Monday, September 26, 2011

Another leg down in this bear market?

Last week's post-FOMC selloff was truly breathtaking. There have been several explanations advanced for the decline. My own take is that bearish traders flattened their positions ahead of the FOMC meeting. (The advance in the previous week looked suspiciously like a short-covering rally as the market seemed to rise on bad news.) When the Fed didn't surprise with another round of QE, the bears re-established their positions.

Nevertheless, the sudden selloff has done enormous amounts of technical damage to the markets, which suggests that another leg down is on the way.

European markets are breaking down
Let's start with Europe since the main source of stress comes from there. A glance at the STOXX 50 shows that it has broken down through an important level of technical support. This index seem destined to test the 2009 Lehman Crisis lows.

Is the cavalry on the way?
The good news is that the financial cavalry may be on the way and there may be a bullish trigger to put a floor on this market. Over the weekend, the Telegraph reported that a €2 trillion bailout fund planned to save Euro as Greece faces default:
German and French authorities have begun work on a three-pronged strategy behind the scenes amid escalating fears that the eurozone’s sovereign debt crisis is spiralling out of control.

Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.

According to sources, progress has been made at the G20 meeting in Washington, where global leaders piled pressure on the eurozone to fix its problems before plunging the world back into recession. In a G20 communique issued on Friday, the world’s leading economies set themselves a six-week deadline to resolve the crisis – to unveil a solution by the G20 summit in Cannes on November 4.

Sources said the plan would have to be released as a whole, as the elements would not work in isolation.
Sky News has confirmed the story, according to ZeroHedge:

As well, Bloomberg confirmed elements of the story by reporting that Angela Merkel stating that "euro-region leaders must erect a firewall around Greece to avert a cascade of market attacks on other European states that would risk breaking up the currency area."

Tepid reaction to plan
The initial reaction has been less than enthusiastic. As I write these lines late Sunday, the EURUSD shot up on the news of the plan but has since retreated back into the red.

Mohamed El-Arian of Pimco believes that waiting until November may be too late:
“They don’t have six weeks,” said Mohamed A. El-Erian, chief executive of Pimco, the world’s largest bond manager. He said fear had reached the very core of the 17-nation group that uses the euro currency, with the price of insurance on German debt rising substantially this week.
The light already is flashing yellow,” Mr. El-Erian said. “They can’t allow it to flash red. You have to give people a vision of what you want the euro zone to look like.”
Yves Smith at Naked Capitalism believes that the market may be disappointed by the too little, too late nature of the plan [emphasis added]:
And in another bit of deja vu all over again, the powers that be in Europe are readying yet another bailout plan, this one supposedly big enough to do the trick once and for all. The problem is that was the premise of several of the last grand schemes, such as the EFSF and the ESM. The market calming effect relatively short lived because analysts quickly pencilled out the programs were inadequate in size and failed to address the problems of lack of a fiscal mechanism at the EU level and the need to address the elephant in the room, bank solvency.
The program in the works claims address the underlying issue of bank solvency, but even the sketchy leak of this weekend reveals it falls falls short, both in concept and in size.
The post is well worth reading in its entirety. She agrees with El-Arian's contention that it may be too late:
The Eurocrats are going to be slow out of the gate. They want to launch the plan at the next G20 meeting, which is six weeks away, November 4. Mr. Market doesn’t care about the schedules of the officialdom, and is highly unlikely to wait that long.
In addition, the banking lobby has already come out against any deal that requires them to take a bigger haircut on Greek debt. Mish had a myriad of problems with the plan, the most important of which (which Yves Smith also pointed out) is that it is locking the barn door after the horse has bolted:
Their aim is to build a “firebreak” around Greece, Portugal and Ireland to prevent the crisis spreading to Italy and Spain, countries considered “too big to bail”.
Mish: If that's the plan it, it has failed already. The crisis has already spread to Spain and Italy. In fact, one look at European bank stocks says it has spread to France and Germany as well.
If Italy and Spain behind the "firebreak", then these stock markets are important "tells" of European stress. The Italian market is currently resting on support going back to the 2009 lows. Watch out below if the dam breaks here!

The Spanish market is in slightly better shape than Italy, though it appears to have sliced through several technical support levels like a hot knife through butter. The last test is also the 2009 lows.

My fear is that this plan will fall flat, just like Bernanke's most recent "I've got a secret weapon" speech at Jackson Hole.

Commodities signaling another leg down
What's more worrying is the fact that commodity prices are now breaking down, which tells me that Mr. Market is starting to freak out over the prospects of a synchronized global recession. The chart below shows that the commodity price retreat is on the verge of breaking into a rout.

What's more. The panic downleg, much like the 2008 waterfall decline, has barely begun.

More specifically, economically sensitive Dr. Copper is signaling that the freefall for the entire commodity complex is just starting. As the copper price crashes, what are the implications for China's copper collateral trade and what are the risks to the Chinese official and shadow banking system?

Bespoke's analysis of commodities, shown here, also shows that all commodities are either in downtrends or broken down from uptrends. Some, such as silver, copper and coffee, are already in freefall.

A glance at the currencies of the commodity sensitive countries tells the same story. The Canadian Dollar broke an important support at par and promptly fell 3c in a hurry. Next stop is 95c and 91.6c after that. Note how much it fell during 2008.

The Australian Dollar is showing a similar pattern. It's virtually impossible to know what the downside target is at this point.

Sentiment indicators are not at panic extremes yet
Another class of indicators that I watch is sentiment and sentiment levels are not at capitulation readings yet. The VIX, while elevated, is not at the-world-about-to-end levels consistent with a wash-out. My inclination is to wait for the reaction to a Greek default or European banking crisis, such as the specter of a major European banking such as SocGen losing its funding and going under.

The other sentiment indicator that I watch is the price action of gold and gold stocks. Up until recently, gold prices had been rising in lockstep with financial tensions and so had gold stocks. When the panic selling frenzy engulfs the market and the margin clerks and risk managers take control, all "risky" (read: non-default-free Treasury assets) get sold.

Take a look at chart of the ratio of gold stocks to gold below. The panic selling hasn't even begun and the descent has been controlled so far. Now look at what happened in 2008.

The gold bugs assert that gold is a refuge in a time of crisis. Unfortunately, when the margin clerks take control - fundamentals don't matter.

The last sentiment measure that is problematical for the bullish trade is the behavior of insiders. Corporate insiders had been buying heavily in early August when the stock market began its initial decline. More recently, TrimTabs reported that insider buying has virtually disappeared, literally overnight .

How far down?
The next question for investors must be, "What's the downside risk?"

I could tell you about P/E ratios (when I asked "How cheap are stocks?") and say that the market could conceivably revisit its Lehman Crisis lows. Instead, a better way of approaching the problem is to watch Europe, which is the source of the stress, and watch how European equities perform in the days and weeks ahead.

The importance of European markets holding the 2009 support is illustrated in this chart of the Dow Jones Transportation Average. The Transports are tracing an eerily similar pattern to 2008 - an indexing breaking down after violating an uptrend. What was surprising is the extent the Transports fell afterwards in the panic.

How European stocks behave is the leading indicator of asset market prices this time around.

A financial winter is coming, but spring will come
A financial winter is coming but there is no need to panic. Just as spring follows winter, the global economy will heal itself and investors can survive and prosper again. Have a plan to manage your way through such periods of market volatility. With that in mind, I offer the following suggestions:
  • Be the predator and not the prey: Food is scarce in winter and predators will take the opportunity to pick off weakened prey. Should the markets panic, asset prices will sell off into unreasonably cheap levels as weakened investors raise cash to meet margin calls, or worse, pay their bills. If you are sufficiently liquid and have sufficient resources, then there will be great opportunities to pick up assets at distress prices as the weak sell to the strong. At the very least, make sure that you are not the weakened prey.
  • Store food for the winter: From a tactical viewpoint, either get more liquid or take positions in default-free long-dated US Treasury bonds whose prices are expected to rally from a rush into safe haven assets. A Canadian investor with a long US Treasury bond position has even greater upside potential because the Canadian Dollar is likely to weaken against the US Dollar in such an environment.
  • Be opportunistically prepared to buy: Looking longer term, low or negative real interest rates generally signal a friendly investment environment for commodity prices. Continued government and/or central bank accommodative policy responses will likely push real interest rates even lower and add to even more future asset inflation. Investors who are opportunistic or prepared to look over the valley can view periods of market weakness as opportunities to accumulate positions in commodities or commodity producers as a hedge against asset inflation. 

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Sion said...

Great Post Cam! Many Thanks.

WimpyInvestor said...

Thanks for your insights. Quick question regarding sentiment not bearish enough: does VIX have to break 48 and go to 80 to mark the final capitulation?

Checking the Ticker Sense survey (in which you participate), the % Bearish this week (58.62%) is actually higher than the 55.56% Bearish on March 9-13, 2009 survey ... can this also be a sign of capitulation? could Blogger sentiment be a contrarian indicator of some sort?

Humble Student of the Markets said...

Wimpy Investor,

I certainly agree that the Ticker Sense survey is showing excessive bearishness, which could lead to a short-term bounce.

However, for a complete wash-out, I think you need the VIX to spike up to Lehman Crisis levels seen in '08. The disappearance of insider buying is also not a good sign that the market has bottomed.

WimpyInvestor said...

Thanks again. Looks like your approach (Inflation / Deflation Timer) is similar to that of Ivy Portfolio ( and Winhaven Tactical Asset Allocation

Basically, stay with the macro trend for the asset class until it stops working ... do not try to get ahead of the market and be contrarian / "buy low" (since oversold market can be more oversold) ....

Have you done backtesting on the performance of your model (risk-adjusted returns) vs. other tactical asset allocation techniques?

I reviewed the Ivy and Winhaven portfolios and found that they have not beaten their respective 60%/40% Benchmarks in recent years ... perhaps the sideways & highly volatile trading markets make it very hard to play the momentum using trend-following methods (e.g, by the time death cross occurs, most of damage is already done? by the time golden cross occurs, most of gains already happened?)

I'm hoping to leverage sentiment models on top of global macro asset allocation / tactical asset rotation strategies to see if it could produce better risk-adjusted returns.

Any thoughts would be greatly appreciated!

Tiho said...

This post is a signal of over bearishness and is very consensus right now. Sentiment everywhere is extremely negative.

I would not short anything right now, but instead look to by. This will not be a repeat of 2008 VIX spiking to 80.