Friday, November 12, 2010

We've Been Here Before

    As Citigroup outlined several days ago, the trend following QE announcements has been for the dollar to strengthen and Treasury yields to rise. Since QE2 was announced last week, the dollar has risen by about 2.5% and 10-year yields have risen about 7 basis points. Although a weakening dollar and falling yields are widely viewed as bullish for the stock market, the opposite action has not materially weakened the current rally. Despite claims that the market is failing to appreciate positive economic news any longer, today offered an example of the opposite.
   Last night, Cisco (CSCO) made public the results of their most recent quarter and offered guidance for the coming quarter depicting significant weakness in sales and profits from expectations. For years, Cisco has been considered a bell weather of the tech sector, providing a valuable gauge on the outlook for general tech spending. Cisco's highly regarded CEO, John Chambers, is also well known for his honest but generally optimistic forecasts. Yesterday on the company's conference call, Chambers said the company faced a "challenging economic environment" and noted the "competitive landscape is getting more intense." These comments combined with an earnings estimate nearly 20% below estimates for the next quarter sent the stock down nearly 17% on the day. Disney also reported earnings today and did so surprisingly (by accident?) during market hours. Disney's earnings and revenue both came in below expectations causing the stock to sell off 3% on the news. Although Cisco witnessed its largest drop in 12 years and Disney reported weak numbers, the overall market managed to hold losses below 1%. This may be good news for stocks, however, for investors who believed volatility and risk were subsiding, Cisco proved that an earnings miss from a large cap corporation can still have devastating effects.
   It appears a primary reason the market has maintained recent gains in the face of a strengthening dollar has been the even more impressive resilience in the commodity markets. Recent news from China showed that inflation was rising faster than expected and although China is nearly certain to continue raising rates and reserve requirements, it appears many investors doubt the nation's ability to truly slow consumption or inflation in the near future. Unsurprisingly, QE2 has sparked dramatic gains in gold, silver, copper, many other metals and raw commodities alike. As these prices continue their upward momentum, so goes stocks of commodities and materials companies.
   While these stocks may retain current upward momentum, it's important for market participants to remember the simple fact that in any market there is a buyer and a seller. I mention this because in order for companies such as Freeport McMoran Copper & Gold to lock in profits from the higher prices of commodities, the company must be able and willing to sell their goods at current prices. However, on the opposite side of the sale is another company being forced to pay higher prices for the same goods. The purchasing company will either face reduced margins due to higher costs or possibly pass along the price increases to the end consumer. In the latter scenario, the consumers' available funds for purchasing other goods is reduced, lowering revenue for firms in other sectors. While this is a very basic overview on the effects of rising commodity prices, it offers a convincing explanation of why forever rising commodity prices will not in itself support higher market valuations. 

A Look to the Past
  Let's take a moment and think back to the beginning of April this year. Following a correction in equity markets that bottomed on February 5th, the Dow, S&P and Nasdaq rallied sharply for the next two months each gaining more than 10%. As April began the Dow stood at 10856.63. Also of note, the dollar index closed at 81.073, the VIX was at 17.59 and yields on 2-year Greek bonds sat at 5.119%. At the time, analysts and investors were overly bullish on the prospects for continued gains in the market and envisioned 3-4% GDP growth or better in the U.S. for the foreseeable future.
   Everything seemed to be moving in the right direction, but then news began to circulate about Greece's hidden debt and the potentially dire state of their government financing. Over the next several weeks, the yield on Greek 2-year bonds steadily rose to just above 7%. Even with the yields and corresponding CDS (credit-default swaps) on Greek debt rising, most market participants believed the chances of Greece defaulting were remote and even if it were to occur, the country was too small to have much impact on the U.S. Given this outlook, stocks rose another few percent while the dollar held steady and the VIX fell below 16. As debate over the true depth of Greece's budgetary problems continued, the market for Greek bonds took a turn for the worst on April 22nd. That day, Greek bonds feel dramatically, pushing the yield on 2-year notes above 10%. Once again, the impact of this sell off on other markets was muted. Heading into the weekend, the Dow rested above 11,200 at a new 52-week high. 

   As markets reopened after the weekend, selling pressure on Greek bonds continued in earnest, sending yields soaring to nearly 16% by the close on Wednesday, April 28th. For the first time, concerns about a potential Greek default began to infect other markets as the VIXDXY) rose 2.5% to 84.45 and the VIX doubled to close at 40.95. Most stunning was the Dow's drop from a close of 11,151 on May 3rd to 10,380 on May 7th, which included the "flash crash" drop of 1,000 points in a matter of minutes on May 6th. 

   Acknowledging the severity of the situation, over the weekend the ECB announced plans to effectively bailout Greece through an extension of loans. The markets responded with exuberance as Greek yields fell more than 10%, the VIX dropped 30% and the Dow rallied nearly 4% on Monday, May 10th. Currency markets didn't respond as positively to the ECB's plan and over the next month the Euro would fall below $1.20 against the dollar, sending the dollar index to its one year high above 88. Since then the ECB has put in place further backstops for Greek debt, while Greece has established numerous austerity measures to reduce budget deficits. Despite all these actions, the yield on 2-year Greek bonds still sits above 11% today and default remains a real possibility for the future.

   Now let's turn to the recent worries of an Irish default in the near future. These fears crept up in mid-October while the yield on 2-year Irish bonds stood at only 3.52%. As a reference, on October 14th, the dollar index was at 76.647, the VIX was below 20 and the Dow was at 11,095 in the midst of a two-month (or more?) rally. Over the following three weeks, Irish yields rose to over 4.3% but other markets mostly shrugged off any potential effects from an Irish default. However, a week ago, yields on Irish 2-year notes jumped to nearly 5% and have continued rising ever since. While the Fed may have announced another $600 billion in quantitative easing, growing concern over Irish debt has pushed the dollar index up 2%. After closing at a new 2-year high of 11,444, the Dow has fallen off slightly the past week. The ECB is currently working out a plan to avoid an Irish default, but in the meantime it appears likely that Irish yields will continue their rapid rise. Most notably, the ECB has suggested that part of an Irish bailout would require bond holders to accept some losses in any restructuring. This is a significant divergence in the post-Lehman era, where bondholders have consistently been made whole, and may spark even greater fears. 

   Today, market participants are again ignoring the Irish crisis, presuming the country is too small to materially impact the U.S. If the experience of Greece taught us anything, it's that fear can spread extremely quickly and exceed most people's expectations. As I look ahead to the following couple weeks and potential impact of Irish sovereign default fears, I'm constantly left wondering, haven't we been here before?

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