Rumours
by Jeffrey Saut, Chief Investment Strategist, Raymond James
August 8, 2011
“Rumours,” yet I am not talking about the 1977 smash album by Fleetwood Mac, but rumors that I heard while watching last Thursday’s Tumble. The two most credible were: 1) A major rating agency is going to downgrade the U.S. credit rating; and 2) A major institution is in trouble and is being forced to liquidate its portfolio. Obviously, one was right and the other wrong as late Friday Standard & Poor’s downgraded our nation’s debt rating to AA+. And, “There is no joy in Mudville – mighty Geithner has struck out,” as our Treasury Secretary has repeatedly declared, “There is no chance the U.S. will lose its top credit rating.” Such statements have left a bevy of cries for Secretary Geithner’s removal fostering at least the illusion of a shakeup in the country’s financial course. While it is doubtful Timothy Geithner is even marginally responsible for our debt debacle, in politics it is all about “illusions.” In fact, the current national malaise reminds me a lot of President Jimmy Carter’s 1979 “Crisis of Confidence” speech. If you have five minutes, click here: (http://www.youtube.com/watch?v=1IlRVy7oZ58).
So what are the implications of Friday’s downgrade? While it will likely take weeks for that question to be answered, as of this writing the answer seems to be “not much.” That “consensus call” is based on what happened to Canada, Australia and Japan when they lost their AAA status. The result was only a minimal economic impact in those countries. That said, we are not so certain that will be the case here given our nation’s reserve currency status and the fact there are so many other financial instruments geared to U.S. Treasuries. As our economist Dr. Scott Brown writes:
“It should go without saying that nobody knows precisely how things will unfold from here. One issue is that while S&P downgraded, Moody's and Fitch have not. Some have suggested that a downgrade would lead to higher borrowing costs for the U.S. However, we haven't seen much of an increase in bond yields in other cases where sovereign debt was downgraded. Treasuries are still considered to be the "safe" asset – so, I wouldn’t expect a big increase in Treasury yields. The bigger concern will be second and third round effects through the financial markets. Downgrades to agency debt (Fannie Mae, Freddie Mac), a number of states, and municipalities will follow on Monday. Money market outflows are likely to increase (as people move to insured bank deposits). The Fed is likely to move to support the money markets (as they did during the financial crisis) and may set up other liquidity facilities. In issuing guidance to banking organizations for risk-based capital purposes, the Fed indicated that risk weights for Treasuries and agencies will not change. Still, a number of banks have large holdings of agency debt and may be inclined to increase capital and tighten loans for consumers and businesses. We’ll have to wait to see how markets react and what the expectations are for U.S. equities.”
Accordingly, we wait to see the economic impact of recent events while contemplating Soren Kierkegaard’s sage words, “Life can only be understood backwards; but it must be lived forwards.”
So what do we think we know about “living forwards”? Well, while I didn’t believe it was going to happen, the D-J Industrial Average (DJIA/11444.61) confirmed the D-J Transportation Average (TRAN/4693.59) last week when both of those indices broke below their respective March 16, 2011 closing reaction “lows,” thus rendering a Dow Theory “sell signal.” It was the first such “sell signal” since November 21, 2007. Unlike the November 2007 “sell signal,” this one came at much lower valuation levels and following a nearly 11% decline since the selling stampede began on July 8, 2011. Recall, however, that selling stampedes typically last 17 – 25 sessions with only 1 – 3 session pauses/corrections before they exhaust themselves. Last Friday was session 21 in the selling skein making this decline long of tooth. Also of note is the Dow’s Dive has left the NYSE McClellan Oscillator more oversold than it has been in years; likewise the percentage of stocks above their 10-day moving averages dropped to 0.79%, the lowest reading (most oversold) since 1991. As the “must have” InvesTech Financial’s astute James Stack writes:
“On today’s close [8-4-11], our short-term Pressure Factor hit an extraordinary oversold -169 (normally, -80 is an ‘extreme’ oversold reading). There were only six occasions in the past 60 years when the Pressure Factor has dropped below -160... None of those instances saw the S&P even 1% lower one week later. Only one instance saw the market negative one month later – last summer which marked the correction bottom. And interestingly – perhaps coincidentally – 5 of the 6 saw the market up over 19% twelve months later. Such oversold extremes typically do not mark the beginning of a bear market.”
While I certainly hope Mr. Stack is correct, I must admit the Dow Theory “sell signal” concerns me. Still, the bone-crushing decline since early July has used up so much energy (read: extremely oversold) making it is reasonable to expect a “throwback rally” from some sort of stock market low. Indeed, just like you can only press down on a spring so far before you get a “boing” bounce back, the same is true in the equity markets. Moreover, I think the recent rout is more about the aforementioned “Crisis of Confidence” environment than the fundamentals. To be sure, as of yet there is no economic evidence the country is sliding into recession -- slow growth, yes; recession, no. That view is reinforced by the Yield Curve, which has been one of the most reliable predictors of recessions. To wit, every recession for the past 50 years has been preceded by an inverted Yield Curve (short-term interest rates above long-term interest rates). Currently, the Yield Curve is very steeply sloped as can be seen in the chart on page 3 from our friends at the Bespoke Group. In fact, the U.S. has the steepest sloped Yield Curve of any I can find.
