Juggling Dynamite

Friday was a fresh record close for the TSX composite. Ending the day at 14,984, the broad market composite has now breached the previous peak marked last October and January. To be bullish from here one needs to believe that stock markets have now fully discounted world recession and credit crunch fears and have at last launched into the next bull market expansion in stocks.
Maybe they will. I wish I could believe this. My belief of course is irrelevant, only time will tell; but critical thought prompts us to look deeper than just the record close headline, and so we should look closely at underlying sectors for insight on present strength.
As I have noted in the past, the TSX 60 Index is overwhelmingly driven by the movement of its three main sectors Financials (29.45%), Energy (29.11%), and Materials (18.73%). The 60 largest cap Canadian companies that comprise the TSX 60 are the most relevant benchmark for our investible market, and in total the above three sectors account for more than 77% of the TSX 60 market cap. These sectors have undoubtedly been the patrons of our strong Canadian market gains since 2003, so their fate from here will be strongly indicative of our future market action.
When we break these main sectors down, we find that the all time high on the TSX this month has been heavily driven once again by energy and materials prices. Financials have continued to lag and have so far not yet broken out in a new up trend. And here is the rub, the higher energy and material prices go the worse it is for the rest of the economy including the profitability of the energy and materials companies themselves as their costs balloon and their production slips.
With oil nearing $130 a barrel, energy prices are scaring all but the most aggressive traders. Many that have been professional oil traders for the past 30 and 40 years are shaking their heads and warning that prices at present levels have gone too far too fast. Traders are estimating that anywhere from $10 to $70 of the present price is based on pure momentum speculation that prices will go higher still. See Oil Prices: Wall Street's game. This type of action brings concerns of a “bubble” forming.
Even in the US, if one strips out Exxon, Chevron and ConocoPhillips, profits at US companies are at their worst level in a decade. Without the profits from oil producers in the past 2 quarters, profits in the other S&P 500 companies tumbled about 30%. With data suggesting on-going economic weakness in the US and many other countries around the world, more earnings downgrades seem likely over the months ahead. See Oil Producers Mask Decade’s Worst S&P 500 Profit Drop.
At some point in this economic down cycle, demand slack will ultimately dent commodity prices. At the same time, the US 10-year Treasury yield having been negative in real terms for many months is now about equal to CPI. Negative real yields were another leg in support of the recent commodity price boom, positive real yields will also help shift capital out of commodities. The trouble is that historically commodity price corrections (even within secular bull trends) have been sudden and dramatic. History offers us our warning here, we must govern our animal spirits accordingly.

The Canadian TSX Index pushed up to 14,700 today for its third pass at the all time high reached last summer. The question for the week is whether buying momentum will now be sufficient to break through to a fresh up leg on convincing volume or whether this time will prove a triple top formation acting as resistance as it did in July and November. Only time will tell.

The main drivers this morning were oil and gold. But oil did a major about face and fell mid-day after a stream of negative economic data underlined that slowing growth and spiking inflation are inflicting economic stress around the world. The on-going “disconnect” between recently soaring equity markets and relentlessly plunging economic data is nothing if not striking.
Today the Organization of Economic Cooperation and Development (OECD) warned that the composite of leading economic indicators (CLI) show the economic downturn in the US is truly going global. See OECD warning as stagflation goes global.
“The OECD's early warning signal is flashing clear signs of economic weakness across the world, with mounting evidence that China, India, and Brazil may soon succumb to the downturn. The closely-watched gauge — known as the Composite Leading Indicators (CLI) — has picked up a sharp deterioration in the eurozone in March, notably in Italy and France where the advance signals are falling even faster than in Britain. The measure tends to anticipate the industrial cycle by about six months.”
Even in emerging markets, building inflation and slowing demand is starting to hamper business confidence. Of the rising powers of Brazil, Russia, India and China, only Russia continues to boom.
Prices across the emerging world are reaching levels that threaten stability and force governments to raise interest rates even in the midst of falling growth. Global stagflation has been an underlying rumour for many months now but recently inflation rates spurred by the weak US dollar and spiking commodity prices are increasingly difficult to ignore:
Reported inflation rates: “Venezuela (22pc), Vietnam (21pc), Latvia (18pc), Qatar (17pc), Pakistan (17pc), Egypt (16pc) Bulgaria (15pc), The Emirates (11pc), Estonia (11pc), Turkey (9.7), Indonesia (9pc) Saudi Arabia (9.6pc), Argentina (8.9pc), Romania (8.6pc), China (8.5pc), Philippines (8.3pc), and India (7.6pc).
Many of these countries are now suffering the worst prices spiral in thirty years, setting off widespread riots. India's government has suspended futures for a clutch of key commodities as states resort to draconian measures.”
Very interesting times we live in. The next US President is likely to be the one that promises more than lip service to a strong US dollar. Paul Volker, the infamous inflation-fighting Federal Reserve Chair that brought the last high inflation period of the 70’s to an end, has recently endorsed Obama for President. My thinking: Volker is exactly the guy I would want to mentor me if I were trying to steer US economic policy over the next 4 years. Today, more than ever, we need the old guys with real life experience in these conditions to help navigate our generation through current hurdles.

Decouple this.
The US is in a recession which is likely to last for another 12 months with slow growth for some time after that. Yes, you say (yawn, yawn) we know, but the rest of the world is going to keep the demand bus rolling, right? Time will test this theory, but so far it is not looking supportive of “decoupling” pundits. All around the world, economic data is continuing to disappoint the unprepared.
US economist Nouriel Roubini, (although last year considered fringe for ominous warnings, was this week named one of the top 100 intellectuals in the world), warned again yesterday that the ongoing US slow down will continue to dampen growth in other parts of the world and in China:
“China is cushioned by domestic demand and should avoid a hard-landing, but it will still see economic growth slide to 8% or slightly below, Mr. Roubini said, ending four years of more than 10% growth.
The U.S. housing recession is the worst since the Great Depression and house prices, which have fallen 15% from their peak, could be down 30% from the peak by the end of 2010, he said. That will hurt consumption, and once the recession becomes evident, there will be defaults on bonds and corporate and personal loans.
The severity of the U.S. slump will, in turn, trigger a recession in Japan and in parts of Europe as housing bubbles have burst and a strong euro hurts exports. In Asia, weak global demand will cause a severe economic slowdown, though not a recession, as exports and financial markets are hit, he forecast.”
One upside benefit of this will be that faced with reduced exports and muted growth, China will be less likely to exasperate its slowing by allowing the Yuan to rise. This could help prevent at least a near-term collapse of the US dollar that some had feared. However the implications for the world economy over the next year seem ominous:
“The risk of a collapse of the U.S. dollar is limited because demand from sovereign wealth funds is strong and if (China stopped buying U.S. dollar assets) the yuan would rise,” he said.
Mr. Roubini said further interest rate cuts will enable the United States to emerge from recession by mid-2009.
See: China not immune from US slowdown: http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080508/REG/499857720/1036