“The fellow that can only see a week ahead is always the popular fellow, for he is looking with the crowd. But the one that can see years ahead, he has a telescope but he can't make anybody believe that he has it.”
To Will Rogers’ point, telescopes are in short supply these days. Ask an investor what they would have predicted for the XLF three years ago, and chances are their reply wouldn’t have looked much like the chart at the end of this note. The reality is that it’s a natural investor tendency to extrapolate the recent past as the most likely path for the next twelve months of trading. Obviously, the problem with this approach is that it misses big turning points.
Looking at the last three years there have been at least six big turning points in the Financials space. We’re not talking about small rallies or corrections. Being on the right or wrong side of these big moves has made or broken investors’ years.
What’s so interesting to us is that in hindsight they seem to follow a very recurring and seemingly predictable pattern. The XLF peak in 2010, 2011 and 2012 occurred on April 14, February 21 and March 26, respectively. The XLF low for those same years occurred on August 30, 2010, October 3, 2011 and as-yet-to-be-determined, 2012, though no earlier than June 4.
We’ve come up with a framework for thinking about why the pattern seems to rhyme so consistently over the last three years. The foundation of the framework is the distortion of government economic data, which was introduced by faulty seasonal adjustment factors arising from Lehman Brothers’ bankruptcy. The recurring annual effect makes many of the government’s data series appear stronger than they really are from September through February and weaker from March through August. We’ve quantified this effect in the initial jobless claims series, and it is strong enough to create the illusion of both robust recovery in Q4 and Q1 of each year and an economy teetering on the brink of recession in Q2 and Q3. Given that we just entered Q3 on Monday, we think the effect still has a few months to go before predictably beginning to reverse.
The second thing to understand is that central banks play a predictable role in exacerbating this trend. As the data appears to weaken steadily over the course of the March through August period, the calls for QE grow louder. In 2010 this culminated at Jackson Hole with the unveiling of QE2. In 2011 QE-Light (aka Operation Twist) was unveiled in September while the ECB’s large-scale LTRO program came out that December. The takeaway here is that the announcement or start of these massive intervention programs coincides with the turning point in the cycle when the economic data is already beginning to roll from bad to good.
This phenomenon is likely to be with us for the next two years. Government seasonality models work on a five year look back, this being the third year following the incorporation of the original data distortion. As such, we’d expect to see this effect present itself again in 2013 and again in 2014. That said, the effect should become progressively smaller, as the government models weight older years less heavily than more recent years.
There are other factors at play. For instance, May 2010 saw Dodd-Frank roll out – a major Financials sector overhang. 2011 saw the debt ceiling debate culminate in the S&P downgrade of the United States. Additionally in 2011, the large cap banks were plagued by mortgage putbacks and Basel III SIFI concerns; none more so than Bank of America. And, of course, Europe has played a central and recurring role in the last three years. This year it’s a combination of Europe (again) and angst over how punitive the Volcker Rule will be for the large banks.
Looking ahead, the most likely candidate on the radar for the next large-cap bank boogeyman is the rapidly emerging LIBOR scandal. So far it has claimed only Barclays as a victim, as that bank agreed to pay three regulators a total of $451 million in penalties in addition to actually admitting wrongdoing – when was the last time you heard a bank admit that? Specifically, the bank has acknowledged that it deliberately reported artificial borrowing rates from 2005 through 2009. The company’s Chairman resigned over the weekend and CEO Diamond bowed to the pressure to resign this morning. Barclays got a slap on the wrist in exchange for enormous cooperation in helping regulators understand the extent of the wrongdoing. Remember that price fixing is a criminal violation under the Sherman Act, so Barclays was treated with kid gloves. The fear that the large US banks will be treated less favorably is appropriate.
There are approximately $10 trillion in loans tied to Libor and another $350 trillion in notional value derivative contracts linked to the rate. Just one basis point of that notional total, for reference, equates to $36 billion. Early indications suggest that Libor may have been manipulated by as much as 30-40 bps, though this has yet to be confirmed. Any way you slice it, the math is big. Back in the Fall of 2010 we estimated that the mortgage putback fiasco would cost the big banks $49 billion in total, with Bank of America shouldering almost half that amount. Putbacks were the principal concern driving BAC shares down to $4.99 (38% of tangible book value). Given the magnitude of the affected securities in this scandal, it doesn’t seem hard to imagine a class action process that reaches into the tens of billions of dollars, with fears and chatter about “hundreds of billions”. We expect this issue to heat up over the coming 12 months as there are active investigations by the Dept. of Justice into all the large banks involved in setting LIBOR. Domestically, JPMorgan, Citigroup and Bank of America appear at risk.
Perhaps the most important thing to understand is that the big banks have, in the last few years, been overshadowed by one cloud of uncertainty after another: mortgage putbacks, AG settlements, Durbin, Reg-E, Volcker, etc. Until it’s crystal clear to the market how much an issue is going to cost and/or how detrimental it will be to the business going forward, the market shoots first and asks questions later. This Libor scandal fits that mold perfectly: it’s big, it’s as yet unquantifiable and the media is in the bottom of the first inning getting its arms around what’s happened. The numbers that will start to get thrown around will be staggering: “trillions”. Very few investors, as well as the banks themselves for that matter, will have any real handle on what the loss profile may look like. As such, the prospects for the large banks finally achieving escape velocity out of their March 2009 to February 2011 price/tangible book value ranges is unlikely over the next year.
As a final point, it’s worth pointing out where we are in this current cycle. It certainly looks as though 6/4/12 was a possible major turning point. From our vantage point the most glaring difference between this year and the last two years is the level of recorded fear. In both 2010 and 2011 the VIX exceeded 45 briefly and traded for some time above 30. So far in 2012 the VIX has only exceeded 25 on a few days and hasn’t exceeded 30 at all. Considering this emerging LIBOR scandal and that the problems in Europe seem larger today than what we faced in 2011 or 2010, it strikes us as counterintuitive that the market would be less afraid today.
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, Germany’s DAX, and the SP500 are now $1, $92.99-98.53, $81.41-82.31, $1.23-1.27, 6, and 1, respectively.
Josh Steiner, CFA
This note was originally published at 8am on June 19, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“First rule is to be able to play tomorrow.”
That’s what Warren Buffett said on May 5th at the Berkshire Hathaway 2012 Annual Meeting. While you don’t hear him focus the marketing message on risk management like he used to, it was nice to hear him highlight a version of his longstanding Rule #1 of investing – “Don’t lose money.”
The preface to his comment was addressing how early he was telling you to buy stocks during the thralls of 2008. “In October 2008, I wrote that article, should have been a few months later, but stocks were cheap.”
Not to keep score, but it wasn’t until 6 months later that “cheap” stocks got a lot cheaper. I’m not Buffett. I am just a small town Canadian who has never received a bailout dollar and would rather retire before accepting one. I went to 96% Cash in Q3 of 2008 and 91% cash yesterday. I may not be the best player in this game, but I will Play Tomorrow.
Back to the Global Macro Grind…
With the SP500 recovering from its early session lows yesterday, US Equity Volatility (VIX) dropped -13.2% on the day and the US stock market moved to a 3 week closing high.
Was it a bird, a plane – or another iQe4 upgrade rumor? Could it be Geithner, Bernanke, or Obama? Sadly, being able to Play Tomorrow also requires an acute sense of hearing. Can you hear the bailout whispers now?
No one ever went broke booking gains, so instead of joining the circus, that’s what I’ll continue to do across asset classes on up-moves to lower highs. I’m not getting wacky net short. I’m just getting out.
After yesterday’s sales of the US Dollar, German Bunds, US Treasuries, Cattle, and Pigs (the COW ETF), here’s where the Hedgeye Asset Allocation Model stands for this morning’s US open:
- Cash = 91% (up from 61% yesterday)
- US Equities 9% (all Consumer Staples – XLP)
- International Equities = 0%
- Fixed Income = 0%
- Commodities = 0%
- International Currencies = 0%
Why sell everything other than US Equities (I might sell those this morning too)?
A) I have absolutely no idea what Bernanke (Fed) and Geithner (Treasury/IMF) are going to do next
B) If you gave me the whisper (inside information), I wouldn’t know what the market’s reaction would be to it either
That, in a nutshell, is also why I’m going to stop hiring for the next couple of months.
You see, I not only run my mouth, but I run my own business. I backstop the company’s credit line. I know what meeting a payroll meant during the thralls of 2008, and I’m not going to be the greater fool rolling the bones on my firm and family’s future for the sake of other people’s short-term political pressures now.
But that’s just me.
I know there are many more important people in many higher places in this country that need to get paid. I’m not the only person who gets that. So have at it boys, centrally plan away.
President Obama is no one’s fool. His economic advisors have reminded him that if he gets the short-term moves in the stock market right, he’ll get the election right. In this morning’s Hedgeye Election Indicator (Chart of The Day), you can see that:
- Obama’s odds of re-election bounced by +200bps week-over-week to 56.1%
- Obama’s odds of re-election are now at their highest level in nearly a month
- Obama’s odds of re-election are still down, hard, from their peak (March 26th) of 62.3%
Obama gets this. If he has his boys continue to debauch the US Dollar in the short-term, both commodities and stocks will like that. The People will have to take that in the pump, but that doesn’t really matter – because Bernanke says that’s “transient.”
Something else (that was not so funny) also happened on the way to the US Political Forum on March 26th. Both the Russell2000 (broad measure of US stocks) put in its YTD high and the US Equity Volatility Index (VIX) put in its YTD low.
Which begs the question– why am I not at 96% Cash again?
At 18.22 the VIX is immediate-term TRADE oversold at another higher-low. At 1344 and 772, the SP500 and Russell2000 aren’t yet immediate-term TRADE overbought. But they will be today. Both are also making lower long-term highs (on no-volume).
No Trust; No Volume. So we’ll see what this morning brings. Either way, and no matter what they throw at us next, we will be positioned to Play Tomorrow.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1617-1640, $95.07-98.26, 81.59-82.16, $1.24-1.26, and 1324-1348, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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TODAY’S S&P 500 SET-UP – July 3, 2012
As we look at today’s set up for the S&P 500, the range is 36 points or -2.09% downside to 1337 and 0.55% upside to 1373.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: on 07/02 NYSE 1255
- Down from the prior day’s trading of 2281
- VOLUME: on 07/02 NYSE 736.11
- Decrease versus prior day’s trading of -32.74%
- VIX: as of 07/02 was at 16.80
- Decrease versus most recent day’s trading of -1.64%
- Year-to-date decrease of -28.21%
- SPX PUT/CALL RATIO: as of 07/02 closed at 1.65
- Up from the day prior at 1.35
CREDIT/ECONOMIC MARKET LOOK:
TREASURIES – the bond market doesn’t have to chase performance like the entire equity community seems to; Treasuries saw yesterday’s ISM bomb (49.7 June vs 53.5 in May) for what it was #GrowthSlowing; that’s our only big Macro long position right now – long the Long Bond (TLT).
- TED SPREAD: as of this morning 37
- 3-MONTH T-BILL YIELD: as of this morning 0.09%
- 10-Year: as of this morning 1.60
- Increase from prior day’s trading at 1.59
- YIELD CURVE: as of this morning 1.31
- Up from prior day’s trading at 1.30
MACRO DATA POINTS (Bloomberg Estimates):
- 7:45am/8:55am: ICSC/Redbook retail sales
- 9:45am: ISM New York, June (prior 49.9)
- 10am: Factory Orders, May, est. 0.1% (prior -0.6%)
- 11:30am: U.S. to sell 4-week bills
- 4:30pm: API inventories
- 5pm: Total Vehicle Sales, June, est. 13.9m (prior 13.73m)
- 5pm: Domestic Vehicle Sales, June, est. 10.87m (prior 10.75m)
- House, Senate not in session
- President Obama returns to White House from Camp David
- IMF issues statement for annual report on U.S. economy, 10am
WHAT TO WATCH:
- Barclays CEO Diamond Quits After Record Libor-Rigging Fine
- Regulators Grappling With Libor Probe Said to Seek More Time
- Banks required to submit so-called living wills to FDIC, Federal Reserve by yday, summaries available by today: JPM, BAC, C, GS, MS, BCS, DB, CS, UBS
- SEC’s Schapiro has deadline of today to respond to House questions on Facebook IPO
- Microsoft writing down $6.2b after AQuantive deal struggles
- U.S. June auto sales: June SAAR could match May’s 13.8m pace
- Fiat to Raise Chrysler Stake to 61.8% in Push Toward Full Merger
- Ireland Plans Market Return With EU500 Million T-Bill Sale
- Boeing Sees Jet-Market Growth Slowing as Jumbo Demand Dwindles
- Slovenia Heads for Sixth Euro Bailout Request to Aid Banks
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
- France Beating U.S. in Wheat Exports After Drought: Commodities
- Europe Burns Coal Fastest Since ’06 Boosting U.S., EON: Energy
- Gasoline Set for $3 Fuels Obama Election Defense: Energy Markets
- Commodities Advance to One-Month High on Stimulus Speculation
- Oil Rises on Global Stimulus Speculation, Iran Supply Concern
- Copper Reaches Seven-Week High as Central Banks May Add Stimulus
- Japan May Reduce LNG Spot Purchases in July on Surge in Price
- U.K. Natural Gas Advances for a Third Day as Dutch Flows Decline
- Saudi Arabia Set to Cut Extra Light Oil Premium to Heavy Crude
- Sugar Rises on Speculation Supply Will Be Limited; Cocoa Gains
- Deutsche Bank Cuts Oil-Price Forecasts on Demand Outlook
- Silver Futures May Rise 25% on Double Bottom: Technical Analysis
- New Life for North Sea Oil Hinges on Coal Gas in $8 Billion Bet
- Tanker Glut Expands as U.S. Drives Billion Fewer Miles: Freight
- Oil Rebounds on Stimulus Speculation, Iran
- Gold Climbs on Speculation Central Banks to Seek to Spur Growth
- Corn Rallies as Heat Wave Hurts Crop Conditions Across Midwest
EURO – this $1.25 line is an important one to keep your eyes on; we’re either going to see another drop to $1.23 or a rip to $1.27 – either should happen in a hurry. We have no idea what the next central planning catalyst is, but clearly bailouts are the new bull case.
GERMANY – the DAX and MIB Indexes look like better shorts than Spain’s IBEX right here and now. We aren’t short either, but may be by day’s end as both the DAX and MIB are testing my intermediate-term TREND lines of 6581 and 14,498, respectively. We’d like to see them both fail there before we move.
The Hedgeye Macro Team
President Obama’s chances of being reelected in November climbed 1.3% week over week to 57.6%. What this election will boil down to is twofold: the outcome of the current crisis in the Eurozone and the performance of the stock market heading into November. This is the third consecutive week of an uptick for President Obama. Globally interconnected risk continues to live on and will remain a dominant theme in the months to come.
Hedgeye developed the HEI to understand the relationship between key market and economic data and the US Presidential Election. After rigorous back testing, Hedgeye has determined that there are a short list of real time market-based indicators, that move ahead of President Obama’s position in conventional polls or other measures of sentiment.
Based on our analysis, market prices will adjust in real-time ahead of economic conditions, which will ultimately shape voters’ perception of the Obama Presidency, the Republican candidates and influence the probability of an Obama reelection. The model assumes that the Presidential election would be held today against any Republican candidate. Our model is indifferent toward who the Republican candidate is as the sentiment for Obama and for any Republican opponent is imputed in the market prices that determine the HEI. The HEI is based on a scale of 0 – 200, with 100 equating to a 50% probability that President Obama would win or lose if the election were held today.
President Obama’s reelection chances reached a peak of 62.3% on March 26, according to the HEI. Hedgeye will release the HEI every Tuesday at 7am ET until election day November 6.
Growing SNAP participation has been a significant tailwind for dollar stores over the last 5-years – that is likely to change by year-end. For this and other factors, we've been growing incrementally more bearish on both DG and FDO.
Since 2007, Supplemental Nutritional Assistance Program (SNAP) - aka the federal Food Stamp Program participation rates have jumped 6pts to a 30-year peak at 15%. However, more notable is the slowing rate of participation growth. In fact, given the current rate of average sequential deceleration over the last 12-months of ~0.6%, SNAP participation growth will turn negative starting January 2013. Not good for the dollar store players (DG, FDO, DLTR) that are sitting at peak margins.
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