Defensive For Time Being (Alfred Lee)

Considering the structural problems in the economy that persist, we believe equity valuations coming into the new year were high relative to their rolling three-year average price-to-earnings (P/E) ratios. The market volatility this year, while not enjoyable for investors, has shaken out some exuberance and thus some excess leverage as we have seen NYSE margin debt measures on the decline since April. Despite this shake-out, equity valuations both in Canada and the U.S still remain high relative to their rolling three-year averages. We believe therefore that downside risk remains since the current outlook does not warrant current valuations. We would also take a cautionary stance given China’s efforts to cool its economy which is proving to be effective as indicated by its falling Leading Economic Index (LEI)1. The slowdown of the Chinese economy will also more than likely affect its foreign trade with neighbours and this is important as the region has been a major growth engine to the global economy.

Furthermore, the yield on two-year U.S. Treasuries indicates fear with investors that have not yet been resonated in equity prices. However, as margin debt levels are not at extreme levels, we don’t foresee a major deleveraging event in equities similar to “post-Lehman”3 should the outbreak of bad news move us into yet another bear market. We do however expect much of the turbulence to continue, especially with the prices of credit default swaps (CDS4) rising for many of the PIIGS5 nations again. Given the continued downside risk, until we see a further decrease in margin levels, we suggest that investors consider
increasing their yield oriented positions which tend to exhibit less volatility than the market. We also suggest that investors consider increasing their fixed income exposure.

(click to enlarge)

1 comment
  1. You write: "While an increased allocation to bonds should provide capital preservation as we wait for the turbulence in the market to pass."

    I recommend that one have no allocation to bonds. I recommend gold, but for those who must be invested, I suggest they go short bonds and stocks both!

    The chart of emerging market bonds shows that these can experienced an abrupt and significant loss of value.

    I would like to present my view that holding debt of any kind, even high grade corporate debt, exposes one to the risk of loss of principle as interest rates go higher. I believe that interest rates were called higher by the markets on September 1, 2010, in response to the US Federal Chairman Ben Bernanke announcing intentions to buy mortgage backed securities on not only one occasion but on two occasions.

    High grade corporate debt, LQD, fell parabolically lower on September 1, 2010, with the purchase of the yen based carry trades, on September 1, 2010, which rallied stocks, ACWI; and turned the tide on bonds, BND, sending them lower, establishing August 31, 2010 as a high in bonds at 82.66, that is, ”establishing August 31, 2010 as peak credit” … bond deflation has been underway since September 1, 2010.

    High grade corporate debt, LQD, peaked on September 1, 2010 at 112.58. It has the same wave structure as BND; so any comments about bonds, BND, apply directly to LQD as well.

    Going over to and sorting on the 3 year returns, LQD shows 7.57%, which is quite good; going all the way to the bottom are such things as Natural Gas and Financial Services, which is quite bad.

    I believe that LQD’s returns will be influenced by a flattening of the 30-10 US Sovereign Debt Curve, and by CDS.

    The interest rate on the 30 Year US Government bond, $TYX, rose strongly September 1, 2010.
    And the interest rate on the US 10 Year Note, $TNX, also rose strongly September 1, 2010.

    September 1, 2010 marks the transition from “the age of neo-liberal Milton Friedman based credit liquidity” to “the age of the end of credit”; this also means ”the end of entitlements” and “the beginning of world-wide austerity”.

    The 30-10 yield curve,$TYX:$TNX, began to flatten on August 11, 2010, reversing a trend that goes back to early 2000.

    This signals risk aversion to sovereign debt. The flattening of the yield curve came as a result of the Federal Reserve Chairman's announcement of August 10, 2010 of the purchase of mortgage-backed securities. Then on August 27, 2010, the Federal Reserve Chairman stated the possibility of an even larger purchase of debt.

    This caused the bond rally in US Treasuries, TLT, and Zeroes, ZROZ, HIgh Grade Corporate Bonds, LQD, that began April 6, 2010, to fail September 1, 2010, sending bond prices lower and interest rates higher.

    The safe haven rally in debt, and the low-interest rates available to corporations, that began with the onset of the European Sovereign Debt Crisis is over, repeat over and done, through and finished. Investors see Mr Bernanke’s plans as monetization of debt; and have gone short US Treasuries, especially the longer out ones such as ZROZ.

    I believe a sovereign debt, read TLT, crisis, is coming soon, as well as a global financial collapse, where there will be no liquidity to buy or sell paper assets; I want something liquid like gold of silver as an investment.

    Systemic risk is quite high. Liquidity evaporation could happen quite easily, either coming through a failed Treasury auction or a situation where there may not be enough buyers of investment securities to meet sellers demand.

    I believe that soon, out of a liquidity evaporation and a bond, BND, liquidity crisis, stemming from a fast fall in bond and/or stock values, that here in the US a Financial Regulator will be announced who will oversee lending and credit, as well as money market and brokerage accounts.

    He will be what I call a credit boss or credit seignior who funds economic operations with an emphasis on seeing that the strategic needs of the country are met and that monies for food stamps keeps flowing. I believe the government will become the first, last and only provider of liquidity and money.

    I believe the intensity of onset of the coming credit crunch will come with a great rush and that the corporate bond market, LQD, will shut down very quickly. Like I say, I believe a lending boss will be announced and pretty much only natural resource companies and defense contractors and food producers will have credit liquidity.

    Furthermore, I see a coming ”see-saw” exhaustion of fiat wealth with stocks, ACWI, and then bonds, BND, alternatively falling lower. There may be days when both fall lower. The chart of Bonds, BND, for September 7, 2010 shows three black crows, with a fall in value to a head and shoulders pattern at roughly 82.00 and then a rise to 82.44.

    The chart of world stocks, ACWI, as well as the S&P, SPY, as of September 7, 2010, shows that the world stocks enter an Elliott Wave 3 of 3 of 3 down having completed a three white soldiers pattern, and a one day down --- ACWI closed down 1.28% and SPY closed down 1.13% on September 7, 2010.

    As the value of stocks falls lower, so will the value of corporate bonds, as they will fall under the influence of a flattening 30-10 US Treasuries curve, $TYX:$TNX seen in chart.

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