C.M.O. 9.26.2011

What a week!  In the five trading sessions between Monday and Friday the Dow gave up more than 700 points closing at 10,771 which was 6.4% lower than the previous Friday’s close and the index’s worst weekly showing since October of 2008.  The S&P closed the week at 1136.43 putting it 16.7% below its April peak of 1363.

Aiding this effort to the downside, 90% of stocks fell on both Wednesday and Thursday and for the week there were 835 new 52 week lows and only 74 new 52 week highs on the NYSE.  It was certainly a “risk-off” week effecting even recent stalwarts like Gold and the emerging markets.  Copper, the metal James Grant of Grant’s Interest Rate Observer says has a PhD in economics was down 7% on Thursday alone and led a broad sell off in industrial metals which included Platinum and Palladium, known for their use in catalytic converters falling 4.3% and 6.9% respectively on the same day.  “Why would you want to own something you make things out of when nobody is there to buy them?” was the question Bill O’Grady, chief market strategist at Confluence Investment asked.

That the recent moves are affecting everything can most easily be seen in that the 10 major sectors of the S&P 500 are averaging correlations of about 96% versus 82% three months ago and high yield corporate securities are mimicking the S&P at an 80% rate.  Robert Bowman, PM with Edelman Financial Services might have described it best when he said, “That’s when everyone starts throwing the baby out with the bath water”.  From a more studied perspective Alan Zafran, co-founder of Luminous Capital was “Seeing some signs of easing, but we believe that investors will continue to see intermittent periods of heightened correlations, until macro issues hanging over the markets come to some sort of resolution”.  The VIX or “fear gauge” as it is affectionately known, is pricing in 4% daily moves from now until November according to Steven Sears, the author of the “Striking Price” column in Barron’s.

Looking at one thing to trade another is not new as the basis for the trading strategy used by the author tracks changes in the credit spreads of companies to generate buy and sell signals for the equities of those companies.  A similar theory is espoused by John Taylor the founder of the $8.5 BN FX Concepts who says, “We use commodities to forecast currencies”, noting that movement of the value of the Norwegian Krone is a function of the price of oil.  The problem with all of these theories is that when correlation reaches the 96% level, all bets are off.  That is, until they are on again.

The driver this past week seems to have been the sovereign debt crisis in Europe with S&P downgrading Italy one notch to –A, which is one tic above where Fitch has the Italians and three above where Moody’s does.  Jason Cimpl at Trademaster Daily says, “No one trusts S&P, so another downgrade by them was viewed as spilt milk”.  The research folks at Nomura Securities North America think “It makes a lot of sense for the Italian Treasury to buy the most distressed parts of the market and reissue in the segment which is supported by central-bank buying and that they should do it while the European Central Bank is actually in the market”.  Adding to the distress Germany’s ZEW Investor Survey’s Current Situation Index fell below 50 for the first time since June 2010.

With S&P’s downgrade of Uncle Sam’s I.O.U.’s fully recognized and Ben Bernanke’s larger than expected Operation Twist 2.0 now announced investors chose to side with Ben and ignore S&P last week pushing the yield on the 30-year to 2.738%, its lowest level since December of 2008 and the 10-year benchmark to 1.672% or 1 “beep” away from that maturity’s 1940 low.  David Rosenburg, Gluskin-Sheff’s chief strategist estimates that “The Fed’s purchases will equal 90% of the Treasury’s long bond issuance through 2012”.  If that’s not robbing Peter to pay Paul I’m not sure what is.

With rates this low conventional wisdom might be to think the economy should be roaring but Polina Vlasenko, a fellow at the American Institute for Economic Research authored a recent study with fellow Fellow, William Ford that found that the Fed’s efforts of boosting the economy through quantitative easing could have cost the economy as much as $587BN and 4.6MM jobs.  “The effect on the depressed income of savers is something nobody talks about”, she says.  “With the additional jobs that might have been created, the unemployment rate could fall to 6.8%”, the study concluded.

Interestingly enough through all of this Q3 earnings estimates have only been reduced by 2% and Q4 by an even smaller 0.8% according to S&P.  Jason DeSena Trennert, chief investment strategist at Strategas Research Partners estimates that if S&P companies earn $95 this year, earnings could fall by 15% to around $80 in 2012.  Using a P/E of 12 that would put the S&P at 960.  This is a number Trennert believes might motivate politicians and world bankers to start coming up with solutions.

Let’s hope it doesn’t take them that long.

Enjoy the week.

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