Monday, June 6, 2011

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: 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.

1 comment:

David Merkel said...

Excellent analysis, Cam. I will be watching this space for more.