The Daily Trading Report

A multi-week high on the Baltic Dry Index, multi-week highs in agricultural, base metals and crude! A quick glance at these key commodity sectors suggests that commodities are climbing the bullish ladder…..and that, for whatever reason, it is only just getting into gear:

Take a look at this article on agriculturals (DBA)

Of course adding to the four charts above is the performance of Gold and Silver. Silver has broken above its near term resistance level, gold remains a mere “days trade” away from a multi-year high. Although we don’t have much of an exposure to gold, we have a reasonable exposure to silver and believe that there is considerable upside left over the coming weeks/months.

A bit of weakness on the Dow & Nasdaq and out the bear pundits come ….this is the start of the new down leg…. there were 30% rallies at the start of The Great Depression to…….it is just a rally in a bear market! Those are the sorts of comments that have been coming out of pages of blogs/magazines/newspapers etc. Yes, if we look at the behavior of the Dow it does look a bit bearish. It has lost upside momentum and a break below 8000 opens it up for a retest of 6600!

But wait…….this time it is different. A few months ago weakness in the equity market was associated with strength in US Treasuries and the US Dollar. However now funds are piling out of the USD and US Treasuries.

Funds are now piling into assets that, only a few months ago, were considered to be just a few clicks away from “toxic waste” status. Those assets are:

• Commodities
• All things emerging market (currencies, bonds, and equities)
• Corporate and Junk grade bonds
• High yield developed market currencies
• Equities in general (and small cap in particular)

It has been interesting to note that, to date at least, there has been no apparent weakness in the former “toxic waste” asset classes. In fact not even the talk of down grade of UK debt, or the North Koreans testing a nuclear weapon has been able to dent the appetite for “risky assets”.

We do not know what the future holds, however, we do know that markets move in broad trends and that, once in place, these broad trends last for months/years (as opposed to days/months). Listen closely to what the market is telling you…………that is all you need to know. While commodities, emerging market currencies, and junk grade corporate bonds (to name three) remain strong we believe that the weakness we are observing in US equity markets is not the beginning of a new tradable down phase and that odds favor equity markets being higher rather than lower over the coming weeks.

In April 2008 there were 3009 oil rigs in operation worldwide……….as of April 2009 this has plummeted to 2055 that is a fall of 32%! These are stats released from Baker Hughes Co. Every week BHI counts the number of drilling rigs actively exploring for or developing oil or natural gas in the US, Canada, and International markets. BHI has issued rotary rig counts as a service to the petroleum industry since 1944. This fall in rig count is one of the fundamental reasons why we are bullish on oil and oil service stocks. Of course it helps that the technical outlook is also favorable:

Gold and silver creep higher. Silver is only a whisker away from closing at a multi-week high and gold is now only 5% away from the elusive $1000 level. We believe that it is only a matter of days before both metals move into “virgin” territory:

What else makes us so confident that gold and silver will trade at multi-week highs over the coming days? It is the conclusive bearish behavior of the USD Index and US Treasuries. Both the USD Index and the US Long Bond ETF TLT are trading at multi-week highs. Experience tells us not to argue with the intentions of the market particularly when they are this strong across the board:

We try not to get too concerned with reasons as to why……we are more concerned at what is happening and whether or not there is enough evidence to support that behavior in the market. We have tried to pick just four charts that suggest the world economy is picking up. Our attempt here is to let the market do the talking……..because the market is always right, it has an unrivaled record of correctly anticipating everything…..including seemingly random events.

We have chosen, a broad commodities index (the CRB CCI), a global shipping fund (SEA), a global coal producer fund (KOL), and an emerging market small cap fund (DGS).

Commodity price behavior is objective, commodity prices go up because of demand outstripping supply…..typical behavior of a phase of economic growth. Such a phase should also be associated with commodities outperforming bonds….that is happening, CCI relative to AGG is at (albeit near) a multi-week high.

Of course increased economic activity can only take place if there is global trade……what better way to understand what is happening in the “global trade space” than to look at how the market is treating shipping stocks relative to the broad market. SEA relative to the S&P 500 ETF “SPY” is at a multi-week high. This behavior confirms the behavior of the CRB CCI index.

And just for good measure……….what commodity, that is not a member of a traded commodity index, lies at the heart of industrial activity and is the 2^nd only to crude in terms of volume shipped at sea? You guessed it – coal! If there is any “substance” to the rise in commodity prices and the outperformance of shipping stocks relative to the S&P there should also be outperformance of coal stocks relative to the S&P……yet again another multi-week high.

And, from a global perspective, what stocks are the ultimate “growth” stocks? No the ultimate growth stocks have nothing to do with sectors….or historical growth rates….or ROE. They are in fact emerging market small cap stocks. Emerging market stocks are firing both in their own right and relative to the S&P. This behavior is confirming the three charts above:

The market is clearly anticipating growth…….who are we to question the markets true intentions.

We have been rather surprised at the strength of emerging stock markets over the last few months. We were expecting emerging markets to recover, but to be honest we were not expecting them to recover well ahead of developed markets (the Dow in particular). It seems that there is more upside to come given the strength of the broad market. Note from the charts below that both large caps (EEM) and small caps (DGS) have made registered multi-week highs again and have almost made back all the losses sustained in Sept & October last year! Also note the apparent lack of a deterioration in momentum:

Why do we look at small cap stocks? They give a very good indication of the underlying mood of the market. There is something else we should take note of……and that is the performance of emerging market sovereign debt (bonds issued by emerging market countries) relative to US Treasuries. We have found that the bond market more often than not picks up problems with “risk taking” well before the equity market does. In closing at a multi-week high, the chart below suggests that buyers of emerging market government bonds are far aggressive than buyers of US Treasuries. This tells us that we should not at all be surprised to see more upside in emerging equity markets (and world equity markets in general) over the coming weeks.

Gold and Silver are getting ready to boom! Every factor   supporting higher precious metals prices is now in place.

• A bear market in the USD is confirmed. We expect a materially lower USD Index over the coming weeks/months;
  
• Commodities in general are bullish. The CRB CCI index is at multi-week highs;
  
• US Treasury markets have entered a bear market. The long dated US Treasury TLT is more or less trading at multi-week lows;
  
• Inflation protected US Treasuries (TIP) are now outperforming conventional US Treasuries (IEF). This suggests that the market is factoring an inflationary environment over the coming months (perhaps even years). Gold generally does well in an inflationary environment.
  

OK when will gold and silver break to new highs (above $1000 and $14.50 respectively)? Assuming that all the four factors discussed above remain in place (and we have no reason to believe that they will breakdown) we believe that the breakout in precious metals will happen sooner rather than later, if we are forced to put a date on it then we would have to say that it should occur within the next 6 months.

Note from the charts below the significance of the $1000 level in Gold……also note that the USD Index is looking precariously bearish trading a mere 1.2% above the last “support” of significance. The CCI is already trading at multi-week highs. Also note how the Gold Miners ETF “GDX” has made a multi-week high. Gold stocks have a unique way of anticipating the movement in gold itself…..

No matter what the US economy does, we believe that in the long-term US Treasuries are in big trouble. The 30-year Treasury has fallen 22% year-to-date. Despite this sharp fall, however, the long-dated Treasury is still yielding 4.1% which is still very low by historical standards. If the economy shows the slightest sign of recovery, long-term yields are almost guaranteed to rise from the recent lows toward more normal levels.

Yet, with so many structural problems in the world’s economy, who really believes that the economy will heal any time soon? Suppose we stay in this “recession” for a while longer, and suppose the Keynesians continue to rule the world, the government will continue to spend more to get things going again. Dwindling tax revenues will cause the government to issue more Treasuries to finance new spending. The liability side of the government’s balance sheet will continue to swell; and debt ratios deteriorate. Credit ratings, and hence prices, of U.S. Treasuries will plummet!

Of course it may not necessarily end this way. The alternative is that the Fed may emerge to make a rescue attempt. However, we already know this rescue will fail. We have already seen this move before. In March, the Fed announced that it was going to buy $300 billion worth of long-dated Treasuries. Treasuries jumped for a day or two after the announcement, but they have resumed falling since. Even if the Fed succeeds at propping up Treasuries, it will only be because of the printing press (Bernanke has famously said that he would “drop money from a helicopter”). The US Government will not default, Treasuries will be repaid, but with paper that, may not exactly be worthless, but will definitely be worth less. This has very bullish implications for commodities and certain sectors of the equity market (namely commodity and energy sectors).

Four ETFs to take advantage of weak US Treasury markets:

We are fully aware that world stock markets have largely “bounced” off their 200 day moving averages after one of the most powerful “bear market rallies” in modern history. Below is the SPDR (S&P 500 ETF), notice how it has not only failed to break above its 200 day moving average but it has also failed to take out the recent high registered in early January. Many pundits/experts/commentators (especially the eternally bearish ones) are now marking this as the turning point in the proverbial “bear market rally”.

We do have our concerns with the S&P 500’s failure to push above its January high (that would be the first sign of a higher high) and the 200 day moving average (not so important in itself but more so by virtue that everyone else seems to think that it is important). However, we are now considerably more confident, than we were 6 months ago, that a major bottom has already been hammered out by the S&P 500. This is because of the behavior displayed by credit, commodity, and currency markets. The collapse in equity markets last year was preceded by “beyond reasonable doubt” bearish behavior in the later.

Below is an innovative index compiled by Bloomberg. It is the Bloomberg U.S. Financial Conditions Index. In essence it combines yield spreads and indices from the Money Markets, Equity Markets, and Bond Markets into a normalized index. The values of this index are z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period. The chart shows that the index reached an 8 month high on Friday the highest level since Sept. 12, 2008. Based on this measure, financial conditions in the U.S. were at their worst in October 2008, and have been improving for the last 7 months. Assuming that an index level of zero is considered “normal,” it might still be some time before financial conditions fully recover, but there has been significant recovery going on for many months, and the index is headed in the right direction. In financial markets it is the journey rather than the destination which is most critical……..the mere fact that the BBG Financial Conditions index is heading in the right direction, and currently shows no sign of weakness, is all important (for the bulls).

We believe that if the weakness in the S&P 500 was real (or at least tradeable) then the Financial conditions index should have begun to show weakness by now.

Furthermore, there should also be a flight back into safe haven assets, like the USD. The behaviour of the USD Index below appears bearish with a head and shoulders in the making and the first evidence of a lower high and lower low:

A deterioration in “fundamentals” should have shown up by now in commodity prices, yet the CRB CCI Index remains at near multi-week highs. This suggests that economic “activity” is picking up and not continuing to fall into the abyss as every economist and his dog would have us believe:

Accordingly, we interpret the recent weakness in equity markets as a buying opportunity rather than reason to sell.

We have been watching the coal sector for some time. We have noticed how a “textbook” bottom formation and subsequent breakout has occurred over the last 7-8 months. In addition to the fantastic technical setups, the fundamental valuations of coal stocks are very attractive relative to the market in general. Coal may not sound that exciting given the poor outlook for energy. However, remember coal is no different than copper, bauxite, tin, crude, or even silver. It is a commodity and a currency. We have a very bearish outlook for paper currencies given the reflation efforts of world central bankers. To be honest over the next few years (perhaps a few more than we anticipate) we would rather own an ore body of a finite resource than hold cash in a bank (as it has been proved cash is infinite – central banks can print as much as they like). We also expect a weakening of the USD over the coming weeks as well, this will be beneficial to the earnings stream of US coal companies.

So perhaps the long anticipated sell-off is now taking place…..perhaps markets will rally strongly tonight and close at a new high by week end. If only we had that crystal ball! Of course two months from now we will know a whole lot more but of course by then it will be too late. We are first and foremost trend followers, not so much trend followers of stock indices rather trend followers of the mood of the market. We use a number of methods to gauge the mood of the market four of which are depicted below. Generally in times of risk aversion problems first show up in the more “risky” securities of each asset class. For bonds it is high yield corporate bonds, in equities it is the broad market and emerging markets, and in currencies it is the high yield currencies (of which the AUD is one of them). Of course there are more indicators that we could incorporate such as the performance of emerging market small caps, US micro-cap stocks, emerging market currencies like the Ruble, Real, and Rand, emerging market sovereign bonds, and commodities in general. However, we have space limitations so we have just included four below.

For each graph we have included the 50 and 200 day moving average. There is nothing special about the 50 and 200 day moving averages, they are there merely to give one a quick representation of where each chart lies based on different time frames. Bullish or bearish? Well a quick glance at each indicator reveals that they are all trading above their 50 and 200 day moving averages. Furthermore, all four of the 50 day moving averages are positive on a rolling 12 week basis. On a very short term basis weakness has only showed up over the last two days in most of the indicators below and that volatility, with the exception of the Value Line perhaps, is not out of the ordinary.

Our proposition is this: we have been expecting weakness to occur in risky assets for over a month now, so the weakness we experienced last night is perhaps somewhat overdue. That being said, we have not seen any evidence (as in out of the ordinary behaviour) that suggests markets are about to turn bearish and that there is going to be a flight to safe haven securities again. Yes, we may well be looking at material downside straight in the face but until we have enough evidence to suggest so we see yesterday’s weakness in the US as a buying opportunity not selling, our fundamental view also supports this as well.