Euro Moving Lower, But "Real Money" Isn't!

Topics Covered

• Equity market breadth warns of possible weakness ahead
• Euro is moving lower, but "real money" isn't following
• Spain is moving towards the edge of the cliff... again!

Weekly Overview

S&P 500 remains in a rally mode, but the bounce from early June lows has been weak. Crude Oil's rally has been somewhat stronger as it moves above $90, while Gold still remains below $1640 level. Agriculture has been a superb performer with Corn and Soybeans at new record highs and Wheat at $9.40, 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

S&P 500 remains the only major risk asset that has made new highs in the cyclical bull market that started in March 2009. Both the DAX 30 and GEMs ETF have registered a lower high in 2012. S&Ps new high is also not confirmed by various credit spreads, risk currencies or commodities either. Global engine of growth, Asia, seems to be slowing down meaningfully. This is reflected by weakness in Commodity currencies and Asian currencies, as well as in industrial commodities like Oil and Copper. Euro is approaching June 2010 lows around $1.20. One major stand out in 2012 has been a huge movement on the upside in Agriculture prices, with Corn and Soybeans making all time record highs.

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

Equity Markets

I recently focused on the US equity market with a post titled Equity Market Topping where I argued various points of why I think that we are approaching a bear market. I highly recommend reading that post, which was written close to the beginning of this month, before you continue with the current post. All I would like to do is offer an update on the equity market right now, especially the non-confirmations and the health of internals.

Firstly, I want to focus on the Dow Theory. I currently see a major non-confirmation between Dow Transports and Dow Industrials as well as a recent minor non-confirmation in the recent rally out of the June lows. While the minor divergence could be a reason to expect further short term selling, the major divergence could be a reason to expect the beginning of a new bear market. Since Dow Jones Transportation Index is more economically sensitive, I tend to always listen to its message much more. It is for this reason that I find it very interesting on how these economically sensitive stocks have not registered any new highs in 2012 relative to their price in June 2011. Technically speaking, Dow Transports could break down as early as next week, so do stay alert.

Secondly, the focus turns to internals of the S&P itself. The index finished the week higher and is now less than 4% below its bull market high. And yet, despite such "positive price action" as many media reports state, I look at the internals of the market in a very worrying way. The chart above shows that despite being close to new highs, less than 60% of the stocks within the S&P 500 are currently trading above their 200 day moving average. Furthermore, majority of those who are above their 200 MAs are of defensive nature and mainly in the Utilities, Telecom, Health Care or Staples sectors. On top of that, if you think this is the only indicator acting bearish, also consider the Bullish Percent Index. It is a completely different measure of internal breadth strength and yet it also tells a similar story.

Thirdly, internals through the individual sectors are also breaking down. There are now less and less sectors helping the S&P 500 reach new highs. Four out of the nine major S&P sectors have not made new 52 week highs in the current cyclical bull market since March 2009. These are Financials, Industrials, Energy & Materials. Even more important is the fact that other cyclical sectors like Technology and Discretionary have started under-performing S&P 500 in a serious manner. The honest truth is, majority of S&P's recent strength has come about from a super strong rise in the defensive sectors as investors chase risk averse high yielding assets (also seen in Treasuries, Corporate Bonds and Emerging Market Bonds).

Bond Markets

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

Currency Markets

One price action that I have found very interesting as of late is the relationship between the Dollar, the Euro and PMs like Gold & Silver. The chart to the left shows exactly what I am talking about. Consider the following: Euro topped in May 2011 together with Silver, as both suffered their first major sell off. Afterwards, all three assets experienced an intermediate top again in early September 2011 and suffered another major sell off. Supports were reached, where Euro hit $1.32, Gold hit $1,530 and Silver hit $26. Moving along, we can see yet another intermediate top in early November 2011, followed by yet another major sell off into late December 2011 lows.

Once again supports were reached where Gold and Silver held their $1,530 and $26 lines in the sand. However, the Euro fell lower into $1.26. Relative strength was beginning to show, but it was still early days. LTRO #2 occurred at the end of February 2012 just as majority of risk assets topped. Gold, Silver and the Euro all sold off together. Support levels were reached once again with $1,530 and $26 still holding for Gold and Silver, while the Euro made yet another lower low into $1.23 by early June 2012. Majority of risk assets bottomed around this time, including the S&P 500. However, Euro is once again making more lower low into $1.21, while Gold and Silver still refuse to confirm the Dollar strength by holding major supports. Relative strength is definitely becoming more evident now.


So the question is, despite continuous Dollar strength against the Euro, can Gold and Silver reverse their recent misfortunes? While it is difficult to answer this question with a Yes or a No, as I personally do not have the skills to predict the future, what I see currently is the fact that investors are treating "real money" in a different manner relative to the relationship between the Euro and the Dollar. And considering that Euro sentiment is rather extremely negative and approaching major support level last seen in June 2010, a case could be made that as soon the EU currency stabilises even slightly, PMs could surprise on the upside. However, a major risk event, like a default coming out of the EU, will most likely render PMs outperformance useless as majority of assets tend to go down in a panic.

Commodity Markets

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

Credit Markets

This panic could definitely come out of the Eurozone, as the credit situation is not improving right now. Some quick charts on Spain revile that the 2 Yr yields are rising vertically again. Interest paid on short term notes is usually the best measure of countries ability to finance itself and a good measure of default risk. LTRO #1 calmed worries in November 2011 when Italy and Spain were falling of a cliff. The can was kicked down the road. However, here we are again, with Spain at the central focus. Spanish 10 Yr yields are also rising to new highs again, above the 7% line in the sand.

Furthermore, the spreads between those bonds and German Bunds of same maturity are also reaching Eurozone historical records as we can see in the chart above. Credit Default Swaps on Spanish debt aren't too far off their record highs either. Every can kicking event has not stopped the rise in government debt risk coming out of the EU, and in my opinion, has only post pond the inevitable: bond haircuts / defaults of some type. There is a real fear going on out there that Spain or Italy could turn into another Greece times ten. Further to that, capital outflows (bank run) are now in full flight out of Spain, which must be serious concern for the politicians and completely undermines confidence in the overall stability of the major Eurozone members.

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. If the triangle breaks on the upside, I will take my hedges off.

• 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, I am getting ready for a possible breakdown of Tech sector (XLK) & Discretionary sector (XLY), especially because these twos actors are much loved by the global fund managers. 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 and in a mist of a bubble phase.

What I Am Watching