China’s Cut in Reserve Requirements – Very Bullish for Stocks

Wednesday, February 22nd, 2012

The PBoC’s announcement of a 0.5% cut in the reserve requirement rate (RRR) of Chinese banks has significant consequences not only for the Chinese economy but also for China’s stock market. The cut to 20.5% for large banks follows a similar cut in December last year after hikes since January 2010 that saw the RRR increasing in 12 increments from 15.5% to 21.5%. It is estimated that one half percent change in the RRR amounts to a change of approximately 400 billion yuan or roughly US$60 billion in liquidity. It therefore means that the jump in the RRR since January 2010 has effectively drained overall liquidity by approximately US$720 billion. That is equal to approximately 6% of China’s GDP in 2010 and 2011 combined.

Although the PBoC cited weak external demand as the main reason for the drop in the RRR, liquidity became very tight in recent weeks and forced interbank rates significantly higher. The CFLP Manufacturing PMI that I seasonally adjust continues to indicate lackluster growth in China’s manufacturing sector largely as a result of weak export orders. As in 2008 the PBoC held off on further increases in the RRR in 2011 when weakness in the manufacturing PMI became apparent. The first cut in the RRR last year was announced when the manufacturing PMI contracted – again similar to what happened in 2008. The latest cut therefore indicates that the manufacturing PMI for February is likely to again show abysmal growth.

Sources: CFLP; Li & Fung; BIS; Plexus Asset Management

The weakness of China’s economy is not only confined to the manufacturing sector, though. While still signaling growth, my seasonally adjusted CFLP Non-manufacturing PMI indicates that growth has slowed to about half of the average since the recovery after the 2008/2009 crisis.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

The weakness in the non-manufacturing sector is driven by weak consumer confidence.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

My GDP-weighted seasonally adjusted CFLP PMI indicates that China’s year-on-year GDP growth has slowed to approximately 8 – 8.5% from 8.9% in the fourth quarter last year.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

The cut in the RRR is consistent with what happened in 2008 when GDP growth fell below 9%.

Sources: NBSC; BIS; Plexus Holdings.

Assuming that a 0.5% change in the RRR equaled US$60 billion throughout, I calculated the cumulative liquidity drain. It is evident that changes in liquidity lead GDP growth by approximately two quarters and the seasonally adjusted manufacturing PMI by three months.

Sources: NBSC; BIS; Plexus Holdings.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

I view the cut in the RRR as very bullish for Chinese stocks. Changes in the direction of the RRR had a major impact on the Shanghai Composite Index (SSEC 2403.59 �‘0.00%) in the recent past. In 2008 the first cut in the RRR coincided with the bottom in the Shanghai Composite Index, while the hike in January 2010 coincided with the start of the slide in equity prices.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

The market is currently not out of sync with the underlying economy and is discounting a not seasonally adjusted CFLP Manufacturing PMI of approximately 50 for February. March and April are normally exceptionally strong months from a seasonal perspective and are likely to be supportive of stock prices. Together with the likely impact of the increase in liquidity I think the next strong bull market in Chinese stocks is underway. I stick to my view that the Chinese stock market will be the best performing equity market globally in 2012.

Sources: CFLP; Li & Fung; Plexus Holdings.

Tags: China Economy, China Gdp, China S Economy, Chinese Banks, Chinese Economy, Consumer Confidence, Economy China, Export Orders, GDP, Half Percent, Increments, Interbank Rates, liquidity, Manufacturing Sector, Pboc, Percent Change, Plexus Asset Management, Rrr, Stock Market, Yuan
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Global Manufacturing PMI: Saved by the U.S.

Friday, December 2nd, 2011

The contraction in the global manufacturing sector continued in November. The global manufacturing PMI that I calculate on a GDP-weighted basis for the major economic regions was virtually unmoved at 49.6 from October’s 49.5. The relatively unchanged PMI masks significant changes in the individual countries and regions, though.

The global manufacturing sector was saved by a higher than expected showing in the U.S. as my calculations show the global PMI excluding the U.S. fell from 48.7 in October to 47.8 In November. The ISM Manufacturing PMI surged by 1.9 to 52.7 from 50.8 in October. Outside the U,S., South Africa, Russia, Turkey and India were the only other economies where manufacturing expanded. The contraction in Brazil’s manufacturing sector eased significantly.

The downturn in the Eurozone is gathering pace as the contraction in France and Germany, the two major economies in the region, is deepening. The Markit Eurozone Manufacturing PMI fell to 46.4 in November from 47.1 in October. After Ireland fell back into contraction, the manufacturing sectors of all countries in the Eurozone are now in recession while the contagion widened to emerging European economies. In both China and Japan the expansion ended abruptly. Elsewhere in the Far East the contraction in Taiwan continues and the contraction in South Korea has deepened.

Sources: Markit*; Li & Fung**; Plexus Asset Management****; ISM*****

Sources: Markit*; Li & Fung**; Plexus Asset Management****; ISM*****

The current state of the global manufacturing sector leaves global central bankers no other choice but to act aggressively to stop the rot. We should expect more announcements in coming weeks regarding lower reserve requirements for banks and interest rate cuts in countries where these cuts can still have a major impact on the economy, especially countries in the BRICS block.

Tags: Contagion, Contraction, Current State, Downturn, Economic Regions, European Economies, Eurozone, Gathering Pace, GDP, Interest Rate Cuts, Ism Manufacturing, Manufacturing Sector, Manufacturing Sectors, Markit, Masks, Plexus Asset Management, Pmi, Recession, S South, South Korea
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S&P 500 Index: Short-Term Buy Signal Confirmed

Thursday, December 1st, 2011

I am writing to you from my hotel room in New York, keeping the post short and to the point as a full day of appointments lies ahead.

Further to my post of two days ago, “U.S. equities – downtrend arrested?“, my short-term technical buy signal for the S&P 500 Index has been confirmed. The rationale is explained below.

The Shiller S&P 500 PE10 has broken the 40-day moving average on the upside.

The PE10 has broken both the 12- and 26-day exponential moving averages on the upside, while the 12-day moving average is about to cross the 26-day moving average on the upside.

The MACD of the PE10 is bottoming.

The VIX has broken the short-term support.

The MACD has crossed its nine-day moving average and signaled a buy for the PE10.

But it will be a rough ride. The VIX is likely to encounter support at 24.

The RSI of the VIX is entering oversold territory.

The PE10 has closed the gap with the VIX.

The RSI of the PE10 and VIX (inverse) has bounced from an oversold level.

Sources: I-Net Bridge; CBOE; Plexus Asset Management.

Tags: Amp, Appointments, Bridge, Cboe, Exponential Moving Averages, Gap, Hotel Room, Level Sources, Macd, Moving Average, Plexus Asset Management, Rationale, Rough Ride, Rsi, S&P 500, Shiller, Stocks, Vix
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U.S. Inflation: Further Significant Declines Expected

Thursday, November 17th, 2011

Year-on-year growth in U.S. consumer prices fell to 3.6% in October from 3.9% in September. Due to its significant contribution of 32% to the overall CPI, shelter continues to keep the CPI in check with its year-on-year gain of 1.8%. The CPI excluding shelter fell to 4.4% in October from 5% in September on a year-ago basis. I was not surprised, though. More than 90% of the change in the CPI ex shelter with a one-month lag can be attributed to the year-on-year absolute change in the price of crude oil as represented by Light Louisiana Sweet.

Sources: I-Net Bridge; FRED; Plexus Asset Management.

The change in the oil price from a year ago indicates that the CPI ex shelter is likely to fall further to the 3.8–4% region in November. Assuming that growth in the shelter PMI remains unchanged at 1.8%, it means the overall CPI is likely to be in the vicinity of 3.2%, marking the lowest year-on-year growth since April this year. It will mean that in November the CPI will plunge by 0.27% from October – the largest decline since November 2008.

Producer price inflation is also rolling over. The change in the price of crude oil from a year ago indicates a further drop in the year-on-year growth rate of the PPI in November and December to approximately 5.5% is on the cards. That compares with 6.1% in October and 7% in September.

Sources: I-Net Bridge; FRED; Plexus Asset Management.

I expect year-on-year growth in both CPI and PPI to moderate further to 2% and 3% respectively in the first quarter of 2012 should the oil price remain unchanged at current levels. I do not think the FOMC will be concerned about slowing inflation as real disposable income will benefit substantially. An abrupt decline in both these gauges is unlikely unless the oil price falls out of bed. A sharp drop in the oil price will indicate global demand is falling and will in any event result in the FOMC acting aggressively.

Furthermore, I expect the growth rate of the core CPI to accelerate as its honeymoon resulting from a weak shelter CPI (contributing approximately 38% to the core CPI) is over as the latter’s growth on a year-ago basis is catching up with the growth in other components of the index.

Sources: I-Net Bridge; FRED; Plexus Asset Management.

Copyright © Investment Postcards

Tags: Absolute Change, Bridge, Cards, Core Cpi, Decline, Declines, Disposable Income, First Quarter, Fomc, Global Demand, Louisiana, Oil Price, Plexus Asset Management, Pmi, Ppi, Price Of Crude Oil, Producer Price Inflation, Vicinity
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U.S. Stocks: Anticipating Too Much, Too Soon

Tuesday, November 15th, 2011

I am on record as calling the U.S. stock market a buy in September when Robert Shiller’s PE10 (S&P 500 expressed as a ratio to the average trailing earnings of the past ten years) dropped below 20 and presented value. The PE10 briefly fell to 18.5 on the first trading day of October but the 12.8% rally in the S&P 500 has taken the gauge to 20.7 currently. That compares to the historical average of 16.4 times since 1881 and the low of 13.3 times during the great financial crisis of 2008/2009.

Sources: Robert Shiller; Plexus Asset Management.

The rating of the S&P 500 as measured by the earnings yield (inverse of PE10) improved as the anxiety levels in financial markets as measured by the CBOE S&P 500 Volatility Index (or VIX) eased from crisis levels.

Sources: Robert Shiller; Plexus Asset Management.

Anxiety levels remain elevated, though as the VIX is approaching crisis levels again. Since 19 October a significant gap has opened between the PE10 and the VIX where the current level of the VIX is calling for a PE10 of 20.0 compared to the current 20.7. It therefore implies that unless the VIX drops to 28, the S&P 500 could get a haircut of 3%. Please note that the following graph illustrates the daily values I calculate for the PE10 and that the VIX is on a reverse scale.

Sources: Robert Shiller; CBOE; I-Net Bridge; Plexus Asset Management.

In the past I have referred to the relationship between the Conference Board’s Consumer Confidence Index and PE10 as the former is an excellent indicator of the valuation of the U.S. stock market with regard to the state of the underlying economy.

At this stage the PE10 and consumer confidence have parted ways, with the former rising and the latter falling.

Decoupling? No, I do not think so. There are times when consumer confidence leads and times when the PE10 leads. Obviously, when the stock market rallies, consumers are more at ease as they feel wealthier (or less poor) and their confidence improves. What the PE10 is telling me is that the market is probably anticipating a huge rise in consumer confidence to in excess of 60, with the current PE10 one standard deviation above what the historical relationship implies.

The recent surge in stock prices will go a long way to restoring some confidence but I doubt whether 60 is within reach in the short term.

The reason why consumer confidence is so important is the fact that it is a determining factor in the velocity of money in the economy or the rate at which money is exchanged from one transaction to another.

Sources: FRED; Dismal Scientist; Plexus Asset Management.

Currently the level of the Consumer Confidence Index correctly reflects the velocity of money with zero maturity (MZM that includes notes and coins in circulation and cash or near-cash deposits of financial institutions).

Sources: FRED; Dismal Scientist; Plexus Asset Management.

A rise in the Conference Board’s Consumer Confidence Index to 60 implies that MZM velocity should rise to 1.57 from the current 1.46. A jump to 1.57 in MZM velocity would mean the year-on-year growth in GDP (in current money terms) has accelerated by 11% or 7.85% from the third quarter. You will agree that such acceleration is highly unlikely.

Sources: FRED; Dismal Scientist; Plexus Asset Management.

The bond market indicates that we should rather expect MZM velocity closer to 1.40 compared to the current 1.46.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

MZM velocity of 1.57 as suggested by the market via PE10 implies a yield of close to 3% on the 10-year Government Bond Index. Again you will agree with me that this is highly unlikely in the short term.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

Although volatile, the yield on the 10-year note has always been an excellent indicator and anticipator of underlying consumer sentiment.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

The 10-year note is currently priced for the Consumer Confidence Index falling to approximately 30.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

Unemployment plays a major role in consumer confidence. (Please note the reverse scale of the unemployment rate.) Consumer confidence is unlikely to improve significantly unless employment increases drastically.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

At this stage of the economic cycle the FOMC would normally be inclined to cut the Fed fund target rate. If the FOMC had not been so dovish in the first half of last year and raised rates even slightly, it would have been in a position to cut the rate earlier this year. Now it has no room to move with the rate hovering around zero.

Sources: FRED; Plexus Asset Management.

It seems to me the FOMC has no alternative but to embark on QE3. There is a flickering of light at the end of the tunnel, though. The 12-month momentum of MZM velocity appears to have bottomed in line with that of the GDP in current money terms.

Sources: FRED; Plexus Asset Management.

The stock market is currently driven by the normalising of anxiety levels, with the S&P 500 Index slightly overpriced by approximately 3% compared to the anxiety levels as represented by the VIX and the PE10. At this stage the current process is resulting in too rich ratings that are out of line compared to the underlying economy as represented by the Conference Board’s Consumer Confidence Index. However, I do think the Consumer Confidence Index is likely to improve close to 50 in the next few months, but not quite to 60 as anticipated by the stock market. The market must therefore be anticipating a big QE3 to justify the ratings!

In sum, I am approaching the U.S. stock market with some caution at this juncture. That said, I remain bearish on U.S. long bonds as I think the U.S. economy is in a somewhat better shape than the bond market is suggesting.

Tags: Amp, Anxiety Levels, Briefly, Cboe, Confi, Consumer Confidence Index, Crisis Levels, Earnings, Financial Crisis, Financial Markets, Gap, Gauge, Graph, Haircut, Market Rallies, Plexus Asset Management, Robert Shiller, Scale Sources, Stocks, U S Stock Market, Volatility Index
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Anxiety Recedes, as Long Term Investors Show Their Hands

Thursday, October 20th, 2011

Financial market volatility has receded significantly over the past two weeks. The CBOE S&P 500 Volatility Index (VIX) dropped from 45.5 at the end of September to 28.2 two days ago, before again edging up a notch.

Source: StockCharts.com

The drop brought the VIX back to less than one standard deviation from its average since 1986. While still high, it signals that anxiety levels have moved away from crisis levels.

Sources: CBOE, Plexus Asset Management.

But what led to the easing of volatilities? In previous articles I indicated that the most important factor that had led to the easing of crisis levels in the past was when prices fell to levels that attracted renewed buying from long-term investors. This is exactly what happened this time round. The Shiller PE10 ratio dropped to 18.67 on Monday, 3 October, the lowest since August 2009. The earnings yield over ten years, or what I call Shiller EY10 (inverse of PE10), therefore rose to 5.36%.

Sources: CBOE, Robert Shiller; Plexus Asset Management.

The value per unit of volatility therefore bounced off the average of the major turning points in the past.

Sources: CBOE, Robert Shiller; Plexus Asset Management.

The S&P 500 bounced strongly and ended last week 11.4% up from its lows on 3 October.

Sources: CBOE, I-Net Bridge; Plexus Asset Management.

Global investors are becoming less risk averse. Emerging-market bond yield spreads are heading south again.

Sources: CBOE, I-Net Bridge; Plexus Asset Management.

The yield on the 10-year government bond note has turned and is rising again.

Sources: CBOE, I-Net Bridge; Plexus Asset Management.

The sell-off in gold bullion is over for now.

Sources: CBOE, I-Net Bridge; Plexus Asset Management.

The sell-off in emerging-market and commodity-dependent currencies has receded.

Sources: CBOE, I-Net Bridge; Plexus Asset Management.

Sources: CBOE, I-Net Bridge; Plexus Asset Management.

Global investors have again found value in emerging-market equities, using South Africa as an example in the chart below..

Sources: Robert Shiller, Dismal Scientist; Plexus Asset Management.

Does that mean that the firestorm is over? I think the global financial system is not out of the woods yet as the European Union is still facing headwinds. Be that as it may, what is of particular note is that global long-term investors have shown their hand by buying the market again. The dire position of some European banks also indicates they have probably shut most of their risk positions and taken their pain – I think the sell-off in gold bullion is an indication of this. The global value at risk through derivatives has therefore probably diminished substantially.

Also, the easing of anxiety in financial market will help U.S. consumer confidence in coming months.

Sources: CBOE, Dismal Scientist; Plexus Asset Management.

As I said in a number of posts last week (see “Stock markets: In long-term indicators we trust” and “Global stock market moving averages – a mixed picture“), I would not be surprised to see a further recovery in global stock markets over the next few weeks, with those markets most deeply oversold relative to their 200-day moving averages offering the strongest recovery potential. However, to add conviction to the rally most of the global indices (as well as the majority of individual stocks) need to better their 200-day lines, and do so on better volumes seen thus far. Until this happens, follow a cautious approach.

Tags: 3 October, Amp, Anxiety Levels, Bond Yield, Cboe, Commodity, Crisis Levels, Earnings Yield, Emerging Market, Global Investors, Gold Bullion, Government Bond, Lows, Management Sources, Market Volatility, Plexus Asset Management, Robert Shiller, Standard Deviation, Stocks, Term Investors, Volatility Index Vix
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Global Manufacturing PMI (Sept 2011): U.S. Shines in Suffering Global Manufacturing Sector

Wednesday, October 5th, 2011

Growth in the global manufacturing sector is on the brink of contraction. The global manufacturing PMI that I calculate on a GDP-weighted basis for the major economic regions fell to 50.1 in September from 50.4 in August, while the JP Morgan Global Manufacturing PMI fell to 49.9 from 50.1. The U.S. ISM Manufacturing PMI masks the state of the manufacturing sector elsewhere around the globe, though. The gauge jumped to 51.6 in September, indicating acceleration in growth from a paltry 50.6 in August.

While Germany is still showing signs of growth the recession in the rest of the Eurozone’s manufacturing sector is deepening. However, it seems as if the contraction in Italy is easing somewhat, but France, the second largest economy in the Eurozone, is sliding fast. In contrast, the manufacturing sector in the U.K. has managed to grow again after contracting in August. The cold spell has spread to emerging Europe as well, with Poland leading the way as growth in its manufacturing sector is close to stalling. Turkey was the exception as its manufacturing sector is growing again.

Asian countries are also suffering. China was the major disappointment as the CFLP Manufacturing PMI only managed to rise by an abysmal 0.3 percentage points to 51.2 in a month that is normally a very strong month from a seasonal perspective. The result was that my seasonally adjusted CFLP PMI fell 2.1 percentage points to 50.1 and therefore indicates that growth in China’s manufacturing sector has stagnated. It had a severe ripple effect on the rest of Asia. Growth in India’s manufacturing sector slowed sharply, while the contraction in Taiwan, South Korea and Australia deepened.

Russia and South Africa held up reasonably well in the other BRICS countries but the contraction in Brazil’s manufacturing sector quickened.

Sources: Markit*; Li & Fung**; Plexus Asset Management****; ISM*****.

Sources: Markit*; Li & Fung**; Plexus Asset Management****; ISM*****.

Tags: Acceleration, Asian Countries, Brazil, BRICs, Brink, Cold Spell, Contraction, Disappointment, Economic Regions, Emerging Europe, Eurozone, India, Ism Manufacturing, Jp Morgan, Leading The Way, Manufacturing Sector, Percentage Points, Plexus Asset Management, Recession, Ripple Effect, Sector Growth, South Korea
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Volatility: The Pulse of the Market

Tuesday, September 20th, 2011

The extreme volatility in U.S. equity markets and other global equity markets prompted me to analyse the current situation in comparison with history and to ascertain what causes significant changes in volatility.

The CBOE S&P 500 Volatility Index, better known as VIX, is constructed by using the implied 30-day volatilities of a wide range of S&P 500 Index put and call options. With the VIX only available from 1990 I have extended the volatility index by adding the CBOE S&P 100 Volatility Index or VXO from 1986 to 1989 to the VIX series.

The VIX is generally used as an indicator of greed/complacency or fear. I call it the pulse of the market. Any move above the average of 20.8 is a reflection of anxiety, while a move below is a reflection of calmness. The current anxiety of the market is clearly evident in the graph below.

Sources: CBOE; Plexus Asset Management.

In the graph below I indicate the average VIX since 1986 (20.8) with one standard deviation above (28.8) and one below the average (12.8). It is evident that VIX values greater than one standard deviation above the average can generally be associated with a large amount of volatility as a result of significant events – as is the case currently.

Sources: CBOE; Plexus Asset Management.

During sustained bull markets the pulse of the market is calm but moves towards neutral and anxiety towards the end of rising markets and the commencement of declining markets. It was evident in the run-up to the 1987 crash when the market went into anxiety mode nine months prior as well as at the end of 1989. In 1997 the VIX started trending towards neutral and anxiety mode three years prior to the spectacular end of the extended bull market in 2000. Anxiety persisted until the first quarter of 2003 before calmness set in. In the second quarter of 2007 the VIX started to trend to neutral and anxiety mode 12 months before the S&P 500 topped out and entered a declining trend. Although the market briefly went into a period of calmness in the first quarter of last year this was followed by brief snaps of anxiety and calmness, ending in the current state of anxiety.

Sources: CBOE; I-Net Bridge; Plexus Asset Management.

But what is the main determinant of volatility as measured by VIX? Greed and fear from my point of view as investor is not indifferent to expanded or contracted market valuation levels. I therefore used Robert Shiller’s PE10 where the price level of the S&P 500 is expressed as a ratio to the average trailing earnings of the past ten years as valuation model and compared it to VIX.

Sources: CBOE; Robert Shiller; Plexus Asset Management.

Timeline:

• The significant jump in the PE10 from 13.4 in 1986 to 18.3 in 1987 was accompanied by a significant increase in volatility and therefore anxiety as measured by VIX. The volatility only returned to neutral levels after the crash of 1987 induced by program trading when the PE10 retreated to 13.4 or to pre-blow-off levels.
• 1990 mirrored 1987’s situation with the Gulf Crisis the trigger to bring valuation levels back to levels that restored calm in the markets. In 1997 the VIX started trending towards neutral and anxiety mode as the PE10 rose.
• Although the Asian crisis in 1997 increased anxiety or volatility it had no lasting effect on the PE10. The Russian crisis of 1998 also had no lasting impact as the PE10 briefly fell from 38 times to 33.5 and rose further afterwards.
• Volatility remained at anxiety levels until the market topped out early in 2001 with a PE10 of 44.2 when the Dotcom bubble burst. The tragic 9/11 followed and corporate scandals such as Enron kept the anxiety levels high but the PE10 remained at elevated levels above 30.
• The September 2002 market crash led the PE10 to bottom in February 2003 at 21.2 – levels similar to that of 1995 when the market last experienced “calmness”. The VIX dropped significantly and the PE10 thereafter remained stable at around 26 for the next 4 years.
• In June 1997 the VIX again rose to and reached anxiety levels in July that year. As anxiety increased the market finally cracked in January 2008 as the PE10 started to fall as the subprime crisis unfolded and crashed in October as volatility increased significantly on the back of the Lehman saga and ensuing interbank collapse. Anxiety started to subside only when the PE10 dropped to a level of 13.3.
• The debt crisis in Greece in June last year saw a significant increase in volatility but the PE10 retreated moderately to 19.7 from 21.8 in April. Calmness was restored and the PE10 rose to 23.7 in May.
• Since then anxiety levels have increased as the European debt crisis deepened and a consumer confidence crisis in the U.S. developed. At the same time the PE10 dropped to 19.8, which is where we are now.

I also assessed the impact of the underlying economy on volatility or VIX. I identified two major indicators of the underlying economy in my analysis, namely consumer sentiment and my calculated GDP-weighted PMI for manufacturing and non-manufacturing combined.

Until the end of 2007 the Conference Board Consumer Sentiment Index (please note the reverse axis) and VIX maintained a narrow relationship but it broke down early in 2007. In August 2007 the Consumer Sentiment Index started to weaken when VIX entered anxiety territory and continued to weaken through March 2008. Sentiment only started to improve when the S&P 500’s volatility started to subside.

Sources: CBOE; Conference Board; Plexus Asset Management.

It is evident that high volatility is consistent with a GDP-weighted PMI below 57 (please note the reverse order of the PMI axis). From July 2006 the PMI started to falter but the VIX remained in “calmness” territory until a year later when the VIX caught up.

Sources: CBOE; ISM; Plexus Asset Management.

The relationship since July 2007 when the VIX entered anxiety level is evident in the following graph (please note the reverse order of the PMI axis). Until September 2008 the VIX reflected the underlying level of the PMI, but since then it has led the PMI by approximately one month. A major diversion is evident in March this year, though. The PMI weakened significantly from February to April but the VIX kept on declining and only started to play catch up in July. Currently the VIX is pointing to the PMI falling to 50 and below in September/October.

Sources: CBOE; ISM; Plexus Asset Management.

In summary, it is clear to me that the volatility of the equity market and that of the S&P 500 in particular as measured by VIX is influenced by valuation levels and the underlying economic trends. But what are the mechanics behind it and who is responsible for the increase in volatility?

Suffice it to argue that when the majority of investors become concerned about extended valuation levels and/or the threat of weaker economic circumstances ahead, the demand for derivatives to lock in profits and to reduce downside risk increases. The demand for, say, put options increases, resulting in higher prices of the options. The higher value investors are willing to pay for put options theoretically implies a higher value for volatility. The implied volatility of the options therefore increases and so does VIX. Therefore it can be said that investors are willing to pay more for the same option and thus are inclined to accept higher volatility.

On the other hand the writer or grantor of the option has the choice of leaving the option naked, thereby effectively going long of the market or to delta-neutral hedge the option by selling sufficient exposure of the underlying asset or the S&P 500 against the written option. The writers of put options who are bullish in a strong rising market tend to do so to collect the premium on the option to boost income.

When the S&P 500 starts to lose momentum or fall, the grantors of the options need to neutralise their positions by selling the underlying asset or buy put options as their value at risk increases. A vicious circle ensues. The price of the underlying asset (in this case the S&P 500) drops and actual volatility increases, while the implied volatility soars due to higher demand for put options. The volatility and downside of the market is often exacerbated by investment banks and other institutions who granted far out of the money put options for plain premium income considerations that all of a sudden threatens the balance sheets of the grantors. The grantors are then forced to sell indiscriminately to protect their balance sheets at all costs.

The price of the underlying asset continues to drop until it finds a level where the majority of investors become less risk averse and comfortable enough to buy the underlying asset. Demand for protective measures falls away and so does VIX as implied volatility drops.

What about the current situation? Where is the VIX heading? What are the implications for the S&P 500?

The current situation is similar to that of the middle of last year with concerns about the global economy given the debt stress in Europe, a weakening trend of the U.S. GDP-weighted ISM PMI and weakening consumer sentiment. The rating of the S&P 500 as measured by the earnings yield (inverse of PE10) is at levels similar to those in July/August last year.

Sources: CBOE; Robert Shiller; Plexus Asset Management.

The current rating is in the same region as in 2003 after which the market turned for the better and volatility dropped. It is evident that the market is extremely vulnerable to further shocks that could see a surge in volatility and a further massive derating. Barring any other unforeseen crisis that could lead to a further spurt in volatility, I believe the S&P 500 offers value at this stage. But do the majority of other investors share my view? Only time will tell, as calm needs to be restored before we will see any sustained upward momentum in the S&P 500 and other global equity markets. What is clear to me is that the market has entered a period of above-average volatility that is likely to be sustained in coming years �’ similar to that of 1997 – 2003.

Sources: CBOE; I-Net Bridge; Plexus Asset Management.

Tags: Anxiety, Bull Markets, Calmness, Cboe, Commencement, Complacency, Current Situation, Extreme Volatility, First Quarter, Global Equity Markets, Greater Than One, Greed, Nine Months, Plexus Asset Management, Second Quarter, Significant Events, Standard Deviation, Vix, Volatility Index, Vxo
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Japan the Achilles’ Heel of U.S. Economy in Q2

Thursday, August 18th, 2011

Much has been said and written about the inability of the Fed to sustain U.S. economic growth. In previous articles I have pointed out the massive impact of the Japanese earthquake disaster on the health of China’s manufacturing sector as measured by the seasonally adjusted CFLP PMI.

Sources: CFLP; Li & Fung; Markit; Plexus Asset Management.

But what impact did Japan’s twin disasters have on the U.S. economy?

I depicted Markit’s composite PMI for Japan against U.S. total imports from Japan, with the latter lagging by one month. It is evident that approximately USD4 billion in imports was shaved off in the first month after the disasters and a total of more than USD10 billion thus far.

Sources: FRED; Markit; Plexus Asset Management.

It is even more profound if the manufacturing PMI is used.

Sources: FRED; Markit; Plexus Asset Management.

Exports by the U.S. to Japan were hardly affected by the twin disasters, though.

Sources: FRED; Markit; Plexus Asset Management.

As a consequence of the twin disasters the U.S.’s trade deficit with Japan shrank by USD3.4 billion or 56% from March to June.

Sources: FRED; Markit; Plexus Asset Management.

Sources: FRED; Markit; Plexus Asset Management.

If I assume that the lower imports from Japan have not been replaced by other goods and services, the lower imports of USD10 billion plus amount to around 0.9% of total retail sales in the U.S. in the second quarter.

The impact of Japan’s disasters on U.S. retail sales is clearly evident in the following graph in which the month-on-month retail sales are depicted against Japan’s manufacturing PMI.

Sources: FRED; Markit; Dismal Scientist; Plexus Asset Management.

The impact is particularly evident in the sales of motor vehicles and parts.

Sources: FRED; Markit; Dismal Scientist; Plexus Asset Management.

Japan’s disasters also played out on the employment front. My calculated GDP-weighted ISM PMI employment index moved in line with Japan’s manufacturing PMI from March through June.

Sources: ISM; Markit; Dismal Scientist; Plexus Asset Management.

That had a major impact on the number of jobs created.

Sources: ISM; I-Net Bridge; Plexus Asset Management.

U.S. imports from Japan had a direct bearing on non-farm payroll employment.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

That in turn impacted on retails sales too.

Sources: ISM; Dismal Scientist; Plexus Asset Management.

My conclusion is therefore that the fallout of Japan’s twin disasters is responsible for most of the disappointing economic data of the second quarter, whether it be GDP growth, employment or retail sales.

A very interesting observation is that when the U.S.’s imports from Japan are compared to those of the same month a year ago, they track my calculated GDP-weighted ISM PMI (manufacturing and non-manufacturing combined). The PMI currently points to further weakness in U.S. imports in July compared to a year ago. No wonder Japan is so anxious to lower the external value of the yen!

Sources: ISM; FRED; Plexus Asset Management.

Now that the U.S. economy has got the Japan twin disasters behind it, with Japan recovering, it raises the question of whereto now. As you might have gathered from the graphs I have presented, the GDP-weighted ISM PMI employment index in July dropped while Japan’s PMIs headed higher. This is serious cause for concern. Was it as a result of the impasse on the U.S. debt issue or is the worsening situation in Europe catching up with the U.S.? Is that not what is behind the extreme volatilities in the markets? The U.S.’s economic statistics for July are likely to be awful but August’s manufacturing and non-manufacturing PMIs hold the key to further direction in financial markets.

Tags: Achilles Heel, Disasters, Dismal Scientist, Earthquake Disaster, Economic Growth, Employment Index, Employment Japan, Ism, Japanese Earthquake, Management Sources, Manufacturing Sector, Markit, Massive Impact, Motor Vehicles, Plexus Asset Management, Pmi, Q2, Retail Sales, Second Quarter, Trade Deficit
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Fed to Start Tightening in Third Quarter

Friday, February 25th, 2011

The general consensus agrees with the minutes of the FOMC of January 26 that the highly accommodative monetary policy will be maintained owing to the expectation that the weakness in the labour market will persist for a long time and inflation is still below target. The FOMC expected to keep the fed funds rate near zero “for an extended” period. But will they?

I had a look at what triggered the Fed in the past to change direction in their monetary policy and especially the fed funds rate. No, it was not inflation nor was it employment as they profess. It was consumer sentiment! Over the past 22 years it is evident that the Fed changed policy a quarter after the Conference Board’s Consumer Sentiment Index crossed its 5-quarter weighted moving average. The only exception was in the third quarter of 2005 when consumer sentiment briefly fell below the weighted moving average.  Yes, they are chartists just like us!

Sources: Conference Board; I-Net; Plexus Asset Management.

The reason for the Fed’s behaviour probably lies in the fact that consumer sentiment normally leads core inflation by approximately ten months. A strong and sustained rise in consumer sentiment is therefore likely to lead to a higher core inflation rate ten months hence. In the current cycle, however, the core inflation rate kept on falling despite continued improved consumer sentiment. That can largely be ascribed to the continued weakness in the housing market and shelter in particular.

I am therefore of the opinion that a sustained improvement in consumer sentiment in the next few months will again see some hawks raising their heads in the FOMC as headline inflation is also turning for the worst. I would certainly start to bet on the Fed raising the fed funds rate in the third quarter of this year.

With consumer sentiment a major factor in the Fed’s monetary policy it is no wonder that the bond market slavishly follows the Conference Board’s Consumer Sentiment Index. The bond market obviously sees a stronger economy and higher inflation ahead.

It brings me to another point – where is the yield on the 10-year Treasury note heading? From the historical relationship between the 10-year yield and consumer sentiment over the past 12 years it is evident that the 10-year note at 3.62% is aptly priced given the current level (60.6) of the Consumer Sentiment Index.

A sustained rise (as I expect) in this index in the coming months is likely to take the yield on the 10-year note higher. Where it will top out I do not know but an improvement in consumer sentiment to 80 could see the yield rising to in excess of 4.1%. Obviously, bonds will rally if consumer sentiment surprises on the downside.

What about U.S. equities?

As in the case of U.S. bonds the U.S. market sentiment is significantly influenced by consumer sentiment. For market sentiment I used Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) or PE10 for the S&P 500. It is similar to the standard price-earnings ratio but instead of dividing the current index by the past year’s earnings, it uses the average earnings of the past ten years. It is apparent that the equity market players are keen followers of consumer sentiment as it is obviously a major factor in their valuation models.

In light of the relationship between the Consumer Sentiment Index and the S&P 500’s CAPE the current CAPE of 23.7 indicates to me that a level of about 77 for consumer sentiment is priced in by the U.S. equity market. That compares with the current 60.6 (January).

If consumer sentiment comes in weaker than the 77, I doubt whether it will result in a major train smash as long as the number is much stronger than January’s. But what about inflation? Higher inflation was the reason why the S&P 500’s CAPE went sideways from 2004 to 2007 despite consumer sentiment rising further. I expect the same to happen when consumer sentiment hits the 85 level. A level of 85 transpires to an S&P 500 CAPE level of 26, though �’ up approximately 10% from the current levels.

Tags: 22 Years, Bond Market, Briefly, Chartists, Consensus, Consumer Sentiment Index, Core Inflation, Expectation, Fed Funds Rate, Fomc, Hawks, Headline Inflation, Housing Market, Inflation Rate, Labour Market, Long Time, Monetary Policy, Moving Average, Plexus Asset Management, Target
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