The Daily Trading Report

Markets are on the verge of breaking out of their respective holding patterns. The breakout is likely to be rather dramatic with many of the charts below (representing the major asset classes) being more or less unchanged since at least October last year. A general rule of thumb is that the longer a market moves in a sideways direction the greater will be the intensity of the breakout.

Now notice how close many of the charts are to breaking to multi-week highs (equities, commodities, gold, corporate debt, and high yield currencies) or multi-week lows (US Treasuries). Which market will break first? We don’t know for sure, but what we are reasonably certain about is that once one breaks the rest will follow in quick succession.

We continue to be positioned for bullish breakouts in equities and commodities and bearish breakdowns in US Treasuries and the US Dollar.

This is the latest of our weekly series “This week in the Markets”. We maintain a long term Asset Allocation Investment Portfolio and this series walks though our market evaluation process, albeit at a very high level.

We all must seek information from a variety of sources. A quick perusal of SeekingAlpha.com and other financial news sites brings forth a plethora of news, opinion, and the odd rather obtuse ravings of those howling at the moon. How does one separate the good from the bad? Modesty prevents us from saying read on!

As we wrote last seek, we look across the major asset classes (equities, bonds, commodities, and foreign exchange) and see to listen the markets lingua-franca; Supply, Demand and Price. Significant changes in any one of these represents both a trading opportunity and a signal to rebalance our portfolio. We believe that such a regular process should be an essential part of managing long-term portfolios.

World Equity Markets
Reviewing the performance of $DJW & $W1SML we can see an almost mirror image of performance between large caps & small caps; both are off the highs of earlier this year, but well off the lows of early February. Should the small caps diverge from the large caps we would view this as an “interesting” event, as yet this has not happened, prices have not breach lows, and so we maintain our portfolio’s long positions.

US Bond & Debt Markets

The following two charts represent government debt and corporate debut. Reviewing the relationship between the two parties provides insight into investor appetite for risk. We could consul against making judgements upon one or two week patterns; we use monthly timeframes to form our views.

Last week we saw a clear pattern of declining appetite for US government debt, and an increasing appetite for US corporate debt. Telling us that investors were looking to put their investment capital increasingly into the “riskier” commercial sector. A big vote of confidence for corporate America there.

This week the picture is somewhat cloudy, hence our view of not making decisions based solely upon weekly timeframes. With respect to government debt (TLT), clearly the situation in Greece, Ireland, Spain, and Portugal is having an effect. We cannot predict how long this effect will last, it may be short lived, or it may be long lasting and increase demand for US Treasuries.

At the moment, there are still underlying dysfunctions in the US economy (more on this below) and we believe that over time TLT will drift downwards again.

We maintain our shorts in TLT and our longs in JNK.

Commodity Markets

We view commodities, as measured by the CRB index, as an indicator of global economic performance. Again, we will keep things simple: when demand is increasing, competition for scarce resources causes prices to rise. Demand will increase when consumer sentiment is high and vice-versa.

What creates demand for commodities? Demand for finished goods.

What we can see by reviewing the CRB index and Gold as that demand, and thus price, for each has been consistently rising over the last six to nine months. Last week TLT had an inverse relationship to CRB and GLD, this week the opposite. All three have risen in tandem. We cannot help but see the continued rise of commodity prices as inflationary.

We will maintain our long commodity and gold positions.

Foreign Exchange

For any trader, this is where the action has been all week. Oh what fun has been had! Seriously, in this article we walk though our longer-term views, but really we live for the short-term market opportunities.
PIIGS is a term that has suddenly arrived, and is the major reason for all the excitement. We’ve watched the flow-on effects on the Euro, USD, CAD, and JPY, and seen the bearish sentiment toward the Euro rise and rise.  There is of course all good reasons for this, but as we noted last week, shorting the Euro has become a very crowded trade. We were not surprised to see a small bounce back over the last few days of last week; and profited from some small call positions; nothing to dramatic.

We understand that the major market participants are waiting and watching to see how the EU handles the Greece debt situation as a precursor to problems of the other nations. Once some certainty is arrived at, we believe that confidence will be restored, and the significant amount of the bad news already priced into the markets will be pared. Of course, being Europeans, this will take awhile.  There is an opportunity for long-term option spreads here; OTM long term Calls are very cheaply priced, one could match this with a more expensive ATM long-term Put.

In reviewing Europe, you should keep in mind that California is just one of a number of US states that has similar problems. California alone is much more important to the US, and the Global, economy than all the PIIGS combined.

To summarise, despite some recent market moves to the contrary, we don’t see the market as undergoing a significant change in long-term price action. So we will maintain our current long-term outlook of long JNK, Commodities and Commodity currencies, whilst being short TLT and USD.

A bull market is loosely defined as one where the average stock is advancing. One area of the market that is often overlooked is microcaps. Important behavioural characteristics can be gleaned from studying relatively illiquid assets of each asset class. In the case of equities microcaps are the most illiquid. Anyway, problems in equity markets often first show up in microcaps due to their relative illiquidity. Now if the equity market was genuinely in trouble then microcaps should have struggled to move higher over the last couple of weeks. Yet, as per the microcap ETF “IWC” they are a mere 2% away from their multi-week high. What do valuations look like? With an average price/book of 1.08x they are hardly demanding by any stretch of a rational man’s valuation.

Comforting behaviour for the bulls no doubt!

Every week we sit down and look at the markets from a high level. It’s a discipline that we go through without fail. It helps to remove ourselves from the day to day analysis detail and see the bigger picture.

For those unfamiliar with our weekly analysis, we are not trying to pick stocks or sectors here. Rather we are trying to “listen” to what the markets are telling us; by looking at the major equity, bond, commodity, and foreign exchange market indices. In doing so we attempt to measure the markets appetite for risk.
Basics are basics. We think of markets as pure supply and demand. If risky assets are in demand, their price will rise and similar to the “less risky” assets. From this we draw conclusions as to how we should allocate assets across our portfolio.

We have a much more detailed process than we show here and have our own proprietary appetite for risk index; perhaps we’ll release that publicly sometime.
And so down to business. Let us first focus on the equity markets, by looking at the Dow Jones World and World Small Caps Index. Keep in mind that we see small caps as riskier assets and so are firstly interested in any divergence between the two markets; of which, at the moment, there is nothing of significance.

Secondly, what does the price movements tell us? Well, it appears that equity market investors across the globe have regained confidence in their markets and are prepared to purchase equity assets again.

The price performance of gold is more than a little interesting. It has managed to maintain its value in USD terms whilst the USD has appreciated significantly against the all major currencies.

We could all argue for hours about the role gold plays in the financial markets, but all we can do at the moment is take note that there is still significant demand for gold in-conjunction with rising equity markets and an increasing USD.

Moving onto the bond markets we now look for signs of confidence in the riskier assets, corporate debt, as measured by JNK  , and the “safer” government debt of US Treasuries as measured by TLT .

Clearly US Treasuries are continuing their downward momentum, unsurprisingly so. Much more interesting, to us at least, is the price momentum of corporate debt. This is a vote of confidence in business and is also complemented by reducing credit swap premiums.

We can only take this as a positive sign for risk appetite.

The euro effect is being felt. We are wondering if perhaps it is becoming oversold. With so many short sellers this has become one of the most crowded trades that we have ever seen. Having seen some violent reversals in the past, we are sitting out this one.

In commodity and high yield currency terms, the USD has not appreciated as the above graph would suggest.

Despite the recent price movements of the USD, we still have troubles with the euro, Dubai, and a whole lot more. We believe that the underlying reasons for the USD weakness of last year still exist and expect downward momentum to reassert itself over the oncoming year.

We’ve now taken a very high level look at the equity, bond, commodity and foreign exchange markets. Our interest is what, collectively, can we learn about general appetite for risk and thus the most likely medium term direction of the markets.

Nothing is ever certain, and as traders, we have to make decisions and live with the consequences. This week we have decided to maintain our long equity and commodity positions, and our short US Treasury positions.

Every week we sit down and look at the markets from a high level. It’s a discipline that we go through without fail. It helps to remove ourselves from the day to day analysis detail and see the bigger picture.

For those unfamiliar with our weekly analysis, we are not trying to pick stocks or sectors here. Rather we are trying to “listen” to what the markets are telling us; by looking at the major equity, bond, commodity, and foreign exchange market indicies. In doing so we attempt to measure the markets appetite for risk.
Basics are basics. We think of markets as pure supply and demand. If risky assets are in demand, their price will rise and similar to the “less risky” assets. From this we draw conclusions as to how we should allocate assets across our portfolio.

We have a much more detailed process than we show here and have our own proprietary appetite for risk index; perhaps we’ll release that publicly sometime.
And so down to business. Let us first focus on the equity markets, by looking at the Dow Jones World and World Small Caps Index. Keep in mind that we see small caps as riskier assets and so are firstly interested in any divergence between the two markets; of which, at the moment, there is nothing of significance.

Secondly, what does the price movements tell us? Well, it appears that equity market investors across the globe have regained confidence in their markets and are prepared to purchase equity assets again.

The price performance of gold is more than a little interesting. It has managed to maintain its value in USD terms whilst the USD has appreciated significantly against the all major currencies.

We could all argue for hours about the role gold plays in the financial markets, but all we can do at the moment is take note that there is still significant demand for gold in-conjunction with rising equity markets and an increasing USD.

Moving onto the bond markets we now look for signs of confidence in the riskier assets, corporate debt, as measured by JNK  , and the “safer” government debt of US Treasuries as measured by TLT .

Clearly US Treasuries are continuing their downward momentum, unsurprisingly so. Much more interesting, to us at least, is the price momentum of corporate debt. This is a vote of confidence in business and is also complemented by reducing credit swap premiums.

We can only take this as a positive sign for risk appetite.

The euro effect is being felt. We are wondering if perhaps it is becoming oversold. With so many short sellers this has become one of the most crowded trades that we have ever seen. Having seen some violent reversals in the past, we are sitting out this one.

In commodity and high yield currency terms, the USD has not appreciated as the above graph would suggest.

Despite the recent price movements of the USD, we still have troubles with the euro, Dubai, and a whole lot more. We believe that the underlying reasons for the USD weakness of last year still exist and expect downward momentum to reassert itself over the oncoming year.

We’ve now taken a very high level look at the equity, bond, commodity and foreign exchange markets. Our interest is what, collectively, can we learn about general appetite for risk and thus the most likely medium term direction of the markets.

Nothing is ever certain, and as traders, we have to make decisions and live with the consequences. This week we have decided to maintain our long equity and commodity positions, and our short US Treasury positions.

Every week we sit down and look at the markets from a high level. It’s a discipline that we go through without fail. It helps to remove ourselves from the day to day analysis detail and see the bigger picture.

For those unfamiliar with our weekly analysis, we are not trying to pick stocks or sectors here. Rather we are trying to “listen” to what the markets are telling us; by looking at the major equity, bond, commodity, and foreign exchange market indicies. In doing so we attempt to measure the markets appetite for risk.
Basics are basics. We think of markets as pure supply and demand. If risky assets are in demand, their price will rise and similar to the “less risky” assets. From this we draw conclusions as to how we should allocate assets across our portfolio.

We have a much more detailed process than we show here and have our own proprietary appetite for risk index; perhaps we’ll release that publicly sometime.
And so down to business. Let us first focus on the equity markets, by looking at the Dow Jones World and World Small Caps Index. Keep in mind that we see small caps as riskier assets and so are firstly interested in any divergence between the two markets; of which, at the moment, there is nothing of significance.

Secondly, what does the price movements tell us? Well, it appears that equity market investors across the globe have regained confidence in their markets and are prepared to purchase equity assets again.

The price performance of gold is more than a little interesting. It has managed to maintain its value in USD terms whilst the USD has appreciated significantly against the all major currencies.

We could all argue for hours about the role gold plays in the financial markets, but all we can do at the moment is take note that there is still significant demand for gold in-conjunction with rising equity markets and an increasing USD.

Moving onto the bond markets we now look for signs of confidence in the riskier assets, corporate debt, as measured by JNK  , and the “safer” government debt of US Treasuries as measured by TLT .

Clearly US Treasuries are continuing their downward momentum, unsurprisingly so. Much more interesting, to us at least, is the price momentum of corporate debt. This is a vote of confidence in business and is also complemented by reducing credit swap premiums.

We can only take this as a positive sign for risk appetite.

The euro effect is being felt. We are wondering if perhaps it is becoming oversold. With so many short sellers this has become one of the most crowded trades that we have ever seen. Having seen some violent reversals in the past, we are sitting out this one.

In commodity and high yield currency terms, the USD has not appreciated as the above graph would suggest.

Despite the recent price movements of the USD, we still have troubles with the euro, Dubai, and a whole lot more. We believe that the underlying reasons for the USD weakness of last year still exist and expect downward momentum to reassert itself over the oncoming year.

We’ve now taken a very high level look at the equity, bond, commodity and foreign exchange markets. Our interest is what, collectively, can we learn about general appetite for risk and thus the most likely medium term direction of the markets.

Nothing is ever certain, and as traders, we have to make decisions and live with the consequences. This week we have decided to maintain our long equity and commodity positions, and our short US Treasury positions.

Every week we sit down and look at the markets from a high level. It’s a discipline that we go through without fail. It helps to remove ourselves from the day to day analysis detail and see the bigger picture.

For those unfamiliar with our weekly analysis, we are not trying to pick stocks or sectors here. Rather we are trying to “listen” to what the markets are telling us; by looking at the major equity, bond, commodity, and foreign exchange market indicies. In doing so we attempt to measure the markets appetite for risk.
Basics are basics. We think of markets as pure supply and demand. If risky assets are in demand, their price will rise and similar to the “less risky” assets. From this we draw conclusions as to how we should allocate assets across our portfolio.

We have a much more detailed process than we show here and have our own proprietary appetite for risk index; perhaps we’ll release that publicly sometime.
And so down to business. Let us first focus on the equity markets, by looking at the Dow Jones World and World Small Caps Index. Keep in mind that we see small caps as riskier assets and so are firstly interested in any divergence between the two markets; of which, at the moment, there is nothing of significance.

Secondly, what does the price movements tell us? Well, it appears that equity market investors across the globe have regained confidence in their markets and are prepared to purchase equity assets again.

The price performance of gold is more than a little interesting. It has managed to maintain its value in USD terms whilst the USD has appreciated significantly against the all major currencies.

We could all argue for hours about the role gold plays in the financial markets, but all we can do at the moment is take note that there is still significant demand for gold in-conjunction with rising equity markets and an increasing USD.

Moving onto the bond markets we now look for signs of confidence in the riskier assets, corporate debt, as measured by JNK  , and the “safer” government debt of US Treasuries as measured by TLT .

Clearly US Treasuries are continuing their downward momentum, unsurprisingly so. Much more interesting, to us at least, is the price momentum of corporate debt. This is a vote of confidence in business and is also complemented by reducing credit swap premiums.

We can only take this as a positive sign for risk appetite.

The euro effect is being felt. We are wondering if perhaps it is becoming oversold. With so many short sellers this has become one of the most crowded trades that we have ever seen. Having seen some violent reversals in the past, we are sitting out this one.

In commodity and high yield currency terms, the USD has not appreciated as the above graph would suggest.

Despite the recent price movements of the USD, we still have troubles with the euro, Dubai, and a whole lot more. We believe that the underlying reasons for the USD weakness of last year still exist and expect downward momentum to reassert itself over the oncoming year.

We’ve now taken a very high level look at the equity, bond, commodity and foreign exchange markets. Our interest is what, collectively, can we learn about general appetite for risk and thus the most likely medium term direction of the markets.

Nothing is ever certain, and as traders, we have to make decisions and live with the consequences. This week we have decided to maintain our long equity and commodity positions, and our short US Treasury positions.

Beware of currency markets when their chart patterns take on a linear appearance. Just when you think it is safe to enter a trade, the abyss opens up! OK so while the chart of the Euro firmly suggests that a downtrend is in place, beneath the scenes something is at play.

We would like you to bear in mind the motto of John Templeton “the best time to invest is at the point of maximum pessimism”. Getting straight to the point – the point of maximum pessimism towards the Euro is about now! Here is our evidence:

Net long positions in Euro futures are at record lows (actually net short positions are at record highs). This suggests that being short the Euro is now one of the world’s most crowded trades. Where is the marginal seller going to come from?

.

Risk reversals are at levels similar to those which existed when the Euro blew out at the end of 2008. In essence risk reversals are the difference between the cost of calls and puts.

The greater the demand for an options contract, the greater its volatility and its price. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative.

This suggests that everyone who wants to be short Euros are already short.

Now the problem with the Euro, as we have been led to believe, is to do with the PIGS, most notably Greece. Yet the Greek CDS spread suggests that the eye of the storm may well have been broken. CDS spreads on PIGS have fallen dramatically over the last few days.

So we have enough evidence to make a contrary bet on the Euro. How do we execute this contrary play? Via the options market – by buying out-of-the-money calls on the Euro 12 months to expiry. So what happens if the Euro continues to fall? Well we don’t care too much, after all we have 12 months for this “call” to play out and run no risk of getting stopped out in the process!

We could not help but be drawn to the following headline and corresponding article from Bloomberg:

Dollar Optimism Climbs to 15-Month High on Deficits

Feb. 10 (Bloomberg) — Investors are the most bullish on the U.S. dollar since November 2008 on concern that weakening government finances in European nations will hurt the global economic recovery, a survey of Bloomberg users showed. The world’s reserve currency will rise over the next six months, according to respondents in the Bloomberg Professional Global Confidence Index. Confidence about the outlook for the global economy among the 2,486 participants in the survey, taken before European Union officials said they may aid Greece yesterday, dropped from the highest level since the series began two years ago.

This article confirms the bearish sentiment towards the Euro. Believe it or not sentiment towards the Euro has never been this bearish. The graph below gives the net long position on Euro Futures:

Well it seems that being long the USD right now (short the Euro and associates) is perhaps the most crowded trade in the world! By default that means being short commodities, equities, and gold is also a crowded trade.

Yes we are well aware there are good reasons as to why one should be short the Euro, but if that involves joining every trader and his analyst in the same trade then it is a very bad idea. This is perhaps one of the most optimal times over the last 18 months at least go to short the USD…..and long everything else.

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.