The Hardest Trade Right Now Is To Go Long
Why I bought into equities early last week
"Stop listening to yourself and start listening to price."
- Michael A. Gayed, CIO at Pension Partners
- Credit Market
- Strategy: Why FC = Bullish?
- Sentiment / Seasonality
Following the "Bernanke Top" in September, when QE3 did not prove to be reflationary, equities experienced a corrective period in October and November that few saw coming. Many blame the correction on earnings or the election; however, these reasons do not explain why Europe was down more than the S&P 500 during this corrective phase. These reasons also do not explain why the market has recovered recently... last time I checked, Obama is still the President and earnings did not get revised upwards. Horrible forward earnings guidance and investors placing "Romney" bets on stocks such as coal, likely helped contribute to the selloff. However, FEAR that Greece would not receive additional financing, and what that could mean for contagion in the Eurozone, was likely much more of a catalyst. As the Greece deal seemed imminent, stocks rallied in anticipation, and European equities recovered as well.
The reason for the MASSIVE "v-like" acceleration back into equities, is essentially what is known as the "Fear Trade" and the "Bear Paradox." (If investors were truly worried about the Fiscal Cliff, then why did equities recover so well?) This is essentially what The Fed is doing through the Wealth Effect, by making yields so incredibly low, below the targeted rate of 2% inflation, and forcing investors into risk assets. The Fed is hoping that by improving the housing sector and inflating equities, consumers will either feel or actually be wealthier, because their home value and IRA's are worth more, and thus they will spend more money in the economy. Essentially, The Fed is trying to force inflation through the system, as the TRILLION dollar stimulus from increases in worldwide market capitalization is much greater than any central bank's balance sheet. The "Bear Paradox" (coined by Michael Gayed) is the idea that as investors panic and rush out of equities and into the perceived safety of Treasuries, the yield on the Treasury drops, while the dividend yield on stocks rises with falling equity prices, ultimately making stocks a better income play than Treasuries. This paradox makes it difficult for the market to drop substantially, barring a credit event (Lehman event), as investors are constantly chasing risk.
Now, we face the looming so-called "Fiscal Cliff", where every major media outlet has a "Countdown" (turn on CNBC), and every headline reads as if a major catastrophe is about to occur. However, last week we had every reason we could've asked for to drastically selloff, and we did not. For example, when Boehner said, "We're almost nowhere" and "The White House needs to get more serious" or when Reid said, "It will be the GOP's fault if no deal is reached."
Below I am going to use multiple asset classes and "intermarket trends", in order to show through price that investors are not worried about the Fiscal Cliff. The market is acting as if either a deal will get done, the Fiscal Cliff won't matter, or it is entirely overblown. How long the move into equities will last is currently unknown, it may be a week or two, it may be a month or two. In a world of probabilities, nothing is certain, but we can try to analyze "inflation expectations" and "risk sentiment", in order to prove this theory and improve our investment decisions. "Stop listening to yourself and start listening to price."
(Please keep in mind that this is a market timing system, no one indicator will always work in isolation, however it is the correlation of multiple inflection points occurring at the same time that will attempt to signal risk on and risk off periods. Additionally, no system is infallible.)
Below is a chart that shows the performance of Treasury Inflated Protected Securities (OTC:TIPS), relative to nominal bonds (7 - 10 Year Treasury Notes). A rising ratio on the chart means that the numerator (NYSEARCA:TIP), is outperforming the denominator (NYSEARCA:IEF):
We can see how in April and September of this year, the ratio made a high that was not subsequently retested, and thus was a good leading indicator for a market decline. Notice on the far right, where the "?" is located, we can see the recent outperformance of TIPS bonds. This chart can make us feel more comfortable that there has been a surge in the return of inflation expectations, and not just a "relief rally". If investors did not think prices would be higher in the future, then why are they buying inflation protection at a faster pace than nominal bonds? Lets look at some more charts to confirm these inflation expectations.
Junk Bond performance relative to the Bond Market:
As money chases higher yield due to higher default risk, it shows that there is a greater demand for risk appetite. As can be seen by the $SPX chart, a rising ratio in the JNK:BND is positive for equities. Also, notice how credit spreads did not decline (or widen), as sharply in November, as they have in past corrective periods. This was very constructive for helping to limit the downside during the recent correction. Additionally, junk bonds being unable to outperform in October like it did in September (failing to make a new high), was a great warning sign for the correction. Look for junk debt to continue to outperform and make a new high in the ratio, further confirming the Fiscal Cliff is overblown.
The "Reflation Trade":
The chart above shows the relative performance of the S&P 500 to long-term Treasuries (IVV:TLT). Notice the positive inflection point we are seeing on the chart. However, no longer is the call for new all-time highs a popular one, like it was post QE3, ironically making the possibility of that scenario much more likely. The acceleration into equities could be mind-numbing if the Fed gets what it wants and reflaton occurs into the equity market. This would happen essentially as investors chase price and performance, and every headline in the world reads: "Dow Hits New All-Time Highs." Read the original piece here: www.marketwatch.com/story/corrective-hes...
The chart above shows how the 30-year Treasury is still at "Lehman panic" levels and also demonstrates the possibility of how it could very easily reflate US equity markets. As investors realize there is no "Lehman event", money could flow from long Treasuries back into riskier equities. Some will point out that The Fed is experimenting with asset purchases and will not let this happen. However these purchases are at fixed auctions, therefore largely a psychological impact, and does not explain the speed at which the Treasury can move from the public's greed or paranoia.
Russell Recent Outperformance:
The entire year of 2012, the Russell 2000 has been under considerable pressure, by consistently making lower highs relative to the S&P 500. The Russell is a great indicator for US domestic economic sentiment, as the index is composed primarily of small-cap and not large multi-national corporations, so their revenues primarily come from the US consumer. Additionally, these companies are high beta names that investors usually favor during risk-on periods. My original thought was that this underperformance in 2012 was because of the impending Fiscal Cliff, but a recent breakout from its downward trend-line means that price disagrees. It could also mean that price had been depressed due fears of the Fiscal Cliff, but now that the event is here, there's a realization that the event isn't as bad as anticapted. This is an excellent indicator for why investors don't currently seem to be concerned about the Fiscal Cliff.
Mid-Caps Have Been Leading Indicator:
The recent breakout in the first chart for the MID:IVV ratio from it's downward sloping trend-line is bullish. When the ratio is increasing, it has proven to be a good indicator for market rallies. Above is the absolute price chart of the MID, and it shows that another test of 1,000 is imminent. This is scary, as previous attempts have failed and led to serious market declines. However, in light of the "inflation expectation indicators" above, we can feel safer that we are at a positive inflection point. Whereas the previous 1,000 level attempts occurred when the market had been feeling hesitation and expecting deflation.
Technology to Resume Leadership?
Technology almost lost an entire year's worth of outperformance in the most recent corrective phase. Many want to act like the corrective phase was not that bad; however, consider the fact that most everyone who owns stocks owns Apple, and Apple was down over 20% at one point. Additionally, Google had a massive decline, and Apple and Google respectively are the two most owned stocks among hedge funds.
Germany is largely considered the best economy in Europe and would be a likely area that investors would chase if they were looking for risk and European exposure. Notice the massive outperformance since August, when Draghi effectively said he would do, "whatever it takes" to preserve the Eurozone, and introduced the OMT program. German money is tied-up in the Greece bailout package, as well as the EFSF, and other Euro programs. If investors were concerned about the failure of these programs, the DAX would be in crash mode, not about to make a multi-year high. Europe likely could be a great place to chase risk, as their stocks are coming off recession-level valuations, don't have as much "Fiscal Cliff headline risk", are finalizing a deal for Greece, and currently Italian and Spanish bonds are yielding relatively low. Investment in Germany relative to the US has clearly re-accelerated recently.
The chart above is the Euro ETF, which has correlated nicely with risk on and off periods for the S&P 500 this year, as fear of a Euro collapse has weighed heavily on investors. Investors in the Paulson Fund have been betting on a European collapse all year, but a collapse has not happened, hence the fund's massive underperformance. Recently, the Euro is in a steady uptrend, likely from the Greece deal and low Spanish & Italian bond yields. With Draghi's promise of "OMT", and no pressing need to bail anyone out at the moment, Europe is quiet and risk can return. We would like to see the Euro test its recent highs and continue with the risk-on trend. This chart further shows the importance of Europe to the psyche of investors.
Dollar Down, Risk On:
The chart above is the Dollar index, which usually rises with global economic worries, as investors tend to buy the Dollar as a safe-haven asset. Notice how the downtrend in the Dollar from the summer, and coinciding risk-on period ended, as soon as Bernanke announced QE3 in September. Recently, we have a reversal of that trade, which is bullish.
Strategy: Why FC = Bullish?
Now we have to answer the ultimate question of all... How can the Fiscal Cliff, which is essentially increased spending cuts and increased taxes, which are both deflationary, be a bullish event? Especially in the face of lawmakers who cannot agree on a single item? Consider this wild theory, from you guessed it, Michael Gayed of Pension Partners: www.marketwatch.com/story/why-the-fiscal... Also here: seekingalpha.com/article/1041301-the-vic...
The theory is essentially that the bond market is under its inflation target, comparatively stocks yield more, and the Fiscal Cliff means that the government will issue less debt to finance its activities. Therefore the Fiscal Cliff is bond bullish, because demand for Treasuries is still there, but there is less supply - making bonds even less attractive to stocks as their yield falls further. Concerns to this theory are either A) Credit event, Lehman event or B) Dividends get cut.
It is highly unlikely that dividends get reduced. First, companies are raising them (Disney just did by 25%, doesn't seem recessionary to me), second, companies have record cash balances, and third, companies go out of their way to insure they do not reduce the dividend payout, as that severely impacts investor confidence. Companies may as well keep buying back shares, issuing a dividend, and thereby improve the EPS bottom line number and shareholder equity value in this declining revenue environment.
Cliff Is A Misnomer
The "Fiscal Cliff" is well publicized, but not well understood, it is essentially a "made for TV drama" as Gayed put it. It is so widespread that it is no longer an unknown, and it should be readily priced-in at the moment. Additionally, the odds favor that a deal gets done, as no politician wants to be the one responsible for a "crisis". The idea of a "cliff" is a misnomer, as the "automatic spending cuts" do not happen instantaneously, but rather over a period of time. It should be referred to as a "slide". When you put into context the gradual spending cuts that would occur, (around $600 billion I believe), which about $109 billion would be immediate, into context of the S&P 500 market-cap of around $15 trillion, are the cuts really that big of a deal?
Sentiment / Seasonality
Here is a link to some relevant seasonality and sentiment survey statistics, provided by Schaeffer's Research: www.schaeffersresearch.com/commentary/co...
Essentially, when the S&P 500 is up this much going into December (+12%), there is an extremely high historical probability that the index will end the month positive. Additionally, if you factor in the high bearish sentiment from the AAII survey, it is a good contrarion indicator when it is at an extreme high.
Last But Not Least
If you found my article useful, you can follow me on Twitter @Rinaldi224 where I use this type of analysis and also apply it towards equity ideas.
I want to give a special thanks to these guys who have taught me a lot the past few months:
Follow Michael Gayed @PensionPartners for the best intermarket analysis and strategy ideas on Wall Street.
Follow @RyanDetrick for Schaeffer's Research excellent detailed work and contrarion approach.
Follow @Sarge986 for his excellent morning blog on macro data for the day and his impeccable SPX & Russell trading levels. He also does a daily video segment for The Street and is a very likeable guy.
Follow @TFMkts for his excellent daily analysis on the credit market and the global macro grind.
Follow @KeithMcCullough for an interesting and usually hilarious take on how he manages his fund and for his view of the world. You can learn some portfolio management skills and learn some accountability too.
Follow @CiovaccoCapital for his unique approach to risk management using intermarket trends, technical analysis, and DeMark counts. His work is really spot-on and rarely misses big moves in the market.