Friday, October 29, 2010

The 'new normal' rolls on

   While the stock market has been relatively tame the past couple days, the same can't be said for other markets. The Treasury markets recent slide was abruptly reversed this morning when Goldman Sachs announced that the firm expects the Fed to include the purchase of 30-year notes in QEII. This is the first major mention of QEII including purchases of the long bond, which is surprising given its timing and differentiation from recent reports. Considering the WSJ report the other day and now Goldman's take, the potential range and make up of QEII appears to be rapidly expanding only days before the announcement. The 30-year yield ended the week just below 4%, while the 3, 5and 7-year yields finished much lower than their auction yields earlier in the week.

   The big economic news of the day came pre-market as well with the preliminary announcement of 3rd quarter GDP. As expected, GDP in the 3rd quarter grew at a modest 2% clip. Other important pieces of news within the announcement were a 2.6% increase in consumer spending and a core CPI increase of only 0.8%. The consumer spending number while the most positive of the recovery, remains muted compared to pre-recessionary levels. As for inflation, despite the down tick, the U.S. remains in an inflationary world. This is an important consideration when comparing the actions of Japan in a deflationary environment versus the U.S.'s low inflationary position. Separately of note, as long as inflation remains around 1%, bond holders earning less than inflation on 2 and 3 year maturities continue to face real losses. On the whole, those who have predicted a 'new normal'  of 1.5% to 2% GDP growth continue to hit the mark.

   Touching on a few specific stocks making interesting moves, Microsoft reported better than expected earnings after the close yesterday. After opening up about 4%, Microsoft drifted into the close with a gain of a bit over 1%. Just two weeks the stock was facing numerous downgrades as it lagged the market, but since it has rallied over 10%. Looking at tech, IBM played a major role in holding the Dow positive, as it surged over 3% to a new 52-week high. There was little news backing this move and IBM has now erased its earnings related losses. I also want to briefly note the 3M disappointment yesterday morning which has cost the stock around 7%. Most notably the company stated growth in the U.S. and Europe was unimpressive. Given the company's earnings are expected to grow around 9% a year and the stock was trading at a P/E of 15 times next year's earnings, further sell off may be warranted. One last note on 3M, it stands out as one of only a few companies to disappoint and garner some media/market attention. (Maybe a telling sign of widespread optimism)

   While America focuses on the midterm elections and Fed meeting, there has not been a lack of news overseas. On the European front, this morning the EU announced that in September unemployment hit a new 12-year high above 10% and the pace of inflation picked up in October, rising 1.9% from a year ago. Rising inflation in the wake of high unemployment will put the ECB in a very tough position going forward. Meanwhile, CDS spreads on the PIIGS continued their recent rise unnoticed. As for Japan, the Yen rose to its highest closing price ever against the dollar putting further pressure on the economy. Few people today talk of the yen carry trade that aided global growth and rising prices for much of the previous decade. A cautionary note would be to consider the effect of the weaker yen on equity prices and the economy in Japan during that period. Considering that the majority today believe an ever weaker dollar will buoy stock prices and the economy in the U.S., Japan's experience shows that conclusion may not be definitive. While troubles abroad may still be resolved, if the EU and Japan continue to struggle, it will certainly put a cap on global growth for the next several years.

   Next week finally brings some answers to the questions that have been lingering in the markets for a couple months now. Although the near unanimous consensus is that resolution will send the market higher, I worry that the answers may only lead to further questions. If the Republicans win at least one house, how will we respond to structural issues amidst a political stalemate? How long will it take to prolong the Bush tax cuts and what will be extended? If Republicans control both houses, will government spending be slashed at a time when the economy remains weak? If the Fed announces QEII with room for future increases or extensions, will those become assumed as future certainties? How long will the Fed continue pumping liquidity into the economy? Will their actions have any impact?

   From my perspective, the real questions may only begin next week and answers may still be far off in the distance. Therefore, volatility may not decline as the masses expect and movements in various markets may very erratic into year's end.

Wednesday, October 27, 2010

Bond Bull Comes to an End

   This morning investors were greeted by some unwelcome news published in the Wall Street Journal. Fed Gears Up for Stimulus, by Jon Hilsenrath and Jonathan Cheng, suggests the upcoming QEII is likely to result in an initial purchase of Treasuries "worth a few hundred billion dollars over several months." For weeks now the generally accepted guess was that an initial announcement of $500 billion was the absolute minimum. The range of predictions, while is primarily clustered around $1 trillion, reached $2 trillion on some accounts. Much of the discussion also revolved around the potential for further "shock and awe" were the Fed to deviate from expectations. The WSJ report has induced greater uncertainty in the markets as we await the official announcement next week.

   As markets digested the news this morning, the dollar continued its recent rally, sparking selling in stocks, commodities and bonds. The durable goods orders, expected to offer positive news, came in above expectations on the headline number. However, excluding transportation, orders actually fell 0.8% in September, coming in well below expectations. As CNBC noted this disappointment, the stock market drifted lower throughout the morning. (Side note: At the market close, CNBC reported that a better than expected durable goods report helped offset weakness from a dollar rally. The multitude of ways each economic report can be broken down does wonders for a media required to explain the markets move each minute of the day.) When the dollar index (DXY) rallied above 78 mid-morning, all other assets sold off dramatically (Dow down 150, Gold down $20, Oil down $2). The VIX surged higher coincidentally by nearly 10%, coming within blows of its 200 day moving average around 22.4 (VIX fell below 18 on 10/13). As the afternoon rolled along, strength in tech rallied the Nasdaq to a positive close, pulling the Dow and S&P back to only minor losses on the day. The strength in stocks continued a recent divergence from dollar strength, which also closed slightly off its intra-day peak. Meanwhile treasuries continued their recent, dramatic sell off as the 10 year yield ended above 2.7% and the 30 year yield moved above 4%.

   The recent sell off in treasuries has practically erased all previous gains since the prospect for QEII was made clear by Ben Bernanke in a speech at Jackson Hole back in August. Surprisingly, the sell off has actually come in advance of QEII, for which the primary intention is to drive down long-term interest rates. Most notably today, the "Bond King", Bill Gross declared in his November investment outlook, Run Turkey Run, an end to the 30-year bull market in bonds. After some poignant comments on politics, Gross explains that while in the short-run the Fed can drive bond prices higher, ultimately inflation and real negative interest rates erode any value. Although many others in the investment community will surely disagree with Mr. Gross' conclusion, his theory is certainly worth contemplating.

   If the bond market's bull run is officially dead, it will be important to understand the potential ramifications on investment decisions going forward. Given the extreme sum of money that has been shifted to bonds over the past couple years, a consistent rise in rates may force many investors to question their portfolio allocations.  Initially funds may be shifted back to equity markets pushing valuations higher. However, just as lower yields imply higher earnings multiples, higher yields will shrink multiples going forward. Many other questions will also be answered in time...

   Given being long bonds is a crowded trade, will consistent selling inspire further position reductions and potentially panic selling? If panic selling took hold, would the Fed step in again and potentially extend its duration in purchases? How will rising rates affect an already weak housing market? If the Fed holds short-term rates near 0% while yields on lengthier maturities rise, will the steepening yield curve benefit banks? Or will banks, currently heavily invested in bonds, face significant investment losses due to rising rates?

   A related investment idea to close on is Annaly Capital Management, Inc. (NLY). Annaly's basic business is borrowing funds at the short end of the yield curve, purchasing Agency MBS and earning the spread in yield. The firm uses swaps to hedge their interest rate risk and a quick read through commentary on their website reveals impressive knowledge of the real estate markets they trade in. The company reported earnings after hours today and the stock dropped several percent following the report. A noticeable weakness in the report was the reduced spread being earned due to the flattening yield curve in recent months. However, with the Fed expected to hold the short end near 0% indefinitely, and potentially rising yields on the long end of the curve, Annaly will likely see increasing spreads going forward. Also, the stock pays out most of it's earnings in dividends and currently yields around 15%, which may prove special in a low-return environment.

Disclosure: No position in NLY.

Tuesday, October 26, 2010

Starting at Neutral

Hello! This is my first blog, so without knowing where to start I figured I'd jump right in...

My intention for this blog is primarily documenting the wide range of thoughts and questions about financial markets and the economy that drift through my mind on a daily basis. If by doing so I manage to answer these questions in time or provide insightful trading ideas, then my goals will have been achieved as well. Along the way I will offer links to insightful articles that have either helped shape my current thinking or, ideally, answer any of the multitude of questions presented. Before I get going, let me also provide a brief background on myself...

At an early age, as part of a gift from my grandparents, I received my first shares of stock: 7 shares of Disney and Coke. Intrigued, I read about and followed the stock market through its rise and fall in the dot-com bubble. During college I studied finance and economics while dabbling in the markets as a small time investor. Internships provided previews to the worlds of day trading, hedge funds and financial advisors. After college, I initially worked for an options market making firm, where I was afforded significant capital for trading and gained insight into high-frequency trading. Then the Great Recession hit and my career path completely changed course. Now, as a part-time graduate student and full-time analyst in the financial industry, my mind is consumed and amazed by the previously unthinkable events witnessed in financial markets and the global economy over the past 2 to 3 years. (Given my current job, I feel compelled to state that any and all comments, opinions or recommendations solely reflect my own personal views and are in no way connected to my employer.)

Today -
   With one week remaining until the eagerly awaited Fed meeting and Congressional elections, U.S. stock markets have maintained or held on to their significant gains over the past 7-8 weeks. Assumptions of $500 billion to $1 trillion in QE2 and Republicans garnering control over the House, and possibly Senate, have created an ideal backdrop for stock market optimism. Combined with near record low interest rates, a weakening dollar, better than expected Q3 earnings, the sweet spot of the presidential cycle and numerous technical bullish indicators, it's no wonder why most investors share David Tepper's recent view that investing in stocks is "win-win."
   The past week, and most noticeably today, impressively strong correlations between markets have started to break down. The dollar, which appears to have set a near-term low on 10/15, rallied higher by nearly one percent. Treasuries followed suit, selling off throughout the day and leaving the 30 year yield pushing on resistance at 4%. However, after selling off strongly in the pre-market and at the open, stocks and commodities rallied back to ultimately finished flat or even higher on the day. Considering these trends over the past week provides further insight into the specific decoupling of the stock market. While the dollar has rallied 3-4%, bonds, gold and oil have all sold off by several percent. Surprisingly to some, stocks have seesawed between failed breakouts and corrections, resulting in small gains across the indices. Although the correlation between markets has been running at historic highs and could simply be reverting to the mean, further strength in the dollar will likely warrant caution in the equity markets.
   The strength in stock markets today appeared most influenced by better than expected consumer confidence and IBM's announcement of a $10 billion stock buyback plan. Although the headlines read positive, both reports should be considered in context. Consumer confidence moved up slightly from the previous reading, a seven-month low, but the outlook for jobs actually weakened. As for IBM's buyback plan, the stock is currently trading at an all-time high and it's important to recall that firms don not have a particularly good track record in terms of buying back stock. Ultimately, fear of being short or missing a fed-induced rally may provide short term protection on the downside.
   Although the election results are important, the Fed's imminent decision and announcement of QE2 will likely have far greater ramifications for markets in the near term. The debate over the necessity and outcome of QE2 has been ongoing for quite some time, however, Bernanke Leaps into a Liquidity Trap by John Hussman of Hussman Funds ( provides several interesting new considerations.
   Looking forward, the implications of Hussman's analysis provide some pertinent questions. If QE2 simply reduces the velocity of money and fails to create an increase in aggregate demand, is the stock market overvalued? How long can market distortions created by QE2 last in the face of continued weakness in the economy? Knowing the history of Japan's failed attempts at QE, why is the U.S. convinced the same flaws will not arise? Shiller's P/E has often provided reasonable medium and long-term investing guidance...will the current high value correctly predict sub-5% returns for the next decade?

   These questions will only be answered in time, but my money remains cautious at the moment...