Is the current correction over?

Discussion in 'Economics' started by mktreflections, Mar 25, 2007.

  1. Is the current correction over?

    The Standard & Poor's 500 index, a benchmark of corporate America's equity, dropped 75 point from 1449 Feb 27, 2007 to 1374 March 5, 2007, a 5.2% correction so far, triggered by a slide in Chinese shares and warnings by Greenspan that the U.S. economy was vulnerable to a slowdown.

    S&P closed at 1436, As of March 23, 2007, just 13 points short of its open on Feb 27, 2007, retracing 82.6% of its loss since the current correction started.

    Is the current correction over? I would probably say yes, in the sense that the bottoms may have been found on 030507 for S&P, Dow and Nasdaq, So, just about 5.2% correction this time? Probably yes.

    The indexes may test the 030507 low again, but it is very difficult for the indexes to go a lot of lower than 030507. I doubt S&P will make it to 200MA of 1354, about 20 points lower than 030507’s close. (

    The strong headwind against bears are from FA and PA, PA being political analysis.

    Let’s start with Fed.

    Fed, being US central bank, is also a political institution, a part of US government. In my “Fed and three representations”, I talked about Fed’s dual mandate instituted by Congress: employment and inflation objectives. That’s politics right there.

    For simplicity, inflation objective is more important for bond holders. As bond holders, higher than expected inflation is bad, with default being the worst. That’s why on the long-end of yield curve, inflation risk has to be priced. If the inflation turns out to be higher than expected, your bond would depreciate, other things being equal. So bond market participants like Bill Gross cares big deal about Fed’s control of inflation.

    Employment objective is more important for workers like average Joe, again for simplicity. For Joe, with a big mortgage and credit card balance outstanding, he probably doesn’t care much about inflation, and theoretically he could even benefit from it as a debtor: creditor’s loss is always debtor’s gain. But Joe needs a job, and for every Bill Gross, there have to be many Joes, ratio unknown. So, there have to be many jobs around.

    Politics is called “balance of power/interest” sometimes. I guess that’s one of the reasons, House Financial Services Committee Chair Barney Frank told Fed chief Ben bluntly early this year that he opposes a specific numerical inflation objective because it might conflict with the Fed’s employment objective as part of its dual mandate. Ben, being an “data dependent” professor and supposedly one of enthusiasts for numerical inflation objective (ECB’s present target is to keep inflation below, but close to, 2%.) , must be disappointed a little bit. But I think Ben understands the message very well, being an inventor of “Ben’s helicopter” himself.

    A government in a capitalist economy would use its power to provide certain level of employment to the working class. Marx had a gap in his capitalism theory on this issue. He thought the working class in England of his time would have to launch a revolution just to survive.

    To make accomplishing its employment objective easier, US government debased US financial system from gold standard long time ago, and has since then practically put US financial system on a “bond standard”. With Fed’s treasury operation, government can manage liquidity in the system according to its policy purpose. Why tie up yourself to a piece of metal like gold or silver? Why tie up yourself to a particular value of CPI such as 2%?

    Fed’s statement on March 21, 2007 was interpreted by market basically as a Ben Put:

    “At the very least, many take comfort that U.S. Fed Chairman Ben Bernanke appears, like his predecessor Alan Greenspan, to be ready to help with easier money if things get rough or in the event of nasty shocks, like this year's subprime mortgage jolt.” (

    As to inflation, if CPI 1-2% is presumed to be Fed’s comfort zone, why 2.7% cannot be presumed?

    Deng Xiaoping proves to be the master of politics, just like his other CCP comrades. “ A cat is a good cat as long as it can catch a mice, color of cat doesn’t really matter, black or white”.

    Bond market

    Through bond market, Fed “controls” (lack of a better word) banks and banks control economy. Average daily trading volume of Treasuries is about $500B, 7 times of that of NYSE and Nasdaq.

    The weekly average of corporate debt sales of 2007 is $24.6 billion, or $100B per month, according to data compiled by Bloomberg.

    So, it is important for bond market and Fed to understand each other, and to keep economy going, so Joe has a job and pays his bill, and Gross makes his profit. It seems they do understand each other well.

    Corporate bonds:

    “Corporate debt sales totaled $34.8 billion in the week ended March 9, more than double the previous week's total of $14.9 billion, when investors fled all but the safest assets” (

    “The perceived risk of owning corporate bonds has fallen from a five-month high, and an index of derivatives tied to subprime mortgage bonds has gained about 14 percent in the past three weeks. Even emerging market bonds, among the riskiest assets, are rallying.”

    The CDS (credit default swap) index I followed:
    iTraxx Crossover 10 Y was 319.33 on 032307, down from
    340.88 on 030507

    DJCDXNI is currently at 34.73, down from about 40 on 030507.

    Mortgage bonds:

    “An index of credit-default swaps on 20 mortgage securities rated BBB- and created in the second half of 2006 fell 36 percent from Jan. 18 to Feb. 27 when it reached a low of 62.25, indicating deteriorating confidence. Since then, the index has recovered, climbing 13.75 percent to 70.81, according to London- based Markit Group Ltd., which administers the ABX-HE-BBB- 07-1. The index traded as high as 97.47 on Jan. 19.”(

    Hedge Fund is never behind anybody

    “Ahead of curve” is the slogan of Citadel’s founder, billionaire trader Kenneth C. Griffin.

    Citadel bought bankrupt ResMae Mortgage Corp. two weeks ago, and took a 4.5 percent stake in Accredited (
    So, Citadel, one of my MMs, even acted long before Fed’s statement on 032107.

    Farallon Capital Management LLC, a San Francisco hedge fund that invests in companies facing cash shortfalls or bankruptcy, said this week it held talks to buy San Diego-based Accredited Home Lenders Holding Co. before agreeing to lend it $200 million.


    Subprime is a big problem without Ben Put, and a manageable problem with Ben Put. Is that the bond market and Hedge fund’s interpretation of Fed’s statement?

    They are probably right, and consequently we probably have seen lows for major stock indexes on March 05, 2007.

    Caution is always advised for traders. As one of big the volume guys in treasuries trading (031207 “What would you do if you are Citadel?” Marketref;, I suspect Citadel probably sold a lot of treasuries last Friday.

    “Selling on news” in Treasuries last Friday pushed down price across the entire yield curve, raising up 10Y and 30Y yield indexes back to the level on or before Feb 27, 2007.
  2. It will be over in a month or so.
  3. What did you mean? The bond sell off and the market rally?
  4. Check out what Jim Jubak wrote today.

    I have no idea if he's right or wrong, but his article YELLED at me, because when I first started investing, a mere 9 months ago, I remember him always being bullish.

    This is a lengthy article, but he cites a lot of specifics as to why he thinks we're going to see increasing volatility and then a big bursting of the debt bubble.
  5. hels02


    Yah, saw that article a couple days ago.

    I can't say I disagree with him, but at the same time, I think that the true fall would be so catastrophic that the entire world would plunge into a mess that would make the great depression look like a mild recession.

    Ergo, I don't see it happening, because every government is well aware of the potential and will do what they can to mitigate. Here, I do tend to trust the government, it's their heads on the line too.

    There are so many bear indicators that market logic would say it will go up for a while yet. :D

    But I'm staying far away from housing, financing and related sectors for a while, because the pain there hasn't really begun, and there are much better stocks to play.

    Yield curve not inverted any more

    The central point of “IS THE CURRENT CORRECTION OVER” is Ben Put as the bond market and hedge fund perceived.

    The yield curve seemed to have confirmed this:

    “For the first time since the Fed ended a two-year run of interest-rate increases in August, the central bank 0n 032107 signaled that its next move might be either to lower or raise borrowing costs, instead of just the latter. The Federal Open Market Committee's statement omitted a previous reference to ``additional firming'' in favor of the more general ``future policy adjustments.''

    Also for the first time since August 2006, 10Y T yield indx exceeded 2Y T yield indx on 032207.

    I have talked much about Bill Gross’s long complaint that he can not make money with an inverted yield curve. Now, the inversion of yield curve has been reversed or flattened, indicating bond market’s current expectation that Fed will cut the Fed’s fund rate, or at least not to raise it.

    About the long end of the yield curve:

    Long-term rates theoretically equal to the average of current and expected future short-term rates, which more or less reflect economic condition or growth rates, plus inflation risk premium and risk premium.

    Inflation risk:
    The Fed on 032107 said ``the high level of resource utilization has the potential to sustain'' inflation pressures, due to the followings:

    Capacity utilization rate

    Overall capacity utilization in February increased to 82.0 percent from 81.4 percent in January, with historical average being 81%.

    Rate of unemployment minus the rate of nominal annual wage growth: if it is not greater than 50 base points, it will be out of Fed’s “comfort gap”.
    Unemployment rate as of 022007: 4.5%

    Hourly earnings rose 0.4% in February. That is a bit stronger than expected, and puts the year-over-year increase at 4.1%.

    Productivity growth

    Productivity growth, slowed to 2.1% over 2005 and 1.4% over 2006, although possibly due to cyclical factors, while trend productivity growth is roughly 2½%.

    The productivity deceleration has contributed to acceleration in unit labour costs of 3.4% over the past year.
    Given the increased likelihood of cuts in short term rates, and may be a slightly upward movement in inflation risk, the long-end of curve may not change very much either directions, other things being equal, more likely to be lower than higher.

    The “worst” had been priced in by stock market
    Earnings growth for S&P500

    Most recent Q1 2007 Q2 2007 Q3 2007 Q4 2007
    --S&P 5.3% 6.3% 3.5% 15.6%
    --First Call 4.3% 4.4% 6.6%
    --One Month Ago (1) 6% 7% 7% 16%
    --Two Months Ago (2) 8.2% 8.5% 5.2% 16.2%
    (1) Combination of First Call and S&P estimates. (2) First Call forecasts.

    IQ and EQ by bond and stock market since Feb 27, 2007

    IQ is information (mostly macro) query, more for bonds, and E for earnings or “emotions”, more for stocks.
    Most of the macro and earnings data have been already “chewed” by market prior to Feb 27, 2007.

    What happened on and after Feb 27, 2007 in terms of IQ and EQ is:
    jolted by subprime, the market was seeing future economic scenario as worst and as far as possible, particularly on March 05, 2007, with all bad information and fears priced.

    One measure of intensity of EQ is VIX. “ VIX, a measure of the market's expectation of 30-day volatility in the S&P500 index, jumped by the most in its 17-year history late in February” (

    One important piece of all bad information “IQ” and “EQ”ed by market priced in prior to 032107 is market’s anticipation that Fed may not change its bias on 032107.

    In that sense, I think, stock indexes may have seen the bottom of the current correction on 03052007.

    Fed’s fourth representation: USD

    I agree with many market participants that Fed has an USD objective, which I think is to maintain some kind of order of USD movement in either direction and within certain range, numerical values unknown, just like Fed’s employment and inflation objectives.

    Considering that the entire US yield curve is probably going to be lower, and with front-end lower than long end, there would be some downward pressure on USD, if Europe and Japan’s yield curves are going to stay where they are.

    USD Indx: after touching a all YTD of 82.75 low on 032107, it is now back to 83.25, still close to all time low since April 2005, after falling below 81 in Jan 2005. USD since then has gone as high as above 92 near the end of 2006 and has been trending down ever after.

    CCP put
    I think, somehow, CCP has a strong interest in supporting an orderly USD, cooperating with US, kind of playing Japan’s similar role in the past.
    Here are some data (

    1. China’s accumulation of USD
    China is currently running 100 billion dollars a year trade surplus;
    About 50 billion dollars of foreign capital flow into China per year to build factories to manufacture goods to be exported to US, to sell into Chinese consumer markets, or just to construct buildings
    There is also about 50 billion dollars a year of so called hot money flowing into China in anticipation of the upward revaluation of yuan against dollar.

    All together, there are about 200 billion dollars a year to be sold for yuans, about 10 % of China's GDP.

    Chinese government must buy up the majority of 200 billion dollars to prevent the plunge of dollar against yuan, and to maintain yuan's undervalued status vs. US dollar.
    Eventually with multiplier effect, the $200B became $1T, mostly in new construction or fixed investment, almost 50 % of the total GDP of China

    In that sense we may say that China's economic expansion is rooted on its export business and the foreign capital inflow, and it is in China’s interest that the trade surplus with US and foreign capital inflow continue.

    2. Recycling of China’s USD back into US

    As for the 200 billion dollars that Chinese government buys up in a year, Chinese government has no choice but to recycle them back into US financial market since US dollar is the legal tender only within US. Chinese government, using the 200 billion dollars at hand, buys US treasury instruments, mortgage backed securities and probably even commercial papers.

    Of course, the total US trade deficit is over 600 billion dollars a year, so the other 400 plus billion dollars are also recycled back into US financial market just like the 200 billion dollars from China; the other 400 plus billion dollars is coming from Japan, Taiwan, South Korea, Hong Kong, oil producing nations and so on that run hefty current account surpluses. The 600 plus billion dollars will eventually flow into the hands of lenders in US to be lent out repeatedly just as in the case of China. Assuming 10 fold increase of the total lending from the seed money of 600 plus billion dollars originated from US trade deficits, the total lending in US will balloon to 6 trillion dollars. In the case of US the lending goes into the hands of businesses and paid out as wages and salaries, and become consumer loans.

    It is already quite a stretch or a “gap up” from Ben put to CCP put, let stretch a little bit further:

    Domestically, US manages its “bond-standard” based economy via Fed and bond market. Internationally, US dominates and manages a “dollar standard” based international economic and political order with CCP, an increasingly important co-stakeholder and co-manager in such an order.

    The first order of business in such a system is for Fed’s four representations and CCP’s three representation to be taken care of, some times at cost of others such as Iran, and again, that is politics.

    Speaking of Iran, I think CCP must have mixed feelings in joining US playing tough cards against it.

    Iran is a nation like China, with one of those four earliest world civilizations, which had made important contributions to the mankind, such as Arab’s numerical system and Chinese’s paper and printing. Without that, the world economy may still be on barter-trade and metal standard.

    Regardless of its glorious history and current national agenda, whatever it might be, Iran presently seems at odds with the status quo of international economic and political order, and it has to be deal with, one way or another.
  7. Current correction: “bottomed out” possible, so is another leg

    That is because of the coming back of stagnation fear.

    Bonds, “The mind of market”, today see the steepest yield curve since June 5 2006, with 10Y T yield rising to 4.61 intra-day, about 4 base points above that of 2Y T yield, and The gap in rates between two-year securities and 30-year Treasury bonds was 24 basis points, the widest since May 18. The gap between TIPS and the regular Treasuries also rose to the highest since September 2006. So, inflation concern seems behind the sell off of T bonds, particularly on the long ends of the curve.

    With money relatively moving from long end of the curve to short-end of the curve, and with curve itself “steepened”, bond market is yelling at Fed: you got reduce the rate to deal with subprime, but inflation risk remains and what are you going to do with that?

    This is familiar scenario seen last spring and summer.
    The stagnation fear, if further worsening, could trig another leg down in the current correction, although unlikely to take out the bottoms which may have been found for stock indexes on March 5, 2007.