2012: The Year That Cried Wolf

Wolf

As we come to the end of 2012 we find that, like a movie, the stresses and strains, the thrills and spills and loose ends are all being tidied up into a relatively happy ending. However, like any blockbuster worth its salt, there are the odd questions left open ready to be picked up again in any sequel (2013). 2012 has seen the resurrection of many dark evils but TMM can’t see one that has actually resulted in the type of global disaster that many tail hedgers had placed their chips on.

The European Zombie Dawn has not torn the heart out of the EU leaving it a bloodied corpse as Greece is still in the Euro, Spain has not defaulted. The US is not in recession, China has not had a hard landing, Iran hasn’t been invaded or closed the Gulf, inflation hasn’t gone hyper through QE and, lo, we are all alive and well (if you are reading this after 21st Dec).

TMM would like to summarise 2012 as “The Year that cried Wolf”. Tail hedging became a theme that saw premiums rise rapidly, whether it was straight volatility for tails or the tail risk products such as CDS. But at the end of the year, though there was money to be made by cunning tail risk traders ( as there is with any market that is wildly moving) the underlying events that these products are designed to insure against did not occur leaving the net sellers of tail risk the beneficiaries.  TMM have had some interesting debates with friends about tail risk and we will probably do a post on it soon, but our simplistic view is that if you bet on a 33/1 horse and the price comes into 20/1 then you have made money irrelevant as to whether the horse actually wins or not. And this year saw a lot of betting on ultimate losers. 

This is probably going to be the last post of the year from us but we hope to come back strong in January with our Non-predictions for 2013 and the marking of the 2012 set. We can’t even remember what they were now and daren’t look. For now we leave you with the 2012 Christmas viewing schedule.

2012 Christmas viewing-

“The Shirakawa Briefing”– Staring Matt Damon. A tale of intrigue as one man fights to discover ancient policies shrouded in mystery since the dawn of time. Only he know’s the dark truth and is determined to warn the world of a frightening new plan being plotted by a mysterious organisation known only as the BoJ.

 “The Fiscal Cliff” prequel to “Into the Void” – Two climbers have to overcome bitter personal resentment and hatred stemming from their disturbed childhoods as political orphans in the House of Representatives in order to overcome adversity and certain death as they face the uncontrollable natural forces of budget control.
O A portfolio manager and his Sovereign CDS holdings are becalmed in the once stormy seas of the European markets when they come across a European Central Bank whose story doesn’t tally. The investor is left on a sinking ship hoping that the central bank’s plans fail and his CDS rescues him before he drowns.

“Big Trouble in Little China” – When an All-British fund manager Anthony Bolton agreed  to take his funds to the Asian stock markets, he never expected to get involved in a supernatural battle between good and evil. Bolton’s funds are rich in greenbacks, which make them a perfect target for an immortal bent system and its three invincible state structures. Suffering huge losses, how can Bolton’s funds now defeat data that can’t be seen. 

“Green Card” – A French national leaves France for tax exile in Belgium to much derision from his homeland, only to find that a benevolent Russian President is willing to give him residency with no questions asked. 

“Tom ‘n’ Rog’ll Fix it” – Far East dealers Tom ‘n’ Rog try to make their own dreams come true by fixing it for themselves. However their shady activities catch up with them years later once they think they are immune from capture leading to huge embarrassment and fines for their employer. Unfortunately, unlike the other old “fixer”, they are not already dead and are about to face prosecution for their outrageous crimes. 

“Apocalypse Not Now” – A  website in the US is inundated by true believers of the ZH cult expecting to be rescued by Aliens and long gold positions from a doom writ large in ancient calendars. However when Greece doesn’t leave the EU, Spain doesn’t default, the US doesn’t go into recession and China doesn’t have a hard landing, as the ancient prophecies predicted, they all have to pack up their meagre belongings, having sold everything else, and trudge back to the realities of a normal curve with their “tails” between their legs.

Happy Christmas and a Happy New Year from Pol, Cpmppi and Nemo.

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The Stock Market Looks Like A Gigantic Powder Keg, Ready To Blow (DIA, SPY)

explosives

Stocks have held up remarkably well lately considering all of this talk about the fiscal cliff and how going over the cliff could hack multiple percentage points off of GDP growth.

However, the apparent dismissal of this impending, high-risk event with a non-zero probability may have turned the stock market into a giant powder keg.

The S&P 500 closed at 1,435 today, which is near a three-month high and just 40 points from a post-crisis high.

Meanwhile, complacency is arguably be high as reflected by the low levels in the volatility index, or VIX (see below).

“The stock market appears to have adopted a surprisingly benign view that Congress and the White House will reach agreement to avert the full impact of the fiscal contraction,” said Goldman Sachs’ David Kostin. “Many portfolio managers now explicitly assume a deal will be struck by year end (or possibly early January) that raises taxes on upper income Americans and curbs the growth rate of entitlement spending.”

This sentiment is also shared by UBS’s clients.

According to a recent survey “approximately two-thirds of investors believe that an agreement will be reached by year end, with a relatively even split between pre- and post-Christmas,” said Jonathan Golub, UBS’s Chief U.S. Equity Strategist. “The remaining 33% believe that a deal will not be struck until next year. Of these, a little more than half expect an agreement before inauguration day on January 21.”

Speaking at a luncheon today, Golub warned that there is only downside risk left in the near-term for the stock market.  “The upside has already been experienced.”

Golub described two scenarios that we’re currently facing: 1) if we get some sort of deal, then stocks go nowhere or perhaps down because a deal is already priced in; and 2) if we don’t get a deal, then the surprised market would sell-off sharply.

Effectively, there’s no reason to be buying stocks until at least after early January since it seems that only bad things could happen until then.

It’ll be interesting to see how things unfold in the next few weeks.

Here’s a chart of volatility during the fiscal cliff and debt ceiling debates courtesy of Bloomberg BRIEF economist Michael McDonough:

vix fiscal cliff

SEE ALSO: Deutsche Bank: 13 Outlier Events For 2013 >

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DAVID ROSENBERG: Here Are 10 Near-Certainties In A Sea Of Uncertainty

David Rosenberg

Europe’s debt crisis continues, the U.S. fiscal situation is up in the air and Japan has entered a technical recession, creating a “sea of uncertainty”.

In an environment with low returns, slow economic growth, and political uncertainty, Gluskin Sheff’s David Rosenberg writes that SIRP – safety and income at a reasonable prices – continues to be his primary investment strategy. 

Despite all the ambiguity, however, some things are almost certain. Here are ten-near certainties that Rosenberg says to invest around [presented verbatim]:

  1. We remain in a classic post bubble ‘fat-tailed’ distribution curve, where the range of possible outcomes is much wider than in past recovery phases. This will remain the case in 2013, and until such time as all the major global debt imbalances have been fully resolved.
  2. Near-6% U.S. output gap; 3%+ global gap. The world is still awash with excess capacity across labour and product markets. As such, disinflation themes will keep trumping inflation themes. This puts preservation not just of capital, but of cash flows, front and centre in terms of core investment strategies.
  3. Fed likely to keep rates near 0% through 2018 (according to our analysis): Interest rate volatility minimized; long-short credit strategies should remain core to any bond strategy.
  4. $1.7 trillion in cash on U.S. corporate balance sheets: Even though yields have plunged in the past year, corporate bonds remain a solid investment given prospective low default risks, especially given still-wide spreads relative to the government sector.
  5. Fed to replace Operation Twist with outright bond buying: Treasury yields to head even lower, making dividend yield and ‘bond proxies’ in the equity market that much more alluring.
  6. Real interest rates to remain negative: This is a very powerful positive thrust for the precious metals complex, and should help establish a firmer floor under the stock market given the implications for “discounted” earnings growth (i.e. a lower cost of capital).
  7. Stephen Harper around until April 2015 (at the least), Barack Obama around until January 2017: Along with diverging monetary policies, the stark political divide is bullish for the Canadian dollar.
  8. Geopolitical tensions — Middle East, China’s political transition, Greek default risks, U.S. fiscal issues, high and rising youth unemployment rates in Europe and Japan-China rift: Exposure to raw materials is a good hedge against these recurring flare-ups.
  9. U.S. energy self-sufficiency: Still a forecast, but this has positive implications for the manufacturing renaissance story.
  10. Malthusian population dynamics: That two billion more people to feed in the next 35 years means we need 70% more food; an agrarian revolution is in its infancy stages.

SEE ALSO: Deutsche Bank: 13 Outlier Events For 2013

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David Rosenberg Presents 10 Things In The Economy That Are ‘Nearly-Certain’

David Rosenberg

Europe’s debt crisis continues, the U.S. fiscal situation is up in the air and Japan has entered a technical recession, creating a “sea of uncertainty”.

In an environment with low returns, slow economic growth, and political uncertainty, Gluskin Sheff’s David Rosenberg writes that SIRP – safety and income at a reasonable prices – continues to be his primary investment strategy. 

Despite all the ambiguity, however, some things are almost certain. Here are ten-near certainties that Rosenberg says to invest around [presented verbatim]:

  1. We remain in a classic post bubble ‘fat-tailed’ distribution curve, where the range of possible outcomes is much wider than in past recovery phases. This will remain the case in 2013, and until such time as all the major global debt imbalances have been fully resolved.
  2. Near-6% U.S. output gap; 3%+ global gap. The world is still awash with excess capacity across labour and product markets. As such, disinflation themes will keep trumping inflation themes. This puts preservation not just of capital, but of cash flows, front and centre in terms of core investment strategies.
  3. Fed likely to keep rates near 0% through 2018 (according to our analysis): Interest rate volatility minimized; long-short credit strategies should remain core to any bond strategy.
  4. $1.7 trillion in cash on U.S. corporate balance sheets: Even though yields have plunged in the past year, corporate bonds remain a solid investment given prospective low default risks, especially given still-wide spreads relative to the government sector.
  5. Fed to replace Operation Twist with outright bond buying: Treasury yields to head even lower, making dividend yield and ‘bond proxies’ in the equity market that much more alluring.
  6. Real interest rates to remain negative: This is a very powerful positive thrust for the precious metals complex, and should help establish a firmer floor under the stock market given the implications for “discounted” earnings growth (i.e. a lower cost of capital).
  7. Stephen Harper around until April 2015 (at the least), Barack Obama around until January 2017: Along with diverging monetary policies, the stark political divide is bullish for the Canadian dollar.
  8. Geopolitical tensions — Middle East, China’s political transition, Greek default risks, U.S. fiscal issues, high and rising youth unemployment rates in Europe and Japan-China rift: Exposure to raw materials is a good hedge against these recurring flare-ups.
  9. U.S. energy self-sufficiency: Still a forecast, but this has positive implications for the manufacturing renaissance story.
  10. Malthusian population dynamics: That two billion more people to feed in the next 35 years means we need 70% more food; an agrarian revolution is in its infancy stages.

SEE ALSO: Deutsche Bank: 13 Outlier Events For 2013

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The Fed’s New Policy Means More Volatility For The Bond Markets

My colleague Bob Eisenbeis will address the Fed’s new policy and what it means for “Fed watching.”  Let me address what I think it means for markets.

We expect market agents to focus on the numbers.  6.5% has become the targeted unemployment rate for the headline unemployment statistic.  That is now the “Evans rule,” named for Chicago Fed President Charles Evans, who pushed for this numerical standard as a threshold for the Fed to change its policy from the present expansive and stimulative one.  Evans argues that the Fed should stay the course until the unemployment rate falls to this level or lower.

The number itself is an unambiguous reference.  It is computed and published monthly.  It is released at 8:30 AM on the first Friday of each month.  Most of the time there is controversy about its computation.  Media coverage has evolved into a game of forecast roulette on each month’s “employment Friday.”  Surveys of economists’ estimates coalesce to a single number as the Friday draws near.  Then the pre-employment-Friday ADP release on Wednesday is a forerunner in forecasting the actual unemployment rate.  ADP’s record is mixed, but it is now part of the circus activity.  Speculation about the employment report has no penalty for error among forecasters.  Out comes the number and all the pre-release commentary is forgotten.

Most important are the revisions to prior numbers, since the first set of releases is composed of initial estimates and the refined numbers are more accurate.  But the revisions get less attention than the roulette game of forecasting.  Oh, well.

Over longer periods of time, the headline unemployment rate is an indicator of the health of the US economy.  From the Fed’s viewpoint it is the single best-understood labor-related number to watch.  Of course, market agents will now try to anticipate the Fed.  Watch the market start to adjust when the unemployment rate falls below 7% and stays below it for several months.  Watch the bond market attempt to project when the rate will reach 6.5%.  We will be seeing that in the shape of the yield curve.  Forward rates can be expected to move quickly every month as the employment number is released.  The closer we get to 6.5%, the more volatility we will see.

Bob Eisenbeis will also discuss the use of “core PCE” again.  He and I have been examining this change in Fed policy since Bernanke revealed it in the Q&A session.  Bob notes the work of St. Louis Fed President Jim Bullard regarding the reasons why “core PCE” is a preferred indicator of inflation.  The selection of this indicator and its use are very important for market agents to consider.

Market instruments do not easily trade on the “core PCE.”  For markets, the reference is the headline CPI.  It is the CPI which determines the pricing of TIPS and rents and social security payments and pension indexing and income tax brackets, etc.  There is a vast difference (30 to 50 basis points) between the CPI and the PCE and more difference between the headline CPI, which includes food and energy, and the “core PCE,” which uses different component weights than the CPI and does not include food and energy.  Markets are now going to have to estimate the gap between CPI and “core PCE.”  This is like estimating the difference between “apples and oranges” (or maybe I should say the difference between the prices of apples and oranges).  Both grow on trees; both make juices.  Oranges make lousy pies.

The computational details of the PCE and CPI are a large topic, but there are references to watch for each of them.  Jim Bianco publishes a comprehensive list of inflation measures each month as the data becomes public.  Many others examine the data with different statistical approaches.  Good work is available on the Cleveland Fed website (median CPI) and on the Dallas Fed website (search under “trimmed mean PCE”).

The bottom line is that there is a lot of variability between the “core PCE” and the headline CPI.  They can be as much as 100 basis points apart and heading in different directions.  Markets will be looking at market-based pricing by examining how the CPI-based TIPS market and TIPS forward rates adjust to each month’s releases.

The danger here is that expectations can and, in our view, will be over-reactive.  We expect that the new Fed policy of predicating policy change on a threshold of 2.5% for “core PCE” will invite more volatility in the bond market, not less.  In fact, the Fed’s action to include this inflation reference may end up being counterproductive to the Fed’s policy objective.  Don’t be surprised if the headline CPI is over 3% and rising on an energy price spike while the core PCE may be simultaneously 2% and falling.  The opposite construction is also possible.  This will be the market’s new conundrum with Fed policymaking.

For market agents, the whole business of managing money has now become much more complicated.  We already have the Fed actively engaged in targeting two points on the yield curve instead of one.  The Fed policy now focuses on both the short-term rate and the longer-term rate.  It has been hard enough for the Fed to get one of them right; now it is trying for a twofer.

Add the fact that the Fed is now focusing on references and thresholds to determine when it will make a policy shift.  It is using the unemployment rate, but it has introduced a conditional inflation rate.  The unemployment rate number is firmly identified; the inflation number is derived from an abstract notion and is questionable and controversial.  Again the Fed has to get two things right, and both are very difficult.

So the Fed now has a two-by-two matrix.  Two interest rates (short-term and long-term) and two economic indicators (inflation and unemployment) need to align for the Fed to make a shift.  And each of them has a mean and standard deviation; and one of them, the “core PCE,” is viewed by market agents as a proxy that reflects itself in the CPI.

It is going to be an interesting few years.

Meanwhile, the near term is quite predictable.  The inflation rate is well below the Fed’s target.  The unemployment rate is well above the Fed’s target.  The Fed has committed itself to several more years of the present low interest rates as a policy.  At the same time, the deleveraging of the last five years is intensifying as financial repression continues to crush the yields of savers when they encounter maturity rollover.  And fiscal stimulus has certainly peaked in the United States and most other major economies, so various forms of austerity are acting as a global agent of compression.

Bottom line:  Interest rates are likely to be low for quite some time.  It is too soon to sell your bonds.  We like spread product and particularly tax-free Munis of higher credit quality.  The bond bull market is not over.

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3 Of The 4 Official Recession Indicators Are Looking Up

Note from dshort: This commentary has been revised to include today’s release of Industrial Production and yesterday’s Retail Sales adjusted with today’s release of the Consumer Price Index.


Official recession calls are the responsibility of the NBER Business Cycle Dating Committee, which is understandably vague about the specific indicators on which they base their decisions. This committee statement is about as close as they get to identifying their method.

There is, however, a general belief that there are four big indicators that the committee weighs heavily in their cycle identification process. They are:

  • Industrial Production
  • Real Personal Income
        (excluding transfer payments)
  • Employment
  • Real Retail SalesClick to View
 

The weight of these four in the decision process is sufficient rationale for the St. Louis FRED repository to feature a chart four-pack of these indicators along with the statement that “the charts plot four main economic indicators tracked by the NBER dating committee.”

Here are the four as identified in the Federal Reserve Economic Data repository. See the data specifics in the linked PDF file with details on the calculation of two of the indicators.

The FRED charts are excellent. They show us the behavior of the big four indicators currently (the green line) as compared to their best, worst and average behavior across all the recessions in history for the four indicators (which have start dates). Their snapshots extend from 12 months before the June 2009 recession trough to the present.

The Latest Indicator Data: Industrial Production and Real Retail Sales

This morning I’ve added two more of the Big Four for November: Industrial Production from the Federal Reserve, the purple line in the chart below and Real Retail Sales, the green line.

The Fed update on IP lead with the following observation:

Industrial production increased 1.1 percent in November after having fallen 0.7 percent in October. The gain in November is estimated to have largely resulted from a recovery in production for industries that had been negatively affected by Hurricane Sandy, which hit the Northeast region in late October. In November, manufacturing output increased 1.1 percent after having decreased 1.0 percent in October; in addition to the storm-related rebound, a sizable rise in the production of motor vehicles and parts boosted factory output in November.   [Link]

For a detailed overview of the latest Retail Sales, see my latest update, which I’ve revised to include today’s release of the November CPI.

Current Assessment and Outlook

At this point, the average of the Big Four (the gray line in the chart above) shows us that economic expansion since the last recession had been hovering around a flat line for the past several months. But the November data for Employment, Industrial Production and Real Retail Sales have shown improvement.

As for the recent data, of course they are subject to revision, so we must view these numbers accordingly.

The behavior of all four of these indicators will be critical as move from the fourth quarter to the new year. Superstorm Sandy has not been traumatic to the economy, and we will see some positive effects from rebuilding in the impacted areas. Holiday season sales will be something to watch in the next Retail Sales release.

On the negative side, the continuing weakness in Real Personal Income Less Transfer Payments is a looming threat, and we may see evidence of it in the final tally of holiday spending. Finally, of course, the outcome of Fiscal Cliff negotiations remains a near-term worrisome wild card in the economic hand.

Background Analysis: The Big Four Indicators and Recessions

The charts above don’t show us the individual behavior of the Big Four leading up to the 2007 recession. To achieve that goal, I’ve plotted the same data using a “percent off high” technique. In other words, I show successive new highs as zero and the cumulative percent declines of months that aren’t new highs. The advantage of this approach is that it helps us visualize declines more clearly and to compare the depth of declines for each indicator and across time (e.g., the short 2001 recession versus the Great Recession). Here is my own four-pack showing the indicators with this technique.

Now let’s examine the behavior of these indicators across time. The first chart below graphs the period from 2000 to the present, thereby showing us the behavior of the four indicators before and after the two most recent recessions. Rather than having four separate charts, I’ve created an overlay to help us evaluate the relative behavior of the indicators at the cycle peaks and troughs. (See my note below on recession boundaries).

 

 

The chart above is an excellent starting point for evaluating the relevance of the four indicators in the context of two very different recessions. In both cases, the bounce in Industrial Production matches the NBER trough while Employment and Personal Incomes lagged in their respective reversals.

As for the start of these two 21st century recessions, the indicator declines are less uniform in their behavior. We can see, however, that Employment and Personal Income were laggards in the declines.

Now let’s look at the 1972-1985 period, which included three recessions — the savage 16-month Oil Embargo recession of 1973-1975 and the double dip of 1980 and 1981-1982 (6-months and 16-months, respectively).

 

 

And finally, for sharp-eyed readers who can don’t mind squinting at a lot of data, here’s a cluttered chart from 1959 to the present. That is the earliest date for which all four indicators are available. The main lesson of this chart is the diverse patterns and volatility across time for these indicators. For example, retail sales and industrial production are far more volatile than employment and income.

 

 

History tells us the brief periods of contraction are not uncommon, as we can see in this big picture since 1959, the same chart as the one above, but showing the average of the four rather than the individual indicators.

 

 

The chart clearly illustrates the savagery of the last recession. It was much deeper than the closest contender in this timeframe, the 1973-1975 Oil Embargo recession. While we’ve yet to set new highs, the trend has collectively been upward. But a closer look at the average shows a clear slowing of the trend in 2012.

 

 

 

 


Appendix: Chart Gallery with Notes

Each of the four major indicators discussed in this article are illustrated below in three different data manipulations:

  1. A log scale plotting of the data series to ensure that distances on the vertical axis reflect true relative growth. This adjustment is particularly important for data series that have changed significantly over time.
  2. A year-over-year representation to help, among other things, identify broader trends over the years.
  3. A percent-off-high manipulation, which is particularly useful for identifying trend behavior and secular volatility.

Industrial Production

The US Industrial Production Index (INDPRO) is the oldest of the four indicators, stretching back to 1919. The log scale of the first chart is particularly useful in showing the correlation between this indicator and early 20th century recessions.

 

 

 

 

 

 

Real Personal Income Less Transfer Payments

This data series is computed as by taking Personal Income (PI) less Personal Current Transfer Receipts (PCTR) and deflated using the Personal Consumption Expenditure Price Index (PCEPI). I’ve chained the data to the latest price index value.

The “Tax Planning Strategies” annotation refers to shifting income into the current year to avoid a real or expected tax increase.

 

 

 

 

 

 

Total Nonfarm Employees

There are many ways to plot employment. The one referenced by the Federal Reserve researchers as one of the NBER indicators is Total Nonfarm Employees (PAYEMS).

 

 

 

 

 

 

Real Retail Sales

This indicator is a splicing of the discontinued retail sales series (RETAIL, discontinued in April 2001) spliced with the Retail and Food Services Sales (RSAFS) and deflated by the Consumer Price Index (CPIAUCSL). I used a splice point of January 1995 because that was date mentioned in the FRED notes. My experiments with other splice techniques (e.g., 1992, 2001 or using an average of the overlapping years) didn’t make a meaningful difference in the behavior of the indicator in proximity to recessions. I’ve chained the data to the latest CPI value.

 

 

 

 

 

 

Real Manufacturing and Trade Sales

This indicator is a splice of two seasonally adjusted series tracked by the BEA. The 1967-1996 component is SIC (Standard Industrial Classification) based and the 1997-present is NAICS (North American Industry Classification System) based. The data are available from the BEA website. See Section 0 – Real Inventories and Sales and look for Tables 2AU and 2BU. The FRED economists use the Real Retail Sales above for their four-pack. However, ECRI appears to use this series as their key indicator for sales. Note that the Manufacturing and Trade Sales data is updated monthly with the BEA’s Personal Consumption and Expenditures release, but the numbers lag by one month from the other PCE data.

 

 

 

 

 

 

Note: I represent recessions as the peak month through the month preceding the trough to highlight the recessions in the charts above. For example, the NBER dates the last cycle peak as December 2007, the trough as June 2009 and the duration as 18 months. The “Peak through the Period preceding the Trough” series is the one FRED uses in its monthly charts, as explained in the FRED FAQs illustrated in this Industrial Production chart.

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