Will a Dollar Reversal Coincide With a Pause in the Reflation Trade?

While the stock market has rallied +57% since the March 9th low, the value of the U.S. dollar, measured against a basket of currencies of our largest trading partners, has dropped by almost -14%. This inverse correlation (statistically measured as -0.66, indicating a strong inverse relationship) isn’t something new; if one looks at the correlation between the market and the dollar it has been negative since the market top in October 2007 (measured as -0.49 since then). There are many theories as to why this is the case, such as the dollar’s reserve currency status in a time of crisis, the reflationary aspects of a weak currency, and the positive effects of a weak dollar on repatriation of earnings for multinational companies.

As the dollar has fallen, it has helped ignite a trade that is commonly referred to as the “reflation” trade. Reflation is the act of stimulating the economy via monetary and fiscal stimulus to expand output. Typically as the stimulus is applied, lower real interest rates and deficit spending combine to weaken the currency, which makes exports cheaper and in turn fuels growth. We consider a number of sectors and asset classes to be particularly sensitive to reflationary policy as well as a weak dollar, including certain US equity sectors (like materials, energy, and industrials), emerging markets stocks, commodities (such as oil, copper, gold, etc.), and other hard assets like property. If one looks at the performance of those assets since the March bottom in stocks (shown in the table below), it’s clear that reflation trades have outpaced the broad market. But beware, since even strong market trends are subject to periodic adjustments, and these reflation trades have reached a point where they seem vulnerable if the markets correct and the dollar bounces.

Our current view is that the cyclical bull market in stocks has not yet fully run its course. At the same time, some of the shorter-term technicals we monitor appear stretched, and a healthy correction would not be surprising. Should that occur, we won’t be surprised to see short term fireworks in the dollar and reflation trades.

Investing For Volatility

The VIX, or the Chicago Board Options Exchange Volatility Index, measures the implied volatility of S&P 500 index options. It is commonly referred to as the fear index because a high value on the VIX implies that it is more costly to protect one’s portfolio. As one could guess the VIX soared to an all time high of 90 on October 24, 2008 near the height of panic. However, the index has steadily fallen from that peak to a reading just north of 25.

Recently, Barclays introduced an ETN (Exchange Traded Note) called iPath S&P 500 VIX Short-Term Futures and trades under the symbol VXX. As there is no way to directly invest the VIX, they have provided an investible vehicle that will hold VIX futures contracts that are continuously rolled forward. Many of the analysts we read are looking for short term correction here as the market catches its breath and we did some surface research to see if the VXX could provide us with a short term hedge. Although it does not seem like a good fit at the moment, we are pleasantly surprised with innovations in the investment world and will continue to scour the world for ways to enhance our portfolios for our clients.

Falling Baltic Dry

At Pinnacle we watch many different global growth indicators and one in particular has peaked my interest. The Baltic Dry Index is an index that measures dry bulk shipping rates in certain shipping lanes around the world, and therefore offers a glimpse of real time demand for infrastructure material. As the chart below shows, this index has recently fallen almost 50% from a May 2009 reading of 4300 to the present reading of 2175 (of course it did rise over 500% from November 2008 to May 2009). This fall is a direct result of an increase in shipping capacity and a decreasing demand for goods, particularly out of China.

As China poured the record stimulus into the market the demand for iron ore and other industrial metals experienced a rapid rise. This caused shipping rates as measured by the Baltic Dry to rapidly rise as well. But it also created an incentive to keep old ships in the shipping lanes to handle the rapid demand rise. And now the shipping companies are experiencing the hangover from artificial demand as the stimulus package is slipping and China’s appetite is waning.

The direct impact on the stock market is not being seen though. Clearly real demand for industrial metals is not present in the global economy, and this would normally portend a weak stock market. But during a liquidity driven market perhaps the index loses its forecasting ability. We will continue to monitor this and many more indexes to judge global economic health.

Technical Take- Fibanocci Charts Mixed, Intermediate Technicals Solid

At Pinnacle Advisory Group, technical analysis is one of the three pillars of our investment process (Macro Fundamentals, Valuation, Technical Analysis) that help us shape our forecast and set portfolio allocation. Technical analysis is a very broad term and we will define it loosely as anything non-fundamental. Some examples are following intermediate term trends (like the 200 day moving average), analyzing sentiment in the market place, and monitoring measures of investor fear (options volatility (VIX) & put/call ratios). One technical indicator we monitor is called Fibonacci analysis, which is based on the mathematical theory of Leonardo Fibonacci. It is used in practice to try and identify trend changes, and entry and exit points in markets undergoing countertrend retracements. Based on Fibonacci’s work, most counter trend retracements will peak somewhere between 50-61.8% before the retracement stalls and the major trend again resumes. If the countertrend retracement exceeds 61.8% it is usually assumed that there has been a trend change from bull to bear or vice versa. Utilizing this technical tool seems particularly valuable right now to help analyze a market that has recently seen a vicious long term down trend give way to a rip roaring rally.

Below is a chart of the value line index, which is a broad index that consists of 1650 equally weighted stocks. When looked at from a top to bottom basis the index has currently retraced more than 76% of the decline off the last market top. This chart would imply that we are currently in a new bull market, and not a bear market retracement. But hold on, depending on which index you look at (the S&P 500 or the Russell 2000, NASDAQ, Emerging Markets etc.) and what time you use to run the Fibonacci numbers (some might use a timeframe closer to the Lehman collapse in 2008 to present, others like the top of the market in 2007 to present) the retracement level may give an entirely different message. After running through a number of markets and different timeframes, the general message I’m seeing is mixed and muddled, which simply means this technical indicator is providing a non-conviction forecast. But one indicator does not make a market, and Fibonacci analysis aside, there area two different technical takes that appear to be more clearly defined. Number one is that the market appears to be overextended in the short term and is vulnerable to correction at any time now. Second, and more important, is that the weight of technical evidence seems to be improving on an intermediate term time frame. That won’t make a correction feel any better when we get it, but right now we are viewing any correction as a healthy consolidation within a bull market, not the beginning of the next bear market.

Portfolio Managers versus Money Managers

In my opinion there is an enormous amount of confusion about who the players are in the investment industry so here is my particular take on the subject. I define portfolio managers as investors who have the freedom to invest in multiple asset classes. Their portfolios are typically constructed with investments in U.S. and international stocks, U.S. and international bonds, U.S. and international real estate, commodities, and other exotic asset classes like managed futures, hedge funds, private equity, etc. While they have the freedom to invest in any mix of these assets that they like, in the traditional world of buy and hold strategic asset allocation virtually all portfolio managers subscribe to Modern Portfolio Theory to come up with the single best or most “efficient” mix of asset classes. The end result for portfolio managers is that the mix of the asset classes they choose never needs to be changed because markets are presumed to be efficient and investors are presumed to be rationale. In short, traditional buy and hold portfolio managers buy and hold asset classes in a fixed mix that changes very little over time while they patiently wait for the past performance of each asset class to materialize.

Portfolio managers invest with money managers like mutual fund managers or separate account managers to invest each asset class in the portfolio. A money manager usually is an expert in managing assets in one asset class, and his or her portfolio performance is compared to a one asset class benchmark. You can find money managers specializing in virtually any asset class, including all of the ones mentioned above. These are the managers who buy and sell individual stocks and bonds as institutional investors, and these are the managers you see on TV who comment on the current state of the markets. They have an immediate and vested interest in the financial news of the day as they actively manage their portfolios to try and beat their one style constrained performance benchmark. For example, a large cap value mutual fund manager who is trying to outperform the S&P 500 Index.

For most retail investors, their financial advisor acts as a portfolio manager. They invest in money managers in the form of mutual funds and separate accounts in order to own multiple asset classes in their client’s portfolio. If they are a traditional buy and hold advisor, once they buy these funds, there is little to do but explain how they perform to clients, check their relative performance once a year or so, and remind their clients to be patient until expected returns arrive, presumably some time in the future. Do not confuse these two types of managers. A portfolio manager who passively invests in money managers is not practicing “active” management. In contrast, Pinnacle Advisory Group actively manages portfolios at the asset class level. There is a huge difference between actively changing the asset allocation of a portfolio management versus passively owning active money managers in a portfolio. Don’t confuse the two.

Could Rising Net Worth Keep the Cyclical Rally Fueled?

Today the Federal Reserve Flow of Funds report was released and with it, the latest look at household net worth. Household wealth increased by $2 trillion in the second quarter on the back of higher stock prices and a firming housing market. This was the first gain in net worth since the third quarter of 2007. One of the more insidious features of the past bear market was the vicious negative feedback loop where each leg of lower prices forced more selling, causing net worth to drop to lower and lower levels at a dizzying pace. Not to get too excited, because the year over year look at this series is still quite grim, and the bears will no doubt be focused on the absolute wealth lost and the second derivative nature (less bad, but still negative numbers) of the move on a trend basis.

But I would contend that some of the feedback loop was produced by an increasing lack of confidence, some of which was the double whammy effect of both lower stock and housing prices. Some will say this is old news and already factored into stock prices. But if individuals begin to feel more confident they may just start spending again. And since spending is still the dominant part of US GDP growth, that could be the catalyst for better revenue, earnings, and a pickup in employment, all of which should flow into higher financial asset prices, and then back to even higher net worth. Essentially, if higher net worth leads to improved confidence and more spending, maybe there’s a chance that we are seeing the opposite of the negative feedback loop – which would make it a positive feedback loop, I suppose.

Chart above - Year over Year Change in US Household & Non Profit Net Worth

Source: Bloomberg

The Recession Is Over!

Everyone can breathe a deep sigh of relief – yesterday, Federal Reserve Chairman Ben Bernanke, in response to a question after a speech he gave, stated that the recession is “very likely over.” That’s great news, right? Not necessarily. First of all, although he’s the nation’s leading monetary authority, Mr. Bernanke is not part of the body that officially declares the beginning and end of recessions. That responsibility belongs to the National Bureau of Economic Research’s Business Cycle Dating Committee. The NBER is a private, nonprofit organization (of which Mr. Bernanke was once a member, but no longer). Second, he warned that the recovery is likely to be lackluster, mostly because the employment situation remains very challenging. And third, if you wanted to be really cynical about it, then perhaps you wouldn’t feel too confident about the predictive abilities of the Federal Reserve, since they certainly didn’t provide meaningful warnings prior to the historic financial crisis that we’re currently attempting to recover from. But we won’t go there.

The problem with the whole recession dating process for investors is that it tends to be very lagging, meaning that the stock market has probably already moved in a big way by the time you find out if a recession has either started or ended. It makes for great headlines, but that’s about it. Instead, we try to focus on various leading indicators and other measures that might give more advance notice of important turns in the cycle, many of which we’ve written about here. We’ve seen a growing number of those improve over the past couple of months, implying that the recession probably did in fact end sometime over the summer. Stocks have certainly anticipated that, since the S&P 500 has rallied an impressive 55% since the low on March 9th. Our focus now is on trying to respect the very powerful rally we’re enjoying, while also being careful not to get caught up in the euphoria that’s sure to build as the market climbs higher and more and more people pile on to the “recession is over” bandwagon.