The Daily Trading Report

Well I guess that headline puts the cat amongst the pigeons! Yes it is well publicized that the Shanghai Composite has entered a bear market. Looking at the chart below me cannot disagree. In fact I don’t know if there are any market technicians who would disagree with this assertion. But is the Chinese stock market in a bear market? 

Shanghai Composite


There is more to reading the market than merely looking at a market cap index. As far as I am concerned a bull market is a “condition” “theme” (call it what you will) that lifts all stocks, that is, a bull market is where the “average listed stock” is engaged in an up trend (an up trend can roughly be defined as a series of higher highs and higher lows).
 
Market cap indices do a rather bad job at depicting the behaviour of the average listed stock because over 80% of their performance is accounted for by less than 20% of the members (well something like that). As an individual investor why should I place more emphasis on the behaviour of GE than say Colt Firearms? If I took my monkey and told him to choose 30 stocks out of a universe of NYSE listed companies (I think there are about 2500) what would this portfolio look like? Well it would not look anything like the Dow or the S&P 500! Yet everyone is obsessed at analysing the behaviour of the major market indices! This is why we like to use equally weighted indices to gauge the behaviour of the average stock or should we say the broad market.

OK getting back to China…….what if we took all the components of the Shanghai Composite and equally weighted them. What would the market for the average Chinese stock look like then? Well look at the chart below, it is just that – a Chinese version of the US Value Line Index! Now beauty is in the eye of the beholder, reconciling the Shanghai Comp and the Equally Weighted Chinese “Comp” reveals that the average listed Chinese stock is not looking so sick after all, at least not any sicker than the average European or US listed stock. I will go so far to say that because the average listed Chinese stock has not made a lower low the Chinese stock market is still engaged in a bull market!

Shanghai Comp (components equally weighted)


OK this is not to say that the average listed stock in China is not going to register a lower low over the coming weeks. But a bull market is a bull market until it isn’t. I guess there is an old Chinese proverb that says: judge a man by his actions not words. We judge a market by its actions not the words of analysts/commentators or “news reporters”.

 It seems that every day the financial press comes up with something new to rally the bears into offensive positions…………but little does the average bear realize that the bulls are starting to push through the bears’ lines where they are least expecting. Yes everyone is fixated on the 1105 level on the S&P 500, as if it were the only stock index in the world that mattered. However, there are a number of markets that are starting to break out of their short term consolidation ranges, take a look at the European markets (as per the Bloomberg Euro500) and Australia (ASX 200), and Hong Kong (Hang Seng). One of our favourite indices is the ASIA APEX Index (in essence Asia ex Japan and Australia). It too has broken higher as per the graph below:

MSCI ASIA APEX 50 Index

However, we are not out of the woods yet. We have to see confirmation of a breakout in Asian equity markets by Asian Currency markets.

JP Morgan Asia Dollar Index


The JP Morgan Asian Dollar Index (ADXY) remains locked in a trading range, and until we see this breakout we will remain nervous bulls…..  

What if the Euro was to “bounce” to the 1.30 level over the coming days? Where would equities, commodities, high yield bonds and currencies and treasuries be then? I don’t think it takes a rocket scientist to work that one out. Now what are the odds of the Euro getting to 1.30 over the coming days? Well let me put a different spin on that…….given that short positions on the Euro are at record highs and sentiment is so bad that the Euro is now talked about at dinner parties, cocktail events, and it now graces the covers of magazines (like Newsweek) and newspapers, it is difficult to work out just where the marginal bear/shorter is going to come from. When markets get to such extreme oversold conditions it does not take much to spark a “short covering” rally from the depths of the earth. What is likely to be the event that ignites a short covering rally? Well it is likely to be as insignificant as the “leaked” document that indicated that Citigroup was profitable in the 1st quarter. If this is over your head this was the proverbial “final straw that broke the bears back” in early March last year!

Anyway I have tried to put this blog together quickly today and perhaps I have not got the words out in the way that does my reasoning/thinking justice. Let me say this, intermarket correlations are either at or very close to record highs. If you are bearish equities then by “default” you are bullish the USD, which by implication means that you are bearish the Euro. Now being short the Euro is perhaps one of the most crowded trades in modern history (maybe second only to being long TMT stocks in February 2000). The essence of The Art of Contrary Thinking  “when everyone thinks alike the opposite is most likely to happen” rings loud in my ears.



It is interesting to note that the US stock market has not broken support levels, and perhaps more importantly the Russell is only a good 10 days away from breaking to multi-week highs again. Have you looked at how the STOXX 600 is behaving lately? Have you seen how emerging markets are close to breaking out of their three week old trading range?

The CCI remains above the key 450 level (that is important to us only). Again given that the CCI has not collapsed given how strong the USD Index has been over the last few months says something in itself. Also note that the JOC Industrial Commodity Index has NOT broken below its February low. We believe that the next big move for commodities will be up. Anyway above 450 on the CCI bullish commodities, below bearish.

Gold making the cover of the NYT, gold ATMs in the UAE, mints running out of coins, demand for Kruger Rands at multi-year highs……all the contrary signs are there for a pull back in gold over the coming days. But we would be buyers of any pull back.

The flow of funds into bond funds (more or less at all time highs)…….more signs to delight contrarians.

No multi-week low in junk grade bonds as yet, which is rather bizarre given how bearish everyone is towards “risky” assets. Yes we can see the weakness in junk grade bonds but we also see JNK and HYG and relatives EMB and PCY intimating that they want to break higher. In any event the mere fact that junk bond funds have not registered multi-week lows after redemptions mirroring those of September/October 2008 is a miracle. Again massive outflows always catch the attention of us contrarians.

If there is one concern we have it is the weakness of emerging market currencies and high yield currencies. Yes they did “breakdown” and that is a rather bearish omen from a technical perspective. But markets are set to test us and often they will break a support line just to fool us. Yes one could accuse us of not getting bearish of emerging market currencies when there is such a significant bearish break but sometimes one needs to bend the rules a little……and now is one of these times. If


Anyway if emerging market currencies and high yield developed currencies make  new lows from here we will run for the hills. Because new lows here will coincide with lows in junk grade bonds and emerging market bonds. And then we will have to stand up and say we are wrong in holding a bullish view on the risk trade. Until then we remain bulls in a sea of bears


Disclosure: long VTI IWM DBC GLD TBT CEW JNK DBV

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).