It is a very dull start to the week with markets fractionally weaker across the board. European bonds are all a touch weaker. CDS is wider in sovereigns, MAIN, IG, and HY. S&P futures are down a touch as IBEX “leads” the way lower in Europe – but even that is down less than ½%.
Every bear is staring at the screens wondering if this is the start of something real, or a respite from the pain that should be taken? Bulls quite frankly don’t seem particularly nervous. The bulls are acting far more confident than a 2.2% move in the S&P 500 would warrant. Yes, while 2.2% in a week is a big move, it hardly seems to measure up to the hype and expectations it has created. IBEX at least had a 6.2% move.
We will see who is right, but it wouldn’t surprise me to see some shorts taken off here on this brief weakness.
When Did the Bernanke Put become the Bernanke Call?
I never fully understood the “Bernanke Put” but I understand the “Bernanke Call” even less.
Back in the “old days” like Q1 and Q2 of this year, the market had a reasonable expectation that Bernanke and the Fed would support the market in periods of economic or even stock market weakness. That even if there wasn’t an actual put with a strike, there was a floor. The market, and investors could take comfort from the fact that Bernanke was there for them.
That didn’t stop the S&P 500 from dropping from 1,406 on May 1st to 1,278 on June 1st. In theory, the Bernanke put was in play then, and Non Farm Payroll numbers of 68k in April, 87k in May and 45k in June are worse than the two most recent of 141k in July and 96k in August.
So the 87k number for May pretty much marked the bottom of the S&P 500, but now at 1,437, we expect a print of 96k with a decrease in unemployment rate, to lead to action that boosts stocks further?
The market is acting far more like we have a call option that a put. That the market isn’t taking comfort that the Fed is there as back-up support, but that the Fed will aggressively promote the market. That mentality is what leads me to believe that far more is priced in than we are likely to get.
There are many ideas for what the Fed can do. Here is my quick take, with thoughts on market reactions:
- Extended ZIRP – It would not surprise me to see the low rates language softened even further, but who cares. Ben has made it perfectly clear he will keep rates low until the economy is better or signs of real inflation hit. He will raise rates if conditions ever warrant. This language is just pabulum for the markets in an era of Fed transparency. Don’t expect any lasting rally on this.
- More Treasury QE – It is possible but highly unlikely. The Fed already owns almost 40% of treasuries in the 5 to 10 year range. Even Ben is unlikely to push that too much further. On top of that, the 10 year has had an average yield of 1.60% since June 1st, so Fed intervention is unlikely to do too much, and the effects of low yield haven’t been obvious. If we get it, expect a pretty strong rally as the market will be looking at the move in late 2010 for guidance on the impact.
- Mortgage Twist – This seems more realistic. It isn’t adding much to the size of the balance sheet, and by focusing on mortgages, it makes it harder to attack politically. This will likely help bank stocks and that is about it. Without true printing, there is little evidence stocks as a whole can be pushed higher. We can argue back and forth on the effectiveness of operation twist, and I will be left to believe that it did little for the market, and the move in stocks has far more to do with LTRO and ECB policies than operation twist. It is unlikely to lead to new loan creation, but will help banks deleverage and book a profit. Funds that loaded up on mortgages ahead of this, should also do well, but the effect on the overall market and economy will be “transitory” at best.
- New Loan Targeting – More complex would be a program that targets new loans. By all accounts, there are a number of areas of the economy that cannot get money, and certainly not at reasonable rates. Many individuals struggle to get new mortgages, small commercial and residential real estate projects have difficulty getting money, small business continue to find it hard to get loans, and middle market lending is thriving at private equity firms since those companies cannot get it from banks. This will be complex enough, and likely small enough initially as details get worked out that the markets will give a half hearted effort to go higher, but as likely to fade as anything. In the end, I think this approach would have the most likelihood of actually impacting the economy over the longer term.
We still haven’t seen an application from Spain or Italy to join the new ECB program, but the rhetoric coming out of Europe is interesting.
The leaders are sounding very dovish. They are going out of their way to downplay “conditionality”. Rehn today made it sound like Spain and Italy have already met the conditions of “conditionality”. This still falls under the, I’ll believe it when I see it category, but I have been arguing that the bears were far too negative on what conditionality would mean. I’ve thought that this is language to appease the hardliners, while likely to be along the lines of the fiscal compact. The ECB has learned lessons from Greece too. I don’t agree with everything the ECB does, but assuming they are stupid and don’t learn anything from past attempts is wrong as well.
I continue to the Rajoy is a bit of a wildcard. He seems to have a “chip on his shoulder” about asking for aid. In some ways I understand that attitude, but it is hurting his country as the delays really do trickle into the economy and make a real recovery harder to attain. The initial bounce will be easier, but a real fix is that much harder the longer this drags on.
FDX and INTC Don’t Matter (or so it seems)
It isn’t often that I get to almost the 3rd page of the morning note and realize all I’ve spoken about is central bank activity. Actually, sadly, it isn’t totally uncommon either. The market shrugged off some weak reports from bellwethers FedEx and Intel last week. Will the intervention in Europe and our own potential QE turn those outlooks around? I don’t think so. I think the market has chosen to get too excited over what central bankers can do, and buying U.S. stocks at these levels based on ECB actions to support Spain and Italy isn’t a great idea. If you believe that Spain and Italy will get help, then buy Spain and Italy. If you believe that the Fed will be aggressive this week then buy banks. Buy the companies that will be most directly effected.
I don’t like the U.S. market at these valuations.
A Bond Pickers Market in Credit
We have said this before, and will say it again later this week in more detail, but this is a bond pickers market. Especially in high yield, where the beta has been played out.
I see far too many high yield bonds that have as much, if not more, rate risk than credit risk. They cannot perform well if treasuries move higher in yield – and remember, if QE manages to trigger “risk on” treasury yields are likely to move higher.
Another subset of high yield bonds just has no juice left. They are trading as yield to call and have limited upside. Yes, they can go a bit higher, but the call schedule is a huge impediment to further big moves higher.
Smaller issues and weaker credits have some value. Single name CDS and the HY CDS index as well. That is where I see potential value as there is spread and duration. Delving into these is not an easy choice for many because the liquidity is poor and the spreads reflect need for real economic or company specific credit improvement to perform well, but that is the area to focus on. Chasing beta is likely to end poorly, and waiting for new issues to fill your portfolio may leave you underweight for too long.