End of January Market Swoon – Some Perspective February 26, 2010
Posted by smarttradepro in Current Issues.Tags: Banks are decreasing their total loan value, there is opportunity here
comments closed
The graphic on the front page of today’s Wall Street Journal was striking.
In fact, it was so striking and the story so compelling and important that I “stopped the presses” on the article I was writing and wrote this one instead. Everyone needs to understand what the graph is telling us.
Let’s look at that front page image from this morning’s WSJ.
The graph shows the year-over-year change in total loan value outstanding. It simply answers the question, “Are banks holding more loans in dollar terms this year versus last?”
The answer: banks are decreasing their total loan value at a pace not seen since WWII.
Perhaps there is an even more important conclusion from the chart: every green year meant that total lending was expanding. That is, cumulative loans have been in a positive trend since the end of WWII. With the exception of the 1990 recession, the bank loan amounts have been in a long term up trend.
The accompanying Journal article talks about at least three factors causing the total loan value to drop at the steepest rate in the last half-century:
- Heightened regulatory requirements, especially the increase in the amount of cash reserves banks are required to keep on hand for each dollar loaned. (Remember that to slow down growth recently, China raised reserve requirements for their banks.)
- Tightening lending standards by the banks. (If you can lend less of your cash, you need to be more choosy about who gets it—and, oh yeah, you just got burned by lots of borrowers who didn’t repay.)
- Weak demand from potential borrowers. (No surprise here!)
So What?
The bank lending situation brings up two important items of note for traders and investors. The first relates to the broader market and the second concerns the banking sector.
In the broader market, if banks aren’t lending, then the sector of the economy that creates jobs—small and medium sized businesses—is not growing. It’s tough to see how a sustained recovery can occur in this scenario. It’s also important to note that after the lending downturn of the early 1990s shown above (which ended in 1992), the market took 27 months to make an overall gain of 10%. Today’s markets are much more volatile than back then, but this delay in market upturn is indicative of the long time it takes the economy to recover after a severe credit contraction.
Secondly, the banking sector’s recovery since the March 2009 bottom has reflected these decreasing loan numbers. Remember, banks generate their revenue from their loans. While the broader market has recovered 50% of the value lost from October 2007, the banking sector has recovered little more than 25%, as you can see in the chart below.
25%, as you can see in the chart below.
Knowing this can serve us in two ways. First, we can be fairly sure that there will be little chance for a sustained market recovery as long as bank loan amounts continue to contract. Second, there is opportunity here for a long term investment play. Banks won’t lag forever; when they finally start making up ground versus the broader market, there will be great opportunities for banking to outperform other sectors in your portfolio.
Great Trading,
D. R.
Perception, Deception and Debt – More Volatility to Come February 24, 2010
Posted by smarttradepro in Current Issues.Tags: volatility in the equities markets to continue.
comments closed
In last week’s discussion on Greek debt, I concluded that uncertainty and hence volatility would remain in the market for some time to come.
As the mainstream press latched onto the situation, the latest revelations have done nothing to change that thinking.
Deception
The most interesting report came in a New York Times article over the weekend that revealed—gasp—Wall Street banks have helped create another debt bubble. This one in Greece.
In summary, investment banks (which are now just “plain ol’ banks”), most notably Goldman Sachs, created customized derivatives or swaps to effectively loan large sums of money to Greece (and other countries in the PIIGS mess). All of this was perfectly legal, even if it wasn’t disclosed.
In essence, Greece swapped future revenues from airports, highways and the national lottery (also known as their safest and most reliable future revenue streams) for a chunk of cash then. Since the transaction was classified as a sale and not a loan, the immediate infusion of cash helped Greece meet some European Union financial guidelines in the short term (back in 2000 and 2001) and pass the problem on to future regimes.
Let’s recognize these maneuvers for what they are: an under-the-table use of financial and accounting gamesmanship that allowed a bubble to grow out of control and off the financial radar screen.
Understand, America has developed “passing the problem to future administrations and generations” to an elevated art form, so I won’t cast any stones. Additionally, the European Union debated the very issue of making such swaps more transparent in back in 2000, but decided against any new reporting requirements. Finally in 2002, disclosure requirements for these types of swaps (and the entities formed to facilitate them) began to appear.
The current “second wave” debt crisis is almost certainly deeper and wider than we currently imagine. Additional volatility and uncertainty will continue as the media uncovers more revelations about the situation.
Perception
And now for a fun guessing game on perception. Let’s look at the debt of two different governments.
| (All $ in Millions) | Annual GDP | Outstanding Debt | 2010 Budget Deficit |
| Government A | $2,000,000 | $75,000 | $40,000 |
| Government B | $400,000 | $443,000 | $50,000 |
Here’s the set-up: Country A has a GDP of $2 trillion, $75 billion in debt and will have a projected budget deficit of $40 billion for this year.
Country B has an economy 1/5 the size of A, has almost 6 times more outstanding debt and will add 20% more debt this year to their bottom line.
Whose bonds would you imagine have the higher priced insurance against default? Which one does the market view as riskier?
Considering the numbers provided, wouldn’t it seem that Government B would have the higher risk for defaulting on its bonds?
Alright, this was a trick question. Government A is actually California. And Government B is Greece.
As strange as it may seem, California had the higher default insurance up until two months ago. California was viewed as a worse credit risk than Greece!
What changed? One thing—perception.
Until December, California had to pay more for bond insurance than Greece did. California’s problems had been in the news for a long time by that point and were very high in the public’s awareness. Since the first of the year, Greece’s debt problems have been in the news more. Now that more people are aware of the issues, the price for insuring against Greek default has risen dramatically.
What a strange game. If one wanted to speculate in government bonds today, it looks to me like buying California bonds and selling Greek ones might be the way to go.
Resolution
In the end, the two primary Greek creditors (France and Germany) will not allow it to default. For the EU, Greece falls into the same category that the American banks and AIG did last year—“too big to fail.” A default on Greek debt would send the EU into a tailspin that most would consider catastrophic. That could lead to the end of the economic conglomerate and create severe financial hardships for member countries in terms of cost of capital. So the member countries will do everything in their power to keep that from happening.
If Greece is too big to fail, then what about California? It’s five times bigger… Some opine that the California debt insurance is as high as it is because the US federal government has given no indication that it will step in to help. But I think that it is a rather safe bet that the U.S. governmental powers-that-be will not allow a California default under any circumstances short of financial Armageddon.
So in the meantime, someone is enjoying the benefit of writing really high-priced California risk insurance.
Until the EU creates some concrete plans for resolution the PIIGS debt problem, look for the volatility in the equities markets to continue.
Great Trading!
D. R.
PIIGS in a Poke: Why Traders Should Care About European Debt Trouble February 12, 2010
Posted by smarttradepro in Current Issues.Tags: What Does This Mean for Traders and Investors?
comments closed
It’s fitting that our title phrase (an acronym takeoff on “pigs in a poke”) had its origins in Europe because we will focus on Europe today.
In the Middle Ages supposedly, meat was scarce but cats were not, which played into one common marketplace scam. At the market, vendors would offer for sale a suckling piglet squirming in a bag. After getting the bag back to the cottage, the poor peasant would discover that rather than containing a piglet to raise and feed the family, the bag actually contained a valueless cat.
The ruse was so prevalent or at least so infamous that several other phrases besides “buying a pig in a poke” (to make a purchase without proper inspection) arose from the practice. “Let the cat out of the bag” (reveal the secret), and “left holding the bag” (receiving nothing for your efforts or stuck with the final responsibility) point to the pervasive nature of this con game.
In modern day Europe, some countries are playing out a different kind of “pig in a poke” game. In the modern case, the PIIGS are Portugal, Italy, Ireland, Greece and Spain. All of these sovereign countries run the risk of a government default on their national debt. (More on that PIIGS acronym later.)
Many are blaming the European Union for accepting these countries prematurely, their own macro version of accepting a pig a poke. With 20/20 hindsight, that may indeed seem to be the case, but it’s hardly helpful now. More important is that the EU allowed these countries into the union on promises that they would shore-up their financial woes instead of waiting until they were financially sound.
Greece is the poster child for this problem and hence the first to face serious risk of default. Their profligate spending, especially as it relates to labor unions and publicly paid positions has left the country with a debt burden from which it has little chance of recovering through normal economic growth. At this point, no one wants to lend Greece more money to feed that insatiable deficit spend/borrow cycle. The problem has grown to the point where lenders are demanding a 4%+ margin of interest versus the much safer German bund.
The Wall Street Journal has a very informative visual depiction of the debt problem and how the perception of the ability (or inability) to repay has grown in the PIIGS countries.
Since this graphic comes out pretty small in the newsletter, allow me to provide a brief summary: the red represents Government debt as a percentage of Gross Domestic Product. The blue represents the credit default swap spreads, indicating the premium that institutions are requiring now to insure sovereign debt.
So What Does This Mean for Traders and Investors?
Every so often, something will embed itself so deeply into the markets’ psyche that every little flinch causes the market to react. This was the case with crude oil in the spring and summer of 2008. Every little speck of news relating to oil made the oil price jump. The same is happening now with the PIIGS debt crisis. The mere fact that Germany is considering a plan to offer Greece loan guarantees caused Tuesday’s markets to spike upward (the Dow rose 150 points).
Until this crisis is resolved, news speculation and rumors will have a big effect on the currency, bond and equity markets. So it’s critical to understand that no matter what your technical indicators say, if Germany balks or otherwise equivocates on guaranteeing Greek debt, markets are going to dive. Conversely, positive news will cause a pop. This is certainly going to keep volatility and uncertainty high.
Some are opining that France and Germany are going to let Greece default. Those two countries, however, are the number one and two top foreign holders of Greek debt with $75 and $43 billion respectively, so this seems unlikely.
Because the European Central Bank is not permitted to provide direct assistance, such aid will have to come from individual countries (acting in concert with the EU), or perhaps, though less likely, from the International Monetary Fund itself. All of these moving parts makes the Greek debt relief situation a very complicated undertaking, which in turn leads to much “will they/won’t they” speculations and rumors. Are you ready for the volatility?
In short, these conditions make for a traders’ market as opposed to a trending market. Expect snap back rallies and quick dives to be equally likely. Consider which of your systems thrive in these kinds of conditions and which tend to be hurt by them. Taking profits quickly and protecting against overnight and weekend gap risks would be a prudent course of action until there are more concrete commitments out of Europe.
And now back to that PIIGS acronym. In an instance of political correctness run amuck, Barclays Capital and the Financial Times, among others, have been forbidden to use the acronym! The use of the porcine reference has been called pejorative and hence the PC police have stepped in at those organizations to prevent possible offense. Orwell’s 1984, here we come…
Great Trading,
D. R.
The Late January Swoon: A Bump in the Road or Something More? February 5, 2010
Posted by smarttradepro in Current Issues.Tags: A Bump in the Road or Something More?
comments closed
The broader U.S. market indexes all made new 52 week highs in mid-January. Then, in the last two weeks, they have given back all of the ground they gained in the previous 10 weeks—since the first of November.
The markets were certainly due for a pullback from overbought conditions. The pressing question for traders, however, is, “Was this rapid drop just a temporary rebalancing or the first leg of deeper drop?” Let’s take a look at some key technicals to gain some perspective.
Bump or Dip?
First of all, look at the magnitude of the late January drop in the chart below. It cuts through two key support structures: a 10 month trend line and the 50 day moving average.
Now it’s trying to approach the 50 day simple moving average (SMA) from below. The next few days will give us some key input as to whether the 50 will act as resistance. This same technical condition exists for the Dow, Russell 2000 (small caps) and the Mid Cap index. However, the QQQQ (NASDAQ Index) is still far from retracing to its 50 (actually, it’s still more than 2 percent below its 50 day SMA).
This gives us an interesting disconnect: tech is not rebounding as enthusiastically as the broader market.
Foreign Market Performance
What about other markets? Let’s compare the major U.S. indexes along with a few representative international indexes to see if their relative performances give us any clues.
This is a “performance chart” from Stockcharts.com. This type of chart shows how several indexes or stocks are performing in relation to each other. For our purposes, I wanted to see the relative performance of the selected domestic and foreign indexes since January 14.
As I mentioned earlier, the S&P 500, Dow, Midcap and Russell 2000 have all had similar performance. You can see that they are the top four lines in the chart above and those four indexes all have had the best relative performance during the market pullback and subsequent two day recovery early this week.
Globally, the worst performers have been Latin America, Emerging Markets, Europe, China and, as previously mentioned, the NASDAQ. These are not encouraging signs for the bulls, and the recent tech sector and foreign market relative weakness is significant for me.
Summary
Sustained S&P 500 price action above its 50 day SMA (especially if the QQQQ can climb up there) will provide a case for the intermediate term upside scenario. Based on the technicals and weak geographic participation in our little two day rally, however, that upside scenario is looking like a lower probability outcome right now.
If the S&P 500 cannot sustain this rally with a strong up week including a couple of closes above its 50 day SMA, we’ll most likely look back at this current rebound as a temporary pause in a bigger down move.
Great Trading,
D. R.
