Where is the Stock Market Headed Now?
Last week we saw the stock market drop, as we have since the beginning of the year. But this time it really dropped. In fact, Friday saw the Dow drop 317 points, or 1.97%, with the S&P following with a 38 point, or 2.10%, fall. But it wasn't so much the points or the percentage that may have signaled trouble ahead; it was the fact that the Dow broke below 16,000 and the S&P below 1800 - both decisively. Without getting too technical here, know that anytime an index breaks above or below such major milestones decisively, especially in a dramatic fashion like this one-day drop, you take notice. In our case today, we've also seen this happen after a persistent down-trend since the beginning of the year.
The question arises: Why? Earnings were touted as encouraging so far this year. Indeed, the fundamentals of some companies do appear strong and getting stronger. But regarding earnings, it seems that for many companies stronger earnings hinge on cost-cutting measures rather than strong growth in sales and revenue. As for those companies with strong fundamentals, those remain good stories, except for the fact that investors need know that such companies may be dragged down with the general market, if that's the direction in which it is headed.
We note also that treasury yields have now reversed their upward trends, with the yield on the 10-year note and the 30-year bond breaking decisively below their 50-day moving averages on the daily charts. Looking at the price, which of course moves in the opposite direction of the yield, of these two bellwether bonds, we see something interesting: the 10-year has just risen to its 50-day moving average, while the 30-year has decisively broken above its 50-day MA. This makes sense in that the 30-year's price is much more volatile than the 10-year. We'll have to see if the 10-year follows suit in coming days.
As for why stocks are falling, one school - the school of "stocks-are-always-a-good-place-to-put-your-money" - says simply that with the market rising so much last year, we're simply witnessing a natural and healthy correction that was inevitable. Such an interpretation makes perfect sense. If that's the case, we should line up our buys and pick our spot during this "dip" to add to our positions - which is, by the way, the venerable concept of "buy the dips."
But we still have to take note of how this turn has been unfolding - what we pointed out above - and ask ourselves if something besides natural correction stands behind this particular drop. And here the bonds may provide a clue.
Given the prevailing wisdom that one would be insane to hold bonds of any signification duration, we must ask whether this change in the direction of yields is a correction of the uptrend, or something that is rather a signal of something of significance going on in the world. So the first thing we might look for is whether a credit crunch - the cause of our last serious crisis in 2008 - is brewing. And here we find that China, which has been experiencing ongoing problems with its credit markets, now has sent contraction signals to world markets. And remember that such signs of contraction come despite the supposedly all-powerful Chinese central government declaring that they will deal with any problems with a strong hand - as they always do. While we may reasonable question numbers coming from Chinese official sources, we do note a surprise announcement by IBM that its business in China has contracted a rather dramatic 40%. Therefore this downturn in the face of the tremendous leverage, i.e, high level of debt, built into the Chinese economy - the result of cheap lending to Chinese businesses over many years - could be the beginning of a real credit crunch that may not last the mere days or weeks we witnessed last year.
The significance here is two-fold. First, China dominates Asian emerging markets, so when it sneezes, all Asian markets catch the flu. And indeed we are seeing a fall in emerging market stock markets that may very well accelerate, with accelerating currency crises to come - something we've seen in the past and should be familiar with by now.
Second, with China now the second-largest economy in the world, and a huge exporter and importer of goods to and from countries around the world, any slowdown in China's imports will have varying impact on other countries, depending on the amount of trade done with China. For example, Australia has been a big exporter of natural resources to China in recent years.
But without parsing through who directly stands to take the biggest hit from a Chinese slowdown, the real concern here is our old friend - or perhaps we should more accurately say enemy - contagion. The Chinese economy is big enough with connections to enough of the rest of the world now to trigger reactions of significance, which if they flow from one economy to the next, could produce quite a negative chain reaction. Whether this occurs, we'll have to wait and see. But at this point, it's certainly something that takes front and center on the radar screen.
Summing up:
While the stock markets decline could be interpreted as a long-awaited correction, and a healthy one at that, it's the action in treasuries that deserves our special attention, if such action is signalling a coming credit crunch beginning with China. Remember that when a credit crunch comes, money rushes into US treasuries. If the new uptrend in treasury prices (and consequent decline in yields) is the result of the first rush to the exits on the part of sophisticated investors, that action could indeed be telling us to watch for a coming credit crunch. And depending on its severity, yet another crisis on a worldwide scale.
Alarmist? I think not. A perfectly reasonable view would be that it never hurts to be prepared for the worst, most especially when evidence for a worst outcome becomes clearer in time.
Makes sense?
The question arises: Why? Earnings were touted as encouraging so far this year. Indeed, the fundamentals of some companies do appear strong and getting stronger. But regarding earnings, it seems that for many companies stronger earnings hinge on cost-cutting measures rather than strong growth in sales and revenue. As for those companies with strong fundamentals, those remain good stories, except for the fact that investors need know that such companies may be dragged down with the general market, if that's the direction in which it is headed.
We note also that treasury yields have now reversed their upward trends, with the yield on the 10-year note and the 30-year bond breaking decisively below their 50-day moving averages on the daily charts. Looking at the price, which of course moves in the opposite direction of the yield, of these two bellwether bonds, we see something interesting: the 10-year has just risen to its 50-day moving average, while the 30-year has decisively broken above its 50-day MA. This makes sense in that the 30-year's price is much more volatile than the 10-year. We'll have to see if the 10-year follows suit in coming days.
As for why stocks are falling, one school - the school of "stocks-are-always-a-good-place-to-put-your-money" - says simply that with the market rising so much last year, we're simply witnessing a natural and healthy correction that was inevitable. Such an interpretation makes perfect sense. If that's the case, we should line up our buys and pick our spot during this "dip" to add to our positions - which is, by the way, the venerable concept of "buy the dips."
But we still have to take note of how this turn has been unfolding - what we pointed out above - and ask ourselves if something besides natural correction stands behind this particular drop. And here the bonds may provide a clue.
Given the prevailing wisdom that one would be insane to hold bonds of any signification duration, we must ask whether this change in the direction of yields is a correction of the uptrend, or something that is rather a signal of something of significance going on in the world. So the first thing we might look for is whether a credit crunch - the cause of our last serious crisis in 2008 - is brewing. And here we find that China, which has been experiencing ongoing problems with its credit markets, now has sent contraction signals to world markets. And remember that such signs of contraction come despite the supposedly all-powerful Chinese central government declaring that they will deal with any problems with a strong hand - as they always do. While we may reasonable question numbers coming from Chinese official sources, we do note a surprise announcement by IBM that its business in China has contracted a rather dramatic 40%. Therefore this downturn in the face of the tremendous leverage, i.e, high level of debt, built into the Chinese economy - the result of cheap lending to Chinese businesses over many years - could be the beginning of a real credit crunch that may not last the mere days or weeks we witnessed last year.
The significance here is two-fold. First, China dominates Asian emerging markets, so when it sneezes, all Asian markets catch the flu. And indeed we are seeing a fall in emerging market stock markets that may very well accelerate, with accelerating currency crises to come - something we've seen in the past and should be familiar with by now.
Second, with China now the second-largest economy in the world, and a huge exporter and importer of goods to and from countries around the world, any slowdown in China's imports will have varying impact on other countries, depending on the amount of trade done with China. For example, Australia has been a big exporter of natural resources to China in recent years.
But without parsing through who directly stands to take the biggest hit from a Chinese slowdown, the real concern here is our old friend - or perhaps we should more accurately say enemy - contagion. The Chinese economy is big enough with connections to enough of the rest of the world now to trigger reactions of significance, which if they flow from one economy to the next, could produce quite a negative chain reaction. Whether this occurs, we'll have to wait and see. But at this point, it's certainly something that takes front and center on the radar screen.
Summing up:
While the stock markets decline could be interpreted as a long-awaited correction, and a healthy one at that, it's the action in treasuries that deserves our special attention, if such action is signalling a coming credit crunch beginning with China. Remember that when a credit crunch comes, money rushes into US treasuries. If the new uptrend in treasury prices (and consequent decline in yields) is the result of the first rush to the exits on the part of sophisticated investors, that action could indeed be telling us to watch for a coming credit crunch. And depending on its severity, yet another crisis on a worldwide scale.
Alarmist? I think not. A perfectly reasonable view would be that it never hurts to be prepared for the worst, most especially when evidence for a worst outcome becomes clearer in time.
Makes sense?
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