A Correction Fireside Chat with the "10th Man"

By Jared Dillian 

I don’t really enjoy these things like I used to. Keep in mind, I’ve traded through a lot of blowups, going back to 1997...1998...2001...2002-2003...2007-2009...2011...Today. They all kind of feel the same after a while.

Nobody wins from corrections except for the traders, which today mostly means computers. I forget who said this: “In bear markets, bulls lose money and bears lose money. Everyone loses money. The purpose of a bear market is to destroy capital.”....And that’s what is going on today.

For starters, long-term investors inevitably get sucked into the media MARKET TURMOIL spin cycle and puke their well-researched, treasured positions at the worst possible time. But I’m not trying to minimize the significance of a correction, because some corrections turn into bona fide bear markets. And if you are in a bear market, you should get out. If it is only a correction, you probably want to add to your holdings.

How can you tell the difference?

My Opinion: This Is a Correction

So what were the two big bear markets in the last 20 years? The dot com bust, and the global financial crisis. Two generational bear markets in a 10 year span. Hopefully something we’ll never see again. In one case, we had the biggest stock market bubble ever and in the other, the biggest housing/debt crisis ever.

Both good reasons for a bear market.

What are we selling off for again? Something wrong with China?

Again, not to minimize what is going on in China, because it is now the world’s second-largest economy. Forget the GDP statistics. After a decade of ridiculous overinvestment, it is possible that they’re on the cusp of a very serious recession, whether they admit it or not. But the good news is that the yuan is strong and can weaken a lot, and interest rates are high and can come down a lot. China has a lot of policy tools it can use (unlike the United States).

Let’s think about these “minor” corrections over the last 20 years.....
1997: Asian Financial Crisis
1998: Russia/Long-Term Capital Management (LTCM)
2001: 9/11
2011: Greece

All of these were VIX 40+ events.

In retrospect, these “crises” look kind of silly, even junior varsity. The Thai baht broke—big deal.

Russia’s debt default was only a problem because it was a surprise. And the amount of money LTCM was down—about $7 billion—is peanuts by today’s standards. After 9/11, stocks were down 20% in a week. The ultimate buying opportunity.

And in hindsight, we can see that the market greatly underestimated the ECB’s commitment to the euro.
So what are we going to say when we look back at this correction in 10-20 years? What will we name it? Will we call it the China crisis? I mean, if it’s a VIX 40 event, it needs a name.

I try to have what I call forward hindsight. Like, I pretend it’s the future and I’m looking back at the present as if it were the past. My guess is that we will think this was pretty stupid.

What to Buy

I saw a sell-side research note yesterday suggesting that this crisis is marking the capitulation bottom in emerging markets. I haven’t fully evaluated that statement, but I have a hunch that it is correct. China is cheap, by the way. But if China is too scary, they are just giving away India. I literally cannot buy enough. And I have a hunch that Brazil’s president, Dilma Rousseff, is going to be impeached and the situation in Brazil is going to improve relatively soon.

Think about it. The most contrarian trade on the board. Long the big, old, bloated, corrupt, ugly, bear market BRICs. Also the scariest trade. But the scary trades are often the good trades. There’s more. If you think we’re in the midst of a generational health care/biotech bull market, prices are a lot more attractive today than they were a few weeks ago. I also like gold here because central banks are no longer omnipotent.

That reminds me—there was something I wanted to say on China. The reason everyone hates China isn’t because of the economic situation. It’s because they made complete fools of themselves trying to prop up the stock market. So virtually overnight, we went from “China can do anything” to “China is full of incompetent idiots.” Zero confidence in the authorities.

You want to know when this crisis is going to end? When China manages to restore confidence. When they have that “whatever it takes” moment, like Draghi. If they keep easing monetary policy, sooner or later there will be an effect.

I Am Bored

I used to get all revved up about this stuff. That’s when I made my living timing tops and bottoms. I don’t do that anymore. I do fundamental work, and I go to the gym and play racquetball. The mark-to-market is a nuisance. Also, if you can’t get excited about a VIX 50 event, you have probably been trading for too long.
There is a silver lining. The disaster scenario, where the credit markets collapse due to lack of liquidity, isn’t happening. Everyone is hiding and too scared to trade.

Honestly, high-grade credit isn’t acting all that bad. And it shouldn’t. I don’t see any big changes in the default rate. Anyway, if you want to go be a hero and bid with both hands, be my guest. It’s best to be careful and average into stuff. These prices will look pretty good a couple of months from now, I think.


Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter @dailydirtnap

The article The 10th Man: A Correction Fireside Chat was originally published at mauldineconomics.com.

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World Money Analyst: Europe....Cliff Ahead?

By Dirk Steinhoff
When Kevin Brekke, managing editor [of World Money Analyst], contacted me last week, I knew it was time again to survey the investment landscape. This month, I will focus on Europe and its decoupled financial and real economy markets.

Globally, the last two years were marked by booming stock exchanges of developed markets, disappointing bond markets, and devastation across the precious metals markets.

Since June 2012, the EURO STOXX 50 Index, Europe’s leading blue chip index for the Eurozone, has advanced by approximately 50% and outperformed even the S&P 500 and the MSCI World indices.

Over the last six months, European stock exchanges have seen a surprising change of leadership: The major stock market indices of the “weaker” countries, like Portugal, Spain, and Italy, have outperformed those considered stronger, like Germany. One of the top performers was a country that was and still remains in “bankruptcy” mode: Greece.

The question at this point is: Can these outstanding European stock market performances continue?

In our search for an answer, let’s start with a closer look at the economic conditions within the European Union (EU), where approximately 2/3 of total “exports” (internal and external) of the EU-28 are traded. And then let’s have a look at the economic setting of some major trading partners, such as the US and BRIC countries, which account for roughly 17% and 21%, respectively, of the external exports of the EU-28.
Although the EURO STOXX 50 Index has soared since June 2012, certain key measures of the underlying real economies paint a different picture.

To start, the GDP of the EU-28 is not really growing. In 2012, it contracted by 0.4% and grew by the smallest fraction of 0.1% in 2013. The GDP growth numbers for the countries in the euro area are even worse: -0.7% in 2012 and -0.4% in 2013. Whereas Germany’s GDP was up in 2013 by 0.5%, economic growth was down in Spain, Italy, and Greece by -1.2%, -1.8%, and -3.6%, respectively.

Real GDP Growth Rates 2002-2012
	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011	2012
EU	1.3	1.5	2.6	2.2	3.4	3.2	0.4	-4.5	2.0	1.6	-0.4
Germany	0.0	-0.4	1.2	0.7	3.7	3.3	1.1	-5.1	4.0	3.3	0.7
Spain	2.7	3.1	3.3	3.6	4.1	3.5	0.9	-3.8	-0.2	0.1	-1.6
France	0.9	0.9	2.5	1.8	2.5	2.3	-0.1	-3.1	1.7	2.0	0.0
Italy	0.5	0.0	1.7	0.9	2.2	1.7	-1.2	-5.5	1.7	0.5	-2.5
Portugal	0.8	-0.9	1.6	0.8	1.4	2.4	0.0	-2.9	1.9	-1.3	-3.2

The EU unemployment rate stood at 10.2% at the beginning of 2012 and stands at 12.1% today. That the European Union is anything but a homogenous body that moves in unison can be seen in the following chart:

Where Germany has a current unemployment rate of 5.2% and a youth (under 25) unemployment rate of 7.5%, the numbers for other countries are worrisome: Current unemployment in Spain is 26.7%, and 12.7% in Italy, with youth unemployment in Spain at an incredible 57.7%, and 41.6% in Italy. And don’t forget Greece, which is mired in a historically unparalleled economic depression where unemployment is 28% and youth unemployment is a shocking 61.4%. Keep in mind that all of these numbers are those officially released by bureaucratic agencies. The real numbers, as we know, would likely be even worse.

Recent EU industrial production numbers have shown some slight improvement. Nevertheless, industrial production has only managed to recover to its 2004 level, and remains way below its 2007 heights (see next graph).

Source: Eurostat

So let’s see: a shrinking GDP, high and rising unemployment, and stagnant production significantly below 2007 levels. Those are not the rosy ingredients of a booming economy (as indicated by the stock exchanges) but of one that is struggling.

Europe is not in growth mode.

This verdict is further supported by the export numbers for trade between EU countries, known as internal trade. In 2001, internal trade accounted for 67.9% of EU exports. Today, this share is down to 62.7%. In an attempt to compensate for sluggish European growth, EU companies had to develop other export markets, such as the US or the emerging markets.

Will these markets help rescue European companies?

Time to Taper Expectations

With regards to the U.S., two important developments are worth mentioning. The first key development, which will have severe consequences for the global economy, was brought to my attention by my friend Felix Zulauf, an internationally well-known investor and regular member of the Barron’s Roundtable for more than 20 years. Running ever-increasing deficits in its trade and current accounts for almost 30 years, the US thus provided an enormous amount of stimulus for foreign exporters. Since 2006, however, the US trade deficit has shrunk, with deteriorating trade data for many nations as a consequence.

The second key development is that the newly appointed head of the US Federal Reserve system, Janet Yellen, seems determined to continue the taper of its bond buying program. This fundamental shift in monetary policy could be questioned if the economic numbers for the US begin to show significant weakness. But in the meantime, the reduction of economic stimulus in the US should lead to a reduced appetite for European export goods.

The emerging markets had been seen, not too long ago, as the investment opportunity and alternative to the fiscal and debt crisis-stricken countries of the developed world. Today, on a nearly daily basis, you hear bad news about the situation and developments in the emerging countries: swaying stock markets, plunging currencies, company bankruptcies, corruption scandals, and even riots.

The emerging markets are dealing with the unintended consequences of the Quantitative Easing (including liquidity easing and credit easing) programs in the West. The increased liquidity spilled over into the emerging markets in the hunt for yield. This flow of capital into the emerging markets lowered capital costs, inflated asset prices like stocks and real estate, and boosted commodity prices. All that, and more, sparked the emerging markets boom.

Now, this process has reversed. The natural conclusion to exaggerated credit-driven growth, the tapering of QE programs, the shrinking US trade deficit, and lower commodity prices has been an outflow of capital from emerging markets, triggering lower asset prices and exchange rates. The attempt of some countries to defend their currencies by raising interest rates will only exert further pressure on their economies.

With weaker emerging market economies and currencies, there will be no big added demand for European exports. Revenues and profits for EU companies (measured in euros) will fall.

When Trends Collide

So, over the last two years we had opposing trends—booming European stock markets and weak underlying real economies. This conflicting mix was mainly fostered by easy money that drove down interest rates to historic low levels. Plowing money into stocks, despite the poor fundamentals, was the only solution for most investors.

At their current elevated levels European stock markets appear vulnerable, and it seems reasonable to doubt that we will see a continuation of booming stock markets. Of course, such a decoupling can continue for some time, but the longer it continues, the closer we will get to a correction of this anomaly. Either the real economy catches up to meet runaway stock prices, or stock prices come down to meet the poor economic reality. Or some combination of the two.

Because of the economic facts that I discussed above, in my view, we may be seeing just the beginning of a stronger correction in stock prices.

Dirk Steinhoff is chief investment officer of portfolio management (international clients) at the BFI Capital Group. Prior to joining BFI in 2007, Mr Steinhoff acted as an independent asset manager for over 15 years. He successfully founded and built two companies in the realm of infrastructure and real estate management. Mr Steinhoff holds a bachelor’s and master’s degree in civil engineering and business administration, magna cum laude, from the University of Technology in Berlin, Germany. 

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The article World Money Analyst: Europe: Cliff Ahead? was originally published at Mauldin Economics

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With Quadruple Witching Behind us, How do we Trade on Monday?

The end of trading last week was interesting for traders. Fridays quadruple witching, [when contracts for stock index futures, stock index options, stock options and single stock futures all expire] is known to create some "dynamic moves" in the market. Most asset classes moved higher in Fridays session, including bonds, commodities, stocks and the U.S. Dollar. This is usually a bullish signal. This usually equates to a U.S. Dollar strength/weak assets trade. When this happened earlier in the fall of 2010 it was a prelude to a rally in most commodity names.

So is all of this just another sign that this economic recovery is more sustainable? This is new territory for this new world economy. Can we have a healthy U.S. economy when it relies on the Chinese economy that has been under performing for months as they try to reel in inflation? Any real growth in China and all of the BRIC nations is only going to bring the U.S. higher gas prices. And the chance of real recovery in the U.S. is ZERO in the face of $4.00 per gallon gasoline.

That's why so many fund managers are moving to a trade only plan and not investing for the long term. Take advantage of these bull runs and take your profits using todays trading numbers.....

Crude oil was higher overnight while extending this month's trading range. Stochastics and the RSI are bearish signaling that sideways to lower prices are possible near term. Closes below the 20 day moving average crossing at 86.82 are needed to confirm that a short term top has been posted. If January renews the rally off November's low, May's high crossing at 93.29 is the next upside target. First resistance is the reaction high crossing at 90.76. Second resistance is May's high crossing at 93.29. First support is last Wednesday's low crossing at 86.83. Second support is the 20 day moving average crossing at 86.82. Crude oil pivot point for Monday morning is 88.50.

Natural gas was lower overnight as it extends this month's decline. Stochastics and the RSI are oversold but remain bearish signaling that sideways to lower prices are possible near term. If January extends this month's decline, November's low crossing at 3.853 is the next downside target. Closes above the 20 day moving average crossing at 4.318 would confirm that a short term low has been posted. First resistance is the 20 day moving average crossing at 4.318. Second resistance is this month's high crossing at 4.637. First support is last Friday's low crossing at 3.951. Second support is November's low crossing at 3.853. Natural gas pivot point for Monday morning is 4.042.

Gold was higher due to short covering overnight as it consolidates some of last week's decline but remains below the 10 day moving average crossing at 1389.20. Stochastics and the RSI remain bearish signaling that sideways to lower prices are possible near term. If March extends this month's decline, the reaction low crossing at 1352.00 is the next downside target. Closes above the 10 day moving average crossing at 1389.20 would confirm that a short term top has been posted. First resistance is the 10 day moving average crossing at 1389.20. Second resistance is the reaction high crossing at 1432.50. First support is last Thursday's low crossing at 1361.60. Second support is the reaction low crossing at 1352.00. Gold pivot point for Monday morning is 1374.80.

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