The Daily Trading Report

We have been watching commentary regarding the US housing/real estate/construction sectors over the last few months with interest. There seems to be a common theme coming through. That is, a flat refusal to entertain the possibility that we have already seen the bottom of the US housing market, or that the US housing “bubble” has been deflated. It would seem that if you wanted to get yourself dragged off to the nut house by strange men in white coats all you have to do is publically announce that you are bullish the likes of KB Homes, Toll Brothers, or Simon Property Group! Let us look to the liquid markets for indications as to what is happening on the property scene.

If we knew no better (and we are none the wiser), it looks as if the US property market has already bottomed! A number of key indices/indicators are either at resistance levels or have already broken through. Of course you can argue until the cows come home about how bleak the outlook for the US housing/construction sector looks but have you stopped to think what will need to happen to turn you bullish? We cannot help escape the echo of John Templeton’s famous quote “invest at the point of maximum pessimism”. We think that this point is about now.

It is encouraging to note that the ETF IYR has performed more or less in line with the Dow over the last 9 months. Given that there is more bearish sentiment towards IYR than the Dow we think that there is probably more upside potential in real estate stocks than regular “blue-chip” industrial stocks(a dividend yield of 8% also helps somewhat). This may seem to be complete madness, but we just cannot help ourselves. Remember, when everybody thinks alike the opposite is most likely to happen!

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

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From the charts below we conclude that equity markets are genuinely bullish as evidenced by:

1. The multi-week highs and the strength of the underlying market (as per market internals, small caps, mid caps, and small cap emerging market indices). If the market was weak then we would not see new highs in small cap indices and particularly emerging market small caps.
2. Any weakness in the indices being quickly arrested. If markets were bearish there would be a sluggish claw back of previous losses.

Are markets overbought again? Yes the NYSE 200 day moving average is up at 80%……but be aware if the market starts trending (we think that it already is) then we can expect it to remain overbought for some time. The 200 moving day average ratio is a good indicator for oversold situations but history suggests that it does not hold a respectable record for calling market tops (the actual %age that is). If the moving average ratio started to diverge from the performance of the S&P 500 then we would start to get worried.

What about volume, it seems that markets have been advancing on decreasing volume! Yes volume has been declining ever since September/October last year……but then what do you expect. We had a crash in Sept/October and then again in Feb/March that was comparable to the big one in 87! The volume going through the market over the last three/four months is not materially different than volumes that occurred over the last three years (taking out the volume associated with the two crashes we have just had).

The market is suggesting that it wants to go higher (for whatever reason). We are positioned accordingly.. who are we to question the market’s intentions!

Our wealth creation portfolio is up 13% from the beginning of the year with approximately half the volatility of the S&P 500.

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Over the course of the last 6 weeks we have been rather intrigued by the level of commentary on how bearish US equity markets are looking. In addition there have been a number of commentators suggesting that market internals have already broken down. Apart from a break-down in the Dow from a “head and shoulders” formation…..we can see little evidence of broad based weakness in equity markets. Why is everyone so hung up on the Dow? Has the Dow now become the leading indicator for what happens to equity markets in general and has it become a leading indicator for currency markets……commodity markets…..and even bond markets? If it is then it would be a first!

We think that the most significant equity index in the US is the Value Line Arithmetic (and considering that US equity markets represent approx 40% of the value of world equity markets it is probably the most important equity index in the world). Considering that it is an equally weighted index of 1650 stocks it gives a representation of the performance of the “average listed stock” in the US. In so doing it is a respectable proxy for the broad market and gives a very good representation of market internals. Accordingly, if the Value Line starts to breakdown then one should get concerned because it suggests the broad US equity market is in trouble.

From the charts below we can see that the Value Line remains above support and, given its construction, it should come as no surprise that market internal indicators also remain above “support” (namely the Advance Decline Line, New Highs New Lows Index and Moving Average Ratio).

The Value Line’s performance since mid March has been rather impressive, being up some 75% from March 8 to June 1. Overbought? Well of course that depends on your time frame. From a medium term perspective it is only up 18% since the start of the year. As far as we are concerned this is not excessive at all. There is nothing stopping this index from advancing another 20% by year end, it is not unreasonable if the behavior of stock indices in bear markets is anything to go by.

Will the latest bought of weakness in the Value Line extend further? We don’t know but we hope that it does because that will certainly shake all the weak hands out of the market! However, given the level of bearish commentary and “disbelief” in the current rally in equities, the majority of weak hands have probably already been shaken out of the long side and joined the dark side of the force (shorting).

We believe things when we see them, right now (for whatever reason) equity markets remain in a bull trend.

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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.

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It does appear that the Dow Jones Industrial is in trouble with a classic bearish head and shoulders chart pattern in the making. The broad Value Line Index is also echoing this same chart pattern. A fall of a mere 125 points on the Dow (1.5%) and 61pts on the Value Line (3.8%) would signal a bearish breakdown. So do we get bearish now? From a bullish perspective we do not like these chart formations……but, we think it is way too premature to get bearish, even if the Dow does break below support at 8200 over the coming days. In order for us to get bearish we need to see a broad based break down in the market (a close below 1600 on the Value Line would be the first piece of evidence of broad based break down). We believe things when we see them so for now it is a waiting game. However, there is more to it than that. We have to carefully analyze market internals.

While the narrow Dow Industrial is behaving badly, this bearish behavior is not being echoed by the broad market. Market internals remain positive and are certainly not behaving the way you would expect them to if this market was genuinely bearish. The classic market internal indicators, such as the NYSE Advance Decline Line, the 200 day moving average ratio and the New Highs – New Lows index are either at multi-week highs or just a few percent away from multi-week highs (as opposed to the Dow which is a few percent away from a multi-week low). The reluctance of the broad market to participate in the downside of the major market indices is a classic tell tale sign of an underlying bullish condition in the stock market.

Many commentators have been suggesting that the stock market is in an overbought condition. While that may have been so on June 1^st with just over 90% of the stock listed on the NYSE trading above their 50 day moving average, that figure is now down to a more neutral 45%. If the Dow was to fall below “support” at 8200 to say 8000 this ratio would probably drop below 30% which would effectively push the market into a short term oversold condition. This would confirm our hypothesis that commentators have been too quick to get bearish. Reading through commentary we get the feeling that the average punter is behaving as if the Dow has already broken through support and is trading significantly below (somewhere below 8000)…….in the same manner that investment grade corporate bonds were priced for a depression rather than a recession in November last year.

We believe that equity markets turned bullish late last year, it was stealth because few could see it. However, as of early April the market made its intentions perfectly known……with broad based advances across all the major market indices in the US. However, markets do not move in straight lines. The weakness we are now experiencing in the Dow and Nasdaq was a little overdue. While market internals continue to resist following the major market indices down we continue to believe that this is just an attempt by the market to shake weak hands out of the market…..once the weak hands are out of the market (probably when we see the NYSE 50 Day Moving Average Ratio trade below 40%) then the market will resume its upward path. We continue to be buyers in weakness.

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Emerging Market Bonds…….you don’t buy “risky” emerging market bonds unless you are genuinely bullish. We believe that the strength of emerging market currencies is being supported by the strength of emerging market bonds. The performance of emerging markets (both equities and bonds) are a reasonably reliable indicator for the performance of commodities. This is due to the sensitivity of emerging markets to world growth. Most emerging markets are heavily involved in the extraction of resources (agriculture, mining, and energy).

The charts below relate to two of the larger emerging market funds available to investors……..both look bullish to us

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