their climbs following recent lulls, as they did a couple of other times this year. Most metals prices remain on uptrends, with copper and lead more than doubling from December lows, and zinc nearly doubling from its February low. Precious metals prices are rallying as the US dollar weakens, with gold hitting new highs. CRB futures price index plummeted along with energy prices during H2-2008. It’s fluctuating around recent highs, 34% above its early March low.
* Energy Prices: What are energy prices up to? They’re trending higher. Crude oil rose 2.6% to $79.44 per barrel yesterday, moving above $80 during the session. The price is up 78% ytd, trading 28.9% above its 200-dma of $61.62. The national gasoline pump price has fluctuated around 2009 highs, with the latest price at the top of the $2.40-$2.65 range recorded since the summer. Natural gas price increased 1.7% yesterday to $4.675Btu. It’s up 86% since hitting a seven-year low in early September. The price is down 17% ytd, though trading 20% above its 200-dma of $3.891Btu.
* Grain Prices: What’s cooking in the grain futures pits? Wheat, corn, and soybean prices have all bounced off the lows of their volatile flat trends. They are up 13%, 10%, and 7%, respectively, from early October levels.