CCM Clients: We looked at the risk profile of all client accounts today, focusing on our mix of stocks, bonds, precious metals, cash, and CDs. The majority of clients have risk profiles that mesh well with the current uncertain environment. We have queued up a few sell orders for a relatively small group of clients. We may execute those orders near the close today. We will continue to assess risk, on a daily basis if needed. We hope you enjoy your weekend.
Archive for July, 2011
Gross Domestic Product (GDP) figures were released this morning. They were very weak, especially the revision to first quarter growth. We mentioned in our previous post that “we need to see improvement in both the fundamentals and the technicals over the coming weeks,” which is not what we got this morning. We are looking at the risk profile of all our accounts today. We may make some adjustments defensively given the weak data that was reported at 8:30 am. Our comments about the debt talks are in the post below.
The deadline for some type of debt-ceiling deal is now only five calendar days away (three trading days). The odds of no agreement of any kind coming together remain relatively remote. The political stakes for all players involved, including both parties and the President, are too high.
If our elected representatives fail to reach an agreement over the next five calendar days, it will be a public relations nightmare for all of them. More importantly, it will be a nightmare for them on Election Day. There will be no political winners if they fail to compromise. Politicians may not be good at many things, but they tend to be very good at looking out for their own interests, especially when it comes to getting re-elected.
Those looking for a resolution on Friday will most likely be disappointed. Obviously, the situation is fluid, but based on our research, it would not be surprising to see a compromise surface in a manner something like this:
- Both of the current bills (House and Senate) will fail to pass both chambers in their present form (emphasis on present form).
- As the 11th hour shifts to the 12th hour, leaders from both parties will produce a bill that has a good chance of passing in both houses. The compromise bill will most likely begin to take shape between Saturday night and Monday night.
- As the pressure mounts and the clock ticks, it will be very difficult for individuals or parties to block the “solution” by voting no.
- A comprise bill will most likely pass both houses on Monday or Tuesday and be signed into law before Wednesday, August 3.
The difficult part relative to the markets is when will the compromise become public? Saturday, Sunday, Monday, or Tuesday? The odds are good the compromise will come to light when the markets are closed, which means the futures may price in the news leaving little opportunity to redeploy cash. If the Dow opens up 200 or 300 points on Monday or Tuesday morning, you cannot capture that gain with cash on a “gap open”.
The scenario above is one of many that may or may not play out over the next five calendar days. From a money management perspective, we must understand several possible outcomes and have plans for each. We are by no means locked into the scenario above, but we do have it as the highest probability outcome as of the close on Thursday.
The bigger questions for the markets may be:
- What form will the compromise bill take?
- What will the intermediate-term reaction be?
How we interpret the market’s reaction will be highly dependent on the bill that passes. If the bill is fairly substantial in terms of taking a first step toward meaningful reform, and the market cannot sustain gains past the initial relief rally, it will be a bad sign for the health of the current bull market. Once the next step is taken on the debt issues in our nation’s capital, the market will begin to focus on the economy, earnings, the Fed, and Europe.
Thursday’s trading session was not as bad as it looked. Volume on the NYSE dropped 7% relative to Wednesday. The NASDAQ saw volume contract by 12%, which indicates institutions were not running for the exits near the close. Market breadth was negative, but also showed an improvement over the previous trading session.
On the debt debate Bloomberg reported:
Senate leaders are working privately to reach a compromise that could clear Congress by Aug. 2, the date the Treasury Department says the nation will breach its borrowing limit and run out of options for avoiding default.
Reid and his Republican counterpart, Minority Leader Mitch McConnell of Kentucky, maintained a private dialogue on developing a path to a debt-limit increase in the Senate, where bipartisan support is needed to gain the 60 votes necessary to ensure a vote on controversial legislation.
The New York Times noted indirectly that they “get it” in Washington:
Leaders of both parties and in both chambers said that it was essential to avoid a default on the federal debt.
The current market looks weak, but not end-of-the-bull market weak yet. The next few weeks should give us a good indication if the second half of 2011 will bring higher highs or lower lows in asset prices. As we mentioned on July 27, our concerns about the market are related to how things evolve after the current crisis passes. We do not believe the markets will have a clear path to the finish line in 2011 even if we get a positive result over the next five days. We need to see improvement in both the fundamentals and technicals over the coming weeks. If we see improvement, we are happy to become a little more optimistic about the remainder of the year. For now, we are cautiously optimistic because the risk-reward profile of the market remains favorable (see tables at bottom of July 28 article).
After the market closed on July 27, we reviewed the latest news from Washington looking for information that can help us over the next six calendar days. Our current interpretation is that a deal will get done in some shape, form, or fashion.
A Bloomberg story noted that the credit markets are not overly concerned about the political banter in our nation’s capital:
Banks in the U.S. are scrutinizing credit-market movements as they look for distress ahead of next week’s deadline to raise the U.S. debt ceiling. So far, those metrics aren’t showing signs of panic.
“If the debt ceiling was such a problem, there’d be a lot more volatility in the credit markets,” said Leon Wagner, who co-founded GoldenTree Asset Management LP, a New York hedge fund focused on debt markets. “What we’re seeing is really just statistical bouncing around a normal trend line. That’s healthy in credit markets.”
Despite their public face of fighting with a singular focus for their constituents, important players in the debt saga are conceding that compromise is slowly coming into the process. From Reuters:
Senator Reid said he could easily modify his bill to incorporate elements of Boehner’s bill in a way that could win support from both parties in the Senate.
“There will be sufficient cooperation so a bill will pass that allows the debt limit to be lifted, with deficit reduction,” Democratic Senator Max Baucus said.
What about the concern that they are running out of time to get a bill passed by both chambers of Congress and signed by the President? The Associated Press reported:
Senator Reid was asked if there was a “drop-dead date” for a deal to pass the House, be amended by the Senate and reach President Barack Obama in time to avoid default.
“Magic things can happen here in Congress in a very short period of time under the right circumstances,” he said.
Amid all the heated rhetoric, it was easy to miss the fact that the differences between the sides actually seemed to be narrowing.
What happens if both bills fail to pass in both the Senate and House? The Wall Street Journal touched on this topic:
At the White House, officials anticipate that neither the Boehner nor Reid plans can get through both houses of Congress, and they are crafting alternatives that could be finalized over the weekend and put to a vote Monday or Tuesday.
We noted on July 27 that the impact of a debt downgrade may be less severe than many believe. The word on the street has been that Standard & Poor’s may downgrade U.S. debt even if one of the current bills becomes law. The Wall Street Journal reported that is not necessarily the current stance of Standard & Poor’s:
Deven Sharma, president of Standard & Poor’s, told a congressional committee the credit ratings agency does not think the United States will default on its debt. “Our analysts don’t believe they would,” he said.
Mr. Sharma said some of the proposed budget plans could help the U.S. bring debt and deficit levels within a range to maintain its AAA debt ratings.
Pressed by panel members on the prospects of a U.S. default, Mr. Sharma said a downgrade does not suggest a default is probable.
“If we change the ratings, it means that the risk levels have gone up, it doesn’t mean it’s going to default. If we believed that, they would change it to default status,” he said.
The New York Times had a similar report that discounted the inevitability of a ratings downgrade:
The president of another rating agency, Standard & Poor’s, also said that deficit-reduction plans currently being considered in Congress could be sufficient to allow the United States to keep its triple-A credit rating.
Deven Sharma, disavowed recent news reports that quoted an S.&P. analyst as saying that Congress would need to achieve at least $4 trillion in deficit cuts over 10 years to maintain the country’s triple-A rating.
Mr. Sharma told a House subcommittee that the $4 trillion figure was “within the threshold” of what the agency thinks is necessary. But he declined to draw a bright line, saying only that “some of the plans” being considered on Capitol Hill could reduce the U.S. debt burden to a level that was “in the range of the threshold of a triple-A rating.”
Shifting gears to stock market sentiment, which can be a contrary indicator when it reaches extremes, Tarquin Coe, a Senior Technical Analyst for “Investors Intelligence”, posted the following on Seeking Alpha:
Bottom line – the market has not yet reached the optimism evident at medium-term market tops. New 2011 highs for the big board indexes are yet to be registered and we see the potential for such records to be notched before the end of the summer. This week’s weakness is an opportunity to accumulate.
The CCM 80-20 Correction Index has weakened, but remains in bull market territory closing at 882 on July 27. Stocks have tended to regain their footing while within the current range. We could see some more downside in stocks and still remain in the current range.
The CCM Bull Market Sustainability Index (BMSI) remains well in bull market territory, but there is quite a bit more orange, yellow, and red not too far below current levels. We would prefer to see the BMSI hold above 2,293; it closed at 2,843 on July 27.
We will maintain our exposure to stocks (SPY), gold (GLD) and silver (SLV) while keeping an eye on developments in Washington and the risk-reward profile of stocks and commodities. As noted after the close on July 27, we hope to see the weekly chart of the S&P 500 regain some traction in the next few trading sessions.
On Friday, July 22 the S&P 500 closed at 1,345 and this was the latest from the Washington Post on the debt situation in Washington:
President Obama and House Speaker John A. Boehner (R-Ohio) are close enough to a debt-deficit deal that Boehner told Republican lawmakers Friday that he hoped the deal would come together soon enough for the House to consider by Wednesday of next week, according to GOP staff who were in the room.
Three trading days later the S&P 500 has dropped to 1,306 and the latest from the Washington Post looks quite a bit worse:
At a meeting of GOP House members, the embattled Republican leader told his colleagues, many of whom had vowed to oppose his two-step bill to raise the debt limit that is expected to hit the floor as soon as Thursday, to “get your ass in line.”
We did some selling today in the vast majority of our accounts. A debt deal looked to be in good order at the end of last week. Today, the possibility of missing the August 2 deadline is much greater. We are also seeing deterioration again on the weekly chart of the S&P 500 Index. If the weekly chart of the S&P 500 does not improve by week’s end, we may take more defensive action depending on the situation in Congress. The two charts and table below illustrate the changes that have taken place in three trading sessions.
If some good news can come out of Washington, the chart above could improve by week’s end, which is much more important that looking at it on a Wednesday night.
Since the United States has carried a AAA debt rating since 1917, the term unprecedented has been properly applied to the possibility of a downgrade to AA. The uncertainty associated with a debt downgrade/short-term default was captured by the Wall Street Journal on July 25:
In one recent meeting at a major bank, executives were asked to suggest what they would recommend buying the very moment the debt limit wasn’t raised. For each argument made, there was a valid counterargument for why the purchase wouldn’t be wise.
Before we cover the possible impact of what appears to be an almost inevitable downgrade of U.S. debt, let’s discuss one possible way to approach the markets. When confusion creeps into a decision-making process, it is always wise to take a step back and focus on the basics. Do we really need Standard and Poor’s to tell us, via a downgrade, that the long-term fiscal outlook for the United States is on less-than-stable footing? Obviously, the answer is “no”. If that is the case, the financial markets may have already priced in a downgrade based on common knowledge of our nation’s budget woes.
If the financial markets will gain no new knowledge upon the announcement of a downgrade, the current trends in asset prices may remain in place. A market’s 200-day and 22-week moving average often serve as good bull/bear litmus tests. Healthy markets tend to have positive slopes on their moving averages; weaker markets tend to have negative slopes. The table below shows the state of affairs as of July 26. The U.S. dollar has been weak and risk assets have been relatively healthy, which depicts an ongoing bull market in risk assets. If the market has priced in the fiscal state of affairs in the United States, then the table below may continue to serve as a good guide for investors.
A “tipping point” scenario looks at the situation from a more bearish perspective. A debt downgrade may be the fundamental straw that breaks the bull market’s back. Numerous straws are already weighing on the market’s spine - a weak recovery, elevated unemployment, debt problems in Europe, and inflation in Asia. If the “tipping point” scenario plays out following a downgrade of U.S. debt, the table above would migrate to a much more red dominated state as the 200-day and 22-week moving averages begin to roll over in a bearish fashion.
In the “tipping point” scenario, the silver lining for the bulls would be the time it typically takes for markets to shift from a bullish bias (as we have now) to a bearish bias (as we saw in late 2007/early 2008). The transition period should allow for some allocation adjustments to be made over a few weeks, or more likely a few months. You can get a better visual understanding of the bull/bear transition period in this July 2011 stock market outlook by focusing on the slope of the S&P 500’s 200-day moving average.
The impact of a debt downgrade on the markets and the economy is difficult to assess due to the unprecedented nature of the situation. However, we do know the United States Treasury market currently has two major selling points: (1) AAA-rated, and (2) very, very liquid. Following a downgrade, the United States Treasury market will have two major selling points: (1) AA-rated, and (2) very, very liquid. Downgrade-related concerns in the markets would be greater if there was a viable and competitive alternative to a debt market that carries a still-sound AA rating and is very liquid. Japan has problems of its own and its debt carries a lower rating of A1. The common currency in Europe makes it difficult to completely separate German bonds from those issued by Greece, Spain, Italy, and Portugal, especially over an intermediate-to-long-term time horizon.
If following a downgrade, with no highly-liquid substitutes for U.S. Treasuries, the question becomes one of repricing. Investors will be willing to pay less for a bond that carries a lower rating and more risk. How much less? According to a New American article:
Tom Porcelli, chief economist at RBC Capital Markets, looked at the price performance of sovereign debt of four countries that lost their AAA rating and said the yields (which move inversely to bond prices) fell just six basis points — six one-hundredths of a percentage point — translating to a decline in bond prices scarcely worth mentioning.
A Bloomberg story pegs the impact as being a little more significant, but not earth shattering:
A cut of the U.S.’s AAA credit rating would likely raise the nation’s borrowing costs by increasing Treasury yields by 60 to 70 basis points over the “medium term,” JPMorgan Chase & Co.’s Terry Belton said on a conference call hosted by the Securities Industry and Financial Markets Association.
Bloomberg reported the results of a debt survey in early July:
Ten-year Treasury yields may rise about 37 basis points if the U.S. government temporarily misses a debt payment while promising to make bondholders whole as soon as the debt limit was raised, according to a mean estimate of 45 JPMorgan clients that were surveyed by the firm. Foreign investors forecast yields would rise 55 basis points.
Note the JPMorgan survey above assumes the U.S. goes into a short-term form of default, rather than just being hit with a downgrade by one of the rating agencies. The ramifications of a default scenario would be more significant than a downgrade alone.
How significant is a 60 basis point move (or 0.6%) in interest rates? Significant, but not all that unusual, and taken alone it is not a reason to move to a portfolio that incorporates your mattress as the primary investment vehicle. On November 30, 2009 the yield on 10-year Treasuries was 3.20%. On December 31, 2009 the yield had climbed all the way to 3.84%, which is a move of 0.64% or 64 basis points. Did the 64 basis point move kill the bull market in risk assets? The S&P 500 closed at 1,095 on November 30, 2009, prior to the 64 basis point move in the 10-year Treasury. Over the next eighteen months the S&P 500 moved from 1,095 to 1,370, despite the 0.64% rise in interest rates.
The current situation is serious, but as we noted on July 25, the bond market has thus far remained stable. Our ongoing concern relative to the markets centers around the “tipping point” scenario rather than the cataclysmic-event scenario. Our portfolios are currently aligned with the table above, which is based on observable facts. If the facts change, we are ready, willing, and able to make adjustments.
Monday night’s nationally-televised addresses by party leaders did little to clear the air in the debt-ceiling debate. Once some form of resolution is born (good, bad, or indifferent), the early reaction, especially in terms of market leadership, will be important. If commodities can regain some traction, it would be a bullish signal for the economy and markets.
The weekly chart of the CRB Index, a basket of commodities, is the poster child for an indecisive market. The index sits right in the middle of the trend channel. A break higher would probably be followed by a move toward the upper end of the channel (near point B). A break lower by the CRB Index might be followed by a move toward the lower bound of the channel (see B2 for a similar move).
Near point A, the orange arrows show the recent bearish bias has not been cleared in terms of the Relative Strength Index (RSI). Healthy and stronger markets tend to see RSI stay above, not below, the orange horizontal line. Near point C, the Williams %R indicator has been unable thus far to clear the midpoint hurdle of -50, which shows an understandable lack of conviction from market participants.
Commodities (DBC), gold (GLD), silver (SLV), and bonds (TLT) will all provide clues about the tone of the post-debt-saga market that is just around the corner. The first three days of trading after some clarity in Washington will help determine which of the two major scenarios is like to play out:
- The market can stand on its own, based on fundamentals, and stocks move higher.
- The fundamentals cannot support stocks; stocks drop and then the Fed begins more chatter about stimulus.
As we discussed on July 13, gold and silver have been looking better relative to stocks. On July 25 we showed the bond market, like commodities, is giving some mixed signals, but bonds are holding up well given recent debt-related events in the United States and Europe.
We are fence-sitting in the commodity markets at the present time. We own both gold and silver. Gold is the better choice if the post-debt-saga market takes on a bearish tone. Holding silver will most likely be more advantageous under more favorable conditions for risk assets.
Leaders from both parties in Washington are playing a dangerous political game with the nation’s AAA credit rating. The first self-imposed deadline of July 22 to have a framework of a debt-ceiling deal in place has already passed. The second and firmer deadline of August 2 is a little more than a week away. Despite Standard and Poor’s warnings of a possible debt downgrade if realistic deficit-reduction plans are not agreed upon, the Wall Street Journal included the following in their update from Sunday night:
Congressional leaders from both parties were developing competing deficit-reduction plans, but they released only broad outlines and few details. Several aides stressed the plans were still evolving.
‘Broad outlines’, ‘competing’, ‘few details’, and ‘evolving’ are not terms that build confidence in the minds of market participants. Although volatility has picked up, the financial markets have thus far remained relatively calm in the face of ever-increasing uncertainty about the outcome over the next eight days. The term default speaks to missing scheduled payments to holders of U.S. Treasury bonds. Like many markets during these uncertain times, the market for U.S. debt has been giving some mixed signals.
The long-term Treasury exchange traded fund (ETF) is shown below; it trades under the symbol TLT. Market sentiment can change quickly, especially when credit ratings are involved, but at the end of last week the Treasury market was not foreshadowing impending earth-shattering doom. The intermediate-term trend for Treasuries remains up (yes, up), as indicated by the series of higher lows (see green arrows). However, the longer-term outlook is showing some cracks. The negative slope of the 200-day moving average (orange and red arrows) is a yellow flag for the price of bonds. The importance of the 200-day, in all markets, is covered in this video. The price of bonds recently made a higher high (see A and B), but the Relative Strength Index (RSI) made a lower high (A1 and B1), which indicates waning short-term interest from buyers of U.S. debt.
The last noteworthy item in the chart of Treasury bonds above is the increasing volume on “up days”. These positive spikes in volume tell us market participants believe some form of a debt deal will get done before August 2. Obviously, that belief is subject to change over the next eight days. Our concern is that the tone in the bond market may abruptly shift in a negative manner if the bickering and political posturing in our nation’s capital does not subside soon (very soon). Our leaders may not fully respect that once the market for U.S. Treasuries makes a sharp bearish turn, it may be difficult to repair the damage.
How does all this help us? The state of the bond market heading into this week questions the validity of the calls for the end of the world as we know it. The markets are in relatively good shape given the problems of the day. Markets that can digest bad news tend to be markets that surprise on the upside. Until the evidence begins to shift (and it may), we will continue to give the bull market in U.S. stocks (SPY) the benefit of the doubt, while holding some gold (GLD) and silver (SLV) as insurance against poor leadership from our elected officials. We will pay close attention to all markets in the next eight days with an open mind.
The latest from Europe says banks may take writedowns (a.k.a. losses) in the neighborhood of $30 billion. While we expect the problems in Europe to linger for some time, the current “fix” may buy the financial markets some time. According to Bloomberg:
“Banks should be able to digest any haircuts on Greek debt, and it is already priced in to their shares,” said Andreas Plaesier, a Hamburg-based banking analyst at M.M. Warburg. “What was really key was supplying capital to Greek banks and stopping the possible chain reaction to lenders outside the country that hold Greek banking assets.”
For now, the dollar appears to have a mixed short-term outlook, but a bearish bias remains for the longer-term (see July 22 video). The S&P 500 also has a mixed outlook in the short-term, but one with a bullish bias for the time being (see July 18 video).
The direction of the U.S. dollar is very important relative to the performance of both stocks and commodities. The video below looks at the current short, intermediate, and longer-term outlook for the U.S. dollar. You can use the button with the four arrows in the lower-right portion of the video player to watch the video in full screen mode. Hit your Esc key to exit full screen mode.
The significance of the 200-day moving average is covered in more detail in this post and video.