TWO DOWN, TWO TO GO / CREDIT BUBBLE BULLETIN

Two Down, Two to Go

Doug Nolan


“U.S. Stocks Finish Best Quarter in More Than 20 Years” – yet another extraordinary period worthy of documenting in some detail.

The S&P500 returned 20.5%, led by energy companies Halliburton (up 89.5%) and Marathon Oil (86.2%).

The Dow Jones Transports returned 19.2%, with Avis Budget gaining 64.7% and Ryder rising 41.9%.

Lagging, the NYSE Financial Index returned 13.1%. Goldman Sachs rallied 27.1% during the quarter.

The broader market outperformed. S&P400 Midcap and Small Cap Russell 2000 indices returned 24.1% and 25.4%.

There were 155 companies in the Russell 2000 that gained 100% or more during the quarter.

The equal-weighted Value Line Arithmetic Index of 1,700 stocks gained 30.1% during Q2, the strongest return since Q2 2009’s 32.2%.

The Nasdaq Composite returned 31.0%.

The Nasdaq100 (NDX) returned 30.3%, led by a who’s who of popular short positions.

Tesla gained 106%, Mercadolibre 102%, Paypal 86.4%, EBay 74.5%, Zoom 73.5%, and Lululemon 64.6%. Apple returned 43.8%, Amazon.com 41.5%, and Microsoft 29.4%.

The Nasdaq Industrials returned 32.4%, while the Nasdaq Telecom Index returned 24.2%. The Philadelphia Semiconductor Index (SOX) returned 32.8%, with two-thirds of the index members gaining at least 32%. The Nasdaq Biotechnology Index returned 26.9%, with almost a tenth of member stocks doubling during the quarter.

Indicative of the pain meted out on the short side throughout the quarter, the Goldman Sachs Most Short Index rose 56.2%. Many popular shorts posted spectacular quarterly gains.

Wayfair returned 269.8%, Big Lots 195.4%, Eldorado Resorts 178.2%, Etsy 176.4%, Bed Bath & Beyond 151.8%, Murphy Oil 125.1%, Jack in the Box 111.4%, Aaron’s 99.3%, Polaris 92.2% and Brunswick 81.0%.

The Philadelphia Oil Service Sector Index rose 35.5%, with nine of 15 index members gaining more than 57% for the quarter. Retailers (XRT) jumped 44.3%, with gainers including GAP (79.3%), CarMax (66.4%), Carvana (118.2%), Dick’s (94.1%), Best Buy (53.1%), Expedia (46.1%) and Kohls (42.4%). The homebuilders (XHB) surged 47.7%, with Toll Brothers up 69.3%, DR Horton 63.1%, Lennar 61.3% and Pulte Group 52.5%.

“Risk on” was certainly not limited to U.S. equities.

Credit default swap (CDS) prices collapsed, reversing much of Q1’s spike. Investment-grade CDS sank 37 bps for the quarter to 76 bps – and is now less than half of the high (159bps) from March 23rd. High-yield CDS sank 141 bps to 516 bps (down from March 23rd high 886bps). The iShares Investment-Grade Corporate Bond ETF (LQD) surged 9.72% for the quarter, with a first-half gain of 6.46%. The iShares High-Yield ETF (HYG) rallied 7.36%, reducing its y-t-d loss to 5.10%. Leveraged loans returned 10.1% during Q2.

Even more spectacular CDS price declines were experienced overseas. The European (high-yield corporate) “crossover” CDS sank 189 bps during the quarter to 382 bps, dropping almost in half from March 23rd trading highs (572). European subordinated bank CDS fell 88 to 167 bps during the quarter, ending June at less than half March highs (367).

European equities posted big quarters. Germany’s DAX rallied 23.9%, with major indices up 15.0% in Italy, 13.5% in France and 8.0% in Spain. The UK’s FT100 index recovered 9.6%.

The gain in European periphery bond markets is more notable – especially considering skyrocketing fiscal deficits. Italian yields sank 26 bps during Q2 to 1.26% - about half the 2.42% March high. Greek yields fell 43 bps to 1.20%, down from the 3.67% March 18th high. Portuguese yields sank 39 bps to 0.47% (March high 1.45%), and Spanish yields fell 21 bps to 0.46% (March high 1.22%).

Perhaps most noteworthy, the emerging markets rallied sharply in the face of a rapidly expanding global pandemic. EM CDS sank 157 bps to 195 bps, down from the 478 bps March high and back to February levels. Stocks recovered 30.2% in Brazil, 30.8% in Turkey, 20.4% in Taiwan, 20.2% in South Korea, 18.7% in India, 10.6% in Russia, and 9.6% in Mexico.

The Shanghai Composite gained 9.8%, with the CSI 500 returning 14.2%. China’s growth-oriented ChiNext Index surged 30.9%, with first-half gains of 36.2%.

EM local currency bonds rallied strongly. For the quarter, yields dropped 172 bps in South Africa to 9.24%, 167 bps in Brazil to 6.95%, 127 bps in Romania to 3.88%, 124 bps in Mexico to 5.82%, 121 bps in Chile to 2.40%, 85 bps in Russia to 5.90%, 67 bps in Indonesia to 7.18% and 56 bps Hungary to 2.15%.

Dollar-denominated yields sank 278 bps in Ukraine (to 7.37%), 165 bps in Turkey (to 6.74%), 115 bps in Qatar (to 2.24%) and 85 bps in Mexico (to 3.39%). Brazil’s dollar-denominated yields jumped 78 bps during the quarter to 4.93%.

For the most part, EM currencies rallied during Q2.

The Indonesian rupiah recovered 14.3%, Russian ruble 10.2%, Colombian peso 7.9%, Thai baht 6.1%, Czech koruna 4.5%, Polish zloty 4.4%, Chilean peso 4.1%, Hungarian forint 3.6%, Mexican peso 3.0%, and South African rand 2.8%. On the downside, the Argentine peso declined 8.6%, the Brazilian real 4.8%, and the Turkish lira 3.5%. China’s renminbi increased 0.26% versus the dollar during the quarter.

The dollar index declined 1.7% during the period.

The Australian dollar rallied 12.6%, New Zealand dollar 8.4%, Norwegian krone 8.1%, Swedish krona 6.3%, Canadian dollar 3.6%, Euro 1.5%, and Swiss franc 1.5%. The Japanese yen declined 0.4% versus the dollar during the quarter.

Australia’s ASX 200 equities index gained 16.5%. Japan’s Nikkei 225 Index rallied 18.0%. Recovering only 6.0%, Japanese bank stocks lagged. In general, bank stocks notably underperformed during the quarter. Hong Kong China Financials index slipped 0.3%. Europe’s STOXX600 Bank Index rallied 7.8%, led by an 18.7% recovery in Italian banks. U.S. Banks (BKX) returned 15.1%, significantly lagging most sectors.

The S&P500 just completed its strongest quarterly return since Q4 ‘98’s 21.3%. There are some parallels.

Having returned a blistering 23.0% y-t-d, the S&P500 traded at a then all-time high 1,191 on July 20, 1998. U.S. markets were completely disregarding mounting Russian fragility.

Devastating “Asian Tiger” Bubble collapses the previous year had required major IMF bailouts.

Despite U.S. market and economic booms, fed funds were at 5.5% in the summer of ’98 (the same level as the end of ‘95). Treasuries had sniffed out trouble on the horizon. After trading to almost 7.0% in Q2 ’96, 10-year Treasury yields were down to 5.4% by July ’98 (and 5% in August). Sinking yields and a boom in leveraged speculation bolstered the liquidity backdrop, with equities turning progressively speculative.

EM contagion hit Russia’s currency and bonds in September. Aggressive hedging heading into the crisis ensured spectacular market dislocation. A disorderly de-risking/deleveraging episode hit the leveraged speculating community, most notably Long-Term Capital Management. The collapse of LTCM’s egregious leverage and massive derivatives positions almost brought down the global financial system.

The Fed cut rates and took the unusual step of orchestrating a bailout for LTCM (and its counterparties). The Greenspan, Rubin and Summers “committee to save the world” worked its magic - and the world would never be the same. Instead of a much-needed reckoning for the aggressive leveraged speculating community and derivatives complex, it was off to the races.

Stocks rallied big during Q4 – and didn’t turn back. Nasdaq nearly doubled during 1999’s fiasco – demonstrating the precariousness of employing monetary stimulus and bailouts with markets in the throes of a major speculative Bubble.

Even in the face of the most conspicuous speculative excess, Greenspan remained wedded to “baby steps.” Fed funds didn’t get back to 5.0% until mid-‘99. The Bubble had turned increasingly vulnerable late in the year.

The economy was downshifting, while fundamentals were deteriorating in the bubbling technology sector. But that didn’t stop one final short squeeze and derivatives-related “melt-up” to push Nasdaq to even crazier extremes in Q1 2000 (record highs not surpassed for 15 years).

I’m not sure Ben Bernanke makes it to the Fed in 2002 if not for all the excess, bailouts and only greater late-nineties Bubble craziness. "The powers that be" believed THE Bubble had popped – and the Fed resorted to mortgage Credit as the mechanism to reflate the markets and economy.

No Bernanke and no mortgage finance Bubble – and I doubt the Fed experiments with QE. If not for Fed QE, does the world succumb to “whatever it takes” QE on a global basis?

Without QE, the world today would be a lot less unstable and troubled place.

June 29 – Financial Times (John Plender): “One innocent explanation for the extraordinary bounce back in global equity markets in the second quarter is that investors have concluded that the worst of the pandemic is over and that recovery is within reach. A less innocent — but all too plausible — alternative reading is that investors now believe central banks will exercise complete control over asset prices for the foreseeable future. In other words, the categorical imperative of policymakers doing ‘whatever it takes’ to counter the current crisis could ensure a lasting decoupling of equity prices from ailing economies. Lending support to this latter view is the growing conviction in markets that the US Federal Reserve may now move to a policy of yield curve control. That would mean following the Bank of Japan in capping borrowing costs by targeting a longer term interest rate and buying enough bonds to stop yields rising above that level.”

The second quarter was momentous for reasons beyond huge securities markets gains. Speculators and investors do “now believe central banks will exercise complete control over asset prices for the foreseeable future.”

There is no longer any shred of doubt: Highly synchronized global market Bubbles are the ultimate “Too Big to Fail.”

Moral Hazard has reached its pinnacle.

And, after unleashing several Trillion at home and Trillions more overseas, central bankers will find it impossible to ween highly speculative and inflated markets off aggressive monetary stimulus.

There were 43,644 new U.S. COVID cases on June 30th, almost doubling the 22,562 reported the last day of Q1. Daily cases are averaging more than 54,000 during the first three days of July. There were a then record 71,000 new cases globally in the midst of a pandemic surge on the final day of Q1. Daily new cases now run above 200,000.

How can markets remain ebullient?

Because a worsening pandemic ensures additional fiscal and monetary stimulus. This is not about economic fundamentals or markets pricing a solid “V” recovery. It’s greed and FOMO (fear of missing out) – Monetary Disorder and a resulting runaway speculative Bubble. This game has been playing out for a while now.

It’s an increasingly dangerous game – one that seems to be building toward some type of conclusion.

It’s worth noting the safe havens were not in the least spooked by Q2’s “risk on.” Ten-year Treasury yields actually declined a basis point to 0.66%. Bund yields rose less than two bps to negative 0.46%, while Japanese yields rose less than one basis point to 0.02%.

As the ultimate safe haven, gold surged $204, or 13%, to $1,781 – the high since the 2012 European debt crisis.

In a year for the history books, two extraordinary quarters down and two to go.