What are the roots that clutch, what branches grow
Out of this stony rubbish? Son of man,
You cannot say, or guess, for you know only
A heap of broken images where the sun beats,
And the dead tree gives no shelter, the cricket no relief
And the dry stone no sound of water…
- T.S. Eliot, The Waste Land
Tuesday (April 10th) was a remarkably red day. Bullish uptrends snapping like dry twigs underfoot. Downside range expansions everywhere you look, on heavy volume with closes at the lows.
So many sectors got crushed, it’s hard to distinguish between those showing internal weakness and those simply decimated by the broader market action.
Homebuilders are an easy example. Take a look at XHB, LEN, TOL, PHM. Nothing special there — just a microcosm of what’s happening all over the place. A good old fashioned “risk off” bloodbath, with the tiny but notable exception of gold.
The major indices were crushed too. Small caps were already weak, and the Nasdaq is hopped up on Apple juice. But as for yon Dow and S&P? Uptrends no more…
We have now entered an Eliot-like waste land — a no man’s land:
Now there is nothing magical or sacrosanct about a trend line (or a 50 day exponential moving average for that matter). Both are handily compact forms of regression analysis and little more.
Nonetheless, when you get a break that hard, and that fast — on surging volume no less — it tends to mean something. This will not be shrugged off. Even if the bulls claw their way back, they will do so badly shaken, and with a pronounced limp.
A Flock of Gray Swans
To those invested in the long case, Tuesday’s selloff was especially disconcerting given the lack of a major catalyst.
Europe is threatening to blow up in everyone’s faces again, yes. But hasn’t that been the on-and-off case for years now?
The following New York Times commentary is notable mainly because it is dateless — it could have come at any point in the past two years or so (emphasis mine):
Spain’s borrowing costs rose Tuesday to levels not seen since early January, raising concerns that the financial crisis in Europe was heating up again after a lull. Stock markets closed sharply lower across the region.
The latest market anxieties come on the heels of a Spanish bond auction on April 4 that barely met the minimum amount sought, a sign that some investors worry that Spain might eventually follow Greece, Ireland and Portugal in seeking a bailout.
Spain is entering its second recession in three years, and the government expects the economy to contract about 1.7 percent in 2012. With unemployment of around 23 percent, there is fear that austerity measures, deemed critical for winning back market confidence, could have the perverse effect of further depressing growth and creating a vicious cycle in which more budget cuts are needed to balance the public books.
- New York Times, Spain Bond Yields Rise, Renewing Fears of a Renewed Euro Crisis
Perhaps it is not so much one thing, but a distressing confluence of things.
What investors face now is a flock of “gray swans” — a series of unpredictable crisis events that, in actuality, were pretty predictable after all (with only the timing left in doubt).
The risk emanating from Europe may not be what it seems. Rather than a fear of Europe imploding, the real trouble may be if it doesn’t!
The European Central Bank (ECB) will print if it absolutely has to. We saw that with implementation of the “LTRO,” Europe’s version of QE3.
The real danger in Europe, then, may not be a full-blown crisis but a German incrementalist approach in which the periphery countries simply bleed out by way of austerity.
Instead of Lehman Brothers redux, picture Spain, Portugal et al as an old country version of Detroit. If the periphery countries are allowed to sink into recession bordering on depression, with crisis measures implemented grudgingly at just enough rate to keep them bleeding along, that is bad for everyone in global economic terms.
This reality is coming back to the fore as crisis persists. The trouble may not be a full-blown ripping apart of Europe, but the cold-water-in-the-face realization that Germany’s attitude towards fiscal stimulus could keep Europe in borderline recession conditions for the duration.
Gray Swan #2: Shadow Collapse in China
Things are bad in China right now. This should be a surprise to no one. If anything the surprise is how long the top-down economic management strategy lasted.
Nowhere in history, or even in the annals of feasible economic thought, does it make sense to imagine a country can grow at double digit percentage rates for decades on end, with major decisions being made by a centralized governing body, while yet avoiding any sort of hard landing.
It’s taken a bit of time, but now we are starting to see China’s internal fabric come apart at the seams, both economically and politically, in shades of the underlying rot that plagued the old USSR. (Anyone still remember what those letters stand for?)
Consider the following dispatches from the China front:
- Shadow Banks on Trial as China’s Rich Sister Faces Death (Bloomberg)
- Food Prices Push Rate of Inflation Up in China (New York Times)
- The Revenge of Wen Jiabao (Foreign Policy)
- Signs of a new Tiananmen in China (The Diplomat)
The Dragon has more back-stabbing drama right now than an HBO mini-series. Multiple pressures in respect to the Chinese economic miracle are coming to a head:
- China’s “shadow banking” network, which funds businesses to the tune of $1.3 trillion in unregulated funds, is coming under severe pressure. What happens when an informal funding system that big collapses? If the government let the shadow banking network get that big in the first place, how much control do they really have?
- The threat of civil unrest, as tied to high and rising food costs, has never been greater. There is no “safety net” in China — no social security, no welfare, no widespread network of soup kitchens. The people spend a large percentage of their income on food. When food prices rise high enough and fast enough, you get riots.
- The internal structure of the Communist party is imploding. Winston Churchill once compared Kremlin politics to bulldogs fighting under a carpet. Outsiders have no idea what’s happening, but every so often a corpse is thrown out. The same thing is happening at one of the most critical inflection points in the ruling party’s history.
- The odds of avoiding “hard landing” were marginal to begin with. A white hot real estate bubble, speculative copper hoarding, grossly inefficient state enterprises, manufactured growth through huge infrastructure spending… how does this story end any way but badly, at least in the medium term?
Bottom up investors are getting more and more excited about bullish domestic spending patterns in China. They should watch out for massive top down risks like falling boulders from above…
Gray Swan #3: Contracting Profit Margins
The Economist had an excellent recent article that asks, “Corporate profit margins are extremely high. Can they be sustained?”
Theory would suggest that profit margins will revert to the mean over time. If profits are very low then companies will go out of business, improving the competitive position (and thus the margins) of those businesses that survive. Similarly, if profits are high then more capital will be attracted into the industry (and existing businesses will be tempted to expand) and the resulting competition will cause margins to fall.
However, the current high level of profits is not leading to a surge in investment. As a proportion of GDP, American business investment is close to 30-year lows. This shortfall has been blamed on many things, from over-regulation in America to uncertainty about the outlook for demand when real incomes are being squeezed by higher fuel prices and the lack of wage growth.
Peter Oppenheimer of Goldman Sachs points out that the high profit share of GDP is simply a corollary of the low share taken by labour. “With high unemployment and further substitution of technology for labour, it is unlikely that this will change dramatically any time soon,” he says.
So the cash is going on other things. Robert Buckland of Citigroup says both American and European companies are choosing to spend their cash on mergers and share buy-backs rather than capital expenditure. As a consequence “while profits remain sensitive to the economic cycle, those waiting for the structural mean reversion in margins will continue to be disappointed,” he says.
- The Economist, Marginal Improvement
True as far as it goes.
But how long can such a devil’s bargain last, without inducing civil unrest and destructive policies in the United States, and/or inflationary stimulus (to counteract unemployment) that ultimately destroys margins through inflation?
We are coming back round to the bullish argument for gold here. But remember, we never said we were long-term gold bears…
Andrew Smithers of Smithers & Co, a consultancy, believes that executives are given incentives to boost margins in the short term at the expense of long-term value for shareholders. Pushing up prices boosts profits quickly, for example, but at the risk of losing market share over time. Similarly, executives might not begin a programme of investment that is vital for a company’s long-term health because of the effect on earnings per share. Woe betide any company that misses its quarterly earnings target.
If Mr Smithers is right, investors may be overpaying for current profits. The earnings forecasts of American equity analysts imply an increase in margins from current elevated levels, since they show earnings growing much faster than nominal GDP. Of course, to the extent that companies sell goods to the emerging markets, the profits of quoted companies can grow faster than domestic GDP. But that requires investment to keep the corporate sector competitive, and capital expenditure has not been happening on a sufficient scale.
This leads to another problem — one visible in the outperformance of multinational companies relying on overseas profits.
Namely, if Europe sinks into the austerity muck as China faces a hard landing, the “commodity supercycle” gets put on hold, stalling out resource-oriented markets too. And if emerging markets on the whole go through a period of economic retrenchment, another source of corporate profit outperformance vanishes…
Governments would like companies to start spending their cash piles. But as James Montier of GMO, a fund-management group, points out, that depends on their own behaviour. In terms of national accounts, massive government deficits are a counterpart to the surge in corporate profits. The surpluses and deficits of the various sectors of the economy (government, households, foreign and corporate) must balance, so a huge surplus in one sector must be balanced by deficits elsewhere. Governments spend money on goods and services (that are bought from the corporate sector) or borrow money to finance social benefits, which are then also spent on goods and services from the corporate sector.
This is not to suggest that chief executives should wish for permanent government deficits. But it does suggest that, as those deficits fall, profits might come under pressure. There is a “good” way that this could happen, as companies recruit more staff and pay higher wages, boosting tax revenues. But there is also a “bad” way for it to happen, if austerity programmes cause a slump in demand. Pray for the first outcome.
There’s another way that profit margins could contract — through the upping of “austerity measures” not just in Europe, but in the United States and possibly China too.
If Republicans win the next presidential election, there will undoubtedly be a new fiscal austerity wave. Even if they don’t, more rounds of “belt-tightening” and Mellon-style liquidation may be called for. (Remember the debt ceiling fun we had last August?)
Meanwhile, China may find its stimulus powers constrained by domestic inflation at home (too much risk of food riots etc).
Here come the earnings…
As a side note, earnings season starts this week — and that could be a mitigating or accelerating factor, depending on how good (or bad) the numbers are. The early look ain’t so hot — via Dow Jones:
Analysts expect the first quarter to be the worst period since mid-2009 for profit growth at U.S. corporations, even as stocks sit near multiyear highs.
On the aggregate, companies in the Standard & Poor’s 500-stock index are expected to report little or no increase in earnings for the first quarter. That represents a marked slowdown from two years of robust expansion fueled by cost- cutting in the wake of the financial crisis and could presage further debate about the prospect for equities.
“You can only squeeze your expenses so much. At some point you have to lean on revenue growth,” said Joseph Tanious, market strategist at J.P. Morgan’s asset management unit in New York. “That’s kind of where we are.”
Gray Swan #4: Federal Reserve Misfire
The final “gray swan” offers another ironic twist:
- What if the Fed holds back this time because the news just isn’t dire enough?
- OR, what if they do come rushing in… and the medicine fails to work?
The Good Friday jobs report was a disaster, but it could still be a somewhat isolated disaster (related to unseasonably warm winter weather patterns).
It’s thus possible that the U.S. economy keeps “muddling along,” at least enough so for the Federal Reserve to only jawbone, or act modestly, while holding back the big stimulus guns.
It’s also possible that Bernanke lets loose another blast, in the hope of keeping markets up so that President Obama gets reelected (allowing Bernanke to keep his job)… and that the blast yet fails.
If THAT happens — and the Fed appears “out of bullets” after three years of coordinated global central bank efforts to beat back the deflationary beast– all hell could break loose.
We’re talking 2008 freefall redux, Dr. Peter Venkman style: “Human sacrifice, dogs and cats living together… mass hysteria!”
In the Mercenary Live Feed we are heavily weighted towards short exposure now, with good concentration in China-related global slowdown plays.
Gonna be a fun summer…
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