Wednesday, November 17, 2010

Boom Goes the Dynamite

The “Chinese Commodity Demand” theme, or the “Liquidity Driven Weak Dollar” theme, has been the investment theme driving the broad markets since the recent leg of the bull market took off in early July. We have written at length about this theme and it is amply expressed in Pinnacle’s current asset allocation. About 50% of our risk assets benefit from this theme one way or another, if you include diversified international funds, emerging markets, gold, commodities, energy, and industrials in the mix. On the one side we have the pundits who believe that growth in China and other emerging markets is propelling global economic growth, as seen most clearly in all assets related to the commodity complex. The other side claims that the U.S. Federal Reserve is on a clear mission to weaken the dollar versus foreign currencies which encourages asset inflation. They believe that the extra liquidity in the economy will find itself flowing to risk assets given that the banking system in the U.S. remains effectively broken. Pinnacle has one foot in each camp. In either case, our investments in the China demand theme or the liquidity weak dollar theme have supported portfolio performance for months.

However, we are most alert to the possibility that this theme can and will reverse at some point and when it does we expect that asset class correlations will remain high, meaning that U.S. stocks, international stocks, and commodities are going to get hit at the same time. And when they do, they are going to become very volatile. Last Friday was an interesting preview of why we have to remain careful about our weak dollar theme holdings. From November 4th through November 12th, the U.S. dollar index, as measured by the Powershares DB US$ Long Index (UUP) has gained +2.91% while during the same period the Currency Shares Euro Trust long Euro Index (FXE) has declined by -3.6%. The carnage has been predictable. On Friday our long-only Commodities Futures Index (UCI) got crushed, losing -5.2%. Our long-short commodity positions, Rydex and Direxion (RYLFX and DXCTX) were down by -3.21% and -3.81%, respectively. Since November 4th the long-only position is down -4.99% and DXCTX has lost -2.62% and RYLFX is down -2.92%.

Here are some other comparative stats since the dollar began rallying on November 4. The broad market (S&P 500 Index) is down -1.68%. Gold is -1.72%. Emerging markets are down -3%. U.S. Industrial Equal Weight ETF (RGI) is -2.06% The biggest surprises might be that energy related funds are doing well, with the broad based energy sector ETF (XLE) gaining +1.52% and the Oil and Gas Exploration ETF (XOP) gaining +3.29%. But if you are Ben Bernanke, Chairman of the U.S. Federal Reserve, and you are printing money like crazy with the expressed intention of lowering longer-term interest rates in the bond market, you must be very unhappy that since November 4th rates have risen and bond prices have fallen significantly. The 7-10 Year U.S Treasury ETF is down -1.93% and the 20-Year U.S. Treasury ETF is down -3.95%. BOOM! It’s highly probable that this reversal is temporary and reflects the overbought condition of these markets. Notably, Pinnacle portfolios perform with a fraction of the volatility of these securities. Nevertheless, we intend to buy this dip if it continues. However, like everything else in the current market environment, it requires our ongoing diligence.