Measures Show That There Is No Favorite New Trade, Sitting on Cash Is Recommended

by: Todd Feldman

At Behavioral Finance Investment Advisors (BFIA) our model signaled in November of 2010 that the emerging markets trade was over and the developed market's trade was on.

In December and January our model signaled that energy and commodities was the trade.

Our measures can be interpreted as a type of sentiment measure where the movement is similar to the VIX. The lower the measure the greater the bullishness and the higher the measure the lower the bullishness. We calculate a sentiment measure for each of the various markets around the world and try to identify the current trade. What makes this measure different is that we find high correlations with the VIX and spread between Baa and Aaa corporate bonds during rational periods in the stock market. However, that correlation dies when markets become irrational. The measure allows us to detect irrational behavior in the stock market. In April we detected irrational behavior in the commodities market and thus sold. However, we are still bullish on a longer term perspective.

Below is a subset of our rankings on November 28, 2010. We rank the markets with one being the most bullish using our BFIA measures. In addition, based on the movement of our measures it is determined whether we should maintain, increase, reduce exposure or sell. The two columns on the right hand side are the returns for the period between December 1, 2010 and February 28, 2011 and December 1, 2010 and April 30th, 2011. We show these two return periods because the model rankings significantly changed in February 2011.

It can be seen that the one of trades was developed markets with the U.S., Europe, Canada and Japan being bullish. The other trade was commodity related markets such as Mexico, South Africa, Canada, Energy and Silver. Emerging markets such as Korea, Chile, Turkey and India were sells.

Figure 1: BFIA Rankings and Returns as of November 28, 2010

Click to enlarge
(Click to enlarge)

It can be seen that there are many markets that are bullish.

What are our current rankings? Is there is a new trade?

Our current model results show that there is no new trade. Our model is not signaling to buy developed markets or emerging markets or sectors such as energy and gold. This means there is no real direction for the financial markets. Below are our rankings for a subset of the markets that we analyze.

Figure 2: BFIA Rankings as of May 22, 2011

The only market that is bullish is the high yield investment market. The model signals to continue to invest in high yield corporate bonds and REITs. If the global stock markets go into a sideways pattern for the next several months, investments that provide a high yields such as REITs and high yield corporate bonds may be the best bet. Even though prices are moving sideways, one is receiving some interest payments. U.S. government debt is also bullish. Yields are so low it is inevitable that government bonds are not a good bet, but our indicators suggest not to short bonds just yet.

Sentiment is mixed. The sentiment around the world suggests that there is no particular trade such as developed markets or emerging markets or commodities. We therefore believe there is limited direction for global financial markets. In this case one should have a wait and see attitude. When there is nothing to carry the market one way or the other it usually means a period of flat returns. Our recommendation is to maintain a decent amount of cash until a new trade appears. By the time that trade is recognized you can use that cash. That trade could still be energy. Even though we received a sell signal in April to sell commodities, our long-term measures are still bullish on energy and other commodities. Therefore, this could be a short-term sell. In addition, emerging markets were making a comeback in April, however, the model suggests mixed results for emerging markets now. There is no clear signs right now. We suggest a wait and see approach until a new market leader emerges. At that point expect another SA article.

Disclosure: I am long HYG, EIDO.