David Rosenberg warns: Chinese stocks lead commodities markets.

I’ll let his chart do the talking:

Source: gluskinsheff.net

To very little fanfare, the Chinese stock market — the first index to turn around in late 2008 — has slipped into a bear market. It is down 15 % from the nearby high and 20% from last year’s interim peak. Why this is important is because the Shanghai index leads the CRB commodity spot price index by four months with a 72% correlation (and over an 80% correlation with the oil price). Don’t get us wrong — we are long-term secular commodity bulls; however, we have been agnostic this year from a tactical standpoint — never hurts to take profits after a double!

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Analysts and institutions: stocks “extremely cheap” despite 1.7% yields after 80% rally. Hussman & Prechter: another crash likely.

Bloomberg today gives a tour of the bull camp, which believes in a V-shaped recovery and soon-to-be record S&P earnings:

Even after the biggest rally since the 1930s, U.S. stocks remain the cheapest in two decades as the economy improves…

…Income is beating analysts’ estimates by 22 percent in the first quarter, making investors even more bullish that the rally will continue after the index climbed 80 percent since March 2009. While bears say the economy’s recovery is too weak for earnings to keep up the momentum, Fisher Investments and BlackRock Inc. are snapping up companies whose results are most tied to economic expansion.

“The stock market is incredibly inexpensive,” said Kevin Rendino, who manages $11 billion in Plainsboro, New Jersey, for BlackRock, the world’s largest asset manager. “I don’t know how the bears can argue against how well corporations are doing.”

S&P 500 companies may earn $85.96 a share in the next year, according to data from equity analysts compiled by Bloomberg. That compares with the index’s record combined profits of $89.93 a share from the prior 12 months in September 2007, when the S&P 500 was 19 percent higher than today.

Those figures would be for operating earnings, not the bottom line. In recent years it has been increasingly common to simply call operating earnings “earnings” and to imply that multiples on this figure should be compared to historic multiples on the bottom line. Ken Fisher, readers may recall, was running obnoxious video web ads through 2007-2008 touting a continued rally just before stocks fell off a cliff. His equity management firm makes the most money if people are all-in, all the time, as it collects fees as a percent of assets.

Record Pace

The earnings upgrades come as income beats Wall Street estimates at the fastest rate ever for the third time in four quarters. More than 80 percent of the 173 companies in the S&P 500 that reported results have topped estimates, compared with 79.5 percent in the third quarter and 72.3 percent in the three- month period before that, Bloomberg data show.

It is impressive how companies have protected themselves since the downturn began, but the way they have done this is by simply cutting costs, hence the stubborn 9.5% (headline U-3) or 17% (U-6) unemployment rate.

David Rosenberg, as usual, is the cooler head in the room:

Alternate Valuation

David Rosenberg, chief economist of Gluskin Sheff & Associates Inc., says U.S. stocks are poised for losses because they’ve become too expensive. The S&P 500 is valued at 22.1 times annual earnings from the past 10 years, according to inflation-adjusted data since 1871 tracked by Yale University Professor Robert Shiller.

Economic growth will slow and stocks retreat as governments around the world reduce spending after supporting their economies through the worst recession since the 1930s, said Komal Sri-Kumar, who helps manage more than $100 billion as chief global strategist at TCW Group Inc. The U.S. budget shortfall may reach $1.6 trillion in the fiscal year ending Sept. 30, according to figures from the Washington-based Treasury Department.

“The correction is going to come,” Sri-Kumar said in an interview with Bloomberg Television in New York on April 21. “You now have a debt bubble growing in the sovereign side, and we’re slow to recognize how negative that could be.”

We are still in the thick of the largest credit bubble in history. Consumer and real estate debt has yet to be fully liquidated (and hasn’t even started in China), corporate indebtedness is the highest ever, and now government debt has reached the point of no return where default is inevitable.

Equity is the slice of the pie left over after all debts are serviced, so to say that it is cheap when it only yields 1.7% (in the case of S&P dividends) is insane. It is much safer to be a creditor of a business than an owner, so debt yields should be lower than equity yields. In today’s perverse investment climate, even 10-year treasuries of the US and Germany yield more than twice equities.

This extreme confidence in stocks and dismissal of risk considerations further indicates that this is a toppy environment, highly reminiscent of 2007.

John Hussman explores this theme a bit further in his latest market comment:

As of last week, our most comprehensive measure of market valuation reached a price-to-normalized earnings multiple of 19.1, exceeding the peaks of August 1987 (18.6) and December 1973 (18.3). Outside of the valuations achieved during the late 1990′s bubble and the approach to the 2007 market peak, the only other historical observation exceeding the current level of valuation was the extreme of 20.1 reached just prior to the 1929 crash. The corollary to this level of rich valuation is that our projection for 10-year total returns for the S&P 500 is now just 5.3% annually.

While a number of simple measures of valuation have also been useful over the years, even metrics such as price-to-peak earnings have been skewed by the unusual profit margins we observed at the 2007 peak, which were about 50% above the historical norm – reflecting the combination of booming and highly leveraged financial sector profits as well as wide margins in cyclical and commodity-oriented industries. Accordingly, using price-to-peak requires the additional assumption that the profit margins observed in 2007 will be sustained indefinitely. Our more comprehensive measures do not require such assumptions, and reflect both direct estimates of normalized earnings, and compound estimates derived from revenues, profit margins, book values, and return-on-equity.

That said, valuations have never been useful as an indicator of near-term market fluctuations – a shortcoming that has been amplified since the late 1990′s. The lesson that valuations are important to long-term investment outcomes is underscored by the fact that the S&P 500 has lagged Treasury bills over the past 13 years, including dividends. Yet the fact that these 13 years have included three successive approaches (2000, 2007, and today) to valuation peaks – at the very extremes of historical experience – is evidence that investors don’t appreciate the link between valuation and subsequent returns. So they will predictably experience steep losses and mediocre returns yet again. Ironically, before they do, it also means that investors who take valuations seriously (including us) can expect temporary periods of frustration.

I’ve long noted that the analysis of market action can help to overcome some of this frustration, as stocks have often provided good returns despite rich valuations so long as market internals were strong, and the environment was not yet characterized by a syndrome of overvalued, overbought, overbullish, and rising yield conditions. In hindsight, the stock market has followed this typical post-war pattern, and we clearly could have captured some portion of the market’s gains over the past year had I ignored the risk of a second wave of credit strains (which I remain concerned about, primarily over the coming months).

It is important to recognize, however, that even if we had approached the recent economic environment as a typical, run-of-the-mill postwar downturn, we would now be defensive again, as a result of the current overvalued, overbought, overbullish, rising yields syndrome. I do recognize that my credibility in sounding a cautious note would presently be stronger if I had ignored further credit risks and captured some of the past year’s gains. But the awful outcome of this same set of conditions, which we also observed in 2007, should provide enough credibility.

Hussman proceeds to offer a detailed statistical analysis of how valuation and market action impact risks and returns. Curious parties are encouraged to read his essay in its entirety.

Here is how he rather bluntly sums up the current environment:

As of last week, the Market Climate in stocks remained characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically produced periods of marginal new highs, slight declines, and yet further marginal highs, followed somewhat unpredictably by nearly vertical drops. I’ve often accompanied the description of this syndrome with the word “excruciating,” because the apparent resiliency of the market and the celebration of each fresh high, can make it difficult to maintain a defensive stance. Interestingly, the analysts at Nautilus Capital recently noted that the most closely correlated periods in market history to this one were the advances of 1929 and 2007. While exact replication of those advances would allow for a couple more weeks of further strength, we’ve generally found it dangerous to expect history to do more than rhyme. These hostile syndromes have a tendency to erase weeks of upside progress in a few days.

I have to agree with this assessment as well as that of Robert Prechter that this spring offers perhaps the greatest short-selling opportunity in history.

David Rosenberg asks, “Can you handle the truth?”

The Gluskin Sheff economist lays it all out in this end-of-year report. Click “Fullscreen” below to read the report. Subscribe to Rosenberg’s free daily emails here.

Special Report Year Ahead 121609 http://d1.scribdassets.com/ScribdViewer.swf?document_id=24216649&access_key=key-7ajim913ehdby1gxbei&page=1&version=1&viewMode=list


Some take-aways:

- Mainstream economists called this downturn “The Great Recession”. But this is truly a gentle way of saying “Depression”

- Perhaps inflation is a consensus forecast, but deflation is the present day reality

- We believe that the dominant focus this coming year will be on capital preservation and income orientation

He sums up the buy-side consensus like this:

At the outset, let it be known that when I read everyone else’s year-ahead prognostications, all I can think of is, “where do I store this stuff for a year so I can look back and say ‘That was so wrong!’.” It’s not that the reports are always bullish every year; it is that they seem so contrived. And, as I mentioned in the December 10th edition of Breakfast with Dave, this year, probably like most years, there seems to be a remarkable level of agreement. Based on my reading, here is what I conclude the consensus views are as we head into 2010:

- Having read various Year-Ahead Reports, it sure seems like there is a remarkable level of agreement for 2010

- Muted recovery, but positive growth, for sure! No risk of a ‘double dip’.

- Equity markets up!

- A barbell strategy of domestic multinational blue chips and emerging market equities.

- The U.S. dollar is…neutral, but we did locate more bulls than bears (so much for the ‘carry trade’ thesis).

- Positive on commodities for the most part.

- Concerned about government balance sheets, and therefore…

…Bearish on long term government bonds because they are the ‘competition’ and, after all, who would tie their money up for 10 years at 3.5% when you can lose 22% in stocks? And, therefore…

…Bullish on spread product (as long as it’s not long-term). And, therefore…

…Really comfortable with high yield (just for the coupon and the view that default rates will come down).

- Certain that volatility will not be an impediment.

- The Fed will begin to raise rates in the second half of the year, but that this will have no impact since they will still be low.

Deflation trade returning?

While Americans were on holiday, the last couple of days have seen some exciting market action. Stock indexes around the world declined roughly 3-8%, “safe” US and German government bonds rallied, and the dollar plunged to a new low then rebounded very strongly. Gold made a new all-time dollar high at $1196 as the dollar made its low, but when the buck turned yesterday gold plunged to $1130 as US stocks futures (which traded round-the-clock through the holiday) wiped out two weeks of gains in about 24 hours. Higher yield currencies such as the Aussie, Kiwi and South African Rand fell 3-4%, oil extended its decline to under $75, and copper got smacked $0.20 off its new high. One spot of green was natural gas, which extended its bounce to 14% off an area of strong technical support.

Gold showed us what can happen to a levered market after a parabolic move breaks its uptrend. In the wee hours today, it fell $55 in just two hours before rebounding right to resistance (the previous support at $1180, which when broken, precipitated the crash). Here’s a chart of the last two days:


Commentators blame the Dubai default for this week’s gut-check, and the event may have acted as a catalyst, but the fact is that the risk/reflation trade had reached new heights over the last couple of weeks on a wave of complacency. Early this week the VIX nearly hit the teens and the daily put:call ratio put in a super-low print, while the Nikkei, Treasuries and yen offered warnings that all was not well. Browsing through the world index charts on Bloomberg, it is striking how few other markets have followed the Dow to new highs this month. The troops have been losing heart since summer as the generals kept charging ahead, a classic case of inter-market non-confirmation, which can also be seen in the weak action in small-caps and sector indexes like the transports, financials and utilities.

In last few trading hours of the week (this morning), many markets staged a very sharp recovery, as you can see here in this 1-month view of S&P futures:

Source: Interactive Brokers

Today’s pattern played out in nearly identical fashion in oil, gold, silver and other stock indexes. The stall point offered a clean spot for initiating or adding shorts, and those who did so were rewarded nicely in the last 30 minutes of trading as everything sold off quickly.

Next week should be very interesting. The risk trade plateaued for the last two weeks and went through the usual distributive action, so I have been expecting a down leg of some magnitude. Wouldn’t it be nice if this were the one to finally put a nail in the reflation coffin? I am sick of this market, as would be anyone who understands how far out of line these prices are with value or economic reality.

As Dubai’s default reminds us, this credit bust is far from over. There are still trillions and trillions in bad debt out there, and nearly every major bank in the world is still bankrupt and contracting lending (down another 3% in the US in Q3). We have all the hotels, condos and strip malls we’ll need for ages, and the consumer culture of the late 20th and early 21st century is just an unfortunate historical blip. Don’t tell that to Wall Street equity analysts, though — they still think the S&P will earn over $60 next year, just like in boom-time 2005.

PS — check out Dave Rosenberg’s latest essay for a good commentary on the week’s action. You have to sign up, but it’s free.  Click here.

Valuation still matters

Many great traders could care less, but investors need value, and there has been none in the US stock market as a whole since about the early 1990s, and no great value since about 1984. Value means getting a lot for your money, and in stocks that means of course earnings, dividends and (honestly priced) assets.

David Rosenberg is about the only bearish mainstream economist left, all the others having drunk too much Keynesian cool-aid and succumbed to the fallacy that Fed printing and government spending is stimulative (is is the opposite). In this morning’s Breakfast with Dave he warns again that fundamental or long-term investors have business touching the stock market at these prices:


Never before has the S&P 500 rallied 60% from a low in such a short time frame as six months. And never before have we seen the S&P 500 rally 60% over an interval in which there were 2.5 million job losses. What is normal is that we see more than two million jobs being created during a rally as large as this.

In fact, what is normal is for the market to rally 20% from the trough to the time the recession ends. By the time we are up 60%, the economy is typically well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended. In other words, we are witnessing a market event that is outside the distribution curve.

While some pundits will boil it down to abundant liquidity, a term they can seldom adequately defined. If it’s a case of an endless stream of cheap money, we are reminded of Japan where rates were microscopic for years and the Nikkei certainly did enjoy no fewer than four 50% rallies and over 420,000 rally points in a market that is still more than 70% lower today than it was two decades ago. Liquidity and technicals can certainly touch off whippy tradable rallies, but they don’t take you all the way to a sustainable bull market. Only positive economic and balance sheet fundamentals can do that.

Another way to look at the situation is that when you hear and read about “liquidity” driving the market, it is usually a catch-all phrase for “we have no clue” but it sounds good. When we don’t have a reasonable explanation for what is driving prices our strategy is to watch from the sidelines and express whatever positive views we have in the credit market and our other income and hedge fund strategies.

I wholeheartedly agree with his take on the word liquidity as it is thrown about these days. All it really seems to mean is that people are bullish and in the mood to take on risk — most assets were perfectly liquid throughout the crash (that is, there were plenty of buyers), packaged mortgage debt included. The banks only pretended their assets were unsaleable because they didn’t like the bids, which, as it turns out, were perfectly reasonable given the reality of default rates and shrinking collateral values.

Rosenberg goes on to discuss exactly how ridiculous the valuations are, even given the extremely rosy earnings forecasts, which seem to imply that Goldilocks was only taking a little nap and that it is not true that she was torn to shreds by the bears:

As for valuation, well let’s consider that from our lens, the S&P 500 is now priced for $83 in operating EPS (we come to that conclusion by backing out the earnings yield that would match the current inflation-adjusted Baa corporate bond yield). That would be nearly double from the most recent four-quarter trend. Not only that, but the top-down estimates on operating EPS, for 2009 are $48.00 for 2009; $52.60 for 2010; $62.50 for 2011; and $81.00 for 2012. The bottom-up consensus forecasts only go to 2010 and even for this usually bullish bunch, operating EPS is seen at $73.00 for 2010, which means that $83.00 is likely a 2011 story. Either way, the market is basically discounting an earnings stream that even the consensus does not see for another two to three years. In other words, this is more than just a fully priced market at this point.

It is, in fact, deeply overvalued at this juncture. Imagine that six months after the depressed lows we have a situation where:

The trailing price-earnings ratio on operating EPS is 26.5x. At the October 2007 highs, it was 18.8x. In addition, when the S&P 500 is trading north of a 26x P/E multiple on trailing operating earnings, history shows that at these high valuation levels, the market declines in the coming year 60% of the time.

The trailing price-earnings ratio on reported EPS is 184.2x. At the October 2007 highs, it was 23.4x. In fact, just prior to the October 1987 crash, the P/E ratio was 20.3x (not intended to scare anyone).

The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the market is trading as it if were at a peak for the cycle, not any longer near a trough. Once again, and we don’t intend to sound alarmist, the price-to-dividend ratio just prior to the 1987 crash was 12x, and at the time, the S&P 500 was viewed in many circles to be at an extended extreme.
Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which of course will never occur again. Fine, on one-year forward (operating) earning estimates, the P/E ratio is now 15.7x, the highest it has been in nearly five years. At the peak of the S&P 500 in the last cycle — October 2007 — the forward P/E was 14.3x, and the highest it ever got in the last cycle was 15.4x. So hello? In just six short months, we have managed to take the multiple above the peak of the last cycle when the economic expansion was five years old, not five weeks old (and we may be a tad charitable on that assessment). As an aside, the forward multiple on the eve of the 1987 stock market collapse was 14x and one of the explanations for the steep correction was that equities were so overvalued and overbought that it was vulnerable to any shock (in that case, it came out of the U.S. dollar market). It certainly was not the economy because that sharp 30% slide took place even with an economy that was humming along at a 4.5% clip.

The entire article (sign up for emails) is worth a read. There is much more good stuff in there on housing, manufacturing, commodities and household net worth. Savvy contrarian that he is, he also had these kind words to say about the US dollar:

We do not like the U.S. dollar at all, but at the same time, from a purely tactical standpoint, we have to recognize that there are no U.S. dollar bulls out there right now, the bearish dollar trade is the crowded consensus trade, and that the greenback is massively oversold. It could snap back near-term — be aware of that, please.

Rosenberg: Latest employment and credit figures show deflationary depression unabated

This morning’s Breakfast With Dave is good one.

There are so many headwinds confronting the U.S. consumer it’s not even funny. For a look at the new harsh reality of soaring usage of grocery vouchers, as well as other supplements to the household budget, have a look at the grim article on page 2 of the weekend FT (Families Take Up Food Stamps as Wages Shrink). On the very same page, there is an article on the latest trend in terms of 21st-century breadlines — Middle Classes Turn to Car Park Handouts. To think we still get asked why we aren’t more bullish over the outlook for spending. Truly amazing.


The U.S. economy is actually 9.4 million jobs short of being anywhere remotely close to being fully employed, which is why any inflation that can somehow be created by the Fed is simply going to be unsustainable noise along a fundamental downtrend in pricing power. After last Friday’s report, we have now lost 6.9 million positions that have been cut during this recession and we have to count in the additional 2.5 million jobs that need to be created — but never were — just to absorb the new entrants into the labour market. The ‘real’ unemployment rate is now 16.8%, so to suggest that this down-cycle was anything but a depression is basically a misrepresentation of the facts.


It is interesting that the equity market has begun to wobble (fade last Friday’s rally on such low volume) because we have noticed that some key liquidity indicators are not behaving very well, all of a sudden. M1 fell 1.0% in the August 24th week and over the past four weeks is down at a 6.5% annual rate. M2 has contracted in each of the past four weeks too and over that time has slipped at a 12.2% annualized pace, which is a near-record decline. We see the same trend in the broad MZM money measure — off at a 15.8% annual rate over the past month. Bank credit also remains in a fundamental downtrend — contracting at an epic 9% annualized pace over the past four weeks.

So for the first time in the post-WWII era, we have deflation in credit, wages and rents, and from our lens this is a toxic brew that in the end will ensure that the focus on capital preservation and income orientation will be the winning strategy over a strict reliance on capital appreciation.