Market Overview: Gold, Oil, REITs, Semis, Canada and the Fed

The melt-up continued in the market, as the unwinding of the End of the World trade continues, with shorts scrambling to cover on any dips and short-term traders jacking the market higher. We are getting overbought, but the market can stay overbought for some time if it is in the mood. Currently, the market feels as if it is a feather on air, and a wind current is keeping it afloat. There is no selling pressure whatsoever.

There certainly has been selling pressure in the commodities. Virtually all commodities are either under pressure or are topping, with one exception – energy.

Oil is reacting to exogenous factors. Natural gas is rising in front of the summer. However, I do not believe that if the rest of the commodity complex is rolling over, energy will stay aloft. Thus, I have been scaling down my energy positions.

I also sold off some gold, locking in profits that were much greater a month ago. I do believe we are in a structural bull market in gold and other commodities, but gold has seen pullbacks of 25% in this run, and silver has fallen 40%. We are at a precarious moment in the precious metals and commodities markets, and reducing exposure if exposure is great is a prudent course of action now, in my opinion. I expect the energy complex to follow suit.

The pattern of the gold bull market is interesting. Most of the past several years of the bull ran has been marked by gold consolidating then bursting higher over a short time period. Gold’s pattern is similar to the recent bull market in the Canadian dollar. The loonie spent about three quarters of its time consolidating, and when it finished going sideways, it burst upward.

Several factors are weighing on gold prices. First, as mentioned above, The End of the World Trade is unwinding. Gold is a safe harbour during times of fear - but fear is abating. Second, the dollar may be bottoming, as the talking heads on the tube keep nattering on about. However, I do not believe that gold is purely a dollar play. Gold has gone up in all currencies during its bull market. But the second leg of the upswing is playing out a little differently than I expected, which is the third factor.

I expected that Europe and Japan would follow suit in lowering rates as the Fed has done. That has not happened. It may yet happened, but the sounds coming out of Europe are responsibly hawkish. There are certainly excesses in Europe, but unlike the Fed, the European Central Bank is not focusing on this ridiculous “core” inflation. The dollar may very well be at a bottom, given that Bernanke and crew may soon be finished cutting rates, and with the Fed funds futures market currently pricing in rate increases next year. However, I believe that the commodities bull will ultimately end with a significant tightening of interest rates, and we are no where near this happening.

I am a long-term commodities bull. Similar to the sharp sell-offs during the equities bull market of 1982-2000, we will and are having sell-offs in the commodities complex. If you have a long time horizon, and can stomach the volatility, I believe that most commodities will eventually top out at much higher levels.

In the near-term, however, I will probably continue scaling back commodities and look for opportunities in stocks, but will be cognizant of overbought and oversold conditions. I will not chase strength but rather will look for stocks that are basing and technically improving.

This is what leads me to the semiconductors, as I noted on Thursday. The worry about the chips is that inventory is building. However, semis often bottom when the outlook is very bad. They can also collapse when the outlook is very bad, but that’s what makes them interesting! I will look for other sectors that could be heading higher over the next several months. If I find anything else that looks interesting, I will not hesitate to buy.

As for the REITs, I briefly perused a Goldman note this morning which was negative on the group. Goldman noted that the economy is deteriorating and the growth will be no where near what analysts are expecting. However, REITs have risen 24% off their bottom at the beginning of the year. According to Goldman, the primary driver has been widening yield spreads between REIT dividends and treasury bond yields. I would also suggest that for investors who must have exposure to financials, REITs – which the constructors of indices deem are financials – have been a safe haven for those wanting shelter from the problems in the credit markets throughout the banking, brokerage and insurance industries. Heck, after being down 40% and the lack of overbuilding endemic to residential housing, the REITs looked downright safe compared to other "financial" stocks!

Goldman wrote that REITs are trading at 16x FFO, well above the sector’s long-term average of 10x-11x. Frankly, I did not delve into Goldman’s methodology. I have FFO at 9.2x, a 17% premium to stocks as of the close today. However, they are smarter than I and know what the hell they are talking about, so I’ll happily defer, since their calculations have REITs being 30% overvalued. A 30% correction would put the IYR below $50. Goldman sees a sell-off as much as 15%-20%.

If the End of the World trade continues unwinding, as I expect, then treasury bond yields will go higher, and the spread between bonds and REITs will narrow, pressuring valuation. If the 10 year rises to 5%, which seems reasonable given that it was 5% less than a year ago, a 5% dividend yield on a security in a stagnant economy with falling underlying real estate values does not seem a good bet to me.

Clearly in retrospect, I should have unwound at least part of my short trade in REITs. However, I think we have another leg down. That may not happen for a bit, and trading accounts that are short may want to cover in a downdraft. However, with the iShares Trust DJ US Real Estate Index Fund (IYR) becoming very overbought, approaching resistance at $72.50, valuations getting stretched and fundamentals deteriorating, I am not inclined to cover at the moment. Traders, however, have to respect the charts, which are bullish now.

If the unwinding of the End of the World trade continues, I do not believe Canada will be a beneficiary. If all the other commodities are selling off, I expect energy to follow. Half of Canada’s market is composed of energy and materials stocks. The TSX Composite is extremely overbought and close to highs.

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I had hedged part of my exposure through ownership of the Horizons BetaPro TSX Bear ETF [HXD.TO]. However, I increased my position to go outright short Canada at these levels. I am not expecting a collapse, but the odds of a pullback are fairly good.

Finally, if you are an unrepentant bear looking for a catalyst to end this party, the Fed meeting on Tuesday may be just your tonic. Even the bulls might recognize that the Fed meeting may trigger a sell the news reaction. A few weeks ago, I began opining to colleagues that the Fed standing pat may have a positive reaction for stocks. Unlike the previous Fed meetings over the past year, when stocks initially rose on more dovish actions by the Fed and sold off when the central bank was more hawkish than expected, no change in the discount rate may be interpreted as the Fed seeing the worst of the credit crisis behind us.

This opinion now seems fairly widespread, though for good measure, a 25-basis point cut accompanied by a hawkish statement is probably what most market participants want. However, with stocks seemingly incapable of going down over the past few weeks, it may be that the market has discounted this news and will sell after the meeting on Tuesday, no matter what the outcome.

Conversely, if the Fed does stand pat, the commodities could easily get crushed. Because of that, I may continue to liquidate my commodity holdings with the intention of buying my positions back in the future.

Disclosure: I am short REITs via my ownership of the ProShares UltraShort REIT ETF (SRS).

Comments

[Ames Tiedeman]

USO is a short, DUG a long. Oil will be headed for a pull back!

[jjason]

I hope to see all commodity prices fall and take out the speculators. The prices for food, gas and consumer goods will have to come down. There are a lot of people struggling to pay the bills and they are going to get mad as hell. The consumer is going to stop buying all kinds of things over the next 12 months.

[Ames Tiedeman]

I think they correct this quarter. Q2