This rally looks technically ok - for now

Three weeks ago, I called for the end of the little correction we had experienced in the beginning of the year, and the reason was mostly technical. Today, I cannot find a technical reason to call for the end of this three week old rally: market breadth and internals are quite good (see this post to understand why these indicators should be followed). Sentiment used to be ultra-bullish, which was bearish. It is not anymore. Most of the liquidity indicators I follow have turned up. Volume is lacking, but it has been lacking since the March 09 bottom.

The fundamentals however are deteriorating. Leading economic indicators around the world look toppy, Greece is only the beginning of a multi-year (multi-decade ?) long round of sovereign credit problems, and the financial sector is likely to face renewed troubles due to fading official support and high default rates in commercial and residential real estate (why does everyone thinks that because banks are paying huge bonuses then they must be fine? This is simply flawed logic). Add to this stretched valuations and soon-to-be fading policy stimulus, and voilà! you have a recipe for some choppy waters in risk assets.

But for now, Mr. Market just doesn't seem to care, and the path of least resistance seems to be up.

Hamilton on the Treasury Supplementary Financing Program (SFP)

Warning: geekiness level more elevated than usual.

Hamilton thinks the increase in the SFP is rather surprising given the other "outs" the Fed could use, and it may be part of a broader, still undisclosed strategy. This strategy in my opinion would simply be the unlegislated bailout of Fannie and Freddie.

Question: Obama worries me more than Greece or anything else so far. Let me know if I should change my viewpoint on the guy...

Don't discount Greece yet. It may be a small country, but the domino effect could be severe (remember subprime? it was a tiny portion of the US mortgage market). Obama unfortunately, has no understanding of economics and has been relying on a financial intelligentsia (Bernanke, Geithner, etc.), who were instrumental in getting us into this mess, to get us out of it. The result is that the U.S. is following the footsteps of Japan and its "zombie banks" and dire fiscal situation (not to mention the fantastic moral hazard risk brought on by bailing out bank bondholders). To me the only good news since Obama took office is that Volcker seems to be getting a bigger and bigger voice in this administration. I hope this is a sustainable trend.

"Bond on bonds – disaster ahead"

... in which Barcap's Tim Bond forecasts developed market bond yields to double over the next decade. I tend to agree with that forecast, although Tim Bond and I have completely divergent reasons why.

He thinks an aging population will cause a surge in government debt/GDP ratios, which will increase risk premia. I believe that an aging population lowers potential GDP growth and thus, bond yields as well. I believe that inflation is the one main driver of bond yields in developed markets: cf. Japan, with it's government debt/GDP closing in on 200% (this is much higher than anything forecast for Europe and US in the next twenty years).

However, I am much less confident that the current handling of the financial crisis will not bring a spurt of high inflation down the road. It's not yet in the cards, but avoiding that scenario will require extreme toughness from policy makers - something I have trouble believing in.

By the way, as I have argued in many posts in the past six months, I believe in the near term the risks to bond yields are tilted to the downside: in my opinion, there is still more risk on banks balance sheets than on sovereigns balance sheets, and renewed flights to quality cannot be dismissed. For now.

Stop it with the data-mining, Mr. Rosenberg

I have a lot of respect for David Rosenberg, the chief economist over at Gluskin Sheff (previously with Merrill Lynch). However, I have a lot of trouble reading his daily commentaries because: 1) they're a tad too long, 2) they often repeat, and 3) Rosenberg much too often cherry picks data to fit and prove his preconceived opinion (opinion to which I agree for the most part - the point being I much rather like people forming an opinion out of data and logic rather than the other way around).

As an exemple, Rosenberg recently highlighted the extremely high (0.95) correlation between the S&P 500 and the Copper/Gold ratio over the past three years. Unfortunately, the reason for this is more the fact that the correlation between stocks and both the metals has been very high over that period. In econometrics, this is known as multicollinearity (a violation of regression assumptions), and is typically detected by a high correlation which carries low significance, reflecting inflated standard errors.

Let's look at the data since 1997: the correlation between stocks and the copper/gold ratio drops to 0.55, while the correlation between stocks and copper is a lower 0.37 (the one between stocks and gold is about zero). 0.37 is still statistically significant so we haven't got rid of the multicollinearity problem, but at least now we can overlook it. Conclusion: Copper/gold has a somewhat significant and relatively high correlation with equities.

Mr. Rosenberg, you see, your point was valid. Why did you have to torture the data to "prove" it?

No more accrued interest for us

I'm talking about accruedint.blogspot.com obviously.

This adds up to an already too long list of great bloggers who have stopped blogging in the past couple years or so. Somehow I feel that, although the quantity of finance blogs has been increasing exponentially in the past few years, the aggregate quality has remained constant.

Stupid headline of the day

"Dollar Soars as China Surprises Markets with Reserve Requirement Hike" (source not disclosed out of kindness).

The dollar may be "soaring" (by a full 0.81% !) today, and China may have hiked rates, but the two events are in no way related. You see, when a country has a fixed exchange rate, it has no control over monetary policy: reserve requirement hikes will induce more hot money inflows (looking for a higher return then dollar-denominated money funds, with no currency risk vs. the dollar), which means a higher money supply - since the central bank has to print the yuan needed to be sold to foreigners in exchange for foreign currency so as to keep the exchange rate constant. China has tried to sidestep this with controls on capital flows but everyone knows they are looser than the US-Mexico border. This is econ 101 and is known as the impossible trinity.

What is the relation between this and my saying the above headline is stupid? Because if China is hiking rates, it shows at least an intent, a signal if you will, of tightening monetary policy. But as I just discussed, this can only happen if China lets its exchange rate appreciate.

And that would be everything but positive for the US dollar.

Reversal?

After opening and spending most of the day in the (deep) red, most risk assets, including equities, managed to turn out a small again gain last friday. This is what technical analyst call a "key reversal day", and is short-term bullish. However, the fall of the past few weeks has done a lot of technical damage: supports and trendlines broken, oscillators and indicators rolling over, etc. As such, the technical picture is not yet supportive of a sustained advance. Stay tuned.

Once again, the Baltic Dry and gold prove to be the best early indicators

They may call it "Doctor" Copper, but the metal is, just like other industrial metals, at best a leading indicator of industrial activity, and industrial activity is preceded by changes in financial conditions. The earliest signals of the correction we are experiencing in risk assets have been given by the Baltic Dry index and gold -- peaking in end November / early December, with copper and equity markets peaking more then a month afterwards:

 

Remember this the next time you watch CNBC and hear about "Doctor" Copper.

As an aside, following this logic, equities are not yet ready to stage a sustained rebound.

More on the uncertainty surrounding 2010 GDP forecasts

This is a follow-up to the previous post, in which I discussed the fact that my GDP model produces a very large range of possible 2010 GDP growth, depending on the number of lags (past observations) of the data.

To illustrate this, I backward tested my model to estimate year-ahead GDP growth as of each January since 2003, in what is called "pseudo out of sample" forecasts. It simply means that I put my model in the situation it would have been at the time, and thus, it cannot use data not known as of that moment. For example, for the 2004 GDP growth forecast, only data published through January 2004 can be used.

I had my model produce forecasts using 8 lags (the past 8 months of data) to 38 lags. Then, I calculated the standard deviation of these yearly forecasts:

 

To summarize, what this tells is that the uncertainty surrounding the 2010 figure is about five times larger than usual.

The conclusion: either my model is misspecified (which I don't rule out, but it's been very good on a pseudo out of sample exercise), or, fading monetary and fiscal stimulus, combined with an uncertain outlook for private investment and final demand, makes it very difficult to have a strong opinion on 2010 GDP. And it could of course be both.

2009 GDP Forecast and a thought on 2010

With the first GDP estimate for Q4 released, I can now compare the actual performance of U.S. GDP with my model's forecast for 2009. A picture is worth a thousand words, so here's a chart:

This is what my model would have predicted in January of last year (well not exactly as I am using revised data. I believe if I used vintage data the prediction would have been less accurate, although in the same ball park).

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

Despite improvements in recent months, my model is still calling for (much) below-consensus growth in 2010. However, because of the extremely wild swings the underlying series have experienced, which are due to unprecedented (in the estimation sample) economic dislocations, I am afraid the model could be being stretched beyond its capabilities.

(Technical note:) What is happening precisely is that, depending on the used number of lags of the data, the forecasts can be extremely different. Lags are how many months of data I let my model use: for example, I could use the past 12 months observations of money supply. I had determined previously that 30 months of observations was a good number of lags, but in any case, if I used 12 months, 24 months or 36 months, the forecasts were not very different. This is no longer the case, and it's a big problem.

However, I believe it is also a reminder that 2010 risks being quite surprising to both bulls and bears. It was easy to forecast a recovery last year when the largest stimulus in history was kicking in. It was also easy to forecast the recession (pardon my lack of humility), when the housing bubble popped. 2010 is a much less obvious story: the contribution from stimulus is going to fade and subtract from growth pretty soon, and private demand seems to be recovering extremely slowly.

Quick market update

I am reminded that I haven't commented on the market in a little while, so there it is: market's overbought oversold short term (only about 30% of stocks on the NYSE are above their 50-day moving average), and new highs still overweight new lows, so we're likely to see some sort of rally or trading range, but who knows. Longer term risks are still to the downside due to high valuations, complacency among participants, and underestimated economic and financial risks. And the same more or less applies to most risk assets, which do include gold and the euro.