To say that world financial markets are living on the edge is perhaps an understatement! Most asset classes are within a few percent of breaching very significant pricing levels. We shudder to think what will happen if these levels are broken. Or should we be worried that if the Wilshire 5000 closes below the 11,000 level the abyss will open up? We continue to believe that the “correction” that we are currently experiencing in risky assets is merely due to panic over the Euro debt “crisis”. If the pull back were based on corporate profit warnings or at least companies missing earnings estimates then we would be concerned significant downside is about to occur.
We have been “fascinated” at how everyone decided three weeks ago to the day that the world was coming to an end. At the end of April we had US equity markets within a few percent of multi-week highs, and this was well supported with the Russell 2000 banging out new highs. We had many commodity prices including crude trading at multi-week highs, currencies (emerging market currencies, the CAD & AUD) and the carry trade (the AUDJPY) were at highs for the year along with junk grade corporate bonds and emerging market sovereign debt. Then all of a sudden BANG! If the sell-off was driven by fundamentals then we should have seen it show up in a sell-off in risky assets (emerging mkt currencies, junk grade bonds, and the carry trade) weeks or at least a number of says prior. This simply was not the case.
Until we see evidence that the US and world economy is faltering we will refrain from betting against the risk/carry/yield trade (call it what you will). Furthermore, we now find markets in a heavily oversold condition. By all accounts they are at the same oversold level now as what they were in back in mid-March last year. So if you were to go short now you would have to believe that we are about to see markets become as oversold as they were in late October 2008! Of course that is a tall ask, but nevertheless stranger things have happened. We cannot sit around and ignore the events unfolding before our eyes. We have miscalculated before and know that we may well be miscalculating again.
Whilst we are going to refrain from betting on material weakness in markets we will acknowledge that there could well be a market ”crash” in the making. Mid last week we bought short dated puts on the AUD and SPY just as a hedge to long positions. We bought more yesterday. If we see key levels broken, as depicted in the charts below, we will buy more. If we are going to see significant downside it will happen within the next two months, perhaps over the coming two weeks.
Note that in all the cases above, it is only currency markets that have broken down, this is particularly worrying because we know that emerging market currencies and the AUD have had a good record of leading equity and commodity markets.
We have been giving this bull market all the benefit of doubt, we have been patient, but if the big support levels above are broken, particularly on equities, currencies and junk grade bonds perhaps something bigger than Ben-Hur is developing!
