Markets exploded higher today on the news of a couple big actions from global central banks. First was the report that China had lowered its reserve ratio by a half percentage point, indicating that it has now shifted to policy easing and boosting economic growth, rather than continuing to battle inflation through policy tightening (as they’ve been doing for the past two years). Then came the announcement that six major central banks -- including the Fed, ECB, and BOE -- were unveiling a new arrangement that lowers the interest rate on dollar currency swaps in an attempt to end the worsening bank funding crunch in Europe.
It seems like we’ve been down this road several times since the European debt crisis began to intensify earlier this year. Some grand plan or solution is floated, and the markets rejoice, only to fall back again when investors realize that the core problem -- the ultimate solvency of over-indebted nations -- has not been resolved. However, we’re also aware that the central banks are powerful enough to spark sustained market advances even in the face of suspect fundamentals, as the Fed has done in the past couple of years with QE1, QE2, etc. So today’s actions can't simply be ignored.
Once again we’re left to ponder whether “this is it” -- the game changer that signals all is well and investors can safely swim in the risk pool again. While today’s rally is certainly impressive, we don’t think we can make that determination just yet. For our part, we’ll be looking for signs of confirmation in coming days – key technical levels being taken out on the upside, a credible plan out of Europe, etc.
Wednesday, November 30, 2011
Tuesday, November 29, 2011
Credit Not Confirming the Equity Rally
Yesterday was a big day for equity markets, and today I did a quick check to see how some of the European credit metrics were behaving. From what I've seen, the credit markets have not confirmed the equity bounce. Below are a few charts we're watching, along with our interpretation.
ECB Eurozone Liquidity Recourse to the Deposit Facility is rising fast again. This implies that banks are afraid to lend, and would rather just park funds at ECB.
Euribor OIS is elevated. This chart is watched as a barometer for interbank lending in Europe, and high and rising levels say that bank lending to other banks remains in a stressed state. This metric confirms the message coming from the prior chart.
Credit Default Swap (CDS) pricing on European Sovereign debt is still surging. This suggests that the cost to insure against European Government default is rising rapidly.
CDS for European Banks are surging up in price. Unicredit SpA(Blue line) is one of Italy’s largest banks. This chart shows that the markets are pricing default risk into European banks at an alarming rate, and many now cost more to insure than they did during the great credit crises of 2008/2009.
The Ted spread is used as a measure of confidence in the financial and banking system, and it is moving up in tandem with the other measures I mentioned. This is not a good sign for the health of the banking system.
There are more charts, but you get the point. Equities had a big day yesterday, but credit markets have not confirmed the latest equity market rally.
Monday, November 28, 2011
The Brutal Realities of Calendar Year Reporting
The year is rapidly coming to a close, and 2011 will be remembered by Pinnacle’s investment team as one of the more difficult in recent memory. The financial markets have faced a variety of challenges, including those caused by natural disasters (the tsunami, earthquake, and nuclear meltdown in Japan), political upheavals (the Arab Spring, U.S. debt downgrades, and ongoing political gridlock), and financial turmoil (the European crisis). The investment team has responded to changing market conditions with a series of transactions that, for the most part, have reduced the risk in our managed accounts in anticipation of volatile markets. By my count we have executed more than thirty trades since June of this year, and more than one hundred transactions since January, each of which has been the subject of intense debate within the team. I hope to never again sit in on a meeting where the topic of discussion is the implications of a cloud of radioactivity drifting over a major industrial city.
Yet for all the hard work, we come to the last month of the year with Pinnacle portfolios basically breaking even versus our various benchmarks for both year-to-date absolute performance and year-to-date relative performance. For those investors who tend to think in terms of “How much did I make?” the year is going to be disappointing. Even a big December rally won’t rescue what is likely to be small single digit returns for the year. Of course, investors who think in relative terms are still in the game. If the markets continue to sell-off as they have over the last couple of weeks, we have an opportunity to beat our benchmarks by several hundred basis points. In a year or two no one will remember all of the work that went into earning our returns in 2011 -- all they will see is the calendar year number buried along with all of our other calendar year numbers.
It is precisely this state of affairs that causes so much mischief in the world of professional investors. The fact that four weeks of performance will dictate how others judge your entire year doesn’t seem fair…but there it is. Unlike the hedge funds that will most certainly ‘game’ whatever is to come in the next month in the hope of making their year, there is nothing in Pinnacle’s playbook that would allow us to do the same. While we’re certainly not passive investors with no tools to take advantage of market opportunities, we simply don’t operate with a four week time horizon, and we won’t change the portfolio positioning from defensive to aggressive in order to try to catch a flash market rally that could reverse at any time. It is possible that the markets will continue to sell-off during the month of December, in which case we will be big relative winners due to the defensive character of our current portfolio asset allocation. On the other hand, the market could easily rally if the market becomes too oversold in the short-term... or if we have a typical “Santa Claus” rally... or if the Fed announces QE3... or if the ECB announces its own quantitative easing program...
It’s going to be an interesting four weeks. Stay tuned.
Yet for all the hard work, we come to the last month of the year with Pinnacle portfolios basically breaking even versus our various benchmarks for both year-to-date absolute performance and year-to-date relative performance. For those investors who tend to think in terms of “How much did I make?” the year is going to be disappointing. Even a big December rally won’t rescue what is likely to be small single digit returns for the year. Of course, investors who think in relative terms are still in the game. If the markets continue to sell-off as they have over the last couple of weeks, we have an opportunity to beat our benchmarks by several hundred basis points. In a year or two no one will remember all of the work that went into earning our returns in 2011 -- all they will see is the calendar year number buried along with all of our other calendar year numbers.
It is precisely this state of affairs that causes so much mischief in the world of professional investors. The fact that four weeks of performance will dictate how others judge your entire year doesn’t seem fair…but there it is. Unlike the hedge funds that will most certainly ‘game’ whatever is to come in the next month in the hope of making their year, there is nothing in Pinnacle’s playbook that would allow us to do the same. While we’re certainly not passive investors with no tools to take advantage of market opportunities, we simply don’t operate with a four week time horizon, and we won’t change the portfolio positioning from defensive to aggressive in order to try to catch a flash market rally that could reverse at any time. It is possible that the markets will continue to sell-off during the month of December, in which case we will be big relative winners due to the defensive character of our current portfolio asset allocation. On the other hand, the market could easily rally if the market becomes too oversold in the short-term... or if we have a typical “Santa Claus” rally... or if the Fed announces QE3... or if the ECB announces its own quantitative easing program...
It’s going to be an interesting four weeks. Stay tuned.
Wednesday, November 23, 2011
Triangle Measure and 61.8% Retracement
Last week, Carl wrote a blog post on the triangle pattern that formed after the large October rally. As he mentioned, this is usually a continuation pattern. However, traders would have been wise to wait for the upside breakout, because the pattern broke to the downside. I marked the triangle with the red and white lines in the chart below, and you can see the price breaking the white line to the downside last week. This has led to a vicious decline over the last few trading days and we now stand at a key inflection point.
When the triangle breaks, an estimated price move can be obtained by subtracting the low from the high of the triangle, and then subtracting the result from the break level. For this triangle that would be 1235-(1290-1220). This gives us an initial price target of 1165, which is the low for today (although the day is not over). Additionally, this level is the 61.8% retracement of the October rally, which I circled in green. So the S&P 500 is testing a good support level right now, and if this does not hold, it's very likely the 1100-1120 lows for the year will not be far behind.
When the triangle breaks, an estimated price move can be obtained by subtracting the low from the high of the triangle, and then subtracting the result from the break level. For this triangle that would be 1235-(1290-1220). This gives us an initial price target of 1165, which is the low for today (although the day is not over). Additionally, this level is the 61.8% retracement of the October rally, which I circled in green. So the S&P 500 is testing a good support level right now, and if this does not hold, it's very likely the 1100-1120 lows for the year will not be far behind.
Tuesday, November 22, 2011
Hanging on a Headline
Today brought a revision to 3rd quarter GDP, which while disappointing, is at least in our rearview mirror. It also brought the Richmond Fed Manufacturing Survey, which was better than anticipated, but still pretty anemic (zero versus the expected negative two). At this point, we’re looking at low volume markets that are whipping all over the place, and appear to be hanging on the next headline.
Thus far, the two high impact stories of the day are the revamping of a credit line by the International Monetary Fund (IMF) and the (apparently early) release of the Fed minutes. Markets caught a bid on the IMF line, but quickly sold back off as the details look somewhat lackluster. The minutes were just released and markets have surged again on hopes that the Federal Reserve might jump to the rescue. Whether that will hold is another story.
As we approach the Thanksgiving holiday, I give thanks for my family, my co-workers, and our clients, who trust us to manage their precious assets. I’d also like to give thanks that Thursday I can eat some turkey in peace without worrying that the next headline might produce another round of high powered volatility.
Thus far, the two high impact stories of the day are the revamping of a credit line by the International Monetary Fund (IMF) and the (apparently early) release of the Fed minutes. Markets caught a bid on the IMF line, but quickly sold back off as the details look somewhat lackluster. The minutes were just released and markets have surged again on hopes that the Federal Reserve might jump to the rescue. Whether that will hold is another story.
As we approach the Thanksgiving holiday, I give thanks for my family, my co-workers, and our clients, who trust us to manage their precious assets. I’d also like to give thanks that Thursday I can eat some turkey in peace without worrying that the next headline might produce another round of high powered volatility.
Monday, November 21, 2011
How to Make a lot of Money Right Now
You know, it’s not that hard to make a lot of money in the financial markets, no matter what you might have heard. For example, I can tell you exactly how to make a fortune in the next couple of months. Here is what you do:
First, assume that Germany will capitulate to the fervent pleas of just about every other country in Europe and agree to allow the ECB to print about a trillion euros, give or take. Never mind that the ECB and Germany have both been firmly on the record stating that this shouldn’t happen because this would be against the law (along with several other better reasons). They seem to take the position that if the central bank prints the money, then the countries with the most debt will probably spend it. Imagine that. As of last week, it appears that without a massive quantitative easing program (the central bankers' term for printing money) the whole euro experiment might go up in smoke. So go ahead and bet that policy makers will suck it up and not allow the Eurozone to fall apart. Once Mario Draghi, president of the ECB, and Angela Merkel, Chancellor of Germany, get serious about debasing the euro currency, prices for credit default swaps on bank debt and sovereign debt will plummet, yield spreads between Germany and all of the other Eurozone countries will crash, liquidity will wash over market participants like a cool breeze and equity markets around the world are going to go vertical.
But that’s not all. This week the world will turn its attention, once again, to the ongoing tragi-comedy that is the U.S. Congress, or more specifically, the Super Committee tasked with coming up with $1.3 trillion in savings in order to avoid $1.2 trillion in automatic, across-the-board spending cuts (starting in 2013, and evenly divided between defense and non-defense spending). By the time you read this post, the committee will have had to announce its verdict, so we may be a little late to get in at the absolute bottom. To make the big money you have to believe that the committee is going to shock the world and go big... really big. If the committee comes up with $3 - $4 trillion in savings based on revenue increases, entitlement spending cuts, savings from pulling out of Afghanistan, and other savings that will kick in far in the future, the market is going to love it, if for no other reason than that we will avoid another embarrassing downgrade from the rating agencies on U.S. debt. Considering the terrible year thus far, a big deal could be the perfect excuse for hedge funds to work their way into a buying panic.
So let’s review. Back up the truck, borrow money from mom, mortgage the house, leverage the portfolio, bust out the derivatives, and empty your pockets, because this is one of those times when risk takers can make a whole lot of money…. as long as the players follow the script I’ve carefully laid out for them. Of course, it’s possible that Germany and the ECB mean what they say about quantitative easing, and the Super Committee won’t get a deal done, in which case, risk takers are going to get slaughtered. U.S. economic data is looking, on average, a little better to me over the past several weeks, and the earnings season has been stronger than expected, but I just can’t get excited about being much of a buyer right now. Europe is going into recession, and I think that will put a substantial damper on the U.S. economy, which at best is going to slow along with it.
I'll let others make the big money if they have the stomach to buy in front of all of this headline risk. If they get it right, they'll be considered brilliant observers of global economic policy and shrewd and calculating risk takers. If they get it wrong, well...
First, assume that Germany will capitulate to the fervent pleas of just about every other country in Europe and agree to allow the ECB to print about a trillion euros, give or take. Never mind that the ECB and Germany have both been firmly on the record stating that this shouldn’t happen because this would be against the law (along with several other better reasons). They seem to take the position that if the central bank prints the money, then the countries with the most debt will probably spend it. Imagine that. As of last week, it appears that without a massive quantitative easing program (the central bankers' term for printing money) the whole euro experiment might go up in smoke. So go ahead and bet that policy makers will suck it up and not allow the Eurozone to fall apart. Once Mario Draghi, president of the ECB, and Angela Merkel, Chancellor of Germany, get serious about debasing the euro currency, prices for credit default swaps on bank debt and sovereign debt will plummet, yield spreads between Germany and all of the other Eurozone countries will crash, liquidity will wash over market participants like a cool breeze and equity markets around the world are going to go vertical.
But that’s not all. This week the world will turn its attention, once again, to the ongoing tragi-comedy that is the U.S. Congress, or more specifically, the Super Committee tasked with coming up with $1.3 trillion in savings in order to avoid $1.2 trillion in automatic, across-the-board spending cuts (starting in 2013, and evenly divided between defense and non-defense spending). By the time you read this post, the committee will have had to announce its verdict, so we may be a little late to get in at the absolute bottom. To make the big money you have to believe that the committee is going to shock the world and go big... really big. If the committee comes up with $3 - $4 trillion in savings based on revenue increases, entitlement spending cuts, savings from pulling out of Afghanistan, and other savings that will kick in far in the future, the market is going to love it, if for no other reason than that we will avoid another embarrassing downgrade from the rating agencies on U.S. debt. Considering the terrible year thus far, a big deal could be the perfect excuse for hedge funds to work their way into a buying panic.
So let’s review. Back up the truck, borrow money from mom, mortgage the house, leverage the portfolio, bust out the derivatives, and empty your pockets, because this is one of those times when risk takers can make a whole lot of money…. as long as the players follow the script I’ve carefully laid out for them. Of course, it’s possible that Germany and the ECB mean what they say about quantitative easing, and the Super Committee won’t get a deal done, in which case, risk takers are going to get slaughtered. U.S. economic data is looking, on average, a little better to me over the past several weeks, and the earnings season has been stronger than expected, but I just can’t get excited about being much of a buyer right now. Europe is going into recession, and I think that will put a substantial damper on the U.S. economy, which at best is going to slow along with it.
I'll let others make the big money if they have the stomach to buy in front of all of this headline risk. If they get it right, they'll be considered brilliant observers of global economic policy and shrewd and calculating risk takers. If they get it wrong, well...
Friday, November 18, 2011
Can Santa Ride Through Frozen Credit?
Right now the equity bulls have a case for another leg higher, resting largely on technical conditions. We’re now into the best seasonal period of the year for stocks, and headed towards the end of a tough performance period that might encourage large financial institutions and hedge funds to try to juice some returns out of this lackluster market. Meanwhile sentiment has been gloomy for months, and a lot of cash likely sits on the sidelines that could potentially fuel a short term run. Given this backdrop, it’s not inconceivable that that we could see a Santa Claus Melt Up that heads for the old highs of about 1360 on the S&P 500.
But anyone following the credit markets lately could also come to the conclusion that the bulls have drunk too much egg nog. Recently the yield levels on European peripheral debt have risen to worrisome levels, the cost to protect European banks have been surging, and there are indications that the plumbing of the European banking system is clogging up in a hurry. Essentially the credit markets are showing some signs of a deep freeze in Europe, which ratchets up system wide risk and threatens to derail global growth over the next few quarters.
Yesterday the S&P 500 broke through the triangle pattern that Carl mentioned a few days ago, which would imply that the next stop for the market should be somewhere in the low 1160 range, if the patterns holds. Investors must decide what this correction means to their portfolio positioning. Those who believe Santa will ride to the rescue will likely use this correction as an opportunity to add risk, and those who believe the Credit Grinch will cancel the Christmas festivities have no reason to abandon their defensive posture. At Pinnacle we are positioned defensively, but have been eyeing up a way to get slightly less defensive, given that evidence we follow is less uniformly bearish than it was a few months ago. I’m not sure if this is time to buy or not, but you can bet there will be some interesting discussions on this topic as we approach the kick off of the holiday season next week.
But anyone following the credit markets lately could also come to the conclusion that the bulls have drunk too much egg nog. Recently the yield levels on European peripheral debt have risen to worrisome levels, the cost to protect European banks have been surging, and there are indications that the plumbing of the European banking system is clogging up in a hurry. Essentially the credit markets are showing some signs of a deep freeze in Europe, which ratchets up system wide risk and threatens to derail global growth over the next few quarters.
Yesterday the S&P 500 broke through the triangle pattern that Carl mentioned a few days ago, which would imply that the next stop for the market should be somewhere in the low 1160 range, if the patterns holds. Investors must decide what this correction means to their portfolio positioning. Those who believe Santa will ride to the rescue will likely use this correction as an opportunity to add risk, and those who believe the Credit Grinch will cancel the Christmas festivities have no reason to abandon their defensive posture. At Pinnacle we are positioned defensively, but have been eyeing up a way to get slightly less defensive, given that evidence we follow is less uniformly bearish than it was a few months ago. I’m not sure if this is time to buy or not, but you can bet there will be some interesting discussions on this topic as we approach the kick off of the holiday season next week.
Wednesday, November 16, 2011
Watching the Triangle
While the latest news on the economy, Europe’s ongoing debt crisis, and the progress (or lack thereof) of the debt “supercommittee” continues to cause plenty of day-to-day volatility in the market, in reality, stocks have been going sideways for nearly three weeks. The bulls are encouraged, viewing this as a healthy pause after strong gains in October. But the bears are also heartened, noting that the market is still struggling to clear its 200-day moving average or surpass the late October high.
Several market technicians have pointed out that the sideways action has produced a triangle formation (shown below using the S&P 500). The pattern basically represents increasing indecision on the part of investors. Typically, the direction stocks take in breaking out of the triangle is a good signal of the next significant move for the market. More often than not, it will continue in the same direction as the prior move, which in this case would be higher, based on the October rally. But that is far from certain, given the current environment. In any case, with the triangle narrowing rapidly, we shouldn’t have to wait long to find out.
Several market technicians have pointed out that the sideways action has produced a triangle formation (shown below using the S&P 500). The pattern basically represents increasing indecision on the part of investors. Typically, the direction stocks take in breaking out of the triangle is a good signal of the next significant move for the market. More often than not, it will continue in the same direction as the prior move, which in this case would be higher, based on the October rally. But that is far from certain, given the current environment. In any case, with the triangle narrowing rapidly, we shouldn’t have to wait long to find out.
Monday, November 14, 2011
Which Commodity is Wrong? Part II
In the previous blog post, Rick Vollaro brought to your attention an important divergence currently happening in the market -- the one between crude oil prices on one side and the CRB RIND (raw industrials) and copper on the other. These three indicators are typically regarded both as important global growth barometers and as highly correlated with the stock market. Figure 1 highlights the relative price action of these three series since 10/3/2011, when the S&P 500 formed a short term bottom. Since then, crude oil prices have risen more than 25% while the CRB RIND stayed flat and copper bounced around to end about 7% higher (though it seems to be in the process of rolling over). Meanwhile, the S&P 500 has been stuck in the middle, looking like it's not sure which commodity to follow.
We performed a historical analysis (weekly data available since 1988) to determine historically which, if any, of the above commodity series was most relevant for the stock market. In addition to coincident correlations (relation between movements in two variables at the same time) we also looked at leading correlations (relation between movements in one variable and movements in another variable at some point in the future) up to 8 weeks. Table 1 reports the results. Thanks to the heat map, we can clearly see that both copper and CRB RIND have historically been much more correlated to the S&P 500 than crude oil prices in coincident terms. Moreover, even when a lead is applied, the correlation of copper and CRB RIND to the S&P 500 remains elevated. Table 2 reports the T-statistics of the correlations in Table 1. In other words we are testing whether the results from Table 1 are statistically significant, using a 99% confidence level. When it comes to the T-stat, the higher the better -- specifically, we want it to be higher than a given threshold (the right-most column in Table 2) in order to achieve the desired level of statistical significance. While the T-stats on copper and the CRB RIND are very large and passed the test by an ample margin, only a few of the T-stats on crude oil passed the test and only by a tight margin. Based on these results, copper and the CRB RIND appear to be more reliable barometers of global growth and to correlate better with the stock market than crude oil prices.
We performed a historical analysis (weekly data available since 1988) to determine historically which, if any, of the above commodity series was most relevant for the stock market. In addition to coincident correlations (relation between movements in two variables at the same time) we also looked at leading correlations (relation between movements in one variable and movements in another variable at some point in the future) up to 8 weeks. Table 1 reports the results. Thanks to the heat map, we can clearly see that both copper and CRB RIND have historically been much more correlated to the S&P 500 than crude oil prices in coincident terms. Moreover, even when a lead is applied, the correlation of copper and CRB RIND to the S&P 500 remains elevated. Table 2 reports the T-statistics of the correlations in Table 1. In other words we are testing whether the results from Table 1 are statistically significant, using a 99% confidence level. When it comes to the T-stat, the higher the better -- specifically, we want it to be higher than a given threshold (the right-most column in Table 2) in order to achieve the desired level of statistical significance. While the T-stats on copper and the CRB RIND are very large and passed the test by an ample margin, only a few of the T-stats on crude oil passed the test and only by a tight margin. Based on these results, copper and the CRB RIND appear to be more reliable barometers of global growth and to correlate better with the stock market than crude oil prices.
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| Figure 1: Relative Price Action Since 10/3/2011 |
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| Table 1: Leading the S&P 500 weekly returns (correlations since 1988) |
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| Table 2: Leading the S&P 500 weekly returns (T-stats since 1988) |
Friday, November 11, 2011
Which Commodity is Wrong?
Right now we're watching some interesting divergences within the commodity complex. Sean wrote a recent post about oil's rise, and he mentioned that many analysts see this as a sign that the U.S. might avoid recession. What’s puzzling is that oil is currently diverging from other commodities that are typically seen as barometers of global growth, like the CRB Raw Industrial Spot Index (RIND), which tracks a basket of 15 economically sensitive commodities, excluding oil (see the chart below).
Some of the technicians we follow are screaming that the strong correlation between oil and equity markets indicates that oil will likely lead the markets higher. They may be correct, but we're currently investigating the potential correlations and lead times between oil, copper and the CRB RIND. Stay tuned for the results of Sauro Locatelli’s research on which commodity is more likely to be wrong... coming soon to a blog near you.
Some of the technicians we follow are screaming that the strong correlation between oil and equity markets indicates that oil will likely lead the markets higher. They may be correct, but we're currently investigating the potential correlations and lead times between oil, copper and the CRB RIND. Stay tuned for the results of Sauro Locatelli’s research on which commodity is more likely to be wrong... coming soon to a blog near you.
Thursday, November 10, 2011
Will Europe Drag the U.S. into Recession?
With signs that Europe is likely in the grips of recession due to their inability to adequately address their debt crisis, we’ve been trying to get a handle on how that will impact the U.S. economy. The reality that economies are more globally connected than ever hasn’t prevented some analysts from predicting that the U.S. will be fine, even if growth in Europe is contracting. We weren’t believers in the idea of “decoupling” when it was popular back in 2007-08, and we find ourselves skeptical again today.
A recent research report from Citigroup illustrates how tightly linked economies are these days. The chart below (from the report) shows the correlation in GDP growth rates between major European economies and the U.S. over the past two decades. In the 1990s, the correlation was only 18.5%, and it was much easier to buy into the idea that the U.S. could decouple from Europe (and vice versa). In the past decade, however, the correlation has jumped up to 72%, clearly indicating that the economies move together more often than not.
If the U.S. economy was firing on all cylinders, we might be more open to the idea that a European recession would be a non-event. But with the current recovery lackluster in many respects and with risks still unusually elevated, we're following economic developments in Europe with significant concern.
A recent research report from Citigroup illustrates how tightly linked economies are these days. The chart below (from the report) shows the correlation in GDP growth rates between major European economies and the U.S. over the past two decades. In the 1990s, the correlation was only 18.5%, and it was much easier to buy into the idea that the U.S. could decouple from Europe (and vice versa). In the past decade, however, the correlation has jumped up to 72%, clearly indicating that the economies move together more often than not.
If the U.S. economy was firing on all cylinders, we might be more open to the idea that a European recession would be a non-event. But with the current recovery lackluster in many respects and with risks still unusually elevated, we're following economic developments in Europe with significant concern.
Wednesday, November 9, 2011
The Euro is on an Island
For months now I’ve been watching two charts very closely on my ticker screen -- the Euro exchange traded fund (FXE) and the S&P 500 (SPY). It’s been amazing to see how movements in the FXE have correlated to SPY (approximately 84% since September). This may be not be much of a surprise since the market has been taken hostage by the European debt crises, to the point where every rumor coming from Europe seems to create a short term market move.
Today I want to point out a technical pattern currently found in the FXE. At the moment the FXE is in the middle of an island reversal pattern (see chart below). Island reversals get their name from the appearance of the chart, where there's a price gap up, and then a gap back down, forming what looks like an island. The key here is that when the pattern forms and the gap is not quickly filled, it's usually a bearish omen for that asset. If the FXE declines and current correlations hold, this won’t bode well for the S&P 500, unless the U.S. is about to decouple from problems in Europe. While I don’t have room to get into my views on decoupling right now, I will say that the last time we heard about it was when people believed that the emerging markets could decouple versus developed markets. That was in 2008, and the theory didn’t work out so well. Those who believe it will work this time may get caught on an island with the FXE.
Today I want to point out a technical pattern currently found in the FXE. At the moment the FXE is in the middle of an island reversal pattern (see chart below). Island reversals get their name from the appearance of the chart, where there's a price gap up, and then a gap back down, forming what looks like an island. The key here is that when the pattern forms and the gap is not quickly filled, it's usually a bearish omen for that asset. If the FXE declines and current correlations hold, this won’t bode well for the S&P 500, unless the U.S. is about to decouple from problems in Europe. While I don’t have room to get into my views on decoupling right now, I will say that the last time we heard about it was when people believed that the emerging markets could decouple versus developed markets. That was in 2008, and the theory didn’t work out so well. Those who believe it will work this time may get caught on an island with the FXE.
Tuesday, November 8, 2011
A Sign of U.S. Expansion
The chart below is the price of West Texas Crude, and you can see that the price has been climbing since the beginning of October. In fact, crude prices are up an amazing 28% in just over 1 month. Many analysts believe this is evidence that the United States has avoided a recession, and that the economies in China and Germany will be much stronger than expected from this point forth.
It is hard to deny the strength in oil right now. The price has risen above its 200 day moving average ($94.87) today after breaking the downtrend line from May to September. The price found little resistance at the 50% retracement level, which was also the same level as the 200 day moving average, and is now moving to the 61.8% level at $100 per barrel.
While this is definitely a good looking chart, I'll still be watching the U.S. equity market for further signs of strength. The S&P 500 and crude oil has been extremely correlated recently with a 95% correlation since July. The S&P 500 is now testing its 200 day moving average as I write and if the stock market fails at this technical level again, I don’t think there's much hope for oil to rise further. And that will help quiet the Avoided Recession camp.
It is hard to deny the strength in oil right now. The price has risen above its 200 day moving average ($94.87) today after breaking the downtrend line from May to September. The price found little resistance at the 50% retracement level, which was also the same level as the 200 day moving average, and is now moving to the 61.8% level at $100 per barrel.
While this is definitely a good looking chart, I'll still be watching the U.S. equity market for further signs of strength. The S&P 500 and crude oil has been extremely correlated recently with a 95% correlation since July. The S&P 500 is now testing its 200 day moving average as I write and if the stock market fails at this technical level again, I don’t think there's much hope for oil to rise further. And that will help quiet the Avoided Recession camp.
Thursday, November 3, 2011
Our Latest Assessment...
Yesterday the Investment Team met to discuss the state of the markets. The agenda was ambitious: We needed to assess Europe’s Grand Plan, recent economic data, technical conditions, and what smoke was coming from the independent analysts we follow. Ultimately we had to decide whether or not our allocation was consistent with the weight of the evidence.
Here is a summary of the meeting and our thoughts.
The European Grand Plan
Is the latest European bailout plan a game changer? No. Most of us felt the plan was an improvement over earlier efforts, but all of us agreed that it lacks details and doesn’t appear to be enough to stem the European problems in the long term. Though equity markets have celebrated, we have not seen credit markets confirm, particularly on the European periphery. Whether it can stabilize things in the short term is more questionable, and the surprise referendum was proof of how fragile the situation is. In short, the plan is an improvement over previous offerings, but is not enough to shift our view.
[In the time since our meeting, we’ve seen rumors that the Prime Minister of Greece will be resigning... and then another that he’ll be staying... and still another that the referendum will be scrapped. Stay tuned. There should be two or three more rumors before the day is over.]
Business Cycle Data
The discussion covered three regions of the globe...
United States
We acknowledged that 3rd quarter data was quite a bit stronger than we expected. However, equity markets appear to have already recalibrated expectations of growth back to moderate levels, and the team was uneasy that many leading indicators still point to slower growth ahead, and that the trend of much of the data we follow is still down. We also noted that other parts of the globe are slowing, which will impact the U.S. In our judgment, it’s still worth defending against the risk of anemic growth, or even oncoming recession. However, if the data continues to surprise us on the upside, we may be forced to change our view on the U.S. economy and admit that we missed it on this front.
From a monetary perspective, the team thinks the Federal Reserve is likely to pursue further options if the situation deteriorates. However, after the recent firming in the data and the equity rally, it’s unlikely that the Fed will start a new program in the imminent future. Fiscally, it doesn’t appear that the government will come up with a material program before the election, and the super committee is unlikely to make the kinds of budget cuts necessary to fix long term problems before November 23rd.
[Since our meeting the Fed left rates unchanged and has not started a new quantitative easing program.]
Europe
Europe’s economic situation continues to get worse, and the Euro-zone might even be recessing. The economic weakness in Europe will likely flow through the globe and press against the U.S. and Emerging Markets, due to the interconnected nature of the world economy. From a monetary perspective, there’s a good chance that new ECB President, Mario Draghi, will start cutting rates to combat the deteriorating economic situation. While that’s good news, the rate cuts will be reactive, not proactive, and it’s questionable whether cutting from a 1.5% starting point will be enough to keep the European barge from turning in a negative direction.
[Draghi cut rates by 25 bp this morning.]
China/Emerging
Chinese data continues to slow, and its prior tightening policy will likely continue to move through the system and inhibit growth. China has shown interbank lending stress and is at risk of a property market slowdown, which creates a layer of system risk in the entire region. The good news is that China has recently stopped tightening and some of the emerging market countries have begun cutting rates, but the effects will take time to work through the system. Part of Asia’s challenge is dealing with a very slow developed world, which will put pressure on exports out of the region.
Technical Conditions
Intermediate technical conditions don’t appear to have turned, but there are definite improvements in the shorter term technical outlook. Given how depressed sentiment got during the latest downturn -- along with the fact that we’re entering a more positive seasonal environment -- most of the Investment Team believes the rally will continue to drift up, perhaps toward the old highs of 1360. Without intermediate measures turning, we have to decide what to do about a short term rally of this nature. The risk to our current outlook is that the money that had been kept on the sidelines is now pouring back into the market, which engenders confidence and brings more investors back into the game. The market is at a crucial point right now: A confirmation or failure could determine the direction the market will take into the year’s end.
Independent Analysis
A number of our independent analysts have gotten more bullish, and while some stay bearish, there are no new bears emerging to confirm our stated view. We don’t rely on any single analyst or view, but the overall tone is getting more positive and we can’t ignore that.
Is the Allocation Consistent with the Current Weight of the Evidence?
None of us are bullish on fundamentals right now, but there has been enough change in technical conditions and analyst opinion to consider whether the allocation is still consistent with the overall weight of the evidence.
Ultimately, the combination of some better-than-expected U.S. data, improving short term technicals, and a change in tone from the independent analysts we follow give us less certainty that the markets will make their way back to levels of 950-1050. Therefore , the allocation needs to reflect this by getting slightly less defensive. In no way are we turning bullish at this time, but we are going to play a bit less defense to acknowledge some of the evidence against our current view.
Magnitude and Tactics
In terms of magnitude, removing our last stop-loss amount (roughly 5% equity) is a reasonable response to the changes. We are currently working out the details of how best to execute our strategy. Stay tuned for details.
Here is a summary of the meeting and our thoughts.
The European Grand Plan
Is the latest European bailout plan a game changer? No. Most of us felt the plan was an improvement over earlier efforts, but all of us agreed that it lacks details and doesn’t appear to be enough to stem the European problems in the long term. Though equity markets have celebrated, we have not seen credit markets confirm, particularly on the European periphery. Whether it can stabilize things in the short term is more questionable, and the surprise referendum was proof of how fragile the situation is. In short, the plan is an improvement over previous offerings, but is not enough to shift our view.
[In the time since our meeting, we’ve seen rumors that the Prime Minister of Greece will be resigning... and then another that he’ll be staying... and still another that the referendum will be scrapped. Stay tuned. There should be two or three more rumors before the day is over.]
Business Cycle Data
The discussion covered three regions of the globe...
United States
We acknowledged that 3rd quarter data was quite a bit stronger than we expected. However, equity markets appear to have already recalibrated expectations of growth back to moderate levels, and the team was uneasy that many leading indicators still point to slower growth ahead, and that the trend of much of the data we follow is still down. We also noted that other parts of the globe are slowing, which will impact the U.S. In our judgment, it’s still worth defending against the risk of anemic growth, or even oncoming recession. However, if the data continues to surprise us on the upside, we may be forced to change our view on the U.S. economy and admit that we missed it on this front.
From a monetary perspective, the team thinks the Federal Reserve is likely to pursue further options if the situation deteriorates. However, after the recent firming in the data and the equity rally, it’s unlikely that the Fed will start a new program in the imminent future. Fiscally, it doesn’t appear that the government will come up with a material program before the election, and the super committee is unlikely to make the kinds of budget cuts necessary to fix long term problems before November 23rd.
[Since our meeting the Fed left rates unchanged and has not started a new quantitative easing program.]
Europe
Europe’s economic situation continues to get worse, and the Euro-zone might even be recessing. The economic weakness in Europe will likely flow through the globe and press against the U.S. and Emerging Markets, due to the interconnected nature of the world economy. From a monetary perspective, there’s a good chance that new ECB President, Mario Draghi, will start cutting rates to combat the deteriorating economic situation. While that’s good news, the rate cuts will be reactive, not proactive, and it’s questionable whether cutting from a 1.5% starting point will be enough to keep the European barge from turning in a negative direction.
[Draghi cut rates by 25 bp this morning.]
China/Emerging
Chinese data continues to slow, and its prior tightening policy will likely continue to move through the system and inhibit growth. China has shown interbank lending stress and is at risk of a property market slowdown, which creates a layer of system risk in the entire region. The good news is that China has recently stopped tightening and some of the emerging market countries have begun cutting rates, but the effects will take time to work through the system. Part of Asia’s challenge is dealing with a very slow developed world, which will put pressure on exports out of the region.
Technical Conditions
Intermediate technical conditions don’t appear to have turned, but there are definite improvements in the shorter term technical outlook. Given how depressed sentiment got during the latest downturn -- along with the fact that we’re entering a more positive seasonal environment -- most of the Investment Team believes the rally will continue to drift up, perhaps toward the old highs of 1360. Without intermediate measures turning, we have to decide what to do about a short term rally of this nature. The risk to our current outlook is that the money that had been kept on the sidelines is now pouring back into the market, which engenders confidence and brings more investors back into the game. The market is at a crucial point right now: A confirmation or failure could determine the direction the market will take into the year’s end.
Independent Analysis
A number of our independent analysts have gotten more bullish, and while some stay bearish, there are no new bears emerging to confirm our stated view. We don’t rely on any single analyst or view, but the overall tone is getting more positive and we can’t ignore that.
Is the Allocation Consistent with the Current Weight of the Evidence?
None of us are bullish on fundamentals right now, but there has been enough change in technical conditions and analyst opinion to consider whether the allocation is still consistent with the overall weight of the evidence.
Ultimately, the combination of some better-than-expected U.S. data, improving short term technicals, and a change in tone from the independent analysts we follow give us less certainty that the markets will make their way back to levels of 950-1050. Therefore , the allocation needs to reflect this by getting slightly less defensive. In no way are we turning bullish at this time, but we are going to play a bit less defense to acknowledge some of the evidence against our current view.
Magnitude and Tactics
In terms of magnitude, removing our last stop-loss amount (roughly 5% equity) is a reasonable response to the changes. We are currently working out the details of how best to execute our strategy. Stay tuned for details.
Wednesday, November 2, 2011
In the Recession Camp
In our blog posts we often mention the ISM Manufacturing Report on Business PMI and the ECRI Weekly Leading Index, which are usually at the front line of the many barometers of economic activity we watch regularly. While the ISM PMI is built so that a reading below 50 signals economic contraction, its historical track record in calling recessions is far from perfect. On the other hand, while the ECRI team has a stellar historical track record in calling recessions, their weekly growth index doesn’t feature an absolute threshold below which a recession signal is triggered, and its interpretation is not as straightforward, at least for outsiders.
John P. Hussman, a Ph.D. in economics and one of our favorite reads, recently suggested a way of combining these two indicators to obtain a single recession signal that is more reliable than the sum of its parts. Following his idea (but doing our own math, as always), we found that over the last 44 years, whenever the ISM PMI was below 54 and simultaneously the ECRI Weekly Leading Index Growth was below -5, the U.S. was already in a recession (as defined by the National Bureau of Economic Research) 86.80% of the time. Moreover, if the U.S. was not already in a recession, there was a 92.59% chance of entering one within three months and a 95.06% chance of doing so within six months. The accuracy of this combination is easily explained: Our research indicates that the ECRI Index leads the ISM PMI by about four months (see chart below). Therefore this set of conditions can be interpreted as economic growth being near stall speed (low ISM PMI) and headed lower (negative ECRI Index). Adding a third condition (negative S&P 500 trailing-six-month return) and lowering the thresholds to 52 for the ISM PMI and to -7 for the ECRI Index worked even better; whenever these three conditions occurred simultaneously, the U.S. was already in a recession 94.19% of the time and was going to be in a recession within the following three months 100% of the time. That means always. Incidentally, this latter combination is the one we observe today (ISM PMI 50.8, ECRI Index -10, S&P 500 trailing six-month return -10.66% as of 10/31/2011).
Just another (heavy) piece to add to the weight of the evidence.
John P. Hussman, a Ph.D. in economics and one of our favorite reads, recently suggested a way of combining these two indicators to obtain a single recession signal that is more reliable than the sum of its parts. Following his idea (but doing our own math, as always), we found that over the last 44 years, whenever the ISM PMI was below 54 and simultaneously the ECRI Weekly Leading Index Growth was below -5, the U.S. was already in a recession (as defined by the National Bureau of Economic Research) 86.80% of the time. Moreover, if the U.S. was not already in a recession, there was a 92.59% chance of entering one within three months and a 95.06% chance of doing so within six months. The accuracy of this combination is easily explained: Our research indicates that the ECRI Index leads the ISM PMI by about four months (see chart below). Therefore this set of conditions can be interpreted as economic growth being near stall speed (low ISM PMI) and headed lower (negative ECRI Index). Adding a third condition (negative S&P 500 trailing-six-month return) and lowering the thresholds to 52 for the ISM PMI and to -7 for the ECRI Index worked even better; whenever these three conditions occurred simultaneously, the U.S. was already in a recession 94.19% of the time and was going to be in a recession within the following three months 100% of the time. That means always. Incidentally, this latter combination is the one we observe today (ISM PMI 50.8, ECRI Index -10, S&P 500 trailing six-month return -10.66% as of 10/31/2011).
Just another (heavy) piece to add to the weight of the evidence.
Tuesday, November 1, 2011
The Euro Mess is the Dollar's Gain
It was just four days ago when the world celebrated the European rescue. Now that has all changed. Carl initially pointed out that the European bond market was not happy with the bailout, and now everyone has joined the party. Not only are 10-year Italian bond yields surging to a worrisome 6.25%, but the Euro is selling off heavily and European financial stocks are well below pre-bailout levels. This is all possible due to Greek Prime Minister George Papandreou. He has called a referendum on the new EU aid deal, which could backfire if his coalition loses the vote.
Due to the increasingly hilarious (in an uncomfortable sort of way) situation in Europe, our Rising Dollar position has rebounded very nicely. The chart below shows the Dollar Index. We were very excited in September when the price level broke above the green line, but became nervous when the green line broke in October. However, after an amazing 4% rally, the index is now once again trading above the green line, the 50 Day Moving Average and the 200 Day Moving Average. We're glad to have our safe-haven hedge in a Rising Dollar Fund.
Due to the increasingly hilarious (in an uncomfortable sort of way) situation in Europe, our Rising Dollar position has rebounded very nicely. The chart below shows the Dollar Index. We were very excited in September when the price level broke above the green line, but became nervous when the green line broke in October. However, after an amazing 4% rally, the index is now once again trading above the green line, the 50 Day Moving Average and the 200 Day Moving Average. We're glad to have our safe-haven hedge in a Rising Dollar Fund.
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