Summary Post Turbulence

It is Sunday afternoon, the 13th of May here in Asia. This week in the US one of the more important data factors I noticed was the fact that consumer confidence continues to improve towards a four year high. In my opinion, this is a contrarian signal, which will eventually be negative for the business cycle. Upturns start at consumer confidence troughs while company earnings are depressed, while recessions occur as confidence starts to peak and company earnings reach record high. We are at the latter, not the former.

In Europe, Spanish IP collapsed further than expected by -7.5%, French IP weakened by -0.9%, while German Factory Orders and IP surprised on the upside (up 2.8% while economists expected 0.8%). Swedish and United Kingdom IP remained quite flat, while Italian IP came in at better than expected figure of 0.5% positive. BoE kept its interest rate decision unchanged, with no further QE, helping the Pound outperform. In Asian, South Koreans kept their interest rates unchanged as well. There are signs of Asia slowing further. Malaysian IP and Indian IP showed a serious slowdowns. But the real focus was China, with major economic data being released on Friday, which included IP, Retail Sales and Inflation.

Chinese Industrial Production was very slow compared to expectations, coming in at 9.3% versus 12%. Chinese retail sales also disappointed and their CPI came in below expectations, giving the officials more room to ease. Chart above shows that during periods of slow growth and negative surprises, China still has plenty of room to ease. As the economic data disappointed, I've debated the possibility of China cutting their reserve ratio by this weekend, and before I even finished this write up, PBoC has already acted with a 50 basis point reduction. The impact should be felt in the asset markets, but before we turn our focus there, let us see what the credit markets are saying.

Credit lines within the economy are like the arteries of a human body. During any turbulent panic sell off stage in the financial markets, the first thing I like to do is check if the credit risk is rising to the point it could possibly create a systematic lending freeze and choke off global growth, like in 2008. After all, we are still in a de-leverging environment and the banking credit lines pose one of the biggest risk to the world economy.

First thing I notice on the positive side, is that the 3 month LIBOR OIS spread in both United States and Eurozone is quite clam for the time being. There are no major systematic banking risks here at present.

In his recent article, Chris Puplava also shows that Eurozone equity markets have become disconnected from the true picture of Financial Stress in both US & EU. In other words, relative to the risks in the credit markets, EU equities have become oversold and should bounce back. This lets us know from the short term that everything on the surface seems to be ok.

However, if the start digging deeper, things are not as rosy as they seem. Scott Grannis recently discussed the European credit conditions over on his blog. Instead of me writing a summary, I will just quote him:

"...Eurozone financial conditions are still under a lot of stress; Euro swap spreads reflect a significant degree of systemic risk. The U.S. has largely avoided Eurozone contagion, but the threat of a banking collapses in Europe still weighs heavily on investor sentiment around the world."

Eurozone Government bond yields continue to diverge as the Core countries are used as safe havens, while Peripheral countries, especially with a strong focus on Italy and Spain, trade as risk assets. Spanish 10 Yr is over 6% yet again, while Italy is not too far behind. LTRO has postponed the final crisis, but not solved it. Credit Default Swaps on these countries also confirm the move as they keep rising higher too.

Large money is now parked in a German 2 Year Bund, where the yield has fallen below Japanese deflationary 2 Yr yields of same maturity. Let me be clear about this - flight to quality due to a possibility of a systematic risk. German is NOT in deflation like Japan, Germany is NOT cutting interest rates to 0.1% like Japan and Germany is NOT in an overwhelmingly strong recession for yields to be this low.

In summary, credit markets are giving us a mixed picture. Certain indicators like Corporate Credit Spreads, Libor rates and Financial Stress indices are showing positive signals. However, other indicators are showing anticipation of a default like event similar to that of Lehman Brothers during 2008. In my opinion, there is no other reason for the German 2 Yr Bund to be trading at 0.07% yield. Therefore, smart money is more interested in return of their capital, instead of return on their capital. Default risk is most elevated in Eurozone banking system, as Scott Grannis explained above, but I do not think it signals armageddon just yet (but... it is coming eventually).

Since I believe the worst is still not going to occur immediately, than we could rule out a crash from current oversold conditions (markets can crash from oversold conditions). Therefore, Chinese rate cut could be the perfect news event to kick off a rally from an oversold readings that the commodity complex finds itself in. In the chart above, we can see that the technical picture of the Continuous Commodity Index (equal weighted) is very depressed. We are also over-stretched on the downside away from a 200 day MA. The price has now declined ten days in the row.

Many individual commodities are extremely oversold too. In the chart above we can see that every single commodity is now trading close to or outside of 2SDs range apart from Natural Gas. That means, as a worst case scenario, at least a rebound is in the cards very shortly. Commodities are not the only oversold assets either. I believe global equity markets have also suffered quite a setback in recent months as well. Looking at S&P 500, one would be saying that the damage was minimal and that the VIX did not jump enough, but that is a very US-centric view. Global equity market correction from the 2012 peak currently stands at following % readings:

• Spain down 24% & Italy down 20%
• Russia down 15% & Brazil down 13%
• France down 13% & Germany down 10%
• Japan down 12% & India down 11%

Traders with shorter term outlook should definitely note that there are number of bullish divergences occurring within the internals of the equity market. These include: % of Stocks Above 50 MA, McClellan Oscillator and 10 day Advance Decline line amongst others. This should make even the biggest perma bears hold back on pessimistic activities, for the time being. The chart above shows that despite S&P 500 making a lower low, a lot of breadth indicators do not confirm this move and have now setup a bullish divergence. In other words, it seems as if the market is willing to go higher from here and even take out previous peak at 1,422. I won't be participating and instead would rather be looking for a short at higher levels from here.

Two main pieces of the puzzle need to fall into place, if we are to have a risk rally occur. First would be stabilisation of the Euro and the second would be a Treasury Bond sell off. Let us focus on the Euro first. In the chart above, we can see that the outlook on the Euro keeps deteriorating closer towards extremely bearish levels again. This week up to Tuesday, hedge funds increased their net short exposure on the Euro by one third and all of this despite Euro still trading close to the $1.30 level. I think that up to Friday, those net short positions increased even further, even towards record highs. US Dollar is now up 10 straight sessions in the row too, which is overdone. All of this could setup a mother of all short squeezes!

The second piece of the puzzle is the sell off in the Government Bond safe haven assets. Money coming out of Treasuries could boost risk assets, if only temporarily. I say that because systemic risks still remain in place and not everyone will get out of bonds. In the chart above, Tom McClellan talks about a possibility of a Treasury market top as majority of the bad news becomes discounted for now. On top of that, German 10 & 30 Yr Bunds yields have dropped to record low yields for six straight sessions. Sentiment here is now very bullish according to the German Animusx Survey. Finally, the US 10 Yr Note rally is now way overdone and overbought. Bloomberg recently reported that:

U.S. 10-Year Notes Add to Longest Gain Since ’88 - Treasuries had the longest streak of weekly gains in more than 13 years after elections in France and Greece added to concern governments may struggle with deficit- cutting plans used to combat the region’s debt crisis.

If these two assets move in the right direction (Euro bounce and 10 Yr Note sell off), than I definitely think risk on rally could ignite as the conditions are very ripe for it. These are: extreme bearish sentiment, oversold technical readings, constant weekly outflows and overall general news / media fear.

----------------------------------------------------------------

Finally, as an aside note, I would like to focus on Gold here: Running the chart from left to right, we can see that Gold went slightly vertical for awhile and peaked around $1,920 on 06th of September 2011. Sentiment was extremely positive with 97% bulls according to DSI and fund flows extremely bullish. The price corrected into 26th of September and fell to the intra day low of $1,535. Sentiment reached 16% bulls, price moved outside of its 2SDs range and fund outflows showed record panic selling. A counter trend rally started and Gold amazingly still managed to finish the year on the upside, clocking its 11th annual gain in the row (I'm very nervous about this).

However, out of a rally price eventually peaked at $1,802 failing to make a new high, on 08th of November 2011. A three stage sharp sell off occurred into 29th of December low towards $1,522. Once again sentiment reached extremely bearish levels of only 7% bulls, priced moved outside of its 2SDs range and physical Gold Tonnage left the ETF in a panic.

Such an extreme sentiment warranted a powerful rally again and that is what we got. Prices rallied from intra day lows for about two months straight without a pause towards $1,790 per ounce on 29th of February 2012. Gold once again failed to better its previous high and made another lower peak. Following the peak, Gold tumbled into its 4th monthly decline (if we include May) and currently stands at $1,578 per ounce. Just like during previous troughs, Gold is oversold at 2SDs outside of its range, sentiment is extremely bearish at only 7% bulls on the Daily Sentiment Index and we have now recorded 10 out of last 11 weekly ETF fund outflows.

I personally think we are at another intermediate bottom for Gold at these levels. A rally should start eventually, and those entering shorts or selling Gold right now, will most likely find themselves wrong footed in coming weeks. Sentiment is negative, retail selling is persistent and prices are oversold - all music to a contrarian investor. 

However, the question is, how strong will this rally be? If this eight month correction in the Gold bull market is really over than price should recover above $1,800 and march higher. If they do not exceed $1,800 and post a higher high to regain a bull market trend, from current oversold and extremely bearish conditions, than I will be expecting more downside for Gold below $1,530 support. This is especially true because Gold is currently trading below its 3.5 year uptrend line and 200 day MA.