Global Macro Notes: Knockaround Market

September 4, 2010
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500 fights, that’s the number I figured when I was a kid. 500 street fights and you could consider yourself a legitimate tough guy. You need ‘em for experience. To develop leather skin. So I got started. Of course, along the way you stop thinking about being tough and all that. It stops being the point. You get past the silliness of it all. But then, after, you realize that’s what you are.

- Knockaround Guys

True confession time: I kind of like it when markets get rough.

This isn’t because I’m a sadist or a masochist. (At least I don’t think I am.) It’s because rough markets highlight comparative advantage.

When you hear stories of how the big name players are struggling… how stuff seems to be slamming around without rhyme or reason… how all is confusion and nobody knows what’s really going on… you know that’s when the weak get separated from the strong.

Another way to look at it is the sailing metaphor — “a smooth sea never made a skilled mariner.”

When the waters are calm, comparative advantage is muted. Foolishness can even constitute an edge when conditions are supportive.

But then, when the sea roils and the skies grow dark, true maritime skills (or the lack thereof) are put to the test. The ability to navigate periods of exceptional confusion, chaos and strife result in commensurate reward when the next cycle of opportunity arises.

In other words: If you can preserve your financial and mental capital when others have depleted or squandered theirs, the long-term rewards will be great.

Of 10K and 1040

Traders pay attention to round numbers, and few have loomed larger in the collective market psyche than 10,000 on the Dow.

With a few tests, the big 10K clearly held up this time around.

In similar fashion, the S&P held 1040 like a champ.

Whereas the Dow allowed for a few minor probes below 10K, the “battle of 1040″ was no contest.

Ranges, Trends and Sentiment

There are some interesting theories going around in respect to ranges versus trends. Chessnwine at ibankcoin has had some good thoughts on this. Here is the idea in a nutshell:

  • 2008 was a “trending” year (down).
  • 2009 was also a “trending” year (up).
  • Therefore, 2010 was due to be a “range” year.


This seems a fair interpretation. But I am not crazy about it, for reasons that will be elaborated shortly.

There has also been a lot of focus on bearish sentiment as of late. Maybe it’s just me, but the sentiment factor seems to have gotten even more play than usual this year, due to the hard-to-grasp nature of the market action.

As an example of what I mean, a number of commentators came out of the woodwork saying “toldja so, too bearish!” when the major indices reversed at key support levels. Barry Ritholtz had a post on this on which I commented:

JS comment excerpt:

I still think the sentiment focus is overblown and, to a large degree, a red herring that is more noise than substance.

Consider that volume in August was extremely light, 2010 has been plagued by “rangebound reversals” the entire year, and furthermore that the extreme uncertainty at this juncture is entirely in keeping with a deeply cloudy economic outlook.

On the one hand, a double dip looks imminent. On the other hand, ZIRP is deeply accomodative to asset prices and true double dips are rare. On the one hand, the China growth story could implode. On the other hand, “a rolling loan gathers no loss.”

August was the worst month for equities in nearly a decade, according to the Telegraph. The economic data suggested that the US economy had “hit a wall.”

Then, surprise! The manufacturing data for both the US and China comes out above the top of the range. Wait! Maybe we’re not double dipping after all!

If we hadn’t seen surprisingly positive manufacturing numbers, the whole market complex could have fallen off a cliff. It was the jolt back to surprise optimism in the data, in a light market in which fewer and fewer players are participating, that gave such a strong push.

From a larger picture perspective, this kind of back-and-forth action is entirely consistent with a deteriorating macroeconomic environment in which things are getting steadily worse, with the secular drivers readily apparent, but one in which occasional blips in the data can easily set off low participation hope jags

Keying off the Data

I am deeply skeptical of crowd-based contrarian indicators. Over the years I have only grown more so. It’s just too easy to make too much of an inappropriate sample group, or read too much into a middling data point, or even deliberately make a spurious connection for the sake of being a meathead: “Hey, you guys are X, so the opposite of X must be contrarian! Ha!”

The time when flat-out crowd contrarianism works, or when the input is of useful consideration at least, is at the extreme outlierswhen you have a screaming mimi, melt-your-eyeballs type situation where everyone is obviously and aggressively full-tilt in one direction or the other.

Examples include the mass panic in early 2009, euphoria at the prospect of V-shaped recovery circa end of year ’09, and the euro at $1.20 with every i-bank desk in the northern hemisphere convinced it would fall straight to par.

Most of the time, though, crowd-contrarian data — this group or that group leaning this way or that way — amounts to “white noise,” meaning the signal isn’t strong enough or reliable enough to be a consistently helpful input in the actual trading process.

Not to mention the “oscillator problem” — in bull markets overbought stays overbought, and in bear markets oversold stays oversold. Crowd-based contrarian indicators thus have the same problem as RSI: Just when you need ‘em the most, they tend to fail you.

This is why I would much rather key off the actual data and reactions to such — while using price action as an interpretive guide — than try too hard to divine a message from crowd-contrarian tea leaves.

Consider, for example, a data-based interpretation of the past few years:

  • 2008 was a trend “down” year because the data was consistently awful.
  • 2009 was a trending “up” year because the data was so consistently robust.
  • 2010 has been rangebound reversal prone because the data has been strikingly inconsistent, with top down and bottom up inputs clashing like crazy.

In other words:

Q: Did the major indices hold and rally this week because of technical support or because sentiment was too bearish?

A: Yes. Those were situational factors. But a helluva more important factor was the surprise of positive manufacturing data out of the U.S. and China, coupled with an acceptably non-crappy jobs number.

The markets have been hard to game this year because they are consistently reacting (and over-reacting) to short term economic data, and the picture presented by that data has been a tough one to clarify.

By simply looking at the markets through a data-response lens, one can then avoid the mostly unnecessary attempts to say we are in “this” kind of market or “that” kind of market.

Markets are complex enough without adding more bells and whistles, be they chart-based or interpretation-based.

Still Japanese…

From a bigger picture perspective, we more or less agree with John Taylor of FX Concepts, in his view as expressed here:

Considering the magnitude of the 25 year leveraging cycle and the depth of the crisis, we find the debt deleveraging counter argument much more compelling. Private credit reached 365% of GDP in the US by late 2008, doubling since 1985. This measure has only recently begun to decrease and if earlier crises are a guide it has a long way to fall.

The above graph, via Crossing Wall Street, makes a powerful point in the same vein.

In a “normal” recovery, company sales tend to rise along with earnings. That is not what has happened this time.

As you can see, operating and as-reported earnings (the blue and red lines) have risen sharply, even as S&P 500 sales (the black line) have stagnated and declined.

That graph is a very succinct summation of the troubles faced by this market. It shows how corporate America has successfully boosted profits via heavy fat-trimming and cost-cutting, but without a corresponding rise in sales.

Unfortunately, we cannot “cut” our way to meaningful economic growth, and maintaing profits through cost-cutting is a self-defeating exercise in that fewer jobs means lower sales.

To recap:

  • Public companies have been successful in growing and protecting earnings. This has cheered Wall Street.
  • A combination of ugly top down factors (persistent unemployment) and rosy bottom-up numbers (solid earnings) has contributed to investor confusion. The disconnect between top down and bottom up has driven the confusion of 2010.
  • As time passes, IT IS NOT CLEAR HOW COMPANIES WILL MAINTAIN THEIR EARNINGS IN THE FACE OF A HOSTILE MACROECONOMIC ENVIRONMENT.
  • As with bonds versus equities, something has to give. Either the macroeconomic backdrop must improve, or company earnings will hit a wall as cost-cutting measures tap out.

Hope on the macro side continues to look foolhardy. As Mish notes,

One year ago the official unemployment rate was 9.7%. Today it is 9.6%.

One year ago U-6 unemployment was 16.8%. Today U-6 is 16.7%.

For all the trillions of dollars in stimulus and additional trillions of dollars in bank bailouts and trillions of dollars of expansion of the Fed’s balance sheet, this is all we have to show for it.

Moreover, the economy is clearly slowing already by many economic reports including new home sales, existing home sales, the regional Fed manufacturing surveys, sentiment measures, and consumer spending trends. The only major discrepancy is ISM…

And the ISM numbers themselves are highly dubious and likely to be revised down, per David Rosenberg, while the ISM services report was surprisingly bad.

A Market That Wants to Go Up?

From a price action and sentiment standpoint, the bulls have retaken control. After a very ugly August, a surprising bright spot in the top down data has given hopeful bulls a reason to charge and bears a reason to retreat.

At the same time, though, the major thematic drivers of this environment have not changed.

We will always heed the price action without deferring to it, as rule number one makes clear. But at the same time, this bullish pop feels entirely consistent with a light, end-of-summer type move that could easily run out of gas (though one should wait for clear signs of such before anticipating).

In that respect, it’s further notable that volume should get meaningful again in September as Wall Streeters come back from the Hamptons and the forward outlook for public companies is more soberly assessed.

Pockets of Strength (and Weakness)


For the past few weeks we have been hammering the “long gold stocks / short retail” theme.

Many retail names rocketed higher this past week as shorts were flushed out by the strong ISM data and bulls went on a stop hunt. XRT in particular (one of our core shorts) exploded higher.

But this only illustrates the importance of strong risk management, as we had established a breakeven stop on XRT as precaution against just such an occurrence. (It is very hard to take a Mercenary’s money!)

Meanwhile, leaders have been emerging in the gold stock area (and vice versa in the retail space). One of our strongest long gold stock positions is in Allied Nevada Gold Corp (ANV), as pictured above. ANV shown exceptional strength relative to its peers.

On the other side of the coin, Mastercard (MA) is an example of a retail short that utterly failed to participate in last week’s pop.

The market is no longer a monolothic monster with all correlations at +1.0 or -1.0. Winners and losers are starting to emerge.

The Intel Tell for Q4?

Last quick note: On the day of Bernanke’s Jackson Hole Speech (August 27th),  Intel hit the market with an overlooked shocker. As Bloomberg reported,

Aug. 28 (Bloomberg) — Intel Corp.’s handling of its sales estimate yesterday and the trading that followed in the stock market left some investors frustrated.

Intel, which is buying McAfee Inc. for $7.68 billion, said at about 10 a.m. that gross margin and revenue would trail estimates, releasing the report just as Federal Reserve Chairman Ben S. Bernanke began speaking in Jackson Hole, Wyoming….

…The world’s biggest chipmaker said at 9:58 a.m. that it expects third-quarter revenue to be $11 billion, “plus or minus $200 million,” compared with the previous expectation of between $11.2 and $12 billion. Third-quarter gross margin may be 66 percent, “plus or minus a point,” lower than the previous forecast of 67 percent

Ponder this:

  • In July, Intel reported its best quarter ever.
  • Intel has a deserved reputation as an earnings-busting juggernaut.
  • Now we get a miss?
  • What might that presage when the ability for companies to maintain cost-cut driven earnings is perhaps one of the biggest question marks for investors, in an openly hostile top down environment, within the classic confines of a secular bear market?

We are heeding the price action and gaming the scenarios accordingly…

JS

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