The Daily Trading Report

A train wreck in slow motion? One cannot deny the weakness in equities and commodities and strength in US Treasuries over the last two weeks. But do we get bearish based on what we have seen over just two weeks? We are all too aware that the market will do its best to keep weak hands out of the game and to ensure that the average trader (the majority) loses money over the long term.

We can handle volatility, after all that is what trading is all about. What does concern us is if this short term volatility transpires into something a little more dramatic! Certainly at this stage no major levels have been broken across the major asset classes. Perhaps the exception to this is the behaviour of the USD Index but it must be noted that at this stage the strength is due more to the weakness in the Euro than anything else.

What has surprised us is the persistent strength in asset classes that should already have broken down, namely the junk bond market. Is this persistent strength in this market (albeit the fact that it has hardly moved) telling us the real story and that the weakness in equities and commodities is merely just a short term thing? Or will junk grade bonds play catch up to the weakness in commodities and equities? If history is anything to go by the junk grade market usually acts as a leading indicator to the equity market whether or not this time will be different of course remains to be seen but we will refrain from betting against it.

We have been somewhat surprised at the level of bearish sentiment that has crept into world financial markets at a mere 7% fall in the S&P 500. We can only imagine the heightened level of bearishness that would prevail if the S&P were to get down to the 1030 level (support) within the next few weeks? Something within us suggests that there are few genuine bulls out there who will keep their heads at even the slightest sign of a hiccup in the market. While this condition holds the path of least resistance for equities and commodities is up at least on a 6 month view.

It has been interesting to observe the bears emerge from their holes with passion, enthusiasm and vigour over the last couple of weeks, in particular the last two days. A few months ago I said that the rally in equity markets has been the most hated in market history. I think little has changed! It just seems that at any remote opportunity the bears reappear with their, double dip, depression, Dow to 400, doom, gloom etc “predictions”. It also appears that the bulls are far from being genuine with any sign of weakness they cross the fence.

Markets do not go up in straight-lines rather they weave their way in a zig-zag fashion. The behaviour in the charts below appears to be nothing more than a counter trend rally. From the charts below there has been no breach of any of the major support levels. In fact, most markets are still trading well above “support” levels – that is levels which would signal a multi-week low/high which would tend to indicate that a fundamental change has occurred. A bull market is characterised by a series of higher highs and higher lows, only when there is evidence to the contrary will we change our outlook.

With respect to equities a bull market is signalled by broad participation in rallies. For whatever reason we have this condition. What will end it? We don’t know but we will know it when we see it. If the S&P 500 makes a new high over the coming weeks but the Russell struggles to do so then equity markets are in trouble. For the time being they are not.

Any area of concern? If we had to put our cards on the table it would be the performance of high yield currencies, i.e. the behaviour of the ETF DBV. Problems in financial markets often show up first in currency markets and DBV is a little too close to confirming a double-top!

So world markets are going to “zero” again! Well that is what the ever-so-quick-to-come-out-of-the-closet-bears would have us believe! Markets to their best to disguise their best intentions and keep the average person from making money! So then let’s have a look beneath the scenes and figure out what the “smart-money” is doing.

For the time being at least the smart money remains stead fast. Junk grade bonds and emerging market bonds relative to the US 10 yr have got a lot of work to do before breaking to multi-week lows. This is not to say that it won’t happen, but until it does we will give the bulls the benefit of the doubt. Markets don’t go up in straight lines and until proven otherwise what we are currently seeing is “conventional noise”.

Of course there is more, if markets were genuinely scared then emerging market small caps should be crumbling relative to US Small Caps and emerging market currencies should have broken down against the USD (convincingly) – yet they aren’t showing any convincing bearish behaviour (yet) – that is there is no evidence of multi-week lows!

Oh those horizontal lines are tipping points (from our perspective at least) because they signal multi-week lows below which we would stand on the bearish side of the fence!

We remain bullish based on our objective observations, but of course you may see things from a different point of view – and that is what makes a market!

There is an expression if it ain’t broke then don’t fix it. Well it certainly appears that the trends in place since the end of 2008 across the various asset classes remain in place today with little to challenge their “legitimacy”. But what if we simply have not looked hard enough? What if we are walking right into a trap! We don’t take our cues from what other people think is going to happen(if the last 18 months is anything to go by individuals have absolutely no idea of what the next 12 month will bring), rather we listen to what the market is telling us that it wants to do.

From an equity market perspective if the market was in trouble then we should at least see non-confirmation from the broader market like small caps or even emerging markets. Yet both the Russell 2000 (IWM), developed market small caps ex US (GWX) and emerging market small caps (EWX) are only a few “pips” from multi-week highs. Market internals in the US remain strong with the NYSE Advance Decline Line showing absolutely no sign of weakness. If the market is getting ready to make a material move to the downside it is doing a very good job of covering its intentions.

We did see some strength last week in US Treasuries and weakness in Junk bonds, but this nothing outside market noise. Both TLT and JNK sit well above their respective resistance and support levels. We have found junk grade bonds to be perhaps the best canaries (of the coal mine variety), or early warning devices, for the prospects for risk taking. We would be really worried if JNK was falling in a crumpled heap but it seems that any weakness is met with strong buying support. Of course this won’t last forever………..but the point at which it breaks down may well be some way off.

The Old CRB continues to display all the characteristics of a healthy bull trend with a series of higher highs and higher lows and now it appears that the precious metals group is taking the lead again. Although the agricultural sector has been showing some weakness as of late (that being said wheat, corn, oats, and soya are far from making a multi-week low) we can find no credible evidence of commodities “topping” out even in non USD terms!

The rise in the USD Index was reasonably substantial but that behaviour is not typical of a long term, even an intermediate term, bottom formation pattern. It is more akin to a short covering rally. The inability, so far, of high yield currencies to break higher against low yield is a concern, but that being said emerging market currencies have yet to show any weakness. So we will give the carry trade bulls the benefit of the doubt.

The market is bullish because it is bullish! Of course this would not get you very far in a job interview for a position as a conventional market strategist. But perhaps the more unconventional would express interest. Has it not occurred to anyone that everyone got it totally wrong last year (albeit 95% of the highly paid economists/analysts/strategists/traders/fund managers that I have talked to or conversed with)?
Let us not forget that this time last year if you had said that the average listed stock in the US would close about 65% higher by year end you would have been marched straight off to a big grey building lined where they perform strange experiments on the emotionally disturbed! In any event, I don’t see anyone changing their method of analysis………perhaps man just cannot accept the unknown without some visionary picture. We think traders (those who want to make money from the market rather than those who merely want to sound intelligent) could do a lot worse than adopting the approach of listening to the market for clues as to what it wants to do.

With the much underrated Value Line Index trading at multi-week highs, 88% of stocks listed on the NYSE trading above their 200 day moving average, the linear behaviour of the NYSE Advance Decline line and the NYSE New Highs New Lows Index what are the equity market bears seeing that we are not? As far as bull trends go they don’t get anymore healthier than this! Perhaps the eternal bears can make an argument for equity markets being overbought? Yes, that is true……but we have seen plenty of markets remain in overbought territory for months at a time.

What do we predict? Nothing, we don’t have a clue, and had even less of a clue this time last year. But last year we did note that, given the way markets were then behaving, the S&P 500 is highly likely to close materially higher rather than merely lower. We don’t know what the future holds (by default we cannot or otherwise our actions would alter the “future”). We do know that markets trend, and this is a strong upward trend. Lets ride it until there is enough evidence that it is about to come to an end! It sounds all so simple doesn’t it…….but because this involves not having a view few will follow it!

OK so what sort of evidence are we looking for to signal that the market’s uptrend is about done? In essence we are looking for divergence between market internal indicators and the performance of the major market indices. More often than not the charts above will start to turn down before the likes of the Dow, S&P and Nasdaq do…..this action is usually supported, if not preceded by a deterioration in the junk bond market.

Rarely have we seen a condition of such clearly defined and broad based trends in world financial markets! Virtually everything within each asset class and between asset classes is confirming each other. We have multi-month highs in equities, commodities and corporate bonds, multi-week lows in Treasuries and near multi-week highs in high yield currencies. The only exception at this stage is the USD Index, but that is more to do with the weakness in the Euro than anything else (the CAD and AUD are near multi-week highs). For how long can this behaviour last? We have no idea…….we have no unique insight as to what lies ahead. All we know is that once a primary trend is in place it tends to last for months if not years. We are starting to hear many talk about equities and commodities being in a bubble…….there are still a fair share of dooms-dayers out there……and few who believe that equities will be materially higher by year end. Perhaps there is considerable upside left in equities, commodities and corporate bonds, and downside in treasuries and the USD. Perhaps the hardest thing this year will be to hold onto winning positions. Of course only time will tell.

If you can see things that we are missing please let us know – those who think they know what is going to happen need not apply.

Perhaps we will leave the last to Yogi Berra and his famous “it ain’t over until it’s over”.

There has been a bit of banter about regarding US Federal Debt levels, rising interest rates and their affect on equity markets. It seems that many economists see the ballooning federal deficit as a bad thing for equity markets….Well we believe things when we see them. Right now it appears as if rising yields on US treasuries is good for equity markets with the multi-week high being registered in the Russell 2000 and soon-to-be-multi week low in US treasuries (TLT).

What is comforting for us (in terms of our bullish outlook for equities) is the upward movement in regional banks (KRE) and homebuilders and mortgage finance stocks ($MFX). Our thinking is that if rising yields are going to be a problem then it will show up right quick in sensitive sectors such as regional banks, mortgage finance and homebuilder stocks. As yields on the US 10 and 30yrs boarder on multi-month highs regional banks and mortgage finance stocks are on the verge of breaking to multi-week highs.

Remember the ballooning US Federal deficit is hardly a secret so if you are bearish on equity markets because of the rising deficit you must have access so some information that very few others have!

The name “Natural Gas” and the three letters “UNG” are perhaps more closely associated with the term “toxic waste” than anything within financial circles. Mention “I’m bullish on natural gas” and you will probably be laughed out of the office or even taken away by men in white coats! Yet, jokes aside, it does seem that the bullish wheels are now in motion for natural gas and the natural gas ETFs UNG and GAZ (particularly the later). Over the last few days we have had multi-week highs in crude, gasoline, and heating oil reaffirming the bullish trends which are now some 12 months old. Looking at the ETF GAZ it failed to make a new low in early December and is now only 10% away from a higher high (a close above $16). UNG needs to close above $12 (up 16% from current levels). We think that these levels will be breached over the coming days.

When it is all said and done, for how long can the CRB and Crude continue to rise and TIPS outperform the US 10 yr before natural gas breaks to the upside? We think that sooner or later natural gas will follow the lead of the two charts below:

We are always intrigued by “forecasts” and the perceived need to perform them at the start of each year. We are intrigued because it is common knowledge that we humans are rather hopeless forecasters, and from a financial market perspective at least, the start of January is no more significant than the start of any other month throughout the year!

It seems that we humans are simply not equipped to deal with the unknown, perhaps forecasting is merely mans’ attempt to deal with the unknown. From painful experience we learnt a long time ago not to get too caught up with what we think the market is going to do, after all the market cares little about what we think. Rather we place considerable more emphasis on trying to understand what the market wants to do. We may not know what the future holds (actually by definition we cannot know because if we did then the future would turnout different) but we do know that markets move in trends. We also know that when the trends are broad based they tend to continue. In essence we try to look for broad based themes (call them trends if it excites you) and ride them until there is enough evidence that they are about to come to an end.

Last night, for whatever reason, we saw equity markets close at multi-week highs. What is particularly encouraging is how broad based the rally in equities is. Not only did many major market indices close at multi-week highs but so too did small caps, and emerging market indices (both large and small cap indices). This behaviour suggests that the underlying trend in world equity markets is strong and we are likely to see considerable more upside over the coming weeks.

It really seems like US treasuries are fast becoming the new junk bonds! Is this because borrowing in the public sector has gone up dramatically but down in the private sector? Well that would be a logical explanation but for whatever reason the trend of outperformance of junk grade bonds relative to US treasuries is very strong so much so that junk grade bonds are trading at a multi-week high and US treasuries are frighteningly close to trading at a multi-week low! Watch for a close below 89 in TLT, we think that this will induce a dramatic wave of selling!

Just a few weeks ago one could have bought the CRB for the same level it was trading at in early August, now it is dramatically higher and trading at a multi-week high! The raggedness of the CRB chart hides the underlying bullishness of the commodity market. If one were to look at more broad based indices such as the old CRB (the CCI) you would see a more linear trend. Precious metals have been somewhat of a laggard over the last month but at least they have been able to hold above resistance levels. It is interesting to note how commodities in general have advanced over the last few weeks in light of a reasonably strong USD Index! Usually when the USD advances the CRB falters……

Is this a turning point for the USD? There is not enough evidence yet, before we get carried away on the bullish prospects for the USD we need so at least see evidence of a bottoming process perhaps a double bottom or something of the sort. So far at least the rally in December looks to be one dominated by short covering.

Basically there appears to be no change in the trends in equities, commodities, treasuries and currencies that were clearly in place by mid last year. Perhaps the biggest challenge this year will be to hold onto winning positions!

The different asset classes appear to be doing their “own” thing largely independent of what other asset classes are doing, i.e. there seems to be a breakdown in inter-market correlations. The USD Index has had a rather significant rally over the last 10 days from 74.5 to 76.50. That is not surprising given how oversold it was. On the back of the strength in the USD, gold, silver and oil fell (also not to be unexpected) but the broad commodity group (the CCI) is largely unchanged – that was unexpected! Usually strength in the USD would equate to a fall in commodities in general!

Furthermore, equity markets have managed to remain unchanged in the face of a very strong USD, which is kind of strange as of the last 12 months! But wait there is more, usually strength in the USD Index, results in a “run” on “high yield” trades such as high yield currencies relative to low yield (DBV) and junk grade bonds (JNK). Yet DBV has remained virtually unchanged and junk grade bonds closed at a multi-week high on Friday!

The desire for “high yield” (call it what you will) is perhaps best illustrated by the behaviour of junk grade corporate bonds relative to US treasuries. In the face of a strong USD junk grade bonds closed at a multi-week high relative to US treasuries (TLT & IEF). Again this is totally uncharacteristic if the last 12 months of inter-market relationships is anything to go by.

OK so what does all this tell us? Well one thing is for sure, it appears that US treasuries are in big trouble and that yields are going much higher! This can only be supportive for the broad commodity group which we see advancing over the coming weeks. Weak US treasuries and strong commodities should also see continued strength in high yield currencies (which just so happen to be “commodity” currencies) and high yield bonds. It would be rather presumptuous for us to say that funds coming out of US treasuries will find their way into equities, but that could well happen. The fact that equities have held their ground in the face of a strong USD and junk grade bonds are at a multi-week high suggests that the next move for equities is to the upside.

At this stage we do not see the strength in the USD Index as anything more than the market’s attempt to squeeze short sellers who got a little full of themselves over the last few months. In order for us to turn bullish on the USD we would need to see some evidence of a bottom formation which we see little evidence of at this stage.

So when it is all said and done – the “high yield” trade is alive and well and traders should be positioned accordingly.

Our wealth creation portfolio is up around 21.69% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

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