RISK - ‘Blue Sky’ indices (index levels divided by volatility measures, such as OEX/VXO) are off the charts

Taken Form: "A Market Likely To Suck Everyone In To Its Last Updraft" Sean Corrigan Of Diapason Commodities Management via ZH

... our favourite ‘Blue Sky’ indices (index levels divided by volatility measures, such as OEX/VXO) are off the charts. Indeed, that particular example is now 2.7 sigmas over a 28?year mean, in a 99th percentile which has only once been surpassed, at the start of 2007, before the first rumblings of the CDO cyclone and sub?prime tsunami were audible to any but the most perceptive listener. In Germany, the DAX/VDAX equivalent sits at a major, new 21?year high, a whopping 3.7 sigmas over its period mean.

Click to Enlarge

There are one or two other technical signals, too. The S&P500 ex?financials has all but completed a handsome?looking long?term profile during the DDIE. The financials, meanwhile, have retraced 50% of their LEH?AIG meltdown. Nasdaq has been on one of Didier Sornette’s exponential accelerations, climbing more ever more rapidly on ever shorter timeframes up into the top few percent of another clean, projected top mapped out off the 2009 lows. Looking further back in time, since that same 2009 nadir, the DJIA has ascended by an amount only exceeded in the run up to 1920, 1929, 1937, 1987, and 2000 – all of them major tops. Juicy!

What we must caution here, however, is that anyone tempted to lean into this particular wind must have the patience to wait for signs of even a temporary exhaustion before setting shorts. Critical, too, will be the discipline to stop out if and when those initial selling ‘tails’ start to fill back in, for fear that this is a signal that the mania has not yet ended and that the buyers of dips are still all too dominant.

EARNINGS - Smart Tax and Balance Sheet Planning

2 Profit Margin Charts You Must Understand 10-29-13 Citi's Tobias Levkovich via BI

One of the hottest ongoing debates in the stock market is about the sustainability of historically high profit margins.

High profit margins have allowed companies to amplify modest sales growth into impressive earnings growth.

However, the debate often gets confused when people don't make the distinction between the operating profit margin and the net margin.

The operating profit margin is generally measured as earnings before interest expenses and taxes, or EBIT. This margin reflects the operating efficiency of a company.

The net profit margin is the profit after all operating, interest, and tax expenses are subtracted. It's the bottom line. Unlike the EBIT margin, the net margin is impacted heavily by financial planning decisions.

"The margin story continues to be far less about efficiencies than smart tax and balance sheet planning," said Citi's Tobias Levkovich in a note to clients this week. "While there is much discussion about companies being able to manage their businesses wonderfully and thus even small revenue gains can generate more impressive bottom-line increases, this mindset is ill- founded, in our view. The broad data shows that overall S&P 500 operating margins have been flat to down for more than six quarters and the true story behind net margins has been lower effective tax rates and interest expense."

Levkovich argues that the earnings surprises we've seen so far during this reporting season have been of low quality because of the nature of these margin trends.

Below is a chart of the EBIT margin and a chart of interest as a percentage of sales.  The latter chart reflects the low interest rate environment.

Many people often argue that corporations have been able generate increasing levels of profits by laying off workers and squeezing the workers they keep.  However, employee costs are included in the EBIT margin, which has been trending lower for the S&P 500.

"The most disturbing issue is the view that EBIT margins have been so good and that companies have been incredibly efficient running their operations," added Levkovich. "Figure 10 should dissuade anyone from believing that misperception. After-tax margins on the other hand have been solid but that reflects lower effective tax rates and lower interest expense as a percent of sales due to low interest rates (see Figure 11). In this context, management teams have been far better at tax planning and balance sheet engineering which is not as impressive as running their underlying businesses but that is not the current talking points for many misguided market observers.

LIQUIDITY - $3 Trillion "Created" In First 9 Months of 2013

JPM Sees "Most Extreme Ever Excess Liquidity" Bubble After $3 Trillion "Created" In First 9 Months Of 2013 10-28-13 JPM via ZH

JPM's Nikolaos Panigirtzoglou, editor of the "Flows and Liquidity" weekly research piece, is one of the greater experts on, not surprisingly, global monetary flows and liquidity. Which as we noted back in 2009, is all that matters in a world in which the micro, and recently the macro, have all been made obsolete by one simple thing: credit-money creation by the monetary authorities. Which is why we read with interest his latest edition in which he sets off to answer a not so simple question: "how much liquidity is there?" What he finds is disturbing.

From JPM:

Excess money supply is currently at record high positive territory. The residual of the regression turned positive in May 2012 and has risen steadily since then. This is both because of real money supply increasing and money demand decreasing due to lower uncertainty (Figure 3). In particular, global M2 is up $3tr or 4.6% since the beginning of the year (to September), outperforming the Global CPI inflation index which is up by only 2% since then. Global M2 reached $66tr in September this year.

Of the $3tr increase in global M2 money supply in the first three quarters of the year, around $1tr is due to G4 countries, i.e. US, Euro area, UK and  Japan. The remaining $2tr is due to EM countries, driven by strong bank lending growth in EM. As we highlighted last week, EM bank loan credit creation has been unaffected by the EM selloff in the summer and was running in July/August at a $170bn per month pace. So strong credit growth in EM economies continues to boost our measure of excess liquidity.

And the conclusion:

The rise in excess liquidity, i.e. the residual in the model of Figure 4, is supportive for risky assets especially when we compare the past nine months with the period between the end of 2010 and the beginning of 2012 when excess money supply was negative. Looking further back in Figure 4, we can see three major episodes of excess liquidity (i.e. positive residual): 1993-1995, 2001-2006 and Oct 2008-Sep 2010. These were periods of strong asset price inflation suggesting that excess liquidity could have been a factor supporting markets at the time. The current episode of excess liquidity, which began in May 2012, appears to have been the most extreme ever in terms of its magnitude.

To summarize:

• In just the first 9 months of 2013, DM countries have injected $1 trillion in liquidity sourced exclusively by central banks; EMs have injected another $2 trillion driven by bank loan demand.
• The total global M2 is over $66 trillion, growing at an annualized pace of over 6%.
• The amount of excess liquidity, i.e. the infamous "liquidity bubble" in the global fungible system is "the most extreme ever in terms of its magnitude"

And that's really all there is to know: the music is playing and everyone has to dance... just don't ask what happens when the music ends.

PATTERNS - Market Reversal Nears (if only Temporary before the Santa Claus Rally)

THE FOLLOWING CHART IS A MULTI DECADE MONTHLY BAR CHART: Note the Historic RSI Levels

A FIVE YEAR TREND CHANNEL MARKETS OVERHEAD RESISTANCE - Notice the Degree of Divergence.

NOTICE THE STRONG DIVERGENCE WITH RSI

NEARING UPPER CHANNEL - A Smaller Degree Look at the Same Channel

AT THE UPPER BOUNDARY CONDITION BANDS ESTABLISHED DURING THE 2007-2008 FINANCIAL CRISIS: Needs to Retest 100/200 DMA for Support

PAY PARTICULAR ATTENTION TO THE EU STOXX 600 FOR CLUES

WE DREW THE BIA$ IN EARLIER IN OCTOBER (First Chart). Second Chart approximates our red line anticpation.

APPROACHING TRIGGER$ ZONE "C"

IF YOU BELIEVE THE JAPANESE CARRY TRADE DOESN'T MATTER

Look at the correlation of the Japanese Carry Trade against the S&P 500

PATTERNS - Pay Attention to the SKEW in Volatility

The recent strong rise in the so-called CBOE SKEW index should be counted among the various divergences that make the stock market's current advance suspect and that we are approaching an inflection point at TRIGGER$ ZONE "C".

Skew  measures the perceived tail risk of the market via the pricing of out-of-the-money options. Generally, a rise in skew indicates that 'crash protection' is in demand among institutional investors (institutional/professional investors are the biggest traders in SPX options). The basic idea is similar to the CSFB 'fear index' or the Ansbacher index (which compares the premiums paid on equidistant calls and puts).

A unusual move in the skew index (which historically oscillates approximately between a value of 100 and 150) is especially interesting when it diverges strongly from the VIX, which measures at the money and close to the money front month SPX option premiums.

Basically what a 'low VIX/high skew' combination is saying is: 'the market overall is complacent, but big investors perceive far more tail risk than usually' (it is exactly the other way around when the VIX is high and SKEW is low). In other words, a surprising increase in realized volatility may not be too far away. Below is a chart showing the current SKEW/VIX combination.

SKEW is rising strongly, even as the VIX is very low – click to enlarge.

Next is a long term chart which we have taken from the CBOE website. This chart looks a bit 'crowded', but it shows that the current level of the SKEW index is historically on the high side:

SKEW vs. VIX, long term. As can be seen, the perception of increased tail risk can be 'early', but it is definitely a warning sign.

And lastly, here is a chart showing two divergences between VIX and SPX – a bullish and a (potentially) bearish one:

The VIX and the SPX – two divergences (lower high in VIX vs. lower low in SPX at the 2011 low, and currently a higher low in VIX vs. a higher high in SPX) – click to enlarge.

So here we have some additional evidence that the risk-reward equation in the stock market has recently shifted toward 'risk'. Once again, these are not precise timing signals – as the longer term chart of the SKEW index shows, investors are at times too early worrying about growing tail risk. On the other hand, it is definitely a 'heads-up', and lead and lag times are bound to vary. This is to say, we cannot state apodictically that they are once again 'too early' or how long exactly the lead time of the rise in the SPX options skew will actually turn out to be before the market gets into trouble this time.

SKEW Analysis Coutesy of Zero Hedge

US TREASURIES - Due for a Bounce

Near Term Bonds are due for a Correction: Alligns with TRIGGER$ZONE "C"

Since mid-October the US$ has been under siege. However, As BofAML's MacNeill Curry notes, that decline is showing signs of exhaustion from which a base and correction higher is likely. Curry's "basing" view is further supported by the US Treasury market, where yields (particularly 5yrs and 10yrs) are poised to bottom and turn higher over the coming sessions...

US Treasury yields set to base

US 10yr yields have reached "Massive" resistance. Specifically, the 2.474%/2.399% zone has been a long standing pivot which has repeatedly repelled. With momentum (14d RSI) at its most overbought since May, odds favor a medium term bearish turn in trend towards the mid-Oct highs at 2.759%.

Source: BofAML

THE US$ is Bouncing Off 17 Month Lows asthe Euro Begins Weakening

A strengthening US$ is not normally good for US Equities, especially after such a move on US$ weakness.

DRIVER$ - 10 Year US Treasury Note

BofAML Warns "US 10Y Yields Have Reached Massive Resistance" 10-27-13

Since mid-October the US$ has been under siege. However, As BofAML's MacNeill Curry notes, that decline is showing signs of exhaustion from which a base and correction higher is likely. Curry's "basing" view is further supported by the US Treasury market, where yields (particularly 5yrs and 10yrs) are poised to bottom and turn higher over the coming sessions...

US Treasury yields set to base

US 10yr yields have reached "Massive" resistance. Specifically, the 2.474%/2.399% zone has been a long standing pivot which has repeatedly repelled. With momentum (14d RSI) at its most overbought since May, odds favor a medium term bearish turn in trend towards the mid-Oct highs at 2.759%.

Source: BofAML

CAPITAL DISTORTION - Global Acceptance of the Bernankean Theory

The ‘No Exit’ Meme Goes Mainstream 10-26-13 Pater Tenebrarum of Acting-Man blog,via ZH

It is interesting to watch how mainstream reporting on certain major topics at times undergoes chameleon-like changes with the meme originally presented suddenly turning into the exact opposite. Not too long ago conviction was extremely high that the Fed would slow down its 'QE' operations and that the economy's weak recovery was going to morph into something one might call 'business as usual'. That notion has never struck us as credible.

Readers who follow Zerohedge may have noticed two recent articles discussing the change in mainstream bank analyst views on the dreaded 'QE taper'. It is instructive to review them: Deutsche Bank now argues that there 'won't be any tapering at all', while SocGen as gone a step further and is now saying 'QE may be increased'.

In other words, mainstream analysts have finally realized that the  insane are running the asylum. Regarding the changing tune in the popular mainstream press, we have come across this recent article at Bloomberg, entitled “Central Banks Drop Tightening Talk as Easy Money Goes On”.

“The era of easy money is shaping up to keep going into 2014. The Bank of Canada’s dropping of language about the need for future interest-rate increases and today’s decisions by central banks in Norway and Sweden to leave their rates on hold unite them with counterparts in reinforcing rather than retracting loose monetary policy. The Federal Reserve delayed a pullback in asset purchases, while emerging markets from Hungary to Chile cut borrowing costs in the past two months.

“We are at the cusp of another round of global monetary easing,” said Joachim Fels, co-chief global economist at Morgan Stanley in London.

Policy makers are reacting to another cooling of global growth, led this time by weakening in developing nations while inflation and job growth remain stagnant in much of the industrial world. The risk is that continued stimulus will inflate asset bubbles central bankers will have to deal with later. Already, talk of unsustainable home-price increases is spreading from Germany to New Zealand, while the MSCI World Index of developed-world stock markets is near its highest level since 2007.

“We are undoubtedly seeing these central bankers go wild,” said Richard Gilhooly, an interest-rate strategist at TD Securities Inc. in New York. They “are just pumping liquidity hand over fist and promising to keep rates down. It’s not normal.”

(emphasis added)

So, have central bankers drunk the Kool-Aid with the acid in it? What we see here is global acceptance of the Bernankean theory – largely derived from Milton Friedman's analysis of the depression era and Bernanke's own analysis of Japan's post bubble era – that even though new bubbles may be staring everyone into the face, central banks must 'not make the mistake to stop easing too early'. It is held that that would 'endanger the recovery', similar to  what happened in the US in 1937 and Japan in 1996.

We have previously discussed that the 'Ghost of 1937' is hanging over the proceedings and tried to explain why this reasoning is absurd. While it is true that the liquidation of malinvested capital would resume if the monetary heroin doses were to be reduced, the only alternative is to try to engender an 'eternal boom' by printing ever more money. This can only lead to an even worse ultimate outcome, in the very worst case a crack-up boom that destroys the entire monetary system.

One of the reasons why we remain convinced that the widely hoped for return to a 'normal expansion' isn't likely to occur is that we have some evidence – tentative though it may be – that the economy's production structure has been severely distorted again by the Fed's interest rate manipulations and the huge growth in the money supply it had to engender in order to keep interest rates below the natural level dictated by time preferences.

As one of our readers frequently points out in the comments section, the policy is mainly a stealth bank bailout, as money is transferred from savers to banks in order to avert the liquidation of unsound credit. How much unsound credit is still clogging up the system after the 2008 crisis? We unfortunately don't know, as bank balance sheets have become even darker black boxes than they already were after 'mark to market' accounting was suspended in April of 2009 (no doubt people who have the time to study the hundreds of pages of bank earnings reports with their endless footnotes in detail could come up with estimates, but apparently no-one really takes the time to do that).

Below is a chart that we use to gauge how factors of production are distributed in the economy. Note that this cannot be more than a rough guide, but it is a guide that has served us well in identifying unsustainable credit-induced bubbles in the past.

What the chart shows is the ratio of capital goods (business equipment) to consumer goods production. When the ratio rises, it means that factors of production are increasingly moving from lower order stages of the capital structure to higher order ones – which is a phenomenon typically associated with credit-induced booms.

Of course this chart cannot tell us how much of the capital drawn toward higher order stages will turn out to be malinvested. However, what it does tell us is that the economy's production structure is in danger of tying up more consumer goods than it produces. In other words, it is an economy that may temporarily already be operating outside of what Roger Garrison calls the 'production possibilities frontier'.

By definition, this state of affairs is unsustainable. Eventually the process will  reverse, namely once market interest rates stop 'obeying' the central bank's diktat and relative prices in the economy begin to revert to something a bit closer to their previous configuration. The revolutionized price structure can of course never return precisely to its initial, pre-boom state. However, if market interest rates were to start increasing, the prices of capital goods would certainly begin to decline relative to the prices of consumer goods. The prices of titles to capital, i.e. stocks, would then begin to fall as well, as would the ratio shown below.

The production of capital versus consumer goods in the US economy – once again reflecting credit bubble distortions – click to enlarge.

For readers not familiar with the long term chart, we show it below. What is interesting about this chart is that prior to the Nixon gold default and the adoption of a pure fiat money, the ratio traveled in a fairly narrow sideways channel. It only began to embark on a strong secular rise once the greatest credit bubble in history took off:

The production of capital versus consumer goods, long term. Prior to the massive credit bubble that started after the last tie of the dollar to gold was abandoned, the ratio traveled in a tight sideways channel between 0.3 and 0.4 – click to enlarge.

To be sure, not all of this structural change in the economy's capital structure can be blamed on the credit bubble. Partly it is probably also a result of the vast increase in global trade, which enabled a different and more efficient distribution of production to be put into place (labor-intensive consumer goods such as apparel are for instance nowadays mainly produced in China and other Asian nations). To the extent that the shift is due to the law of association it is beneficial and nothing to worry about.

Nevertheless, it can be clearly seen on the chart that even if we allow for a structural shift that is to some degree the result of benign developments, periods in which the credit bubble expands more strongly are accompanied by strong increases in the ratio, while busts result in 'mean reversion' moves.

The reason why these mean reversion moves don't play out more forcefully is that the central bank always does its utmost to arrest and reverse the liquidation of malinvested capital and unsound credit.

Conclusion:

Once the economy's capital structure is distorted beyond a certain threshold, it won't matter anymore how much more monetary pumping the central bank engages in – instead of creating a temporary illusion of prosperity, the negative effects of the policy will begin to predominate almost immediately.

Given that we have evidence that the distortion is already at quite a 'ripe' stage, it should be expected that the economy will perform far worse in the near to medium term than was hitherto widely believed. This also means that monetary pumping will likely continue at full blast, as central bankers continue to erroneously assume that the policy is 'helping' the economy to recover.

FINANCIAL REPRESSION - The Suspension of Price Discovery

Rediscovering The Price Of Money... When Things Can't Get Any Worse 10-27-13 Steen Jakobsen, CIO Saxo Bank (via Trading Floor.com),via ZH

I’ve been starting my speeches for some time now by saying: “I am the most optimistic I have been in almost thirty years in the market—if only because things can’t get any worse.”

Is that true, and more importantly, how do we get a fundamental change away from this extend-and-pretend which prevails not only in Europe but also the world?

History tells us that we only get real changes as a result of

• war,
• famine,
• social riots or
• collapsing stock markets.

None of these is an issue for most of the world—at least not yet—but on the other hand we have never had

• less growth,
• worse demographics, or
• higher unemployment since WWII.

This is a true paradox that somehow needs to be resolved, and quickly if we are to avoid wasting an entire generation of European youth.

The West's central banks' policies are akin to Soviet-style central planning. 

Policymakers try to pretend we have achieved significant progress and stability as the result of their actions, but from a fundamental point of view that’s a mere illusion. Italian banks today own more government debt than before the banking crisis, leaving them systematically more exposed to their own government, not less. The spread on government bonds between Germany and Club Med is down below historic averages, but the price has been a total suspension of the “price discovery” of money.

The price discovery of money is the cruel capitalistic part of any system.

An economics  textbook would call it the modus operandi by which capital is allocated where it can find the highest marginal utility. In practice, this should mean that the market dictates the price of money beyond one year—while at durations of less than one year, the central banks determine the price of money. The beauty of the system is that money is allocated in an auction where the highest bidder for “money” or “credit” gets filled on the price he or she deems to match his expected price of money.

Contrast the market-driven model with the present “success story” of relatively low sovereign spreads in Europe, which are driven by the European Central Bank president Mario Draghi’s promise to do "whatever it takes" to keep the euro out of trouble. He has threatened to activate the European Financial Stability Facility and the European Stability Mechamism plus the full arsenal of policy tools to ensure stability.

By doing so, he has effectively suspended price discovery for sovereign debt and for money, as the ECB and local central banks will provide infinite liquidity to local banks and hence indirectly to their government in any market conditions. This one-sided offer from the ECB and the market means there is no power to discipline the government with higher rates or to allocate credit more generally. We have simply disconnected the market and the price of money.

This comes after Draghi’s longer-term refinancing operation, a cheap funding for banks with little or no collateral, or the closest thing to quantitative easing you can have without calling it quantitative easing.

This is a problem because corporations that need to finance long-term projects, like building a power station over six to eight years, need a price for the credit they require throughout the building period. Right now they have an almost flat yield curve from zero to 30 years, which would be fine if it were realistic. But the problem is that one day in the “distant future” when the market normalises, interest rates should revert to their normal price, which is roughly inflation plus a risk premium.

In the case of an industrial company, an appropriate loan rate calculation could be something like: inflation plus Libor plus a risk spread, which might work out to about seven percent. Compare this with the rates available for highly creditworthy companies. Recently, Nestle  was able to issue a four-year corporate bond at 0.75 percent—the lowest ever. Yes, it’s nice for Nestle but remember the situation is created by the central banks presence in the market, not just due to the financial strength of Nestle.

A move from less than one percent to seven percent would administer an ugly shock to companies.  We have created a negative vicious circle in which not only investors, but also companies are depending on low interest rates forever. They have priced their future earnings and costs on government support prices rather than on realistic market prices.

WHY CRONY CAPITALISM (GordonTLong.com Notation)

The worst thing about the situation, however, is that the reason a blue chip company like Nestle can borrow at less than one percent in the capital market is the lack of alternatives for banks and investors. Less creditworthy small and medium enterprises (SMEs) which make up as much as 80 percent of many countries’ economies are not allowed to borrow. They are deemed too risky to lend to at the current “market rates” even though they hold the key to improving the employment and productivity picture.

They are willing to work cheaper, longer, harder and with higher risk tolerance in order to survive.

So the remaining 20 percent of the economy occupied by large and publicly listed companies and banks gets 95 percent of all credit and 99 percent of all political capital. In other words, blue chips receive artificially low interest rates only because the SMEs don’t get any credit. Herein lies my continued belief in the my traditional opening statement: things must get better soon because they can hardly get any worse.

We have never been in a more dysfunctional state at the corporate, political and individual level in history. It’s time to realise that the reason capitalism won the war against communism in the 1980s was its strong market based economy—itself based on price discovery. Now the policymakers in their “wisdom” are copying everything a planned economy entails: central planning and control, no price discovery, one supplier of credit, money and the corollary effect of suppressing SMEs and even individuals.

Finally, history offers a compelling lesson: the last time the Federal Reserve engaged in a sizeable quantitative easing was in the 1940s. The low growth and falling inflation only reversed when the Federal Reserve stopped intervening due to a severe recession brought on by the policy mistakes of keeping QE in place too long.

In 2014, a bout of near or real recession in Germany and the US could kick start the price discovery mechanism again, which will help us to start healing the deep wounds left by years of policymakers compounding their errors with round after round of extend-and-pretend. Getting to the bottom is good in one sense: the only way is up.