Diary of a Financier

Outlook: 2H2011 & Beyond

In Capital Markets, Dissertation, Economics on Tue 5 Jul 2011 at 08:16
  • The fundamental predicament of today’s EMU is the same as its predecessor, ERM, on the eve of Black Wednesday.
  • Strengthening against every pair except CNY, USD will start an intermediate-term bull run by finding its prime meridian at 82.
  • I will buy UUP when DXY dips below 74 in coming days.
  • In this bifurcated economy (strong micro/weak macro), businesses are cost-cutting their way to profitability. No investment means no revenue growth & no nominal GDP growth.
  • The Japanese resurgence will provide one last round of US inventory builds, then fiscal stimulus in alt/renewable energy has to rear organic demand.
  • SPX looks to rally all the way up to 1425 in a few quarters, but right now Japan offers better risk-adjusted return.
  • 10 & 30-year yields will bound a bit higher, creating a buying opportunity by Congress’ debt ceiling vote; but consistent with their QE1-end analogue, front-end rates will start to rise on a lagging basis.
  • While Ireland & Greece are submitting to indentured servitude, I expect Spain to defect from the Euro, dissolving today’s EMU just like its predecessor. Using Black Wednesday UK as a guide, this year’s grand slam could come from Spain.

I heard a saying early in my career that has really stuck with me:

A trader can start an avalanche, but he can’t move the mountain underneath.

Keep that in mind for this entry, because the theme is laced throughout. It makes me think of the gun-slinging trading style of a Paul Tudor Jones, and it’s spot-on. Trading, trends, psychology and reflexivity can push a security up or down, but long-term, fundamentals are an undeniable attractor to which true value is chained.

European Monetary UnionFundamental Disintegration

To put that in empirical terms, look at the European Exchange Rate Mechanism (ERM), an unnatural agreement by Euro states to manage their independent currencies’ exchange rates within a bandwidth to promote trade back in the late 1980s and early ’90s. ERM artificially manipulated FX rates for too prolonged a period. You can’t fight nature for the long-term and expect to win. Hence, the Black Wednesday crash in 1992 manifest the gravitational force constantly drawing the Pound Sterling (GBP) and Italian Lira (ITL) down toward their fundamental equilibria. The force intensified the longer ERM exerted FX dislocations per its “bandwidth pledge.”

The current European Monetary Union (EMU) and its single currency, the Euro (EUR), will suffer the same fate as the shattered, defunct ERM. The Euro has re-deployed the same half-baked economic pact offered by its predecessor. However, EMU took the pact one step further by committing members’ autonomous governments to constrained fiscal requirements. That’s half-baked-squared, since today’s recessionary bouts in the Eurozone cannot be met by traditional Keynesian easing like deficit spending (not that I favor the Keynesian school). Without political unification–a la the American states and their Federal parent–the Euro was setup to fail.

In that vein, the predicament of today’s Euro is reminiscent of the ERM iteration, particularly ERM on the brink of Black Wednesday:

  • 1992: European fringe states festered in deficits & recession, while Germany exacerbated its neighbors’ struggles by swinging its big stick with egocentric intent. Bundesbank President Helmut Schlesinger insisted on strengthening the Deutschemark (DEM) to nix local inflation in the robust German economy. This forced Britain & Italy to break from the ERM pact and devalue their currencies to save their own economies.
  • 2011: European fringe states fester in deficits & recession, while Germany continues to exacerbate its neighbors’ struggles by swinging its big stick with egocentric intent. European Central Bank President Jean-Claude Trichet insists on another rate hike to nix inflation in the robust German economy. To be continued in real time.

Failure is rather incontrovertible, although it’s arguable who will defect first (Portugal/Ireland/Italy/Greece/Spain). Whether by devaluation or dissolution, the Euro will perish just like its predecessor. Not only that, but it will perish for the same reasons.

It’s like an opus that headlines virtuosos when the fundamentals and the technicals harmonize to play the same score. That’s a capital markets masterpiece in my opinion, and I intend to capitalize on it. In my story of Europe’s ERM, I’ve covered part of the fundamental background. I have to dabble with technicals now en route to more conclusions and a unifying ending. In summary, the charts are setting the stage for a Euro collapse too. But first, I have to digress from the Eurozone before arriving at that end…

US Dollar- Returning to Equilibrium

As did the ERM, EMU & pegged Asian currencies of yesteryear, the Chinese Yuan (CNY) is currently undergoing its own correction after years of manipulation. I recently argued that China will be forced to appreciate CNY further. China will shift gears and build its future economy upon domestic consumption, which is conventional thinking on the Street (since it helps the sell-side sell blue-chip stocks in a bad economy). Everyone ignores the implications of that for the US trade deficit: a weak USD relative to CNY will reverse the flow of commerce between the US & China, and China will become the net importer, neatly tending to its domestic demand. Chinese imports will come increasingly from the US, because that weakening USDCNY will be an exception for an otherwise robust USD.

The Sino-American relationship is surprisingly reminiscent of the Plaza Accord from 1985, which revalued the Japanese Yen (JPY) against USD. The major difference lies in the per capita income comparison between 1985 Japan and 2011 China. Today’s Chinese are much further from the relative standard of living in 1980s Japan, which provides for the breakout consumption patterns that can cure American deficits.

CNY is not an input into the basket of currencies that compose the US Dollar Index (DXY). This month, the USD is trading at the bottom of its secular range, and it will strengthen against every major FX pair henceforth. That Dollar strength is in spite of a weak USDCNY; perhaps it’s even attributable to it since CNY revaluation will repair US deficit issues. I’ve been waiting patiently for this turn for some time now.

The overlay of today’s USD v 1992’s USD is very valuable. With the Savings & Loan Crisis waning, stimulus/monetary policy normalizing and ERM disintegrating, 1992 illustrates a neat base case for 2011. Compare the two years’ Dollar Indexes:

DXY monthly (through 1992)

DXY monthly (through 2011)

The USD rallied mightily out of 1992, closing the decade up more than 50% from lows. Even more striking than the price pattern resemblance between 1992 & 2011’s USD: the technical indicators align perfectly. Momentum is building as DXY trades down to the bottom of its range.

In light of the ERM Black Wednesday story, et al, I’ve considered the ramifications of artificial intervention in FX markets. One way or another, the Fed/Treasury have artificially dislocated the USD from its natural equilibrium for too long. Looking at the monthly DXY fractals from a wider lens, that attractor seems set at a prime meridian around 82:

DXY monthly- Prime Meridian @ 82

In fact, I expect to pickup some US Dollar ETF (UUP) after DXY drops under 74 in a short-term undulation in coming days/weeks (today’s close at 74.50). The weekly chart shows bullishness, and it will pull an oversold monthly fractal up with it.

US Economy- Bifurcation Illustrated by CAT & CSCO

Most people have grown accustomed to a strong USD rendering weak stocks. I don’t think that’s the case in the coming weeks & months, as I’ll explain later.

I approach US equities from a bearish angle, because frail economics seem so handicapping. My only fundamental explanation for intermediate-term technical SPX bullishness derives from profit margins. Since the 2009 bottom, the microeconomic growth recipe has called for a rotation between widening margins (cost-cutting/layoffs/tax incentives) and inventory restocking. Nowhere therein does aggregate demand or nominal GDP reap organic growth. That, in essence, is the redux of the bifurcated American economy: a micro churn within a macro burn.

As an example, I need not look further than the juxtaposition of Caterpillar (CAT) & Cisco (CSCO). The former is achieving both record profits & stock price via record gross margins, mass layoffs and capex freezes. The latter faces modern lows in both revenue growth & stock price due to a lack of its clients’ investments in technology, networks and systems. While I won’t comment on the folly of a narrow-moat business like CSCO’s (or their management’s lack of vision to date), I can deduce something of the broad economy’s infliction. Similarly, I can assert that a business like CAT’s will not sustain long-term profit growth on the legs of operating margins alone–not beneath a declining top line.

My entry on Thursday noted the onset of yet another wave of layoffs in the Financial sector. This is the last go-around for this recipe. It gets the US economy to one more cycle of inventory restocking, to which I’ll attribute the Japanese resurgence. After that, what happens next?

For starters, unsung headlines on Thursday morning spoke of new government loan guarantees for California solar projects. A company I’ve ridden up twice in the past two years, First Solar (FSLR), opened +8% on the news. This is the domestic alternative/renewable energy revolution I’ve been talking about. The US Treasury reserved a little [big] part of the American Recovery & Reinvestment Act in 2009 for the Department of Energy to transform itself into the world’s biggest Venture Capital fund. (Read all about it in my Bookshelf, where I’ve stored a Time Magazine article on the topic.) In 4q2010, I wrote a long piece for SeekingAlpha about the potential of that initiative, and it’s finally coming to fruition.

The DOE has 25% of its alternative/renewable energy seed capital still waiting to be deployed. Offseting the effects of discontinued monetary easing (QE2), this kind of fiscal stimulus could get the US through 4q2011 under investor optimism. It ignites the economy’s engine and rears organic growth. (It’s government investment that should have come in smaller doses across 2002-04, when it would have kindled innovation. Instead, unnecessary Fed easing promted the proliferation the shadow banking system.)

Without strong population demographics and without a trade surplus, America can only find organic growth in innovation. The last time America had such innovation was the technology boom between 1995-1999. Coincidentally, that was a period of strong Dollar/strong stocks correlation–a rare feat which we should see replicated throughout the coming months.

S&P 500- Intermediate-term Bullish, but Japan Bullisher Now

At the end of last week, I mentioned my long S&P 500 ETF (SPY) position, which I later qualified with the expectation for a rally to the 2008 resistance around 1425. Well, I sold SPY at the top of Thursday’s rally because “rally is too far too fast.” I reallocated into the Japan ETF (EWJ), a lower-risk/higher-return opportunity in equities. Look at the overlays of SPY v. EWJ:

EWJ v SPY daily- SPY at the top of its trading range with the threat of bearish momentum divergence. EWJ shows no such reservations, with room to run north and an $10.75 resistance to fill gap.

The weekly chart shows Japan poised for a blockbuster 3q11, with EWJ ready to fill the gap all the way back to its pre-crisis level above $11:

EWJ weekly- bullish indicators & bullish MA cross are harbinger for rally back to pre-earthquake levels.

In a matter of a few quarters, the S&P 500 (SPX) will outrun Japan indices. For now, SPX has a few hurdles en route to my 1425 target, even though it’s back above its last Fibonacci retracement level. I’ll be sure to take notes in 3q11 about the hand-off from Japanese stock leadership to American.

Interest Rates- Wait for Bear Flattening

One of those hurdles for SPX originates in the bear flattening of the yield curve. One of our biggest money-makers in the first half came from a precise, contrarian call on falling 10-year rates. I had also expected short-term rates to start rising at the end of June. While 3-month Treasury yields (IRX) spiked a few times this past month, nothing lasted, and I found no confirmation in the charts that allowed us to capitalize on the ebbs & flows at that front-end.

I’m growing more comfortable with the flow of IRX as we turn the page into July. My original call on short-term rates kind of jumped-the-gun, because today’s IRX is still following its QE1-end analogue, just on a 3-month lag:

IRX (03.2010)- QE1 end

IRX (06.2011)- QE2 end

I attribute that lag to fear & the Fed’s extraordinary presence at the front-end of the curve. The crisis in Europe has diverted a lot of activity in the interbank market into short-term T-Bills. Perhaps my focus on the interest-rate risk among American banks distracted me from the trump of global macro currents. I still expect a rising tide here when the Fed stops its purchasing (July 1). It’s not so much the absence of a buyer, the Fed, that makes me restless in short-term T-Bills; it’s more my expectation that Ben Bernanke will have to raise the rate he pays banks on their excess reserve deposits to avert a run on the Fed.

Moving on, recall the spot-on analogue of 10-year Treasury rates (TNX) from the end of each QE1 and QE2. I’ve updated it here:

TNX (03.2010)- QE1 end

TNX (06.2011)- QE2 end

Up until the last week of the quarter, traders piled into T-Bonds. They were likely prompted by the same analogue I followed; I bid a confident “likely” because the move started even further in advance of QE2’s end than the analogue dictated. I fully expected that, and I caught the entire rally from bottom to top. (The leads & lags in these analogues burns a lot of traders who bid in size. Morgan Stanley’s fixed income prop desk got burned recently by mistiming a flattener trade. That’s why it’s so important to enact thematic trades only when the technicals confirm a timely entry point.) Keeping with the theme, the chart tells me that long-term yields will continue bouncing up for a few weeks before resuming their decline. Not only is the 20-year+ Treasury ETF (TLT) getting sucked into a classic Head & Soulders, but 10 & 30-year yields are flashing technical signs of resuming the upward trend (consistent with my analogue). Both are bearish for short-term T-Bond performance, yet a buying opportunity should arise around the August 2nd Congress debt ceiling vote. As this chart of the 30-year yield (TYX) displays, long-dated yields will continue to fall in the disinflationary channel they’ve been caught in since the Volker Fed (1980s):

TYX monthly (1994-present)- Disinflationary channel

You won’t see TNX & TYX break that trend until the technical indicators in the monthly charts extend the bullish divergence that’s started to mount.

2011’s Home Run- EMU Dissolution

Markets don’t operate in a vacuum. Rather, every market is interdependent. Every node of this Outlook passes a test of interdependence consistency. That’s a huge plus. When I go to work on a global macro puzzle like this, there’s nothing worse than completing the jigsaw but having an extra piece leftover that just doesn’t fit. No such anomaly remains here.

Throughout the calendar year, we focus on preservation of capital, picking up a few extra dimes along the way. More often than not, our patience is rewarded when we find ourselves batting with bases-loaded. Preservation of capital with intermittent grand-slams makes for legendary risk-adjusted returns. The Euro’s decline is one such RBI opportunity.

The Euro rally is tired. Fundamentally, the fringe states cannot survive with such a strong currency punishing their international competitiveness. Either Germany relents or the fringe collapses–by hell or high water, EURUSD falls from today’s precipice:

EURUSD weekly

That gambit checks out according to the technicals in the chart above. Therefore, I wanted to know how to capitalize on that macro theme–whether it be a total disintegration of the EMU or just a Euro bludgeoning. So, I turned to the example of the UK’s FTSE 100 (UKX) from the wake of ERM dissent. Here, I show an overlay of UKX v Pound Sterling (GBP) from 1992:

UKX v GBP- Black Wednesday (9.14.1992)

Note the obvious plunge in GBP coupled with a [well-documented] rally in British stocks. Here’s a tighter view of that equity gap up on Black Wednesday:

UKX- Black Wednesday (9.14.1992)

It’s terrific to have the UK as a guide through the mess of currency bloc dissolution. It’s more terrific to know which Eurozone member will defect first in today’s sequel. While Greece & Ireland appear content to accept indentured servitude, my guess is that the Spanish have the resolve to defect from EMU before they’re enslaved in a forced austerity too. With 20% unemployment and an insolvent banking system, Spain has drawn my attention. Italy still wrestles with decades of political & economic ineptitude that pre-date all currency unions. There’s not enough angst among Italian citizens to stir the pot; they will fold next–something I’ve compared to AIG given the systemic exposure. Thereafter, Spain has the riots. It also has resentment for the EMU. The Spanish hold the single currency regime responsible for their trade deficit, their real estate boom/bust, and their international political subordination.

Shorting the Euro against the Dollar might yield an RBI double. Trading in the fray of Spain’s defection from EMU might yield a grand-slam. I will watch technical hints from Spanish stocks & bonds.

–Romeo

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  1. A big question in my mind: would Spanish defection from Euro be deemed a default (“credit event”) by ratings agencies? I think it would, since repayment of liabilities in another currency (Spanish peseta) is a breach of the sovereign’s contract with bondholders.
    That makes the EMU a lot different than ERM–something I will keep in mind when using the UKX analogue from 1992. Even though the sovereign bonds would be in default, the principal & interest should continue to flow; consequently, I don’t expect credit markets to cutoff Spanish access. With that bullet in the chamber, keep in mind that I’m looking to buy Spanish EQUITIES if the country were to leave the Euro. As long as Spain can access liquidity, I think the analogue to UKX fits.

  2. […] nobody left to bid over the next days/weeks, the downside is the most probable detour from here. My Outlook remains the […]

  3. […] JPY breached that support once during the earthquake 1q2011.  The BOJ stepped in (as it has in the past) to weaken JPY in defense of its exporters/competitiveness.  I shorted JPY last time we touched that threshold, but this go-around looks more conducive to continuing the rally.  With traders challenging the BOJ to act, I find no high-probability opportunities here, so I won’t trade this breakout.  As an important variable in my UUP long position @ $21.39 on 7/6/11, I have to follow this JPY breakout.  (See USD Outlook.) […]

  4. […] wanted to update the progress of my Japan ETF (EWJ) position.  Recall my comments (everything accounted for in real-time over at StockTwits): I sold SPY at the top of Thursday’s […]

  5. […] atmosphere for small business hiring. All are bleak for 3q2011, but corporate America’s magic formula suggests we weather this quarter’s layoffs to reach next quarter’s inventory […]

  6. […] 3.55, but it will test lows near 2.90 in a matter of weeks-months, which is also consistent with my mid-year Outlook. Crazy, I know: TYX daily- perhaps a relief rally up to 1st resistance at 3.80, 2nd at 3.90 is […]

  7. […] Fed Funds Rate easing. I’ve also kicked & screamed about the long-term impotence of monetary manipulations–especially given America’s ZIRP […]

  8. […] the Euro (EUR) on the brink, I don’t think I need to offer any more corollaries.  Check my full explanation from […]

  9. […] in the 1990s, she’ll do it again today,’ I pitch my counteroffensive, which I’ve maintained since the start: the European Monetary Union will disband.  The EU-17 should prefer to disband, but […]

  10. […] short selling ban on financials, and we’ll see it again in Europe’s.’ I’ve cited the same notion in regards to currency pegs a la the Asian crisis, China’s Yuan, and the ERM: […]

  11. […] companies restock inventories for a third time since 2009? That’s been the America’s “magic formula” since the crisis began: margin expansion>inventory build>margin expansion>etc. In […]

  12. […] companies restock inventories for a third time since 2009? That’s been the America’s “magic formula” since the crisis began: margin expansion>inventory build>margin expansion>etc. In […]

  13. […] The only false signal I’ve included in those charts above is 1992′s Black Wednesday dissolution of the ERM I. In that instance, US Treasury markets rallied markedly in a safety-trade, but VIX and SPX hardly […]

  14. […] the realists are in control. These creditors are reverting the Greek market to its fundamental attractor, a locus toward which all markets are eventually drawn by the laws of gravity. (The EMU’s […]

  15. […] addition to that top-down assessment, I’ve also discussed the growth recipe for American companies on a microeconomic scale: Since the 2009 bottom, the microeconomic growth […]

  16. […] I’ve maintained some position in the US Dollar ETF (UUP) since last summer, when I expected DXY to rally from <;74 to its 82 prime meridian. 11% later, mission […]

  17. […] my ERM I/Black Wednesday analogue, the sudden withdrawal of a core nation like Spain from the EMU could lift the pall from atop […]

  18. […] positions us at the same hinge upon which the world swung on the eve of ERM I’s dissolution: Black Wednesday, […]

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