Dull. Bye.

This whole Dubai thing is a non-story. So what if a few banks are going to lose a few billions. The amount of write-downs in the past couple years was what, 1500 billions? Wait a few months for the pain to come in the U.S. commercial real estate market, and the Alt-A and Option-ARM mortgage troubles. THAT is going to hurt.

There might be one interesting thing in this, and it's the way the markets have reacted. It seems the 9 months-old rally is finally getting frightened by bad news. This is not a sign of strength. Financials have been underperforming for weeks now. Not very good.

Shadow inventory in housing

Again, from David Rosenberg:

Meanwhile, the deflation risks in housing have not gone away, and we saw that in the 1.7% slide in median existing home prices in October (sharpest slide since April). This was the FOURTH month in a row of negative pricing action in the resale market. So, while this data may well show that the inventory backlog has come down to what seems to be a respectable 7 months’ supply, we also know from the U.S. Census data that there are around 3½ million homeownership units that are currently being taken off the market for unstated reasons. (We reckon that this is a pretty good proxy for the ‘shadow’ foreclosed inventory at the banks). In other words, we very likely have the inventory backlog at closer to 14 months’ supply and this is why prices are still declining. At the margin, there are still many more sellers than there are buyers.

David Rosenberg writes a very interesting daily report, available here.

More tidbits from the Consumer confidence report

From David Rosenberg:

In terms of financial markets, and this is a good contrary indicator, those expecting the equity market to go up (33.1 to 36.3) and those expecting it to go down (28.7 to 23.8) have moved to levels last seen in July 2007 (right when the market was peaking out and about to roll over).

Interest rate expectations, meanwhile, have moved in a bullish direction for bonds. Those respondents expecting yields to rise went from 50.1 to 51.3 in November and those expecting yields to fall slipped from 15.3 to 12.9 — levels last posted in August 2007 in what were the early stages of one of the biggest bond rallies in the past 30 years.

Consumer confidence vs. GDP growth

The highest correlation that can be found between consumer confidence and GDP growth... is not that high (about 0.5):

This makes consumer confidence one of the less-reliable leading indicators of the economy.

Even more on the dollar carry trade

From "BarCap analysts", via FT Alphaville:

The size of carry traders is notoriously difficult to measure, and there is considerable speculation on their size based on very incomplete evidence. Consider, however, a measure of the classic incentive to put on carry trades — volatility-adjusted spreads. We use two such measures, the volatility-adjusted spread between AUD and JPY and the volatility-adjusted spread between AUD and USD. In each case, we divide the 10y yield differential between by one year implied volatility.
These measures do not encourage the view that carry trades would be put on in size . Whatever the incentives from the rate differentials, implied volatilities remain high enough to discourage carry trades. In both cases, the incentives are not only well below the peak, they are well below the average.

If anything, this suggests that the market may be overestimating the extent of carry trades now in place and underestimating the potential for carry trades to be instituted if implied volatilities pull closer toward historical norms and realized volatility.

Well excuse me anonymous BarCap analysts, but you are pretending to be more stupid than you actually are. The carry trade everybody's talking about is more about capital gains than about pure yield carry, and your measures are not adapted to this. These measures were useful when the carry trade was about shorting yen and going long higher yielding currencies (notably as you mention, AUD) using enormous leverage, hence the need to monitor volatility. The topic du jour is about borrowing dollars and going long low- or zero-yielding things like commodities, stocks or other low-yielding bonds and currencies, presumably with a much lower leverage. Volatility has become less important, but more to the point, AUD volatility is pretty much irrelevent to the debate.

A more interesting argument comes from David Rosenberg (I actually think he borrowed it, I saw that somewhere else recently):

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April. There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring. Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

Hester: Economic Data Surprises index

I love Mondays. Why? Every Monday John Hussman, maybe the most brilliant mind in the business (let's say it's a tie with El-Erian), publishes his weekly market comment:

The cumulative tally of surprises in economic reports (a metric we credit to Bridgewater, which Bill Hester adapted here), has also turned down decidedly. Though the historical correlation is not always as strong as it has been during the recent downturn, shifts in economic surprises have tended to lead market turns in recent years.

Still, with market internals mixed but not clearly collapsing, prices strenuously overbought but still achieving marginal new highs, and valuations unfavorable but not as extreme as they were in 2000 or 2007, investors may be convinced that there is still a little bit of punch in the bowl

CR: Effect of Fed buying MBS

From Calculated Risk Blog:

It isn't that Fannie and Freddie "can’t sell to an end buyer", it is that the GSEs [securities] will be selling for a lower price (higher yield) when the Fed completes the MBS purchase program. At that time mortgage rates will probably rise by about 35 bps to 50 bps (relative to the Ten Year) in order to attract other buyers. Alone that isn't all that "scary".

The Fed has issued more than a trillion Federal Reserve Notes (otherwise known as dollars) to buy mortgage backed securities. This is is serious currency debasement for 50 bps! However, I believe the total impact has been bigger: for one, it probably has driven Treasury yields lower than otherwise, so even though the effect on the spread is only 50 bps, the effect on the yield must have been bigger. Second, it has increased liquidity in this market and increased confidence (perception) towards the ability of the GSEs to retain their role in the financial system.

But combined with the growing problems at the FHA, the distortions in the housing market caused by the first-time home buyer tax credit, rising delinquencies, the uncertainty of the modification programs, and likely further house price declines in many bubble states - there are serious problems ahead for the housing market.

Click here for the full post.

U.S. GDP Forecast update

Here are my latest forecasts. As a reminder, my model uses only cold hard statistical data. There are no assumptions made here, except for the one that past relationships between leading indicators of the economy and GDP will continue to hold.

One-time unexpected short-term fiscal effects, such as the Cash for Clunkers program, may thus not be captured, and I won't try to make up for it by artificially boosting my model's forecasts. The public demand component is accounted for through other variables, and I do expect my model to capture most of it over the medium-run.

GDP Forecasts:

Next 12 months: 1.5% growth
Q4 2009: 1.1%
Q1 2010: 0.8%
Q2 2010: 1.0%
Q3 2010: -1.3%
Q4 2010: -2.1% (as always, this last one is to be taken with a grain of salt as my model is not made to make forecasts more than 12 months out).

Below is a graph of my monthly GDP forecasts (annualized), along with the 50%, 75% and 90% confidence bands (click to enlarge):

Hulbert: The average gold timer is now more bullish than on each of the past four occasions in which the gold market has topped out.

Full article here.

Leading Economic Indicators Index increases again

I am a big fan of the Leading Economic Indicators, however I like much less the Index of Leading Indicators. The reason is because of the way it is constructed: the weights of each component are designed to smooth out the index (precisely, each one of the weights is calculated as the inverse of the component's volatility). As such, the weights don't reflect the predictive power of the indicators, nor their lead length relationship with the economy.

Secondly, the weights are recalculated each year and the components themselves have changed about once a decade.This invalidates historical comparisons.

Still, I prefer to see a rising Index rather than a falling one (click to enlarge):

Unemployment might be peaking sooner than you think

Although I am more bearish in my GDP forecast than many others (see these posts), I don't believe that should necessarily translate into unemployment peaking in the mid-teens. See this graph (click to enlarge) :

Using this transformation of the data, since the growth in initial claims for unemployment insurance has peaked, the unemployment rate could follow soon. How slowly it will go down is another question.

More on the U.S. Dollar carry trade

Paul Kasriel believes that proponents of the dollar carry trade hypothesis do not have much evidence on their hands:

There is a lot of chatter that global speculators are borrowing greenbacks at bargain basement interest rates and buying higher-yielding assets denominated in foreign currencies. Some have suggested that this dollar-carry trade is creating yet another asset-price bubble. Other than the fact that the U.S. dollar has been depreciating on a trade-weighted basis in recent months, where is the evidence for this dollar-carry trade? In other words, where is this alleged massive bubblicious U.S. dollar credit creation showing up? I will tell you where it is not showing up – on the books of U.S. commercial banks. In the 26 weeks ended October 28, 2009, loans and investments at U.S.- domiciled commercial banks have contracted at an annual (Devil’s) rate of 6.66% (see Chart 1).

Two remarks here: first, the fact that total loans are contracting does not mean that loans for carry trade purposes are contracting as well. It could mean that loans to the non-financial sector are contracting at an even lower pace than that of the total figure. Second, the top U.S. banks hold large amounts of FX and FX derivative exposure (see Reggie Middleton, subscribtion required). Some of this exposure may be off-balance sheet and thus may not appear in the Federal Reserve figures used by Kasriel and be a part of the carry trade story.

A common misconception I would like to address

From a very famous source: "The U.S. trade deficit has been closely correlated to Mortgage Equity Withdrawal (MEW, aka "Home ATM"), and I doubt MEW is coming back soon, so I'm not sure we will see a huge increase in the deficit this time".

While the point about MEW is valid, the current account deficit is always equal to the net borrowing of the nation, not only households. The U.S. government borrowing is and will probably continue to be the driver of the current account deficit this time.

Building permits and U.S. GDP growth

The highest correlation that can be found between building permits and subsequent year-over-year GDP growth is 0.64:

(Note: This is a 15-months rate of change, and Building Permits are advanced 6 months.)

This illustrates one of the missing private demand leg in this recovery.

Bloomberg links: Fed Watch

Fed Faces Biggest Blow to Authority, Independence in Dodd Banking Measure The Federal Reserve faces the biggest blows to its authority and independence in five decades under legislation championed by its lead overseer in the U.S. Senate.

Fed Officials Say Recovery Will Be Slow as Unemployment Hampers Spending The U.S. economy will be slow to recover from the deepest recession since the 1930s as rising unemployment curbs consumer spending, Federal Reserve officials said.

Fed's Lockhart Says Banks' Commercial Real Estate Losses to Slow Recovery Federal Reserve Bank of Atlanta President Dennis Lockhart said the economy will probably recover slowly from the deepest recession since the 1930s because of rising bank losses, especially in commercial real estate.

Equities: short-term caution

Many of the short-term technical indicators I follow have turned bearish in the past few days: market breadth and internals, although having not broken down during the last correction, have not been strong during this week's rally. There were eight up days in the past ten days, and the market is back to a short-term overbought condition.

Since in my opinion, valuation levels do not provide for strong long-term returns, the only case that remains to buy stocks now is that, in the mid-term (a few months), the economic recovery is going to be strong enough to support those lofty profit expectations, but not strong enough that the Fed is going to remove accomodation any time soon. This is a thin line the market is walking. Some call it a bubble.

October Senior Loan Officers Survey

From Asha Bangalore: Improved Picture of Lending Conditions, but Demand for Loans was Weak.

Note: this is a well-made report, however it still belongs to the "less bad news" camp. We're not yet seeing "good" news yet from either supply of or demand for loans.

More on gold (charts)

As I was saying in my previous post, in this gold bull market the metal's price has tended to go up in spikes, followed by long periods of correction and consolidation. If history repeats itself once again (which I believe is the case), gold, which has just broken out of an ~18 months trading range, has recently started a new spike. At which price will it start to correct is anyone's guess (mine is about $1300, but as I said, it's just a guess). Keep in mind that I wouldn't personally start buying here because 1) who knows when the spike will end, 2) the correction is likely to bring the price back to current levels (maybe even below), and 3) the consolidation period is likely to be quite long-lasting. These are the exact same reasons why I'm not trying to trade in an out of this bull market: I'm just holding to my positions. Below are a few charts to support that (click to enlarge)

 

 

 

 

 

Gold is overbought

I have been an advocate of gold as an investment for many years. I allocated the greatest part of my savings to gold in 2003 when it traded below $350 an ounce, and I can't say I regret that decision. I believe gold is still in a bull market, however now may not be a fantastic entry point:

• The Fed is not going to stay on hold forever. Although we are many months away from removing accomodation, Fed officials have already started to discuss exit options. Moreover, Fed balance sheet expansion is probably over (at least for now, until and if we get a second economic leg down). Fedspeak might also become increasingly hawkish as the dollar falls and bubbles develop everywhere (see previous posts). So we may see a short term sell off if and when that happens.
  
• Inflation is not an immediate problem. Fiscal deficits by themselves don't cause inflation, money does. Inflation might become a problem eventually as the money supply has increased quite a lot last year, but since the rate of growth in the money supply has slowed of late, one could still imagine that the money supply will be reined in before inflation pressures develop. I personally don't think that will happen, but that possibility can at some point be priced in by the market, which will not be gold-friendly. Finally, I believe we will see slower than expected growth next year, which will put a damp on inflation expectations (at least for a little while longer).
• Gold is overbought. Just look at any chart: it's overbought by any measure on daily charts and weekly charts. Plus it has closed up almost every week in the past several months, which means it has become a one-sided bet.

Since gold tends to go up in spikes, it might go up another 10% or 20% before it corrects. However, when that happens, it is likely that it will go down back to the current levels, maybe even lower. I already own gold and I'm in for the long-term, so I'm not selling (I'm not trading gold, I'm just sitting with it until I believe the bull is over). However, I wouldn't advise anyone to buy a significant amount of gold right now, and short sellers should be on the lookout for a potential short candidate in the near future.

Updates:
Charts
Hulbert Sentiment Index

November Stock market update

A couple weeks ago I made a case that U.S. equities were overbought and overvalued. We've had a little correction since then, and I've been asked if I think this is the beginning of a sell-off or a opportunity to buy the dip. My answer in a nutshell is: neither.


Stocks (on average, notably if you look at the S&P500) are still overvalued. This, especially in the context of less than goldilocky economic backdrop (see here and here), means that buying at these prices is speculation more than investment.


Furthermore, veteran technical analyst Richard Russell makes a strong case for a deterioration in market technicals (not online):

(1) Far too many distribution days.

(A distribution day is a day when stocks close lower on rising volume.)

(2) The bullish percentage of stocks on the NYSE is declining.
(...)
(5) The Transport Average broke below a preceding decline low October 28.
(6) Sentiment is too bullish regarding the market. Nobody expects this rally to top out and fall apart. Analysts consider it impossible that the March lows will be revisited again. I don't share their opinion.

Well this might not be entirely true: Mark Hulbert's sentiment index isn't showing worrying stubborn bullishness.

(7) My PTI is now only 8 points above its [moving average] and therefore very close to a sell signal.

The PTI is Russell's proprietary stock market indicator.

(8) The Dow, so far, has not been able to close above the 50% level of the 2007-to-2009 decline. The 50% level was 10725.

[10] Whether Lowry's Buying Power and Selling Pressure are spreading apart or coming closer together. Example, if on a given day, Buying Power drops and Selling Pressure rises, the spread between the two widens. That's technical deterioration. Since Oct. 19, the spread between BP and SP has widened by 45 points.

On the other hand, although market internals and breadth have turned a bit weaker in the past couple weeks, they haven't completely broken down in the way I would expect them to if we were on the verge of a nasty sell-off. Plus, in recent days they seem to have stabilized.


In conclusion, my best bet for the short term is that equity indices are going to settle in a trading range and test their recent highs. Whether the highs are bettered remains to be seen, and I am worried that an important top might be in the process of developping. The answer to that story could take weeks or even months to unfold.

Roubini: "Mother of all Carry Trades Faces an Inevitable Bust"

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

(...) Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies.

 http://www.rgemonitor.com/roubini-monitor/257912/mother_of_all_carry_trades_faces_an_inevitable_bust

The current state of the economy

From John Hussman:

One possibility, which is clearly the one that Wall Street has subscribed to, is that the recent downturn was a standard, if somewhat more severe than normal, post-war recession; that the market's recent strength is an indication that it is looking forward to a full “V-shaped” recovery, and that the positive print for third-quarter GDP is a signal that the recession is officially over. Applying the post-war norms for stock market performance following the end of a recession, the implications are for further market strength and the elongation of the recent advance into a multi-year bull market.

The alternate possibility, which is the one that I personally subscribe to, is that the recent downturn was the initial phase of a more prolonged deleveraging cycle; that the advance we've observed in recent months most likely represents mean-reversion – qualitatively and quantitatively similar to the large and often abruptly terminated “clearing rallies” of past post-crash markets; that major credit losses are continuing quietly but are going unreported thanks to changes in accounting rules by the FASB this past spring, which allowed for “substantial discretion” in accounting for loan losses and deterioration in the value of securitized mortgages; that a huge second-wave of mortgage losses can be expected from a reset schedule on Alt-A and Option-ARMs that has just started (following a lull in the reset schedule since March) and will continue into 2010 and 2011; that intrinsic economic activity remains abysmal; that recent GDP growth is an artifact of massive fiscal stimulus that is unlikely to have sustained follow-through; and that recent market valuations are not representative of those observed at the end of most post-war recessions, but are instead similar to those observed at major market peaks prior to the mid-1990's.

GDP forecast update

Here is my updated forecast for U.S. real GDP growth (chart below). My model doesn't use assumptions about any economic variables, the behavior of households, fiscal policy, etc.: it just uses cold hard data. This data in turn is supposed to lead the state of the economy by a few quarters.

A few comments:

• For the next twelve months, real GDP will grow by (1%) 1.1% according to my model. This is much below the consensus.
• Although most comentators have already declared the end of the recession, my model says we could see negative growth in some quarters.
• Don't be too alarmed by the huge drop forecasted for the last quarter of 2010. The model isn't supposed to be able to do well that far in the future (it does best at a horizon of 6 months or so).
  

So I hope my readers will not be surprised by disappointing GDP figures, notably starting mid-2010.

Note: the green bands represent the 90%, 75% and 50% confidence around the central forecast.

See below for back-testing against other forecasters for the 2005-2008 period. The model fares much better when 2008 is included as it predicted minus 2% growth for 2008, while no other economist polled by the WSJ called for negative growth. I called my model VAR(30).

ranking among WSJ-polled forecasters

Firm	Average absolute error (%)		Rank		Excluding 2008 (%)		Rank
VAR(30)		0.52		1		0.57		16
UCLA Anderson Forecast		1.13		2		0.22		1
Merrill Lynch		1.14		3		0.43		7
UBS		1.17		4		0.34		2
The Northern Trust		1.24		5		0.50		10
Lehman Brothers		1.24		6		0.50		11
Standard and Poor's		1.25		7		0.42		4
Vanderbilt University		1.26		8		0.43		6
Perna Associates		1.27		9		0.50		12
Decision Economics Inc.		1.28		10		0.48		8
Goldman Sachs & Co.		1.28		11		0.58		17
Global Insight		1.28		12		0.42		5
Swiss Re		1.32		13		0.51		13
Maria Fiorini Ramirez Inc.		1.35		14		0.54		14
Econoclast		1.36		15		0.36		3
Morgan Stanley		1.38		16		0.95		38
Credit Suisse		1.39		17		0.73		26
Wells Fargo & Co.		1.40		18		0.61		18
Mortgage Bankers Association		1.45		19		0.64		21
Comerica Bank		1.48		20		0.65		22
RSQE, U. of Michigan		1.48		21		0.55		15
Median Survey forecast		1.50		22		0.64		20
FedEx Corp.		1.55		23		0.61		19
The Conference Board		1.55		24		0.71		25
Wachovia Corp.		1.55		25		0.48		9
Barclays Capital		1.58		26		0.69		24
Economic Analysis		1.60		27		0.75		28
Bank of America		1.61		28		0.83		29
High Frequency Economics		1.62		29		0.88		35
Keystone Business Intelligence India		1.63		30		0.85		32
AllianceBernstein		1.64		31		0.74		27
Hanmi Bank		1.67		32		0.87		34
Wayne Hummer Investments LLC		1.67		33		0.67		23
Nomura Securities International Inc.		1.69		34		0.86		33
National City Corporation		1.76		35		0.85		31
Moody's Investors Service		1.77		36		0.94		36
Eaton Corp.		1.77		37		0.83		30
Bear Stearns & Co. Inc.		1.83		38		1.02		39
Deutsche Bank Securities Inc.		1.84		39		1.13		41
Macroeconomic Advisers		1.84		40		0.94		37
National Association of Realtors		2.09		41		1.13		40