May, May, Please Go Away

Winter: Cold Then Hot
The story begins January 20th when morning headlines read ‘Greece to Crack Down on Tax Evasion’. From that day forward, the market (the S&P 500) would fall 9.2% through February 9th. By that date, chatter of the PIGS (Portugal Ireland Greece and Spain) was gaining momentum. But the mood changed and positive news of an economy on the mend took the market 16.7% in other direction until April 26th peak. Quietly, the Euro had shed 7% since mid January.

Spring: Cold
On April 27th, the headlines read Greek Debt Rating Cut to ‘Junk’ Status. Two days later I wrote an email to a client for whom I had promised a trading proposal: “I have been a little hesitant to make any suggestions. The market had essentially made no moves greater than 1% in the last 2.5 months, and it has moved over 2% in both directions in the last 4 trading days. I have been trying to get a feeling for how it might break.”

Now we know. The euro would fall another 8% over the next 4 weeks and the U.S. stock market would fall 14.6% peak-to-trough through early Tuesday morning May 25th. A headline that morning from a budget conscious NYT travel writer was ‘Greece - Why Now’. The last time we had such volatility was late February / early March 2009, the final capitulation phase of the 2008/2009 bear market.

Greenback: Warming
I have heard from TV pundits that Obamanomics is creating mountains of public debt, its regulatory zeal is spooking corporations, and his tax policies are forcing business owners to tighten their wallets undermining job creation. The combination of all this is a hostile investment environment for the greenback and at any time China might pull the plug. Despite the hostile environment, big budget deficits and the $13 trillion mountain of debt, the dollar is on the rise and the real bottom started in March of 2008, long before Lehman and Obamanomics.

Money Flow: Climate Change
On the surface, it would appear the dollar is doomed. But understanding the nature of money in our global system may help investors understand why the dollar has been on the rise for nearly two years despite dim prospects for the Land of Liberty. Expensive Euros will buy lots of cheap greenbacks, or U.S. dollar denominated assets. Just as air will move from areas of high to low pressure, money will flow from expensive assets to cheap assets until they are no longer cheap. Until 4 months ago, €1 would buy a $1.50. 10 years ago the Euro would only buy 85 cents USD. Those are likely two extreme levels. The right level is probably somewhere in between. But many investors have been positioned for a weak dollar / strong euro environment which has been the proper posture for the last decade.

Weather Front
The weak dollar / strong euro era has probably come to a close with the accelerated drop in the Euro in recent weeks. Many private investors, hedge funds, governments, corporations, pensions and endowments are realizing they are on the wrong side of that trade. When air moves from areas of high to low pressure it is preceded by bursts of warm or cold air followed by weather. Atmospheric change is a seemingly chaotic event that can result in wind, rain, sleet, hail or snow, all swirling about. But as pressure finds new equilibriums, the sky begins to mellow out and the disturbance eventually disappears. The end of weak dollar / strong euro has upset the global equilibrium and money is flowing from one place to another find a new equilibrium. This process increases uncertainty and volatility.

Nasty Squall
On April 22, a deep-water drilling rig off the coast of Louisiana exploded and sank to the bottom of the Gulf of Mexico with 11 people aboard. By April 27th, news reports were suggesting it would be a serious oil spill. That same day, selling began in earnest when news hit the wires that Greek debt was now junk. The next 5 trading days were volatile with the market moving over 2% in each direction. On May 5th, 100,000 people took to the Greek streets in protest of government austerity measures. On May 7, the stock market fell roughly 9% in course of about 10 minutes (the so-called unexplainable Flash Crash) leaving most market participants with a knots in their stomachs. Though the stock market recovered 6% of those losses by the close that day, shockwaves hit debt markets and ancillary markets like preferred stocks.

Over the next few days the market rallied and made a full Flash Crash recovery, but violence in Bangkok reached new crescendos that lasted for the next week. Sellers returned, driving stocks down for the next 9 sessions. On top of all this, the House and Senate spent these days debating financial reform legislation. This issue, like the health care debate, is fraught with divisive prescriptions and remedies. Now in reconciliation, the uncertainty of the outcome and the potential unintended consequences of a major piece of legislation have all parties on pins and needles.

The bottom came on May 25th as investors awoke to headlines that Kim Jong-il, Supreme Leader of North Korea, was mobilizing his army for war with South Korea. The market fell 3% at the open, but buyers came in accumulating stocks all day with the session ending at nearly the highest print. Nothing like the potential for a nuclear war to bring buyers into U.S. stocks. On May 29th, after a few good days, Fitch downgraded Spain from AAA to AA+ in the middle of Friday’s trading session before the Memorial Day weekend. All this begs the question – ‘Was this just the squall before the hurricane?’

Weather Cycle
One way to think about financial markets is think about the annual weather cycle. If we are truly at the beginning of a new economic expansion, early cycle, then we are probably in spring. With spring come some nice days, but also a lot of cold, rainy days. As spring progresses, the weather improves. From time to time, you may have a thunderstorm, or a tornado, if you live in such a place. When summer comes, the weather is generally nice. This period is called mid-cycle for economic expansion. You are past peak tornado season and before hurricane season. It is the longest phase of the economic cycle and the stock market cycle.

The fall could be considered late cycle, the point in the economic cycle where inflation pressures are building up and the prices of things are reaching extremes. During this time, bank coffers are full and lenders want to find places for their depositors’ money. Early contraction begins in the late fall and is marked by mostly cold October and November days. The rain and sleet return, maybe even an early blizzard. When there are no more warm days, this is the end of expansion. Full contraction is winter. Day upon day of gray skies, cold and snow turned to ice that won’t melt. The economic cycle is generally 4 years, but it has gotten longer since WWII. The 1980’s and 1990s had very long expansions that made some observers think we had licked the business cycle. But this last recession has brought people back down to Earth.

Spring
When I look at the market action of recent weeks, I have to raise my level of apprehension as the Euro area debt problem, or even the U.S. debt problem may derail this economic cycle. I have to ask myself – “Have we entered a major cooling period like the ice ages where great expanses of the economy become frozen and the last 3 quarters of economic growth will be snuffed out by a this super cycle looming just over the horizon. Or are the events of May just a squall and summer is just around the corner.’

My gut tells me that the economy will be better off 6 or 12 months down the road. While European bond vigilantes give me worry, I think the EMU is on the right track to stave of global cooling. With $1 trillion just off the presses to buy debt of the PIGS, snowplows are on the streets clearing this late spring blizzard. Deflation is a symptom of excessive debt and inflation is exactly what central bankers are using to fight it. I am generally not one to fight the Fed.

Just Another Storm?
It has been my observation that these kinds of storms eventually pass. In 1994, in order to bring soaring budget deficits and debt under control, President Clinton abandoned his campaign promise of tax cuts. This was the result of advice from his Treasury Secretary, Robert Rubin, former co-Chairman of Goldman Sachs. U.S. government debt was under significant selling pressure as so-called bond vigilantes shunned treasuries. James Carville, Clinton’s top political adviser, said,

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

In 1995, Newt Gingrich would lead a Republican charge that shutdown the Federal government for several weeks. Through bi-partisan efforts and austerity, the deficit would fall and surpluses would come from 1997 – 2001. (Source: www.whitehouse.gov/omb)

Severe Weather Watch
Deflation is still the problem and inflation will have to wait its turn. Inflation is a symptom of excessive money supply and is a late cycle phenomena. We have a few more seasons that must pass before we get there. But do not get me wrong. If I sense that a much nastier storm is coming, we may have to batten down the hatches.

It rained again all day. The high was 52 degrees. It will be June in four days and the summer solstice is June 21.

Jason McMillen, Chief Investment Strategist, PPWM

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