Someone Called the Cops to the Fed's Party

by: Cam Hui, CFA

Regular readers know that I believe that the Fed has been throwing a party, in the form of QE2. Valuations are getting stretched, but in the short-term, neither valuation nor macroeconomic conditions matter. Only momentum and liquidity does.

The key for traders, therefore, is to enjoy the party but to keep an eye on the exit. Well, it seems that someone finally called the police to the Fed's party and the cops are on the way. The first clue was given by the Inflation-Deflation Timer Model, which recently moved from an "inflation" reading to a "neutral" reading - a signal that investors should shift from the high-beta trade to a more neutral stance. The Timer Model, uses commodity prices as a barometer of global growth and inflationary expectations. Commodities have begun to weaken and have broken down through the uptrend which began in September 2010.

Cyclically important commodities such as copper also show a pattern of a break from its price uptrend.

Similarly, measures of risk aversion, such as the ratio of Consumer Discretionary stocks to Consumer Staple stocks, are behaving the same way.

The effects of QE
The chart below from SocGen shows a remarkable correlation between the Fed's balance sheet and US equity returns, which reflect the effects of quantitative easing. If you look closely, there appears to be a 1-3 month lead between quantitative easing program and stock returns. Assuming that QE2 ends on time at the end of June and it is not followed by QE3, now is about the right time to head for the exits.

Time to sell on strength
Tactically, the market appears to be oversold on a short-term basis. This model, which uses the 50-day and 150-day moving averages in a rather unique way, just flashed a buy signal on stocks indicating a favorable near term risk-reward ratio.

In addition, Mark Hulbert, who monitors newsletter writer sentiment, noted that his sentiment readings are flashing bullish as of the close on Monday before Japan cratered by 10.5% [emphasis added]:

At the end of February, for example, the HSNSI stood at 58.2%. By last Thursday night, this benchmark had already dropped to 49.1% — and since then has dropped even further to 43%. This is a surprisingly big drop, given that the Dow — at least so far — is only about 3% below its bull-market high, hit in mid-February.

This fear factor is even more in evidence among market timers who focus on just the Nasdaq market — an arena where the mood among retail investors particularly predominates. The Hulbert Nasdaq Newsletter Sentiment Index (HNNSI) currently stands at just 20%, down from 73% on the date of the market’s mid-February high.

This retreat of the bulls is not what is normally seen at the beginning of a major decline. If the bull market had truly ended at its mid-February high, and sentiment adhered to the typical pattern, then the bulls would have stubbornly clung to their positions — if not actually increased them in the wake of the decline, treating the market’s weakness as a buying opportunity.

This is looking a lot like Lehman...
While my inner trader remains relatively sanguine and is ready to take some risk off the table on market strength, my inner investor is whispering, "This is starting to look a lot like Lehman..."

Valuation and macro risks are everywhere. The Tobin Q ratio, a measure of the market value of equities to replacement cost, shows the market to be immensely overvalued. Jeremy Grantham's estimate of fair value on the SPX is about 900, compared to the current level of about 1,300.

Then we have to contend with stories of unrest in Bahrain, Libya, Yemen and, the elephant in the room, Saudi Arabia. On top of that, we have the risk of European default and the possibility of another downleg in the US real estate market.

Then there is China. The most recent report of a trade deficit was shrugged off because of poor seasonality. Maybe it's true, maybe not. The weakness in copper and other commodity prices is worrying as there have been reports that the Chinese have been speculating in commodities on margin and possibly pyramiding their positions.

All these reassurances that everything is fine sounds a lot like Ben Bernanke's assurance in March 2007 that the subprime problems were well contained:

At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.

Prolonged weakness in commodities could send not only commodity prices, but investor confidence, into freefall. If the Chinese had indeed been hoarding commodities on credit and prices turned down, any orderly retreat would easily turn into a panic and, in the words of Dennis Gartman, "a margin clerk market" where everything is liquidated to meet margin calls and the correlation of virtually all asset classes converge to 1.

Investors should re-calibrate their risk tolerances with care. Traders can try to catch the rally but don't forget to define their downside risk control parameters.