A Boy Who Cried Wolf

Topics Covered

• Global economy seems to be playing "boy who cried wolf"
• Fund manager try to predict further Fed stimulus measures

Weekly Overview

S&P 500 remains in a rally mode, but the bounce from early June lows has been very weak. Major commodities have found resistance levels with Crude at $90 and Gold at $1640. Agriculture has been a superb performer with Corn and Soybeans at new records and Wheat at $9, despite abundance of bears calling for new lows. US Dollar remains close to its 52 week high, while the Long Bond is not too far off either. Sentiment is extreme on these safe haven assets. The bottom line still remains the same: investors are fearful of a disorderly default in the Eurozone and intense funding pressure on large economies like Spain and Italy. At the same time, Asia and especially China is slowing down meaningfully. Global economy is edging closer towards a recession.

Global Macro

Nothing new to report. Refer to the side menu for previous articles.

Economic Data

Global economy continues to slow. At the start of the month JP Morgan's Global Manufacturing PMI was sitting at 50.3 but I am pretty sure in a two weeks from now (when the new report comes) the reading will be showing a contraction for the first time since 2009. Furthermore, the Global PMI has now given us a negative signal with its 3 month moving average. This builds a case that the global economy is potentially entering a serious slowdown.

When we look at the Developed World economies, my main focus tends to be on the US and Germany. US leading indicator, constructed by the ECRI, remains below the 2 year moving average. The indicator also shows that the economic fundamentals are not confirming the new highs in the stock market earlier this year and furthermore, it is obvious that each central bank stimulus program has created less and less effect. This builds a case that the US economy is failing to reach "escape velocity" necessary to create a self-sustaining expansion.

In Germany, business conditions continue to deteriorate as ZEW report showed yesterday. On top of that, the awfully large Industrial Production drop within a single month, usually tends to signal the beginning of an economic contraction (unless caused by a natural disaster). Rest of the Eurozone is pretty much in a recession already, so no need for us to discuss that once again.

So why aren't investors in full panic mode?

Well majority are clinging onto Bernanke's every word in the hope of further stimulus and another short term sugar rush. More importantly, majority also do not believe we are actually sliding into a global recession, despite Europe. There seems to be optimism that de-coupling is possible. Many economists are constantly appearing on Bloomberg and CNBC telling us that current data does not point to a US recession. Many internet blogs are filled with articles of charts trying to explain why we aren't in a recession. This type of thinking approach is a trained habit thanks to the markets false scares of the past. It comes from the fact that this is now a third soft patch since the recession ended in 2009 and majority were wrong in predicting recessions in the first two. Let me explain.

As we can see in the chart above, the first one occurred in the summer of 2010. Majority feared a Double Dip was about to occur, Greece was front page news everywhere and the Euro was falling off a cliff. But eventually, EU bailed out Greece, Bernanke did a QE2 and all was well. The second soft patch occurred in the late summer months of 2011. Global manufacturing stalled due to the Japanese earthquake, US credit rating was downgraded, Italy was front page news everywhere and rumours were circulating that a major EU bank was about to default. Once again, we were saved by Mr Draghi and his LTRO banking program and Bernanke's Operation Twist.

It is important to note that investors realised the economic scares were just that and nothing more. Furthermore, majority understood that both of those short term panics were buying opportunity in the current cyclical bull market and personally, they have been shaken out. Fast forward to today's sell off. Presently investors seem complacent, as if they refuse to be shaken out again. They seem to be thinking we are repeating 2010 and 2011 buying opportunity. I would argue this is due to greed. I personally believe that majority missed entry points in August 2010 and October 2011 and are sick of the market's wolf cries. However, this time investors might just pay the price if the economy really turns for the worse. The third soft patch seems to be much worse than the first two and the reason why is Asia.

As Europe is already in a recession and US is just muddling long, Asia has been the main global growth engine since the recovery started in 2009. However, it seems now that China and Asia as a whole is slowing down meaningfully. The chart above shows that unlike previous soft patches, the current one has Asia participating too. Citigroup Economic Surprise Index for Emerging Markets  shows that Asian and Latin American economic data is surprising to the downside by the most since 2009. Furthermore, Industrial Production in the overall Emerging World has been slowing since the middle of 2011. It is worth stating that in recent months, Chinese IP has totally collapsed on relative basis towards similar levels last seen in 2008 and electricity production is also below average. Therefore, I am not so sure that this time around we will follow the same script as in 2010 and 2011. This time, the wolf could actually be around the corner.

Equity Markets

Merrill Lynch Global Fund Managers Survey was released yesterday. Apart from the regular data that it prints, this time around there was a heavy focus on central bank stimulus questions. In the first chart above, I found it interesting that over 50% or the majority of fund managers think Fed's next QE program will come in Q3 or Q4 of this year. Dead smack right in the middle of US elections? Hmmm... somehow I'm finding that hard to believe.

More importantly, the next question revolved around the price level of stock market and further stimulus measures. As we can see above, the average price level of S&P 500 that fund managers think needs to be reached before Fed starts QE again is around 1150. Considering that equity markets  are only about 4% away from their highs, we might be in store for a large capitulation drop, before Ben acts. Let us not fogey that the internal market breadth is remarkably weak for an index that is only a few percent away from its recent peak.

Bond Markets

Nothing new to report. Refer to the side menu for previous articles.

Currency Markets

Nothing new to report. Refer to the side menu for previous articles.

Commodity Markets

Nothing new to report. Refer to the side menu for previous articles.

Credit Markets

Nothing new to report. Refer to the side menu for previous articles.

Trading Diary Update

• Outlook: I believe that we approaching another bear market as the global economy starts slowing down meaningfully. US GDP has grown 5 quarters at around 2% or lower which tends to be stall speed. Over the last 60 years, whenever the economy grows at subpar levels it has always entered a recession. Recessions occur every 4 years of expansion during secular bear markets, so next year we are overdue for a slowdown. However, it could be much earlier as leading indicators show not all is well right now. At the same time corporate earnings and gross profit margins are at record highs, so I expect a mean reversion. On average earnings tend to fall by 25%, so a drop to $70 from current levels in earnings could take the S&P down below 1,000 points on a 12 times multiple. Cash levels in money market funds are extremely low, financial stress is starting to rise, volatility is at very complacent levels and credit spreads are very narrow relative to fundamentals, so I expect a risk off scenario in due time.

• Positioning: I've positioned myself towards long PMs especially Silver (SLV, PSLV, SIVR) and have recently just accumulated more, because I believe central banks will continue to print money and devalue currencies whenever the economy gets worse. Furthermore, investors were heavily exposed to US Dollar and the sentiment on Silver is also extremely negative, so from a contrarian point it makes a lot of sense. On the other side of my book, I have recent opened a short on Junk Bonds (HYG, JNK), as I believe credit spreads will spike into the future, similar to the VIX. Further to that, I have recently hedged a decent amount of my Silver longs and plan to do more if the triangle breaks below $26 support. Finally, I am getting ready to short US equity sectors, especially the much loved Consumer Discretionary and Technology sectors.

• Watch-list: On the long side, commodities still remain on my watch list as they are extremely oversold. At this point I see the most value in the Precious Metals (CEF, SLV, PSLV) and Agriculture (RJA / MOS) sectors. On the short side, Tech sector (XLK) & Discretionary sector (XLY) are on my list of stock shorts. I am also looking at Emerging Market bonds (EMB) as a potential short. Finally, a major short in due time will be US Treasury long bonds (TLT), as they are extremely overbought.

What I Am Watching