3 Things I Think I Think….
It’s Friday and my mind is wandering so let’s play 3 things….
1) The Euro crisis is not over.
I know I sound like a broken record about this, but the crisis is not over. Every “fix” they’ve implemented is a band-aid on a gushing wound. This crisis is not overly complex. Here’s what happened. You have a bunch of countries relinquish the right to print currency and enter into a single currency system. This also eliminated floating exchange rates. So you had a serious structural imbalance by design – you were guaranteed to get trade imbalances due to the single currency because there was no floating exchange rates to rebalance and no ability to print money to offset the imbalance. So we ended up with periphery nations buying everything from the core and then borrowing more to continue this unsustainable trend in “growth”. The party ended when bond traders realized the periphery nations couldn’t borrow forever. So here we are. And the only fix is to fix the currency union. That involves creating currency sovereignty. So we either break-up or we create some sort of fiscal entity that essentially guarantees the debts of the periphery nations and eliminates the risk of sovereign default. Until then, bond traders will continue to rule the roost in Europe.
2) Corporate profits trends are becoming worrisome.
As I highlighted earlier this year, the outlook for corporate profits doesn’t look all that great. Margins have likely peaked, corporate America can’t cut all that much more and revenues appear to be sagging. Just 43% of companies are beating earnings this quarter and we’re beginning to see fragility in reporting that very much reminds me of the late 2007/early 2008 period when corporate profits were good, but clearly deteriorating. Mean reversion in profit margins is one of the few things that is a relatively reliable profit occurrence. Of course, timing that event is practically impossible since it occurs over such a long period, but it’s clear that we’re likely facing headwinds here. And as we know from the Kalecki profit equation, the risk of the fiscal cliff could torpedo profits since the budget deficit has been a huge driver of growth. I’ll have more on profits in the coming week.
3) The risks to the market are building
I’ve been dialed in to this market pretty well over the last few quarters. In early April I was looking for a sell-off and then in early June I was expecting a rally. I think we’re nearing a point where the market once again looks increasingly risky. We’ve had about a 9% rally off the June lows and I am having trouble thinking of a positive catalyst at this juncture. The key to understanding most of the market rallies in recent quarters has been dialing into big policy moves. Every time the Fed or ECB has responded with a big policy maneuver the market has rallied. Now, there’s a chance that the Fed implements QE3 at the August 1st meeting, but if we don’t get it there then the market has to wait a full 6 weeks before any policy response occurs. And that’s all as Europe’s woes just tumble on without action. I’m trying to think like a chess player here and consider the possible future catalysts, but I just can’t think of too many. I’m sure readers have some opinions here. If so, please chime in….
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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41 Comments
Saw your 100% cash call yesterday on Twitter. Looking good so far. Keep us up to date please!
Lucky timing. I’m no day trader….
Thanks, Cullen. What would mark a definitive end to the Euro crisis in your opinion?
1) Full fiscal alignment for all euro members
2) Creation of supra-national european government (including central Treasury)
3) Wealth transfers from North to South to compensate for current account imbalances
Sounds right to me! Thanks Frenchy.
Frenchy/Cullen,
could you give an example of wealth transfers from North to south?
thank you
As simple as “gifts” John – the newly created “Euro” government/treasury collects taxes from all Euro nations and disburses them to where they are needed.
e.g. a country doing well (say Germany) will obviously pay more taxes given its economic strength. Some of those taxes are used to pay for unemployment benefits and hospitals in Spain.
That’s how a proper fiscal union works.
A true political union must have the biggest expenditures and top-level functions of government (military, trade, foreign relations, bank regulation, deposit insurance, social security, etc…) run at the Federal level. It will need to have a universal citizenship for the union, and true labor mobility. If the EU adopts these features, I’ll believe that their fiscal union is real. I suspect we will be waiting a very long time..
Agreed, except about the “waiting a very long time” – I believe it will NEVER happen.
I am however open to the prospect of them forming some sort of fiscal union which may not be “true”, but is sufficient to stabilise things economically (at least for quite a long time)…
Indeed, these look like necessary conditions to stop the current crisis without either mass default or devaluation.
Quite obviously these are impossible to implement under current conitions.
Three will never happen. Germany will see no point in exporting goods to to the south if it has to give up the wealth it accumulates from said exports. The “new fiscal authority” needs to be in charge of compensating for current account imbalances, not the individual nations. There also needs to be some structural reforms within the periphery once the insolvency threat is eliminated.
The EU Federal Government can assume functions that have the effect of spreading wealth and harmonizing labor costs. They can subsidize big public works projects and assume control and funding of all universal pension schemes. The can assume full power and responsibility for banks and for defense. They can harmonize labor rules. Germany’s labor costs would go up, and the labor costs of the others would go down.
Germany will no longer be a country. All of Europe will be the country. Ohio and Iowa are in the same country and pay taxes to the same federal government
and recieve transfer payments from the federal government.
The easiest way is for Germany to leave the Euro zone.
The only bullish indicator I currently see is the high level of pessimism and media attention on European mess. That said, EZ seems poised to deteriorate further (i.e. Italian yields back to the highs) before any concrete short term action is implemented. Also: I don’t think equity mkts are obscenely underpriced, it seems risk-reward ratio is starting to favor a short.
+1. There is some type of disconnect here. On one hand I keep hearing people saying how bad things are, but on the other hand volatility index is near multi-month low and market is only a few % off recent high. Stocks that beat EPS but miss on revenue and guide down for FY 2012 actually goes up (witness Intel). It’s very confusing. Only thing I can think of is the Fed put but at SP 1370? No way.
Re: 3) & QE policy rallies. At least for equities … what’s odd is TLT did not sell-off on the recent equity rally. Sort of hints to me that all the equity support is foreign inflows or reluctant grasp for high-risk equity cash flow yield (just look at REIT yields … in any other planetary economic cycle I would have sold those long ago).
Re: 2) other than that it doesn’t really feel like 2007. Housing is looking up. Financials are holding up. Heavy trucks holding up. Debt sideways or euphoric in some sectors. No inverted yield curve.
With short rates pegged at zero the yield curve cannot invert – not unless you would postulate nominally negative 30 year yields being possible in the real world.
So many cross-currents here it’s impossible to be too confident on any stock market call but here’s a shot-in-the-dark just for the heck of it based on all my work, a mix of technicals, sentiment, historical price patterns, economic data trends, election-year and other seasonal patterns plus euro-political factors:
Short-term (days/weeks max): sell-off, shakeout + the return of fear
Medium term (into fall): sharp rally to new highs (on rebounding econ data / central bank action), followed by complacency & stock market top above 1450 on $SPX
Longer term (Q4 2012 – 2013): Start of the long, grinding, downward phase of the secular bear. US recession starts, the euro endgame begins.
Two successive market fakeouts, one to the downside (now) and a big one to the upside (into fall or beyond) pretty much guarantees anyone with a rigid bullish or bearish view here will take a walletectomy by the time the year is done.
Investors Intelligence still with a significant number of bulls (43.6%) and only 24.5% bearish combined with a 15 VIX, I believe is the recipe for a significant sell-off based upon the catalysts Cullen laid out above. If the bulls move to 50 and the bears under 20 in the next few weeks that would be a very reliable sell signal.
Reversal in economic data to the upside? Almost nobody mentions that. I would not too. Yet what would prompt the fed to act on August 1? Earnings are pretty satisfactory, if not good so far, all previously reported data are priced in (as per Bernanke congress speech), the market is very close to the highs. The new set of data, most importanlty unemployment will not be known by August 1st. What then???
And without “good” data, what type of QE can they do to satisfy market?
Unfortunately, it is outright speculation, yet I would bet they do nothing and reiterate readiness to act immediately if situation worsens.
On the different point, if we indeed entering cyclical recession, QE would not help.
The cleanest dirty shirt effect may have a lot to do with recent gains…I don’t think the fed will just sit back and watch the markets rot, but given the limitations of their resources they’ll wait as long as they can, things must run smooth during a presidential election you know. QE2 didn’t start until SP1100 so it’s not hard for me to imagine that the fed would wait for <1200 now. After the elections our elected officials might (maybe) be able to make a save if they're smart, quick, and decisive oh hell what am I sayin
My favourite financial market indicator peaked in March and has gone down ever since. Not a good sign.
OK. I’ll bite. What is your favorite financial indicator?
Thanks
Copper looks weak. But there’s still way too much complacency.
Are you still short interest rates?
I am long TBT. But I have drawn a line in the sand where I’ll quit this short position. The picture looked dismal for a while. Perhaps I’ll go long TLT again.
Interesting website with a lot graphs, including the US yield curve:
http://www.martincapital.com
Where’s your line on TBT? I am in TBT also, not doing so hot, not looking to drop yet.
GDP report next week, then the market waits for the fed aug 1st meeting. That’s your catalyst. Poor GDP and no fed action = a brutal Aug and Sept.
Most anglo/americans opininists still don’t understand the rationale behind the euro project. This is a political investment and not just an economical one. The euro project will sink when it will loose political support in the 3 founding countries: germany, france and italy. All the other countries don’t matter. Support is fading because of huge political and economical mistakes, but there is still room to complete the project. In the short time (from now to the end of this year) the BCE will more or less silently backstop all the financial necessities of south europe. So if someone is betting hard on the dissolution of the eurozone this year, he will loose tons of money. For 2013 and beyond it’s a different matter, but a lot of hedge funds are over exposed on a fast dissolution of the euro zone. We will see some of them go burst in autumn.
And, as Cullen perfectly wrote on this short but essential piece, there are points 2 & 3. I will add a point 4 and 5:
4) china is hard landing. Don’t be fooled by the official numbers coming from the ministry of truth in Beijng. The implication of this should be obvious. For me, there two huge short bets on the horizon and no… it’s not the euro.
5) the probabilities of a devastating war with iran are growing by the day. I don’t know if this history changing event can happen before or after the US elections but i suspect it will happen in late august to early october
I believe we are living of the worst and most critical time from 1939 and I also believe there are no safe heavens or good investments except our own family.
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Is this news to anybody? If the Euro crisis isn’t fully priced in, then it has to be pretty close.
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I’ve lost count of the number of times I’ve read this one too.
First, you need to be looking at margins globally not as a percentage of US GDP. 50% of S&P 500 profits come from outside the US, and margins as a percent of global GDP are not high.
Second, falling margins would imply that US corporations are once again beginning to hire in a meaningful way. Will a falling unemployment rate be bad news for the market?
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Really? How about just a partial reversal of the extreme negative sentiment as measured by record-low interest rates and record outflows from equity mutual funds, and a marginal decrease in the equity risk premium? Or QE3?
Hi – your economic ignoramus, here. My two cents worth:
Something just “feels” wrong.
Troll,
I don’t know who that’s directed at, but it’s not a useful comment in any way. If you think someone is wrong then explain your position without calling people names. If you can’t do that then don’t bother commenting at all. Thanks.
Cullen
Cullen,
I think you may have misread him here. I believe he is describing himself as an economic ignoramus, like Spiderman saying, “your friendly neighbourhood Spiderman.” He’s just acknowledging at the outset that he doesn’t pretend to really understand economics.
Mathew
I hope so! He’s a regular around here. If so, I am sorry.
I don’t always agree with Cullen, but he is a straight shooter and one of the best economic commentators on the web. Get lost, Troll.
Upon reading his comment again I think I was in error and that he was calling himself an economic ignoramus. I had a brain fart. Sorry Troll.
I agree but with 2 other points:
4) china is not just slowing and this is not priced it. Of course there is a huge feedback with points 2) and 3) For traders I think this will open up a huge short trade against the AUD in autumn, expecially if AUD/U$ climbs to 1,08 or ever higher. AUD and YEN are the most overvalued currencies in the world but AUD is much more volatile and will fall when the marked will change opinion, YEN will depreciate when the japanese autorities (and not the market) will understand that they have no other alternatives to keep the economy alive.
5) the war with iran is getting closer and closer. This will be a history change event and will precipitate the world to near collapse. But it will also be a huge opportunity to really create double digit inflation and destroy many trillions of debt in a few months. For this reason it’s getting more and more “interesting” for over indebted countries (that is almost all). People will pay as always.
Cullen,
Your “100% cash” call last Thursday on Twitter was great timing, a great call. But I want to ask: do you think the bond market is in the process of topping out? Why did you not call for 50% bonds, and 50% cash rather than 100% cash. I still think we are headed toward a 10 yr Treasury rate of about 1.20% when we hit the bottom. I am mostly in corporate bonds. What are your thoughts?
Fundametals look bad. Earnings down, job growth stalled, consumers still tapped out.
Europe in recession and Chine uncertain.
European financial crisis in early stages and chaos likely, whether they default on the sovereign debt or agree to print money to rescue the bond holders and finance their budgets (not enough is being made of the political and economic ramifications of essential financing government by printing … after all, who will buy European bonds if they pay 0 percent).
Bulls are holding onto hope that QE3 will boost the market, not that they believe in QE, but they believe the other guy believes it.
All in cash, waiting for blood on the streets.