Saturday, July 23 - 2005 at 08:52
Buy the VIX index for renewed volatility!
Given all the directional uncertainty mentioned below, I regard that the purchase of the VIX Index at around 11 as an extremely attractive proposition. Moreover, it is not only stock market volatility that is near record lows but also bond market volatility.
A recurrent theme of this commentary since the end of last year was that money supply growth had been slowing down in the US, and that international liquidity growth had been decelerating. We, therefore, expected the US dollar to strengthen and industrial commodity prices to weaken. We also expected the global economy to slow down, and for the S&P 500 to encounter heavy resistance in the 1200 to 1225 range.
So far so good, but where do we go from here? Looking at the recent miserable performance of the Baltic Dry Index, declining air cargo volumes, falling steel, aluminum, tin, zinc, and lead prices and the miserable performance of economic sensitive stocks, it increasingly appears that the global economy is now far weaker than what the super bulls on the US economy want us to believe.
Not a pretty picture! I may add that, in late June, when Google just broke out on the upside through $ 300 barrier, a well-known CNBC commentator told the audience that the stock was a 'must own' and that it would go straight to $ 350. On the same day, an analyst told the audience to sell Oracle. Since then Google is down 5% while Oracle is up almost 15%.
This is not to say that my forecasting record is any better, but that the performance of stocks and commodities are usually a far better forecaster of economic activity than the endless analyses and commentaries of strategists, analysts, and mentally disturbed economist who find a home at the US Federal Reserve Board. So, if at the same time, Aluminum prices and steel stocks break down, maybe something is no longer all that rosy in the economic environment.
Please note that at today's level, aluminum prices are lower than they were at the beginning of 2004! Similarly, the shares of US Steel are now no higher than they were in early 2004. US Steel is also down by almost 50% from its early 2005 high, when one could not find one bearish analyst on the steel industry, as 'China was expected to buy all the world's available steel'.
As a side, I may add that when US Steel's stock was inexpensive and trading a tad above $ 10 in 2000 and 2001, analysts were in love with 'new economy' stocks and recommended to avoid old economy stocks like the plague. To be fair to the analytical community, if any strategists or analyst had been recommending steel stocks in the midst of the NASDAQ bubble in 2000, investors would have, at that time, paid as little attention to such an odd recommendation as to the one to buy gold and oil.
I should like to emphasize here that it is not analysts' recommendations that make markets move. However, when markets move for a while in a direction, then analysts and strategists, and at the very end of the trend, even TV personalities will jump on the subject. They will then write extensive studies and make comments that justify and explain the price increases. In fact, the longer the price of a stock or industry goes up, the thicker the research reports will become.
Weighing up analysis
Thus, as an investor, you need to buy a post office scale. When all the reports on a stock or sector are light, it means 'buy'. Conversely, when weekly the reports you receive on an industry add to several kilos then 'sell'! So, after all, brokerage research does have a very useful function but not through its content but weight.
But back to the 'strong' and 'healthy' economy of the invincible empire! It is not capital spending that would lead to rising durable goods orders but consumption, which, as explained on numerous occasion before, is being driven by a huge credit expansion that lifted home prices and allowed money to be extracted from homes through refinancing activity.
Now, someone could argue that weakness in some industrial commodities and steel may be isolated cases of weakening demand but that the rest of the economy was in great shape, as we continuously hear from well known economists in the world's leading financial media. But then you look at the stock chart of International Paper - a company that should actually do rather well in a housing boom and when the economy expands.
But the stock has just collapsed to a multiple year low. In fact, what is fascinating about the US financial scene is that the stocks of practically all major industrial sectors including autos, steel, aluminum, chemicals (look at a stock chart of Dupont), paper, and numerous manufacturing companies are doing badly while selected specialty retailers, homebuilders, and energy stocks have performed well.
The financial market is accurately reflecting the totally imbalanced US economy, which is characterized by a shrinking industrial base at the expense of over-consumption, a housing bubble, and an overblown financial sector, which is evident from its more than 50% contribution to S&P 500 earnings.
I have expressed my negative views about US homebuilding companies before. Since then, the bubble has become even larger and homebuilders have recently made a new high.
This is wonderful news for the bulls and bad news for me, but there is hope for the homebuilding stock bears for the following reason. Technically, the stocks look like having made a euphoric 'exhaustion' top in the 3rd week of June. Moreover, the most recent rebound was accompanied by declining volume, which is negative. Also investors should consider the following.
Recently it has become quite common among bond market experts to predict an extension of the current bond market rally. Some authorities on bonds predict 10-year treasuries note yields to decline further from presently slightly over 4% to less than 3.50%.
Beware a bond market rally
Now, I am not suggesting that bond prices could not rally and yields fall further, however, investor should also be aware of the following: Bonds have been rallying since 1981 when long-term US treasury bonds were yielding more than 15.5%. So, we are in a very 'aged' bull market already, which is likely to give way at some point to a bear market (the global bond bear market may already have begun since yields are now still higher than in June 2003, when Japanese government bonds were yielding less than 0.5%).
Therefore, it would take great optimism and confidence to buy a 30-year US government bond yielding around 4.5% with the view to hold these bonds for 30 years. After all, it is likely, that at some point in the next few years we shall again experience in the US far higher consumer price inflation than now. Why?
Well, with the great destroyers of the purchasing power of paper money at the Fed and, given the huge debt as a percentage of GDP and the overheated housing market, the Fed with its economic doctrine of sophism will, one day, find no other option than to print money like there is no tomorrow. But make no mistake!
This time, money printing may not help the economy, as the bond market and the dollar will tank. So, the housing market is now threatened from two sides.
For as long as Mr. Greenspan, who bases his economic forecast on what some junior journalists may have written in the previous day's edition of the Wall Street Journal, assumes that the economy is 'strong' and 'healthy' but that some minor 'froth' is evident in the housing market, he will likely increase the Fed Fund rate further.
Further Fed Fund rate hikes would likely slow down home price inflation. In this situation, however, the long-term bond market will feel comfortable, as further Fed Fund rate increases will be perceived as leading to future economic weakness.
Still, bonds may not rally further (bond prices may just hold around current levels) for two reasons. Investors are already heavily long bonds and the bullish consensus is running at very high readings. Moreover, the bond market (and also the dollar) will begin to discount renewed money printing by the Fed well in advance and so begin to decline several months before the money printing exercise gets underway. This would in turn also hurt the housing market through higher long-term rates.
Lastly, think about the following situation. The US manufacturing sector becomes very weak. The housing market falls and consumption declines. But oil goes through the roof because the empire of eternally rising home prices has just bombed Iran (very likely, in my opinion). Now the Fed cuts interest rates and eases massively.
Just think what the stock, bond, foreign exchange, and gold market will do? The initial reaction might be a flight to safety - into government bonds and gold, and out of stocks. But, thereafter, a massive sell-off in bonds could occur as inflationary pressures build from sky high energy prices and massive money printing.
I have to confess, that I am not so sure exactly how this situation would play itself out, but it is worth thinking about it. In any event, I am puzzled. Given so much uncertainly, and most likely very high future financial market turbulence, which would follow the event I just discussed above, it is amazing that volatility in all markets hovers at near record lows. Volatility jumped seven times above 30 since 2000! And, in 2005, volatility rose already once from around 11 to 18.
Buy the VIX Index
Therefore, given all the directional uncertainty I mentioned above, I regard that the purchase of the VIX Index around 11 is as an extremely attractive proposition. Moreover, it is not only stock market volatility that is near record lows but also bond market volatility.
To conclude, the poor performance of economic sensitive stocks and the recent break down of industrial commodity prices from rising long-term wedge patterns is a bad omen for the global economy. Only two industrial commodities have not yet broken down: copper and oil. And while oil is likely to decline over the intermediate term, I am reluctant to short oil because of the possibility of the US bombing Iran.
Copper, however, is an excellent short sale candidate. Copper demand growth is weakening and 'hidden' inventories are reported to be large. Moreover, downside moves originating from rising wedge patterns tend to be very sharp!
The US stock market has, in my opinion, little upside potential. Not only are economic sensitive stocks weak but also importantshares like GE, Wal-Mart, IBM, and MMM are not confirming the most recent advance. Most of these shares show distribution patterns.
The US dollar could continue to appreciate for some more time. However, it is now significantly overbought short-term, and a consolidation around the present level or some weakness is likely. The dollar uptrend, nevertheless, should remain in place for the next few months, although I am now looking at a selling opportunity on further strength. In January 2005, we recommended to short the British Pound against the dollar. I would now look at covering these short positions.
At the end of every bull market (October 2002 - present), the strongest stocks are the last ones to break down. Consistent with this observation would be that homebuilding shares should start to decline shortly.
Whereas a weak economy and cracks in the housing market should be supportive for long term US government bonds, much of the by the bond market expected economic weakness may already have been discounted by investors. And when the Fed stops raising rates and moves toward monetary ease, bonds could sell off. In any event, from a longer term perspective, US long dated bonds are not attractive and represent a better short sale than a buy.
Although the direction of markets is - and has always been - difficult to predict, it is very likely that sometime within the next twelve month volatility will soar. Hence, buy the VIX Index. |
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