Five Signs of Financial Reckoning Day
If you believe, as we do, that we’re in an historic secular bear market, these five indicators will help you measure the level of stress in the system…and determine when to head for the hills.
The direction of the stock market is difficult, if not impossible, to predict.
All you can really try to determine is how likely a given scenario is to come true. Right now, for instance, the financial economy, or "fictitious economy," is most likely running out of steam. The stimuli of low interest rates and tax cuts have almost certainly lost their potency, without leading to major new job creation.
But what, specifically, do I look at to draw these conclusions? There are five major indicators I use. In deference to Bill and Addison’s book, I jokingly call them the "Five Signs of Financial Reckoning Day." But I’m only half joking.
What these indicators DO represent is how close we are to a sudden massive shift away from "financial assets" and into hard assets, or out of the dollar and into gold. In other words, they tell me how likely it is that Financial Reckoning Day is close at hand.
Put/Call Ratio: The Volatility Index
First, I look at the Volatility Index (VIX). The VIX is a gauge of investor sentiment, mostly fear. The lower it is, the more complacent investors are. And right now, it’s about as low as it’s ever been. It did creep up a little earlier this month…but last Friday, it opened at 17.7 and closed at 16. Fear in retreat. Greed on the march. Stocks on the rise.
Next, I look at investor appetite for speculation. If investors are feeling lucky and bullish, it tends to show up in the put/call ratio. Bullish investors buy calls. Bearish ones buy puts.
Put/Call Ratio: The Put/Call Ratio
Of course, a bullish investor may buy puts to hedge his bets. But generally, the put/call ratio is a good measure of speculative sentiment. Last Friday, the put/call ratio fell to 0.63. If you look closely at the numbers, though, you’ll see that the put/call ratio for indexes was 1.72, while the put/call ratio for individual equities was 0.46.
I prefer to look at the put/call ratio for individual equities to get a read on what speculators are feeling. The indexes are traded by institutions and firms looking to hedge big bets. And while companies may speculate in their own individual options, the equity put/call ratio tells you more about how strongly bullish or bearish individual investors are.
I also prefer this to general surveys about bullish or bearishness…because it’s what people are doing with their money, not what they’re saying. It’s one thing to say you’re bullish. Quite another to put your money on the line behind it.
The first two indicators I look at tell you about investor sentiment and the strength of that sentiment. The next three tell you more about the overall direction of market and the perception of systemic risk.
To get a grip on these factors, you have to look for clues as to whether money is moving out of one asset class or sector and into another. In today’s market, what you’re looking for is an indicator that tells you how close the financial system is to a major shift away from financial speculation and toward hard assets.
If you don’t believe that we’re in an historic secular bear market, these indicators won’t mean much to you. If you do, however, they’ll give you some idea of the level of stress in the system…and whether the levee is poised to break. Let me explain…
Put/Call Ratio: The OEX
First, you must look at the state of the ‘financial economy.’ When I say ‘financial economy,’ I mean the S&P 100, or OEX. The OEX is made up of the stocks driving this bear market rally. It’s the most powerful concentration of stocks that gain the most from low interest rates, and have the most to lose when interest rates rise.
The OEX has a market cap of $5.7 trillion. That’s 55% of the S&P 500’s market cap of $10.2 trillion. To put that in perspective, it means that less than 100 companies make up over 50% of the S&P 500’s total capitalization. If you’re looking for a concentration of stock market wealth, this is where you’ll find it.
What’s more, the two sectors that have most benefited from low interest rates (the lynchpin of the financial economy) make up nearly 40% of the OEX. There are 27 financial stocks and information technology stocks in the S&P 100. They have a combined market cap of $2.27 trillion.
Finally, the OEX is driven by financial and tech stocks. And the companies on the OEX represent the most actively traded stocks in America, in terms of dollar volume. Keep in mind that the OEX companies are listed on the three major exchanges, (NYSE, AMEX, and NASDAQ). This truly is a cluster of the most actively traded stocks in America – the ones critical to a new bull market, or an even worse bear market.
If you’re looking for a broad indicator of where the stock market is headed, you look to the OEX. It’s a pure proxy for the financial economy. And here’s what the OEX is telling us: the S&P 100 began what I believe is a new major downward leg in the bear market on January 26th. On that day, these stocks reached a peak…which they have yet to regain. The financial economy follows, by extension.
Nothing notable happened on the 26th that would single it out as the day the second big down leg of the bear market began. But stocks did achieve some technically significant advancements that day…from which they have retreated.
If the OEX tells us what the financial economy is doing, the Commitment of Traders (COT) report and the BEDspread tell us what’s going on behind the scenes.
Put/Call Ratio: The COT Report
First, I use the COT report to judge the "smart money’s" interest in gold. If large speculators and commercial gold companies are bullish on the future price of gold, it can mean one of two things (or both): first, that a general bull market in commodities is underway; or second, that gold bulls are acting as "financial bears" undefined that is, fleeing from financial assets to gold, the ultimate hard asset.
I believe both readings are accurate today. And the more bullish large speculators are on gold, the more dire the prospects for OEX and the financial economy.
The truth is, as long as the dollar keeps falling, the gold price will rise. I believe there’s a great deal of upward pressure building under gold right now…ready to pop. I’m keeping my eye on the COT report to gauge the intensity of this pressure.
Put/Call Ratio: BEDspread
Finally, there’s the BEDspread. The flip side of gold bullishness is dollar bearishness. And the ultimate measurement of dollar risk, in my view, is the spread between U.S. debt and emerging market debt, as measured by my proprietary BEDspread. [Faithful DR readers will remember the BEDspread from Dan’s essay last fall: "Convergence Under the Bed Spread " ]
In short, the BEDspread tells you how close the market is to bailing on the dollar and forcing interest rates up. It’s the difference between the yield on GVT and EMD, two indexes that represent U.S government debt and emerging market debt, respectively.
The BEDspread has been hovering around 4.5 for a month now. Emerging market debt yields went up on sell-offs in the last two weeks, driving the yield on GVT to 9.25%. Some would describe this as a flight to quality. I would not. With an annual deficit of $521 billion and cumulative Federal debt over $7 trillion, the U.S. government is hardly a "quality" borrower.
But for now, the market is content to punish the dollar for the government’s spending sins while sparing the bond market. For now. When the yields start converging, with GVT’s rising and EMD’s falling, we’ll know a seriously blow has been dealt to the psychological health of the bond market. The dollar pain will begin to have bond consequences.
These five ‘Signs of Financial Reckoning Day’ lead me to believe that the financial economy is on its last legs. There is only so far the combination of low interest rates, easy credit and tax cuts can propel it…sooner or later, as financial debt swells, these stimuli cease to be effective.
That the financial economy will soon run out of steam is not certain. But it is highly likely.
for The Daily Reckoning
February 10, 2004
Editor’s note: Dan Denning is the editor of the monthly advisory, Strategic Investment, as well as the brains behind its fast-moving Strategic Options Alert service. Dan is currently researching the calamitous effects of the U.S.’s "twin deficits" on the economy. If you’d like to learn how to prosper during the period in which these deficits correct, see Dan’s latest:
Strategic Options Alert
The trouble with trouble is that there is not enough of it.
At least, not yet.
When markets are at bottoms – such as they were in August of 1982 – investors are timid. As prices rise, they are emboldened, but only reluctantly. Each sector, each milestone, each day’s news is threatening. They are prepared to hunker down at the slightest hint of trouble. Gradually, as long as no really serious trouble develops, the market climbs the ‘wall of worry’ and the news becomes less threatening.
Eventually, the absence of trouble breeds a carefree attitude…a certainty that trouble is a thing of the past…that whatever happens, investors will continue to hunker up towards higher and higher prices – forever.
This was the state of mind of millions when the first phase of the present bear market struck in March of 2000. A touch of trouble had arrived. But not enough, apparently. Investors remained buoyant, positive…and more delusional than ever, for now they included the ‘survivor’s illusion’ among their many hallucinations. Having survived the bear market and recession of 2000-2002, they believe they have some special grace…
They are "emboldened by their own survival," says Seth Klarman in Barron’s. "If three years of losses did not extirpate investor greed, it seems likely only truly excruciating circumstances will do the job."
The work Klarman refers to is the job of changing investors’ moods…and asset prices. Once extremely expensive, one would expect to see them at least modestly cheap before they are extremely expensive again. And that requires trouble. A lot of it.
Somehow, investors must come to want to sell, something they have been – thus far – loath to do.
Au contraire, even at today’s prices, they still seem to want to buy.
"The Consensus stock index and the Market Vane index of investor sentiment," explains Steve Leuthold, also in Barron’s, "were recently around 81% bullish. I have never seen a reading that high. Usually, above 65% is getting extreme. I’m uncomfortable in crowds, and this bullish crowd is huge…just about everybody is bullish. I don’t remember a time at the start of a new year when we have had so much unanimity of opinion, and that is scary."
Stocks, bonds, real estate. There is hardly a single asset class that is still cheap. Yields are pathetic almost everywhere. Even junk bonds produce little more yield than treasuries. Risk? "What risk?" the lumps ask. Apparently, investors’ moods are bullish on everything.
"Short sellers are again aging in dog years," comments Klarman.
"History tells us a correction is overdue at this point," adds Leuthold.
And now…more news from Eric, our man in New York…
Eric Fry, on the trading floor in Manhattan…
– A "technical glitch" shuttered the American Stock Exchange for three hours yesterday. But equity trading on the AMEX resumed about midday. A different sort of glitch hobbled the Big Board: buyers failed to show up. The Dow Jones Industrial Average slipped 14 points to 10,579, while the Nasdaq Composite Index fell 3 points to 2061.
– The major stock averages drifted listlessly all day, as did bonds and the dollar. There was little reaction, if any to the G7 meeting in Boca Raton. The gold market featured a small bit of excitement, as the yellow metal jumped $3.20 to $407.40 an ounce. But that was all.
– Since the newswires contained conspicuously little news yesterday, let’s turn our attention to a few back-page stories. First up, as Northern Trust economist Paul Kasriel notes, "Banks are willing to lend and businesses are taking them up on it."
– Says Kasriel: "Last week, the Fed released the results of its January 2004 Senior Loan Officers Survey…Banks greatly eased their lending terms to large- and medium-sized firms. A net 18% of domestic banks eased their lending standards on commercial and industrial (C&I) loans in the three months ended January. This was the largest net easing in lending terms since the latter half of 1993. Interestingly enough, businesses seem to be taking their bankers up on their new-found willingness to lend. For the first time since early 2001, C&I loan growth at commercial banks on an annualized 13-week basis edged (barely) into positive territory in the second half of January."
– Of course, American corporations are not the only entities in this fair land of ours that have been stepping up their borrowing and spending. Heck, borrowing and spending is our national pastime, and no one plays the game better than Uncle Sam. One week ago, President Bush released his budget proposal, forecasting a $521 billion shortfall for the current fiscal year. Remarkably, the news scarcely caused a ripple in the bond market.
– The astonishing thing is that a half-a-trillion dollar deficit arouses nary a whisper of protest. Since the President released his budget, bond yields have actually fallen. In this age of financial heresy, the old rules of financial conservatism and austerity seem not to apply. Thus, expensive stocks may rise without limit; profligate governments may borrow without limit, and the currency in which expensive stocks rise and profligate governments borrow may fall without limit…And none of these financial marvels ever begets an adverse consequence. (It’s ALL good, man!)
– Earlier generations of investors would worry, occasionally, about financial excesses like overpriced stocks and over-indebted governments. But we do not worry, nor do we modify our behavior. That’s because we have learned that big P/E ratios and big budget deficits are just big numbers…big numbers of no particular – and certainly, no immediate – consequence.
– "Most people old enough to vote can remember the 1980’s, another time when the government spent more than it had," the NYTimes remarks. "Few people can think of any lasting harm those debts caused. So it may come as no surprise that only 2 percent of Americans named the deficit as the main issue they would like to hear candidates discuss in the 2004 presidential election."
– If budget deficits are of little or no concern to the lumpeninvestoriat, then the dollar’s waning purchasing power must be of no concern whatsoever. The lumps seem to care only about the purchasing power of their houses.
– Thus, the Bush Administration, while keeping a steady eye on the public opinion polls, pumps up the public spending no one cares about, while deflating the dollar no one cares about. As a result, the administration hopes to create the economic recovery that everyone cares about…and if a recovering economy happens to escort President Bush to a second term, well, that’s okay too.
– But maybe the Wall Street strategists and economists are right. Maybe our massive deficit-spending is no big deal. Maybe the old rules are, in fact, old rules that no longer apply. And maybe the Greenspan/Bush team should submit its innovative economic prototype to the U.S. Patent office as the first-ever fully operational "free lunch."
– Or maybe, as we suspect, big budget deficits are still bad and a plummeting currency is still not good. On paper, we Americans are all poorer than we were last year. We owe more dollars per capita than we did last year and the dollars we have are worth less than they were last year.
– Is this what prosperity looks like?
Bill Bonner, back in Madrid…
*** Manufacturing shrank again in January, bringing the number of consecutive months of decline to 42. But who cares? We have a ‘service economy’ now, right? While factory employment slumps, people get jobs in nursing homes, restaurants and brokerage houses. What’s wrong with that?
Nothing, really. Except that, somehow, Americans will have to pay for all the things they import from overseas.
Service industry jobs are protected from low wage competition because you cannot import someone to park your car or wash your laundry. But neither can you export car parking or laundry services overseas. There’s the rub. If you can’t export them…you can’t sell them to foreigners. And you can’t use them to pay for the things you import.
*** We got to the Charles de Gaulle airport at 7am. By 7:05 we were ready to board a plane. No one asked if we were carrying weapons. No one rifled through our luggage. No one threatened to tow our car away…or warned us against making unwelcome comments. There were no long lines. We didn’t have to take off our shoes. It was as if we lived in a civilized country.
*** Everything seems overvalued. Except coffee, which is near 100-year lows. Does anyone know where we could buy a coffee plantation?
*** "If you are not buying gold," says the great Mogambo, simplifying things, "you are an idiot."
*** Our friend Byron King, back from Guatemala, sends these thoughts…
"Permit me to comment on a news event and related article, as reported in the New York Times of 06 February 2004.
Last week, a Russian industrialist named Viktor Vekselberg arranged to purchase the entire Faberge collection that was accumulated over many decades by the late Malcolm Forbes.
"The Faberge collection was recently put on the auction block by members of the Forbes family. The collection includes nine Imperial Easter Eggs, created by the House of Faberge in the late 19th and early 20th centuries on commission from Russia’s Czars, and about 180 other Russian-related Faberge pieces. Mr. Vekselberg’s purchase price was in excess of $90 million in a transaction arranged through Sotheby’s and in lieu of public auction.
"Mr. Vekselberg intends to return the Faberge eggs and other items to Russia before 11 April, which is Easter this year according to both the Russian Orthodox and Western Christian holy calendars. The new owner plans to exhibit the historic pieces in the city of Yekaterinburg, where members of the Romanov dynasty were executed by the Bolsheviks in 1918.
"According to Mr. Vekselberg, as quoted in the NYTimes, ‘Right now in Russia, capital is being accumulated at a huge rate and there is a question of how to use private property.’ Mr. Vekselberg, apparently, has no ‘question’ in his mind as to how to use at least some of his accumulating fortune, the fruits of his efforts in the Russian aluminum and oil industries.
"’I consider it my duty to do this,’ he told the Times, referring to his purchase of the Faberge treasures and his intent to return them to Russia. Thus do the Czars’ Faberge eggs travel full circle.
"Sold off to foreign interests by the Communists and what few members of the Romanov dynasty who survived, these articles are now returning home, courtesy of a contemporary Russian tycoon.