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 all too easy to get caught up in the panic surrounding the Euro debt “crisis”. The media are having complete field day with the drama surrounding the Greek debt crisis (call it whatever crisis you will). They are conjuring up every reason in the world why the Euro is going to zero, how the Greek crisis is going to systematically spread across the Eurozone nations……and the list goes on. Given the tone of the commentary coming out of the media of popular opinion one could be forgiven for thinking that equity markets have already entered a bear market or at least a material correction. However, as at time of writing, the major market indices in Europe have yet to break critical pricing levels – just take a look at the Stoxx 50 index below. Yes that support level is a little too close for comfort, but really how sick is the average listed stock?

Stoxx 50 Index

We don’t place too much faith or importance on large cap indices mainly because everyone else looks at them so looking at them is hardly going to give us an edge. Also large cap indices are heavily weighted to the performance of a few mega caps which can provide rather misleading behavior.

A bull market is defined as one where the average stock or the broad market is rising. We have found that the best representation of the behavior of the broad market is small cap indices. Now take a look at how the MSCI Europe Small Cap index is behaving. If one was to take away the behavior of the last two days then it is only a few percent away from a multi-week high! This is quite contrary to what you would think based on the media banter! It has got someway to go before it breaks any critical pricing level which would signal the start of a bearish phase.

MSCI Europe Small Cap Index

Bear markets are supposed to sneak up on you when you are least expecting, when your attention is focused else. If this is the start of a material downturn in the market it is certainly not typical!

All technical or behavioral aspects of this market aside, has anyone sat down and looked how cheap large caps are in Europe? Well below are a few fundamental metrics of the members of the Stoxx 50 index. As simplistic as it seems (and that is the way we like it) you can now pick up the big multi-national stocks (like Bayer, Nestle, BASF, Daimler, LVMH, Nokia, L’Oreal, and Danone) on a forward P/E of 10x and a Price/Book of 1.25X……….maybe this will be 1.20 within a few days! These stocks are as global as any of the Dow components, and one can only wonder how much more competitive they have just become given the breakdown in the Euro!

Wasn’t it Rothschild who said “buy when there is blood on the streets”…..wasn’t it Getty who said “when they are yelling I am selling and when they are crying I am buying” ok it might have been Rockefeller or JPM……but I know it was Templeton who said “the time to buy is at the point of maximum pessimism”! I say no more.

We bought the Stoxx 50 yesterday. Judge us by our actions not words.

Our wealth creation portfolio is up around 25.70% 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.

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A casual scour of popular blog sites and the media of popular opinion reveals that there is a growing belief that inflation is no longer a problem in the “foreseeable” future. This belief is perhaps embodied in the results of the recent Merrill Lynch Fund Manager survey, highlighted by a recent Bloomberg article which stated:

March 16 (Bloomberg) — Risk appetite rebounded as concern eased that interest rates will have to rise later this year to cool inflation, prompting investors to cut cash holdings and buy equities, a BofA Merrill Lynch Global Research report showed. Seventy percent of survey respondents, who together manage about $589 billion, expect the Federal Reserve to keep interest rates at a record low until at least the fourth quarter of 2010, as concern that inflation will return dropped sharply. Fifty percent said they expect the European Central Bank to keep its benchmark interest rate unchanged until 2011. “The big change for investors is the drop in inflation worries,” Gary Baker, head of European equity strategy at BofA Merrill, said at a press briefing in London today. “Investors are now much less concerned about when they expect interest rates to rise and see it more as a 2011 event.

Well what is the market suggesting? Let’s go to the market and try to interpret what it is telling us as opposed to why we think is going to happen in the “foreseeable future”. Like when is the future ever foreseeable! We will look at the inflation “issue” from a number of perspectives;

1. The behaviour of long dated US Treasuries. If there were genuinely no inflationary fears then yields on the US 30yr should be nowhere near multi-week highs. Yet at 4.57 the 30yr yield is only a few good days away from breaking above the previous multi-week high of 4.75. OK one could argue that the 30yr yield has failed on at least three occasions in the last 10 months to break to a multi-week high. Then again perhaps it is getting ready for the big push over the top? In defence of a break above 4.75 over the coming days/weeks is the fact that the Fed has been an active buyer of treasuries over the past 10 months. What would the yield on the 30 yr look like if there wasn’t support from the Fed? We think a lot higher.

   

2. After reaching a multi-week high during the opening days of 2010 the “granddaddy ” of commodity indices has sold off and is now trading at the same levels it was in early August last year. This is not the sort of behaviour that one would expect if inflation was taking hold as commodity prices generally do well in times of high inflation. In support of the bulls though there has not been any evidence of lower lows or lower highs. The uptrend (as ragged as it may seem) remains intact.

   

3. And inflation premiums? It shouldn’t take someone with a finance/economics degree to figure out that if inflation expectations were moving higher then TIP 10yrs should be outperforming non inflation protected 10 yr treasuries…..yet as with commodities and the yield on the US 30 year something seems to have happened around about the 8^th of January. TIPs have begun to underperform. The inflation premium attached to TIP 10yrs is now at the same level it was in November. Is this enough to denote the start of a bear trend in inflation premiums? Well of course it is a start but we would have to see inflation premiums drop rather dramatically before we got concerned about a “deflationary” scenario. Of course given the “skulduggery” that has gone on in the treasury market as a whole we would not be surprised to see some manipulation going on in the TIPs Treasury market.

   

4. Perhaps this is a little unconventional but if there were no inflationary fears then Gold should be doing badly relative to US Treasuries (here we use TLT as a proxy for the US Treasury market). Well as with the three charts above gold relative to long dated US treasuries has gone nowhere since the start of December. We would to have to give the benefit of doubt to the bulls at this stage but of course if this chart broke down one would have to start asking questions about the “inflation trade”.

   

5. But wait what is this? This is the Journal of Commerce Industrial Commodities Index. Could this be the missing link? We are not conspiracy theorists but we suspect that the gold, crude, and treasury markets are subject to manipulation……but we are very confident that industrial commodities as a whole (yes all 18 of them) are not subject to manipulation. Anyway, conspiracy theories aside, industrial commodity prices moving higher in a linear fashion is not exactly the sort of behaviour that you would expect if there was “no inflation threat in the foreseeable future”.

   

On the face of it there is evidence that inflation expectations have declined over the last three to six months. When we say on the face of it we are referring to some of the conventional measures of inflation (the behaviour of US treasuries and commodity futures). But these measures have not behaved in a linear fashion and are perhaps subject to manipulation by the powers that be. So we have to be somewhat sceptical of any short term weakness that is being depicted (in the first four charts). However, it seems the deeper we dig the more the market begins to reveal its true intentions. In the real world commodity prices are on the rise. It is difficult to argue that rising commodity prices are not a dead giveaway for rising inflation pressures…..call it what you will.

We would like to let you in on our way of thinking……or at least on what we have seen happening and what we “envisage” occurring over the coming weeks.

First cast your eyes on the futures charts below (specifically the USD Index, CAD, Crude, Gold, 30 yr, and S&P 500). What do you see? With the exception of the USD Index (and the Euro) we see markets that have essentially gone nowhere since August – October last year (that is a 5 – 7 month period). OK, so what? Well the longer a market moves in a sideways direction the greater will be the force of the breakout. So when the breakout comes it is liable to be violent.

OK so which way will markets break? Well this is how we see market trends evolving:

It all centres around the behaviour of the Euro. Yes the USD Index is looking rather bullish…….but is it? Take a look at the CAD Future, is this looking bearish? We think not. The USD Index is looking bullish primarily due to the weakness of the Euro which represents 55% of the index. But what happens if the Euro continues to fall? Yes it could but given the record amount of short positions on the Euro future we find it highly unlikely that there will be any more downside in the Euro over the coming weeks.

We believe that the Euro will bounce, because of less than bad data coming from the PIGS “fiasco”. This will lead to the Euro rising above the 1.38 level which will induce a wave of short covering. Needless to say the press will pick up on the dramatic improvement in the Euro and will find positive news to justify the move, maybe they will start looking at the problems of the US again (be it California, New Jersey etc). The big rise in the Euro will of course send the USD Index down.

This will lead to commodities (aka gold and crude) moving above resistance levels to multi-week highs,

Which will lead (or be preceded by the US 30 year yield breaking above the key 4.75 level (the future below 115)

…….and the S&P 500 breaking above the key 1150 level to a multi-week high.

OK it might not occur in that order but we think the “tipping” point will be a bullish breakout in the Euro. What will lead to the Euro breaking higher? Perhaps a butterfly flapping its wings over the middle of the Mediterranean!

Everything in this world is connected…………nothing exists in isolation!

Another nail in the coffin for deflationists! Gold traded at multi-week highs against paper currencies last night. Perhaps the most significant move was gold’s close above $AUD1180. The charts below suggest that something powerful is building in gold……perhaps something that will rival what we witnessed in the late 1980s. The evidence is there as plain as daylight for all to see, of course whether you choose to believe it or not is entirely up to you.

Now we wait on Crude and the CRB to breakout in Aussie dollar terms…..But given what has just happened with Gold (and what is happening with Baltic Freight rates, TIPs vs. US 10yrs we think Crude and the CRB will follow! Watch the CRB and Crude in Aussie Dollar terms. A break above 3.20 and 0.90 in the charts below will be the final nail in the coffin for deflationists!

“In religion and politics people’s beliefs and convictions are in almost every case gotten at second-hand, and without examination, from authorities who have not themselves examined the questions at issue but have taken them at second-hand from other“

This quote from Mark Twain applies equally to investing and economics as well. We say believe not in what others tell you but in what the market is telling you.

Our wealth creation portfolio is up around 17% 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.

We are not currently taking new subscribers. Please enter your email address if you would like to follow our commentary and be notified when we open our service for subscriptions.

It appears that capital flows into emerging markets remain strong and there is no credible evidence that the strong absolute and relative (to developed markets) trends are about to come to an end anytime soon.

Emerging equity markets are now higher than they were at the time of the Lehman’s collapse and have yet to show any deterioration in upward momentum. We believe that there is more upside to come in equities because the underlying breath of the market is strong. Small cap emerging equity indices are only a few points away from multi-week highs suggesting that even the highly risky “rats and mice” stocks are continuing to make new highs. Usually prior to any significant correction the underlying market turns down. From a relative perspective emerging market equities continue to outperform the S&P 500, with EEM less than a 2% away from a multi-week high against the SPY.

Emerging bond markets also show no deterioration in upward momentum from both an absolute and relative perspective (relative to US investment grade bonds). The relative outperformance of emerging market sovereign bonds (to US investment grade) also suggests that the appetite for risky assets remains “positive” for whatever reason.

On the emerging market currency front CEW is less than 1% away from another multi-week high signalling a new high for emerging market currencies in general against the USD.

Note the appearance of the two foundation members of the emerging market universe. The South African Rand and Brazilian Real are more or less at multi-week highs. Having spent considerable time in both countries over the last 10 years we question as to how they can still be regarded as “emerging”. Anyway we think the classification of “emerging” is merely semantics.

Given that equity, bond and currency markets are all confirming each other with levels either at or very close to new multi-week highs, we think that more upside is likely in anything emerging market cover the coming weeks. We don’t know what the future holds, but we do know that markets move in trends and we know a strong trend when we see one.

Our wealth creation portfolio is up 16.32% 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.

Intra-day the Kiwi has reached a multi-week high against the Yen. This came on the back of an increase in the price of milk. Milk products account for some 20% of New Zealand’s export earnings.

We think that the breakout in the Kiwi Yen is very important because it highlights a continuation of the:

1. high yield trade;
2. demand for commodity currencies;
3. inflation premium in bonds…..which should be followed by higher commodity prices.

Now all we need is a confirmation of the breakout in the Kiwi/Yen by the Aussie/Yen and Brazilian Real/Yen. We think that this confirmation will happen over the coming days.

Notice how the Aussie Yen has gone nowhere since mid June……and also notice how the high in June corresponded with the high in West Texas Crude in June. Since mid June the Aussie Yen made another multi-week high but crude and the CRB struggled to do so. Of course this is stating the rather obvious. Perhaps what is not so obvious is that the commodity currency yen crosses have been a leading indicator for the behavior of crude and by default the broad commodity group since late last year.

The key levels to watch for now are:

1. AUD Yen – 82.0
2. Crude – $75
3. CRB – 270

These levels should be broken in consecutive fashion over the coming days. Breaches of these levels will have disastrous consequences for those banging on about deflation!

You may be wondering about the significance of milk! Just go into a supermarket and try to come out with a product containing an ingredient that is not a derivative of milk………even your daily glass of wine has a preservative which is a derivative of milk! It is kind of strange to think that wine growers in California and New Zealand Dairy farmers have a lot in common. Yes everything in this world is connected in more ways than you know! Beware of the consequences of rising payouts for Kiwi “cow cockys”!

Back in January this year when the British pound was falling in a crumpled heap a certain investment great came out and said this about the GBP:

“For the last 26 years, the U.K. has been selling oil, the North Sea. That’s what’s saved the U.K. in the past three decades. It’s finished. The North Sea oil is running out. Within the decade, the U.K. will be importing oil again. And then they’ve got nothing to sell… I mean, again, I hate to say it, but I would not put any money in the U.K. I’ve sold all of my sterling…”

To be fair he also had this to say about commodities and emerging markets:

“The real opportunities remain commodities and emerging markets. I continue to think that real assets are the best place to be because that’s where the shortages continue to develop. If the world economy develops and gets better as Mr. Geithner says, then obviously raw materials will be the best beneficiary. If the world does not get better, raw materials will still be the best beneficiary because the governments are printing so much money all over the world, and throughout history that has led to higher prices.”

Some of you may remember that the famous investor was Jim Rogers. For the time being he has been wrong about the GBP (in USD terms at least) but right about commodities and emerging markets in both GBP terms and USD terms. Anyway the point here is not so much on how wrong Rogers has been about the GBP (perhaps he has a much longer time perspective than us and in which case he may well not be wrong) but rather to highlight that when you hear comments from a highly respected commentator/investor justifying the current market action when by all historical accounts the market is in an extreme oversold or overbought condition…….odds suggest that the market is ripe for a reversal.

Whilst commentary on the GBP is far from being extremely bearish as it was in the 1^st quarter of this year it still remains in a generally bearish state. Yet the GBP continues to hold out against the US and looks as if it is getting ready for the next big move up.

Investing in currencies is a very different art than investing in stocks because currency investing is a relative game. Whilst a currency is to a country what a stock price is to a company the valuations of a currency are expressed as a relative (to other currencies) whereas a stock price is expressed as an absolute. So whilst the fundamentals of Great Britain may appear to be poor (as Rogers points out)……they are perhaps not as bad as those of the US. Of course now it comes down to which currency is a better of a bad bunch.

We think that the GBP has more upside, however…..if you are a long term investor then perhaps Rogers was right all along. Perhaps he just forgot to say against which currency he was valuing the GBP. We have a funny suspicion he had in mind the GBP against the Aussie.

We have yet to witness any wild bullish claims about the prospects of the Aussie dollar so we believe that its upside is far from over. But as always happens, the Aussie will climb until such a point that the crowd reaches universality of bullish opinion and then will start to move against the crowd. Enjoy the ride.

Our wealth creation portfolio is up 14.9% 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 is more or less bearish business as usual for the USD. Across the board the macro trends that began late last year remain firmly in place. The USD Index remains firmly gripped within a bear trend and there is little hint of any impending change to that trend. We place considerable emphasis on the behavior of emerging market currencies and emerging market bonds relative to US Treasuries to gain insight into the likely direction of the USD Index. For the time being at least emerging market currencies as a whole (depicted by the ETF CEW) are close to breaking to a new high against the USD(the South African Rand already has). This behavior is confirmed by the relative outperformance of emerging market bonds relative to the US 10 year. Emerging market bonds are still yielding about 9% (as per the yield on the SEI International Emerging Bond Fund SITEX) whereas the Yield of the US 10 year is about 3.3%. Whilst emerging market bonds will always (famous last words perhaps) trade at a premium to US Treasuries, the current premium (about 500 pts) is still excessive and suggests that emerging market bonds have more upside left and that emerging market currencies are likely to continue their assent against the USD over the coming weeks/months.

Keep watching the ETF CEW, its holds the key to understanding so many macro trends trading place in global financial markets.

Our wealth creation portfolio is up 14.6% 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 USD Index sits on a knife edge! At 79.00 it is a mere 50pts above support at 78.50. Once it breaks this level then we think it will quickly fall to the next level of support which is at 72.00. We will put our heads out and say that it will at least trade at the 72 level before year end. We don’t want to have preconceived ideas but now that the financial crisis is over (perhaps we are sticking our heads out again) it appears that the USD is in the process of resuming its bear trend that started way back in 2002. We don’t think that the efforts of the US treasury or the FED over the last 12 months has done anything to improve the competitiveness of the US economy and fundamental outlook for the USD. Looking to the markets it appears that it is destiny in motion for the greenback. Across the board most currencies are on the brink of breaking to multi-week highs against the USD and some, like the Brazilian Real and South African Rand, have already moved to multi-week highs. We think that the USD Index will follow the lead set by the Real and Rand, we certainly are.

But wait there is more! The global bond market continues to suggest that the USD is heading lower. Yesterday the global government bond ETF “BWX” moved higher against its US equivalent “IEF”. It is only a matter of time before our favorite FXA and FXC positions move to a multi-week high against the USD and get to parity.

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.

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