11-23-2011

The Commerce Department revised our US 3rd quarter GDP downward to 2% from a previously reported 2.5%, off by 20%. The DOW ended lower for the 5th day in a row. Total volume was down across the board as expected due to the holiday week.

The flight from riskier assets into bonds and money markets continues. However, how long will this last? My bet is until Bernanke formally announces more stimulus and Europe comes up with their solution.

I know investors, especially older investors, are looking for income. But going forward bonds will not be the right answer.

At the risk of stating the obvious, I want to be sure readers understand the inverse relationship between bonds and their respective interest rates, or yields. As interest rates go up, the prices of bonds go down. Conversely, as interest rates go down, the prices of bonds go up.

Thanks to our Federal Reserve, interest rates are close to historic lows. The long term (dropping) interest rate cycle that began in 1981 is coming to an end. Over the longer term, interest rates have nowhere to go but up.

There are two main driver of interest rates; inflation and risk. If inflation rises, investors demand a higher coupon to offset inflation. This is known as the inflation premium.

Risk also drives interest rates. If investors perceive higher risk, they demand a higher coupon to offset the risk. That is why “junk” bonds pay a higher premium than investment grade bonds and this is known as the risk premium. Taken collectively, these premiums will determine the interest rate for a given bond.

Deflation is normally good for bonds as it makes your interest payments and principal payments hold or even increase purchasing power. As other asset prices are going down, you payments can buy more stuff. The question I have is will this common knowledge during these uncharted times hold true, especially for sovereign and government bonds.

As the global economy slows, tax revenue will decline greatly diminishing the ability for governments to pay back their immense debt loads. This is what the debt crisis is all about. Governments have been covering as well as they can, but the dam is about to break.

There are only two solutions; spend and print (increase debt even more) or drastically cut spending. The solution most governments and central banks will take is to try to spend and print their way out, causing massive inflation. This, in turn, will cause interest rates to rise naturally and be bearish for bonds.

If governments take the honorable way out cutting their budgets, they will slow their economies even more to such a degree that their tax revenue will go way down. Then they will be unable to service their debt making their bonds much riskier to hold. This, too, will cause interest rates to rise as investors demand a higher coupon and many will sell their bonds altogether.

This is the Hobson’s Choice we have been talking about. The next bubble to burst will be the bond bubble. Do not get caught in this Bond Trap. Do you want to be early or late?

If you own individual bonds, you need to begin phasing out of them before there is a rush for the exits. Once it becomes apparent interest rates are rising (and it will happen quickly) there will be a dash for the exits. Individual bonds will be harder to sell and become more illiquid. I would rather be early than late.

If you own bond mutual funds or bond exchange traded funds (ETFs) it will be much easier to exit. You can simply sell the fund as you see interest rates beginning to rise. That said, some bond sectors are already coming under pressure.

Emerging market bonds, high yield (or junk) bonds, and many regional bonds like European bonds (except German bonds) are already selling off in a flight to other bond sectors or cash. This is a “flight to quality” to what investors perceive as safer bonds. The risk premium is driving up interest rates in the above mentioned sectors and their prices are coming down.

But this will happen across all bond sectors once interest rates rise in the overall economy. That is why you need to plan ahead, before it happens.

If you are looking for income, but with protection against inflation, you need to begin looking elsewhere. Your bonds have served you well over the past few years but the party is coming to an end. Yesterday’s newsletter mentioned Master Limited Partnerships (MLPs) which is one alternative. Another alternative is utilities.

The main thing is you need an exit strategy in advance before interest rates begin to rise quickly. Again, the 30 year bull market in bonds will come to an end, probably sooner rather than later.

In overnight trading (Tuesday 9:45 p.m. CST) the Asian equity markets are in the red. Gold is up as in the US dollar against the other major currencies. The US equity futures are also down, and fairly significantly. Concerns over the global slowdown are taking root, let the bailouts begin.

The economic data came out lukewarm yesterday. Initial Jobless Claims rose by 25k from last week, but the moving average appears to be getting a little stronger albeit not enough to make any change in the unemployment rate.

The Consumer Price Index ex Food & Energy (MoM) came out at .2% versus expectations of .1%, and this is the number the media touted as being mild or under control. However, the real number that effects our spending and pocketbook, CPI (including food & energy) came out at .4%. This means our real cost of living just increased by this amount. If you annualize this it is almost 5% assuming it doesn’t accelerate which I believe to be wishful thinking.

In any event, our markets showed resilience in the afternoon. The markets sold off in the morning on the news but then rallied. The DOW, S&P, and NASDAQ ended positive between .2% to .31%. The NASDAQ was the weakest, especially the NASDAQ 100.

Up Volume on the NASDAQ was only 60% and marginally stronger at 67% on the NYSE according to Lowry Research. Total volume has been declining over the past few days especially on the NASDAQ. Breadth was more than 3 to 2 on the NYSE and less than 3 to 2 on the NASDAQ again illustrating the underlying weakness in the NASDAQ.

The weakest sectors are consumer, healthcare, telecom, and financial. The strongest sectors are utilities, materials, and the precious metals. Gold was up almost 2% and silver was up 3 2/3%. Most of the commodities were up with cotton spiking over 7%.The dollar strengthened against the Euro and the Yen. So we did see gold, most commodities, and the dollar go up in tandem today.

Once again I must stress that the market is overbought and the risk is high even though the market keeps trudging upward. Buying has been weakening over the past few days but selling has not come into the market. Without selling increasing, you are not going to get a significant selloff. The key now is selling volume relative to buying volume.

Treasury yields came down today and their corresponding bond prices rose. The dollar strengthening and the “mild” inflation could be one explanation, but I believe there is another.

Remember a few days back I told you that the European finance ministers increased their lending facility (for emergencies) from 250 billion Euros to 500 billion without much explanation. Well, use of the European Central Banks lending facility has also increased dramatically. This is the emergency facility available for banks.

Additionally, credit default swap (CDS) spreads in the financial sector (banks) over in Europe, essentially insurance against default, have been going up significantly over the past week. Something is brewing over in Europe.

This could also explain why there is a “flight to quality” into Treasuries away from European bonds. If you are short Treasuries, be careful in the short term. In the long term, rates are going up, but in the short term, anything is possible.

We need to keep a careful eye out for any news or hints about events unfolding in Europe.

The economic news did not support a recovery yesterday. The Producers Price Index came in higher than expected confirming we have inflation in the production pipeline. Industrial production was down and capacity utilization came in at 76.1%. This does not bode well for employment as companies have no reason to hire until they are closer to full capacity.

Mortgage Applications came out weaker and Building Permits were down significantly month over month. The only positive news, and an anomaly considering the other real estate data, was that Housing Starts were up significantly. One plausible explanation is that people planning to build in the future have decided to build now before interest rates go higher and financing becomes too expensive. Also, building materials such as lumber etc. continue to rise due to inflation. Therefore, sooner may be significantly cheaper than later.

Despite mostly negative economic news, the markets showed strength yesterday after weakness in the late morning. Buying increased along with breadth. Breadth was 2 to 1 on the NYSE and 3 to 1 on the NASDAQ. Lowry Research supports this reporting Up Volume was 69% on the NYSE and slightly stronger on the NASDAQ coming in at 71%.

All technical indicators are still “overbought” and there is elevated risk for new buying at these levels. You may want to hold off on any new buying, but if you decide to buy you should stay with the strongest companies in the strongest sectors. The strongest sectors yesterday were energy, materials, and utilities. Also, with the recent pullback in oil and tensions beginning to rise again in the Middle East, you may want to explore energy companies or an ETF based upon the spot price of oil itself.

Additionally, gold and the dollar are gaining strength. I have attached two graphs, one short term and the other long term, of the SPDRs Gold Shares (GLD) which is an ETF based upon the spot price of gold. You can see it is just breaking through resistance and the trend line. As I write this newsletter, gold is up in overnight trading in Asia.

GLD L-T 2 16 2011

GLD 10 Mo M-T 2 16 2011

I have also attached two graphs, one short term and one long term, of the dollar index based against a basket of currencies. The dollar also seems poised to break through resistance.

Dollar Index Spot DXY S-T - 2 16 2011

Dollar Index Spot DXY L-T - 2 16 2011

Therefore, you may see gold and the US dollar rise simultaneously. This is unusual as gold is priced globally in US dollars so as the dollar gets stronger, gold usually goes down. If this happens, the media will be perplexed but you will know why.

…Now Back to the Equity Markets

The markets had their first across the board weak day in quite a while. The economic data came out weaker than expected both in the US and Europe, and our markets demonstrated their displeasure.

Europe is slowing down especially in the weaker economies of Greece and Portugal, and France seems to be stalling. The finance ministers of Europe have just double the lending facility from 250 billion Euros to 500 billion to help the sovereign nations. Looks like more printing is in store for Europe.

In the US, our consumer spending was less than expectations. It looks like our spending engine too may be stalling.

The good news is that our markets came off their lows of the day and staged a late rally recouping some of their losses. The DOW and S&P both ended down about 1/3% and the NASDAQ about 1/2%. Energy and basic materials, the strongest sectors as of late were the weakest sectors yesterday along with some of the commodity sectors.

Overall volume was brisk and higher from the past few days but selling was not alarming. Lowry Research tells us that Down Volume on the NYSE was only 54% but higher on the NASDAQ at 67%.

One day does not make a correction or sell off and there is nothing yet based upon volume or price movement to indicate a selloff is imminent. However, the market is technically overbought, and if we get more bad economic data and/or investor sentiment changes, selling could accelerate.

We need to pay close attention to over the next few days to see whether this is just a pause or correction, but as always, price and volume will be key. The midterm bullish trend is still firmly in place, thus far it is just the short term that is in question.

I have discussed bonds and interest rates over the past year, but it is so important you understand what is happening. It is vital to your investments. For those of you who completely understand, please bear with me but it won’t hurt to reiterate and take a refresher course.

Additionally, our newsletter subscribers have doubled in the past month or so they may not have heard this before. It is about interest rates, the direction of interest rates, and their effects on your investments.

The long term direction of interest rates is up, no question about it. We may get a short term downward spike temporarily if we got a major event in the Middle East, a sovereign default, stock market correction, or some other global scare. But the long term downward trend from 1981 was over in October of last year.

Since that time, the interest rate yield curve steepened significantly. The yield curve is the relationship between short term rates and long term rates and implies how much risk and inflation investors perceive going forward.

For instance, if investors do not perceive a lot of risk or inflation, long term rates will not be much higher than short term rates. If, however, they perceive a lot of risk or inflation, long term rates should be significantly higher than short term rates. So, the steeper the slope from bottom left to top right with Time on the X axis and Yield or Rates on the Y axis, the more the perceived risk and/or coming inflation.

Do you know what the yield curve is telling us right now? I will tell you. It has become the steepest yield curve in HISTORY, and it has done so in just 3 months (see the Treasury Yield Curve Graph below, especially how steep it is from 6 months to 10 years). This means investors believe there is an extremely elevated level of risk and/or inflation now and on the horizon.

US Treasury Yld Curve 2/14/2011

You can see this in the downward pressure on bond prices over the past few months, especially sovereign or government bonds. Remember your economics class in college talking about supply and demand. Well now we have sovereign or government bond supply, lots of it.

President Obama just announced today that our National Debt was 14 trillion dollars and equal to our GDP. He also said our deficit this year would be 1.65 trillion and that our national debt would soon be over 15 1/2 trillion. This means we have a 100% debt to GDP ratio and getting worse FAST!

This is not sustainable and all it takes is China or Japan to refuse to buy our debt, our interest rates would spike even worse, and we are DONE. By the way, Japan is in worse shape than we are and their debt to GPD is 200%, and their economy is slowing. Japan is already done, it is just a matter of time. How much they eventually devalue their currency is speculation.

Europe is in bad shape too. Italy just had an auction today. Yields were higher and the Italy did not raise all the capital they attempted to at reasonable rates, but the media tried to put a positive spin on the auction.

One example is the Wall Street Journal. They had an article with the title “Italian Auction Bodes Well for Portugal” and stated “Italy sold $7.01 billion of government debt today, nearly the maximum amount it had intended, confirming investor demand. Yields were somewhat higher than previously, but the result still offered hope for Portugal and Spain, which will sell government debt later this week.”

The WSJ is attempting to put a positive spin on this auction, but it was not fully subscribed at the rates Italy wanted. Portugal & Spain have their auctions later this week, and Portugal reported today that their growth slowing – not good.

The whole point is we are having mountains of new, sovereign debt (supply) coming to market quickly and investor (demand) can afford to be choosy. When you have more supply than demand, the price goes down. This mean that interest rates will rise as they already have, and bond prices will go down further.

What does this mean for you as an investor? It means you need to be very careful with any bonds, especially longer term bonds and sovereign bonds. Going forward I would only hold high grade corporate mid and short term bonds.

This is the coming debt collision Dan Cofall and I have been talking about ever since the first bailouts of 2008. It is here and the effects are already being felt with the rising rates.

For further clarification or help in deciding what you should do specifically, feel free to contact me.