Sunday, December 14, 2014

Man What a Week!, Scary Credit Spreads, Oil, The Next Two Weeks Don't Matter, and Your Weekly Update

Man what a week we just had! China's Shanghai Composite Index fell 9.2%, Greek stocks took a 20% hit, the European index ETFs we're adding to some portfolios saw 4.9% and 5.2% declines, and the S&P 500 saw its number taken down a 3.5% notch. So what just happened? Well, there's one CNBC host who likes to say "it's simple, there were more sellers than buyers." Problem is, that's impossible. If there were more sellers than buyers---if to be a "seller" means you sold something---well, I couldn't have told you how "bad" last week was. For there would have been no price discovery. Truly, to put a number on an index we have to know what was paid for the shares of the stocks it tracks when the last trades were made. The fact that the markets went down last week means that the buyers were not willing to pay the beginning of the week prices for shares of stock. And make no mistake, those who bought near the close on Friday were thinking last week was a great week---in that they received a nice 4 to 20% discount on the stuff they bought. While the sellers in no way shared that "great week" feel.

As for the long-term holders of stocks, eh, no big deal. Stocks go up, stocks go down. Always have, always will...

As for the U.S. economy, well, if last weekend your crystal ball had foretold of what you'd see in the indicators during the coming week, you would have no way predicted a drubbing of the U.S. stock market. I.e., the Conference Board's Employment Trends Index increased for the 11th straight month, the NFIB Small Business Optimism Index jumped to its highest level since February '07, weekly jobless claims dipped back below the $300k mark, retail sales blew away expectations and the consumer optimism surveys showed multi-year highs.

Given that U.S. GDP is two-thirds consumer spending and that small businesses are the backbone of the U.S. economy, you'd think that all of the above would've been celebrated by the market.

Ah, but there's the rest of the world out there. And a lot of the rest of the world ain't looking so good in the eyes of short-term investors. That said, the vast majority of pundits are crediting plunging oil prices as the reason for virtually all of the recent volatility. That there's a bubble a popping, and we all know what happened the last time a bubble (the housing market) popped, right? Well, yeah, but the key distinction is that a house is something you own, while oil is something you consume. The plunging price of an asset on your balance sheet is a wholly different proposition, with dramatically different ramifications, than the plunging price of an expense item on your cash flow statement. Yes, plunging oil prices are a huge net positive for the economy.

Now---to understand where the naysayers are coming from---given that such a thing is presented as a "net" positive, there has to be a calculation where positives are netted against negatives. So then, what are the negatives? Well, I've already touched on the obvious. 

In case you forgot:
I’ve heard a number of pundits downplay the economic stimulus story of plunging oil prices. They cite the boom in states like North Dakota, and how the folks there will suffer if this keeps up: A good number of those jobs will go away and that’ll reverberate throughout the rest of the economy. Well, they’re right, and, well, they’re wrong. Yes, some folks could lose their jobs, but if “reverberate” means that a cut in U.S. oil production will effectively nullify the economic gains of lower oil prices, they’re wrong—on two fronts. One, the U.S. oil boom has been the result of newly adopted (i.e., it’s been around awhile, but it’s just now being used en masse) technology that doesn’t rely on human capital like the old technology did. Meaning, the productivity of today’s oil industry is way higher than yesterday’s. I.e., it takes substantially fewer man hours to fill a barrel of oil than it used to. Plus, the U.S. remains a net importer of oil. Meaning, the boon to the U.S. consumer and industrial user of oil overcompensates for the hit to the oil producing states.

But there's a not so obvious concern that, believe it or not, smells a little like the bursting of the housing bubble---and this one clearly has some folks questioning the net positive story. It has to do with the debt market (mortgage debt was the bubble that brought the global economy to its knees). As it stands, no small percentage of today's outstanding high yield debt (junk bonds) was issued by the energy sector. In fact, it has been one of the highest issuers of high yield bonds over the past few years. One indicator I track as a gauge of financial stress in the system---and, therefore, a potential pre-recession indicator---is the spread between the yield on junk bonds and the yield on the 10-year treasury note (the bond market has historically been a somewhat more sensitive economic indicator than has the equity market). And it's been spiking of late.

Here's a scary 30-year graph showing the high yield spread (purple line) and recessions (red lines): click to enlarge

HY spread and recessions 30yrs

Okay, "scary" may be a stretch given that spikes in the yield spread are not uncommon and don't always mean recession, but, clearly, they're something to pay close attention to.

In terms of stocks, the year to date graph below tells you why the market might be a little nervous these days (purple = yield spread, white = S&P 500):  click to enlarge

High yield spread and spx

So then, the calling into question the health of issuers of below investment-grade corporate debt---evidenced by investors demanding higher yields on said debt---could mean that the bond market sees dark clouds on the horizon. Which could, if not should, spook equity traders in a hurry. Today's question, however---given the growing strength of the U.S. economy, and the lack thereof in the energy sector---would be: is it the outlook for merely the energy sector that's pushing out the spread, or is there a macro threat looming? The given (growing economy/weakening energy sector) of today's question suggests that it's primarily the energy sector doing a number on the spread.

Therefore, no---particularly when we consider your traditional recession indicators (the treasury yield curve, the trend in the unemployment rate, the St. Louis Fed Financial Stress Index and the Recession Probability index, all of which I recently charted for you)---I'm not seeing much risk of a U.S. recession anytime soon. 

In fact, I'm struggling with the whole premise that the recent volatility is all about plunging oil prices and spiking credit spreads. I'm thinking, counter intuitively perhaps, that it's more about the strengthening U.S. economy. You see, stocks love low interest rates. And almost nothing (other than high inflation) kills low interest rates like a growing economy. Which means all eyes are on the Fed, and the Fed meets next week, and everyone expects the Fed to leave out those three market-placating words, "considerable time period" (between now and the first fed funds rate increase), from its post-meeting statement. Which means the zero interest rate party may be coming to an end in the not-too-distant future. Which, as I suggested two weeks ago, may spell a bit of trouble for the stock market---at least at the outset (or as we anticipate the outset).

All that said, I wouldn't be the least bit surprised to see the market catch a nice bid sometime between now and year's end. Not because I want it to---and am therefore grasping at positive signs---(pragmatically speaking, I'm [other than as a source of material] uninterested [and so should be you] in short-term market direction) but because lots of folks trade seasonality (the last couple weeks of the year are often positive for stock prices) and lots of professionals, particularly hedge fund managers, got creamed this year and need desperately to catch up. Plus, we have a Fed that is being stared down by a skittish stock market, remarkably low inflation, plunging oil prices and a dollar that's been dwarfing other currencies like there's no tomorrow. I.e., while I don't expect that "considerable time period" will find its way into next week's statement, I do expect the Fed to nonetheless find the words that'll calm the market's nerves.

We'll see... And it (whether or market rallies the next two weeks) truly doesn't matter if you're a long-term investor...

The rest in a nutshell:

As for non-US markets: The volatility we've seen of late has been about legitimate concerns over economic weakness. Therefore, when it comes to China, Japan and the Euro Zone, central bank tightening is not something they need to worry about anytime soon. In fact, there's every reason to believe that we'll see precisely the opposite (aggressive loosening) going into next year. Which, at present valuation levels and recent underperformance (relative to the U.S.), makes some of those markets look very interesting going forward.

As for the price of oil: Given the magnitude of the recent plunge, one has to ask, at this juncture, if it isn't as much about the technicals (selling momentum exacerbated by the breaching of support levels drawn on graphs) as it is about supply and demand? Yesterday morning CNBC's Joe Kernan pondered how the experts who make their living following the oil market can know that there's a glut at $58 a barrel, when they didn't know it when it was recently at $90 (click here for the three-minute interview). Make no mistake, OPEC production notwithstanding, the present glut (at whatever extent it exists) will evaporate if the price continues its present trend.

I could go on all day (virtually every indicator below deserves its own essay), but I wouldn't expect---if you're even still with me---you to. So I'll leave you here with the highlights from last week's (U.S.) economic journal:                       

Thanks for reading!

DECEMBER 8, 2014

THE CONFERENCE BOARD'S EMPLOYMENT TRENDS INDEX increased in November. Here's from the press release:
NEW YORK, December 8, 2014…The Conference Board Employment Trends Index™ (ETI) increased in November. The index now stands at 123.24, up from 122.8 (a downward revision) in October. This represents a 6.1 percent gain in the ETI compared to a year ago.

“The Employment Trends Index increased for the 11th straight month in November, and recent solid improvements suggest that strong job growth is likely to continue into early next year,” said Gad Levanon, Managing Director of Macroeconomic and Labor Market Research at The Conference Board. “We will probably reach the natural rate of unemployment, 5.5 percent, within a few months, and these tighter labor market conditions should lead to acceleration in wage growth.”

DECEMBER 9, 2014

THE NFIB SMALL BUSINESS OPTIMISM INDEX jumped on expectations for an improving economy. The opening paragraph, featured below, says the expectations for an improving economy and increased sales volume explains the very good reading. However, it tells us that certain "hard" index components didn't improve. Of course if small businesses are correct in their optimism, we should expect the other components to improve in the coming months:
The Small Business Optimism Index gained 2.0 points, taking the Index to its highest level since February 2007. The average of the Index from 1974Q4 to 2014 to date is 98, which includes all the Great Recession readings. What didn’t improve were the four “hard” Index components: job creation plans, plans for capital outlays, job openings and inventory investment plans, together adding a negative 1 percentage point to the Index. The entire gain in the Index was accounted for by two components: Expectations for Business Conditions in Six Months and Expectations for Real Sales Volumes, adding a combined 21 percentage points to net favorable responses, perhaps a response to the November election results.

THE ICSC RETAIL REPORT had same store sales falling last week by 1.5%. Year on year, the sector picked up .1% to 2.9%.

THE JOHNSON REDBOOK RETAIL REPORT showed the rate of growth decelerating on a year over year basis to 3.9%, vs 4.8% the prior week. The report says this is typical for the first week of December... i.e., it follows the late November rush. The report says retailers are optimistic for the balance of this season...

THE JOB OPENINGS AND LABOR TURNOVER (JOLTS) REPORT showed that there were 4.8 million job openings at the end of October. Up slightly from September's 4.6 million. The all-important quits rate was little changed at 1.9%, which has been growing of late, and is a sign of strength in the labor market. I.e., folks don't quit their jobs unless their prospects are better elsewhere. The pre-recession level was 2.1%... the recession's worst level was 1.3%...

THE WHOLESALE TRADE REPORT showed inventories steady in October, up .4%, vs .2% increase in sales. Leaving the inventory to sales ratio at an historically healthy 1.19%... The draws in inventory came from computer equipment, farm products, chemicals and furniture... Low inventories in a strengthening economy are an optimistic sign for production going forward.

DECEMBER 10, 2014

MBA PURCHASE APPLICATIONS were uninspiring. Here's Econoday's summary:
In a nearly identical reversal of the prior week's readings, the Mortgage Bankers' composite index rose 7.3 percent in the December 5 week, vs a 7.3 percent decline in the November 28 week, while the refinance component rose 13.0 percent following the prior week's 13.0 percent decline. The difference, and there's not much, is the purchase component which rose 1.0 percent in the latest week, down slightly from the prior week's 3.0 percent gain. But there is one more perfect match in the latest data and that's a 4.0 percent year-on-year decline for the purchase index which hasn't shown much life at all this year. Rates moved mostly higher in the week with the average 30-year mortgage for conforming loans ($417,000 or less) up 3 basis points to 4.11 percent.

THE EIA PETROLIUM STATUS REPORT had crude inventories growing by 1.5 million barrels last week, gasoline by 8.2 million barrels and distillates by 5.6 million barrels... Oil prices are tanking on the news.

DECEMBER 11, 2014

WEEKLY JOBLESS CLAIMS dipped down to 294k last week... The 4-week moving average remains barely  below the 300k mark at 299,250... this is up from early November by 15,000...

RETAIL SALES came in very strong, up .7% vs .4% estimate, despite falling gasoline prices. Car sales jumped 1.7%... ex-autos retail sales were up .5%. Gasoline sales (retail sales data are based on dollar volume) declined 1.3%... This is a good number for Q4 GDP...

IMPORT AND EXPORT PRICES both declined... month over month down 1.5% and 1.0% respectively. Year over year down 2.3% and 1.9% respectively. Of course oil is a factor, but not nearly the only. Ex-oil, import prices fell .3%.. Ex-food and fuels, -.5%... Clearly, the strong dollar explains much of the import price decline, however the exports side of the data doesn't support that notion. Falling oil prices are no doubt impacting the global price environment...

BLOOMBERG'S WEEKLY CONSUMER COMFORT INDEX speaks volumes to what I've been reporting for weeks. That the confluence of an improving jobs picture and lower gas prices are inspiring a feel-good spirit among consumers. From Bloomberg's release:
Dec. 11 (Bloomberg) -- American consumer confidence reached a seven-year high last week as job gains and plunging fuel costs propelled the economy and boosted spirits in the midst of the holiday-shopping season.

The Bloomberg Consumer Comfort Index increased to 41.3 in the period ended Dec. 7, its highest since December 2007, from 39.8 the week before. Measures on the economy and buying climate also climbed to the strongest levels in seven years.

The lowest gasoline prices since 2010 and the biggest job gains in more than a decade are giving consumers the means to boost spending.

BUSINESS INVENTORIES rose slightly in October, but, most importantly, show no notable change relative to sales. The inventory to sales ratio remains at a very comfortable 1.30...

NAT GAS INVENTORIES fell 51 bcf last week...

THE FED BALANCE SHEET rose $2.7 billion last week to a monster $4.489 trillion...

DECEMBER 12, 2014

THE PRODUCER PRICE INDEX dropped .2% month over month and 1.4% year over year. Ex-food and energy, the month on month change was zero, year on year up 1.7%... The inflation indicators, by themselves, do not support the case---at least from an inflation standpoint just yet---that the Fed is behind the curve... 

THE UNIVERSITY OF MICHIGAN CONSUMER SENTIMENT INDEX surged this month to 93.8 vs the 89.5 consensus estimate. This is the best read since January '07. Both current conditions and expectations components show a consumer who's feeling very good about his/her circumstances...

TODAY'S CBOE EQUITY PUT CALL RATIO sits at a very high 79, up substantially from .49 a month ago. Last time we saw these levels was October 14, which was the day before this year's best rally in stock prices occurred. For contrarians this is a classic sentiment indicator... i.e., the time to buy the market is when sentiment is decidedly negative. This contrarian read however is not supported by Wednesday's AAII INVESTOR SENTIMENT SURVEY, which showed a 2.3% weekly increase in bullishness to 45%, and 3.6% decrease in bearishness to 22.3%... However, from my last recorded number, on 12/5, this represents a 7% decline in bullishness and a 1.5% increase in bearishness. That 12/5 52% read was historically high: interesting how the market has sold off since then... Yet another contrarian signal was the drop in short interest (denotes an increase in bullish sentiment), as of 11/28, in every sector, save for energy...            

TODAY'S BALTIC DRY INDEX reading is 863. This is a sharp decline from 10/31 when it peaked at 1,428 (which represented a 40% spike from the end of September). In October I reported that spike as a bullish signal for commodity-producing economies and as a signal that commodity users, such as China, were looking up. The recent trend completely reverses that sentiment. It'll be interesting to see if the Bank of China steps up stimulus as many expect. This data point provides fuel for that fire...



  1. […] a higher risk of default. As you’ll notice below, the yield spread has expanded of late. As I explained in mid-December, the energy sector has a little something to do with it. Nonetheless, this one deserves close […]