The Dow struggled along with the S&P 500 to fight back to the plus side; it made two attempts to get back to the opening price, but failed.
For the past four weekends the financial press has run pieces suggesting that stocks have gotten ahead of economic prospects, but these articles had zero effect on investor sentiment over the last three Mondays. The fourth time seemed to have some influence on things, at least for one day. That said, yesterday’s decline was mild and the market continues to show remarkable resilience as the degree of decline in futures trading (pre-market open) suggested the broad market would get hit by 2%-3%.
There is no doubt the market will pullback though after a run of this magnitude, even if it is from a very very low level. This has been what I’ve tried to prepare people for over the past couple of months – it’s too much about momentum and too little about fundamentals, which have been overshot. The more we run to the upside, the deeper the correction will be. There still seems to be a lot of money waiting for a pullback to get back in. This means the first pullback may be a mild 5%-10% move, at which point we’ll test the recent highs again. But the following pullback, which may result from a failure to meet expectations (bottom line growth failing to meet the expected timeline, home sales and consumer activity rolling over again, continued bank issues via commercial real estate and consumer default rates, and the opening of Pandora’s box from too much government involvement) is likely to be more pronounced – this is inevitable after a run of this magnitude if history is any guide.
Naturally, as has become the trend, the dollar rallied on a down market day as the greenback has only the safety trade going for it. Under normal circumstances, the USD would trend higher with a rising stock market or improved economic growth prospects. This is not the case these days and it’s not a good sign for old green. It will take much higher interest rates to get our currency moving in the right direction again, and that won’t be good for economy, one of the main reasons I do not expect the economic upturn to be long-lasting – there is a lot of stimulus that will have to be removed.
Financial, energy and basic material shares led the losses. Lower commodity prices put pressure on the latter two sectors, while financials were led lower by shares of American Express.
Volume returned to its weak-is-normal ways of the past few months as just 1.1 billion shares traded on the Big Board – that’s in line with the three-month trend but about 13% lower than the six-month average.
Market Activity for September 21, 2009
Treasury AuctionsWe’ve got another record week of government debt issuance coming with $112 billion of 2, 5 and 7-year note auctions. Demand remains strong, although we have seen some decline in the level of purchases from the Chinese. Still, based on the mere size, these auctions have resulted in a higher level of anxiety than is generally the case.
At some point the music is going to stop, investors and governments will eventually demand higher interest rates to continue to absorb this level of issuance. And China (and it’s hardly one sided as the Chinese are more dependent upon us than we are on them) can always send shockwaves throughout the bond market by sitting out an auction or two. As we get into 2010 some trouble may arise in the bond market as we will issue another couple trillion dollars in public debt and the inflation gauges begin to show the inflation picture is not as benign as many currently believe.
To expand on the parenthetical statement, China cannot allow their currency to substantially increase in value as this will hurt their vital export market. Thus, they must continue to buy dollar-denominated assets. To this same point, their export markets need the U.S. consumer and if U.S. interest rates go higher this makes life even more difficult on consumer activity – that doesn’t help the Chinese much now does it. But the Chinese cannot be expected to buy dollars to the degree they have in the past. If this occurs, rates will begin to creep higher, especially once the Fed stops manipulating the bond market with their quantitative easing campaign.
The bond market is much larger than just Chinese buying though, whichever direction that government takes with regard to their dollar exposure. You cannot expect interest rates to remain at these levels for a prolonged period. Even a move to 5.5%-6.0% on the 10-year (hardly close to the super elevated rates of the very early 1980s and lower even than the 8% hit on the 10-year in 1995) will make things difficult for the economy considering the state of things. What’s more, it will exacerbate a number of things coming down the pike, such as $500 billion in IO (interest-only mortgages) resets scheduled for 2010-2011. Higher interest rates will make this reality intensely harsh for the banking industry to endure as they deal with commercial real estate defaults too.
The most troubled areas of the economy are currently being propped up by short-term policy decisions, and as these policy crutches that currently support growth are removed (whenever that may be) they will turn from support to something that more closely resembles an Andrew Jackson wielding his hickory cane and begins to beat the economy with a vengeance. While this may be a little bit farther down the road than most economic commentators seem to be willing to look, it’s careless to ignore.
LEI Index
The index of Leading Economic Indicators rose 0.6% for August, marking the fifth-straight monthly increase, which is the most since 2004. (Prior to this rebound in LEI it had declined for 20-straight months, the longest stretch since the 1970s). This is signaling the recovery is under way, and indeed activity has increased from the depths of the previous three quarters. But as implied above, the concern is that we’ll fail to enjoy the normal business-cycle upturn – the duration and sustainability of this move is a big question
As we touched on yesterday, and when talking about the previous LEI release for that matter, people need to be careful not to put too much into this indicator as it is being driven by stock prices, cash for clunkers (CFC) and the Fed’s zero-interest rate policy, rather than an economy that is rebounding on its own. Stock prices, the pace of supplier deliveries and an aggressively sloped yield curve (short-term rates much lower than the long end of the curve), all components of LEI, were by far the main drivers for August. Here are some things to think about regarding these components.
Stock prices are not always the best leading indicator, and this time it is especially suspect as one must acknowledge the possibility that Fed interest-rate policy is goosing the market (this enables banks to borrow at zero and lend much higher, leading to strong interest income – those profits then move to the stock market).
This aggressive positive slope of the yield curve, the spread between two-year Treasury yields and that of the 10-year, currently sits very near record wides. This steep slope, as the Fed keeps short-term rates near zero, was the second biggest contributor to LEI – this situation cannot last
And finally, the pace of supplier deliveries (slower deliveries means this segment adds to LEI as it suggest suppliers cannot keep up with orders) clearly got a boost from CFC and the 700,000 vehicle sales in July and August. This clunker-cash program has now ended and we’re seeing the regional factory readings that are out for September show supplier deliveries have sped up again, which suggest orders have slowed.
Have a great day!
Brent Vondera, Senior Analyst
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