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business newsReports of Worldwide Economic Growth Are Exaggerated
By
Ram Seshadri
Nov 01, 2011 11:20 am
QE3 and the EFSF are a pretty dream, but they aren't going to save the market in the absence of any foreseeable economic growth here or in Europe.
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The reason for this is simple: Hedge funds chase something known as "Alpha," which is the excess return that you earn over and above the return associated with the market (known as "Beta"). This excess return or "Alpha" can come in two ways: One is the "Macro" way, which is trying to find times in which the market will decline so you can short ahead of the decline. The other is the "Micro" way, when you short an individual stock ahead of a decline. The former requires doing "macroeconomic" analysis to divine where the overall market is going, and the latter requires performing "microeconomic" analysis where you to try to find when an individual company is going to stumble. Both require considerable leg work and skill, but when you get it right, you are rewarded handsomely, as I outlined in my own experience in 2008 when I was net short in Tech and made money while legions of investors and traders lost money (see 2008 Vs. 2011: Tech Analysts Miss the Macro Picture Twice).
There is, however, a downside as well, as I found out in 2010 when I was net short in August and the Federal Reserve announced QE2. The market then took off like a scalded dog and I had to run for cover (see Why India, China, and the US Will Have the Devil to Pay in 2012). Fortunately, I took control of my senses (and my portfolio) to halt the decline and end the year in the black. The reason for this long introduction is to set you up for my current predicament.
I wrote in my last article, titled Tech Sector: Leading Indicators Say Sell, Laggards Say Buy, that all the leading indicators that I watch and respect "were warning me of an imminent recession," while all the laggards were telling me that things were fine. I timed the article perfectly, as my warning was noted by Mr. Market as the sign of the "last bear" growling and took off like a Saturn V rocket. Though I was prepared for a short two-day rally due to the oversold conditions, what I got was more of a face-ripping 16% rally (SPX $1,100 to $1,280). The USD short that I outlined as a trade declined from $30 to $27 after my article was posted, and then jumped to $40, a nearly 48% up-move from its intraday bottom. That is a huge move, no matter how you slice it.
But let me give you an idea of what has happened since then, and hopefully that will give you an idea of what hedge fund traders do in situations like this.
What has happened since my last article is that:
1. The Fed has gone from being silent on the subject of QE3 to going full-throated about mortgage bond purchases and QE3. This has given traders a chance to dream about what happened last year (when the Fed announced QE2) as the template for this year.
2. The European situation has had more headlines about the European Financial Stability Facility, which is a fund (actually, a special purpose vehicle) created to soak up the debt of highly indebted eurozone countries. This highly leveraged entity is supposed to solve all the problems that beset Europe.
2. The European situation has had more headlines about the European Financial Stability Facility, which is a fund (actually, a special purpose vehicle) created to soak up the debt of highly indebted eurozone countries. This highly leveraged entity is supposed to solve all the problems that beset Europe.
Let me discuss the above two headline-grabbing events in more detail below:
1. QE3: The prospect of the Fed buying mortgage-backed securities was floated as another QE3 by self-serving commentators on Wall Street. That is absurd. The Fed is not creating money this time as QE2 did. This time, the Fed is just moving the type of money that will be on its balance sheet around. Hence this is strictly unlikely to be a liquidity-boosting event. The more likely prospect for the market to rally was that once the chattering classes started saying that this was QE3, traders who don't have the megaphones that talking heads have quietly decided to unwind their short bets and move to the sidelines. Today was the first day that we saw a big decline, which tells me that shorts are being put on, though not massively since volume was rather anemic.
2. EFSF: The EFSF is a big, complex program. To benefit from it, traders have to actually buy Greek, Italian, Portugal, Irish, and other dodgy countries' debt and have to actually suffer a haircut before lining up in front of the EFSF for reimbursement (up to 20% of loss). Does this sound like an exciting program that traders will want to do? It sounds more like an invitation to dump these bonds to produce a loss to someone of beyond 20% to see how the EFSF will actually respond to such off-limits (or extreme) scenarios. Don't think it won't happen? We already saw that some Italian banks have retraced almost their entire run-up after the EFSF headlines.
Putting the two together, my thoughts are as follows:2. EFSF: The EFSF is a big, complex program. To benefit from it, traders have to actually buy Greek, Italian, Portugal, Irish, and other dodgy countries' debt and have to actually suffer a haircut before lining up in front of the EFSF for reimbursement (up to 20% of loss). Does this sound like an exciting program that traders will want to do? It sounds more like an invitation to dump these bonds to produce a loss to someone of beyond 20% to see how the EFSF will actually respond to such off-limits (or extreme) scenarios. Don't think it won't happen? We already saw that some Italian banks have retraced almost their entire run-up after the EFSF headlines.
1. Despite the hoopla over the Q3 GDP print, we have no improvement or uptick in ECRI's Weekly Leading Index, which is the single most important index that I follow regarding the onset of a recession. In fact, ECRI has now posted a video of their 2008 call on their website that articulates how Wall Street sometimes gets drunk (on euphoria) while the economy actually tanks. Until this index zooms upward, I am not going to waver or worry one bit about my market decline call. We can always postpone a decline, but we can't postpone a recession whose seeds have already been planted. Sorry.
2. After listening to a number of earnings calls over the last month, I am absolutely convinced that all the leading indicators such as Semis have warned while all the lagging sectors such as Software and IT Services have crowed about how great everything is. Yeah right! Do you want to know who the leaders are? It's the Hardware and Semi people. They are the ones making all the tech toys that Corporate IT and Consumer geeks love. Everyone from Apple (AAPL) to Amazon (AMZN) to Texas Instruments (TXN) has told us that business is soft. But if you listened to the Rightnows (RNOW) and Fortinets (FTNT), business can't be better. But wait one quarter and you will hear a torrent of bad news from the Software folks, and about one more quarter later, all the IT Services guys will cry uncle. That's how it always is and always will be. You cannot change corporate or consumer spending behavior. Once they go into a deep shock, they usually don't come back quickly.
3. The Industrials are the other canary in the coal mine. While everyone was celebrating Caterpillar's (CAT) results, I was glancing nervously at 3M (MMM) and GE (GE). Where is the vaunted global recovery that everyone is crowing about? It was nowhere in their results.
4. Irrespective of the headlines from the US and Europe, here is what I see and hear: China is still slowing, India is still tightening, and Brazil is still a mess (that Lula gifted to Donna). These are the three big economies that matter. They are not accelerating. Europe is still a tale of two economies: Germany and the rest. The US is not growing and is at best at stall speed (2% growth or below is considered stall speed for the US economy). So where is growth going to come from? Remember, despite all the headlines from around the world about bailouts and easing, there is only one thing that stands between a country and its maker: Growth. Without growth, a country is dead. That's why politicians of all stripes and central bankers of all colors run around like headless chickens when their countries hit stall speed or worse: Without Growth, all their Ponzi schemes, all their money printing, all their tax cuts are worthless. Without growth, they are dead. They know it, and you should know it too. I don't see big, capital letter growth around the horizon anywhere. All I see are headlines about slowing and decelerating. That is a big red flag. Once you see headlines about growth, you can start diving deep into markets. Until then, I wouldn't recommend it.
I hope I have given you a decent summary of what I am thinking. I still believe that the shorts that I recommended will work, and with one month under the belt, I can definitely say I am bruised but not broken.2. After listening to a number of earnings calls over the last month, I am absolutely convinced that all the leading indicators such as Semis have warned while all the lagging sectors such as Software and IT Services have crowed about how great everything is. Yeah right! Do you want to know who the leaders are? It's the Hardware and Semi people. They are the ones making all the tech toys that Corporate IT and Consumer geeks love. Everyone from Apple (AAPL) to Amazon (AMZN) to Texas Instruments (TXN) has told us that business is soft. But if you listened to the Rightnows (RNOW) and Fortinets (FTNT), business can't be better. But wait one quarter and you will hear a torrent of bad news from the Software folks, and about one more quarter later, all the IT Services guys will cry uncle. That's how it always is and always will be. You cannot change corporate or consumer spending behavior. Once they go into a deep shock, they usually don't come back quickly.
3. The Industrials are the other canary in the coal mine. While everyone was celebrating Caterpillar's (CAT) results, I was glancing nervously at 3M (MMM) and GE (GE). Where is the vaunted global recovery that everyone is crowing about? It was nowhere in their results.
4. Irrespective of the headlines from the US and Europe, here is what I see and hear: China is still slowing, India is still tightening, and Brazil is still a mess (that Lula gifted to Donna). These are the three big economies that matter. They are not accelerating. Europe is still a tale of two economies: Germany and the rest. The US is not growing and is at best at stall speed (2% growth or below is considered stall speed for the US economy). So where is growth going to come from? Remember, despite all the headlines from around the world about bailouts and easing, there is only one thing that stands between a country and its maker: Growth. Without growth, a country is dead. That's why politicians of all stripes and central bankers of all colors run around like headless chickens when their countries hit stall speed or worse: Without Growth, all their Ponzi schemes, all their money printing, all their tax cuts are worthless. Without growth, they are dead. They know it, and you should know it too. I don't see big, capital letter growth around the horizon anywhere. All I see are headlines about slowing and decelerating. That is a big red flag. Once you see headlines about growth, you can start diving deep into markets. Until then, I wouldn't recommend it.
No positions in stocks mentioned.
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