What Has Changed Since Last Week?

If we posed this question to Yahoo! Answers, we already know the best answer we could get:  “Depends on who you ask!”  The market’s volatility has caused us all to craft reasons for the volatility.  An 18% correction (since the recent peak in late April) demands not just reasons, but big reasons.

How volatile has the market been?  The VIX Index, which is the best measure of volatility in the stock market, shot up to 48, putting it into historic territory.  48 matches the highest point of 2010, which was in the wake of the first Greek bailout and the flash crash.  It’s also near the level (53) reached in March, 2009, when the S&P 500 bottomed at 666.  It’s also higher than the capitulation points of the nasty stock market correction in 1998 (think Long-Term Capital Management), 2001 (9/11), and 2002 (the end of a tortuous -50% bear market).  Historically, VIX peaked at the same time that stocks bottomed, but in 2008, VIX peaked at the height of the financial crisis, at 89, while stocks didn’t bottom until 4 months later.

The Dow has now recorded 3 of the 11 largest ever point drops in the last week.  Monday’s drop, 634 points, ranks #6.  Yesterday slots in at #9, and last Thursday was #11.  Tuesday’s 429 point gain ranks #10 for best point gains for the Dow.    None of these, however, reached the top 20 in terms of percentage drops or gains.  But still, this correction has been extremely swift, which has led to the spike in the VIX.

The percentage of stocks that rose on Monday was apparently the lowest for any day since 1940.  1940!!!!  In a great sense of irony, that day (May 13, 1940) was the day the Germans blew through the (French) Maginot Line.    On Monday, France and Germany teamed up to try to save Spain and Italy from their woes by buying their bonds.  However, concerns arose that France might not deserve its AAA rating, which exacerbated the selling.  Safe stocks, like consumer staples and health care stocks, did manage to outperform cyclicals on each down day in the last week, but not much.  It’s of little comfort when your “safe” stock falls 4% on a day when the market falls 6.66%.

The inescapable conclusion is that this appears to be some stage of capitulation.  Just like in 2008, it may not be the final capitulation.  Generally, capitulation ends when there is an actual solution to the actual problem that caused the capitulation.  And the solution needs to be legitimate enough to have a growing number people buying into it.

Back to Why the Market Dropped

The unfortunate aspect of the market’s rapid ascendancy from March, 2009, to April, 2011 (a gain of more than 100%) is that it was not driven by the individual investor.  Inflows to equity mutual funds have been negative all the way up.  Instead, hedge funds moving from short (betting the market will fall) to long (betting it will rise) has been the primary factor.  That simplistic explanation undermines that the market has had good reason to rise.  Corporate earnings have recovered incredibly, and are at new-record levels, at the same time that corporate balance sheets have never been healthier.

The unfortunate part of that is when they move from long to short.  Unfortunately, the market’s direction should continue to be determined largely by them, barring an unforeseen push by individual investors into stocks.  We have long believed the individual investor will eventually come back, but probably not in the midst of a crashing market.

Hedge funds are in the business of making money, but also not losing money.  If they see a strong case for pressing shorts on the market, they will.  What they see now is a growing list of concerns:  a slowly-unfolding European debt crisis, a stagnant U.S. economy, a lack of catalysts to grow the economy, and the recent downgrade by S&P of U.S. credits.  Given the market’s extreme volatility, you’d think our economy and financial system are both headed into the abyss.

Contrary to what the market is “telling” us, the economy is not falling off a cliff.  We covered the current state of the economy in our report last Thursday, also posted to The Library.  In it, we acknowledged that the risk of a no-growth economy has increased.  However, we believe it would be temporary, and we are very doubtful that a serious, 2008-type recession can recur.  Furthermore, we believe a global recession is unlikely, given that catalysts for so many countries to continue to grow internally (without the aid of exports) are still present.  This belief gets even more meritorious when you consider that so many other countries, which have no budget problems and relatively high interest rates, have so much capacity to provide both fiscal AND monetary stimulus, which would help stabilize economies all over the world.

We find it very, very instructive to look at how people view the government spending “standoff.”  It seems like half are worried that government spending didn’t get cut enough in the debt ceiling negotiations, which, of course, led to S&P’s downgrade of our debt to AA+.  Another half are worried that government spending shouldn’t be cut at all, as our economy is too weak to withstand the withdrawal of fiscal stimulus from the government.  Who’s right?

For those who were concerned about a selloff in U.S. bonds, in the wake of the stalemate in Washington which led to the fictitious “near default” on our debt, and then to the downgrade over the weekend, you can put that fear behind you.  Treasury bond prices have soared, leading to a precipitous drop in yields.  In fact, the 10-year yield has blown through the levels of last summer, and now, at 2.07%, has reached the lowest levels reached in late 2008 amidst the financial crisis:

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The U.S. dollar has also risen during this panic phase, which makes sense under the guise that U.S. assets are a safe haven relative to the rest of the world.  But that could be surprising to those who had wondered whether the U.S. was still safe at all.  Granted, “safer havens” like the Swiss franc and gold have risen even more, but the saying is still true that, compared to the euro, the U.S. dollar is “the best house in a bad neighborhood.”  Similarly, while U.S. stocks have tanked, European stocks and emerging market stocks have fallen harder.

On that note, the rolling European sovereign debt “crisis” has been a “crisis” for 19 months now since Greece announced it had cooked its books and its budget didn’t look so good.  19 months is a long time to still be labeled a crisis.  After bailouts now of Greece, Ireland, and Portugal, in exchange for budget cuts in each country, the market has turned its eyes on Spain and Italy.  The European economy in the next few years could go a few different ways.  The first scenario is a never-ending series of rolling bailouts, coupled with continued fiscal austerity, all leading to stagnation in Euroland.  The second would be a breakup of the euro, leading to concerns that “this is unprecedented, so we don’t know what the result will be.”  Admittedly, the range of outcomes in the short term is wide.  Eventually, we suspect it would lead individual countries which have left the Eurozone to use their new, politically-motivated central banks to pump up their money supply in order to stimulate their economies, and thus deflate their new currencies.  The hope would be that newly recaptured national identities will lead banks to lend all that newly-created money, and for companies to use the newly deflated currency to crank up exports.  Of course, this would skew to the “good outcomes” column.

Our view of the U.S. economy continues to be that we’re still just skating along, searching for a catalyst.  An unfortunately large number of eyes (and fingers) are pointed at Washington, which is, at best, an unsettling position.  Strategas wrote a great piece on Tuesday about how the government could structure “pro-growth tax reform” even in the face of spending cuts.  The report is long, so we’re not posting it here, but we have it available in .pdf format; if you want it, we can send it to you.

The outlook for business spending is not as strong as we hoped, thanks to the continuing lack of confidence in the rest of the economy (outside of the corporate world).  But incredibly low interest rates are a new catalyst, suddenly.  This should serve to stimulate another round of home refinancing, corporate borrowing, and potentially takeover activity.  Companies that might have been on the fence about an expansion project when the hurdle rate was 5% could be pushed over the fence (into doing the project) at a 4% hurdle rate.

As for the market, predicting short-term trends is always dangerous.  When you consider who is actively directing the market right now, it’s scary.  You can use this as an excuse to review your own financial situation, to be sure you’re abiding by some basic planning tips.

1)     Have enough cash, bonds, and/or cash flow to get you through a couple years.  If your “at risk” allocation to stocks won’t be needed for 2+ years, it’s a lot easier to make decisions to buy and/or hold stocks today.

2)     Make sure your investments are strong enough to make it out alive of whatever comes our way.

3)     The only sure way for an investor to cripple his long-term performance is to sell near the bottom.  That isn’t exactly helpful because we don’t know when the bottom is, but alas, we do know stocks are very cheap under virtually all economic scenarios.

When stocks plummet and treasury bonds rise, it makes us wonder about the safety of corporate America.  The chart below, however, turns everything on its head.  54 U.S. companies now are perceived to be safer borrowers than the U.S. government, judging by 5-year credit default swaps.  CDS are a tradable market; traders are buying and selling them everyday.  The numbers essentially reflect the probability of default within the next 5 years.  They are in basis points, so Merck is judged to have a 0.218% chance of default.  For comparison, the U.S. government slots in at 0.56%.  There are some very cyclical companies on this list!  We continue to make the case that U.S. multinationals are NOT the same as the U.S. economy, let alone the U.S. government.  They have access to faster-growing markets elsewhere.  They have cost flexibility.  They can redeploy cash flow to either grow the business or enrich shareholders.  We would not hesitate to put money to work today in safe stocks, as well as select cyclicals.


We end this never-ending report with Jason Trennert’s (Strategas) “speech that President Obama should have given.”  As always, don’t hesitate to call us.

Once More, With Feeling

The Press Conference the President Should Have Presented Yesterday

Jason DeSena Trennert

Good afternoon, everyone.  On Friday, we learned that the United States received a downgrade of its credit rating from Standard & Poor’s.  Although we all might feel an impulse to blame the messenger, the downgrade reflects many indisputable financial realities.  Chief among them is that no country, even one as great as the United States, can spend money it doesn’t have indefinitely.  For now, the dollar retains its status as the world’s reserve currency, the world’s preeminent choice as a store of wealth and a medium of exchange.  Sadly, history has shown us that this is no divine right.  The United Kingdom, the Netherlands, and the Roman Empire all prove that economic and military might is temporal, not eternal.

It would be easy to play the blame game today but the fact of the matter is that a combination of overextended military commitments and entitlement programs over the past 50 years is now at risk of bankrupting us, not today or tomorrow, but soon.  Of course, we didn’t get into this situation overnight and there are no silver bullets that will solve our problems quickly.  Over the last week, the markets have sent us a clear message that we, as elected officials in Washington, have no choice but to start to act like adults and make tough choices about our long-term fiscal health.

In economic terms, the downgrade of our debt is as serious as any war might be to the nation’s long-term security.  Whether it was World War II or 9/11, the American people have shown that they have a remarkable ability to pull together and make sacrifices not as Democrats and Republicans, rich or poor, labor or management, but as Americans.  One nation, united.  From many, one.  If we act as patriots, I have no doubt that we can make tough but acceptable changes to our budget that will ensure that we remain the greatest country in the history of history.

And so I am calling on Congress to come back to Washington today.  Recess is now over.   The Select Committee on Deficit Reduction should be selected within the next 24 hours and the tough work of putting our country on a sound fiscal path should start immediately.  Our citizens often need to work nights and weekends to get their jobs done and our men and women in uniform have no choice but to be on watch 24 hours a day to protect us.  As politicians, we cannot, and I will not accept, the idea that we are somehow different.  With great power comes great responsibility.  Our economic future is, in fact, now. Let’s honor the principles of our founding fathers and put the lie to the idea that Washington is broken.

Let’s get to work.

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