Thursday, September 26, 2013

A Rorschach test for bulls and bears

Earlier this week John Murphy at wrote about the gold/copper ratio as a measure of how Mr. Market is perceiving macro-economic sentiment and momentum::
Gold is bought in times of financial stress when stocks are in trouble. Copper is bought when economic conditions are better and stock prices are rising. The gold/copper ratio tells whether investors are optimistic or pessimistic. The fact that the ratio has been falling over the last two years suggests more optimism on the economy and stock market. A stronger global economy supports the price of copper, and diminishes the appeal of gold.
He overlaid a chart of the SPX against the gold/copper ratio. In my analysis below, I inverted the ratio to copper/gold (optimism/pessimism, in red) against a chart of the SPY (stocks) against AGG (bonds) as a measure of risk appetite (in grey):

This chart presents a Rorschach inkblot test for both bulls and bears alike. Do you focus on the enormous gap between the SPY/AGG ratio against the copper/gold ratio and interpret it as stocks have run too far too fast? Or do you focus on the uptrend in the copper/gold ratio as a sign of positive momentum in global macro economic conditions, with the belief that it is the direction of the copper/gold ratio that matters and not the magnitude of the move?

I can argue both sides. My inner investor tells me to focus on the gap, as stocks appear to be overextended against bonds. My inner trader, on the other hand, tells me to stay with the momentum until we see signs that the copper/gold ratio starts to roll over.

John Hussman: Bull and bear
Even the perennially cautious John Hussman agrees. In his latest commentary, He remains highly cautious [emphasis added]:
The challenge at present is that last week’s Fed’s decision does make an already precarious situation more precarious. So the question is how to respond. From the experience of the past few years, the risk is that enthusiasm that the Fed is “all-in” could prompt a surge of further speculation, and even greater financial distortions. At the same time, examining market cycles over a century of market history, present conditions cluster among the most negative 2-3% of data points in terms of average return and downside risk.
However, he is allowing for the possibility of what he terms "a speculative blowoff":
My impression is this. Based on numerous past speculative episodes in the financial markets, we know that financial bubbles have often proceeded in an oscillating pattern featuring increasingly frequent cycles of advance, punctuated by gradually shallower declines reflecting an accelerating eagerness to buy dips. This can produce what Didier Sornette has called “log-periodic” oscillations (see Increasingly Immediate Impulses to Buy the Dip). Given the negative return/risk estimates we observed in April and early-May, I believed that this series of oscillations was ending several months ago. In order to preserve a log-periodic pattern, further oscillations needed to exhibit an even faster alternation between steeply-sloped advances and shallow declines. Yet despite the strongly negative return/risk estimates we already had in April and May, this is unfortunately what has unfolded. With the Fed’s decision last week, we can’t rule out one particularly extreme version of a log-periodic bubble that is consistent with price fluctuations to date. That version is pictured below, and would comprise an advance above 1800 in the SP 500 over a period of about 6 weeks. Again, this is emphatically not a forecast, but the conditions for a final wave of speculation may have been created by the Fed’s decision last week, and it leaves us unable to rule out this admittedly hypothetical possibility – particularly in the context of what has been a classic Sornette-type bubble to-date.
So what does he do? He is buying out-of-the-money calls on the market [emphasis added]:
Strategic Growth Fund remains fully hedged, with a “staggered strike” position that places the strike prices of its index put options close to present market levels. Last week’s decision by the Federal Reserve to defer any reduction in the pace of quantitative easing adds near-term uncertainty. My concern is that investors may draw on this decision as evidence that the Federal Open Market Committee (FOMC) has placed some sort of “safety net” below the market, and that the surprising extension of its current policies could spark a short-term speculative “blowoff.” Given the relatively depressed level of implied volatility (which affects the cost of index option premiums), combined with some potential for the Fed decision to provoke a steep, if short-lived speculative response, we added a very small position in out-of-the-money index call options in Strategic Growth Fund late last week. This position serves mainly as a low cost “contingent” stance that may reduce the impact of our hedging in the event that the major indices advance by more than a few percent in the coming weeks.
Hussman is an example of how you can be both a bull and bear at the same time. It is an example of his inner investor and inner trader at work.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

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 blog 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 I may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Anonymous said...

Impressive commentary- thanks for the informative ideas. I am extremely interested in the mathematics of market sentiment and bubble dynamics and this gave me excellent material. Stuart Davies