(By Darrel Whitten) Despite all the gloom and doom about the Eurozone crisis, the U.S. fiscal cliff, slowing China growth, and "crisis of confidence" on Wall Street, the S&P 500
continues to recover and climb a wall of worry, after holding comfortably above the 1,250 level in the recent sell-off below its 200-D EMA. Signals of more concrete action by the ECB as reflected in Mario Draghi's "we will do whatever it takes" speech, and in continued high expectations that the Fed will be compelled to move again by the end of September, has kept the equity shorts/bond vigilantes at bay for the time being.
But a closer look at Spain 2-year bond yields versus 10-year bond yields shows traders bidding the 2-year down 270bps from 6.0% to 3.3%, while the 10-year bond yields have moved much less, implying continued concerns regarding a longer-term, lasting solution.
Not Very Enthusiastic Participation
|Spain 10-Year Bond Yields|
Trading volume in U.S. equities is tepid and individual investors are basically a no-show. About $171 billion has flowed out of equity mutual funds over the last year, according to the Investment Company Institute, while some $208 billion has flowed into the bond market over the same period. The fact that so few long-term (individual) investors are in the stock market has exacerbated already HFT-heavy volatility, since it often seems as if the only people who are trading stocks are the professionals. But the apparent apathy of retail investors toward individual stocks may also be a reflection of them investors just giving up on trying to make intelligent calls on individual stocks and parking the money mainly in U.S. equity ETFs as well as bond ETFs, which is much simpler.
|Source: Bianco Research|
While there appears to be a high central bank action expectation factor at work, the Citigroup economic surprise index also indicates the economic news could begin to become more positive, or at least not as bad as feared. Goldman Sachs for one believes the recent economic data point to a modest improvement in US growth. They cite, a) a housing recovery that is picking up steam, b) a continued recovery in real disposable income, c) better financial conditions as measured by the Goldman Sachs Financial Conditions Index. Better-than-expected-non-farm payrolls added to this conjecture.
|Hat-Tip: Pragmatic Capitalism|
On the flip side of the stock rally is long-bonds and USD, which are both taking a breather. The dip in the TLT index below its 50-day EMA suggests more than a touch-and-go correction.
Energy and Industrial Sectors See a Strong Bounce
The S&P 500 has been buoyed all along by consumer durables and consumer discretionary, but the sharpest gains since July have actually been in energy as well as industrials, suggesting those actually buying stocks are not as bearish about the economy as blogsphere chit-chat would have you believe, and that a "risk-on" component has definitely returned to the stock market.
Risk-On, Risk-Off Groups are Splintering
From a different perspective, market action has splintered from the simplistic "risk-on, risk-off" shifts seen over the last couple of years. In the risk-on camp, the S&P 500 financials has clearly been leading, although the more recent movement in commodities has been much sharper because of soaring agricultural prices and the impact of geo-political unrest on crude prices.
In the risk-off camp, income-producing REITs have been the clear winner, as interest rates don't look like they are going anywhere in a hurry, and there is evidence of at least a bottoming process in the U.S. housing/commercial property space. On the other hand, gold has been a major laggard.
More Divergence in the Emerging Markets
There is also increasing divergence in the emerging markets space, with the MSCI EEM basic of emerging markets responding well to the latest risk-on shift, while China's Shanghai Composite continues to March to the beat of a different, bearish drummer.
While there is still insufficient evidence of a sharp slowdown in China's economy, foreign investors don't trust the economic numbers coming from China, and government efforts to re-stimulate the economy so far appear half-hearted. If the trend of the Goldman Sachs/NBS leading indicator of China's economic activity is to be believed, the slowdown has been quite dramatic, and almost as dramatic as the prior slowdown, even though other developed and even developing nations would mortgage their grandmothers for the absolute level of growth that China is still producing. Eurozone's Problems Run Too Deep for Even a ECB Silver Bullet to Fix
Even if Mario Draghi can make good on his promise to "do whatever it takes" to save the Euro, the Eurozone's problems run too deep for even an ECB QE silver bullet to fix. This is becaus one-sided funding via state-controlled banks and central banks will still inevitably lead to high debt-to-GDP ratios and a downhill vicious cycle of recession. Europe will not be able to bring Spain and Italy yields sustainably down to 4% anytime soon, and even if they could, it wouldn't be enough to get Spain and Italy out of financial trouble. As PIMCO's Bill Gross points out, interest rates over and above each country's nominal GDP growth rate will inevitably add to a country's debt as a percentage of GDP, even if budgets are in primary balance. At current yields, growth rates, and deficits, the spread may incrementally add 2-3 percent to Spain and Italy's tenuous debt ratios.
Thus the Eurozone crisis is likely to be with us for a long while, characterized by long periods of dismay, and only temporarily interrupted by flashes of hope that produce "dead cat bounces" in oversold EUR and Eurostoxx Banks index levels. As the secular trend remains down, generally avoid Euroland, and if you must, trade the bounces with eyes wide open.
While More Exposed to the Eurozone, UK Stocks are Outperforming Japan
It is interesting to note the contrast in the performance of the U.K.'s FTSE 100 to Japan's Nikkei 225. The FTSE 100 has noticeably outperformed the Nikkei 225 even though the U.K. is slipping back into recession and is directly exposed to the Eurozone crisis. Conversely, Japan's economy and corporate profits are recovering from the March 2011 earthquake disaster.
The main impediments keeping the Nikkei 225 in the doldrums vis-a-vis the U.S. and the U.K. are, 1) the continued strength in JPY, particularly against EUR, 2) the high dependence on trade with China, whose import demand has dramatically cooled, 3) the transitory nature of the "Tohoku bounce", and 4) continued heavy structural net selling by domestic institutions.
Flush with cash from middle east sovereign wealth funds and pension money fleeing the Eurozone crisis, GBP-based investors have shown much more interest in Japanese stocks because of the substantial appreciation in JPY vs GBP. Between Q3 2010 and Q3 2011, JPY appreciated nearly 20% against GBP, and has seen a more substantial appreciation over a longer period of time. Thus for GBP-based investors, just having flat Japan stock prices resulted in nearly 20% gains. In terms of total GBP-based returns, this meant strong 40%+ gains in a GBP-denominated Nikkei between December 2011 and April 2012. Unfortunately, the capital gain portion has since been all but completely erased. On the other hand, when viewed in USD terms (such as the EWJ MSCI Japan ETF), there has been no currency kicker to speak of .
|Source: Pacific Exchange Rate Service|
Looking at Japan equities performance by size, it is interesting to note that the Nikkei 225
is now the best performer, closely nosing out the JASDAQ
in the past weeks. The large-cap Topix Core 30 remains a heavy burden on Tokyo stock prices, as it is populated by the oligopolistic electric power companies as well as the big cap electronic majors now in such deep earnings trouble, like Sony
(6758, SNE) and Sharp
(6753), whose stock prices are at multi-decade lows.
Looking at the year-to-date best and worst performers in the Nikkei 225, there is a dramatic divergence even in sectors. For example, the semiconductor related stocks like Advantest
(6857) and Nikon
(7731) are up well over 20% YTD, and essentially all of the real estate majors, Sumitomo Realty
(8830), Tokyu Real Estate
(8815) and Mitsui Fudosan
(8801) are up between 34% and 20% YTD, while stocks like Sharp
, Kansai Electric Power
and Asahi Glass
have virtually imploded. The whole market is again selling under stated book value, but heavy losses in companies like Sharp mean equity in some cases is seriously at risk, and therefore historical PBRs do not fully account for the rapid equity erosion--meaning a not insignificant portion of the Nikkei and Topix are value traps.
While most international/global portfolios already have only a smattering of Japanese names left in their portfolios, we continue to see the Japanese stock market as a very selective market of individual stocks, not a stock market.
Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email firstname.lastname@example.org