After the -56% drop in equities between October of 2007 and March 2009, we find ourselves rebounded +64% after a recent -9% pullback. There has essentially only been one trade: you are either long or short risk. Every day is a tug-of-war between reflationary and deflationary pressures: the Federal Reserve furiously expanding monetary base while the Treasury promotes real-estate purchases through tax credits in an attempt to revive the wealth vessel that most American net-worth is held in: houses.
It doesn’t work, of course. Unlike China, but very much like Japan, you cannot force a snake-bitten financial sector that doesn’t want to make loans (where 5% of their existing loans are 90-days delinquent) to lend money to the even less credit-worthy. In fact, trying to force banks to lend by feeding them newly printed money is a lot like pushing on a string: financial institutions will hoard their cash for their self-fulfilled rainy day prophecy, and only sparingly invest the money into extra liquid assets like stocks, treasuries & commodities.
This leads us to an environment with a 10y which has surpassed 4% & oil which has surpassed $80 at the same time that unemployment is 10.6% (seasonally unadjusted; 9.7% if adjusted, or 21% if you revert back some of the lies the BLS has introduced since 1994). The last time oil was $80/barrel, headline unemployment was less than 5%. A combination of inflation, Chinese hoarding and long-term decline of oil supply — peak oil — has essentially doubled the economic cost in unemployment of oil.
High energy costs & interest rates combine to create a scenario Gregor Macdonald calls the Double Overhead Crush. As complacency from the liquid risk asset market rally sets in, global political solidarity for reflation is beginning to crumble as the Chinese and Europeans engage in gigantic games of macro-economic chicken.
My conclusion to all of this is that risk of real economic activity materially growing in 2010 is low.
What are the risks of real economic growth in 2010?
The most substantial risk of real economic growth in 2010 is that 77% of the $787B stimulus package has yet to be spent. My principal counterpoint is that the vast majority of stimulus is tax cuts, state aid, unemployment programmes & health-care. Other than tax cuts, these measures only stem some of the bleeding. There is no great productivity or efficiency project: no Tennessee Valley Authority or Hoover Dam. Most states are quickly running out of (or already have run out of) unemployment insurance money, and are not far away from mass layoffs and wage slashes. The remainder of the stimulus will treat the bleeding first – and likely not much more.
My second counterpoint is that if we actually did undertake large efficiency project (like solar/nuclear build-outs, or mass transit in a serious way), $80 oil would be a wistfully pleasant number of the past – much like $15 oil is today.
Housing Prices Gaining Traction
Existing home sales volume has been crushed – it is near cycle trough, and the median price has set a new trough low. 38% of existing home sales were distressed. New home sales have been falling every month since the small rebound peaked in July of 2009. The only thing holding up the low-end is massive government government support. With the tax credits expiring for first-time home buyers, and without further action, we’re going to see lower real estate values.
I’m unsure if Obama or the Democrats have the political capital left to pull off much here.
Record low (<20%) home equity reinforce the inelasticity of wages. As global competitive pressure is put on inelastic wages, this will continue to crush housing.
The final negative pressure is housing inventory, which sits at 3.27 million houses – a 7.8 month supply.
There may be one final push to move houses as spring arrives, and before the first-time credit expires.
The S&P 500 P/E is sitting at a very average 20.33. The earnings multiple curve remains steep. This is typical in an early business cycle, but we seem to have already passed a tipping point where consecutive earnings surprises have turned into disappointments. Look at earnings day performance for many of the biggest companies in the S&P 500:
- Microsoft: -3.34%
- Google: -5.66%
- QCOM: -14%
- JP Morgan: -2.26%
- Goldman Sachs: -4.12%
- Pfizer: -2.31%
It’s becoming more difficult to beat expectations, and companies will have to engage in earnings management to meet or beat moving forward. This would imply that they could likely continue to beat on paper for some time, but that’s very negative for GDP out a few quarters.
This should at least mute stock performance for the next few months. As a consequence, I’m writing vertical call spreads on SPY to earn some income while I wait for something more interesting to happen. Given the macro environment, I’ll be shorting ES futures directly on the 200×50 MA cross. I will reconsider my options and ES shorting strategy if we see a meaningful improvement in unemployment and housing prices without corresponding yield & oil hikes.
My suspicion is that we will see the down-draft in the 2nd half of 2010, after earnings management becomes more difficult, high energy & rate input costs, and the European debt crisis comes to a head.
Until then, I am going long periodically on the RSI-2 mean reversion as long as my risk index remains positive.
Canadian Dollar: A Tale of Two Economies
For many years, the Canadian economy has been a strong exporter. The nation’s productivity is reflected in the numbers: over the past decade, Canada has a net surplus of 531 billion dollars – more than twice what Revenue Canada takes in income tax every year. In 2007, exports comprised of 35% of Canada’s GDP. Canada’s economy is clearly inexorably dependent on it, and any decline is keenly felt around the country. This mighty aggregate savings has driven demand for the Canadian dollar. At the same time, more than 400,000 manufacturing jobs have disappeared since 2002 largely because Canadian dollar strength has made it too expensive to manufacture in or buy from Canada.
There have been some misdirected cries by unions to curtail investment in tarsands oil projects, which strengthen the Canadian dollar as oil demand grows. That would be like trading a position of strength for a position of weakness. It does illustrate that Canada is a Tale of Two Economies. The economies in the Eastern half of the country are driven by manufacturing and exporting durable goods — cars, in particular — to the United States. For this to be effective, the Canadian dollar needs to be closer to 77 cents than parity. In contrast, the economies of the West require high oil prices for the tar-sands projects to be economical.
Beloved Canadian Prime Minister Pierre Trudeau led Canada the last time the Canadian dollar flirted with parity. He was driven out office when he let the currency appreciate, and the US manufacturers left for more competitively priced labour. Canadians are once again close to the same point. Speculators have treated the Canadian dollar like a developing world resource currency — a currency proxy to oil. There are some serious problems with this thesis – mainly that Canada is an advanced manufacturing economy which is dependent on exporting durable goods to the USA using cheaper labour as a competitive advantage.
This Tale of Two Economies provide fairly hard limits on the upside and downside of the Canadian dollar: the longer as the Canadian dollar is near parity, the more Canadian economic data will deteriorate as Canadians lose their well paid manufacturing (& services to manufacturing labour) jobs.
At the same time, a Canadian housing bubble is brewing. Yes: Canadians are mimicking the same conversion of productivity into debt that their American cousins did between 2004-2007. I’m not willing to short this directly, yet: a bubble can stay longer than I can stay solvent. The chief reason I believe that this bubble will be more short-lived than the American analogue is the state of the economy as it relates to currency strength (and corresponding manufacturing weakness), as well as the structural limits imposed by interest rates & energy inputs on its biggest trading partner, the United States. Except in Alberta — and only short-lived there — these conditions will not support the wage growth necessary to sustain housing price inflation.
This leads us to complete our Canadian economic trifecta of doom: much like the mid-late stages of the US housing bubble, prices are supported by credit growth.
The great myth is that Canadian banks are better regulated than their American counter-parts. This is largely bullshit. There are some differences: Canadian banks did not engage in the kind of securitisation & poor quality lending that is largely blamed for the American credit crisis. The problem is that the small fraction of US mortgages that sub-prime comprised of didn’t take out the US economy: they were merely the canary in the coal-mine. On the other side, Canadian banks have something even scarier: no fractional reserve limit, and poorer reporting requirements. We really won’t know how many skeletons are in Canadian banking closets until they would need to raise more capital than is largely suspected they need. Follow the interactions between the Canadian banks and the credit markets to track this issue. This will potentially be aggravated with a housing bubble — in its final stages, supported by credit growth — popping. There could be a lot of skeletons here.
There isn’t a trade against banks, yet, but I’ll be watching closely, and probably shorting Canadian banks on something simple like the 100d MA. The Canadian dollar is a different story: I’m writing options against parity, and shorting it on 100d MA crosses. The principle risks associated with shorting the Canadian dollar are higher oil prices, and the Bank of Canada raising interest rates prematurely to snuff the housing bubble. I don’t think either are likely, but I am still mostly comfortable with the resulting economic changes: anything higher than $80 oil will have long-term demand destruction, and a housing bubble murdering rate-hike will take the rest of the economy — and almost certainly the banks — with it.