GOLD - One for One With DOW?

Chart of the Day 02-07-13

For some perspective on the long-term performance of the stock market, today's chart presents the Dow priced in another global currency -- gold (i.e. the Dow / gold ratio). For example, it currently takes less than a mere 8.5 ounces of gold to 'buy the Dow' which is considerably less than the 44.8 ounces it took back in 1999. Priced in gold, the Dow has been in a massive 13-year bear market. The Dow priced in gold paints an entirely different picture than that of the Dow based on the US dollar (which continues to trade near post-financial crisis rally highs). On a positive note, the Dow priced in gold has just broken above resistance of its latest downtrend channel.

SHADOW BANKING - Purchasing Power Out of Thin Air

What you need to know:

Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys, then use that newly transformed collateral via further repo as cash to fund simple stock purchases, and at the end of the day nobody knows where the exposure came from, who the counterparty is, and what the ultimate liability is!

And that is why in the current market, the Fed has no choice but to keep the music going, because while an unwind of traditional liabilities will result in a maximum collapse of some $13 trillion in conventional financial liabilities, it is the $15-20 trillion in shadow banking exposure which nobody knows about except for the banks themselves (we hope), and which allows banks and hedge funds to literally create purchasing power out of thin air, that once the house of out of control deleveraging cards starts falling, it is truly game over.

When it comes to the actual functioning of capital markets, there is always much confusion within the made for TV punditry for one simple reason: the number of people who truly understand collateral transformation courtesy of the shadow banking system, which until recently was a massive $23 trillion off the books repository of everything the banks did not want you to know about, can be counted on one hand. That certainly would explain the existence of such media trolls as "conscientious" NYT columnists, and various three letter "modern" theories explaining how money would work in a world if only all practical reality was removed.

And while we have previously explained extensively how it is that what actually happens behind the scenes is so very different from what most believe is market reality, especially with our three+ years series on shadow banking, confusion is still rampant. Which is why we hope an extract from Fed Governor Jeremy Stein's speech titled "Overheating in Credit Markets: Origins, Measurement, and Policy Responses", will finally make it sufficiently clear that when it comes to shadow banking collateral transformations, modern day alchemy does in fact work, and one can transmogrify junk bonds into Treasurys with the wave of a magic (yield) wand.

From Stein - extracted from full speech:

The maturity of securities in banks' available-for-sale portfolios is near the upper end of its historical range. This finding is noteworthy on two counts. First, the added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully--especially since existing capital regulation does not explicitly address interest rate risk. And, second, in the spirit of tips of icebergs, the possibility that banks may be reaching for yield in this manner suggests that the same pressure to boost income could be affecting behavior in other, less readily observable parts of their businesses.

The final stop on the tour is something called collateral transformation. This activity has been around in some form for quite a while and does not currently appear to be of a scale that would raise serious concerns--though the available data on it are sketchy at this point. Nevertheless, it deserves to be highlighted because it is exactly the kind of activity where new regulation could create the potential for rapid growth and where we therefore need to be especially watchful.

Collateral transformation is best explained with an example. Imagine an insurance company that wants to engage in a derivatives transaction. To do so, it is required to post collateral with a clearinghouse, and, because the clearinghouse has high standards, the collateral must be "pristine"--that is, it has to be in the form of Treasury securities. However, the insurance company doesn't have any unencumbered Treasury securities available--all it has in unencumbered form are some junk bonds. Here is where the collateral swap comes in. The insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trade. 

Of course, the dealer may not have the spare Treasury securities on hand, and so, to obtain them, it may have to engage in the mirror-image transaction with a third party that does--say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.

There are two points worth noting about these transactions. First, they reproduce some of the same unwind risks that would exist had the clearinghouse lowered its own collateral standards in the first place. To see this point, observe that if the junk bonds fall in value, the insurance company will face a margin call on its collateral swap with the dealer. It will therefore have to scale back this swap, which in turn will force it to partially unwind its derivatives trade--just as would happen if it had posted the junk bonds directly to the clearinghouse. Second, the transaction creates additional counterparty exposures--the exposures between the insurance company and the dealer, and between the dealer and the pension fund.

As I said, we don't have evidence to suggest that the volume of such transactions is currently large. But with a variety of new regulatory and institutional initiatives on the horizon that will likely increase the demand for pristine collateral--from the Basel III Liquidity Coverage Ratio, to centralized clearing, to heightened margin requirements for noncleared swaps--there appears to be the potential for rapid growth in this area. Some evidence suggestive of this growth potential is shown in exhibit 8, which is based on responses by a range of dealer firms to the Federal Reserve's Senior Credit Officer Opinion Survey on Dealer Financing Terms. As can be seen, while only a modest fraction of those surveyed reported that they were currently engaged in collateral transformation transactions, a much larger share reported that they had been involved in discussions of prospective transactions with their clients.

Mr. Stein may not have evidence... but we do. Below, direct from the NY Fed, is the total amount of collateral pledged any given month with the NY Fed, courtesy of Tri-Party repo custodian JP Morgan of course:

To summarize: the volume of "such transactions" is currently very large and rising rapidly.

Keep in mind the above is merely the base collateral: one can think of it as SM 0 (or Shadow Money 0). What must be done next is apply a specific "collateral chain" (as explained previously) to get the full level of explicit recycled collateral. The most recent estimate of the average shadow bank collateral chain from Manmohan Singh was 2.5x as of 2011. It is a certainty that this is now back to its 2007 levels of about 3x in net collateral rehypothecation. Which means that just the repo market alone allows market players to create some $6 trillion in credit money out of the Tri-Party repo alone. Add the nearly $2 trillion in hedge fund capital which is then transformed via broker-dealers in the same way, and one gets a whopping $12 trillion in buying power created by, using Stein's extreme example, using worthless collateral and converting it into pristine Treasurys, while promising pennies in front of a steamroller to all the counterparties in the collateral chain.

But wait, there's more.

Because as Matt King explained all too well back in September 2008, when the above alchemy happens, yields are created, trillions in counterparty risk is generated, collateral is transformed and can be used for fingible purchasing purposes and... nothing.

Click to Enlarge

By nothing we mean there is no balance sheet entry!

Thanks to the magic of FAS 140 banks can literally transform worthless garbage into supersafe Treasurys, then use that newly transformed collateral via further repo as cash to fund simple stock purchases, and at the end of the day nobody knows where the exposure came from, who the counterparty is, and what the ultimate liability is!

And that is why in the current market, the Fed has no choice but to keep the music going, because while an unwind of traditional liabilities will result in a maximum collapse of some $13 trillion in conventional financial liabilities, it is the $15-20 trillion in shadow banking exposure which nobody knows about except for the banks themselves (we hope), and which allows banks and hedge funds to literally create purchasing power out of thin air, that once the house of out of control deleveraging cards starts falling, it is truly game over.

FED BULLYING - Investing in a World oF Financial Repression

Jeremy Grantham And The Dead Donkey Economy: "All Global Assets Are Once Again Becoming Overpriced" 02-08-13 via ZH

The Fed’s negative real rates regime, designed to badger us into riskier investments in order to push up equity prices and grab a short-term wealth effect (that must be given back one day when least comfortable and least expected), has gone on for a long and, for me, boring time. This low interest rate period is serving, therefore, as a sneak preview of what a permanently lower rate regime might look like (although any permanently lower rates reflecting lower GDP growth would be by no means as low as these engineered rates that we are currently experiencing). So what are some of these effects?

• The artificially low T-Bill rates first work their way slowly up the curve.
• Next, the most obviously competitive type of equities – high yield stocks – begin to be bid up ahead of the rest of the market, as has happened. “I’ve just got to squeeze out some higher rates somewhere, anywhere,” is the pension fund plea.
• Then, this low rate competition begins to filter into other securities, historically sought after for their higher yields: higher-grade real estate, where the “cap rates” slowly fall; and, unfortunately, also forestry and farmland, mainly of the larger and more standard varieties that appeal to institutions, which show declines in their required yields, i.e., their prices rise.
• The longer the engineered rates stay below true market rates, the higher asset prices become until, yes, you’ve got it, corporate assets begin to sell way over replacement cost.
• Then, if the heart of capitalism is still beating at all, a long period of over-investment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good healthy market crunch. (This strategy will be seen in future years as archetypical of the Greenspan-Bernanke era: badger and bully investors into taking more risk and eventually pushing assets – houses or stocks or both – far over replacement value, followed eventually, at long and hard-to-predict intervals, by exciting crashes. No way to run a ship, but it does produce an environment that contrarians like us, who can take a few licks, can thrive in.)

The normal capitalistic response described above runs smack into the new tendency for corporations to either sit on money or buy stock back (regardless of how expensive it may be!), which works in the opposite direction to create shortages, drive prices up, and, as a by-product, lower job creation and GDP growth. So where does this all come out? You tell me. All that I know is:

a) if we in the U.S. don’t invest, others will and it will, in the longer run, definitely end badly;

b) that even if there is a lower-return world in the future it is still better to own the cheaper assets; and

c) it behooves buyers of “cap rate” type assets like real estate to realize that the current low rates are flattered by current Fed policy, which will, like everything else in life, pass away one day, leaving them looking overpriced. It can’t be too soon for me.

In the meantime for us at GMO it means emphasizing care and maintaining a heightened sense of value discipline, not only in stock selection, as the whole world is once again bid up over fair value in a way so typical of the post 1994 era, but also in forestry and farmland. GMO has investments in those areas too and recognizes the need to sidestep overpricing by emphasizing the nooks and crannies. Fortunately there are more nooks and deeper crannies in forests and farmland than there are in almost any other area, certainly including stocks.

This doesn’t really fit in with a quarterly letter emphasizing important good news, but being about the Fed, I have to make an exception.

The Fed appears to be still assuming a 3% growth rate for future U.S. GDP.

It would be safer and more confidence-inspiring, now that Bernanke appears to take his responsibility for growth seriously, that he at least have a reasonable growth target (preposterous as that notion is to me that the Fed should or even could affect long-term growth simply by messing about with interest rates). The growth in available man-hours has definitely declined by about 1% a year, yet Bernanke’s assumption for our GDP’s normal trend growth appears unchanged at its old 3%. Ergo, he must be assuming an offsetting rise of 1% in productivity. But why? We should treat these assumptions quite seriously for this is famously (for me) and painfully (for all of us) the man who could not see a 3¾-standard-deviation housing market, and indeed protested that all was normal, etc., etc., etc. (Dear handful of niggling readers, this 3¾-standard-deviation event is calculated on the assumption of a normal distribution, as is often done in investing, even though we [especially at GMO] know this is not true but is just a convenient statistical device. In fact, we at GMO know quite a bit more on this topic for we have studied more or less all assets for as long as we can find data and we have found a remarkable total of 330 “bubbles,” 36 of which we call “major, important bubbles,” which we define as 2-standard-deviation events, given the same assumption. Well, a 2-sigma event should occur every 44 years in a normally distributed world and they have occurred every 31 years. This is much closer to random than we had previously thought. Yes, financial asset data is fat-tailed; that is, there are more outlying events than are found in a normally distributed series, but they are not extremely fat-tailed. They show up as 2-sigma events but occur as often as 1.8-sigma events would occur in normal distributions. Extrapolating, we can assume that Bernanke’s 3¾-sigma housing bubble would occur, adjusted for our fat-tailed real-life history, not every 10,000 years, but somewhere more like 1 in 5,000 years! I previously used “a 1-in-1,200-year event” as a casually selected very large number to describe the 2006 housing bubble. But under challenge, these current numbers are more accurate. No, this does not mean we have 10,000 years of data or even 5,000. It is just statistics, full as always of assumptions, which in this case we hope approach rough justice. What it does definitely mean, though, is that it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it. This is a doubly amazing miss because his and Greenspan’s policy caused this bubble in the first place!) In comparison, his willingness to target an unrealistic 3% level for GDP growth is statistically a microscopic error, a picayune mistake. Unfortunately, though, in the hands of probably the most influential man in the global economic world, it is an extremely dangerous one. I like the analogy of the Fed beating a donkey (the 1% growing economy) for not being a horse (his 3% growing economy). I assume he keeps beating it until it either turns into a horse or drops dead from too much beating! Fine-tuning economic growth, an impossible job for the Fed anyway, is hardly likely to get any easier by badly overstating trend-line growth. It seems nearly certain, therefore, that the Fed will keep trying to whack the donkey for far too long. The likely consequences of this policy are, to be frank, over my head, but my colleague Edward Chancellor will address them briefly if I can nag him effectively.

Courtesy of the above Fed policy, all global assets are once again becoming overpriced. This reminds me of the idea sometimes attributed to Einstein that a workable definition of madness is constantly repeating the same actions but expecting a different outcome! But, as always, asset prices are not uniformly overpriced: emerging markets and, we believe, Japan are only moderately overpriced. European stocks are also only a little expensive, but in today’s world are substantially more risky than normal. The great global franchise companies also seem only moderately overpriced. Forestry and farmland, which is not super-prime Midwestern, is also only moderately overpriced but comes with our nook and cranny sticker attached. But much of everything else is once again brutally overpriced. Notably, U.S. stocks (ex “quality”) now sell at a negative seven-year imputed return on our numbers and most global growth stocks are close to zero expected return. As for fixed income – fugetaboutit! Most of it has negative estimated returns on our data, and longer debt, as always, carries that risk that may be slight in any period, but is horrific if it occurs – accelerating inflation.

When one combines:

1. the apparent determination and influence of those who do the bullying
2. with the career risk and short-termism of the bullied
3. and the desire of the general public to believe unbelievable good news,

... these overpricings can go much further and the Fed can win another round or two. That’s the problem. A clue to timing would be when we begin to hear more passionate new era arguments: profit margins will always be higher; growth will snap back to 3% for the developed world; and new ones I can’t think of … maybe “when the discount rate is this low the Dow should sell at, perhaps, 36,000.” In the meantime, prudent managers should be increasingly careful. Same ole, same ole.

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

RISK - Excess Euphoria

Euphoria 02-06-13 Citi and Credit Suisse via ZH

Presented with little comment aside from noting that the only time stocks have been this 'euphoric' was right before the collapse in 2000 and right before the collapse in 2008.

Equity Euphoric...

and Credit Risk Appetite rolling over...

as Global Risk Appetite heads for Euphoria...

Source: Citi and Credit Suisse

Tale Of Two Markets (Again) 02-06-13 Zero Hedge

The Good, The Bad, And The Ugly Six Charts Of Europe 02-06-13 Zero Hedge

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

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

STATISM - Facts versus Illusions

All Is Well 02-06-13 Jim Quinn of The Burning Platform blog, via ZH

“Facts do not cease to exist because they are ignored.” – Aldous Huxley

I woke up this past Saturday morning and opened my local paper to find out that all was well. An Associated Press article declared a healthy jobs market, fantastic auto sales, a surging housing market, and a stock market rocketing to new all-time highs. What’s not to love? If the mainstream media says the economy is as good as new, it must be so. Why should we let facts get in the way of a good storyline? The stock market has surged to 2007 highs, so the country’s employment situation must be strong.

..........

It comes down to this. The monied interests, high financiers, corporate interests, captured politicians, government apparatchiks, and corporate media have a vested interest in maintaining the corrupt and destructive status quo. They have become rich and powerful through their manipulation of the currency, ravenous sacking of the national wealth, destruction of the working middle class, and ability to use mass media propaganda to convince the willfully ignorant masses to learn to love their debt servitude. Our once proud, liberty minded, self-sufficient nation of freedom loving individuals has devolved into a kleptocracy,  where a small cadre of powerful men run the show solely to increase the personal wealth and political power of officials and the ruling class at the expense of the wider population. They are essentially running a state sponsored embezzlement and Ponzi scheme to pillage the wealth of the dumbed down, sedated, technologically distracted masses. Our entire system has been captured and we are entering the final stages of decay and ultimately a day of reckoning where the guilty and innocent alike will suffer the awful consequences of currency collapse, death and destruction on a wide scale, and likely civil and world war.

 “The Fed is now engaged in a control fraud, and what appears to be racketeering in conjunction with a few big investment banks. They may have entered into it with good intentions, but they seem to have been turned towards deceit and corruption. This is not an historical event, but an ongoing theft in conjunction with a number of Wall Street banks, and politicians whom they have paid off through a corrupt system of campaign financing and influence peddling. This is nothing new in history if one reads the un-sanitized version. But people never think it can happen today, that somehow yesterday things were different, as if one is looking at some distant, foreign land. This is a facet of the illusion of general progress.

We are now in the cover-up stage of a scandal, similar to Watergate when the White House was stone-walling. The difference is that the corruption and capture of the government is much more pervasive now, and includes a significant portion of the mainstream media, so meaningful reform is difficult. Most of what has transpired so far has been designed to distract and placate the people in their righteous anger. The Fed deceives the Congress and the public, turns a blind eye to glaring conflicts of interest, and is essentially debasing the currency while transferring the wealth of the nation to their cronies. And still the regulators do not enforce the laws they have, and Washington drags its feet while accepting buckets of cash from the perpetrators.” – Jesse

The entire system is corrupt to its core. Both political parties, regulatory agencies, Wall Street, the Federal Reserve, and mainstream media are participants in this enormous fraud. They grow more desperate and bold by the day. The lies, misinformation and propaganda being spewed on a daily basis become more outrageous and audacious. They are using the Big Lie method on a grand scale. They frantically need to lure the muppets into the stock market and the housing market to keep the game going a little longer. You can sense we are reaching a tipping point. The system they have created is mathematically unsustainable. Therefore, it will not be sustained. The world is going mad. Governments across the globe are all trying to out debase each other. Austerity and inflation for the peasants and caviar and champagne for the Davos class is the chosen path. All is not well. Ben Bernanke and the oligarchs running the show will be immortalized in history books forever when this farce comes to a spectacular conclusion.   

 “If all else fails, immortality can always be assured by spectacular error.” – John Kenneth Galbraith

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

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.

CURRENCY WARS - The Dirty Little Secret

Currency War Has Started 02-04-13 WSJ

"Devaluing a currency," one senior Federal Reserve official once told me, "is like peeing in bed. It feels good at first, but pretty soon it becomes a real mess."

In recent times, foreign-exchange incontinence appears to have been the policy of choice in capitals from Beijing to Washington, via Tokyo. The resulting mess has led to warnings of a global "currency war" that could spiral into protectionism.

The roll-call of forex Cassandras reads like a who's who of global finance and politics: German leader Angela Merkel, Federal Reserve Bank of St. Louis President James Bullard, Bundesbank President Jens Weidmann and Mervyn King, the outgoing governor of the Bank of England. And the list goes on.

The luminaries are wrong on a couple of points. The world isn't "on the verge" of a currency war, as they seem to think, but right in the middle of one.

Currency wars have been a staple of modern finance ever since the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s. As Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co., says: "Most governments believe that their currencies are too important to be left to the markets." So policy makers have often tried to manipulate the value of their currencies by intervening in the markets.

In recent years, China stands out as the country that has done the most to keep its currency weak in order to boost exports. But it isn't alone. China's efforts have sparked what Fred Bergsten, senior fellow at the Peterson Institute for International Economics, calls "emulation and retaliation" from many countries.

At their worst, these periodic crosscurrents of intervention have led to "beggar-thy-neighbor" policies—self-defeating attempts to improve one country's economy at the expense of everybody else's.

The present situation is, however, fundamentally different. Most of the currency-market tensions aren't the byproduct of direct intervention or trade wars but of extreme monetary measures that are attempts to make up for nonexistent fiscal policies.

As developed countries like Japan and the U.S. try to kick-start their sluggish economies with ultralow interest rates and binges of money-printing, they are putting downward pressure on their currencies. The loose monetary policies are primarily aimed at stimulating domestic demand. But their effects spill over into the currency world.

Since the end of November, when it became clear that Shinzo Abe and his agenda of growth-at-all-costs would win Japan's elections, the yen has lost more than 10% against the dollar and some 15% against the euro. The greenback last week plumbed its lowest level against the euro in nearly 15 months.

These moves are angering export-driven countries such as Brazil and South Korea. But they also are stirring the pot in Europe. The euro zone has largely sat out this round of monetary stimulus and now finds itself in the invidious position of having a contracting economy and a rising currency—making Thursday's meeting of the European Central Bank a must-watch event.

The dirty secret is that using monetary policy to weaken a currency, whether voluntarily or not, is a shortcut to avoid unpopular decisions on fiscal and budgetary issues.

"I don't remember central banks being so deep in experimental mode," says Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co. "It is equivalent to a pharmaceutical company that feels forced to bring a new medicine to the market even though it has not been properly tested."

How will it end? There are two binary results: apocalypse or redemption.

James Rickards, a veteran financier and author of "Currency Wars: The Making of the Next Global Crisis", predicts the former.

"People ask me who's winning. I say nobody," he told me. "I expect the international monetary system to destabilize and collapse. There will be so much money-printing by so many central banks that people's confidence in paper money will wane, and inflation will rise sharply."

Breakdowns of the global foreign-exchange system have occurred with dramatic regularity, but that doesn't mean this currency war will end in tears.

For a start, common sense could prevail, putting an end to the dangerous game of beggar (and blame) thy neighbor. After all, the International Monetary Fund was created to prevent such races to the bottom, and should try to broker a truce among forex combatants.

If that sounds naive, consider the possibility that this huge bout of monetary stimulus will succeed in engendering a solid recovery driven by domestic demand. Or that fiscal policy will finally be put to work.

Either outcome would take away a big incentive for competitive devaluations and prompt governments to bolster their currencies to avoid stoking inflation.

Growth cures a lot of ills. Even forex incontinence.

AMERICA - The Statistics of the Working Poor

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