What are the Bulls Looking At? (Rosenberg)

This article is a guest contribution from David Rosenberg, Chief Market Economist, Gluskin Sheff.

WHILE YOU WERE SLEEPING

Asian equity markets are flying high this morning and Europe is mixed-to-up as it rides a four-day winning streak. Emerging markets gained 0.8% today, closing at the best level since May 4th. Asia-Pac surged 1.7% today. The Chinese market has undergone a resurrection, having posted its best week in seven months, and is breaking out, which bodes well near-term for the commodity complex – and if you strain your eye just enough, you will see the Baltic Dry Index is forming a bottom.

Copper is heading towards its best week in five months (+9%), oil is still hovering near 11-week highs and gold has made its way back towards $1,200/oz on dollar slippage and news of higher India imports. As such, the resource-based currencies are firming up again – the Australian dollar is back trading at a two-month high, as an example. Earnings season is going well thus far– not across the board but across some heavyweights with CAT and MSFT (beating on both the bottom and top lines) the latest reports to generate enthusiasm.

The latest economic data points out of Germany have been surprisingly good – especially the just-released IFO survey for July, which soared to a three-year high of 106.2 from 101.8 – the consensus was at 101.5 (though other numbers in the Eurozone such as French consumer spending left a tad to be desired). U.K. GDP for the second quarter also offered up an upside surprise –+1.1% (not annualized!), the best since 2006Q1 and about double the consensus expectation (Sterling has rallied a further 1% today on the news).

We just got some soft CPI data out of Canada that should help Carney sleep better at night. The headline dipped 0.1% in June, as expected, reducing the yearly rate to 1.0% from 1.4%. After a year of huge housing-induced growth, we have a 1% inflation rate in this country. The core CPI was a surprise, dropping 0.1% as well and this took the YoY rate down to 1.7% from 1.8% – a touch below the BoC’s estimate for Q2. No doubt we will see a pop in July due to the HST, but the inflation trends are actually very conducive to friendly rates environment.

Optimism abounds over the European bank stress tests. So earlier concerns of a European economic meltdown have yet to occur, and likewise regarding fears of a bubble-bust or social unrest in China where signs of a cooling off in property prices have triggered expectations of an early exit from the government’s policy tightening program.

The safety of government bonds is losing a bit of an allure here as the 10-year T-note yield seems set to retest the 3% mark on the upside but let’s not lose sight of the visible slowing taking place right now in the U.S. economy. Sentiment is one thing; economic reality something else altogether. Be aware – the overwhelming consensus is for no double-dip, for yields to rise and for a summertime equity market rally (which seems to have already occurred, though both Bob Farrell and Walter Murphy have recently entertained that view that this thing may have more legs).
On the technicals, a break of 1,100 on the S&P 500 would be widely viewed as a significant and positive near-term development by many a chartist. While volume has been lagging (we highlight that below), what many a bull will point to is the fact that the ratio of new highs to new lows has risen now for …. three days running.

So what else are the bulls looking at right now?

• Congress extending jobless benefits (yet again).
• Polls showing the GoP can take the House and the Senate in November.
• Some Democrats now want the tax hikes for 2011 to be delayed.
• Cap and trade is dead.
• Cameron’s popularity in the U.K. and market reaction there is setting an example for others regarding budgetary reform.
• China’s success in curbing its property bubble without bursting it.
• Growing confidence that the emerging markets, especially in Asia and Latin America, will be able to ‘decouple’ this time around. We heard this from more than just one CEO on our recent trip to NYC and Asian thumbprints were all over the positive news these past few weeks out of the likes of FedEx and UPS.
• Renewed stability in Eurozone debt and money markets – including successful bond auctions amongst the Club Med members.
• Clarity with respect to European bank vulnerability.
• Signs that consumer credit delinquency rates in the U.S. are rolling over.
• Mortgage delinquencies down five quarters in a row in California to a three-year low.
• The BP oil spill moving off the front pages.
• The financial regulation bill behind us and Goldman deciding to settle –more uncertainty out of the way.
• Widespread refutation of the ECRI as a leading indicator … even among the architects of the index! There is tremendous conviction now that a double-dip will be averted, even though 85% of the data releases in the past month have come in below expectations.
• Earnings season living up to expectations, especially among some key large-caps in the tech/industrial space – Microsoft, AT&T, CAT, and 3M are being viewed as game changers (especially 3M’s upped guidance). Even the airlines are reporting ripping results.
• Bernanke indicating that he can and will become more aggressive at stimulating monetary policy if he feels the need and yesterday urging the government to refrain from tightening fiscal policy (including tax hikes).
• Practically every street economist took a knife to Q2 and Q3 GDP growth, which has left PM’s believing we are into some sort of capitulation period where all the bad news is now “out there”.

From our lens, this is still a meat-grinder of a market. The bulls have the upper hand, but only until the next shoe drops in this modern-day depression and post-bubble credit collapse. The S&P 500 is still down 2% for the year, the Dow by 1%, the FT-SE and Nikkei by 11%, the Hang Seng by 5% and China by over 20%.

Ask the bullish community if by this time of the year we were supposed to see bonds outperforming stocks – folks like our friends Byron Wien at Blackstone and Jim Caron at Morgan Stanley thought we were on our way to a 5.5% yield on the 10-year T-note. So let’s keep the whippy, albeit positive, action in the equity market into perspective. This is the sixth (!) multi-week bounce in the equity market so far in 2010 and the year is barely seven months old.

So the best we can say is that we do have a tradable rally on our hands and that at the 50-day moving average on the S&P 500 we also are at a critical technical juncture - but remember, in a secular bear market, these rallies are to be rented, not owned. To be sure, 140 companies have reported so far and the news overall is good … but earnings are a coincident, not a leading indicator.

As for the bond market, it is quite remarkable that everyone focuses on what Ben Bernanke has to say and what the impact will be on equity market sentiment (we even field calls as to whether the Fed would ever buy equities!). Well, all we know is that historically, there is a 160 basis point spread between the Fed fund rate and the 10-year T-note yield, and a 210 basis point spread between the funds rate and the long bond yield. So at a minimum, all the Fed has to do is continue to pledge to keep the overnight rate close to 0% and then do the math as we embark on Bob Farrell’s Rule #1, which is classic mean reversion and you will see why it is that seeing the 30-year down to 2-1/2% is a far less controversial call than meets the eye.

And that remains the pain trade for many a fixed-income portfolio manager who fear small numbers but do not see the huge potential gains in total return terms because of the power of convexity at today’s interest rate levels. The answer is “no” – there is not one way for bond yields to go in a prolonged deleveraging cycle, and “yes”, this is Japan all over again. The record-low yield on the 2-year note after a year of statistical economic recovery has already told you that (not to mention the need for the Fed at this point to even have to contemplate another round of quantitative easing)!

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