E-piphany

Well, I said that I thought we would revisit the flash-crash lows, and we seem to be well on the way there with today’s 3.9% decline on heavy volume of better than 2bln shares. I thought that would happen (although I didn’t think it would happen so quickly) since the reason the market was declining – it was pricing in a normal, or even faster-than-normal, recovery and was even a bit frothy for that, while the trends in global growth seem to be rolling over and the fissures in the financial system seem to be growing wider – had nothing to do with the sudden breakdown in liquidity we saw that one day.

But the perennial bulls seem perplexed by the mathematics, as they always are. They seem not to understand the mathematical reality that for most developed nations, debt and deficits are so large and demographic trends so poor that lower spending and/or higher taxes and/or monetization are inevitable. They are enthusiastically invested in over-levered financial institutions that have not gotten significantly less levered, and moreover whose market valuations imply ongoing high leverage, wide spread, and high turnover (all of which are threatened by regulation). They welcome government intervention in messy markets, not recognizing that little good can come of quickly-written, populist government policies designed to damage the entities that add liquidity to markets, to erect barriers against trade, and to manipulate markets.

“But,” says CNBC, “the markets must be oversold.” Over and over throughout the day today, the talking heads did not ask whether the markets are oversold, but instead “How oversold are we?” But why would they think the market is oversold? Because it went down? Down doesn’t equal oversold. Technical oscillators are showing the market neutral to just slightly south of neutral (daily 5-3-3 stochastics on the S&P are around 50%; 14-day RSI is at 31%). Moreover, in trending markets (as any neophyte technician is aware) markets can become overbought or oversold and stay that way for a long time. “Oversold,” in short, is the last refuge of people who recognize that the fundamentals don’t support their thesis, so they’re hoping to at least get a bounce to sell into.

It is evidently not the case that the economy is improving rapidly. Initial Claims were 471,000, considerably above expectations and right back into the old range. Maybe hiring is up, but firing is just as robust. (The best part of today’s release, though, was the ill-phrased Bloomberg headline saying “More Americans unexpectedly file claims for jobless benefits.” Really? How do you unexpectedly file? Do you wake up in the morning and discover that in a drunken stupor last night you accidentally filed for unemployment? ‘Wow, that was unexpected!’)

The Philly Fed index was on consensus, but the New Orders and Number of Employees sub-indices weakened a bit: not the sign of an imminent collapse, but neither the sign of a broadening and strengthening recovery.

Bond traders certainly have changed their minds recently about the state of the economy. While the rally in the bond market arguably began as a flight to quality, two elements of the recent trade suggest there is more than that to the rally now. First, the yield curve today was flattening during the rally (TYM0 +22.5/32nds; 10y yields down to 3.26%), meaning that investors were reaching for longer-dated bonds. In a flight-to-quality, typically the curve steepens as it rallies (to be sure, the fact that the Fed made clear yesterday that they aren’t about to be selling Treasuries any time soon probably helps the supply/demand dynamic for longer bonds as well). Second, market-based measures of inflation expectations declined sharply again with inflation swaps closing 10 to 16bps lower across the curve.

Indeed, TIPS yields at the short end of the curve actually rose; short-dated TIPS have been over-owned because investors have been looking for a inflation protection without having to be long duration in real yields that are at historically low levels. For the first time in a while, forward inflation expectations are topping out no higher than 3%. From today’s closing inflation swaps curve, we can divine the market’s expectations for calendar-year (Dec/Dec) inflation:

2010: 1.2%

2011: 1.3%

2012: 2.1%

2013: 2.4%

2014: 2.6%

2015: 2.8%

2016-2017: 2.9%

2018-2020: 3.0%

TIPS are still not cheap, as real yields are quite low; however, they are increasingly getting cheap to nominal Treasuries again. Short-dated TIPS at 0% real yields are not too bad any more, compared to nominal Treasuries near 0% nominal yields!

But, although I generally shy away from discussing particular securities, I will mention one that I bought today. It is a preferred stock issued by SLM Corp which acts like a floating-rate inflation-linked bond with a maturity in 2017. The symbol is OSM; I bought some today at a price of 16. The notional value of the bond is 25, and it pays a coupon of CPI+2%, so together with the discount the effective yield is CPI+10% approximately. Of course, I have credit exposure to SLM, which isn’t the greatest, but even stripping out the value of the credit (which I could do if there were exchange-traded CDS) the payout is roughly CPI+5%. The fact that it is a preferred security means I am senior to the common, which will be small comfort if the firm goes under but leaves me with a chance of recovery in a bankruptcy.

That is, however, the only foray I am making onto the stock exchange these days. If the market continues to fall, I am willing to buy some stuff, but my usual neighborhood (high-dividend-paying, low-leverage, low-PE names) carries some added risk given all the talk about changing the taxation of dividends. If there were an appreciable relative increase in the tax on dividend income, and it seems this is plausible, then the stocks I tend to hold will be getting cheaper, and some of them will cut dividends (DO, which is controlled by a family that likes to take big dividends, for example, might well display less of a preference for that sort of distribution; CHKE mentioned in its annual report the possibility that it may cut its dividend if there are adverse tax-law changes). Since it is well known that companies that pay higher dividends tend to have higher earnings growth (see for example this paper), this leaves me scratching my head about how cheap the non-dividend payers would have to be before I’ll simply trust management to do right by me. Pretty cheap, is the answer.

We may well have a chance to buy cheap equities. Remember, Richard Russell has warned that stocks trading where they are now could be a precursor to a “major crash.” Nouriel Roubini, always a cheerful chap, says we are going down another 20% (which isn’t too bad given how much we have rallied over the last year). The Senate is moving to a final vote on financial regulatory reform. Coincidence? Sure.