The Daily Trading Report

The Bond markets are one of the main focal points of our analysis. Financial market trends begin and end in the money markets. We spend condsiderable time reviewing emerging market and US corporate debt. These are particularly sensitive to investors propensity for risk, and as such, useful indicators for equities.

We’ve seen some fairly choppy trading over the last month, and one may now be thinking that investor sentiment has swung 180 degrees in this time. In this time we’ve gone from multi-week highs in numerous markets to testing, and in some case breaching, multi-week lows. We’ve included some longer term graphs (2 years), which puts the recent downturn in some perspective.

Firstly lets look at the ETF EMB. This attempts to map the performance of the JPMorgan EMBI Global Core Index, and holds liquid debt instruments in emerging market countries.

It is the simple things in life that matter. Deflationary conditions are characterized by fixed income securities (corporate bonds and treasuries) outperforming commodities and during inflationary conditions underperforming commodities. Yes one could get technical and look at long dated fixed income securities (20-30 yr) vs. commodities but we choose to keep the analysis simple. We know that financial markets move in trends but there is a whole lot of white noise in between. From a simple observation it seems that commodities have been outperforming fixed income securities as a general group since the start of the year. However, the performance of fixed income securities relative to commodities has been negligible since early June. Yes that is stating the rather obvious, of course the million dollar question is; in which direction will fixed income move relative to commodities?

We continue to believe that the charts below will break down. We say this because of the inability of non inflation protected treasuries to break higher against non inflation protected treasuries and due to our fundamental outlook. Yesterday there were two important news releases one concerning New York factories orders and the other concerning US producer prices. In both cases analysts/economists estimates were well below actual figures. This suggests to us that analysts are well “behind the curve” in terms of pricing in inflation.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a9kyqIpQktTg

http://www.bloomberg.com/apps/news?pid=20601087&sid=a0jz9TBzHhxo

Watch the market, it tells you all you need to know about what is likely to happen (human behavior moves in trends). Interestingly enough, when you study the market hard enough, economic news announcements rarely take the market by surprise. It seems news announcements only take those who think they can outsmart the market by surprise.

Our wealth creation portfolio is up 16.3% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

It seems that fundamental news continues to improve. Last night there was positive news coming out on home sales and factory orders. However, the market (as per the S&P 500) did not budge. Is this the beginning of a top in the market? We would not be surprised to see some sort of correction in the magnitude of say 5% over the coming days. However, we do not see any correction being enough to warrant short or bearish positions.

We would like to draw your attention to the behavior of emerging bond markets and also the high yield corporate bond market. If equity markets were in fact getting ready to move materially lower we should have already seen weakness show up in the bond markets. From what we can tell there does not seem to be any weakness worth noting and no apparent loss of momentum. We use the Fidelity New Markets and High Income funds as proxies for the emerging market bonds and US high yield corporate bonds.

When will we get bearish on equity markets? We don’t know when, but we do know what will cause us to become bearish. And that is an out of the ordinary bearish move by both high yield and emerging market bonds. Something like when both the charts above have become bearish on a rolling 60 day basis.

Our wealth creation portfolio is up 15% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

The world bond market continues to send very strong signals that US treasuries is the worst place to be on the planet to park/invest your cash (albeit up there with the worst). For whatever reason US Treasuries are underperforming:

1. emerging market bonds
2. junk grade corporate bonds
3. international govt. bonds
4. investment grade corporate bonds

At multi-week highs and with no deterioration in upside momentum it would appear that US Treasuries have got a whole lot more underperformance left in them. After the 5% fall in Shanghai yesterday it was interesting to note just how much US Treasuries didn’t outperform their “more risky” counterparts. This even surprised us!

What are the implications of these graphs above? Risk seeking/taking, yield seeking (call it what you will) is still alive and well. This implies that we are likely to see continued strength in commodities (albeit a move to multi-week highs), emerging market currencies, and equities. Obviously this implies weakness in the USD and US Treasuries.

Our wealth creation portfolio is up 15% from the beginning of the year with approximately 40% of the volatility of the S&P 500.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

We have been watching with interest the behaviour of both the USD Index and the US 30 year treasury over the last two months given the weakness of equity and commodity markets. We have been saying for some time that the lack of “bullish” conviction in the USD Index has been a rather telling factor that the “risk aversion trade” would not get far and that the weakness in equity and commodity markets would be shallow. Note what we said on July 10^th at thedailytradingreport.com. It now appears that the USD is about to challenge the 78.50 level which is its last line of support before last year’s low at 72. We believe that the USD Index will fall below 78.50 over the coming days and then before year end it will have at least traded below the 72 level.

In support of a falling USD is the failure of the US 30 year to break-out of the down trend that began at the start of the year. From a longer term perspective a breach of the 115 level on the US 30 year opens it up to the 105 level which is a significant movement from current levels. We are reasonably confident that the US 30 year will trade at 105 before year end.

In support of lower US treasuries (and by implication a lower USD Index) is the continued outperformance of non US 10 year govt debt (BWX and PREMX). This suggests that “pure” USD assets are rapidly falling out of favour with international investors (and probably many US investors). If US 10 treasuries are underperforming emerging market 10 years sovereign debt this situation is rather serious

So we continue to position ourselves for a weaker USD and weaker US treasuries. Of course we are not expecting them to go down in a straight-line fashion. It is going to be a bumpy ride but we have time on our side.

We have a number of trades on which reflect our bearish USD and UST stance which we discuss with subscribers.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

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The weakness in the Dow Industrial is not being echoed by the USD Index……or if it is then it is a very faint echo! This is rather different behaviour than that which occurred over the last 12 months where every time there was weakness in the Dow it was preceded with rather substantial strength in the USD Index.

So what do we trust…….the break down in the head and shoulders formation in the Dow or the lame performance of the USD Index? We believe that currency markets are far more powerful than equity markets so we are sticking to the evidence put forward by the currency market. We also believe that the front runner to currency markets is world bond markets.

The bond market’s action suggests the USD is about to break down again. The charts below are the relative performance graphs of ETFs that track developed market debt ex US (BWX) and emerging market debt (PCY) relative the US 10 year treasury. In both cases the up trends over the last 4-6 months are strong with little to suggest that the up trends are about to come to an end anytime soon. With the breakdown in the Dow we would have expected that these relative graphs to also have broken down by now ……but they haven’t. We don’t know what the future holds but we do know that underlying macro investment themes move in observable trends. In essence we track and trade these trends. Right now the trends below are up……..which paints a rather bearish picture for the USD Index

We would be using any strength in the USD Index to increase short positions……we are sure that by year end the USD Index will be trading at a multi-year low. We believe that there are more effective ways to get short exposure to the USD than simply buying the ETF UDN or shorting USD Index futures.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

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The weakness in equity markets as of late has been rather strange. It has not been accompanied by weakness in the risky areas of each asset class and it has not been accompanied by a blow out in “risk indices”. Usually weakness in the major market equity indices (like the Dow and S&P 500) is either accompanied by or preceded by significant risk aversion behavior. How do we measure risk aversion behavior (or at least the mood of the market)? We use risk indices. A good indicator of the mood of the market is the Bloomberg Financial Conditions Index. In essence it is comprised of yield spreads
from the Money Markets, Equity Markets, and Bond Markets and expressed as a normalized index. The values of this index are z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period.

The failure of the Bloomberg Financial Conditions index to break down (so far at least) is largely a result of the bullish behavior of bond and money markets. For whatever reason, highly risky junk bonds and emerging market sovereign debt remains reasonably strong. Given the degree to which the Dow Industrial and Dow World Index have fallen over the last 6 weeks one would have thought that junk bonds and emerging market debt funds would have already fallen materially.

There
is a clear non confirmation of the weakness in equity markets by corporate and emerging market bonds. So will bond markets remain strong and pull equities higher or at least ensure that any downside in equities is limited? Or will the weakness in equity markets spillover into corporate and emerging market bond markets pulling them lower? Our money is on the former. We think that the weakness in equity markets as of late is a “false move” and that it is unlikely that there will be material downside in the major market indices. Accordingly one should be looking at buying into weakness rather than selling.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

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