Friday, December 24, 2010

Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.
One could describe the global economy as a race between the U.S. and China, to see who goes down first.
We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.

Wednesday, December 22, 2010

State Budgets: Day of Reckoning

While the VIX has been trending down to below 16%, the lowest level since April of 2010, the Muni bond market may be telling us something quite different. The yield spread (against an index of the highest-rated muni bonds) on debt issued by the State of Illinois, for example, has been increasing rapidly from pre-crisis level of about 0.2% (2008) to about 2% in late 2010.

The video below from CBS 60 Minutes is a must see.


Will weak local governments create a similar systematic financial problem posed by the weak Euro members?

Thursday, December 16, 2010

Rising mortgage rates goes with rising housing starts?

Housing starts have been in the dump for most of 2010, especially after the experiation of the tax credits. This morning's report shows some life in this important sector. Perhaps the sector is now ready to stand on its own feet.

Mortgage rates however have been rising rapidly since the Congress and the Administration started to work on extending the Bush-era tax cuts. Investors have been shunning Treasuries, in favor of cash, commodities, or equities. This is not necessarily a reflection of rising inflation expectations, although that could be part of the reason (judging from the implicit inflation rate priced into TIPs). On balance, investors are probably betting that the expansionary monetary policy as expressed in QE2 should work well in the thort term with the accommodative fiscal policy should it passes the House. Rising long-term T rates, which causes the T yield curve to steepen, is a sign that the economic recovery may quicken 2011-2012.

The Fed's goal was to stimulate the economy via asset inflation. It has so far succeeded in chasing investors away from the "safe haven" of the Treasuries, into more risky assets that are more tied to the US and global economies.

That's only the beginning. For this twin stimulus to work, the private sector needs to move up in a big way to employ more works. Millions more. More jobs would help housing starts. And more housing starts would jump start more construction jobs.

For people looking to buy a house, mortgage rates in 5-6% are still relatively low. The dominating variable is job security. Besides, when the rates rise to a certain level, bond funds and foreign government would purchase more long-term US government bonds to help hold down the rates.

In this mix, banks that have repaired their balance sheets and have successfully re-positioned themselves to take advantage of the steep yield curve and the economic recovery should be ready to print profits in the boat loads. One of the prime beneficiaries will be Wells Fargo, whose market cap has again overtaken that of JP Morgan today with its share rising over $30. A recent Barron's article has put WFC's shares at $35-40 range based on its normalized earnings power, which it should start to show itself in 2011 when Wachovia branches are all converted.

Investors should hold on to these bank shares, and some of the home builder shares for an interesting "rabbit ride" in 2011. 

Friday, December 3, 2010

Job news so bad that the market doesn't care

It was a lousy headline: the economy added only 39,000 jobs in November against the expectation of 150,000. Unemployement rate creeped up to 9.8% from 9.6%. You would think that the Dow should take a nose dive and gave up all gain from the two previous sessions. Instead all major indices held their grounds pretty well.

The BLS report stands in stark contrast to recent data from ADP (+93,000 jobs), and modest Challenger layoff announcements (+48,711).

The employment index from the ISM Non-manufacturing release today also showed a pick up in hiring.

So, perhaps the market is looking forward to upward revision in the BLS data.

Or, perhaps that the market takes the bad news as a piece of good news in the sense that the Fed now can use it to strengthen its bond-buying program announced in November. The next FOMC meeting is only 10 days away. The Fed's support was essential for the market's run from late August to early November.

If the headline had been a positive surprise, the market may actually get worried.

Gold runs up either way...

Thursday, December 2, 2010

The European debt crisis ...

Greece. Bailed out.
Now Ireland.

But the sovereign debt crises, and Euro crisis, are merely delayed. See Krugman's article "Eating the Irish." See also some other discussions by economists.

It's striking to see how the bond market and the sovereign CDS market have behaved this year.


(Data source: Atlanta Fed)

The Greek bond spread continues its rise after the bailout. Ireland's looks to widen further, even after today's decrease. The fundamental economic problem has not been solved.

Next in line is Portugal, but the elephant in the room is Spain, because of its size and its huge unemployement rate of 20%.

How would all these affect the US? Here is an interesting analysis.

This is one of the big risks that can derail the global recovery, and the advance of the stock market.

Consumers back in the driver's seat

Car sales have been strong. So both Ford and GM are doing well. GM just had a big and successful IPO. What a change.

Holidays sales are going up strong for this season. Expect to see increased traffic in malls.

The big surprise today is the pending sales of existing homes. They rose a record 10% in October, aided by low mortgage rates and improving consumer confidence. That should help clear out more of the bloaded inventories. Home builder stocks are gaining grounds.

After two years of belt-tightening, are American consumers ready to take charge?

The graph below shows that the Personal Consumption Expenditures (PCE, the largest component of GDP) are on track to grow back to its trend line.


Much of this improved picture will continue to depend on job creations. Governments can help. Central banks can help. But it looks like the private sectors are slowly moving ahead to expand. 2011 will probably be slow going, interrupted by lingering credit flare ups (Euro zone especially). But if consumers start to take charge, we expect to see some acceleration of growth in the 2nd half of 2011.

It was a good day for the market today. Tomorrow's good news in employment number may have already been baked in. As Dow is closing in onto the height of the year, it would be wise to raise cash.