The Daily Trading Report

This Week in the Markets is a weekly series that describes, at a very high level, how we manage our long-term portfolio. We use John Murphy’s inter-market ideas, looking at the performance of equities, bonds, commodities and foreign exchange markets. We attempt to measure appetite for risk, and from that draw conclusions on whether to go long or short these asset classes.

We have various proprietary market algorithms, risk and commodity indicators that we use. But they are for another article. What we show here is intended to be understood and acted upon by investors of every level.

Before we begin let us just remind ourselves that the Euro has not broken down over the last few weeks, despite a backdrop of unprecedented bearish sentiment. Definitely where the action will be this week; more on this further down.

World Equity Markets

The Dow Jones World and Dow Jones World Small-Cap indices are as broad based as you can get. Over the last week investors have demonstrated that they feel equity markets are undervalued and that appetite for risk is back.

US Bond Markets

Here we look at US Government Debt (as measured by TLT – 20 Year Bonds) and US Corporate Debt (as measured by JNK – Corporate grade debt). We see this relationship as risk appetite indicator.

TLT appears to have resumed its downward momentum, whilst we see steady support for JNK. This tells us that investors are increasingly prefer corporate grade debt compared to government debt.  In other words, investors are prepared to risk their capital on the higher, but riskier, returns of business.

From this we conclude that risk appetite is increasing, or at the very least not decreasing. Hence we will maintain our short TLT and long JNK positions.

Commodity Markets

We use commodity prices as indicators of supply and demand for physical things, be it food, railways, motor vehicles, electronic goods, etc. Increasing prices indicates increasing demand (it may indicate decreasing supply of course – but this is one reason why use such a broad index).

In our view all investors should be regularly reviewing commodity price trends across a range of currencies.

Gold has been in the news of late. With several notable fund fillings indicating that they have taken large positions, along with several government treasuries increasing their holdings.

We think that this indicates a long term lack of confidence in US Treasuries to hold their value. The key phrase here is “long term”.

We will stay long Commodities and Gold and are prepared to hold these positions for a number of years.

Foreign Exchange

We’ve mentioned previsously that shorting the EUR/USD was the single most crowded trade that we’ed ever seen and were going to sit this one out (actually, just to be contrarian, we took a small long option, that is now in the money!)

We suspect that there will be some disappointed EUR/USD speculators out there, and would not be surprised to see a short-covering bounce soon. Those who utilized long term options for their shorting should be fine. Those who traded spot may be re-thinking their positions right about now.

Also note the performance of DBV over the week. We expect an upwards movement as the carry trade makes a return.

As a trading outlook for the next weeks, we expect TLT and $USD to move downwards, pushing $CRB to a multi-week high.

We also think that markets have moved sideways for the last few months and pressure has been building up. Breakouts, if the come, are liable to be quite strong. We are reasonably confident of breakouts occurring over the next few weeks. Risk appetite appears to be back.

Hubris knows no bounds, and, we could be wrong.

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.