Stock Markets Pause for a Reality Check

According to a Bloomberg article, Japan’s 3.7% annualized bounce in Japan's Q1 FY09 (April~June) GDP ended the country’s worst postwar recession, but there is little confidence that this signals a real recovery. According to Tokyo-based economists, only about 1/10th of what was lost last year in economic activity was recouped in the quarter. Everyone is keenly aware that Japan's recovery hinges on overseas markets, and investors are ultra-sensitive to perceptions about US consumption. The central bank estimates Japan’s potential growth rate has fallen to about 1%, or half the pace of Japan's last six-year expansion through 2007.

On a year-on-year basis, Q1 FY09 GDP was still declining over 6% YoY compared to an 8.4% YoY decline the previous quarter, and exports were still declining over 30% YoY. Capacity utilization in Japan is till 60%~70% of 2008 levels, meaning companies intend to keep a tight reign on capital expenditures and wages, which marked the steepest drop (4.7% YoY nominal) since 1956 during the quarter.

China Index Signals Countertrend Rally

China's Shanghai Composite sold off further once it broke through its 50-day MA. Investors are worried that the Chinese government is worried enough about bubbles forming in China's property and stock markets to try to reign in the speculation. Pressure is already on China's banks to reign in rampant growth in lending, and investors also noted that foreign direct investment in China fell for a 10th straight month in July. While the decline in foreign direct investment is not new news, the accelerating decline (FDI fell 6.8% in June) is. China stocks, like stocks in Japan, also reacted negatively to the negative surprise in the August Reuters/University of Michigan consumer sentiment index, which fell in August for the second month in a row to 63.2, the lowest level since the übergloom of March. Economists had expected the index to rise.

Since China stocks bottomed first last year, it is not surprising they turned first as well. The recent spurt in the VIX reflects the same sentiment, i.e., that global stock prices had rebounded too far, too fast and needed a reality check.
The counter-trade of course is the USD and 30-Year TB prices, both which upticked with the VIX as global equities were selling off.


Counter Trade in VIX, USD Index and 30-Yr Treasuries

How far this counter-trade goes is anyone's guess, but demand for recent US treasury auctions appears strong, particularly now in the longer-dated maturities, suggesting that investors see the sell-off in Treasuries as overdone. Thus it looks like we are in for a period where the VIX, USD index and longer-dated treasuries rally while essentially everthing else sells off, including China (FXI ETF) and other emerging markets like India (EPI ETF), commodities led by crude oil (USL ETF) and copper (JJC ETF) and developed market equities like Japan (EWJ ETF) and US equities in that order.

For the bear case (i.e., stocks break down through the March lows) to endure, one has to deny that the global economy is mending, or belive that central bankers will remove the excess liquidity too soon and/or that the fiscal stimulus largess will soon fade and trigger a double dip.

Since we are not in that camp, we will be buying emerging markets and commodities as they sell off rather than chase the "15 minutes of fame" USD and risk aversion trades.