The Bullish Plot Thickens

by: Daily Trading

What is the purest definition of a bull market in equities? In a few words it goes something like this: when the average stock is rising. Looking at the behavior of the Dow World Small Cap index it is difficult to argue that the average stock is not rising. Just a week ago the small cap index registered a multi-week high in what appeared to be a healthy trend of higher highs and higher lows. Something is driving equities higher and whatever it is it does not seem to have lost any momentum. Only when small caps start to diverge from the behavior of the major market indices should we begin to question the uptrend. For the time being we see no evidence of divergence, in fact small caps remain somewhat stronger than large caps.

Have you noticed the tendency of the Russell 2000 to bounce by more than the Dow over the last few weeks after a sell-off? This is classic bullish behavior. Yet the bullish plot thickens; have you also noticed that junk grade bonds are trading at multi-week highs undeterred by the apparent weakness in the Dow and the European debt "crisis". To be honest we have been rather surprised because usually with any sign of a "crisis" junk grade bond buyers head for the hills.

Until we see small cap equities and junk grade bonds laboring we will remain of the opinion that there is more upside left in equity markets.

Just how US treasuries can advance in the face of rising precious metals and energy prices, rising spreads between yields on non inflationary protected bonds and TIPs, and continued earnings surprises is completely beyond us. Either we are missing something of a higher order or we just have to accept that the US treasury market is behaving completely irrationally and be able to ride the irrationality and remain solvent and sane at the same time.

Yes, we are aware of the argument that it is banks investing cheap short term funds in long term bonds to earn an advantageous spread. If this is really the case then this may well be the big bubble. Forget any connotation of "bubbles" in equities and or commodities.

Could it be that the junk bond market is behaving rationally with its uptrend being a natural response to improving company fundamentals resulting in improving cashflows? We would like to think so. We would also like to think that improving cashflows are ultimately more inflationary in nature rather than deflationary. Some 18 months - 2 years ago junk bonds were crashing and US treasuries were rising. That made sense. Now how does rising junk bonds and rising US treasury prices make sense?

The old CRB (an equally weighted index of 17 commodities) continues to look more bullish than bearish. Space does not permit here but do yourself a favor and look at what is happening on a commodity by commodity basis. Most commodities are either at new highs, or very close to breaking out. The obvious exception to this is the grains but they too now appear to have found some sort of long term bottom. Also have a look at what is happening on the spot market via the CRB Spot Indices. The price behavior of commodities in the real world appears to be a lot more bullish than financial world commodity prices.

Technical analysis is nothing more than identifying critical pricing levels. Note the behavior of gold. Note how it is approaching its previous high. Now we would not take it too seriously on its own, but given that it is rising in conjunction with its poor cousin (silver) and that it too is within a whisker of a multi-week high.......well that is something to take a whole lot more seriously. Something is up and it promises not to be some fleeting thing.

Usually we look at the US Dollar index, however, given that it is heavily weighted in favor of the Europeans (the EUR, GBP and CHF make up about 70% of the index) it is not really a good representation of how the USD is performing against the world. So we resort to looking at emerging market currencies against the USD mainly because of the availability of the ETF CEW. Well, all we will say is this: Emerging market currencies were more or less at multi-week highs against the USD a few weeks ago and that is a bull trend if ever we saw one. Yes the USD is in trouble.

Perhaps we have saved the best for last. The carry trade is alive and well with the ETF DBV registering a multi-week high just yesterday. This suggests that risk taking or yield seeking (call it what you will) remains in vogue. The action in DBV is highly supportive of continued upside in equities, commodities, and downside in US treasuries and the USD.

Watch the direction of holds the key to everything.

Disclosure: Long VTI, IWM, TBT, JNK, CEW, DBV, DBC