Rebel Traders – Analysis Without The Hype

So far, we have managed to get back to the highs of the year on the S&P 500. Emerging markets have also participated in their boom.

As the markets are now reaching overvalued territory considering the current growth, the question now remains lingering in the mind of many traders: where are we headed from here? Different theories have been thrown around some basing themselves on the same elements but deriving very different consequences. The answer to that question divide themselves in four, according to the analysis (bearish or bullish).

The Two Schools of Double-Dippism

Two type of analysis predict a double-dip recession on contradictory hypotheses: one on a deflationary thesis, the other on an inflationary thesis. Needless to say, with the hike in gold these last weeks, the inflationary double-dipists have obtained a few points in their favor. You may count in that group analysts such as Andy Xie or Nouriel Roubini. In recent economic news, their thesis seems to have been somewhat comforted by some level of higher spending in retail. Some of the inflationary double-dippist maintain that higher retail spending is not necessary; it is enough that the markets “anticipates” inflation to automatically realize it (cfr. the writings of Andy Xie).

The double-dippists on a deflationary view (Denninger for instance) postulate that the expectations of the markets are too high to be fulfilled and that the US consumer will not be able to be a frantic spender as before. As credit remains contracted, the money unleashed by the Fed remains locked up and does not circulate in the economy. This should ultimately bring about a shock (by some weird coincidence both the schools of double-dippists have now moved to Q1-Q2 2010 as the time of reckoning – which is a notable evolution for the deflationists who were expecting a crash since last March), crashing the markets a second time and opening all hell loose. Unfortunately, the double-dippist also remain very silent as to what follows after the apocalypse they predict. Of course, I left aside a lot of nonesense on “manipulation” and government intervention that is often added up to the mix of the deflationary double-dippists.

The Inflationist Bulls

The bullish analysis generally is an optimist variant of the inflationary double-dippist. Only, instead of seeing the markets crash under high assets prices and the economic cost associated, the bullish view sees inflation as the answer to all the issues of the US and the resolution of the spending contraction. As credit will slowly unfreeze, demand should pick up and we should end in a wonderful bubble of all assets giving way to wonderful growth all over the place (and at the same time, a devaluation of the cost of the US debt). US demand will pull ahead the global production, thus launching a “virtuous circle”, and so on. Needless to say, in periods of inflation you are better off both with a credit and/or with tangible assets rather than money. You can file hereunder the “Inflationary Bulls” all the hedge funds buying gold or commodities right now.

What the Inflationist Bulls often omit to say is that, eventually, you get another deflationary bubble burst… or another protracted agony of the housing and stock market with high taxes over several years.

The Savings Bulls

That analysis misses the big issue of deleveraging and the fact that the credit crisis has essentially brought the US on its knees. With the trauma of the credit crunch, many Americans have taken to saving in big proportions. These savings can become an essential tool for helping industrial investment in the US. However, the recent stats pointing out a resumption of spending cast a serious doubt on how much this change of heart really entered the American habits.

There is no question that compared to last March, the general mood is more optimist; And it is worth noticing that this week no single bank has gone into failure, a remarkable piece of news when you think that the “Black Angel” of bank analysts, Meredith Whitney was predicting 300 + bank failures by the end of 2009.

The “savings bulls” postulate that we are going to revert to a virtuous circle, where high savings will allow the development of industry and a recovery from the spending binge of the Greenspan era. Maybe even a partial answer to the US debt issue, as money invested into T-bills may help keep the debt proceeds within the country. The problem being that we are in unprecedented times, with an unprecedented debt and with unprecendented amounts of liquidity out there.

In addition, all the tools for investment are already out there. Why isn’t there a fury of investment then? Because most banks park their money either at the Fed or play with it on the markets, in a schizophrenic game of low risk/high risks game.

So additional savings will be a great thing – in the future, a few years from here. Short-term, it is not sure that this will have any tangible effect on the economy except invalidating any keynesian policy.

Conclusion: Any Prediction On the Future will be a bet

Are we out of the through then? The most prudent analysts point out that while Q3 may be still positive for the companies, thanks to an extension of the cost-cutting measures and an amelioration of the overall economic situation, the most likely scenario will be a U-shaped recovery. In short, whomever missed the huge rally from the lows of March should not hope for a continuation of those violent and miraculous progressions in the markets – unless, of course, the inflationary double-dippists get their way. So far, we can expect only a long and protracted recovery, while deleveraging follows its course, and maybe, a new culture of frugality pervades the US.  So we may still go higher… But the road will be much more bumpy now even if the conditions are not reunited for a dramatic crash too soon. But any prediction can only be a bet.

In that respect, Ben Bernanke admittedly confessed to maintaining liquidity in the system to encourage spending by companies and individual consumers through the expansion of credit. We know this credit is remaining frozen for now.

However, as time goes by and the economy strenghtens itself,  the Fed will have to pull out the excess liquidity from the system… Thus encouraging a continuation of the credit contraction (which may favor any of the deflationary double-dippists and the savings bulls depending on the ultimate effect).

In the meanwhile, the lower dollar encourages US exports, and maybe even foreign investment in the US, as the current desperate condition on the labor market may encourage people to accept lower-paid jobs.  So there is a bright side, even to the dollar’s depreciation.

Given the number of variables at play, it is very difficult to predict the economic future with any clarity. There are many black swans hatching around the world that may pronounce the doom of the markets… And there are just as many white swans that may blind bears with hope. In these conditions, it is difficult to make any call except a very cautious call to be pragmatic and trade the market as it is. The question remains open: “who wants to fight the Fed?”

So far, the best thing to do is for traders to play the swings with a certain love of risk and without pre-established prejudice; and for investors who have long positions to hedge them against unexpected reversals. The market rewards cynicism towards it, not naive beliefs.

Recently, disgruntled bears have begun pointing to the Baltic Dry Index’s (BDI) fall as a sign that there is a divergence that should lead the markets down. Once again, that translates a bad understanding of the correlations (or lack thereof) between the BDI and economic activity.

For starters, the BDI reflects the cost of shipping dry goods and generally especially raw materials across the globe.In recent months, its value has been hiked by China’s stockpiling of commodities and demand for shipping on short term.

The BDI is also very sensitive to marginal increases in demand and thus can be overreacting to temporary phenomenons such as Chinese stockpiling, if this demand exceeds the supply of ships then present.

This can be confirmed when you relate the BDI to the  very bleak picture of the US Industrial Production painted by this graph:

However, and that’s where a slip is often being made, the BDI reflects more the demand in shipping of commodities at a given moment than some real changes in economic activity. It does not predict or reflect the markets (hence often these reflections about the “illogicity” of the markets). Especially it does not reflect the activity of industries which have a supply of commodities nearby.

The correlation of the BDI to the stock markets is all but clear:

The Baltic Dry Index is currently riding an eleven day winning streak during which the index has gained 43%. Year to date, the index is now up 228%. Given that it is a measure of shipping rates, the increase in the Baltic Dry Index is regarded by many as an important indicator of an improving global economy. How this translates The Baltic Dry Index is currently riding an eleven day winning streak during which the index has gained 43%. Year to date, the index is now up 228%. Given that it is a measure of shipping rates, the increase in the Baltic Dry Index is regarded by many as an important indicator of an improving global economy. How this translates to the stock market, however, is unclear.

Illustrating the point here is an overlay of the S&P 500 and of the BDI:

And any correlation that may have existed imperfectly in the past has been totally turned around:

Over the long term (since 1985), the Baltic Dry Index and the S&P 500 have had a positive correlation of 0.5 (1 = perfect correlation, -1 = perfect inverse correlation). Like everything else recently, though, that relationship has been turned completely upside down. As shown in the chart below, the S&P 500 and the Baltic Dry Index have been moving in opposite directions for most of 2009. As one has risen, the other has declined, and when one falls, the other seems to rise. Looking at the correlation between the two shows that year to date, they have had a negative correlation of -0.4, which implies a significant inverse relationship between the two.

Because the BDI reflects the demand for shpping in cases like the Chinese example, it could go up when the Chinese are stockpiling and fall as a rock thereafter. In addition, in general, an excess supply of ships could very well drop the index as well, as illustrated by Vincent Fernando, a former analyst of shipping at Citigroup.

But essentially one problem with using the BDI for economic forecasting is that the BDI could feasibly go up in an environment where commodities demand was shrinking, if the supply of ships was shrinking even faster. These would be negative economic factors. This is because the BDI’s value is not solely driven from the demand side. To me, it makes far more sense to just look at nominal demand for commodities rather than the BDI since the BDI has the complicating factor of vessel supply growth one needs to consider. The other thing is that the BDI is a measure of spot rates for dry bulk commodities consumers who, generally, are in the near term forced to pay whatever it takes to get their raw materials shipped (A steel plant needs to keep operating despite some higher ore transportation cost). On the flipside, vessel owners are in a similar boat (no pun intended), and in the near term are generally forced to take whatever rate they can get to fill their ships. (A ship sitting around is just a cost, ie. fixed costs are high, thus using a ship at a loss is usually better than not using it at all)

This is excellently illustrated in the example Fernando shows to illustrate his point:

Because of these inelastic characteristics of supply and demand, and since the BDI is a measure of spot rates, the BDI is thus absurdly volatile. I can explain why via the following simplified example, which I used to use frequently at Citi.

Imagine you have 10 loads of iron ore and 9 ships, and that every load of iron ore must be sent no matter what while every ship must be filled no matter what. Imagine the bidding war between those 10 iron ore consumers fighting over just 9 ships. Shipping cost would skyrocket since they all need to ship regardless of cost. Now imagine if a week later two more ships enter the market. Now imagine the bidding process. Suddenly the tables have completely changed. You have 11 ships, that all need to be filled no matter what, and only 10 loads of ore. Shipping rates would plunge, despite a period of just a week passing by. This is, in a simplified nutshell why the BDI is so volatile.

Now, add to this the fact that predicting ship supply and commodities demand has a pretty high margin of error, at the same time remembering how sensitive the BDI is to small mismatches due to the inelastic nature of its underlying supply and demand, and you quickly realize that predicting the BDI is a fool’s game and also that it is not a reliable forward indicator given that it is a spot rate index in a market where both sides are basically forced to close a deal due to high fixed costs. The BDI is measure of supply/demand mismatch at the moment, and can change drastically on a dime. Its little else beyond this. It hit its peak not when the global economy was in its healthiest state, but in early 2008 when things were already starting to come apart, but Chinese commodities demand growth still had some steam and just kept outstripping stagnant vessel supply growth. For a moment. And then it all collapsed. And BDI correlators got annhilated in popular stocks such as DryShips (DRYS). Thus, let’s hope that we put to rest any talk of the BDI as a reliable leading indicator, even if in six months someone datamines some new, latest correlation.

Now, for the final demonstration of the argument. It just happens that Mr. Fernando’s point was illustrated by what happened in August. In fact, with the drop in demand from the Chinese for commodities, the dry bulk ships were in oversupply considering the low level of industrial production around.

Hence, what is driving down the BDI is merely the laws of supply and demand on that specific point. Sure, the stats indicate a recovery of Industrial Production in several countries, but this has mostly been the case of an inventory reduction across the board. While producers remain cautious, they will not stockpile on commodities for now, unlike the Chinese.

Case in point:

The Baltic Dry Index, a measure of shipping costs for commodities, fell for an eighth consecutive session in London as the supply of ships exceeded demand.

The index tracking transport costs on international trade routes fell 83 points, or 3 percent, to 2,689 points, according to the Baltic Exchange. That’s 23 percent lower than before the declines began. Last week’s 17 percent slide was the steepest drop since the end of October.

“Charterers out there seem to be well covered for their requirements, and as such we do not expect any turnaround in the short-term,” Rikard Vabo and Lars Erich Nilsen, analysts at Oslo-based Fearnley Fonds ASA, said in a note. “Congestion is also coming down quite significantly.”

What conclusion to draw from this story? Well, for one, beware of people who think they can draw simplistic correlations. If such was the case, then the traders all around the world would all be successful and rich. Markets play on hopes and fears. They don’t obligatorily relate to the present-day economy and they don’t care about the feelings of the people being trudged upon in an economic recession.

For the future, the demand of commodities will be important to see how the global economy rebounds (if it rebounds). But it is better to use other tools than the BDI to check that demand. Again, Q4 will the quarter of reckoning if the market has not figured it out before.

An excellent, excellent and extremely funny post on panic buying by Joshua Brown, from the blog “The Reformed Broker” (hat tip to Carrz for finding it!). A quite useful (and funny) reminder as our further progression (if any) is now taking place in tense waters. Dedicated to all the bears who lost their money valiantly fighting the greatest rally in history (me included).

The Five Stages of Panic Buying!

1.  Denial (Late March/ Early April)

“Ha, another Bear Market rally…wait til the foreclosure/ new home sales/ confidence data comes in!  Right back to 6500, maybe lower…bagholders”

“Dude, the stress tests are coming out next month.  B of A may be done-ski.  Sell the May 10 calls, you’ll never have to cover.”

2.  Anger (Mid-April)

“What the f@&% do you mean the goddamn banks are cheap based on normalized earnings?  They will never ever earn anything again, ever!  Idiot!”

“You gotta be kidding me with these retailers running now.  RETAILERS?  Are you nuts?  They’re FINISHED!”

“If one more consumer discretionary name rallies on a less-than-expected loss, I’m gonna kick this Bloomberg down a flight of stairs.”

3.  Bargaining (May-June)

“Okay, I can stomach picking up some large cap tech and I’ll nibble – NIBBLE! – at discount retailers, but I will absolutely NOT buy Goldman Sachs at 130.”

If China would just pull back 5 to 7% I’d get in, but I can’t chase it here…except Sohu, and I guess a little Baidu and I’ll just take a quarter position in China Mobile just in case.  But I’m not chasing here.”

“(whispered) Dear market god, please stop the tape.  Just give me one crack at the Nazz and some banks and I will never doubt the solvency of the US balance sheet or the wisdom of the Troubled Asset Relief Program ever again.”

4.  Depression (July)

“I can’t believe I missed it.  Those D-bags next to me are high-fiving after every earnings report.  Hate those f@&%ing guys.”

“How could Las Vegas Sands do this to me?  I’ve been watching this stock go up for 900% now.  Couldn’t just give me one chance to get in.  I suck.”

5.  Acceptance (Early August)

“That’s it!  I don’t give a damn anymore, GET ME IN NOW!  Forget the big ones, they’re already up too much, are there any $5 stocks left that haven’t done anything yet?

“I gotta blow out this stupid GLD, it does nothing, sick of it and sick of hearing about inflation.  Even Paulson blew it out.  Get me some $2 biotechs and some midwest regional bank stocks, I gotta get poppin’ over here!  We’re going to 10,000 baby!”

If hearing these words and phrases from somewhere outside of your own inner monologue was at all cathartic or helpful, then you’re welcome.  I don’t care how smart you think you are, at some point this spring/ summer, we’ve all had to chase something.

To panic buy is to be human, just make sure you weren’t the last one in and keep your eyes on the exits.

(Reproduced with the kind authorization of Mr. Joshua Brown)

We have been in a mixed mood on the markets since the beginning of the week. Positive stats (German confidence, for instance) were mixed with less positive news about retail spending on Friday and a lower PPI yesterday.

Whereas the markets’ pullback was limited yesterday and saw some form of bounce at mid-level in the market… Asia seems to pull the markets back down today.

The main reason: doubts on the capacity of China to pull itself out of the recession by itself and doubts on the capacity of Asian governments to support their economies without increasing debt, and a serious issue with the large Chinese stimulus and the government’s need to curtail it.

Now, for Asia, it is true that it seems to be acting as a vanguard on the markets, by pulling back rather stiffly. But then, I had indicated a number of factors, both on the economic front and on the market front which may explain this pullback. In addition, the markets are anticipating a tightening of the monetary policy by China.

Namely, we have 31 Bn of new shares entering the Shanghai market. We also have several other events taking place which bode ill for the overvalued Shanghai stocks.

So recovery, there could well be. But is it sustainable without selling massive amounts of junk to the US or Europe?

The four largest Chinese banks reported that despite a massive surge in lending, they still booked a loss in H1.

China’s four largest listed banks are expected to see their first-half net profit reduced by narrower net interest margins and higher loan-loss provision requirements, despite having extended record loans over the period, analysts surveyed by Caijing said.Commercial banks loaned 7.4 trillion yuan in the first six months, and the scale of lending could moderate profit declines for some of these banks, analysts said.

An official at Central Huijin Investment Co. Ltd., the controlling shareholder of Industrial and Commercial Bank of China (SSE:601398, HKEX:1398), China Construction Bank Corp. (SSE:601939, HKEX:0939) and Bank of China (SSE:601988, HKEX:3988), told Caijing the investment firm was satisfied with the three lenders’ first-half net profits.

Bank of China booked first-quarter net profit of 18.57 billion yuan, down 14.41 percent year-on-year, while China Construction Bank’s net profit fell 18.2 percent to 26.3 billion yuan. Bank of Communications Co. Ltd. (SSE: 601328, HKEX: 3328) booked growth of just 0.8 percent in first-quarter net profit to 7.9 billion yuan.

Bucking the trend, ICBC recorded a 6.2 percent rise in net profit to 35.1 billion yuan, supported by one-time forex gains and bond disposals.

Commercial banks had a combined provision coverage ratio of 134.3 percent at the end of June, up 17.9 percentage points from the beginning of the year, according to the China Banking Regulatory Commission.

The regulator has ordered banks to meet a new minimum provision coverage ratio of 150 percent within the year.

The increased provision coverage ratio will put added pressure on lenders, which will have to allocate some of their net profit to these provisions, an insider from a large bank’s risk management department said.

Bank of Communications is scheduled to release its interim report on Aug. 19, ICBC on Aug. 20, China Construction Bank on Aug. 21 and Bank of China on Aug. 27. 1 yuan = 14 U.S. cents

The doubts on the continued recovery of China are accentuated wit the news that coal inventories have again increased in Chinese ports – which points to a resumption of production with no exit for the production.

» Inventories in China’s largest coal port in Qinhuangdao reached 5.45 million tons by August 17, up 599,000 tons from two days earlier.» The inventories have rebounded to late July levels.
» Industry analysts say the rising inventories are mainly due to the increasing rail transportation of coal and production resumption of many smaller mines.» Coal prices have remained stale despite the rising inventories.

In addition to the multiple signs of warning, we had announced a few weeks ago, on the grounds of a study by Andy Xie that the tightening of the Chinese monetary policy would begin by Q4. The pullback or fall in Shanghai’s market is probably anticipating this move. Remains to see if it will be sufficient to take out all the steam of the Chinese markets.

Another analyst, Fiona Lake, seems to confirm the hike in Q4:

We expect a 50bp hike in the reserve requirement ratio (RRR) in Q4 of this year and three 27bp hikes in the 1-year lending rate through 2010 Tightening to start in earnest in Q4 Signs are emerging that the Chinese authorities are starting the process of moving away from the incredibly easy monetary policy stance in place at present. In July, the People’s Bank of China (PBOC) initiated a moderate liquidity withdrawal and mild window guidance.

In our view, the Q3 GDP data is likely to provide enough evidence for the Chinese authorities to start that process, and shift into meaningful tightening in 2010 on the back of stronger growth and higher inflation. Specifically, we expect a 50bp hike in the RRR in Q4 and a further 150bp increase in the RRR through 2010 bringing the RRR back to its highs in mid 2008 (note that the RRR was not reduced aggressively through the easing cycle). Turning to interest rates, we expect the 1-year lending rate to rise from 5.31% at present to 6.12% by the end of next year, in three 27bp clips.