The Daily Trading Report

The bears came out with passion and excitement on Friday with the release of the infamous employment report……….apparently the 41,000 private jobs added was just not good enough. So to the bears that confirmed that the US economy is definitely heading back into a recession/double dip/tripple dip (take your pick). But does the number of jobs added to the economy in any one month tell you much about the health of the economy, enough to justify a drop in the Russell 2000 of some 8% in three days?

We think that the employment report (as per last Friday’s variety) is about as useful as a Zimbabwean Dollar to put it politely (the stuff that Kimberly Clark produces is actually far more useful). Why? Because the number of jobs added (or lost) in anyone month is a lagging indicator at very best.

We place more emphasis on the number of job openings than jobs added. Why, well in very simplistic terms…..there has to be a job opening before a job is added to the economy. On Tuesday the job openings report was released (the JOLTS report). We suggest you read it and take careful note. In essence there were 2,785 openings in March and 3,078 for April, an increase of just over 10% – now that is significant!

JOB Openings Total

OK in case you are wondering……..most of the job openings are accounted for by the private sector. Now what if employers did not hire but cracked the whip and got employees to work longer hours…….few people paid attention to the fact that the average hours worked by employees increased, and the trend has clearly been up since October last year!

I would take the increase in job openings and average hours worked far more seriously than the number of jobs added in any one month.

I never like to sit on the fence as you are probably well aware……….I see little credible evidence suggesting that the US Economy is in trouble/slowing down/faltering……or heading for a proverbial “double-dip”. We see the latest weakness in the US stock market as a correction of the primary bull trend (it is a buying opportunity rather than reason to sell). It is exciting being a bull in a sea of bears!

Here is something to consider. If there was really a problem from a fundamental perspective in the US (lower corporate earnings and cash flows) then shouldn’t we have already seen a dramatic rise in distressed corporate debt? The chart below is the TRACE Index. It is an index of the number of bonds that are trading in a distressed state. “Distressed” refers to a condition where a bond trades in excess of 1000bpts above yields of US treasuries (i.e. bonds that are in real deep trouble). Unless I am missing something (and it has happened before) there does not appear to be any breakout in the number of bonds trading in a distressed state. Can we logically conclude that there is not a problem with the recovery in the US economy? Could we also conclude that the rush into US treasuries is merely the result of panic which is not fundamentally justified! We think so.

We find ourselves in somewhat of a predicament, although we still have yet to see breaches of key pricing levels in the major asset classes we follow those “support” lines are getting way too close for comfort. Anyway let us assume for a minute that we do see beaches of “support” on the Wilshire 5000 and the Russell 2000 over the coming days (perhaps hours). What then, do we get bearish? Well yes one would logically think so but it is not that simple. Stocks are already in a very oversold condition. Based on the percentage of stocks trading above their 50 day moving average on the NYSE, the average stock in the US is already as oversold as it was in early March last year.  If the Wilshire were to break below the 11,000 level (about 2% away from where it is currently trading) then stocks would enter an extreme oversold condition challenging that of late October 2008! So in essence if one were to go short now then you are implying that markets are about to get significantly more oversold than they did at the very worst of the crash of 08! That is a very tall order but of course there is always that proverbial black swan!

An up trend is defined as a series of higher highs and higher lows, so far at least the up trends of the Wilshire and Russell remain in place. In fact the Russell 2000 still has some way to go before it breaks out of its up trend. But if one were to take the tone of commentary coming through on blog sites and the sensationalist media you could be forgiven for thinking that equity markets were already well entrenched in a bear market (having already made a series of lower lows and lower highs). At this stage we think that the market is still cleaning out the weak hands that “got onboard” in the last 6 months (well in the weeks leading up to the 1st of May). Just look at how linear the price behavior of the Russell was in March and April. Linear behavior is evidence of weak hands entering the market


If equity markets are in an extreme oversold condition then the opposite applies to bonds. We note that the flow of funds into bonds has reached extreme proportions. Well if there is one thing for sure, if shorting US treasuries was a crowded trade some 2 months ago it certainly isn’t anymore!

The behavior of junk grade bonds is also not fitting with a “bearish” view. Just how junk grade bonds have not already collapsed is puzzling, also how the likes of JNK and HYG (not to mention PCY and EMB) only fell by 0.5% on Friday when the Russell fell by some 5% does not add up. This is a very different situation from that which existed two years ago going into the “crash” of 2008.
Well although commodities (as per the old CRB) are not looking too healthy, “bear” in mind that much of the weakness in commodities can be attributable to the strength of the USD over the last month. If one looks at the behavior of the CCI in AUD, CAD, and European currency terms then commodities are not that sick, actually they still look rather bullish.

And one certainly cannot get bearish on commodities when gold continues head on up in multi-currency terms.

The USD is now as overbought as it was in 2008/early 2009. Furthermore it is about to run into very stiff resistance. Anyway for the life of us we cannot understand how a bad employment report can be positive for the USD…….taking this to extremes, so if the US goes bankrupt then the USD is going to all time highs and yields on US treasuries are going to zero! This is completely illogical!

Yes it is worrying how emerging market currencies have broken down. Again just how emerging markets as a whole are in worse financial condition than the US is beyond our rational thought processes.

So into the valley of darkness we go again. We remain bullish on equities, commodities, and bearish the USD and US Treasuries, needless to say that in the last 5 weeks we have absolutely nothing to show for our efforts. We are protected somewhat by puts on the S&P and AUD, but that is only to hedge incase we are very wrong, yes it has happened before.

Over the course of the last few weeks I have been saying that the equity market is not behaving in the manner it should be if this was the start of a “genuine” bearish phase as opposed to a conventional “cleaning out of weak hands” (or correction as it is commonly referred to). It seems that those who were bulls in March/April had absolutely no problem in crossing the great dividing range between the bullish and bearish camp. Bull markets typically come to an end with the bulls refusing to throw in the towel, this creates what can be described as a churning action in the major market indices and a gradual beakdown in the breadth of the market. Looking at our traditional measures of market internals or breadth we do not see evidence of churning or a gradual rollover. As at the end of April the NYSE AD Line and New High New Low Index were registering multi-week highs with no apparent loss of momentum. Yes we do see the weakness………….but do you get bearish over a mere three weeks of negative behaviour in market internals? We think not.


The weakness we have observed over course of the last few weeks in the major market indices is nothing more than the market’s attempt to keep Joe Average investor poor………as such this weakness should be seen as a buying opportunity rather than reason to sell.

Going long the USD now is more or less the equivalent to buying greenbacks at the peak in late 2008, or should we say at the height of desperation! There are a number of ways of looking at how overbought the USD is. Apart from gazing at magazine covers and talking to the average fund manager/trader we look at the option market to gain an understanding of just how the crowd is positioned. Specifically we look at risk reversals (in essence the difference in price between like for like put and call options). Right now the premium paid for put options on currencies is at a premium to calls far exceeding that which occurred in late 2008. So if you are short currencies against the USD now in essence you are saying that things are going to get much worse than in 2008. Yes stranger things have happened…….have a go and join in on the one of the most crowded trades financial markets have witnessed ever since the TMT bubble broke in 2000!


Of course the case against the USD thickens. Note just how close the USD Index is to the previous highs (those of 2008)! Those are very significant resistance levels which are just a percent or so away from current levels.

And for those who fancy their chances at timing the market, perhaps now is an opportune time. A tripple top, well it could be……


We look for extremes in crowd sentiment and place options positions that go against how the majority of participants are positioned. Given how cheap call options are now on the likes of the EUR, CAD, GBP, and CHF we think that being positioned for a crack in the USD over the coming days/weeks is well worth the punt! Remember it is not a case of being right or wrong rather how much you stand to make if you are right vs. how much you will lose if you are wrong.

If this is the start of a bearish phase (something more than a 10% correction) then the market is certainly going about it in a most “untraditional” fashion. I say untraditional because generally the onset of a bear market is characterized by bulls refusing to throw in the towel, right now it seems that anyone who was remotely bullish some 5 weeks ago has had absolutely no problem in jumping to the bearish side of the fence. Secondly, a bearish phase is usually preceded by a breakdown in equity market internals, again up until a few weeks ago equity market internals were very healthy this is evidenced by the Russell 2000 making new highs and outperforming the Dow. One could also argue that usually there is a sell-off in risky junk grade corporate bonds. Yet prior to the 1st of May junk grade bonds were registering multi-week highs.

Perhaps more perplexing is how the sell-off has come on the back of no observable change in fundamentals for stocks. When I mean observable I am referring to company earnings, company earnings guidance and even analysts earnings forecasts. It seems that everyone has taken complete fright over the whole Greek debt crisis (ok it actually is a little broader than that now). Yes I am well aware that the market is selling off because it is factoring in a slow-down on the back of a “austerity” measures. But one wonders just how much government spending helped the lift the average company’s earnings over the last 12 months in the first place!

Of course there is something else that I am finding difficult to get my head around……should one go short now, given that;

•  major market indices are down some 10% in a space of 4 weeks,
  
• sentiment (as measured by the ratio of stocks trading above their 50 day moving average) is at levels now comparable to early March last year,
  
• no significant support line has been broken in equities, commodities, treasuries, corporate bonds.
  

I certainly don’t want to be accused of being stubbornly bullish, or even a perma-bull, but I refuse to walk on the bearish side of the fence until there is complacency towards risk. A quick glance at blog sites suggests that the general crowd is far from being complacent towards risk. That being said, if the big support levels (as depicted in the charts below) are broken) I will have to either hedge long positions or heaven forbid turn bearish. We have already done so in high yield currencies.









Note it is only currency markets that have broken important support levels. That is real worrying because from an inter-market perspective problems in world financial markets more often than not first show up in currency markets.

We’ve all had some fairly exciting time of late. We are a global macro fund and most of what we do is aimed at identifying the longer term trends and positioning for conditions 2+ years hence. Market movements like we have seen over last few weeks have happened before and will happen again. Our role is to discern if we are experiencing a change of trend, or just normal market movements.

We’ve written numerous times of our belief in on-coming inflation and commodity price increases. Now is an opportune time to return to the this theme and ask; have the longer term themes of rising commodity prices survived the recent turmoil, or do we need a new set of assumptions?

To this end we are going to look at the relationship between CCI and UDN. The Continuous Commodity Index (CCI & the old CRB index) is based upon an equally weighted basket of 17 commodities and so is a reasonable indicator of supply & demand. We use it in an inter-market sense, both as originally devised as well as an indicator of equity and currency trends. UDN, on the other hand, measures short USD futures. Based upon the USDX futures contract, it attempts to replicate short USD against a basket of currencies (mainly EUR, then a varying mix of YEN, GBP, CAD, SEK, & CEF).

y looking at CCI verses UDN we are measuring the price trend of commodities removing the effect of the USD. Concentrate now, as there is much to be gleaned from this measurement.

One would expect that a that a rising USD would be bearish for commodities. But these are not normal times. A rising USD is usually seen as bearish for US interest rates as well but nobody expects interest rates to go lower than the extraordinary low levels as now. One also might be thinking that the rising USD has removed an inflationary threat.

However, what we are not seeing is commodity prices turning bearish in non-USD terms. This tells us a number of things; most importantly that there is real strength in commodity prices. This strength will only increase as the worlds economies gradually improve. The most likely outlook is that commodity prices will continue to increase against all Fiat currencies.

And so to answer our question; we think the longer term commodity trends are still in place. This is not apparent to the casual market observer who may be equating rising USD to bearish commodities. Keep in mind that markets can, and do move counter to fundamentals (and stay irrational longer than one can stay solvent!) for long periods.

Being macro traders will hold our positions for the long term (years, not days or weeks).

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!

It is that time of the week again to take a long hard look at our view on the markets, to look at critical pricing levels of the major asset classes and to try and interpret what the market is telling us or should we say understand where it wants to go. We try to keep things very simple, our underlying philosophy goes something like this;

1. The future cannot be predicted if it could then actions taken now would change its course. Humans just cannot cope with the unknown, it could be said that superstition is mans way of dealing with the unknown.
   
2. Markets are driven by broad based themes, or some sort of “force”. These broad based themes last for considerable lengths of time, months even years.
   
3. The market will do all it can to keep the average investor from making money, that is, it will do whatever it can to keep weak hands out of the market. Peter Lynch highlighted this fact when he said that the majority of investors in the Magellan Fund lost money while he ran it, even though for some extraordinary length of time it was one of the best performing mutual funds in the US
   
4. People need drama in their daily diet….and that is what the media feeds us.
   

The media and popular market commentators would have us believe that the “austerity” measures taken by European nations is going to affect the global economy/economic recovery and the price of fish in New Zealand. They would also have us believe that there is a reasonable probability that the EU is going to be disbanded and that it is all over for the Euro. We have no idea of what is going to happen to the Euro…….but we will say that this sort of commentary is  “text book classic” of that which occurs either at or very near a cyclical market bottom. Let us not forget all the commentary that predicted the end of the world as we know it back in October 2008 and the 6 months that followed! We find it rather amusing that most of the doomsayers who were predicting the end game in late 2008/early 2009 are the very commentators who are predicting the end of Europe and the Euro right now!

In all the 8 charts below representing all the major asset classes  from a global perspective note the degree to which they have all advanced (fallen for US treasuries) since the depths of 2008. Markets do not move in straight lines, they weave their way in a general direction.  Every time a linear trend becomes apparent it indicates that too many weak hands have entered the market and accordingly it goes through a cleansing action. We think that this is what is happening right now across the different asset classes. Yes you may well argue that “this time it is different”……..it is all about the concerns about the PIIGS. Well if it wasn’t PIIGS it may well be GOATS or SHEEP or some other bizarre reason.
The good news is that weak hands have been taken out of most markets. If the carry/yield/risk/inflation/growth trade was popular a few weeks ago it certainly isn’t so popular now. Yet what has changed? Certainly from a fundamental perspective little appears to have changed, in fact economic and earnings releases appear to have improved. From a behavioural perspective we see absolutely no evidence that any key pricing levels of the major asset classes has been breached.
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Of course from the charts above you will notice that in a number of instances the market is treading alarmingly close to the “edge”. Will it topple over? A bull market is a bull market until proven otherwise. Perhaps it is too simple for most to accept!

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.

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The beginning of another collapse? Well reading through blog sites (the best means by which to gauge the mood of the market) would have us believe that it is a foregone conclusion that it is about to happen…….equity markets have peaked out, gold is about to go to the stratosphere along with US treasuries, the Eurozone is on the verge of breaking up, and the USD is going much higher!

The level of bearish commentary is rather intriguing in that it is reminiscing of the depths of 2008! I really struggle to find any commentary that is remotely bullish! It is very bizarre because this level of bearish sentiment is usually found after a dramatic move to the downside not before…….that is material falls in equity markets are usually preceded by a high degree of complacency.

OK so equity markets have yet to break down (we have yet to see the major market indices close anywhere near multi-week lows, most are only a few percent away from multi-week highs). But what are leading indicators doing; do we see any evidence of breakdowns? Again prior to material downside in equity markets we usually see risk assets lead the bearish charge. Let’s have a look at a few indicators outside of the equity market for bearish confirmation.

First let us look at the spread between emerging market sovereign debt and US treasuries. Historically, blow outs in equity markets have been preceded by investors running to the relative ”safe haven” of US treasuries. From the graph below we did have a blow out last week but by hook or crook the spreads have since come back down……no multi-week high here (a multi-week high would be bearish for equity markets).

Secondly, has the cost of insuring junk grade debt from default increased relative to investment grade corporate debt? The graph below is a custom index of the US CDS index of investment grade relative to the CDS Index of Junk grade debt. A rising index indicates that it is costing relatively less to insure junk grade debt from default relative to investment grade debt. Accordingly a rising index is bullish for equity markets. Yes you could argue that it is topping but as yet there is no breakout. We will believe the breakout when (if) we see it.

Thirdly, problems in equity markets are usually preceded by a breakdown in the so called carry trade. The graph below is the DB Currency Harvest Index, the index on which the ETF DBV is based. No breakdown yet, in fact just two weeks ago it was trading at a multi-week high.

So for the time being at least we have yet to see breakdowns in the very asset classes/securities/indicators that usually precede a general breakdown in the equity market. Given the level of bearish sentiment out there one could argue that if they haven’t broken down now they are unlikely to breakdown anytime soon.

A bull market is a bull market until proven otherwise. Yes it is lonely out there being a bull in a sea of bears!

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.

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.