A Longer Term Perspective on Today’s Markets

Another week, another 1% climb in the S&P 500…bond yields coming back in slightly…commodities starting to move a bit more sideways…Dollar pulling back. Ho hum. For this week, with the short term macro picture not giving us much to get excited about, we will step back to take a longer term view and consider where these markets might be heading…

Please visit me at Seeking Alpha on Monday to read what I hope will be a timely and helpful analysis of the financial markets from a long term trend perspective.

Japanese Stocks Power Ahead

Several weeks ago I made a passing reference in a weekly review to having begun to take an interest in the Japanese stock market, as it was starting to show signs of positive movement. This trend has continued and in recent days the iShares Japan ETF (ticker: EWJ) has begun to accelerate and outperform the S&P 500:

The relative strength is most commonly attributed to Yen weakness, which would be bullish for the stocks of export driven Japanese firms. Over in the currency markets, there is talk of the Yen carry trade reviving. This is a trend we should watch as it is potentially profitable.

Contrarian Data Point of the Day

Courtesy of Reuters, BofA-ML fund manager survey finds stock bullishness at a new 10 year high. Early market action is down following retail sales miss.

Whether this marks a short term top only time will tell, but with the market as extended as it is, we need to be vigilant. The more extended the market, the faster and sharper the correction when it comes. We have some nice gains built up, let’s hold on to them.

Michael Pettis on China Stock Outlook

Our favorite China analyst is out with an informal projection of Chinese stock market performance for this year. The full text can be found here:

 

Highlights:

The first and most obvious question now is whether the latest interest rate hike will hurt the market.  I am pretty sure it won’t, except for some of the most obviously liquidity-dependent stocks, like real estate developers…

In general I think ample liquidity is going to drive stocks higher until at least the end of the summer (assuming of course, perhaps unrealistically, that no more countries unexpectedly fall into default or revolution).  But later this year I think a lot of people are going to be rethinking their positions, and investors should be prepared for a rocky end of the year…

…by the end of this year a lot of insiders are going to be wondering about the policy objectives of the new leaders and whether it is indeed true, as the rumors have it, that they are uncomfortable with the current investment-driven growth model.  Any revision of the model will inevitably have big impacts on growth, profitability, and commodity prices.

But until then the market should be strong…

There you have it. His outlook in brief seems to favor being long until the end of Q3, and out – or perhaps short for the more intrepid – some time in Q4. As always, we’ll do our own analysis and let the market data lead our positioning.

In the interest of full disclosure, I am long the iShares FTSE China 25 and the Matthews Asia Dividend funds.

The Week Ahead, Feb 7 – 11

It’s time for a little exercise in humility. Over the past couple of weeks I have been looking at the markets and thinking it was time to lighten up on risk positions. In last week’s post I suggested it was time for the risk off trade, and could hardly have been more wrong…and no, I’m not going to cop out and say I wasn’t wrong, just early. If you’re trading, early is wrong! So here is a mea culpa: I just blew it, pretty much completely. Now, with that said, let’s take another look at the markets.

Week in Review

Stocks: Every S&P 500 sector was up last week, with a clear inflationary bias: the leading sectors were producers of commodities – Materials and Energy. The lagging sectors were users of commodities – Utilities and Consumer Staples. The signal couldn’t be more clear if it were painted across the sky. The market is positioning itself for inflation. The SPX gained 2.7%, small caps over 3%. Foreign developed and emerging markets also posted gains, albeit smaller.

Bonds: The ten year US Treasury yield jumped 9.5% on the week, breaking out of a seven week channel to finish near 3.7%. In keeping with the risk on theme, junk bonds continued to rally, but every other major bond sector sold off. Holders of the long bond saw the value of their paper fall nearly 3% on the week. More inflation signals here.

Commodities: It was a week of high volatility in food commodities. We saw grains go limit up and limit down in the same day, livestock rising early in the week and falling later. Trading was all over the map as this was where the hot money was in play. Energy was relatively tame, with a soft tone as both oil and natural gas fell, West Texas crude ending under $89 a barrel.

Currencies: We saw a mid-week reversal in the currency markets, starting with US dollar weakness and euro and Yen strength, and then moving in the opposite direction. Rising commodities brought strength in the Aussie and Canadian dollars, with both approaching recent highs.

The Week Ahead

Stocks: The US stock market looks as extended as it did three weeks ago, key technical indicators still signal caution, and to that extent the risk averse outlook remains valid, but we shouldn’t forget that the most important indicator is price, and there’s really nothing in the price plot of the SPX (see below) which suggests an imminent correction. I have lightened up on stock positions, as regular readers know, anticipating one.

However, we did see a modest correction in the small caps. Note that the rate of change on the RUT has broken out of a declining trend.

One of the foundational principles – don’t fight the tape – has kept me from going short. For this week, I’m standing pat in my stock positions, and will be watching to see whether the small caps break to new high ground for a buy signal. It seems very possible that, rather than an imminent correction, we could be looking at another leg up in stocks.

Bonds: Not much ambiguity here. Yields have broken out of a base and this is a fairly clear sell signal for Treasuries:

Investment grade has felt the heat from commodity spikes and Fedspeak as well:

I see no reason to hang around and wonder about this, preferring to hit the sell button and preserve capital when trouble shows up. It was only a few weeks ago that I was short bonds. I don’t intend to go short again just yet, but will be keeping an eye on this market.

Commodities: This is where the action has been, as noted above. Not being a big risk taker, I have been perfectly happy to watch the party from a distance. Here’s a look at the broad CRB…seems to me this party might be running out of steam:

The softness in the CRB is coming from energy, which is quite remarkable considering the ongoing turmoil in the Arab world. The most interesting chart of the week, in my view, is West Texas crude. Note that we have a convergence of the bottom of the rising wedge pattern, the key $90 mark, and Friday’s closing price. My suspicion is that this is significant, and the next move could give us a profitable trading opportunity.

Currencies: Let’s drop back and take a longer view of the US Dollar. On the chart below, we look at a price plot since the start of the financial crisis. We can draw a price channel, noting that there were large spikes outside the channel following the Lehmann collapse, the Q1 2009 panic, and the May 2010 flash crash. We’re now at the bottom of this rising trend. It is important for the Dollar to hold this level and, with yields having risen sharply in recent days, I suspect it will.

Now a shorter term look at the Dollar, euro and gold:

Uncle Buck, to use Dave Fry’s pet term, seems to be holding up reasonably well. If we see Dollar strength in the coming days, it may lend more support to the view that the commodity rally, and perhaps the risk asset rally in general, may be winding down.

In summary, the risk rally is still on, I still find it suspect with unfavorable short term risk/reward , and will be in wait and watch mode going into the coming week. After making a bad call on market direction, it’s time to refocus on the data, rethink, and let the market tell me what it wants to do.

Good luck, happy trading, and as always be careful out there.

The Week Ahead, Jan 31 – Feb 4

And so it began, with an unexpected catalyst, but the rally reversal we have been anticipating for the last couple of weeks appeared to arrive with the unrest in the Arab world. Let’s get into the details and look at the week ahead.

Week in Review

Stocks: The eight week winning streak of the Dow Industrials came to an end as video of tanks rolling through the streets of Cairo led stock investors to hit the sell button. Friday saw 85% down volume on the NYSE, nearly 90% on the NASDAQ. Small caps, which we noted last week were already in a correction, had been staging a recovery but gave up nearly the entire week’s gains. The SPX ended down fractionally.

Bonds: Bonds were up pretty much across the board on risk aversion, the exceptions being high yield corporates and foreign sovereigns. The 10 year Treasury yield fell again to finish at 3.32%. Emerging market bonds, which had been much in favor for so long, have had a particularly tough time of it.

Commodities: West Texas crude had a big day on Friday, reversing several days of losses, and closed up fractionally for the week – yet still finished below the $90 mark. Natural gas, whose positive price trend we noted last week, was off by more than 8%. Gold also got a Friday bounce from the fear trade, but was off for the week, as were the grains.

Currencies: The US Dollar index spent most of the week building a base just under 78, before benefiting from safe have buying on Friday. The Swiss Franc was another winner, while the euro and commodity linked currencies dropped.

The Week Ahead

Stocks: Clearly the start of the week will be dominated by events in the Middle East where, as of this writing, it looks like the Mubarak government is on its last legs and the unrest has spread beyond Egypt. This should keep stocks on the defensive, but there was a softness even before the protesters took to the streets. Earnings reports from a number of companies, such as Amazon, Ford and Microsoft, were not well received and there was a negative tone in after hours trading on Thursday. We have been looking for an imminent correction for a couple of weeks now and, while there is some debate about this in the context of news-driven selling, it really doesn’t matter. Selling is selling, and that’s enough. We’re playing defense this week.

Bonds: There is a lot of negativity on the US Treasury and municipal bond markets due to the longer term fiscal outlook, and in the long run it may well be justified, but the near term picture for bond investors looks more positive. The 10 year Treasury yield has been in a range between 3.3% and 3.5% for a couple of months now, and showed no sign of going higher in spite of rallies in stocks and commodities. Municipals are recovering from their rout and have broken out of the downtrend. The near term picture looks constructive.

Commodities: Geopolitical concerns have stepped in to check a reversal in the commodities, so the near term outlook is more positive than it otherwise would be. Oil has broken a short term uptrend and, while there may be a long side trade on the news, I prefer to stay on the sidelines for this one. Gold, which has been correcting for a few weeks, may also be the beneficiary of a brief fear trade, but the trend is down…and it seems to me it has farther to go.

Currencies: The US Dollar is at a support level, and given the situation, has a good chance to hold it. There is no denying that it has been selling off hard, but with a generalized weakness in risk assets we may well see 80 before we see 76.

In summary, for this week my position is bearish on stocks and commodities ex oil, bullish on muni bonds and Treasuries, and neutral on gold and the Dollar.

Good luck, happy trading, and be careful out there.

The Week Ahead, Jan 24 -28:

The week ahead is setting up to be an eventful one, as we will get data on housing and durable goods, and there will no doubt be more discussion coming out of the eurozone, all in the context of financial markets that are showing signs of a turn. Let’s get to the details.

Week in Review

Stocks: The market was speaking to us last week, and it was telling us to be cautious in several ways. One was the performance differential between the largest stocks and their smaller counterparts:

Another was the difference, with the S&P 500, between defensive and cyclical sectors:

Still another is the performance of a market leader:

The noise: the Dow was up for the week, extending it’s winning streak, and former market darling GE gained 5% on a strong earnings report. The signal: market internals are deteriorating appreciably.

Bonds: There wasn’t a great deal of noteworthy action in the bond market aside from a modest relief rally in the ongoing muni bond rout. Yield on the benchmark 10 year Treasury rose 2.5% for the week to finish just above 3.4%. Sovereign eurozone bonds gained on talk of monetization by the Financial Stability Fund in attempt to cap yields, though it wasn’t clear whence the money would come.

Commodities: If we were simply to look at the weekly change in the CRB index, we might think nothing happened; however, as usual in the commodity space, beneath the calm surface was much movement:

The big winner was the March natural gas future contract, up over 5% and extending what looks like a rally…more on this below.

Currencies: The US Dollar was off 1%, euro up 2%, the other major currencies up ordown fractionally. Apparently the market was buying what the eurozone policy makers were selling. Hmm…

The Week Ahead

Stocks: While all the major indexes are above their primary moving averages there has been, as we noted, marked deterioration in the internals. Tuesday we saw a surge in volume with little price advance followed by a couple of days of selling and a failed rally attempt on Friday. Foreign stocks have also been selling off, notably including the relatively strong Korean market. This suggests to me that the risk/reward picture for the coming week is tilted toward the risk side, so I have further reduced long positions and raised more cash.

Bonds: The interesting sector, to me at least, is the municipals. We have seen a pretty drastic selloff fueled by concerns about the condition of state and local government finances, the end of the Build America program, and Republican efforts to introduce state bankruptcy legislation. Last week the munis had a bounce that looked similar to previous failed rally attempts in mid November and mid December.

Will the third time be the bottom? It’s too early to tell, but note the technical divergence on the chart below: the rate of change and money flow into the iShares national muni fund (MUB) have been improving even as the price has continued to trend down. Yields in this bond sector are more attractive than any other; investors just need to understand the risk. In the interest of full disclosure, I hold open and closed end muni funds in taxable accounts, but do not hold MUB.

Commodities: There are a number of different things going on here. Precious metals, though they do have their intrinsic fundamentals, had been rallying on fiscal and monetary stability concerns. That rally appears to be slowing, with selling pressure on volume. Oil had gotten ahead of the supply fundamentals, and seems unable to hold a price above $90. Agricultural commodities on the other hand are rallying in line with their fundamentals, and this rally appears more durable. In particular, I think there may be opportunity in livestock futures, as the spread between corn and the live cattle and lean hogs is unusually wide.

Another area I find interesting is natural gas, which has been a late participant in the energy rally. It’s a commodity that has given me good gains in the past, but I’m hesitant to jump in here, as the inability of oil to hold 90 suggests there isn’t strong across the board price pressure in energy.

Currencies: There isn’t much new to say here; the activity remains largely driven by political moves. I simply am a euro skeptic, so you know where my bias lies, because I still don’t see how they are going to make the numbers work. If I were trading this, which I’m not, my strategy would be to sell euro rallies and buy Dollar pullbacks. There are easier ways to make money.

Summary

As stated above, I don’t care for the risk/reward or the internal rotation, and have been trimming long stock positions for several weeks now in anticipation of a correction. However there is no reason to think it will be anything more than a garden variety and perhaps overdue adjustment. My outlook for precious metals is similar. Bullish on agriculture. Neutral on oil and natural gas as well as bonds, where I would be looking for yields to fail at recent highs before buying.

The Week Ahead: Jan 17 – 21

Sometimes you get it right, sometimes…not so much. Last week my short term outlook on the markets was to play defense and look for an imminent correction in commodities and US Dollar strength. Needless to say, I blew that one. Before we look at the next week, let’s review last week’s action.

Week in Review

Stocks: The rally in US stocks continued as the SPX added 1.7% for a seventh consecutive week of gains. Sector action was growth oriented, with energy and financials both up more than 3%, tech up 2%, and the defensive sectors bringing up the rear. The telecom sector actually posted losses, investors seeming to fear a margin sapping iPhone price war between AT&T and Verizon.

Bonds: 10 and 30 year Treasuries and investment grade bonds were nearly unchanged on the week, but there was renewed carnage in the muni market, with prices off ~3% as heavy mutual fund outflows continued. Foreign sovereigns, on the other hand, posted big gains on what appeared to be good news on the eurozone front – however, they did not fully recoup the prior week’s losses and remain well below October levels.

Commodities: The various commodity groups went in different directions. Oil jumped 4% on the week and closed above $92, off the high but still showing strength. Agriculture also moved up, led by a nearly 5% rise in the Dow Jones grains index. On the other hand, precious metals fell again, gold closing below the 50 day SMA for the first time in five months. Selling volume has been on the heavy side.

Currencies: The US Dollar index fell sharply to close at the support level a few ticks above 79, barely remaining in the range we have seen since November. Of course, the euro index rose just as sharply, on new optimism as mentioned above. Interestingly, with commodities rallying, the Aussie and Canadian dollars were little changed.

The Week Ahead

Stocks: The stock rally continues to roll along, and though the market looks extended according to some technical indicators, and momentum in the SPX is slowing, the trend is the trend. There is nothing to indicate that it is about to turn. I have taken some of my profits and lightened up on long positions, but am not completely out of this market. At this point I’m standing pat, waiting for a correction to add to longs, but can’t say when we will see it.

Bonds: The sudden surge in bond yields after the Fed’s QE2 announcement appears to have ended; the benchmark 10 year Treasury peaked a month ago and is spending a lot of time in the 3.3 – 3.4% range. This is rather remarkable when you consider what has been happening in the commodity markets. I have made the comment before and will make it here again: when there is an apparent disconnect in the financial markets, my tendency is to go with the bond traders. They don’t seem terribly worried. Having said that, I still don’t find yields very attractive on Treasuries or investment grade issues.

Muni yields, on the other hand, are beginning to look very interesting – they are back to levels last seen more than two years ago. Now, I’m not going to recommend trying to catch the proverbial falling knife here, but there is a case to be made for considering whether the bear case is overdone. This selloff smells of panic, and panic usually means opportunity. I took a position in a closed end muni fund in December 2008 that has been very good to me. This market is beginning to look quite familiar.

Commodities: We just made reference to commodities in the context of bond yields. In the short term oil and grains remain in confirmed uptrends but the bond market appears unfazed. Here we might benefit from taking a longer view. The CRB index has retraced very nearly 50% of the move from the June 2008 high to the March 2009 low, and sits 5% away from the 350 level, which was resistance through most of 2006 and again at the end of 2007.

Whether the index can break through that level will be very interesting. If it does not, we will be looking at a large head and shoulders top. If it does, then the June 2008 highs are wide open…and this will be a problem for stocks and bonds alike, to say nothing of the economy as a whole. At this point I’m not making a call, but staying on the sidelines until this picture resolves.

Currencies: The real action here is in the euro, with the consensus expectation seeming to be that the meeting of finance ministers on Monday and Tuesday will bring strengthened commitments to the stability of the common currency. Given the composition of the respective indexes, the rise in the euro index almost by definition equates to a fall in the Dollar index. This is a situation where the market is not moving due to normal economic activity such as balance of trade, yield differentials, etc., but due to the effects of political activity.

In that context, it’s difficult to analyze these markets in the conventional way. All of which is to say that I don’t necessarily see the recent slide in the Dollar as either fundamentally warranted or indicative of any particular direction in the markets in the short term.

In summary, for this week my outlook is cautiously bullish on stocks and commodities and neutral on bonds…but I remain overweight cash and looking for a correction to add to stock positions.

Good luck and happy trading!

The Benefits of Diversification?

Apropos of the announced acquisition by Russell Investments of fledgling ETF provider US One, here’s a little exercise to evaluate the product.

US One’s lone offering is called “One Fund” (ticker symbel ONEF), an ETF which holds a portfolio of other ETFs in order to provide investors with a globally diversified portfolio in a single holding. Their approach is passive and capitalization weighted indexing intended to capture 95% of the global equity market.

In it’s short existence – the fund has been trading since May 2010, how has the diversification benefited investors? The correlation between ONEF and it’s largest holding, Vanguard’s US large cap ETF (ticker symbol: VV), listed on the sponsor’s website as 48.73% as of this writing, is .988.

While the sample size is too small to make for a definitive conclusion, at this early stage the benefit of diversification is nearly non-existent. For what little diversification it does provide, the investor is paying an expense ratio of 0.51% as compared to 0.07% for the Vanguard fund. Is it worth the extra expense?

The Week Ahead: Jan 10 – 14

Having taken a longer range view of the year just ended, and the long range themes for the new year, it’s time to return to our regular weekly survey of the markets.

Week in Review

Stocks: The market began 2011 in a buying mood as the first day of trading saw gains following the opening bell. From there it was choppy trading, with reversals on Tuesday and Friday, the SPX finishing with a gain of a little over 1%. The tech sector led the way with a rise of better than 2.6%, while consumer staples lagged, posting a loss of nearly 1%. Several leading consumer companies, such as McDonalds, Coca Cola and Target, sold off hard on strong volume. Some analyst commentary suggests that these types of stocks could be leading the market in terms of direction, so this is a development we need to watch in the coming days.

Bonds: The yield on the benchmark 10 year Treasury note, after rising steadily since mid October, seems to have found resistance at the 3.5% level, and has been in a range between 3.3 and 3.5 for several weeks now. It closed at 3.32%. The 30 year yield is finding resistance around 4.6%. For now it appears the rout in Treasuries has ended. Corporate bonds also began to find some support in mid December and have staged a bit of a recovery rally, as have TIPs. Munis and foreign bonds, on the other hand, still look weak.

Commodities: The broad CRB index pulled back 2.6% on the week, Commodities that had been rallying most strongly gave back the most: silver nearly 7%, gold 3.6%, the agriculture group 3.4%. Oil fell more than 3% to close at $88.41 per barrel, and could be falling back into that long trading range after a brief break out above $90.

Currencies: The US Dollar jumped nearly 2.6% for the week, resuming its post-election and post-QE rally. The euro, with the holiday cheer having worn off, fell 3.6% on the by now familiar concerns. The Swiss Franc, Aussie Dollar and Yen all saw significant drops as well, albeit for varying reasons.

The Week Ahead

Stocks: In our look at the macro picture for 2011, a good probability of a correction early in the year was a part of the outlook. My sense is that we are looking at it here and now; to that end I took profits on a couple of my energy stocks in the trading portfolio. It may be early, and I can (and probably will) buy them back later, but the moves in some key stocks, as well as the Dollar and bond yields, lead me to think the coming week will see sellers take the lead. Taking 30% and 17% profits in 6 months isn’t a bad outcome. One market I have been watching for several weeks and will mention here is the Japanese stock market. Just looking for now, but with keen interest.

(click on charts to enlarge)

Bonds: As mentioned in the review above, the rise in yields has broken. Although my near term outlook was for the rising trend to continue, and the chart tends to support that view, my longer term outlook is not as bearish as many analysts out there. With the moves in the markets last week, and my profit taking mood, I closed out my short position in long term Treasuries in the trading portfolio, booking a 22% gain in 90 days. For this week my near term outlook is neutral as yields stabilize.

Commodities: My near term outlook here is less ambiguous – and it’s negative. While commodities remain in longer term up trends, they had gotten well ahead of the fundamentals and are due for a correction. In the precious metals group, while the metals themselves are pulling back, the miners’ stocks are getting hammered – Silver Wheaton down 14%, Pan American and Hecla off 11%, Anglogold Ashanti down 9%…all on heavy volume. At this point I have no commodity positions open and, were I feeling more aggressive, would consider trading the short side on a bounce, as the correction looks to have more room to run.

Currencies: Regular readers know I have been a US Dollar bull for some time; to me this trend looks intact. Simply put, the US is – despite all the posturing and rhetoric – getting on with the business of putting its affairs in order. While serious issues remain, as compared to the problems facing Europe and China, the US is in relatively good shape. While I am not much inclined to trade currencies directly, this does set the tone for trading in all the other asset markets, and my position is to trade them with an outlook for a firm Dollar.

In summary, my stance for this week is defensive across the board, overweight cash and looking for the next directional signal.

Good luck and Happy Trading!