It seems like someone or something has hit the "pump" on a macro scale. I use the term "pump" because I cannot find a better or more fitting description and perhaps it is fitting of an injection of "liquidity". Yes it is very real, just have a look at the graphs below of each asset class and the associated risky areas of each asset class. I will not be drawn into a detailed discussion on what exactly is driving the rise in equities, commodities, corporate bonds, and fall in US treasuries and the USD. We tend to keep our investment process simple by looking at what is actually happening rather than what we would like to happen to stroke our egos. In time the reasons for the current action in the market will become obvious, the problem is that the reasons we are being fed by the press of popular opinion are mere justification for what has just happened and more than likely are just random reasons.
Anyway, on to more pressing matters, is the rally in equities, commodities, corporate bonds, currencies (against the USD) and weakness in US treasuries sustainable? Well if the movement in the least risky area of each asset class is confirmed by the behavior of the riskiest area of each asset class and if recent inter-market correlations hold then one can make a very strong argument that the behavior that we have witnessed since the end of May in general and September in particular will continue. In essence, we have that condition within asset classes and between asset classes (I will discuss this in more detail below).
OK, but maybe markets have reached an overbought condition (commodities, equities, and currencies against the USD) and are due for a pull back. Yes, perhaps from a very short term perspective. But on a medium to long term perspective many major market equity indices have gone nowhere since October last and are either marginally down or up since the start of this year. Most currencies (as depicted by the AUD) are only marginally higher against the USD since October last year and up until a few weeks ago at least so were many commodities. Furthermore, there seems to be a general condition of "disbelief" in the rally in equity markets at least. I struggle to find anyone claiming that this is the start of the next big bull market in equities or comments to the effect "Dow 15,000 by December 2011. Only over the last 10 days have commodities started to gain attention by the press but it is certainly nothing like the attention they gained in early - mid 2008 when crude was marching north of $100 a barrel. And currencies? Well, who is talking about the Euro at 1.50? No one...my case in point.
My concerns? Yes I have a few, three actually:
- The seeming unwillingness of Yen crosses to breakdown. For the Yen to be stronger than the USD is a tall order but it should be blowing out against other currencies like the Euro and AUD. There has been little or no follow through since the Japanese central authorities intervened.
- Crude. How crude continues to wallow when just about every other commodity is registering multi-week highs is beyond me. Is it being held down? Well it would not surprise me one bit. Who would be holding it down? No idea, maybe someone who is terrified of the inflationary affects of an exploding crude price. I don't think you would be wanting to own long dated US treasuries if crude was doing a repeat of the 1st half of 2008.
- Which leads me to the last concern - US treasuries. Inflation is the worst enemy of long dated US treasuries but yet they seem happy to advance in the face of exponential growth in commodities across the board (crude products excepted). Since when have ramping foodstuffs and industrial commodities been deflationary in nature?
Have you noticed that the news seems to be "less bad" than before? That even a small positive surprise (last Friday's durable goods orders are a case in point) is greeted by big moves to the upside? Do you also realize that if you had shorted major market indices the day before the flash crash you are actually now losing money. Yes, a little concerning given all the negativity to hit markets over the last 5 months. We have breaks to the upside on major market indices from four month old trading ranges. The market has had every reason in the book to go down but it hasn't. What is this telling you?
Just on the quiet, while the western world was being bombarded by deflationists and double-dippers the likes of Roubini and Rosenburg, highly risky emerging markets moved higher and are now at multi-month highs. Surprise, surprise major market indices in the US follow the lead set by emerging market small caps (yet again).
Investment grade bonds are struggling. Just have a look at US treasuries (NYSEARCA:TLT) and mortgage backed securities (NYSEARCA:MBB). Divergences have begun which are usually a precursor to change in direction
I have mentioned this on many occasions before, there is no better leading indicator of the health of corporate America than junk grade bonds. Digging deeper, TRACE indices suggest that there has been no increase in distressed debt over the last five months (issues trading inexcess of 1000bpts over US treasury yields). This is a total rebuttal of the assertion of an economic slow-down or the infamous "double-dip".
If an index of 17 commodities equally weighted making new highs day after day in a parabolic fashion isn't inflation then what is?
The longer a market moves in a sideways direction the greater the intensity of the breakout. Well, silver is definitely a case in point. Something big is happening on the silver front. Whatever it is it certainly is not deflaitonary or supportive of strong paper currencies (that is inflation in it purest definition).
Bullish on this chart? Well that implies that you are betting that it will get back to the 28.50 level. Oh that just happens to equate to the Euro getting back to 1.50. Think I am mad? Well perhaps that is why it is going there. It appears that the PIGS thing masked underlying problems in the USD.
And the problems in the USD are a lot more serious than one typically expects. Note that up until three weeks ago the average emerging market currency was little changed against the USD in some 11 months. Emerging market currencies overbought you say? I think not, rather we have a breakout of a trading range. Take careful note of the action in silver with respect to breakouts of trading ranges.
I think the hardest thing to do over the coming weeks/months will be to hold onto winning positons. What you may think as being overbought/oversold may well become a whole lot more so.