London financial stocks track Spanish woes - Financial Times London financial stocks track Spanish woes - Financial Times

Wednesday, May 30, 2012

London financial stocks track Spanish woes - Financial Times

London financial stocks track Spanish woes - Financial Times

May 30, 2012 9:05 am

Think stocks can’t rise 40% in 2012? Think again - Marketwatch

By Michael A. Gayed

"A sudden bold and unexpected question doth many times surprise a man and lay him open." — Francis Bacon

Before I begin, let me provide an update on credit markets, which are indeed improving since I first brought up the idea that the risk of a near-term crash in equities was rising.

Two weeks ago on the day of the Facebook /quotes/zigman/9962609/quotes/nls/fb FB -9.62% IPO, I appeared on Bloomberg , bringing attention to what was then a sudden, precipitous drop in junk debt /quotes/zigman/1510831/quotes/nls/jnk JNK +0.83%  and emerging market debt /quotes/zigman/1511363/quotes/nls/emb EMB -0.03%  relative to nominal Treasuries /quotes/zigman/1480195/quotes/nls/tlt TLT -0.31% . In that segment, I stressed that the speed and magnitude of the credit-spread blowout signaled an event may have been upon us in credit markets.

I began writing a series of articles here on MarketWatch expressing my concern that the odds of a "flash crash" were rising, but that it wasn't a prediction. In the article "Forget Facebook; stocks are at serious risk" , written on May 18, I very specifically started the writing saying "something major has changed in the last 48 hours which could result in a 'mini-Flash Crash' in stocks if not reversed shortly."

I ended the writing by saying that "I am specifically highlighting something which is a timely observation driven by a sudden change in risk-sentiment in the bond market. If a breakdown can be averted, a significant move higher remains a very real possibility in risk assets."

U.S. markets last week stabilized despite European markets remaining wobbly. On May 21, in the article "Reflecting on reflation and the Spring Switch", I noted, as it related to the prior week's dramatic increase in credit spreads, that "should what happened last week be a complete overreaction, another 'melt-up' rally could return as reflation kicks back in alongside risk-taking as money gets uncomfortable with Treasuries yielding levels below the Fed's 2% inflation target. The Spring Switch [out of bonds and into stocks] may get flipped simply because the catalyst ends up being no (negative) catalyst at all."

I have gone to great lengths to stress that my fear over a potential crash was very short-term, and even re-emphasized on CNBC last Tuesday that my base case scenario wasn't for a breakdown but for a continuation of reflation.

On my very last writing titled "Crash risk could turn Spring Switch to Ditch" on Friday, I put things in perspective by explicitly saying "..IF the bond market is right, stocks could go down much further even from oversold levels. Is the bond market right? I have no clue — I have made the case that the bond market could be wrong as part of my 2012 reflation thesis and in relation to the 'bear paradox' and negative narrative concepts.

“I believed that should the 'mini-correction' I wrote of on April 6 prove that stocks are resilient, then it would only further increase the chances of the Spring Switch getting flipped. So does the Spring Switch become a 'Spring Ditch' thanks to Europe? The answer depends on if resiliency remains and healing occurs in the bond market, coinciding with Treasury yields rising, dividend stocks underperforming, and some kind of catalyst likely coming out of Europe."

On Tuesday of this week, nearly all three of those conditions were met as junk debt VERY strongly performed while Treasury /quotes/zigman/1480156/quotes/nls/ief IEF -0.08%   yields rose ever-so-slightly. Dividend-paying sectors such as health care /quotes/zigman/246154/quotes/nls/xlv XLV +0.33% , utilities /quotes/zigman/246354/quotes/nls/xlu XLU +0.31% , and consumer staples /quotes/zigman/246134/quotes/nls/xlp XLP +0.71% uniformly underperformed in the rally.

And as to Europe? Pro-bailout sentiment in Greece and some kind of near-term resolution to Bankia through Spain's nationalization may have been the necessary catalysts needed. While the credit spread contraction of the last few days hasn't been enough to fully undo the damage of two weeks ago, the trend in strength is unquestionably a bullish sign, and a continuation of that diminishes my own concerns over a further collapse in equities from oversold levels.

Again, it was never a prediction because I myself had no idea if credit markets were right as I explicitly said. Further recovery in the bond market takes the immediate concern I brought up off the table in the very near-term. The next few days should provide additional clarity on this.

If we assume that spreads will continue to narrow (which again reduces significantly the risk of a further breakdown in stocks), then we go back to my original base case scenario that this was simply the "mini-correction" I wrote about on April 6 in the article titled "Bad jobs numbers, a correction and risk-off" . This was around the time my company's own ATAC (Accelerated Time And Capital) models largely positioned our clients defensively out of stocks and into bonds.

I have argued all along since then (before the crash risk writings of last week) that IF stocks were resilient, it would increase the odds of the Spring Switch getting flipped. U.S. markets have fallen off their highs, but no where near in a significant way.

Part of the reason for my original thesis that the U.S. would go through a "mini-correction" related to the idea of a "Bear Paradox" and the negative narrative which I wrote about on May 4th (right before the decline was about to pick up post-European elections).

The Bear Paradox (which is a U.S. specific idea) is a term I came up with which describes the dilemma of being too bearish on stocks. With Treasury yields already not keeping up with inflation, a significant breakdown in stocks in the U.S. means you are betting on a continued flight to safety in bonds, sending those yields down even further.

Meanwhile, the deeper the stock correction goes, the more attractive stocks get as those dividend yields from equities rise. This automatically makes stocks more attractive on a comparative basis relative to bonds.


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