Thursday, December 30, 2010

First tripwire for market weakness

The Christmas Chinese rate hike took the markets by surprise and in ensuing sessions, the Shanghai Composite, which is shown below, dropped through important technical support as well as a Fibonacci retracement level.

There are a couple of good reasons why this could be the early signs of market weakness. First, China has been a bright spot of global growth and a slowing or worse, a Chinese hard-landing, would be highly negative for the world's economy. In addition, investor sentiment has been excessively bullish, which is contrarian bearish and makes stocks vulnerable to market weakness.

Intermediate term top or correction?
Given that commodity prices and cyclically sensitive stock markets, such as Australia, Canada and South Korea, remain in uptrends (see my previous analysis here), I am inclined to give the bulls the benefit of the doubt for now. Even if this were the start of a market correction, my base case calls for a minor pullback of 5% or so.

Were the markets to weaken, here are some signs that I am watch for to see whether this is just a minor correction or the start of a more serious downturn:
  • How does investor sentiment behave? I will be monitoring the sentiment measures to see whether investors panic, which would be bullish, or if they remain sanguine and buy the dip, which would be bearish.
  • What about China?  My base case is that China does not crash here. Here are three reasons why China won't experience a hard landing. I would also add a fourth, namely that the Chinese have sufficient financial reserves to mitigate the effects of a hard landing (for this cycle). Nevertheless, I would welcome signs of panic from analysts such as Mish, Andy Xie and others as signs of sentiment capitulation.

  • How do the financials behave? A prerequisite for a financial crisis is the technical deterioration of the financials. The chart below shows the relative returns of the BKX Banking Index relative to the market. The Banks, after undergoing an extensive relative downturn, have actually begun to improve and outperform the market. This canary in the financial mine seems to be chirping quite happily.

I have written extensively about the macro risks to the global economy in this blog, but the problems of China, Europe and America are 2H 2011 stories, rather than immediate threats to the market. For the time being, I am still inclined that the intermediate term is up and any problems are more likely to manifest themselves as we move into the summer and fall.

Monday, December 27, 2010

A test of political will

Meredith Whitney recently went on 60 Minutes and warned about widespread municipal defaults. Rick Bookstaber also indicated that the munipal bond market is an accident waiting to happen.

Many American cities are in deep trouble. No doubt that hard choices will have to be made. People are starting to speak up. For instance, Mish has been on a crusade to point out unaffordability of the compensation packages of many state and municipal workers.

Is there the political will to act?
What's more, failures are starting to occur. The New York Times published an article about the town of Pritchard, AL that stopped sending out pension checks. This has had a devastating effect on retirees:
Since then, Nettie Banks, 68, a retired Prichard police and fire dispatcher, has filed for bankruptcy. Alfred Arnold, a 66-year-old retired fire captain, has gone back to work as a shopping mall security guard to try to keep his house. Eddie Ragland, 59, a retired police captain, accepted help from colleagues, bake sales and collection jars after he was shot by a robber, leaving him badly wounded and unable to get to his new job as a police officer at the regional airport.

Far worse was the retired fire marshal who died in June. Like many of the others, he was too young to collect Social Security. “When they found him, he had no electricity and no running water in his house,” said David Anders, 58, a retired district fire chief. “He was a proud enough man that he wouldn’t accept help.”

As government worker bashing becomes more popular, expect to see more stories like these about retired dedicated police officers and fire fighters who can't cope. Will the political will be there to make those cutbacks?

People are getting cranky and The political environment is becoming more volatile. Watch out.

Wednesday, December 22, 2010

A Christmas card from my accountant

This speaks for itself.

Happy Holidays!

Tuesday, December 21, 2010

Hedge fund commoditization

I see that HFRX is now listing their HFRX Global Hedge Fund Index as an ETF:
UBS AG and Hedge Fund Research (HFR) have launched the UBS ETFs plc - HFRX Global Hedge Fund Index SF, the first Exchange-Traded Fund (ETF) built on the industry’s most widely used standard investable benchmark of hedge fund performance globally, it was announced today.

The UBS ETFs plc - HFRX Global Hedge Fund Index SF-I was listed on the Deutsche Boerse Exchange on 3 December 2010 (symbol UIQG). The “SF-I” share class is targeting qualified investors. UBS and HFR anticipate additional listings in coming weeks. The ETF is UCITS III compliant.
I rhetorically asked in my first post in November 2007 why investors were paying 2 and 20 for hedge funds. While I recognize that the returns of HFRXGL includes fees, this is another step in the commoditization of hedge fund strategies.

Monday, December 20, 2010

Inflation, here is thy sting

Last Thurday, David Rosenberg wrote a headline entitled Inflation, Where is Thy Sting? (subscription required). He outlined his bull case for bonds by showing the chart below of core CPI and went on to comment that there are many disinflationary and deflationary forces at work in the economy.

The mistake that economists like Rosie and central bankers make, IMHO, is to look at core CPI, or the Consumer Price Index ex-food and energy. Inflation is happening in hard assets, i.e. commodity prices. QE2 is blowing a hard asset bubble and it is precisely this blinkered view of measuring inflation as inflation ex-inflation that created the conditions for the last financial crisis.

My Inflation Deflation Timer Model defines inflation as commodity inflation. It is in commodity and hard asset prices that we see inflation. Take a look at the point and figure chart of the CRB Index, which shows the reflation in commodity prices much more clearly.

Inflation stinging in emerging market economies
The sting of inflation is showing up in the emerging market economies, where rising food prices are stinging the consumer. (Oh sorry I forgot, food inflation isn't inflation!)

China has a de facto USD peg and that policy means that, in the absence of other action, US monetary policy is Chinese monetary policy. The tsunami of liquidity that the Fed loosened on the markets is washing up on Chinese shores, where it has resulted in see-through buildings and empty cities (see the satellite photos here). What's more, all that liquidity sloshing around has fueled a boom in Chinese antiques, where stories of record prices paid for an antique vase and for jade carvings abound.

That is where inflation is stinging. Asset bubbles never end well. The latest round of QE is just a case of pouring gasoline on the fire.

Commodity prices are the canaries in the mine
Eventually, Rosie will be right. I wrote before that today's conditions feel like late 2007/early 2008. Tactically, we are seeing a commodity price blowoff and world stock markets are rallying. For now, the path of least resistance is up.

Commodity prices are the canaries in the mine. The CRB is facing a technical hurdle of double-top resistance. How that chart pattern resolves itself is an important "tell" of where the markets move in the near term. Longer term, should any of the economic timebombs blow up, the path of commodity prices will also be an important important signal of the market direction, of whether it is a Dubai-event to be shrugged off or a Russia event that brings down the house of cards.

Wednesday, December 15, 2010

Europe 2010 = Subprime 2007?

The news out of Europe seems to get worse and worse. Last week Bloomberg reported that the price of default protection, or credit default swaps, of American banks (despite all of their problems) were lower than those of European banks. Then IMF chief Dominique Strauss-Kahn criticized Europeans for taking a piecemeal approach to solving their problems, rather than to undertake a big picture comprehensive solution.

Many eurozone supporters have been afriad to say this, but the traditional IMF solutions to sovereign debt crises would not work in Europe. When a country gets into trouble and asks the IMF for help, the usual package is to offer loan assistance in return for the demands that the country goes on a fiscal diet (cut spending drastically) and get a job, any job (currency devaluation). Devaluation, it is believed, gives the economy a shot of export adrenaline and the reduced spending puts the budget in better shape to benefit from the export jolt. In the case if the PIIGS, devaluation isn't possible, so only fiscal austerity is left to support any adjustments. Even the post-crisis pains that we have seen in places in Argentina, Indonesia and Malyasia won't be enough in the wake of the lack of currency devaluation.

The only obvious solution is default, which the Germans, French and other core eurozone countries will not tolerate because of the threat to their banking system. In fact, Dani Rodrik was to latest to suggest that an amicable divorce is the best solution for Europe.

Still in denial
Europeans appear to be in denial over their problems. Dylan Grice of Societe Generale wrote about the three stages of denial:
The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us.

Right now, it seems that European pronouncements are somewhere between stage one (not a problem) and stage two (not a big problem). They sound a lot like the US reaction to the subprime crisis. As late as March 2007, Ben Bernanke testified before Congress and stated [my emphasis]:
At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.
There is no need to panic, yet. Grice wrote that "When they start blaming everyone else for their problems, we’ll know their crisis is nearly over Until then, their plight likely has some way to go. " To be sure, despite his criticism of European policy, Dominique Strauss-Kahn also stated that he expects that the euro will still exist in five years.

A repeat of 2007/8?
For me, the markets today have a feel of late 2007/early 2008 to them. We have a commodity price blowoff now much like the price blowoff that began in late 2007, which are typical signs that we in the late innings of the bull market cyclical rotation. Problems are mounting (Europe and China) but the bull is roaring ahead.

I recognize that history doesn't repeat but rhymes. However, given the psychology of the eurozone's PIIGS problems, it seems to me that any blow-up is likely a 2H 2011 or 2012 event. In the meantime, enjoy the bull but don't forget your risk control discipline.

Monday, December 13, 2010

A (bullish) tour around the world

The headlines read Market breaks out to new highs, but how real is this move?

Technicians often look to other indices for confirmation of a trend. So I decided to review both US and international indices to see what the patterns are in those averages. By and large, my trip around the world shows that this bull move does look real.

In the US, the picture is mixed. The broader NYSE Composite is still flirting with resistance.

While small caps have broken out to the upside and appear to be in an uptrend:

Europe looks constructive
In Europe, equities look constructive. The broad STOXX Index seems to be shaking off the bad news. The pattern is a rising wedge, with the average not far from overhead resistance.

The German DAX Index has already broken out and is in an uptrend, which is perhaps reflective of the strength of the German economy:

Cyclically sensitive and resource markets look good
Back when I was at Mother Merrill, we used to watch the South Korean KOSPI closely because Korea was believed to be highly sensitive to global cyclical influences. Here we can see that the KOSPI has broken out to the upside and it's in a well defined uptrend.

The pattern of another cyclically sensitive market looks constructive. The resource-heavy Australian All-Ords looks like the European STOXX: in a rising wedge with overhead resistance ahead.

Here in Canada, which also has a resource tilted market, the TSX has already broken out to the upside and it is in a well defined uptrend:

The R/J CRB Index of commodity prices has already broken out and it's now testing upside resistance:

All in all, these charts other markets show either clearly bullish or constructive patterns.

The technical risks
There are, however, a few risks to the bullish outlook. The elephant in the room is China. The Shanghai Composite has been pulling back, but it is resting on a level of Fibonacci support, which is hopeful for the bulls.

In addition, the Baltic Dry Index, which is an indicator of shipping rates, is weak and near the bottom of its range. This pattern is indicative of possible weakening global trade patterns.

For the time being, markets are very overbought in the face of a tsunami of Fed induced liquidity (see sentiment comments and readings herehere and here). My former Merrill colleague Walter Murphy used to term some conditions as a "good overbought" and the current circumstances seem to fit that criteria. Equities could tactically pull back at any time but I would view any pullback as a buying opportunity.

Looking out over the intermediate term timeframe, both my Inflation-Deflation Timer Model remains bullish on the reflation trade. However, I am watching these last two charts carefully for advance indications of deterioration in the bullish picture.

Wednesday, December 8, 2010

What could go wrong

Further to my last post indicating that the bulls are firmly in control of the stock market, I received a number of comments to the effect of "what are risks in your forecast?"

Bullish call for traders only
First of all, I would emphasize that my bullish call is for traders only. Investors should be cognizant of the macro risks inherent in this market. I agree with John Hussman that central bank action is only propping up a house of cards and the macro risks are considerable [my emphasis]:
I continue to view Bernanke's apparent objective for QE2 - to create a "wealth effect" by encouraging speculation in risk assets - to be dangerously misguided. Historically, the elasticity of GDP to changes in the stock market is on the order of 0.03 to 0.05, and is transitory at that. In plain English, this means that even large changes in the value of the stock market do not translate well into changes in GDP. This is because consumers correctly consume on the basis of what they see as their "permanent income," and are well aware that changes in volatile assets tend to be transitory when they are not accompanied by growth in real output and incomes. Bernanke is not thinking as an economist in this regard. He is thinking like a witch doctor calling on animal spirits (ooh, eee, ooh-aah-aah, ting, tang, walla-walla bing-bang).
And the ECB seems to be getting into the act as well:
Finally, last week, Jean Claude Trichet, the head of the European Central Bank, provided early indications that the ECB would be stepping up its buying peripheral government debt issued by Ireland, Greece, Portugal and Spain. Of course, the ECB prefers to "sterilize" these interventions, so it can be expected to sell the debt of stronger members such as Germany. Accordingly, yields dropped on the debt of credit-strained European countries, while German yields pushed to fresh yearly highs.

It doesn't take much thought to recognize that, like Bernanke's actions, the actions of the ECB are ultimately likely to represent not monetary policy but fiscal policy. When you buy the debt of countries that have a high likelihood of defaulting on this debt, or will avoid default only by the creation of currency that could have been issued to finance fiscal expenditures, it follows that you are engaging in fiscal policy without the authorization of elected governments.
For the time being, my inner trader continues to believe that central bankers are intent on throwing a huge party - so enjoy it while you can (but don't forget to keep an eye on the exit).

Keep an eye on China
While the risks posed by the actions of the Federal Reserve and the ECB are longer term in nature, the biggest risk to the near term outlook continues to be China.

The Chinese economy may be slowing. Indicators such as the Baltic Dry Index are suggestive of incipient weakness. The Chinese have indicated that they are worried about inflation and  they may take further stepss to tighten monetary policy by increasing banking reserve ratios in 2011. Other analysts have indicated that the Chinese authorities may resort to interest rate increase and possibly price controls.

I believe that as long as the RMB-USD peg remains, Federal Reserve actions (QE2, QE3...) are likely to export asset price inflation to China and the Chinese authorities have limited tools available to combat domestic inflationary pressures. The real risk becomes one of China going overboard on the limited toolset that they have and send their economy into a hard landing.
Moreover, with the US recovery continuing to be anemic for the forseeable future and the 2012 presidential election just over the horizon next year, trade tensions with China are likely to rise in 2011 because of domestic political considerations.
What happens if either Washington or Beijing miscalculates?

Watch for signs of weakness
For the time being, I am watching the Shanghai market closely. The chart below shows that while that market has retreated from recent highs, it appears to be only corrective action (for now). Should the Shanghai Composite weaken further, along with other indicators such as the Baltic Dry and more signs of Chinese tightening, then it's time for the bulls to head for the exits.

Monday, December 6, 2010

Risk on!

Further to my last post about climbing a wall of worry, market technicals point to a continuation of the bullish momentum seen last week. I call this the QE2 risk trade and what we saw last week could be the start of a significant move higher in risky assets. My Inflation-Deflation Timer Model agrees and remains at an inflation reading as it calls for the high beta trade of  commodities and emerging markets.

Cyclicals look healthy
Market relative charts can be revealing. The chart below of the Morgan Stanley Cyclicals Index compared to the market shows that the cyclicals staged a relative breakout last week, indicating that investors are piling on the QE2 train. The US economy is showing surprising resilience and Barry Ritholz has speculated that we could even be in for an upside cyclical surprise in 2011.

Speculation is not excessive
The QE2 risk trade has much more upside potential. Since QE2 is a form of currency debasement, its effects should show up in gold and commodity prices. As a measure of investor sentiment in this trade, consider the action in gold stocks.

Despite gold prices moving to all-time highs, levels of speculation in the precious metal equities are not excessive. Take a look at this chart of GOX vs. HUI. GOX is an equal-weighted index and therefore gives higher weight to smaller capitalization gold stocks, while HUI is a capitalization-weighted index and gives a higher weight to the more senior names. The chart shows that small cap golds have actually been lagging large caps. These are not signs of speculative blowoffs that accompany major tops.

Here in Canada, I also watch the performance of the TSX Venture Index, which represent the small cap juniors, compare to the more senior TSX Composite. The chart below shows that the small caps have been fair steadily outperforming the large caps since late 2008. While the TSX Venture Index is at an important Fibonacci retracement level relative to the TSX Composite, they are nowhere near their previous highs indicating that speculation is not excessive.

Giving in to the Dark Side
The social and economic risks of the current backdrop are enormous and when it blows up it will be a doozy. As well, central bankers tend to be closed-mouthed and reserved in their comments by their very nature. (Paul Volcker once quipped that when he went to a restaurant during his tenure as Fed Chairman he was compelled to say "I'll have the steak but that doesn't mean I don't like the lobster.")

When a central banker speaks out and actually takes a position, you have to sit up and take notice. Thomas Hoenig of the Kansas City Fed wrote a New York Times Op-Ed about the social risks of the class divide between Wall Street and Main Street [my emphasis]:

Americans are angry in part because they sense that the government was as much a cause of the crisis as its cure. They realize that more must be done to address a threat that remains increasingly a part of our economy: financial institutions that are “too big to fail.”
In spite of the public assistance required to sustain the industry, little has changed on Wall Street. Two years later, the largest firms are again operating with bonus and compensation schemes that reflect success, not the reality of recent failures. Contrast this with the hundreds of smaller banks and businesses that failed and the millions of people who lost their jobs during the Wall Street-fueled recession.
He went on to warn about the social risks of the Wall Street/Main Street Divide [my emphasis]:
Crises will always be a part of our capitalist system. But an absence of accountability and blatant inequities in treatment are why Americans remain angry. Without accountability, we cannot hope to build a national consensus around the sacrifices needed to eliminate our fiscal deficits and rebuild our economy.

Party on dude!
The Divide is large and growing. This November the GOP regained control of the House and the wrangling over tax cut extensions have begun. The newly emboldened Republicans have vowed to hold up the extension of jobless benefits until their tax cut proposals pass and the tax cut proposals have bogged down in the Senate. Consider what this price relative chart of Tiffany's vs. WalMart says about the current environment:

I could rail all day about the inequities in the system. I could also say that this path is highly risky and it will all end in tears. I agree with John Hussman that equity valuations are stretched. My inner trader tells me that none of this matters, until it matters. Even Jeremy Grantham has allowed that the SPX could rally up to 1500 before falling to GMO's fair value estimate of 900 (my comment: but markets always overshoot fair value so expect another 2008-like episode with 50-ish% haircuts.)

For now, it's time to take a walk on the Dark Side and ride the Wildness. Just don't forget your risk controls and overstay the party.

Saturday, December 4, 2010

Weekend reading

Some things to consider on the weekend:
  • Australia's social and political divide: When outsiders look at countries like Australia and Canada, they just see a resource-based economy. This is an excellent story about the social and economic divide in Australia between the mining based economy in the west and the finance and manufacturing in the southeast. Here in Canada we have a similar problem with the mining and energy economies of BC/Alberta/Saskatchewan/Newfoundland and the population heavy manufacturing/finance of southern Ontario and (partly) Quebec.
  • David Wilmott worries about algo-based high frequency trading (HFT) excesses. Be prepared for more flash-crash like volatility?
  • See this fascinating video on the effects of wealth on population health (via Slope of Hope). These are important points to consider for emerging market investors when thinking about development economics.

Thursday, December 2, 2010

Climbing a wall of worry

It is always instructive to see how markets react to events. Right now, traders are focusing on the positives in the market and ignoring the negatives, for now.

Mark Hulbert made a couple of important points this week. First, TrimTabs reported that the long fund inflow by fund investors into bond funds may be over. Net flows into bond funds turned negative last week. The rolling 3-month correlation of daily returns between SPY, as a proxy for stocks, and AGG, as a proxy for bonds, is negative and has varied between -0.1 and -0.5 in 2010. With fund flows into bond funds going negative, could they more likely to buy stocks?
Hulbert also reported investor sentiment has pulled back from bullish extremes to a more neutral reading after a minor correction. These sentiment readings are supportive of higher equity prices.
More importantly, the financial sector of the stock market outperformed on Monday and Tuesday when the markets hiccupped over fears of an Irish contagion spreading to the other peripheral eurozone countries. The chart below shows the performance of the financials relative to the S+P 500. The news that Ireland had to be rescued by her EU partners and that WikiLeaks announced that the next set of paper dump “would target a major bank” should have sent the financials reeling. Instead, they outperformed.

This suggests to my inner trader that the markets are washed out and the path of least resistance is up in the near term.