The Daily Trading Report

While the press of popular opinion appears to be doing their utmost to convince the average mom and pop  and wanabe trader that the World economy is about to fall into the abyss………that “here comes 1932“, beneath the scenes something very different is playing out and most commentators are missing it completely, or at least refuse to believe it!

Yes it is the TED spread and the USD Index. The TED is narrowing and has been doing so since mid June just a few days after the USD peaked out. Taking a step back for a bit what is the significance of the TED? The TED spread is an indicator of perceived credit risk in the general economy.
This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases.


Note, that the TED started to rise in mid March (yes easy in hindsight I know), but by the start of May it was already showing out-of-character behavior (so as far as the TED was concerned the flash crash and the ensuring collapse in May was no surprise). Anyway what I am trying to say is that the TED foretold of problems (a breakdown in confidence) before May, and of course now it is foretelling that “confidence” is returning to markets, well from a liquidity perspective at least – which is at the heart of confidence as far as financial markets are concerned. It also helps that the big USD Index is confirming the action of the TED.

The confirmed “head and shoulders” formation on the Dow and the Dow Theory sell signal……..is one big bear trap. Watch the back end of the market, that will tell you everything you need to know.

Over the course of the last few weeks we have been absolutely bombarded by commentary by the press of popular opinion that the US economy is headed for a double dip. The big talking points have been (and continue to be) the turn down in the ISM Manufacturing indices and the lack of improvement on the jobs front. I am not going to get caught up in a detailed analysis/debate/argument, what I do want to do is to put into context the recent down-turn in the ISM Manufacturing Survey and the increase in continuing claims.

Below are the long term charts of both indices. I will go out on a limb (yet again) and say that the data releases over the last few days/weeks are nothing out of the ordinary. If think people were expecting the ISM manufacturing index to keep moving above the 60 level when a reading above 60 hasn’t been achieved in a very long time. Actually a very reasonable reading is 55 (above 50 signals expansion). So why has everyone suddenly jumped on the “double-dip” bandwagon. Is it because the S&P 500 has fallen below “support” at 1040 to form a “head and shoulders” pattern and now we need to justify that action?

Now it seems that the media is getting sick of the Euro debt crisis thing and is now discovered something new that they can dramatize in the lack of improvement on the US jobs front. Surely the economy must be “stalling” if there is not a continuous reduction in continuing and initial claims each week? Well there is the chart in the overall scheme of things everything looks OK to me!

From a slightly different angle here is the JP Morgan Global PMI. The weakness that the crowd is currently possessed with is nothing more than random noise!

Now if the US economy was genuinely in trouble wouldn’t you logically expect to see commodity prices on their knees already? Once again it seems that the press of popular opinion suddenly has a unique insight as to what is going to happen. Yes commodity prices have gone sideways for some 8 months (a miracle in itself considering how strong the USD has been) but that doesn’t necessarily mean that the next big move is down. Remember, when everyone thinks a like the opposite is most likely to happen.

Seeing is believing and I certainly do not see any credible evidence that the US economy is slowing down in a material sense, certainly nothing suggests that we are heading back into a recession! Incidentally have you taken time out to check out what is happening down at your local container terminal/port……….or are you just relying on the Baltic Dry Index?

It is a lonely existence being a bull in what seems to be a sea of bears! Now it would be very easy to throw in the towel and say that it is overs for the S&P 500 with its breach of the 1050 level, that we are destined for a double dip and that the US economy, and by default world economy, is about to re-enter a recession! But hang on a minute, there is a lot more to interpreting the mood or sentiment of the market than looking at a few major market indices. Instead of concentrating on what everyone else is analysing, notably the major market indices, which we refer to as the “front-end”……….we concentrate on the back-end of the market, that is, the places that few pay any attention to.

Anyway getting straight to the point. The market is suggesting to us (or at least our interpretation of its behaviour) that it is still in a primary bull trend and that the sell-off we are currently experiencing is merely a correction. That implies that the next move of significance will be to the upside not downside. Now let me walk you through my reasoning or at least what I am observing in the markets.

Let me first start with market internals. In short we have yet to see a breakdown in market internals. By breakdown the NYSE Advance Decline and the New Highs New Lows Indices are still trading above their May lows. Furthermore, there is now a divergence between market internals and the NYSE Comp which is essentially trading at a multi-week low. The behaviour we are observing now is very different from that which existed in 2007 and 2008 where market internals were persistently weak.


If the US economy was in genuine trouble, as implied by the equity market and the press of popular opinion why have junk grade bonds not broken down yet? It seems that junk bonds are one of the safer places to be invested right now, as bizarre as it may seem. Note what happening on the junk bond front in 2008 prior to the “crash”.

While junk grade bonds are the proverbial canary in the coal mine with respect to growth in the US economy, we believe that emerging market small caps are the canary of growth for the world economy. Why? Well in essence emerging markets are producing nations rather than consuming (primarily of the resource variety). If demand for resources dries up (indicating a slowing/contraction of growth) you don’t want to be invested in emerging market stocks and certainly not in the highly sensitive small cap variety. Note what was happening in 2008, emerging market small caps were heading down in a linear fashion well before the crash. And what is happening now? Well they are above their late May lows which is in clear divergence to what is happening to the major market indices in the US and Japan.

And if the world economy is slowing down then why have commodities not fallen out of bed as they did in 2008? For those of you who don’t know the CCI is the old CRB. The CCI is made up of 17 commodities all of which have an equal weighting. Accordingly it gives a representation of what the average commodity is doing. Yes you may argue that it is going to go down but as far as we are concerned seeing is believing and right now it remains in a bull trend and it isn’t too far from taking out its January high. Yes it is a bit hard to reconcile the behaviour of the CCI with what “deflationists” are touting right now.


So there we have it, as far as we can see the world economy is not about to fall into the abyss and neither is it about to enter a deflationary period. We remain bullish……against all odds!

The deflationist “school” is been rather vocal as of late taking their queues from the strength of US treasuries. Yes, from a “technical” perspective at least it is hard to disagree with deflationists that the US treasury market is looking rather bullish with a break to below 4.0% on the US 30yr looking rather immanent.

However, from an intermarket perspective things don’t quite add up. The worst enemy for US Treasuries is inflation. Now what is a dead give away of rising inflation (a breakdown in confidence of paper currencies)? Well a “rise” in hard currencies…….ok crude is not exactly hard in a physical sense, and neither is wool, or rubber, or oats, but I hope you get the point. Quietly in the background the old CRB (now referred to as the CCI) has been moving up and now is within only 2% of making a post April high. 

What is the CCI and why do we prefer to it over the new CRB. The CCI is an equally weighted index of 17 commodities……..the essential difference between the CCI and the CRB is that the CCI has a 20% exposure to energy whereas the CRB has a 40% exposure. We like the CCI because it gives a representation of what the average commodity is doing. I guess it is a bit like comparing the Russell 1000 to the Value Line Index.

Look in essence we are saying this the average commodity is very close to making multi-week highs which is certainly not what you want if you are bearish on the outlook for inflation and by default bullish on US treasuries!

We would like to single out the behavior of silver. Yes gold is on everyone’s mind, but in the background silver is very close to breaking out of a 9 month old “trading range”. We know that the longer a market moves in a sideways direction the greater the intensity of the breakout. What will happen if (when) silver closes above 19.50? Well we think it will quickly make up for lost time and race above $25, of course gold will follow……and crude……..and you will see the CCI trade at a multi-week high (above 500).

Now if we see silver at $25, crude at $90, and Gold at $1300…….what will your outlook on inflation be then……..and what will happen to that dog ETF TBT? Yes every dog has its day and TBT’s s coming. Deflationists prepare to dig in, an inflationary hurricane is building rapidly.

If the weakness in the S&P 500 over the last two days was the start of a move that will take it below the key 1050 level and thereby confirm a highly bearish head and shoulders pattern wouldn’t we have seen confirmation from risk indicators? That is shouldn’t the proverbial canaries in the coal mine of each asset class be very close to breaking out/down or at least showing out of character behaviour? Yes logically you would think so, but that does not seem to the case. In any event let us have a look at the following measures of “risk”:

1. Emerging market bond spreads relative to US treasuries,
   
2. Spreads between high yield (junk) and investment grade corporate bonds,
   
3. The number of corporate bonds trading in a distressed state (1000bpts over US treasury yields),
   
4. The behaviour of emerging market small caps,
   
5. The percentage of stocks in the S&P 100 trading above their 50 day moving average.
   

JP Morgan EMBI Sovereign Spread

Spread Between High Yield and Investment Grade Corp Bonds

TRACE Index (Number of corp bonds trading in a distressed state)

MSCI Emerging Market Small Cap Index in Local Currency

OK beauty is in the eye of the beholder and you may well differ in your interpretation of the charts above. From our perspective we have not seen the sort of behaviour that should occur if this was the start of a genuine move to the downside in the S&P, that is a move below 1000 and beyond. If the weakness we have witnessed over the last few days was the start of something big then shouldn’t we have already seen a significant blow out in the yields of emerging mkt bonds relative to US treasuries, junk grade bonds relative to investment grade, the number of bonds trading in a distressed state, and a general unwillingness of emerging market small cap equities to bounce back after the fall in May?

But wait there is just one other thing, you should only worry about significant downside in equity markets when there is a general complacency towards risk. With a mere 17% of stocks in the OEX trading above their 50 day moving average it does not appear that there is a general complacency. Furthermore, if we see the S&P fall back to the 1050 level we are likely to see less than 10% of OEX constituents trading above their 50 day moving average, and that would equate to the same oversold condition that prevailed on the 6th of March 2009! We need more upside before we have to worry about significant downside.

Until we see the risk indicators listed above roll over we continue to believe that the S&P 500 is hammering out a bottom from which a meaningful rally to new highs for the year will ensure. Believe it or not!

The behaviour of emerging markets relative to developed markets leads us to important clues as to macro trends in not only emerging markets but virtually every other asset class. Over the last few years this has become increasingly so as correlations between asset classes have moved closer to 1! Why pay so much attention to emerging markets? Well there are a number of reasons but by far the most important is that they are the proverbial canary in the coal mine with respect to world growth. This is because emerging markets are essentially resource producers. Accordingly changes (albeit perceived) changes in the level of economic activity in developed markets show up first in emerging markets, be it in stock or bond markets relative to developed markets.

Everyone seems caught up with the ECRI Growth Index these days, citing that it turned down in October and has been heading lower ever since. I find it rather comical that the majority of commentators couldn’t even tell you one of its components. Anyway that aside, note that emerging mkt equities relative to the S&P topped out in October last year (along with the ECRI Growth) and EEM /SPY has been trending down ever since. However, it seems that this downtrend is now being challenged.



A down trend is a series of lower lows and lower highs, which is currently in place with respect to EEM/SPY. But it is not going to take too much for this series of lower lows to be broken. A few good days of outperformance by EEM should do it.

Although emg mkt equities did break down relative to the S&P 500 it is interesting to note that emg mkt bonds didn’t relative to US treasuries. Although that being said they have not exactly gone anywhere since October last year. And neither has the Aussie Dollar, the average commodity, crude, or the world stock market!  Come to think of it trying to trend trade markets since October last year has been a lesson in pain as any macro trader can testify to.

Maybe we can be accused of jumping the gun but there does seem to be short term evidence of a willingness of emerging mkt bonds to begin outperforming US treasuries again.


Anyway we think that it is imperative for the world growth “story” or economic recovery (call it what you will) that emerging mkt equities and bonds continue on a path of outperformance relative to US equities and treasuries. If we see breakdowns in the  charts above – buy as many puts on the S&P as you can Jan12 exp and run for the hills!

Of course we are not ones to sit on the fence, we are expecting emerging markets (equities, bonds and currencies) to break to the upside against US markets and developed markets in general over the coming weeks.

While the intense, and often personal, banter about whether or not the strength in equities we have witnessed over the last few weeks is real………….has anyone noticed what is unfolding in the ”high risk” bond markets? On the quiet junk grade bonds and emerging market sovereign debt markets have been etching higher after hammering out a reasonably solid base. Who is buying these assets? No idea but what I do know is that you don’t want to be remotely near these asset classes if you smell trouble on the horizon. From the market action of JNK and EMB over the last week it does not appear that any trouble is on the horizon as in the “double dip” variety (yes I guess it is a little hard for us mere mortals to comprehend given what the popular press would have us believe) 


But wait there is more, take careful note of what is happening on the emerging market small cap front. To us emerging market small cap stocks are the proverbial canary in the coal mine with respect to the world stock market. Perhaps this is because emerging markets are a geared play to world growth and any problems within equity markets usually show up in small caps first.  

How sustainable is the current rally in the S&P 500? Well if the S&P continues to rise over the coming days and junk bonds, emg mkt debt, and emg mkt small caps rally alongside it then yes the rally will likely lead to the S&P moving materially higher over the coming weeks. At this stage the three charts above appear to be leading the S&P 500 which is bullish confirmation. But watch out if the three charts above start labouring! That will be your queue to run for the hills.

Well I guess that headline puts the cat amongst the pigeons! Yes it is well publicized that the Shanghai Composite has entered a bear market. Looking at the chart below me cannot disagree. In fact I don’t know if there are any market technicians who would disagree with this assertion. But is the Chinese stock market in a bear market? 

Shanghai Composite


There is more to reading the market than merely looking at a market cap index. As far as I am concerned a bull market is a “condition” “theme” (call it what you will) that lifts all stocks, that is, a bull market is where the “average listed stock” is engaged in an up trend (an up trend can roughly be defined as a series of higher highs and higher lows).
 
Market cap indices do a rather bad job at depicting the behaviour of the average listed stock because over 80% of their performance is accounted for by less than 20% of the members (well something like that). As an individual investor why should I place more emphasis on the behaviour of GE than say Colt Firearms? If I took my monkey and told him to choose 30 stocks out of a universe of NYSE listed companies (I think there are about 2500) what would this portfolio look like? Well it would not look anything like the Dow or the S&P 500! Yet everyone is obsessed at analysing the behaviour of the major market indices! This is why we like to use equally weighted indices to gauge the behaviour of the average stock or should we say the broad market.

OK getting back to China…….what if we took all the components of the Shanghai Composite and equally weighted them. What would the market for the average Chinese stock look like then? Well look at the chart below, it is just that – a Chinese version of the US Value Line Index! Now beauty is in the eye of the beholder, reconciling the Shanghai Comp and the Equally Weighted Chinese “Comp” reveals that the average listed Chinese stock is not looking so sick after all, at least not any sicker than the average European or US listed stock. I will go so far to say that because the average listed Chinese stock has not made a lower low the Chinese stock market is still engaged in a bull market!

Shanghai Comp (components equally weighted)


OK this is not to say that the average listed stock in China is not going to register a lower low over the coming weeks. But a bull market is a bull market until it isn’t. I guess there is an old Chinese proverb that says: judge a man by his actions not words. We judge a market by its actions not the words of analysts/commentators or “news reporters”.

 It seems that every day the financial press comes up with something new to rally the bears into offensive positions…………but little does the average bear realize that the bulls are starting to push through the bears’ lines where they are least expecting. Yes everyone is fixated on the 1105 level on the S&P 500, as if it were the only stock index in the world that mattered. However, there are a number of markets that are starting to break out of their short term consolidation ranges, take a look at the European markets (as per the Bloomberg Euro500) and Australia (ASX 200), and Hong Kong (Hang Seng). One of our favourite indices is the ASIA APEX Index (in essence Asia ex Japan and Australia). It too has broken higher as per the graph below:

MSCI ASIA APEX 50 Index

However, we are not out of the woods yet. We have to see confirmation of a breakout in Asian equity markets by Asian Currency markets.

JP Morgan Asia Dollar Index


The JP Morgan Asian Dollar Index (ADXY) remains locked in a trading range, and until we see this breakout we will remain nervous bulls…..  

What if the Euro was to “bounce” to the 1.30 level over the coming days? Where would equities, commodities, high yield bonds and currencies and treasuries be then? I don’t think it takes a rocket scientist to work that one out. Now what are the odds of the Euro getting to 1.30 over the coming days? Well let me put a different spin on that…….given that short positions on the Euro are at record highs and sentiment is so bad that the Euro is now talked about at dinner parties, cocktail events, and it now graces the covers of magazines (like Newsweek) and newspapers, it is difficult to work out just where the marginal bear/shorter is going to come from. When markets get to such extreme oversold conditions it does not take much to spark a “short covering” rally from the depths of the earth. What is likely to be the event that ignites a short covering rally? Well it is likely to be as insignificant as the “leaked” document that indicated that Citigroup was profitable in the 1st quarter. If this is over your head this was the proverbial “final straw that broke the bears back” in early March last year!

Anyway I have tried to put this blog together quickly today and perhaps I have not got the words out in the way that does my reasoning/thinking justice. Let me say this, intermarket correlations are either at or very close to record highs. If you are bearish equities then by “default” you are bullish the USD, which by implication means that you are bearish the Euro. Now being short the Euro is perhaps one of the most crowded trades in modern history (maybe second only to being long TMT stocks in February 2000). The essence of The Art of Contrary Thinking  “when everyone thinks alike the opposite is most likely to happen” rings loud in my ears.



It is interesting to note that the US stock market has not broken support levels, and perhaps more importantly the Russell is only a good 10 days away from breaking to multi-week highs again. Have you looked at how the STOXX 600 is behaving lately? Have you seen how emerging markets are close to breaking out of their three week old trading range?

The CCI remains above the key 450 level (that is important to us only). Again given that the CCI has not collapsed given how strong the USD Index has been over the last few months says something in itself. Also note that the JOC Industrial Commodity Index has NOT broken below its February low. We believe that the next big move for commodities will be up. Anyway above 450 on the CCI bullish commodities, below bearish.

Gold making the cover of the NYT, gold ATMs in the UAE, mints running out of coins, demand for Kruger Rands at multi-year highs……all the contrary signs are there for a pull back in gold over the coming days. But we would be buyers of any pull back.

The flow of funds into bond funds (more or less at all time highs)…….more signs to delight contrarians.

No multi-week low in junk grade bonds as yet, which is rather bizarre given how bearish everyone is towards “risky” assets. Yes we can see the weakness in junk grade bonds but we also see JNK and HYG and relatives EMB and PCY intimating that they want to break higher. In any event the mere fact that junk bond funds have not registered multi-week lows after redemptions mirroring those of September/October 2008 is a miracle. Again massive outflows always catch the attention of us contrarians.

If there is one concern we have it is the weakness of emerging market currencies and high yield currencies. Yes they did “breakdown” and that is a rather bearish omen from a technical perspective. But markets are set to test us and often they will break a support line just to fool us. Yes one could accuse us of not getting bearish of emerging market currencies when there is such a significant bearish break but sometimes one needs to bend the rules a little……and now is one of these times. If


Anyway if emerging market currencies and high yield developed currencies make  new lows from here we will run for the hills. Because new lows here will coincide with lows in junk grade bonds and emerging market bonds. And then we will have to stand up and say we are wrong in holding a bullish view on the risk trade. Until then we remain bulls in a sea of bears


Disclosure: long VTI IWM DBC GLD TBT CEW JNK DBV