DIVERGENCES - They Are Global

Europe's WTF Chart 02-06-13 Zero Hedge

Much has been made of Europe's impressive market performance last year (and ongoing this year) with its strength yet another confirmation-bias proving indication that every US stock dip should be bought. In recent days a few cracks in the armor of European invincibility have begun to show as political and banking system fraud comes back top haunt along with rising concerns and jawboning about the strength (or lack thereof) of the Euro. With a somewhat split view of Thursday's ECB meeting (will Draghi cut to hold EUR down for exports or hold to maintain the optics of a strong EURUSD meaning a strong Europe), it is perhaps notable that the outlook for 2013's GDP growth continues to sink. However, as the chart below so obviously highlights, expectations for earnings growth in Europe have massively disconnected from macro fundamentals (just as in the US) as nominal stock indices is all that matters anymore.

European Stock EPS Growth expectations vs GDP growth expectations for 2013...

Notice the disconnect really began when the ECB went 'extreme' with LTRO - and never looked back. Will the current payback of LTRO bring reality closer?

As BNP notes (advising clients to short Europe),

Fade to Fundamentals? Europe still needs to substantially deleverage and is in the midst of a recession. Investor focus should fade back to these still concerning fundamentals. Positive economic surprises are unlikely to catch up with market expectations for growth.

European Misses More Likely: Despite substantial foreign revenues, it is rare for an equity market to manifest double-digit EPS growth while the underlying domestic economy is in recession. This current contradiction is almost always resolved in favour of the economists.

Euro losing the Currency War. The trade weighted Euro has risen by 12% since last July. In addition, the Euro rallied by 32% against the JPY over the past 6 months driven by part by “Abenomics” politics in Japan and the 200bn LTRO repayment contracting the ECB balance sheet driving up European rates. Europe is therefore becoming less competitive relative to other regions.

Not Cheap. On sector adjusted valuations or free cash flow yields, Europe looks expensive. The US however appears cheaper than implied by headline P/E given “Equity Easing” through share buyback and distortive effects of cash on balance sheet (cash P/E>100x).

Perhaps, that is what credit markets are so concerned about (as well as Bail-Ins)...

Chart: Bloomberg

CANARIES SINGING - Brace For A Stock Market Accident

"Brace For A Stock Market Accident", GLG Chief Investment Officer Warns 02-05-13 Jamil Baz (CIO, GLG), Originally posted at The FT via ZH

Brace For A Stock Market Accident

Profits and leverage are locked in a deadly embrace

• There is a time-honoured tradition in statistics: whipping the data until they confess. Bullish and bearish equity analysts are equally guilty of this practice.
• It would seem that statistical conclusions are merely an ex-post justification of a long-held prior belief about equity markets being cheap or overpriced. Clearly, consensus, notably among sellside analysts, is bullish. I present the bullish view before discussing a bearish counterpoint.

BULLISH CASE

1. Earnings yields – a proxy for real equity yields – stand at comfortably high levels. For example, the forward earnings yield on the S&P 500 is 8.3 per cent.
2. Contrast real equity yields with real bond yields: with the US Consumer Price Index at 1.7 per cent and the nominal Federal Reserve funds rate at 15 basis points, real bond yields are at -1.55 per cent.
3. The difference between equity and bond yields – also known as the equity risk premium – is therefore close to 10 per cent. This is way above the 4-5 per cent premium required by investors to own equity, and therefore indicative of an ultra-cheap equity market.

There are two reasons why this consensus is misguided.

• First, because it uses dubious metrics. It is wiser to use a long-dated real bond yield because equity is a long-dated asset.
• And forward earnings yields are misleading for well-documented reasons:
  • analysts’ earnings consensus forecasts are known to be wildly optimistic;
  • in a bid for juicier equity and call option compensations, managers encourage their accountants to inflate earnings numbers; and
  • earnings are partially squandered by managements as they seek to prioritise growth over profitability.
• So it is probably a good idea to use dividend-based – as opposed to earnings-based – equity valuation models. Unlike earnings, dividends do not lie.

• Second, because consensus disregards leverage. Profits and leverage are linked (in a deadly embrace, it turns out). If deleveraging is yet to happen, then earnings growth can only be headed south.
• So what if you trust dividends more than forward earnings? In a simple dividend discount model, the real equity yield is the sum of dividend yield and real dividend growth.
• The S&P dividend yield is 2.15 per cent. The real dividend growth has been historically 1.25 per cent.
• The real 30-year yield is 0.4 per cent. Using these numbers, the equity risk premium is now 3 per cent, less than the premium level deemed acceptable. But we are not done yet, as we have not factored leverage into our equation.

LEVERAGE

Enter Michal Kalecki, a neo-Marxist economist who specialised in the study of business cycles and effective demand. Mr Kalecki showed that profits were the sum of investments and the change in leverage. In the current environment, the implications of this equation are clear:

• in G7 economies, total debt is at a record 410 per cent of GDP. And this is excluding the net present value of social entitlements and healthcare expenditures, which is larger than the total debt.
• Because leverage stands at unsustainably high levels in advanced economies, it should fall substantially over the long term, affecting profits negatively.
• It can be assumed conservatively that the total-debt-to-GDP ratio needs to fall by 100 per cent before the debt position becomes sustainable in advanced economies. This would bring the US back to 1995, when the profit-to-GDP ratio was 45 per cent lower.
• We can value the S&P under the following scenario:
  • dividends fall by 45 per cent over a zero-growth period of 10 years.
  • Then they resume their real growth of 1.25 per cent per year.
  • Again, assuming a real yield of 0.4 per cent and a required risk premium of 4.5 per cent, fair market value is only one-third of current market levels.

Leverage is hence the fly in the ointment, begging the obvious question: when does the deleveraging take place?

Answering this question is tantamount to timing the next major bear market. It is, of course, futile to predict a date, but as economist Herbert Stein used to say, if something cannot go on for ever, it will stop.

It is increasingly obvious that governments will take no active step towards deleveraging unless they are under the gun. But there are institutions and mechanisms that will trigger deleveraging, namely:

1. Basel III,
2. the bond market,
3. default and,
4. rarely, courageous politicians.
5. Inflation can also help delever, except in economies where social entitlements are inflation-indexed.

In the short term, it is clear that central banks need to entertain the illusion of viable stock market valuations by pulling rabbits from a hat. But as high-powered money reaches ever higher levels, the probability of accidents looms large.

EARNINGS - Barclays Says InsufficentGrowth - SPX of 1325 More Realistic

The New Normal In Nine Charts 02-03-13 Zero Hedge

the situation going forward is nothing but awful as negative pre-announcements continue to surge...

which leaves the S&P 500 looking anything but cheap against 40 year average valuations.

As Barclays' Barry Knapp notes, relative to historical valuation metrics, equities look modestly cheap to cash flow (low capex is the likely reason), fair to earnings metrics and notably elevated to balance sheet and debt based measures (EV).

which, given how weak revenue growth is looking this quarter, leads him to continue to believe current implied EPS growth (~18%), well above Barclays' 7% estimate, is too high.

But, in the new normal, a drop back to the reality of 1325 on the S&P 500 seems so out of the realm of possibilities to most buy- and sell-side strategists as to be worthy of ridicule; as opposed to the likes of Gross, Dalio, Singer, Grant, Bass, and Klarman who all see our current farce for what it is - entirely unsustainable!!

MARGINS - Outlook for Margins is Absurd

The Outlook For Profit Margins Is Outrageous 02-05-13 BI

EARNINGS - Tax Loopholes A Stickly Wicket!

How Obama's Balanced "Tax-Loophole" Closing Will Crush S&P Earnings 02-05-13 Goldman Sachs via ZH

• The US has the second highest global 'statutory' tax rate but less than 10% of S&P 500 firms have paid this rate over the last decade.
• Somewhat shockingly, since 1975, taxes have had the largest cumulative impact on S&P 500 ROE as effective rates fell from 44% to 30%.
• They estimate each percentage point rise in effective tax rate would lower S&P 500 ROE by 22 bp and EPS by $1.50, all else equal.

Closing all the loopholes would smash year-end 2013 expectations from Goldman's 1575 to around 1300 with Staples and Tech the hardest hit.

With the 'market' the only policy tool left, it would seem not even the Fed could monetarily save us from this fiscally fubar action. 

DISTRIBUTION

IMPACT

AMERICA - The Statistics of the Working Poor

Nearly Half Of American Families Live On The Edge Of Financial Ruin 02-04-13 BI

STATISM - The Reality of It & Aaron Swartz

Aaron Swartz's Girlfriend Has A Damning Theory About The Young Reddit Co-Founder's Suicide 02-05-13 BI

RISK- ON-OFF: Bonds Most Overbought in 55 Years

BOND GOD: The World Is Changing, And Bonds Are The Most Overbought I've Seen In My 55 Year Career 02-03-13 BI

FUNDAMENTALS - Turning Down

The New Normal In Nine Charts 02-03-13 Zero Hedge

Revenue Growth looks dismally recession-prone...

as does the stagnant earnings growth...

Q1 EARNINGS - PE Mutiple Expansion as Earnings Fall But Stocks Rise

Earnings Expectations Continue To Come Down 02-04-13 BI

YARDENI FORECAST - Year-End S&P target of 1665

YARDENI: A Market Melt-Up Could Send The S&P 500 To 1,665 Within Months 02-04-13 BI

MARGINS - Clear Topping Pattern Forming

The New Normal In Nine Charts 02-03-13 Zero Hedge

Bob Janjuah Sees "Final Parabolic Spike Up" To 1575 Followed By Up To 50% Market Crash 02-05-13 Bob's World: Are We There Yet? via ZH

From Bob's World: Are We There Yet?

I last wrote in November (Risk not on?) and since then markets have broadly continued to track the medium-term bigger picture outlook set out in that note, as well as the shorter-term tactical "S&P500 1450/1475 rule? that I also discussed in that piece and in my earlier September note (Stop Loss Update). I wanted to publish now to provide some extra clarity:

1 – The medium-term and the ‘1450/1475 rule’: I wanted to recap the views set out in the above notes. Over the medium term – the first half or so of 2013 – I expected risk assets to rally with the S&P500 trading in the 1500s. Drivers were largely centred on more kicking of the can by policymakers. In terms of the "1450/1475 rule? for the S&P500, in place since September, the call has been and remains that on any weekly close above 1475, the outlook for risk assets is bullish and remains bullish until and unless we see a weekly close below 1450 for the S&P500, at which point the outlook flips to bearish. And the 1450/1475 zone for the S&P remains the neutral/zero position/no-go zone.

2 – Fundamentals vs. Policy – also known as "the gap between the real economy and financial markets high on the synthetic intoxicants coming out of central bank laboratories?: I have written before about the grotesque – in my view – and persistent misallocation of capital (in financial markets) being caused by the mispricing of capital/money by central banks; by their ongoing "promises? to misbehave – seemingly forever – such that anyone with good common sense will eventually be battered and beaten into submission and be forced into the misallocation game; and by the – again, in my view – irresponsible behaviour of fiscal policymakers too. Collectively, we have a huge global game of kicking the can down the road driven by excessive and wasteful government largesse, funded by explosive growth in central bank balance sheets. Future generations will and indeed already are beginning to pay (chronic youth unemployment in the Western world is the current channel) for what I see as deeply depressing policy settings and failed policymaker thinking, which persists with the idea that some form of debt-fuelled asset price elevation will lead to real wealth creation, which in turn will fix all our ills. The "movie? has been run before – too many times – and failed. Mispricing capital and forcing indebtedness into the system is an artificial booster of asset prices – in other words, such policy settings create asset price bubbles that always burst badly. NASDAQ 5000 was one recent example. And of course the huge bubbles that burst in 2007/2008 are another. Real wealth can only be created by innovation and hard work in the private sector, with policymakers, the financial sector and financial markets there to aid and encourage/incentivise. Real wealth is not created by the printing press and by excessive government spending. We simply cannot turn wine into water – after all, if it were that easy, why have we not done this before (with any lasting success, as opposed to abject failure, for which there is plenty of evidence)! Sure, central bankers through QE can create a chemical/synthetic concoction that may well get us even more intoxicated than real wine, but like most chemical processes that are focused on by-passing the rules and focused on immediate quick fixes, the "wine? they are synthetically creating will I fear ultimately lead to either a large market hangover (at best) or – at worst – to the "market equivalent? of serious liver poisoning or something even worse. The scale of the fallout will I feel be determined largely by how far markets and policymakers are willing and/or able to stretch the elastic band between real world reality and liquidity fed asset markets. Past experience shows us that this band can be stretched a long way, and we know that central bankers have a bad track record at both spotting and managing asset bubbles.

3 – Positioning and Sentiment: The most significant new developments have been in the realm of positioning and herding. Market sentiment had already been turned primarily by Draghi in the early summer of 2012, and the Fed's QEI leant heavily into this – as has the subsequent actions and/or words of other notable policymakers. But – and with the benefit of some hindsight – the missing link in calling the big top in the secular equity bull run out of the 2008/09 lows has been positioning. Market participants had – on a broad-based basis – simply been too cautious in terms of positioning structurally in risky assets. Without extreme positioning (long or short) markets tend to only see medium-sized corrections at best/worst, rather than big collapses. A key part of the positioning extreme is LEVERED positioning. Well, based on everything I have seen and heard from the flows and from talking to clients across geographies, across asset classes and across investor types, positioning is now getting structurally long risk. Folks are fearful of missing a raging bull market (no matter how poor the foundations of such a bull run maybe in their eyes), they are fearful that everyone else will enjoy a risk-on bonanza while they suffer from being too cautious, and they are looking to buy all and any dips. Herding is a natural animal phenomena and the markets are now beginning to herd in the "it?s all gonna be OK, get short bonds and get structurally long risk? camp. At peaks we see levered positioning in risk, and this is now clearly on the increase too. The number of times I have heard from clients that "with central banks in full QE mode, financial market risk asset prices can ONLY rally? can now almost be described as a cacophony. The key word here is "almost?. I don't think investors are yet "fully? positioned. We are "not there yet?. There is not yet sufficient leverage in risk-on positioning in my view. I think we need at least another round or two of "buying the dip? before we can consider positioning to be at extreme enough levels to set up the conditions necessary for a major sell-off (25% to 50%) as opposed to a minor correction (5% to 10%).

4 – Market Outlook: As can be inferred from the above, in the medium term (2 quarters +/- 1 quarter), and as per the route map in my previous notes, I think risk can rally further. I continue to believe that the S&P500 can trade up towards the 1575/1550 area, where we have, so far, a grand double top. I would not be surprised to see the S&P trade marginally through the 2007 all-time nominal high (the real high was of course seen over a decade ago – so much for equities as a long-term vehicle for wealth creation!). A weekly close at a new all-time high would I think lead to the final parabolic spike up which creates the kind of positioning extreme and leverage extreme needed to create the conditions for a 25% to 50% collapse in equities over the rest of 2013 and 2014, driven by real economy reality hitting home, and by policymaker failure/loss of faith in "their system?. I always like to remind clients that, in the run up to the 2000 and 2007 highs, before the significant collapses that followed in the subsequent 18/24 months, markets seemed infatuated in Greenspan and his famous "Put? the same way today?s teenagers seem infatuated with Justin Bieber, investor complacency was off the charts, volatility was at record lows, belief in "the system? was sky high, and positioning was at extremes. The flashing common sense warning signs were being ignored, if not mocked. Time – the next 18/24 months – will we think provide the answer as to whether we are witnessing a repeat disaster in the making. IF I AM WRONG AND WE TRULY HAVE FOUND ECONOMIC AND MARKET NIRVANA SIMPLY THROUGH THE CENTRAL BANK PRINTING PRESS AND ENORMOUS INDEBTEDNESS, THEN I WILL HAVE NO HESITATION IN ENJOYING THE FUTURE, THINKING ABOUT THE FUNNY MONEY MIRACLE, NEVER NEEDING TO WORRY ABOUT ECONOMIES OR GROWTH EVER AGAIN (all hints of sarcasm entirely intentional). Tactically, over the next quarter or two, I expect to see one or two (at least) 5% to 10% dips or corrections ((there are after all many banana skins ahead in terms of politics, policy, and economic fundamentals), but which I think will be short lived and heavily bought into largely by latecomers (retail?) to the party, encouraged by more central bank promises. One such correction is due now and should take the S&P500 down by 5% or so (from 1515 to 1440ish) over the first few weeks of February. Over the end of February and the first half of March (at least) we should see risk assets rally back into the 1500s (S&P500) – and most likely above 1515. Two asset classes that may lag any such a rebound rally are credit (IG and HY) and EM. Credit markets in particular are I think great early indicators of a secular change in the direction of (equity) markets and it may well be the case that we have already seen, or will over the very near future (the next quarter) see the grand cycle tights for credit spreads.

Enjoy the dips. And focus on being very tactical and liquid, whichever way you feel markets are going to trend. Now is not the time to be getting overly levered, overly "structured?, or overly illiquid with respect to portfolio positioning. And good luck for 2013 and beyond.

DIVERGENCES - Continue to Expand

The New Normal In Nine Charts 02-03-13 Zero Hedge

Top-Down - US equity valuation appears notably divergent from New Orders...

and overall macro performance...

which both seem to indicate a 12.5x Fwd P/E is more appropriate than ~14x

MONETARY EXAPNSION - Losing Effect on Market

The New Normal In Nine Charts 02-03-13 Zero Hedge

The pump-effect is having less and less impact (flatter and flatter slopes of nominal recovery)...

ANALYTICS - German 'Reality' Check Divergences

The Un-Manipulated Market That Keeps Merkel Awake At Night 02-03-13 Zero Hedge

It would appear that either Germans have stopped using electricity (now that is some severe austerity) or the 'real' economy in the core powerhouse of Europe's growth is struggling notably more than the nominal price of its stock market would imply. Applying the same 'myth-busting' data-series to Germany as we have in China, it is clear that expectations for greater electricity demand (and implicitly economic growth) are grossly different to the expectations priced into German stocks.

...or they just discovered cold fusion...

Charts: Bloomberg

PATTERNS - Money is ALL IN

Charts To Panic The "Money On The Sidelines" Hopers 02-02-13 Citi, Goldman, Barclays via ZH

If yesterday's indications of the near-record overweight net long positioning in Russell 2000 Futures & incredible net short VIX futures positioning, along with the extreme flows contrarian indication was not enough to concern investors that the 'money' is in, then the following four charts should cross the tipping point.

1. Citi's Panic/Euphoria guage for US stocks has only been more euphoric on two occasions - Q4 2000 & 2008;
2. Goldman's S&P 500 positioning has only been this extremely long-biased on two occasions - Q4 2008 & Q2 2011; and
3. Barclays' credit-equity divergence has only been this over-bought stocks on two occasions - Q4 2008 & Q2 2012.

It doesn't take a PhD to comprehend the extent of excess priced into stocks currently - no matter what Maria B tries to tell us.

CITI

Citi's Panic/Euphoria Model indicates extreme 'euphoria' - which has led to significant equity market losses in the past...

GOLDMAN

Goldman's S&P 500 Positioning has only been this extreme long twice before - and both were followed by dramatic sell-offs....

BARCLAYS

and Barclays points out what we have discussed, that stocks (and implied vols) are dramatically over-priced relative to Investment grade credit...

and high-yield credit...

via Barclays,

At the index level, the drop in equity volatility over the course of the last month has resulted in credit spreads in the US appearing too wide relative to SPX weighted average implied volatility. While we have been highlighting this for the HY index over the last couple of months, the cheapness of credit relative to equity implied volatility is now a feature even in the case of the IG index.

Whether the smart money is all-in ready to unwind to the dumb money is unclear but one thing is clear - the US equity market is as levered long and over its skis as it has ever been - trade accordingly...

Source: Goldman Sachs, Citi, and Barclays

FINANCIAL REPRESSION - Sign Posts of the Roadway

The Government Generously Offers To Help You "Manage” Your Retirement Account 02-02-13 Michael Krieger of Liberty Blitzkrieg blog, via ZH

[ZH: We have discussed this threat over the past several years (must read).] The obvious concept is that when the government runs out of money, or they face a drying up in interest for its debt, they will come for the $19.4 trillion in American’s retirement accounts.  It seems that day may be finally drawing near.

I stopped contributing to my 401k back when I worked at Bernstein, and I will probably now have to give more serious consideration whether I want to take the penalty and move the funds out of my retirement account entirely.  I haven’t made any decisions, but will be watching closely.

I’m sure the government is just trying to protect your retirement account from terrorists.

From Bloomberg:

The U.S. Consumer Financial Protection Bureau is weighing whether it should take on a role in helping Americans manage the $19.4 trillion they have put into retirement savings, a move that would be the agency’s first foray into consumer investments.

That’s one of the things we’ve been exploring and are interested in in terms of whether and what authority we have,” bureau director Richard Cordray said in an interview. He didn’t provide additional details.

The bureau’s core concern is that many Americans, notably those from the retiring Baby Boom generation, may fall prey to financial scams, according to three people briefed on the CFPB’s deliberations who asked not to be named because the matter is still under discussion.

The Securities and Exchange Commission and the Department of Labor are the main regulators of U.S. retirement savings vehicles and funds. However, the consumer bureau — established by the 2010 Dodd-Frank Act — sees itself as a potential catalyst for promoting a coherent policy across the government, the people said.