Selling Pressure Abating
(December 18, 2008)
Dear Subscribers and Readers,
The dynamics of the stock market changed substantially in yesterday's session. Ever since late June, every overbought condition in the stock market has always been met with intense selling – more often than not to fresh bear market lows. Selling started getting intense in early August, even as crude oil prices were coming down from their all-time highs. The market sold off again in mid to late September, as the Lehman bankruptcy and the failure of the TARP bill in the Senate destroyed market confidence, even when it became apparent that the Senate would eventually pass the TARP bill. Finally, the late October to early November rally lasted only six trading days (with the Dow Industrials rallying from 8,175.77 to 9,625.28 during that timeframe). Over the last two weeks, however, the market has remained resilient even as the market stayed in overbought territory. This was even more apparent in yesterday's trading, as the Dow Industrials suffered a correction of only 1.12% despite a rip-roaring 4.20% rally on Tuesday. Interestingly, the Dow Transports actually rallied 2.53%, while the S&P 400 Mid-caps rose 0.95%. There is no denying it – the selling pressure in the US stock market has been abating over the last couple of weeks. Whether this lasts until the end of the year is up for debate, but there is no doubt that the market action and dynamics have changed substantially starting in late November.
In the meantime, the direction of the world's equity markets will be determined by three things: 1) The reaction to Obama's proposed $850 billion fiscal spending plan, 2) The outcome of the Big Three automakers bailout, and 3) The direction of the Japanese Yen. As of the end of 2007, the US gross national debt stood at 65.5% of GDP, or approximately $9 trillion. As of today, the US national debt stands at around $10.6 trillion, or 74% of GDP. Assuming the passage of Obama's $850 billion fiscal spending package, the US national debt will increase to approximately $11.5 trillion, or just slightly over 80% of GDP. The US national debt has not been over 80% of GDP since the early 1950s –a time when the US government was paying its debt incurred during World War II! By early next year, I believe France would be in a similar situation, as the French government is now preparing for its own dose of fiscal stimulus. Assuming oil prices stay below $50 a barrel, the Canadian government may also have no choice but to raise its debt to similar levels, given the correlation of its economy with that of the US. The muted reaction in the Treasury markets, meanwhile, signals that investors have already factored in Obama's fiscal spending package.
At a national debt level of over 80% of GDP, only two other major economies in the G-20 will have a higher national debt level – Japan (at 173% of GDP), and Italy (at 113% of GDP). Once we reach that point, my sense is that it will become very politically difficult to enact yet another fiscal stimulus plan, as the government's budget will definitely continue to be in deficit (even in the absence of the $850 billion fiscal spending package) for the next two years. Absent further monetary stimulus from the Federal Reserve, Obama only has one shot to cushion the US economy from a potential (very) hard landing.
Of course, this does not mean the Obama administration cannot come up with other creative ways to prop the economy. As I am typing this, the unemployment rate is Michigan is near a steep 10%. If the federal government does not bail out the Big Three automakers, my sense is that another wave of personal and business bankruptcies will hit Michigan and the Rust Belt. In a “Black Swan” scenario, there could also be social unrest and riots. Obviously, such a potential scenario is politically unacceptable. Whether GM or Chrysler will operate as a going concern or as bankrupt entities in 2009, there is virtually no doubt there will be federal assistance. Word is that the Bush administration will reach an agreement with the automakers and the UAW sometime this Friday. Subscribers please stay tuned.
Turning to our third topic, the Japanese Yen has also played a significant role in the financial markets over the last few years, as speculators/investors who have been involved with the Yen carry trade can certainly attest to! No doubt, the strength in the Yen over the last couple of weeks has been particularly painful. Fortunately for many of these investors in Eastern Europe and South East Asia, the strength in the Yen has been partially offset by the jump in US dollar liquidity over the last few weeks – in particular on Tuesday when the Federal Reserve formally adopted a “quantitative easing” policy. Providing US Dollar liquidity to the global financial market is still of particular importance, as many countries, companies, and retail investors alike have been heavily engaged in the US Dollar carry trade (just like the Yen carry trade) over the last few years. A quick unwind at this stage would unleash further damage on the financial system. The inverse relationship between the US Dollar (trade-weighted) and other “risky assets” can be seen from the following cross-correlation chart, courtesy of Goldman Sachs:
* Click on image to view larger image
The above cross-correlation matrix is divided into an upper-right half that charts the three-month correlation and a lower-left half which charts the one-year correlation. The color of red suggests that the current correlation is below that of its historical mean – and that the brighter the color, the further away it is from its historical mean. For example, the current three-month correlation between the US Dollar (on a trade-weighted basis) and many popular stock market indices are at a “bright red” stage, signaling that the three-month correlations between the US Dollar and these assets are two to three standard deviations below their means. As can be seen in the above table, both the three-month and the one-year cross correlations between the Japanese Yen and the world's major equity indices are more negative when compared to those between the US Dollar and the same equity indices – suggesting that unless the Japanese Yen starts to decline, the global equity rally will ultimately run out of steam. Fortunately for the bulls, the Japanese finance minister has gone on record signaling that the Japanese government is ready to intervene in the foreign exchange market (for the first time in four years) to bring down the Yen. Finally, there is increasing speculation among analysts that the Bank of Japan will cut its policy rate again when it finishes its two-day meeting this Friday.
Finally, I want to bring our subscribers' attention to the following (quarterly) chart showing US households' financial obligations ratios (essentially debt, rent, and auto lease payments as a percentage of disposable income) from Q1 1980 to Q3 2008:
Interestingly, the financial obligation ratios of US households have declined substantially over the last three quarters. For example, as of the end of 2007, US households were utilizing 19.49% of their disposable income for debt, rental, and auto lease payments. Since then, this has declined to 19.05% as of the end of the third quarter of this year. Given that annual US disposable income is approximately $10.7 trillion, this is equivalent to a $46.6 billion decline in debt obligation payments for US households on an annualized basis. Note that by the third quarter, much of the effects of the first $168 billion fiscal stimulus has already wore off – suggesting that this decline is due to lower debt payments or lower debt levels rather than an increase in disposable income. This is an encouraging sign, although I do not expect this ratio to dip any further unless we start to see the US economy growing again.
Henry To, CFA