Making short-term predictions about equity markets is mostly a mug’s game, while making very long-term forecasts is relatively easy. The problem thus becomes the medium-term (i.e. one year) outlook. And this medium-term outlook for US equity markets is, today, as hazy as we can remember it.
As all of our readers know, we experienced a somewhat vicious correction this summer. And, this summer’s correction was very different from those experienced in recent years. Indeed, corrections from 2003 through 2006 were related to inflation expectations flaring up, causing the bond market to get a little ragged and the market to worry about future rate hikes from central banks. The August correction, in the wake of the sub-prime crisis, felt to us a lot more like a “growth scare”. And, sure enough, the US has been slowing for over a year, under the weight of the housing downturn. This summer, it became clear that other G-7 economies were also slowing:
With the growth slowdown, we suspected that the markets would go through some kind of “de-leveraging” process and that, consequently, at least as far as “developed” markets were concerned, the near-term upside would remain limited to previous highs. We wrote as much earlier this summer. We explained that the surge in net margin debt was putting the market in a precarious position and, quite possibly, risking a liquidity disruption (or, even worse, a full-blown crisis).
1-The Market Levers, and Delevers
Let us explain what we mean with a few charts. In the chart below, net margin debt simply represents margin debits minus margin credits. When net margin debt rises, it means that investors are levered long. Off the summer 2006 lows, the market staged a fantastic move—on the back of a lot of leverage. In fact, the only time we have ever witnessed such an increase in leverage was following the LTCM low in 1998 that extended into the March 2000 peak and into the NASDAQ peak.
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Net margin debt has dropped from $80 billion to zero in the last month.
Unfortunately, in the last month, net margin debt has gone from positive US$80 billion to zero. The last time we witnessed such a rapid drop was in the fall of 2000, as market participants gradually realized that the economy was heading into a recession, and as banks tightened credit available to corporates.
Yet, interestingly, despite this massive deleveraging, US indices are still close to all time highs. So who is doing all the buying? One possible explanation is that, along with the deleveraging, we have seen a big drop in the amount of shares sold short on the NYSE. In other words, people are simply curtailing their books (reducing the leverage and buying back their shorts). The chart below shows the number of shares short against the monthly volume of the NYSE. This possible explanation is further confirmed by the big drop in volume.
To cover their shorts,
short sellers have been buying stock from the guys who are selling
to reduce their margin positions…
This is not a backdrop of strength—but it will set up a better buying opportunity.
The internal market dynamics seem to point to a situation where investors have been buying back stocks to cover their shorts from investors selling stock to reduce their margin positions. This is hardly a backdrop of strength, though it is a cleansing process which should set up a great buying opportunity.
2-So What Now?
The SP500 reached old-time highs of approximately 1550 on October 11 but, since then, seems to have begun a new down leg. Interestingly, on or around that day, the liquidity environment made a negative reversal, too. This raises the question: Are we now entering a second phase of a liquidity contraction? A number of liquidity indicators are, unfortunately, pointing that way.
First, in recent weeks, the Euro/Yen cross peaked and reversed.
The Euro/Yen cross recently reversed.
Secondly, commercial paper spreads are once again widening between financial and non-financial paper.
Commercial paper spreads are widening again.
Thirdly, it looks like the VIX has begun another spike and is dragging with it credit spreads. Note the upturn in BAA spreads in the last few weeks.
The VIX has spiked.
Fourthly, swap spreads are widening back out again as well.
Swap spreads are also growing.
We also like to look at the relative strength of the SP500 against the VIX for a feeling of risk/reward, and we feel more confident when the SP500 rises relative to the VIX. Unfortunately, on this ratio, we seem to have entered another down leg here.
While we prefer to see the S&P 500 rising relative to the VIX,
it has fallen through its moving averages again.
Worryingly, we can also observe a deterioration in the breadth of the market, as this second-wave liquidity setback started to hit two weeks ago. Here we see NYSE net advances, 20-day moving average having fallen from near 400 back to around 100.
NYSE net advances have fallen to 100 from 400 in just a couple of weeks.
The NYSE cumulative net advancing volume shows the same pattern.
Advancing volume is also weakening.
Another signal we do not like is a divergence between the trend in the CBOE put/call ratios and the VIX. Such a divergence started to appear a couple of weeks ago, and this gave us pause. A rising VIX and falling put/call ratio is a warning sign, and the gap usually closes with the put/call ratio moving. Sure enough, in the last couple of weeks, the turn in the VIX has finally caused the put/call ratio to reverse.
Warning: The VIX is rising, while the put/call ratio is falling.
If we bring together the trend of the put/call ratio and the SP500, we come up with the chart below. In the chart, we also draw a trend-line of the put/call ratio and one standard deviation lines around that trend. The put/call dipped through one standard deviation on the downside and has now reversed.
In fact, the put/call ratio recently fell more than one standard deviation from its
historical trend. (It has since rebounded slightly)
3-From the Markets to the Real Economy
With the surge in MZM in the last few weeks, it is hard to argue that money isn’t plentiful—the problem is that it may be more difficult to come by (this has happened time and again in Japan over the past 15 years). With that in mind, we worry that disruptions in the credit markets are working their way into the real economy. Housing, the epicenter of concern in the US, looks like it has been negatively affected by the credit markets. Last week we got the latest NAHB survey results and data on existing home sales was released today. These charts show that the housing slowdown is accelerating on the downside, catalyzed by concerns in the mortgage market.
While money may be plentiful, it is certainly not as accessible as it once was.
Concerns in the mortgage market are contributing to the deterioration in the US housing market.
Concurrently, oil prices have risen through $85 a barrel and there are still more questions than answers with respect to how and when SIVs will be rescued. This, no doubt, is related to the huge foreign selling of US assets in the last month.
Rising oil and uncertainty contributed to the large drop in net foreign security purchases.
And, despite a 50 bp cut in rates, we still don’t see the FED working very hard to stimulate the economy. In fact, on a one quarter annualized rate of change basis, the monetary base—in nominal terms—is basically not growing.
And the FED hasn’t done much more to get things going—
growth in the monetary base is nearly zero
.
As we have said, inflation is about the last thing we should be worrying about right now. With the 10-year bond yields breaking out on the downside today (4.31% as we write), the bond markets are obviously increasingly concerned with growth.
Yields continue to fall, raising further concern about the US economy’s capacity to grow.
The markets appear to have finally realized the growing risk to the economy…
It seems that a second wave of the liquidity crisis may be unfolding. Perhaps we are simply overreacting after this summer’s challenging and testing times. Nevertheless, as far as developed equity markets are concerned, we would rather put some powder on the sideline until new highs are decisively broken.
Are we facing a second wave in this liquidity crisis?
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