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...

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.

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.

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.

Figure 1: Relative Price Action Since 10/3/2011

Table 1: Leading the S&P 500 weekly returns (correlations since 1988)

Table 2: Leading the S&P 500 weekly returns (T-stats since 1988)

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.

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.

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.