Monday, April 23, 2012

Not enough panic to buy yet

Now that we are nearly at support on the Spanish IBEX 35 Index, my inner trader tells me it's too early to be buying. We need to wait for more pain and panic to materialize. My inner investor says that signs of value are starting to show up in a number of natural resource sectors and it's time to start accumulating positions in resource cyclicals.

Spain a contrarian buy, but not yet
Soon after I wrote my last post (see Why I am buying the pain in Spain), Macro Man and I seemed to be on the same page when he wrote that Spain is unlikely to crash:
To TMM [ed. TMM=Team Macro Man] it would appear that the only scenario that supports selling right now is one where Spain crashes, doesn't receive assistance, defaults and the euro and then Europe break up. Now call us picky but though that indeed is one potential outcome there are a lot of other scenarios and most of them involve some internal resolve, even if it does involve printing your amount of money. Elections may change the leaders of some countries but as the UK Con/Lib coalition is finding out, they are but the tip of the iceberg of the machine that is government. There is enough mass below the waterline that knows where its true interests lie to stymie any threats to them. Yes Minister indeed.
In fact, they were piling into the Spanish trade:
Having piled back into equities last week the current mood should be considered as red flags to us and we really ought to run with the pack, chop the longs, swing short and whip up the doom. Instead though TMM have decided to do the reverse and have broken the glass on the cabinet containing their Kevlar Gloves and bought some Spanish stocks of international appearance ( braced for comments). Hold on tight !!
Recall that my original premise for buying Spain is to wait for a period of maximum pain and panic (see How much more pain in Spain?). The defining moment was the 2009 lows, which would be a level of technical support for Spain's IBEX 35 Index.

Now that we are nearly there, I don't think we've seen sufficient pain and panic in the markets for Spanish equities to be a contrarian buy yet. My inner trader thinks that TMM should be following his initial instincts to "run with the pack, chop the longs, swing short and whip up the doom."

Consider this chart of European stocks, which exhibited a break of an uptrend, but the index is not showing any signs of panic yet.

What about the euro? The EURUSD exchange rate is holding in nicely, thank you very much.

So are 10-year Treasury yields. No signs of panic there either.

Is the market about to hit an air pocket?
I am starting to see the signs of a change in leadership. While my Asset Inflation-Deflation Trend Model remains in at a weak neutral reading and I am not in the business of anticipating model reading changes, my best wild-eyed guess for the stock market is a gut-wrenching correction, followed by an explosive rally as the Bernanke Put and Draghi Put kicks in.

Consider the relative return charts below. The top chart shows the relative return of the Morgan Stanley Cyclical Index compared to the market. Cyclicals are underperforming and they have been in a relative downtrend after topping out in early February. By contrast, defensive sectors such as Consumer Staples and Utilities have been bottoming out relative to the market this year and recently started to outperform.

These are the signs of a change in leadership pointing to a deeper correction in stocks.

Value in resource sector
Despite the negative near-term prospect for cyclicals, I am seeing signs of value showing up in the deep cyclical sector, particular in the resource sector. Canada's Globe and Mail featured an article detailing that while energy companies were going like gangbusters:
Alberta’s oil patch is roaring. Oil prices are flying, pipelines are pumping millions of barrels a day, and companies are engaged in a rollicking spending spree.

Every 2½ weeks, companies shovel another billion dollars into oil sands projects. Drilling rigs across the province are tapping big new pools of oil. And firms desperate for skilled workers are scouring the globe to help them get on with ambitious growth plans. Western Canadian oil output is expected to surge by more than a third to 3.6 million barrels a day by 2018.
Their stockholders were missing out on the party:
Alberta’s energy frenzy has all the makings of a hollering rodeo party. But there’s one group conspicuously missing out on the action: investors.

In the midst of a boot-stomping boom, oil and gas has been among the country’s worst-performing sectors of the stock market. Since the global economic crisis, benchmark oil prices have soared from below $40 (U.S.) a barrel to above $100. Many Canadian energy stocks, however, have been left in the dust.
Indeed, this chart of the XOI, or Amex Oil Index, against the price of WTI shows that energy stocks are historically cheap against oil. Arguably, the graph doesn't show the true picture as XOI is shown against WTI, which has been trading at a discount to Brent, which is becoming the de facto benchmark for the world price of oil.

We see a similar picture with gold mining stocks. The Amex Gold Bugs Index, or HUI, is trading at a huge relative discount to gold bullion and the relative relationship is approaching the post-Lehman Crisis panic liquidation and capitulation lows.

The slope of the recent price action of the energy stock/oil and gold stock/gold ratio, however, tell the story of controlled selling rather than the panic selling that characterize a capitulation low. That's the same picture that I see in the IBEX 35, the Euro STOXX 50, Treasury bond yields and the EURUSD exchange rate.

A market crash is unlikely
Longer term, however, I expect that asset prices to be well-supported by the Bernanke Put and Draghi Put. Consider the Italian MIB Index as a bellwether of market fortunes. While there is downside risk, tail risk is likely to be mitigated by the Draghi Put and the near-by presence of major technical support that stretch back to the mid 1990's.

As the table below shows, this week is a big week for Spanish equity market, as most of the Spanish banks are expected to report earnings. Bad news could provide a catalyst for another downleg, which would be a set up for the good contrarian to start buying.

In summary, my inner trader tells me that there isn't enough panic here for him to step up to buy, but my inner investor, who has a longer time horizon, tells me that it's time to start nibbling away at long positions in distressed sectors, such as Spain and resource stocks, at current levels.

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.


WimpyInvestor said...

How does this type of trading / investing reconcile with the Inflation / Deflation Model?

Are you now both "Trend Following / Momentum" and "Contrarian / Value"?

Cam Hui, CFA said...

I was just expressing my views independent of the Trend Model. With all models, you need to exercise a "sanity check" once in a while as not all models work all of the time.