Monday, May 31, 2010

Another look at the inflation-deflation debate

Last Friday, CNBC featured two guests who debated the inflation vs. deflation story. I think that the CNBC participants were missing the point. There is both inflation and deflation in the system, if you know where to look.

Certainly when you look today, you will see a strong case for deflation: a weak consumer, in both the US and Europe, rising unemployment, excess capacity and debt problems everywhere (an example of one of many arguing the deflation case can be found here).

Does that mean that inflation is dead? Not quite. Shadowstats’ CPI figures show that their alternate CPI is north of 9%:

Chart of U.S. Consumer Inflation (CPI)

What kind of inflation?
The question shouldn’t be one of inflation or deflation, but what kind of inflation given the deflationary landscape. Scott Grannis at Calafia Beach Pundit showed that there is inflation in services but deflation in durable goods:

To that analysis, I would add “inflation in raw materials”. As I wrote before:

A portfolio that relies on commodity and commodity-linked equities would be an effective inflation hedge under such a scenario. However, portfolios that rely on fixed income based solutions, such as inflation-indexed bonds like TIPS or even yield steepener trades, may be less effective as these kinds of inflationary signals may not show up as well in those markets.

Timing the inflation/deflation trade
I think that another reason that many market participants are confused about the inflation vs. deflation debate is the degree of macro-economic volatility that we are observing. While it is true there is a great degree of volatility in the economic outlook, investors can profit from that volatility with a timing system such as the inflation-deflation timer model, which is currently showing a neutral reading right now.

Friday, May 28, 2010

Buy Singapore, sell Hong Kong?

Further to my last post about buying Australia and selling Canada, an alert reader emailed me and asked me to comment about buying Singapore and selling Hong Kong as another pair trade with the Asia Ex-Japan region.

Here again, is Bill Hester's analysis of relative country valutions based on cyclically adjusted P/Es and dividend yields. Indeed, it shows that Singapore as very undervalued and Hong Kong as roughly fairly valued.

The chart below shows the relative total performance of the iShare Singapore ETF compared to the iShare Hong Kong ETF, both in USD. This chart casts more doubt on the profit potential of a Singapore/Hong Kong pair trade.

I wrote in my previous post: "Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada."

The Australia vs. Canada pair trade that I proposed had the benefit of a valuation spread and price mean reversion. In the Singapore vs. Hong Kong case, the pair is already moving in Singapore's favor and it does not appear to be a mean reversion trade. There appears to be less of a historical price relationship between those two markets than Australia and Canada.

Under these circumstances, I would steer clear of the trade.

Wednesday, May 26, 2010

Buy Australia, sell Canada

Recently Bill Hester of Hussman Funds did some analysis of average country valuation based on a composite of cyclically adjusted P/E ratios and dividend yields and concluded that US equities remains overvalued compared to its own historical average.

What fascinated me about the chart was the degree of overvaluation exhibited by Canada, compared to Australia, which is trading at roughly its own historical average. The economies of Australia and Canada are similar in character. Both are resource based economies and about the same size. There is a minor difference as Australian resource industries tend to be more tilted toward the bulk commodities (i.e. coal and iron ore) whereas Canada has a higher weight in energy.

Long Australia/Short Canada
The chart below shows the relative total performance in USD, which takes out any currency effects, of the iShares Australia ETF (EWA) and the iShares Canada ETF (EWC). This chart suggests that Australian and Canadian markets have tracked each other relatively closely since late 2002 and Australia is now at the bottom of a trading range relative to Canada.

Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada.

The risk in the trade is seen in the recent steep selloff in the Australian market, attributable to the news of a super-tax of up to 40% being imposed on resource companies. Nevertheless, the trading range is indicative that the risk-reward ratio is positive for this pair trade and that most of the bad news is already in the Aussie market.

Here are some of the things that could go right for the trade:

  • Australia took the lead, but the super-tax contagion could spread. How long would it take for budget constrained countries like Canada or Brazil to consider a form of super-tax on resource extraction companies? The 40% tax rate is awfully tempting and forms a very high ceiling rate from which to impose a new tax. Sympathy for resource extraction companies is low, especially in offshore oil extraction given BP’s environmental and public relations nightmare.
  • The Australian government has indicated that the door is open in changes to the tax regime. While the news is bad right now, the Aussie market could rally should the government step back and ease up its tax proposal.
  • The Reserve Bank of Australia is ahead of the curve in its monetary policy, as it has moved into tightening mode. By contrast, the Bank of Canada remains behind the curve in its monetary policy. What would happen to the Australia/Canada spread if and when the BoC tightens?
A long Australia/short Canada trade is a highly speculative position. As such, I would be entering into such a trade with a target and pre-defined stop loss levels.

Tuesday, May 25, 2010

A classic reversal day

US equities experienced a classic reversal day, where the market opened up spiked down, rallied and then closed at the highs of the day.

Combined with indications of a sentiment washout, this is a classic price reversal day that portends the short-term rally that I was looking for.

Monday, May 24, 2010

Revisiting the gold standard

As the Greek crisis engulfed Europe, the euro fell against both the US Dollar and gold. The most interesting thing to emerge out of this episode is that gold appears to have re-asserted itself as a reserve currency as its price climbed in USD terms.

I had previously written an article questioning the role of gold. With the Eurozone crisis fresh in our minds, is it time to revisit the idea of a gold standard?

Do we really want currency inflexibility?
To put the idea of a gold standard in context, consider this comment at Pragmatic Capitalism [emphasis added]:

The irony behind the Euro crisis is that it is not at all a condemnation of fiat money. In fact, it is a condemnation on single currency systems such as the gold standard. I have long argued that the mess the EMU created in 1999 with the inception of the Euro was unlikely to survive a serious global recession. This was due to one primary argument. The gold standard and single currency systems have all ended in demise for similar reasons. This was due to their inherent inflexibility and inherent weaknesses imposed on particular trade partners within the currency system.
Despite of the problems in the UK, the British must be thanking their lucky stars that they didn't join the eurozone as they have the flexibility to devalue their currency if necessary.

What about a hedge against chaos?
The other classic argument for holding gold is that it is the ultimate store of value during periods of political chaos. Fortunately, most of us haven’t experienced that kind of chaos in our lifetimes, or our parents’ lifetimes, so we are only relying on the theory of gold as an ultimate store of value. Consider this discussion posted by Cassandra does Tokyo, who spoke with someone that came from the former Yugoslavia and had first-hand experience of political chaos [emphasis added]:

Starting with the [now seemingly forgotten] crisis, we talked of many things, before it turned to "Gold", which he volunteered, he thought was dumb. Not that he thought the vaulting price was stupid. He offered no opinion of that. But, he said, the war years were tough. Really tough. (He was not of Serbian descent, as it would happen). He'd seen his friends, he explained, do the smash-n-grab (not literally) thing following the disintegration of what was Yugoslavia, rolling up ill-gotten gains into (amongst other material objects) hoards of gold. Their hedge. Their so-called mad money, for which he said chided them at the time, though to little effect. But, he went on, when things got really dire, there was no market for it. There was no way under the circumstances to reasonably convert the hoards to what one really needed. As a result, the going rate was all over the map, but half-ounce or ounces were commonly traded for sugar and flour in ratios that would make the wealth-hedging gold-bug weep. I listened intently, though it was just an anecdote, but an interesting one nonetheless.
So it turns out that gold may not be such a flexible store of value if everything fell apart. Cassandra does Tokyo went on to state that basic necessities such as sugar and petrol (gasoline) would be better stores of value under cirumstances of social chaos:
Viewed from this point, gold is a trade, for ruminating upon my Bosnian acquaintance's anecdote, there is a point - call it the "Oh Fuck moment" beyond which Gold is quite sub-optimal, and sugar, petrol, some vegetable seeds, a goat or two, an alembic, all make seeming better sense. Or, perhaps in the extreme, the best hedge in the event (if you believe in the event) of a breakdown in the rule of law, is to BE the baddest thug, and/or join/align yourself with the meanest thugs around, a paradoxical feedback loop that leads one down a disturbing rathole indeed.

A gold and commodity bubble
Despite all these negatives, I remain a long-term gold and commodity bull. George Soros believes that gold is in a bubble – and I agree. While some have interpreted Soros' comment as gold could collapse at any time, I have a different take. Recall that I wrote before about his belief about recognizing bubbles and to ride the wave of euphoria as a way of making money.

If this were indeed a gold bubble, then I would not be surprised to see bullion top out at between 5K and 10K or more before this is all over. As an indication of bubble conditions, Patrick Chovanec recently wrote that China is catching the gold bug – which is an indication that this gold bull may have a long way to go.

Am I a long-term gold and commodity bull? Yes. Fiat currencies are in decline and hard assets are in a secular bull market, though it will have cyclical ups and downs.

Do I support the idea of bringing back the gold standard? No, that’s a really bad idea.

Friday, May 21, 2010

Are we there yet?

About the time when this market downdraft began, I wrote a post on May 6 [emphasis added]:

Already I see a number of technicians calling for an intermediate term bottom at around the 1040 to 1100 level on the SPX. Given the weak action of the broader NYSE Composite, my best guess is that support materializes closer to 1040, which also coincides with the February lows. If the market does descends to those levels, how will market participants react should we approach those price zones?

I would watch the sentiment indicators. Is there widespread panic (which would be bullish) or are traders more constructive (which would be bearish) to see if this is just a 10-15% corrective air pocket or something more serious.

Now that the SPX is within the 1040 to 1100 zone, psychology has in a very short time turned from decidedly bearish to a full blown panic about a market crash. Barrons recently reported widespread put buying and Richard Russell is running for the hills.

More telling, a recent CNBC poll saw an incredible 38% of respondents believing that the Dow could go to 5,000, which represents a further 50% haircut from current levels:

Does this sound like panic? Even though you may be a bear, do you believe that markets go up or down in a straight line?

The ferocity and intensity of this move has surprised a bear like me. The stock market is extremely oversold and now trading at an intermediate term support zone. My inner trader tells me to get ready for a short sharp rally before re-entering on the short side.

Thursday, May 20, 2010

Globe and Mail blogger poll

Canada's Globe and Mail has a poll of the best of money bloggers. If you consider Humble Student of the Markets to be worthy, come and vote for me (second question in the poll).


Wednesday, May 19, 2010

An alternative view of Vancouver real estate

Recently David Rosenberg pointed out the nosebleed levels of the Canadian residential real estate market, as shown by the chart below. The most expensive market in Canada is Vancouver. There have also been a number of posts in the blogosphere about the stratospheric levels of Vancouver real estate market (for examples see this, this and this). I have thought long and hard about this issue and the conventional explanations appear to be unsatisfactory.

It’s time to think out of the box and I would like to offer an alternative explanation for the elevated levels of Vancouver property prices.

An overheated market
Vancouver house prices have indeed been on a wild ride.

Affordability is way out of sight for the average resident, according to RBC, as the % of the typical household income taken by ownership costs are at levels only fantasized about by real estate bulls:

The most expensive market in the world
In fact, Vancouver is the least affordable city in the world, according to a report by Demographia International. Anecdotally, I would tend to agree with the conclusions of sky high affordability. A “good” detached house on Vancouver’s west side is around $2 million, give or take, but a “good” job in the local newspaper pays $50-70K a year – you can do the math. There are cheaper houses in the suburbs and better paying jobs, but these examples vividly illustrate the affordability problem.

The standard explanations: Retirement capital, Asian money
Vancouver home prices have tended to command a premium over Canadian cities. It offers a milder climate and a better quality of life, but these kinds of valuations can’t account for these prices as there are other parts of the Canadian west coast that don’t cost as much.

Another standard explanation has been the influx of Asian money into the city. Ahead of the Chinese takeover of Hong Kong in 1997, there was a significant influx of Hong Kong residents into Vancouver. These new immigrants did not fit the profile of the poor fresh-off-the-boat immigrants of the past, but brash and wealthy. As a result, Vancouver earned the nickname “Hongcouver” for a brief time. There continues to be Asian money coming into Vancouver. Today, instead of Hong Kong residents, there are more wealthy residents from Mainland China, who have buoyed not only the Vancouver property market, but Sydney and now Hawaii's as well.

To me, the explanation of Asian funds as the sole explanation for buoying Vancouver prices is unsatisfactory. The 1997 effect would have been a one-time shock and would have worn off – and did.

The Overseas Chinese are culturally predisposed to showing of their wealth and the signs aren’t here. When I compare the local streets to Hedge Fund Heaven in Connecticut, where I had lived before, I don’t find the same level of luxury vehicles on the streets in Vancouver. The streets here are clogged with Toyotas, Hondas and Fords, whereas in Greenwich, CT, there are more Mercedes than Toyotas.

The Elephant in the room
One explanation that few people talk about, but is common knowledge about local residents and pops up in unusual places, is the underground economy in British Columbia. Hard figures are difficult to come by, but it is said that the size of marijuana crop, nicknamed "BC Bud", is about the same as the forest products industry in this province.

In addition, the local gangs have diversified into other drugs which are exported to the United States, namely different variants of ecstasy as meth labs have become more common in Vancouver.

Multiplier effect on steroids
Washington based Stratfor did an intriguing analysis on the effects of the drug trade in Mexico [emphasis mine]:

The amount of money pouring into Mexico annually is stunning. It is estimated to be about $35 billion to $40 billion each year. The massive profit margins involved make these sums even more significant. Assume that the manufacturing sector produces revenues of $40 billion a year through exports. Assuming a generous 10 percent profit margin, actual profits would be $4 billion a year. In the case of narcotics, however, profit margins are conservatively estimated to stand at around 80 percent. The net from $40 billion would be $32 billion; to produce equivalent income in manufacturing, exports would have to total $320 billion.

In estimating the impact of drug money on Mexico, it must therefore be borne in mind that drugs cannot be compared to any conventional export. The drug trade’s tremendously high profit margins mean its total impact on Mexico vastly outstrips even the estimated total sales, even if the margins shifted substantially.
If drug trade profit margins are in the order of 80% then its effects on the local economy must be much larger than its stated GDP contribution. While BC’s drug trade might be roughly equivalent to the forest products industry, its economic footprint is likely to be many times higher because of the higher multiplier effect as these enormous profits ripple through the local economy, which is inflationary.

Imagine all this excess liquidity sloshing around in a localized economy. On top of that, all this illegal money has to get laundered. Some of the liquidity is likely to leak into the real estate market, one way or another.

I had pointed out before that property can be used as a store of wealth and real estate is just another form of money. So why not in Vancouver?

Threats to the drug trade
If the underground economy were to form a substantial part of the explanation for the stratospheric level of Vancouver property prices, then there are a number of distinct threats to the well-being of the local drug trade. After all, most of the product is likely going south to the US and not much comes back in the way of trade (except for guns, as Canada has much tougher gun control laws, but I can’t believe that the value of weapons imports could offset the value of drug exports).

The Canadian Dollar: The Canadian Dollar has risen from around 0.85 to roughly par in the last 3-4 years. The unfavorable exchange rate difference must squeeze profit margins. (It is difficult to conceive that drug gangs have major foreign exchange trading desks hedging their forex exposure.)

Changes in regulatory regime: There are other signs that the marijuana business is becoming more legitimate. California has an initiative to legalize pot. Legalization or decriminalization would take much of the price premium out of this illicit trade as you can see from this story about the legal marijuana market.

Harmonized sales tax: On July 1, 2010 the province will combine the federal Goods and Services Tax (GST) with the Provincial Sales Tax (PST) to form the Harmonized Sales Tax (HST). Some goods and services that were PST exempt will now be subject to HST. While decried as a tax grab by local taxpayers, it will create an environment that may make money laundering more difficult. The HST is a value-added-tax. Businesses are required to charge HST on all their transactions, but may deduct the HST that they pay as a credit to the taxes that they remit. These changes creates a paper trail of cash flows and make cash transactions more difficult - which will have the unintended effect of hindering money laundering operations.

Drought conditions: There are forecasts for drought conditions for much of British Columbia this year. Such conditions would serve to disrupt any agricultural product.

Looking for alternative theories
Economists have been struggling in the wake of Great Recession as many of the standard equilibrium models had failed. As a result, many have searched for alternative explanations of the current state of the world.

In the same vein, standard explanations of Vancouver real estate prices appear unsatisfactory. It’s time to think out of the box and look for other causes. I therefore believe that the underground economy forms a significant part of the explanation for the stratospheric level of Vancouver real estate.

Disclaimer: This post is not intended to condone or be an advocate for or against the drug trade, but an economic analysis of the possible effects of the underground economy on monetary liquidity and real estate prices.

Monday, May 17, 2010

Blood in the streets?

Baron Rothchild was quoted as saying to buy when there was blood in the street. I wrote back on May 6 to watch the progress of market psychology for an indication of near term market direction.

Well the answer is in. We have widespread panic. Consider the following:

Mark Hulbert notes that his survey of market timers is showing a fearful reading, which is contrarian bullish.

ISEE option sentiment, which is a call-put ratio, is showing that market players have suddenly tilted to a bearish extreme, which is also contrarian bullish.

Not quite the magazine cover effect: but the media is highlighting stories about the loss of confidence in Wall Street and the markets. For instance, Barry Ritholz has pointed out that the market cheerleaders at CNBC are talking about the total loss of confidence in Wall Street. Has even CNBC thrown in the towel? Here's another story from the LA Times about how the equity allocation of some financial planners and advisors have fallen to 10-15%. 10-15%??? I believe what's significant isn't the planner's views, but that the markets columnist for the LA Times chose to focus on the story.

Meanwhile, the free-falling euro is trading at a long-term support zone. This looks an awful lot like blood in the street to me. While we may accept the premise that the bears have taken control of the market, these sentiment readings are setting the markets up for, at the very least, a bear market rally.

Bears need to tactically prepare for volatility. The markets is poised for a short and sharp rally which could happen at any time.

Thursday, May 13, 2010

Not every problem is a nail

Readers of these pages know that I am an advocate of thinking about your assumptions when modeling. Just because you have a useful tool doesn’t mean that you should use it on everything.

A colleague sent me the work from the folks at Equity Clock, who are doing research on market timing based on seasonality:

Criteria for model evaluation
When I look at this research, several questions come to mind:

I understand turn-of-year effects, which has been well documented in academic literature, but what is the economic basis for seasonality on sectors and industries like Consumer Staples, Utilities and Biotech? What about small cap growth and value?

If we were to accept the premise that seasonal effect observed in the Energy sector, why does the seasonal effect for natural gas not coincide with Energy stocks? Are their fundamental drivers that different?

When I evaluate the effectiveness of a quantitative model, here are some of the considerations that I think about:

  • What is the alpha, or average incremental return over the test period?
  • What is the batting average?
  • How consistent is it? For example, did it work as well early in the test period as later in the test period?
  • What is the turnover? What are the implementation costs, i.e. can we trade this model and make money?

Don’t use a single tool indiscriminately
A number of years ago I did some research into seasonality effects on selected industries. We found that there was a weak seasonal effect for US retailers around Black Friday. In addition, turn-of-year effects have been cited by many researchers in many markets around the world. CXO Advisory recently did some work on gold and gold stock seasonality, their conclusion was that you get very different conclusions depending on what test period you chose.

Seasonality is a tool that can be used in certain circumstances, but it’s not a universal tool. Don’t fall into the trap that if you have a hammer, every problem looks like a nail.

Tuesday, May 11, 2010

An important "tell" for the market

OK, PIIGS are flying and we have stepped back from the abyss - now what?

An important intermediate term "tell" for the future direction of the market is China, which has been the sole engine of growth in a growth-starved world since the Lehman crisis. Currently, the Shanghai Composite is not behaving well technically as it has broken down in numerous ways:

Lost in the noise that came out of Europe on the weekend was the news that the Agricultural Bank of China is expected to press ahead with world's largest IPO [emphasis mine]:

Agricultural Bank of China, aiming for the world's largest-ever initial public offering, will press ahead with its plans despite weak market sentiment, one of its underwriters said on Saturday.

Market jitters will probably delay the launch of an international board in Shanghai for the trading of overseas firms' shares, Li Jiange, chairman of China International Capital Corp, told reporters on the sidelines of a forum.

But when asked whether ABC might postpone its dual listing, which could be as big as US$30 billion, in Hong Kong and Shanghai, he said: "I think there will be no impact."
How the issue will be received will be an important barometer to the intermediate tone of global stock markets.

Monday, May 10, 2010

The perils of short sales

When I discuss the Inflation-Deflation Timer model with other investors, I have sometimes been asked why I don’t use the model output to initiate short positions, instead of switching to another asset class. (To review, the model is an asset allocation model that uses trend following principles to switch between asset classes, namely commodities, the inflation hedge, US Treasury long bond, the deflation hedge, and equities, the neutral position.)

Cutting to the chase: Investors, i.e. market participants with relatively long time horizons, shouldn't go short for risk control reasons. Simply put, asset classes tend to be more volatile when they are in bear markets and rallies tend to be vicious, such as the current one in response to the European rescue package. Thus, the investor pays for higher returns (even if he is right) in the form of higher volatility. Short sales are more suitable for traders seeking to make a directional bet for short-term profit, or for hedgers, e.g. paired trading.

Short positions are more volatile
Since the Inflation-Deflation Timer model is based on trend following principles (see previous posts on trend following models here, here and here), I illustrate my point about why I don’t go short by applying a trend following model based on 50 and 200 day moving averages to the S&P 500. The rules for the backtest are:

Bullish signal: Index > 50 day MA > 200 day MA (long index)
Bearish signal: Index < 50 day MA < 200 day MA (short index, if allowed) Neutral signal: Otherwise (cash)

For the purposes of this exercise, let's assume that execution is done the day after a signal is given at the closing price and there are no commissions or trading costs. If the model goes to cash, a 0% return is assumed. Returns on the S&P 500 are total returns, as proxied by SPY. The chart below shows the results of the backtest, which began on December 31, 1999 and goes to the present. For the entire period, a buy and hold strategy would have returned -0.2%. If you had used the timing model only to go long, the return would have been 0.5%. A long and short strategy performed best at 2.7%.

When I look at these results, several conclusions can be made. First, these classes of models are good at avoiding much of the brutal downdrafts of bear markets. The long only strategy beat the buy-and-hold strategy by 0.7%, but downside volatility was significantly lower than the benchmark. While the long/short strategy was the best, that performance was achieved at the price of much greater volatility. The incremental volatility was experienced during periods when the model went short, i.e. during bear markets.

Bear markets are more volatile
This study leads to the conclusion that bear markets are more volatile, which should be intuitively obvious to traders. After all, the VIX Index, which is a measure of implied volatility, tends to rise when the stock market is falling.

I did a quick check if the rising volatility effect was true in other asset classes. The chart below shows the standard deviation of different asset classes for different assets over differing time periods: DJIA (from 1928 to the present), AGG as a proxy for the US bond market (from 2003) and the CRB Index (from 1999). [Yes I know the time periods are different and I am not exactly comparing apples to apples, but I want to study the behavior of different asset classes during bull and bear phases.] I defined a bull market as when the index was above its 200 day moving average and a bear market as when it was below.

The chart shows a consistent pattern: bear markets tend to be more volatile than bull markets. Technicians have an adage that confirms this observation: "Bottoms are events. Tops are processes." In other words, the price action at bottoms tend to be emotional, spiky affairs - which is what account for the volatility.

Short sellers profit from falling markets, but bear markets are more volatile. Even if the shorts are right, their higher returns come at the price of greater volatility.

Buy the negatively correlated asset instead
In an asset allocation model such as the Inflation-Deflation Timer, a better way to get higher risk-adjusted returns is to move into a more favorable asset class when the trend following model flashes a “go short” signal. For instance, an investor can get better risk-adjusted buying the negatively correlated asset, such as the US Treasury long bond, instead of shorting commodities when we see a “deflation” signal.

That's the path to a higher return that lets you sleep better at night.

Saturday, May 8, 2010

Another way of thinking about the NFP report

Boy the market really liked the Non-Farm Payroll numbers! While job gains did come in at above expectations and analysis shows that temporary jobs continue to rise, albeit at a lesser rate, equities sold off as investors continued to de-risk.

Real-time market based signals
I have always been an advocate of looking at real-time market based signals instead of backward looking economic indicators for top-down macro analysis. So here is another way of thinking of the employment situation in the US.

Here are some charts of temp agencies and headhunters relative to the S&P 500. There aren't a lot of publicly listed companies but these charts give us a good idea of market expectations at a bottom-up level. Consider Manpower, which staged a relative rally in late November but broke down again. The chart is not a pretty picture:

The relative chart of Kelly Services tells a similar story:

Here is the relative chart of Heidrick & Struggles. While HSII has rallied somewhat in May, it remains in a relative downtrend.

It's the same story with Korn Ferry:

Regardless of what the NFP report said about employment gains, the market believes that employment is still weak. Get the picture?

Thursday, May 6, 2010

Market tripwires: What now?

In my post time to be fearful yet of April 19, 2010, I wrote about the cross-currents in the market:

I believe that the market is in a fragile state, but that's the equivalent of riding around on a motorcycle at 100mph without a helmet on. It doesn't necessarily mean that you get hurt. It just means that if you hit a bump in the road the damage will be very, very bad.

My inner investor is therefore a blubbering nervous wreck. The Goldman Sachs news Friday is a typical "bump in the road". It remains to be seen what kind of damage it causes to market psychology and whether Goldman's failure to disclose the receipt of a Wells Notice is the beginning of a death spiral for the investment bank (or the market). My inner trader, on the other hand, tells me to stay with the positive momentum for now, watch for technical breaks and maintain very tight stops.
An intermediate term correction
Regardless of how tight the stops people have put on their long positions, the market action of the last few days have been the signs of technical breaks that I have watching for. The technical damage has been too great to ignore for the bulls and an intermediate term correction is most likely underway. The most important ones for me has been the action of the Shanghai Composite, which not only violated an uptrend but important support levels:

The other critical data point I have been watching is the relative price action of the Morgan Stanley Cyclical Index against the SPX. Many investors have piled into the cyclical sector as they became convinced that a sustainable economic recovery is under way. These stocks have also broken a relative uptrend and support level:

What’s the downside target?
A chart of the SPX shows the market is bouncing off initial support at the 50-day moving average. We’ll see if that level holds.

If this were indeed an intermediate term correction, then the logical support zone would be somewhere between 1050, the 50% Fibonacci retracement level, and about 1100, the 200-day moving average, which is also situated slightly above the 38% Fibonacci retracement.

By contrast, the more broadly based  NYSE Composite is not behaving as well as the SPX. This index has already violated its 50-day moving average support level, but it’s still above the uptrend line that began in July 2009, which should provide an area of technical support.

Watch how market psychology develops
Even though I have been leaning to the bearish side, I also recognize that markets don’t go straight up or straight down. Even the Crash of 1987 began with a top in August, which sparked various trendline violations, and the Crash didn’t happen until October, a full two months later. In the near term, the market is likely to stage some sort of reflex rally from current levels. At that point, we need to watch for signs of how the psychology develops.

Already I see a number of technicians calling for an intermediate term bottom at around the 1040 to 1100 level on the SPX. Given the weak action of the broader NYSE Composite, my best guess is that support materializes closer to 1040, which also coincides with the February lows. If the market does descends to those levels, how will market participants react should we approach those price zones?

I would watch the sentiment indicators. Is there widespread panic (which would be bullish) or are traders more constructive (which would be bearish) to see if this is just a 10-15% corrective air pocket or something more serious.

Tuesday, May 4, 2010

Readings and my reactions

Here are selected readings from the past few days and my reaction to them:

Is this the tipping point for Peak Oil? Matt Simmons, the author of Twilight in the Desert, has asserted numerous times that when Saudi oil production rolls over, then we are looking at the peak of global oil production as there is little chance of replacing Saudi production. Now Khalid al-Falih, head of Saudi Aramco, has warned that Saudi Arabia will start to wane in the coming years as domestic demand surges and spare capacity drops.

What's the difference between a single hedge fund’s hiccup and a hedge fund strategy's return? Zero Hedge reports that market neutral funds are getting “carted out feet first” and cites the performance of the Highbridge HSKAX Index:
The Highbridge HSKAX index just suffered its biggest drop since March 2009. Market Neutral players are getting carted out feet first…

Actually, HSKAX is actually a fund, not an index. Here is the performance of the HFRX Equity Market Neutral Index. While performance has hit an air pocket, the chart below shows that drawdowns are not that serious and market neutral funds can’t be characterized as getting “carted out feet first.”

Is a crowded long threatening the bull run in equities? Further to my last post about the fragility of the financial system, the combination of excessive bullishness stock sentiment and bearish bond sentiment is highly worrisome for equity bulls. Alan Abelson noted in Barrons:

Alan Newman, a crack technician, and chief cook and bottle washer at newsletter CrossCurrents, offers another intriguing contrary-sentiment indicator in his latest commentary. It’s based on investor preferences in mutual funds, and he credits some Rydex charts on the Decisionpoint Website with supplying the necessary info.

Recently, Alan relates, money-market and bear-fund assets both fell to multiyear lows, while bull- and sector-fund assets mounted to their highest levels since the October 2007 market peak. Currently, he reports, there is roughly $7.50 in bull and sector funds for every $1 in bear-market fund assets, which he calls “the most ridiculously one-sided sentiment we have seen since the tech mania convinced folks that no price was too high to pay.”
The Barrons Spring 2010 Big Money poll also shows an unbelievable reading of 1% of institutional money managers bullish and 78% bearish on the safe haven of US Treasuries.

As a confirmation of the cautious view from the sentiment indicators, Mark Hulbert also reported excessive bullishness among short-term Nasdaq market timers. All these signs point to likely corrective action by the stock market in the near term.

Sell in May...

Monday, May 3, 2010

One big China bet

We are experiencing a very fragile economic rebound and growth has been very unbalanced. If we were to examine this rebound from the bottom up, consider the recent financial results of heavy equipment supplier Caterpillar as Joe Weisenthal asked how can this be a recovery with Caterpillar sales like this? He observed that Asia has been the only engine of growth in a growth-starved world. Most of the growth comes from China.

EAME = Europe, Australia, Middle East
ROW = Rest of World

Mother of All Financial Bubbles
For the rest of the world, the risk is that China is currently blowing the Mother of All Financial Bubbles and that it may burst soon. Andy Xie reports that Chinese housemaids are now piling into the property market, which is a sure sign of a top for contrarians:

“My maid just asked for leave,” a friend in Beijing told me recently. “She’s rushing home to buy property. I suggested she borrow 70 percent, so she could cap the loss.”

It wasn’t the first time I had heard such a story in China. Some friends in Shanghai have told me similar ones. It seems all the housemaids are rushing into the market at the same time.
Xie also confirms my observation that the Chinese are using property as a store of wealth and real estate is just another form of money in China. Moreover, the expectations of the revaluation of the RMB is keeping funds in China, which serves to further inflate the bubble:

[T]he revaluation story has kept Chinese money inside the country. The dollar has always been the safe-haven asset for Chinese. This is why Chinese banks had a large dollar deposit base. Of course, anybody who was somebody had dollars offshore. Now all that money is back. More importantly, any income, legal or otherwise, now stays in China.
Everything seems to be linked to China these days. Econbrowser reports that Latin American financial markets are now becoming more correlated to China. Emerging market equities are now becoming one big China bet.

Shanghai Composite is breaking down
When all these excesses blow up is anyone’s guess. When housemaids are scrambling to get into the market, we are much closer to the end than the beginning. What's more, the technical behavior of the Shanghai Composite looks downright scary - and that was before the news of additional tightening measures.

I have no idea when all this house of cards topples on us. Even though the charts may may point to China undergoing a downdraft, it may not be the disaster that the bears assume because of another possible round of stimulus, which should serve to buoy markets. Nevertheless, when this bubble pops, it won’t be pretty, not only for China but for global financial markets as well.

Is this an indication to sell in May and go away?