RIMM vs. Nokia

Marketwatch recently conducted a poll: Nokia vs. Research in Motion: Who's in worse shape?

Who I am not crazy about the long-term competitive position of RIMM compared to Nokia, who I believe to be in comparatively better shape, tactically RIMM seems to be in a better technical position than NOK. Consider this chart of the relative performance of the two stocks:

RIMM is at the bottom of the trading range against NOK in the last two years. Tactically, this sets up RIMM to outperform NOK in the short term.

I would add that the caveat that putting on this pair trade is fraught with company specific risk and anyone who enters into this does so at their own risk. I would further suggest to define your risk and target levels before entering into such a speculative trade.

The dam breaks

When it rains, it pours. On Friday Macro Man detailed the big macro concerns the market faces (TMM=Team Macro Man), namely the US, Europe and China:

TMM reckon that the current state of the World can be described as follows:

The US: The slowdown is dramatic (more on this below) but positive actual GDP prints, a Pavlovian dog-like response in the form of dip-buying on weakness (learned over the past two years), and a belief in the Fed coming to the rescue have prevented both the PhD and punting community from embracing a negative view.

Europe: Smoke is coming out of the tail pipe, kangaroo-ing down the the road. Going to break down soon.

China: "DON'T TALK ABOUT ANYTHING NEGATIVE!" as China is the only hope the West has. It seems to TMM as though punters are looking through to the peak in inflation and holding onto the soft-landing view - something they sense from the fact that most commentaries on China they receive seem to talk about how too many people are fearful of a hard landing/inflation etc... where is the *real* consensus?

Of the three, I am least concerned about the US macro outlook. It appears that market is pricing in growth of about 2% but it is about to decelerate to 1%. Add in the end of a dose of QE2 market steroids, the adjustment process for the equity market will likely be painful, but such a move is best classified as a plain vanilla correction of 10-20%.


Europe's Bear Stearns moment?
The problems in Europe and China, however, have Russia Crisis or Lehman Crisis written all over them. Matthew Lynn, writing in Marketwatch, expresses the consensus opinion that a deal will be done to save Greece:

Forget all you’ve read about it being a catastrophe for the markets when it happens, however. Only things that nobody really forecast make prices move in any dramatic fashion. A Greek default is about as unexpected as Rafael Nadal making the finals at Wimbledon this year.

In reality, it is already priced in. And the Germans and the French aren’t going to let it happen until they know their banking systems are safe — so there isn’t going to be a Lehman-syle collapse.

Felix Salmon, on the other hand, believes that a Greek default has not been priced in by the market:

[N]o one has any idea what would actually happen in the event of a Greek default. In order for markets to be pricing in a default, traders would have to be buying debt now on the expectation that if Greece defaults the price of its debt would not fall further. I don’t think anybody’s doing that yet — as Stopford says, they might be taking risk off, but they’re not expecting catastrophe. If Greece were actually to default, I’m pretty sure that markets would fall further.

In 2008, Bear Stearns' hedge fund imploded in July - a precursor to the Lehman collapse a few months later. The Greek situation is starting to look a lot like Europe's Bear Stearns moment. Looking more closely, Joseph Cotterill at FT Alphaville writes that the ECB is caught between a rock and a hard place. Greek banks are experiencing a run on their assets, but where do they go for funding?

But whatever has caused the depositor flight, it’s odd that not many are making the connections to Greek bank funding at the European Central Bank. Having fewer deposits to draw on, the only other place Greek banks can go for replacement funding is from the ECB. That means pledging more, not less, Greek government-backed collateral.

So, what are we to make of the ECB’s repeated threats to cut off the collateral’s eligibility if the Bank is prevented from dictating terms on a bond rollover?

I have been closely watching the relative strength of the Banking Index (BKX) as a barometer of the market perception of systemic risk in the financial system. Previous technical breakdowns have been signals of serious problem, i.e. Russia Crisis (1998) and Subprime Crisis (2007). Looking at the chart, the relative strength of the BKX just broke down:
 
 

 
Uh-oh...
 
The relative performance of the BKX is important is because exposure to European credit doesn't stop at the shores of the Atlantic. No one quite knows how much indirect exposure American financials have to European credit in through the credit default swap (CDS) market. Kash at The Street Light has made a stab at estimating the exposure:

As last week's new BIS data showed, it appears that US banks indirectly have substantial exposure to the peripheral Euro-zone countries that are teetering on the edge of bankruptcy. Exactly what form that exposure takes is a bit uncertain, though it seems likely that much of it is in the form of credit default swaps (CDS) written by the US banks to provide insurance against default to the holders of bonds from Greece, Ireland, and Portugal.

But it's a bit frustrating not to have a clearer understanding of exactly what form this exposure takes. So I've been trying to see if there is any public information that can give us a hint about exactly how the big US banks have incurred such exposure.

The problem is, no one really know. Here are his tentative conclusions:

1. Bank of America, Morgan Stanley, and Goldman Sachs are the most aggressive in terms of taking open positions on default outcomes. But we have absolutely no idea how much of those positions (if any) were with peripheral Euro assets. Also, while the last two firms don't break out income attributable to CDS activities (at least not that I could find), B of A made a huge portion of their profits in 2010 from them. (Note that Citi did not indicate how much of the CDS protection that they sold was covered by purchases of CDS insurance, so they may or may not be in that list as well.)

2. The aggregate CDS exposures of the big US banks are certainly large enough to be plausibly consistent with the BIS estimate of about $100 bn in indirect exposures to peripheral Europe. If you add up the highlighted numbers (and make a guess at Citi's position), it seems reasonable to guess that the total net open positions on CDS protection sold to third parties by the big US banks is between $1,500 and $2,000billion. Attributing $35 bn of that (about 2%) to Greece, which has certainly had one of the most active markets (proportionally) for CDS contracts over the past year, doesn't seem to be a stretch.

3. Banks do not have to provide much detail about the indirect credit exposures that they take on when they sell default insurance through the CDS market. We have incredibly scant information about the positions that US banks take through default insurance, and therefore no idea about how any individual bank will be affected by a Greek default.

4. It's hard to find any other potential exposures to Greece, Ireland, and Portugal in the banks' public filings, other than through CDS contracts. Combined with points 2 and 3 above, the process of elimination suggests to me that CDS contracts are indeed likely to be the source of the bulk of US banks' indirect exposures to a Euro-zone default.

As for the current Greek crisis, I am sure that the troika will find the few measly euros to tide the Greeks over to the next deadline (though Mish has reported that Der Spiegel claims the agreement negotiated between  Merkel and  president Sarkozy has collapsed and Bloomberg reports Europe will pressure Greece by withholding half of the next tranche of money). In the next round of negotations that begin in July, the rescue numbers start to get much bigger. If the Greeks default or restructure, the Apocalypse looms. Here is what I think happens next:

• The Irish, the Portuguese and the other peripheral countries will cry, "What about us?" The troika may the resources to rescue the Greeks, but they will be faced with a wall of protests to "reschedule" other peripheral debt. As an example, consider this interview with Kevin O'Rourke on the Irish attitude that the EU "owes" Ireland for bailing out the Irish banks and therefore deserving of relief.
• A flight to safety will ensue. Risky assets get sold - the result is a cascading "margin clerk" market where everything gets sold.

Does this sound like a Lehman moment about to happen?


China: The elephant in the room
In addition to the looming crisis in Europe, the risk of a hard landing in China is real and it could spark a substantial selloff in risky assets as the markets price in a synchronized global recession. Such a prospect is too scary to contemplate in a fragile global economy.

The indications of a China slowdown are already there and real estate prices are cooling. Last week Standard and Poor downgraded Chinese developers' outlook from "stable" to "negative". Moreover, the Hang Seng Index has decisively broken support, which is a sign of trouble.

The technical picture of the Shanghai Composite is more complicated. It has broken an initial level, but arguably it is now trading in a support zone.

Will the Chinese authorities be able to engineer a soft landing? It's starting to look a little dicey, given the economic headwinds of China's trading partners in North America and Europe.

Given that the markets are oversold and poised for a tactical rally, I would be using market strength as a opportunity to lighten positions.



Addendum: David Merkel pointed out to me that Bear Stearns blew up in 2007, not 2008. I stand corrected.

Getting the China call right

In the current investment environment, getting the China call right can make or break a career. The bull case for China and the emerging markets is well known. For the bear case, just consider this CNBC interview with noted China bear Jim Chanos. In the wake of poor loan growth figures, Doug Tao of Credit Suisse now believes that the risk of a hard landing is rising.

So it is with great interest that I read some more balanced comments about China's excesses from Patrick Chovanec. Here is an example about the property bubble in China:

It will take a significant change in attitude for Chinese investors to starting bailing out of property. How and when that will happen, I am not sure. But of course, that’s the tricky thing about bubbles — since the beliefs that sustain them are not based in economic reality, but in economic misconceptions, psychology, not economics, is what finally tilts the balance one way or the other. If the market stumbles, and that stumble confirms growing fears on the part of investors, the turn in sentiment can be severe, all out of proportion to any real change in underlying conditions. Will this happen in China, now that property prices seem to be going soft? Possibly.

If the Chinese sell property, Chovanec rhetorically asks, "Where would the money go?"

If the Chinese do start pulling their money out of real estate, one reporter called to ask me, where would they put it? After all, one of my arguments for why people in China use property as a “store of value” is lack of attractive alernatives. Well, assuming they successfully find a buyer (which is always the problem when everybody decides to sell), there are three possibilities:

1. They put it into other assets. Last spring, when Chinese investors got spooked about government plans to “cool” the real estate sector, a lot of them started putting their money into gold instead. Jade, artwork, antiques, or even stockpiles of commodities like copper or nickel are potential alternatives. We could even see a situation where Chinese investors bail out of real estate in some cities, which they see as vulnerable, only to buy property in others — in which case, we could see some markets drop while others continue rising, for now at least.
2. They spend the proceeds. If Chinese investors decide to cash out of real estate, and try to turn the proceeds into buying power to improve their quality of life, expect a surge in consumer inflation. Given the explosion in China’s money supply (by more than 50% over the past two years), the question isn’t why inflation is treading 5%, but why we haven’t seen more inflation sooner. The main reason is because most of that new money went into investment rather than consumption, mainly fueling asset inflation. But if those inflated asset values are suddenly transformed into higher consumer demand, the CPI rates we’ve seen so far will look like small potatoes.
3. They hoard the cash. If this happens, the velocity of money will drop and the money supply will decline — in effect, a lot of the money that was created the past two years will simply disappear. This is what happens during a credit crisis, and it’s called liquidation. The good news: no more worries about inflation. The bad news: a lot of financial assets people thought they owned will go up in smoke.

The post is well worth reading in its entirety. In addition to addressing concerns about the property bubble, he addresses other issues such as political unrest, Chinese foreign policy, etc.


Timing the turn
There is no doubt in my mind that China will both soar and crash, but timing the turns in China will not be easy. There are certainly signs of froth in China today. Consider, for example, this story from earlier this year about a Chinese multi-millionaire paying GBP 1 million for a dog because it's a good investment. Is this a sign of a major top?

When you are in a bubble or mania, the difference between the investment hero and goat is timing. During the internet bubble, I recall looking at the Netscape IPO and concluding that it was a sign of froth and it would be wise to stay away from the sector. That assessment eventually proved to be correct, but in the meantime, the markets saw the run up in internet stalwarts like AOL, Amazon, Yahoo! and a whole host of others, as well as the takeover of Netscape by AOL, before the whole house of cards collapsed on us. Yet others who timed the Tech Wreck top correctly are (rightly) hailed as heroes.

The lesson I learned from my Tech Bubble experience is that while it's good to be right, making money is more meaningful. While it is important to consider fundamentals, it's also ok to embrace the dark side and buy fundamentally overvalued assets with strong price momentum. These days, I depend on trend following models to spot intermediate term economic trends. Assuming that you have the right risk controls in place, these models should take you out when the trend reverses itself.
 
As for the question of making the right China call, I use commodity prices as the canaries in the coal mine of global growth and inflationary expectations. If and when they turn down, that will be the signal to exit the risk trade in general and China specifically.

Poised for a "transitory" rally

After six straight weeks of losses, the stock market is poised for a "transitory" rally. Investor sentiment has turned decidedly bearish, which is contrarian bullish. Most overbought/oversold indicators are well into oversold territory.

NYSE New Highs - New Lows

My favorite intermediate term overbought/oversold indicator is also signaling that the market is poised for a countertrend rally lasting 1-3 weeks.

Here is another warning for the bears. We are heading into option expiry week this week, which historically has had a bullish bias.


No all-clear for bulls
Nevertheless, the intermediate and longer term pictures doesn't look very positive. Measures of risk appetite has already turned down and the risk-off trade is in a well-defined downtrend.

Long term headwinds
In addition, Lakshman Achuthan of economic forecasting firm ECRI, which has corrected call previous recessions, stated that the US economy is on the verge of a sustained slowdown.

More worrisome is the technical position of the financials. I wrote before here that the BKX was on the verge of a relative breakdown. Such events have been associated with high levels of systemic risk in the financial system (i.e. Russia Crisis and Subprime Crisis). Well, the BKX definitively broke down last week, though it rallied on Friday to test the bottom of the relative support zone.

This relative breakdown is confirmed by the performance of the broader financials against the market.

Bottom line: The equity market appears to be setting up for a decline of unknown proportions. The decline could be just a plain vanilla 10-15% correction. However, there is a definite possibility that it could be something more serious, such as a repeat of the Lehman Crisis of 2008.

The markets are poised for a tactical rally. My inner investor is extremely cautious and inclined to be very defensive. On the other hand, my inner trader tells me that despite the technical breakdowns, don't start new short positions at this time.

The Fed's (inadvertent) role in the class war

To give some context to Bernanke's remarks yesterday about inflation being "transitory" and his apparent blindness to commodity inflation, investors should consider the recent paper by Gauti Eggertsson of the New York Fed which asked, "Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?"

Eggertsson discussed the episode in 1937 when the Fed saw a burst of commodity inflation and responded with a tightening policy. He rhetorically asked:

The question for the contemporary reader is this: If we could transport a modern-day economist back to 1937, would he or she have made the same mistake? My suggested answer—admittedly somewhat hopeful—is no. I base this view on the fact that most economists today distinguish between the temporary movements in the consumer price index that stem from volatility in commodity prices and the movements that reflect fundamental inflation pressures. Hence a modern economist most likely would have identified the price rise in 1936 and 1937 as a temporary upswing in commodity prices that did not signal a significant increase in overall inflation.

In other words, modern economists would view the current episode of commodity and asset inflation as transitory and the Fed should not react with a tighter monetary policy.


Different kinds of inflation = Different winners and losers
While there are the usual caveats to the Eggertsson discussion that it does not represent the views of the New York Fed, it is clear to me that the sanguine attitude towards commodity and asset inflation is dominant at the Bernanke Fed.

This got me to thinking about central bankers think about inflation, which is mainly measured as core CPI, or some inflation measure ex-food and energy, i.e. commodity prices. The central bankers of the developed world today learned in the 1970's the way to break the back of inflationary expectations is watch labor costs carefully. If you don't allow labor costs to rise, then you suppress the feedback loop that leads to ever rising inflationary expectations. (Meanwhile outside of the West, things are different. Consider this iMFDirect comment about how food inflation has affected the Middle East).

Indeed, we can see that philosophy at work at the Fed. The accompanying chart shows that US hourly earnings (red line) have lagged the increase in CPI (blue line) for the past few decades.

While that approach may be a solution to controlling inflation, such a technique creates different winners and losers. When the Fed turns a blind eye to asset inflation and but remains vigilant on wage inflation, it tilts the playing field in favor of the owners of capital and away from the suppliers of labor.

Add that to that the current ugly employment situation...

...a record low in labor's share of national income (as per David Rosenberg)...

...and the fiscal ingredient of ever present calls for lower individual and corporate income tax rates (but not payroll tax rates), you have the ingredients of a class war. Taken to its logical end, America loses its competitiveness and becomes Argentina.

The bulls attempt a goal-line stand

At the end of the week, the major equity market averages were looking dicey. The US equity market was at a level where it was testing support:

Moving around the world, a similar pattern can be found in the stock market in Europe:

...in Shanghai:

...Hong Kong:

...commodity sensitive Australia:

...and commodity sensitive Canada:

A tactical rally possible, but intermediate term internals point south
Given that the markets worldwide at now resting on technical support, look oversold on a short-term basis and investor sentiment is decidedly bearish, I would be prepared for a tactical rally lasting 1-3 weeks. After that, the market internals still look terrible.

Consider my favorite indicator of risk appetite, namely the relative performance of US Consumer Discretionary to Consumer Staple stocks. This measure shows that its relative uptrend was broken in mid-March, indicating that "risk on" trade was coming off, and went into a downtrend indicating that the "risk off" trade is now definitely on.

A similar pattern can be seen in the relative strength of the cyclicals, as measured by the Morgan Stanley Cyclical Index against the market.

The Industrials, which had been strong leaders since July 2009, are now rolling over and leadership change is often an indication of a sea change in market direction.

Rising systemic risk
As I have noted before (see On the fence, watch for an Apocalypse), the deteriorating relative performance of the financials is worrying. I am closely watching the relative performance of the BKX against the market. The violation a major relative support level has historically signaled rising systemic risk and financial panics (Russia Crisis in 1998 and Subprime Crisis in 2007). Looking at the chart today, the BKX has arguably already violated a primary relative support level, shown in blue. One could argue, however, that it is still testing a secondary support level, shown in violet.

In this week's newsletter [free registration required], John Mauldin pointed out to analysis from hedge fund GaveKal that came to a similar conclusion. GaveKal also found that their stress indicators are headed south:

As we have highlighted in recent Dailies, our Velocity Indicator has been heading south rather rapidly. At first glance, this might appear surprising as there are few signs of stress in the financial system today: corporate spreads are decently tight, IPOs continue to roll out, and the VIX remains low. Sure, Greek debt has now been downgraded below Montenegro’s and stands at the same ratings as Cuba’s, but even acknowledging this, the recent depths reached by our Velocity Indicator is still somewhat surprising. Why, in the face of fairly benign markets, is our indicator so weak?

GaveKal and I independently found the same result, which is the underperformance of banks is a sign of concerns over systemic risk [emphasis added]:

The answer is very simple and it is linked to the recent underperformance of banks almost everywhere. Indeed, with short rates still low everywhere, and yield curves positively sloped, we are in the phase of the cycle when banks should be outperforming. The fact that they are not has to be seen as a concern. So does the underperformance come from the fact that the market senses that losses have yet to be booked (Europe?)? Is it a reflection of a lack of demand for loans (US?) or that more losses and write-offs are just around the corner (Japan?)? Is the bank underperformance signaling that we are on the verge of a new banking crisis, most likely linked to the possibility of European debt restructurings? Or perhaps it is linked to the coming end of QE2 and consequential tightening in the liquidity environment (see our Quarterly published earlier today for more on this topic)?

In our view, any of the above could potentially explain the recent bank underperformance. But whatever the reasons may be, it has to be seen as a worrying sign. One of our ‘rules of thumb’ is that if banks do not manage to outperform when yield curves are steep, the market must be worried about the financial sectors’ balance sheets (given that, with a steep yield curve, there are few reasons to worry about the bank’s income statement).

Mauldin went on to warn about the contagion risk from Europe [emphasis added]:

There is $600 trillion in derivatives now loose in the world. Who knows which banks have written them and to whom? Who are the counterparties? We did not fix this with the last political fix. The next crisis has the potential to be just as bad or worse than 2008, which is why I think Europe’s leaders are so dead set on avoiding a day of reckoning.

Apocalypse not yet, but watch this space!
In addition, FT Alphaville highlighted a research note from Ruslan Bikbov and Priya Misra of BoA/Merrill Lynch. These analysts looked at cross-asset correlation, which is an indicator of systemic risk, and observed:

It is very unusual, however, to see high levels of cross-asset correlation together with declining volatility. This is because cross-asset correlations tend to rise during times of market stress, and these times normally experience high volatility.

They went on the point out the contagion risk which could result in another financial panic [emphasis added]:

Given that the assets under management of macro hedge funds are 30% higher than in 2007 and leverage has likely increased since the peak of the crisis, crossasset portfolios could be a potential for a contagion risk, which can be amplified further by the net short volatility base of the hedge fund community. The collapse of LTCM in September 1998 is a case in point. At that time a seemingly small shock in the EM (Russian default) resulted in severe global market volatility due to fire sales of an over-leveraged hedge fund community.

Given the likely oversold rally that is just around the corner, I interpret these conditions as Apocalypse Not Yet - but watch this space.

Investors should take steps and ensure that their portfolios are protected in case downside volatility (another financial crisis) and positioned to profit in the case upside volatility (QE3). I am, with the Inflation-Deflation Timer Model.

Where is the next bubble going to be?

Most recently, Paul Kedrosky wrote the following about investment bubbles:

The whole point of venture capital is to create and ride bubbles. To pretend otherwise is hopelessly silly, not to mention naive.

[On the subject of LinkedIn and the existence of a technology bubble:] And we are in the middle of major transformations, mostly driven by technology. It’s not surprising that public and private markets are excited about it all — there is much to be excited about, from mobile, to location technologies, to social technologies, to exa-data and on and on. The only thing that would be surprising is if all this didn’t get markets and investors jazzed.

Beyond following goings and comings of VC investment flows, how can we spot the next bubble? Qwest Investment Management just published my monthly article that considers the question of Where is the bubble going to be? If you are looking for a bubble, here is a chart of the mother of all bubbles:

Yup, it's a picture of human population growth. Bubbles will emerge from the story of rising human population, rising demand and human ingenuity. In the article, I examine the question of the next investment bubble and identify five possible candidates as investment themes:

• Agriculture: It's the story of rising demand from newly affluent emerging market economies.
• Water: We are running out of fresh water, which is essential for human survival.
• Alternative Energy: The appearance of Peak Oil is likely to hasten the search for alternative energy sources.
• Biotech: There will likely be a raft of life extension technology commercilization opportunities in the next ten years.
• Nanotech: Nanotechnology advances are still in the lab but there are some mind blowing applications and truly transformative technologies to be seen.

More details here.

Turning beta into alpha

Joe Weisenthal over at Clusterstock recently reported that quants have become beta chasers:

In a survey of quant investors done by BofA/ML, the number of respondents who say that beta is a key factor in their stock screens, has surged overtime, from less than 20% in the mid 90s to over 70% now.

This observation confirms what I suspected all along - we have returned to a single-factor CAPM framework from a multi-factor APT framework. In other words, investment decision making has returned to either "risk on" or "risk off".

Given the current environment, I chose to turn to active asset allocation and apply a momentum model to the beta decision of others, i.e. the Inflation-Deflation Timer Model, as my principal source of alpha.


Playing poker, not backgammon
Many quants think of investing as a structured game with some randomness thrown in, like backgammon. I believe that in investing, you have to watch what others are doing as well. Don't forget that Edward Thorp, who was one of the original quants, was a poker player.



Correction: A colleague pointed out to me that Thorp was known as a blackjack player, not a poker player. Despite the incorrect analogy, I continue to believe that quantitative analysts think about the structure of the game that they are playing - which resembles poker than a structured game like backgammon or blackjack.

Time to sell? Roach turns bullish on China

When I was a portfolio manager in the 90's, my Morgan Stanley salesman used to invite me into New York from Boston for meetings and lunches, which I never attended. I used to quip that I would see him in New York when their (then) strategist Stephen Roach turned bullish. Even then, Roach was the perennial grump and bear, much like David Rosenberg and Albert Edwards are today.

So it was with some surprise that I saw Roach's bullish commentary on China entitled 10 Reasons Why China is Different.

When the perennial bear turns bullish, is it time to sell?

Which part of Goldman is right?

Many of you will have heard about Goldman's bullish call on oil (via ZeroHedge), with a target price of $130 for Brent. Not are they bullish on oil, but the entire commodity complex.

At the same time, Goldman is forecasting for an economic slowdown in China:

Our new GDP estimates show a significant slowdown in 2Q11 to 8.0% qoq (significantly below trend), then recovering towards trend in 3Q11 at 9.0% and returning to trend in 4Q11 at 9.3%. This is both a sharper and more extended slowdown than we had previously forecast.

How can Goldman Sachs be oil and commodity bullish when China consumes 25-50% of many key commodities?

Izabella Kaminska at FT Alphaville points out some analysis from Simon Hunt of Simon Hunt Strategic Services which suggests that rising copper demand seen in China is the result of re-stocking and not final demand, which remains weak:

What is now being seen is that fabricators who have been operating on a hand to mouth basis, now seeing prices having fallen by $1000+ , are replenishing those inventories. It is not a signal that actual production of semis, i.e material going into furnaces has improved. On the contrary, I expect to be told that business is pretty weak.

Who is right? Which part of Goldman Sachs is right? Are they all right?

I don't know. This is a "feature" of sell-side research, where you have encounter analysts with competing views.

On the fence, watching for an Apocalypse

Whew! The world didn't end Saturday. There is another form of Apocalypse - a financial one, that I am watching for. Already, the shares of Goldman Sachs appear to be in freefall (and on high volume).

A breakdown in Financials = Rising financial stress
Of greater concern is the performance of the PHLX Bank Index (BKX) against the market. The chart below plots the relative performance of the BKX to the market going all the back to 1993. Right now, the banks are now testing a critical relative support level. Instances in the past where it has broken these support levels have been signals of rising systemic risk in the financial system that ultimately culminated in market meltdowns. The first instance warned of the Russia Crisis, which brought down Long Term Capital Management. The second occurred in April 2007, which was the subprime crisis - whose ultimate conclusion was the Great Recession of 2008.

The bull case

While I just trade the signals and don't try to anticipate signals, the prognosis is mixed and I am on the fence on whether it is likely to break down. The banks have not shown me that they have definitively broken relative support - which would be a warning of severe distress. They are just testing support levels.

There is a bullish case to be made. Scott Grannis points out that systemic risks are low right now, largely because of the message from the bond market. I have learned over the years that given a choice between believing the message from the bond market and the stock market, I would tilt towards the bond market.

The bear case

On the other hand, a glance at the relative performance of the Financial Sector SPDR (XLF) for the past two-and-a-half years shows that the Financials may have already broken down on a relative basis. The sector is definitely in a relative downtrend. XLF may have already violated relative support, though arguably it is still in the process of testing a relative support zone.

A place to hide

Nevertheless, I remain conflicted. Certainly there are risks, but the presence of risk doesn't mean that the world is certain to blow up.

During these periods of analytical uncertainty, I believe that a disciplined model such as the Inflation Deflation Timer Model, coupled with secondary indicators such as the BKX or XLF vs. the market, are a good place to hide. If the Timer Model were to signal a period of heightened financial stress, then the model portfolio would rotate into the safety of the US Treasury long bond (unless the crisis is a US default, in which case I would find something else, e.g. Canadas). On the other hand, if things turn around because of a policy response, e.g. QE3, then the Timer Model would move into the aggressive, high beta trade of emerging markets and commodity producers.

The bears in control

I got some push-back from readers after my last post, Ursa Major or Ursa Minor. The gist of the objection was that stock market leadership can rotate and a commodity price sell-off is not necessarily a precursor to a bear market. Stocks can continue to rise because of the stimulative effects of lower oil and other commodity prices.

I beg to differ.

Many secondary indicators of risk appetite and cyclicality are rolling over. The weight of the evidence suggests that the bears are now in control of the stock market. Consider, for example, the ratio of relative performance of the Consumer Discretionary sector (XLY) to Consumer Staples (XLP), my favorite measure of risk appetite. This ratio topped out in February and has been in a relative downtrend ever since, indicating that risk appetite is in retreat.

The market rally from the March 2009 bottom has driven by the expectations of a cyclical rebound. The accompanying chart of the Morgan Stanley Cyclical Index against the market shows a similar pattern of broken relative uptrends. Can the equity market continue to advance when cyclicals are going sideways relative to the market?

Also consider where market leadership is coming from: defensive sectors such as Consumer Staples. Is this the sign of a healthy bull?

Other defensive sectors, such as Utilities, are also leading the market.

Mark Hulbert pointed out that Ned Davis Research concluded that their studies of market sector rotation is pointing to a market top. I concur with that assessment.

The bigger question is whether this is just a minor pullback or the start of something bigger. For that answer we will have to watch and wait.

Ursa Major or Ursa Minor?

I have been getting increasingly more cautious about the equity markets, starting in early April and more cautious last week. Now that the markets seem to be in a pullback mode, the key question is: What's next?

Regular readers know that I use commodity prices as the canaries in the coal mine of global growth and inflationary expectations. The canaries are not behaving well, as shown by the chart of the CRB Index below. Commodity prices have broken out from a steady uptrend and they are now testing a critical support level. I am now watching to see if those key support levels hold.

Commodity sensitive stock markets like the Canadian market is showing a similar pattern of testing important support levels.

Looking further at emerging market equities, which is another important barometer of global growth expectations, EEM has already violated an initial support level, with the next support at 44. I will be watching if there is further weakness and if the critical support at 44 holds. Looking across the BRIC markets, both Brazil and Russia have broken down technically, with the former in a clear downtrend.

Then there is the elephant in the room - China. Given the fragility of the global economy, getting the China call right is going to be really important. I am now watching closely how the Shanghai Composite behaves at the different support levels.

A clearer picture can be seen by watching the Hang Seng and if critical support at around the 22,600 level can hold.

In short, the market is clearly in corrective mode and my inner investor believes the markets have the echoes of 2008 here. Then, we had a commodity price blowoff, just as we do now. Then, we had looming macro risks overhanging the market, just as we have now. Consider, for example, John Maudlin's excellent explanation of European sovereign risk here.

On the other hand, my inner trader tells me to listen to the markets and trade their whispers, rather than listen to my own biases. Though the major market averages in the US and Europe aren't behaving as badly as some of these charts that I have shown above, watching how the different markets behave at these critical support levels will give us clearer signs of whether we are dealing with Ursa Major or Ursa Minor.

Take a ride on my demographic train

I wrote back on July 8, 2010 about an academic paper by Geanakoplos et al entitled Demography and the long-term predictability of the stock market, where the authors related stock market returns and long-term P/Es. Reading between the lines, they forecast a 1982-style (my words, not theirs) market bottom about 2018.

Now, I see that others have jumped on the story. Mark Hulbert has highlighted some analysis from Ned Davis Research indicating that American age demographics will be more youthful than China's by 2020. Hulbert pointed to a paper that concluded that investors don't pay much attention to demographics, even though age demographics is highly predictable and such trends exploitable by investors. Here is the abstract [emphasis added]:

Do investors pay enough attention to long-term fundamentals? We consider the case of demographic information. Cohort size fluctuations produce forecastable demand changes for age-sensitive sectors, such as toys, bicycles, beer, life insurance, and nursing homes. These demand changes are predictable once a specific cohort is born. We use lagged consumption and demographic data to forecast future consumption demand growth induced by changes in age structure. We find that demand forecasts predict profitability by industry. Moreover, forecasted demand changes 5 to 10 years in the future predict annual industry stock returns. One additional percentage point of annualized demand growth due to demographics predicts a 5 to 10 percentage point increase in annual abnormal industry stock returns. However, forecasted demand changes over shorter horizons do not predict stock returns. The predictability results are more substantial for industries with higher barriers to entry and with more pronounced age patterns in consumption. A trading strategy exploiting demographic information earns an annualized risk-adjusted return of 5 to 7 percent. We present a model of underreaction to information about the distant future that is consistent with the findings.

My conclusion has been equity markets are likely to go sideways until the end of this decade. I wrote that:

Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.

During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Inflation-Deflation Timer Model to capture the swings of a flat market.

Sell in May?

In the wake of the commodity rout last week, the Inflation-Deflation Timer Model has moved into "neutral" from an "inflation" reading*. This told my inner trader that he should take some risk off the table. Given the high level of macro risk, I would be inclined to take more more defensive position than usual.

This signal to de-risk isn't a surprise. In early April, I wrote about negative divergences (see Getting ready to sell in May). How the market reacts to news is also a good short-term indicator of direction. The fizzled Osama bin Laden rally should have been as clear as ringing the bell in the town square to traders that this market was looking tired.


What happens now?
Now that the Timer Model has gone neutral, what happens now? Mr. Market could take one of two paths.

First, this could be the start of a run-of-the-mill 5-10% correction in the equity market, with an extreme downside limit of about 15%. VIX and More has tabulated the market pullbacks in the 2009-11 period and the average depth of these correction was 6.5%.


Macro risks everywhere
I am concerned that the market is acting vulnerably during a period of heightened macro risk. There are three major sources of macro risk:

• Europe: As I write this, Greek 2-year debt is sporting an eye-popping yield north of 25%. These stratospheric levels reflect market fears that bond holders will have to take a significant haircut on Greek debt, which would be a devastating blow to the already fragile European banking system. If Greece re-structures, then it could very well take down Spain - which may be too large for the EU to rescue.
• China: The PBoC has signaled that it will take further steps to cool its superheated economy and there are "no limit to how far it can raise the reserve requirement". Already, there are signs that its property bubble is being deflated. Recent reports indicate that Chinese property developer profits are falling and their debt is approaching $1T in a climate of rising inventory.
• US default: The political horse-trading over the debt ceiling continues to be worrisome. A default by the US Treasury would send shockwaves all around the globe and it would be the financial equivalent of the comet that hit the Earth and created the Gulf of Mexico in prehistoric times.

The current market environment is likely to resolve itself with a plain vanilla 5-10% correction. However, if any of these macro risks were to manifest themselves during that pullback, the downside has the potential to extend itself to 40-50%.

My inner investor has already heeded these warnings and de-risked his portfolio. My inner trader is inclined to be more defensive than normally called for.


* The announcement of signal change was delayed on this blog out of consideration for the clients of Qwest Investment Fund Management.

Where's diversification when you need it?

One of the rationales for the formulation of the Inflation-Deflation Timer Model was the failure of asset diversification in the Financial Crisis of 2008. During that panic episode, investors found that asset class return correlations converged to 1. All assets moved together because it was one giant risk trade. Even balanced funds failed to diversify risk.

In response, the Timer Model was built in such a way that during deflationary, or panic episodes, I analytically identified assets, i.e. risk-free US Treasuries, as the safety trade - without reference to any historical correlations.

I see that a number of others agree with my analytical approach to risk analysis. John Authers wrote the following in his book, The Fearful Rise of Markets:

In the future, it would make more sense to divide the world by risk. If an investment is not prone to the same risks as the others you already hold, then buying it will reduce your overall risk. If it is subject to exactly the same risk, then buying it is pointless, even if it is in a different asset class or country. Rather than balance between stocks and bonds, for example, it might be better to balance the risks of inflation and deflation, which both affect stocks and bonds. Diversification itself is as good an idea as ever. You should not put all your eggs in one basket. But in the globalized world, you can put your egg into a different country an still find that it is in the same basket.

EDHEC said the same thing, but in a slightly different way. (Note that my Timer Model is a dynamic asset allocation model) [emphasis added]:

The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies.

When do you want risk control the most? During "normal" periods when diversification dampens volatility and returns? Or during extreme crisis events when standard diversification techniques break down?

Comparing private and government compensation

There is an assumption in many quarters of society that virtually any form of government is inherently bad. Private enterprise and the free markets can do things much better. Consider this essay entitled If Supermarkets were like Public Schools, as one of many examples. Donald Boudreaux lays out the scenario:

Suppose that groceries were supplied in the same way as K-12 education. Residents of each county would pay taxes on their properties. Nearly half of those tax revenues would then be spent by government officials to build and operate supermarkets. Each family would be assigned to a particular supermarket according to its home address. And each family would get its weekly allotment of groceries—"for free"—from its neighborhood public supermarket.

No family would be permitted to get groceries from a public supermarket outside of its district. Fortunately, though, thanks to a Supreme Court decision, families would be free to shop at private supermarkets that charge directly for the groceries they offer. Private-supermarket families, however, would receive no reductions in their property taxes.

He went on to assert that private enterprise, or the free market, could deliver those services much better [emphasis added]:

Being largely protected from consumer choice, almost all public supermarkets would be worse than private ones. In poor counties the quality of public supermarkets would be downright abysmal. Poor people—entitled in principle to excellent supermarkets—would in fact suffer unusually poor supermarket quality.

If the free market is the superior choice in virtually all instances, then incentivizing workers by their output, as well as a business friendly tax policy, is the correct solution. Nowhere else can this attitude be found than the gargantuan compensation packages found on Wall Street.
 
The Epicurean Dealmaker has a more nuanced interpretation of banker compensation. He explains that investment banks are networks that can be rented by clients. The investment bankers and traders are also valuable in and of themselves:

Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.

So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.

So if you accept the principle that someone makes a zillion for the bank, he deserves a reasonable cut of the profit (with definition of the term "reasonable" subject to later discussion).


Greed is Good, but it isn't the only motivator
Contrast that to the paradigm of how government works. Civil service workers have little incentive to do a better job, largely because market based signals are largely absent.

Now think about the jubilation over the death of Osama bin Laden and the adoration of the anonymous SEAL team that executed the raid. Now think about these questions:

• Why is there all this adoration over a bunch of people who work for the federal government?
• There was a $25 million reward for OBL, why didn't that get results earlier?
• Would we have seen better or faster results if these civil servants had been incentivized properly (perhaps to give a three or six sigma effort)? Should this SEAL team, along with the numerous intelligence analysts involved in the operation be incentivized with multi-million dollar Wall Street bonuses?

People do things not just because of greed. Greed is a powerful motivator, but it isn't everything.

Upcoming conferences

Here are some upcoming conferences of interest that I want to highlight.


Pacific Northwest Economic Conference: Fixing Global Finance

If anyone is around Victoria, BC next week, I will be on a panel at the Pacific Northwest Regional Economic Conference on May 13, 2011 discussing Fixing Global Finance, with Yves Smith of Naked Capitalism and Marion Wrobel of the Canadian Bankers Association. The conference runs May 12-13.


The inflation-deflation debate continues
In addition, AIMA Canada is running a debate on May 25, 2011 in Toronto entitled Inflation or Deflation, which risk should you prepare for? I have been writing about inflation-deflation debate since mid-2009. There are some well-thought analysis on both sides. I believe that many deflationists are confused about is the meaning of the term inflation (see my previous comment here). There is little or no inflation in consumer goods (TV and cars) but signs of massive asset inflation (commodities, collectibles, etc.) Those who watch CPI or core CPI will find little or no inflation, while those who watch commodity prices will find the opposite picture.

I expect to be in attendance. Come to the session if you are in or around Toronto. I am sure it will be worthwhile.

Cheap way to get Aussie exposure

I have written about the Australia/Canada pair trade before. Both economies and their stock markets are structurally similar. The major difference is that while Australian resource exposure is tilted towards mining, Canadian resource exposure is more heavily weighted in energy.


Buy Canada/Sell Australia
The chart below shows the relative performance of the iShare Canada ETF (EWC) compared to the iShare Australia ETF (EWA), both measured in USD. As you can see, Canada is near the bottom of a relative trading range.

The Canadian election held Monday gave the Conservatives a rare majority government. These results should take some of the political uncertainty out of the Canadian market.

Given the relative performance of the two markets, traders may want to consider going long Canada and shorting Australia. More risk averse investors can think of the Canadian market as a cheap way of gaining exposure to an Aussie-like stock market.

As always, pairs trading is not for the faint of heart and any trade should be entered with well-defined risk limits in mind.

Is Bernanke more brilliant than we ever conceived?

Many analysts, myself included, have watched in horror as the Bernanke Fed seems to have ignored the perils of incipient inflation and monetary debasement in implementing QE and later QE2. Lately I've been thinking that Ben Bernanke is a evil genius with a secret agenda that is more brilliant than anyone has conceived before.

Nick Rowe, writing at Worthwhile Canadian Initiative, inadvertently laid out Bernanke's nefarious scenario. First, he wrote:

There's a general principle in economics: first you eat the free lunches; then you look at the hard trade-offs. Functional Finance says "first eat the free lunches". The Long Run Government Budget Constraint says "then look at the hard trade-offs".

Everyone likes a free lunch. The Washington Post reported that in a poll, Americans would like to cut the budget deficit, but they oppose entitlement, defense and across-the-board tax increases cuts.

The survey finds that Americans prefer to keep Medicare just the way it is. Most also oppose cuts in Medicaid and the defense budget. More than half say they are against small, across-the-board tax increases combined with modest reductions in Medicare and Social Security benefits. Only President Obama’s call to raise tax rates on the wealthiest Americans enjoys solid support.

In other words, they want a free lunch. (Consider, for example, this more realistic assessment of the budget from former Reagan budget director David Stockman where he blames both sides of the aisle.) Rowe postulated that there are certain circumstances where the American People could have their free lunch:

Suppose, just suppose, that if you kept on doing what you were planning to do, you never had to worry about inflation. Not now, not in the future, not ever. Because Aggregate Demand was too low now, and was projected to be too low forever. So you are not worried about inflation. Instead you are worried about deflation. And you were a government that could print your own money. What would you do?

You would print money and spend it. Or print money and use it to finance tax cuts. And you would keep on doing it, more and more, until you got to the point where you did start to worry about inflation. You first eat all the free lunches.

When the US Dollar is the de facto reserve currency of the global economy, there is a free lunch of sorts. But what about the consequences? Rowe has an answer to that as well, given that the global economy collapsed in 2008 and remains very fragile [emphasis added]:

Suppose inflation isn't a problem right now, because Aggregate Demand is currently too low. Does that mean the government should print money and spend it? Not necessarily. Print money yes, but instead of spending it on goods, or on tax cuts, it might be better to use it to buy back some interest-paying government bonds. Because even though inflation isn't a problem right now, it may be a problem some time in the future. So you can buy the money back in future, by re-issuing the bonds (and save on interest in the meantime) without having to raise future taxes or cut future spending.

Isn't that what the Fed is doing, in its own way, with QE2. Okay, it's not retiring government debt but putting the paper on the Fed's balance sheet. Nevertheless, the Treasury can now finance new debt at lower rates because Aggregate Demand is so weak.

Is this the evil genius Dr. Bernanke at work? Or just the government acting rationally? Either way, it's utterly brilliant!



Addendum: In a future post, I will write about an "out-of-the-box" plan to address the US federal deficit in a relatively painless way.