Spotted a strange conviction-based FT article from a week past today. The author believes we’re in the middle of a new bull market (’stage 2′) and it’s really just a question of when we begin the next move up…

In conclusion he says we shouldn’t panic because of the following 3 ‘key positives’:

In recent decades there has never been a US recession, or double dip, when US companies have been throwing off spare cashflow nor when the yield curve is steep (signalling an ongoing recovery). US recessions are driven by the retrenchment of the corporate sector in response to shocks. When companies are cashflow rich, they are resilient to shocks.

We already had the recession. What we are in now is a period of long drawn out malaise in which businesses that have cash use it defensively (before governments find a fiscal method of extracting it to service their own debts) and those whose job it is to supply the credit grease that keeps the system ticking over – decline from doing so to meet similarly austere measures from a government with nothing left to give.

Despite some renewed balance sheet stress, credit conditions globally are easing, especially outside Europe, as banks have recapitalised in recent quarters and as evidence of the turn in the credit cycle continues to emerge

The credit default markets still tell us it is more likely Greece defaults than not. Euro banks non-take up of ECB emergency funds notwithstanding, looking at the corporate market new issues have dropped off dramatically of late. The fact is credit conditions are abnormal and no sane person is saying this will go away overnight.

Growth in emerging markets remains robust – in particular in China; Chinese leading economic indicators, whilst slowing, remain in an uptrend; most importantly Chinese monthly lending growth rates have picked up from the slowdown in the second half of 2009.

One of these leading indicator’s was revised down sharply before yesterday’s opening, highlighting the difficulty not only in interpreting this data but it’s integrity. Is it just me or are revisions to prior data readings becoming increasingly pronounced?

Granted it may well be a sign of uncertain times.

So I’m sceptical of the case for the bulls, if the above is it. But pertinently if what a lot of the optimists are saying is true – that corporates have got rid of their supply overhang and are preparing for a new cycle – where are all the jobs?

On Friday I questioned the validity of relying on a single, relatively unreliable and untested measure as a leading indicator. At the risk of sounding like an economist that is not to say I disagree with the conclusions made.

Indeed watching the UK consumers’ response to their emergency ‘austerity’ budget may be a useful predictor for the likely US retrenchment, whenever Obama decides (or more likely, is forced) to follow suit.

Though rather than being a function of the consumer, there is a case to be made that the next major index movement will come from a government’s inability to pay it’s bills and hence stopping the stimulus-led consumer ‘growth’ story in it’s tracks.

Debt Induced Recession

First off is an article from Sunday’s Telegraph that points out the cost of hedging against Greek default is more expensive now than at any time since the current crisis began. And that’s with massive European intervention.

Then there is the US itself, where in California alone spending must be reduced by a sum greater than Greece, Portugal, Ireland, Hungary, and Romania combined. 45 other US states have budget deficits to cut by this time next year. Obama at the surprisingly low key G20 summit appeared to bow to pressure from other world leaders to move to cut budget deficits by half inside 3 years.

Does anyone really believe this will happen?

Gross American debt is predicted (by the government) to hit 100% of GDP by 2011 – over 15 trillion dollars. The painful fiscal tightening that any attempt to reduce this – no matter how hollow – will when taken with similar tax objectives from individual states, likely precipitate a substantial fall off in GDP growth. Hastening such a scenario is the ending of the existing Bush-era stimuli such as extended benefits in July. Housing has already been shown to have retrenched following the New Home Sales tax credit scheme shutting down.

Lack of demand points to deflation and this points to more expensive debt servicing and a final slip from recession into acknowledged depression. But the longer Quantitative Easing is pursued, the longer the money is printed, the bigger this final reckoning will become. Ultimately the Fed’s unwillingness to accept the Business Cycle is the chief obstacle in this war against the inevitable.

But all the signs are there that the market thinks we’re closer to that tipping point than is currently being reported.

“When America sneezes the UK catches a cold.”

Such has been the accepted logic in financial markets for decades now. The logic being that as our largest trade partner outside of the EU – together with it’s sheer scale – it’s health directly affects the well being of companies on this side of the pond. A one-way heuristic that may well be about to be reversed at least temporarily.

With Obamaland now inevitably looking at austerity measures similar to the other nations with unsustainably high budget deficits, the fact the new UK coalition government has already embarked on an emergency cost-cutting budget will perhaps be useful in analysing future US index movements.

The effects in the UK of increases in tax – VAT – and the cutbacks to runaway public spending will be watched keenly by the market to see it’s effect on consumer demand. Sentiment shows a nervous market – the FTSE has dropped 200pts since the budget accouncement last week. But it will be a few month before the effects begin to filter through from the consumer frontline.

This will still be a long time before any related measures are taken on the other side of the Atlantic – commentators and government alike seen the UK cutbacks as ‘unnecessary’ despite their own dire financial situation – so it seems natural that the first port of call for insight on likely equity movements will be towards the FTSE back in the UK.

I don’t read too much into Mark Hulbert’s commentary over at Marketwatch. Although a contrarian he chooses to place a large emphasis on correlations that simply do not stack up imo.

Take for example the Dow Theory, a dated system that makes judgements based indicators one of which is divergence of Dow Transports Index from DJIA – begging the question why would Transports nowadays have advance knowledge of the market demand any more so than the producers they service? Producers have whole departments dedicated to forecasting demand for their goods. By the time a profits warning comes in at Transports you can be sure producers have already given appropriate guidance on their expectations. It’s part of market listing regulations.

Obviously when the Dow Theory was being developed markets were not quite as developed. So why use it today? Smacks of column filler rather than serious financial insight.

However he’s completely correct when he calls out the current chorus of praise by analysts for a leading indicator known as the ECRI WLI. It’s not the value itself that’s being lauded as ‘prescient’ by the investment community but the growth rate – which currently stands at -4.7% with a value of -10 a near certain sign of recession (and in this market’s parlance, the advent of the 2nd downer in the double dip).

Never mind the fact only 3 out of the last 7 -10 readings has the WLI actually succeeded in being a leading indicator of government recognised recession, Hulbert makes a more pertinent point. That relying on a metric that only has been backtested 7 times is completely useless in a statistical analysis. It’s one of the fundamental problems with market analysis today. The other – seeing correlation in numbers regardless of relationship – being Hulbert’s main weakness, but more about that another day.

Like most financial models, this is fine when in median times. We’re not in that comfort zone yet.

So what happens when a historical anomaly upsets the apple cart? Who knows. We could compare it to the Great Depression, but it would be incorrect not to point out the massive government intervention poured into the economy this time round has not skewed realities somewhat. This may still, somehow & unbelieveably, work out. Upbeat future guidance is an interesting quirk of a variable to be gauged over the coming earnings season.

Massive and sustained job losses will stop a recovery. Governments have already thrown everything we’ve got at it. We are not immune to what may turn out to be government mismanagement. Future growth has been mortgaged in this respect.

So if things do go the way of the early 30s – the development of a 2nd dip – the warning sign to watch will be more job reports like those of last week.

While the usual sources of financial infotainment were puzzled at the pullback – citing an absence of negative macroeconomic news – this is in fact a telegraphed “the rally has run out of steam” message. Trader sentiment changes as a function of time, and it is this inability to read the same data consistently that has the greatest impact on market direction beneath the long-term trend. So people have had enough of drinking the government-led recovery Koolaid for now.

What we then look to are combat indicators giving us signs of whether indeed everyone sees this and are still prepared to presevere with a contrarian rally – “climbing the wall of worry”. In such an event watch for a sharp drop as sellers get out quick followed by an equally sharp rebuttal as traders look to get in on the next leg of the rally.

The 2nd scenario is that this is indeed the end of the current rally, whether it then plays out to be a bear market one or the first phase of a recovery would remain to be seen.

So keep an eye on this throughout the week, my thinking at the moment is we’re seeing the beginnings of a summer pull back based on low volume and lack of strong recovery numbers.

Ignoring the earnings reports which ‘beat forecasts’ – when you have analysts dropping expectations to nothing that is not an argument to buy shares – the reasons I believe are twofold: An outbreak of Obamamania together with a fall in dollar Libor.

3-month Dollar Libor stands at 1.02 percentage points. It’s fall has been inversely proportional to the rise in the stock market. It may be that bank share prices have been hit so bad their market cap was having a direct effect on their liquidity, maybe even solvency. So the rising tide floating all boats scenario we have seen unfold over the past month has allowed the interbank lending rates to come down. Although it has much to fall to get to the perceived normality of 22 basis points prior to the crunch.

Obama has weathered the storm of expectation and disappointment in his first few months quite well. His finance team seem to be blundering along ok, accompanied by the rest of the Wall St walking wounded. Nobody seems to have wrapped on the general bail out everything at all costs world consensus. That seems to be doing the trick.

But for how long will this sense of benign calm last? The automakers are racing for bankruptcy sometime this summer, the banks look nowhere near ready to remove themselves from their recapitalising drip feed & economic numbers aren’t getting any better. There is also a whole host of other issues with game-changing potential. I believe Libor & consumer sentiment are leading indicators but while they have no doubt improved they are still bad.

From a trading point of view there will be plenty of time to catch the resumption in bear-related activities. Likewise if the governments really have managed to shock the economy back to life with their debt mountains the return to pre-Crunch levels (Dow 9000 for me) will not be a quick one.   Lets just sit this one out for now. 

Update: The eventual failure of this rally appears to be telegraphed by most reliable commentators. I’m sure many are looking to the stress test report out next week to maybe provide a catalyst for a reversal. I don’t think this will happen. The expectation is that it will require more bank fundraising. No surprises there. And surprises are what will take this market down.