Monday, February 6, 2012

Buy growth and inflation hedge vehicles

Last week, my Inflation-Deflation Trend Model moved from a "neutral" reading to an "asset inflation" reading, indicating that model portfolio should move to an aggressive risk-on trade of growth stocks and commodity producers. This is a somewhat surprising development as the Trend Model only moved to a "neutral" reading from a defensive "deflation" reading in mid-January.

The Trend Model is an asset allocation model based primarily on commodity prices. Trend following models generally don't from one extreme (defensive) to the other (aggressive) in less than a month. From an analytical viewpoint, however, the development is not entirely unexpected as the signs of global healing are abundant.

Firstly, commodity prices have move out of a downtrend and staged an upside breakout from a wedge, which is bullish. As well, I wrote last week (see Time to ride the commodity bull) that long-term fundamentals, medium term sentiment and short-term catalysts are pointing to another bull run for commodity prices.

The global uptrend in the risk-on trade has been confirmed by most stock markets. US equities saw a well-publicized Golden Cross, which is a bullish condition that points to an uptrend in prices.

Looking around the world, there is an imminent Golden Cross in UK stocks as well.

Across the English Channel, the Euro STOXX 50 has shrugged off worries about Eurogeddon and in the process of staging an upside breakout.

The cyclically sensitive South Korean KOSPI has staged an upside breakout.

Even the Brazilian market, which had been a laggard last year, saw a recent Golden Cross.

The only fly in the ointment has been the dismal performance of the Shanghai Composite, which remains in a well-defined downtrend.

Is the Shanghai Composite signaling a dramatic downturn in the Chinese economy? I'm not sure, but I am somewhat comforted by the price action of the Hang Seng, which recently rallied above its 200-day moving average.

Considerable the upside potential
If we are indeed poised for a major bull move in risky assets, then the next question has to be, "What's the upside potential?"

The upside potential can be quite high. Consider, for example, the resource heavy Canadian market as measured by the TSX Composite. One analog might be to think about is the market reaction after the Lehman Crisis of 2008. The Trend Model correctly moved to a defensive "deflation" reading in August 2008 and went "neutral" in late March 2009, about three weeks after the March bottom. It later moved to an aggressive "asset inflation" reading in August 2009.

This time around, the Trend Model moved to a defensive position in late August 2011, but Eurogeddon did not materialize. It went "neutral" in mid-January 2012 and flashed an aggressive "asset inflation" signal last week.

If we were to measure the TSX Composite from the March 2009 neutral signal to the market peak in early 2011, the move was roughly 6,000 points and roughly 4,000 points from the "asset inflation" signal in August 2009. So how far up can the market move up this time?

Another way to think about this is to look at the relative performance of the high-beta and recovery candidate US Broker-Dealer Index (XBD) relative to the stock market in the wake of the Lehman Crisis. From the bottom in 2008 to the peak in 2009, the XBD staged a relative rally of close to 60%.

A more logical technical target for this bull move, should it develop, would be an outperformance of roughly 30% against the market.

My inner investor says that the aggressive signal from the Trend Model is not altogether unexpected. Central banks are throwing parties and it's time to participate. The ECB's February LTRO auction is expected to attract bids of over a trillion. The Fed is standing ready to unleash QE3.

My inner trader is well aware of calls for a correction and he is a nervous bull. He is tempted to wait for a pullback before deploying new cash as some of the short-term measures appear overbought. Should we see a sustained up move, however, the overbought condition could be what my former Merrill Lynch colleague Walter Murphy calls a "good overbought". An example can be found in the bullish impulse that began in late 2010 after the onset of QE2. The market began to move up and saw periods of sustained "good overbought" conditions.

In any case, enjoy the party. It promises to be a good one.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Amar Harolikar said...

That's a well timed analysis. I also hold the view that a new global bull run is in the making. US is already near its all time high, European and Asian markets have either just broken out of their bear market trading ranges or about to do so. China, however continues to be the biggest laggard and in a contrarian sense, provides the greatest opportunity.

I have found that a rise in US 10 year yields and a rise in commodity prices to be leading indicators for the first leg of a major bull run post a bear market. I am keenly watching those

Amar Harolikar

Tiho said...

New bull market? I don't think so. Earnings remain at record high levels and the current business cycle has expanded for over 33 months (average is about 40 over last 100 yrs).

"New" bull markets starts when earrings are depressed and profit margins are low. We had a strong correction in August, but no recession... too many got bearish.

Now the bears are bulls, as a 25% rally has already unfolded. Funny that...