Summary Of Recent Events

Topics Covered

• Global business cycle in US and Germany continues to slow
• Equity defensives still keep outperforming cyclical sectors 
• Bond market technicals reveal a potential bearish divergence
• Central banks easing cycle will continue as economy slows
• Gold's GLD ETF holdings reduced as retail investors sell

Big Picture

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 Emerging Markets ETF have registered a lower high in 2012. S&Ps new high is also not confirmed by various credit spreads, risk currencies or commodities. 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. This is also reflected in the strength of Government Bonds (Treasuries, Bunds, Gilts, JGBs) and the Japanese Yen. Euro is bouncing of the June 2010 support around $1.20, while one major stand out in 2012 has been a huge movement on the upside in Agriculture prices.

Big Picture will now be updated during every post to give readers a clear understanding of global macro asset market price movements.

Leading Indicators

Citigroup Economic Surprise Indices, seen in the chart above, show that currently we have had an uptick in global economic data beating expectations. However, before you jump the gun and proclaim that another upturn is here, let me remind you that it has become easier and easier to beat economist forecasts. For example, only three or so weeks ago, US economists were expecting GDP numbers to come in at 1.9%. Suddenly, they realised the economy is slowing much faster so they quickly revised their forecast lower towards 1.4%. And than by some "amazing miracle" come this week, GDP data has beaten economists forecast by coming in at 1.5% (we all know it will be revised even lower later) and as the French would say "Voilà". Quite a joke really...

ECRI Weekly Leading Index still remains below the 2 year moving average and has been trending with lower highs every since April 2010. Also worth noting is various swings in the ECRI since 2009, as this business cycle is a lot more volatile than the previous two. Do take note that each central bank program has bought less effect on the economy and has also bought less time. Finally, as one can already notice, there is a major bearish divergence between the US stock market and the leading economic indicators (Wall Street vs Main Street). Majority of the time, the stock market eventually plays catch up to economic fundamentals.

Leading Indicators will now be updated during every post to give readers a clear understanding of global economic activity / data from week to week.

Business Cycle

German business confidence continues to deteriorate, as we can see in the chart above, and has recently fallen to a two year low. Majority of contrarian investors would argue that business confidence is a contrarian tool, so when CEO confidence is depressed a new upturn is waiting around the corner. That is true, however we have not fallen anywhere near the low levels of confidence, like in 2001/02 and 2008/09, so in my opinion the prevail trend in global activity is still down.

In the US, the manufacturing cycle is stalling just like the GDP growth. The recent Richmond Fed regional survey was a total disaster, in my opinion. Nothing new obviously, as it confirmed what the Philly Fed told us several weeks ago. If we consider the chart above, we can see that there is a potential for the overall ISM Manufacturing to disappoint quite handsomely in coming months and if that was to occur...

...I am pretty sure the S&P 500 would follow the ISM down into negative return territory. It is quite easy to see that during a secular bull market in stocks, from 1982 to 2000, manufacturing contractions did not necessarily force the stocks on the downside every time. However, during secular bear market in stocks, which started in 2000 and has been ongoing, we can see that the correlation between the manufacturing business cycle and stock returns is very closely correlated. Therefore, if the economy does slide into another manufacturing contraction (ISM consistently below 50) over the coming months and quarters, hold onto your hats.

Pavlov's dogs will obviously argue that Mr Ben Bernanke and his printing press will stimulate the economy and fix the manufacturing slowdown, but than again that is nothing new. They start barking every time Helicopter Ben or Super Mario open their mouth. Investors should buy PMs to protect from currency devaluation, but not expect Renaissance in manufacturing from here onwards.

Furthermore, the whole world has gone mad with stimulus talk. Since the birth of United States republic, we have had 40 plus recession over the last 200 plus years. Every single president has tried to stop an economy from entering a recession through stimulates, but all have failed. Furthermore, the Federal Reserve was created in 1913 and since than, it has been trying to stop a recession every time it was obvious a slowdown was in progress through stimulus and they too have failed every time too. Let mother nature do its works, you damn Keynesians! 

Equity Markets

Let us focus on US equities by looking further into the index via the magnifying glass. S&P 500 index strength is a smoke screen facade in my opinion, because the underlying sectors show a totally different picture. Chart above shows that early and late cyclical sectors are no where near making new highs, as the overall market rally is running on defensive outperformance for the last three months. Defensive leadership is only common near downtrends or bear markets. Furthermore, out of the 9 major sectors, 4 have not made highs above the May 2011. These include Financials, Energy, Industrials and Materials.

Looking at the overall breadth, I find it very interesting to note that if the S&P 500 was to gain only 2.5% it would register a new bull market high and yet there are less then two third or 66% of stocks within the index above their respective 200 day moving averages. Furthermore, early cyclical sectors like Semiconductors and Technology show remarkably weak internal breadth dynamics with less than 50% of stocks above their 200 day moving averages. These tend to be leaders in a bull market and laggards n a bear market.

Finally, I would not be buying any equities right now as VIX is this low. During periods of high volatility, which is what we have seen since late 2007, whenever VIX enters a reading of 16 or lower, it has almost always signalled that a top is closer than a bottom. I definitely expect VIX to be much higher in coming months and quarters and prices of stocks most likely lower within the same timeframe.

In summary, the current indicators I follow have not changed the underlying conditions since the last few articles I have written. Defensives still lead the charge to new highs while cyclicals continue to under-perform, which is something that we saw during July and August 2007 and July and August of 2011. Both instances lead to a downtrend over the next few months, with serious loses.

Furthermore, there is a major divergence between MSCI World Equity Index and the S&P 500. This divergence will need to be resolved soon enough, so either the World Index will play catch up on the upside or the S&P 500 will play catch up on the downside. Considering that the US equity market is a lone wolf making new 2012 highs, while the rest of the world struggles, I believe the US economy and its equity market will eventually succumb to a global slowdown (EU and China) as there will be no de-coupling.

Bond Markets

There have been some technical developments in the Treasury market which are also worth reviewing this week. As we can see in the chart above, common technical indicators like RSI and MACD have registered negative divergences with the current price action of a marginal new highs also known as a potential bull trap breakout. One could make a strong argument that Treasuries are extremely overbought.

Furthermore, a longer term chart also reveals that the Long Bond's distance away from the 200 day moving average is diverging with the price action too. All in all, these indicators suggest that the parabolic rise in the bond market is running on lower momentum right now and that at best a correction is in progress, while at worst a major top could be here. Still, technicals aside, markets do not change major trends without a proper catalyst, so the current speculation is that Draghi is about to pull out a "bazooka" to save Spain from a potential default, as its yield curve inverted only recently.

Currency Markets

There has been a lot of talk about US Dollar topping and the Euro bottoming around current levels, especially because of Draghi's comments this week. In my opinion, what we are seeing a mean reversion as sentiment on both currencies has been at either side of extreme. Furthermore, Euro has landed around the $1.20 level, which is a strong support region - so it is quite possible for the currency to recover a bit and stabilise for awhile. This can also help PMs rally too (more on that below).

Having said that, if we were to focus on a longer term picture and analyse the fundamentals, than I would have argue that the current economic slowdown around the world has most likely not yet played out in full context and therefore I think that the global central bank easing cycle has also not yet fully played out either. As global central banks continue to ease instead of hike, we should see that action benefit safe haven currencies like the US Dollar and the Japanese Yen.

Obviously, it is not to say that the Dollar cannot correct when it becomes overbought from time to time, but as long as one holds a view that China, EU and US is still slowing - and there is nothing to suggest that is changing - one should be prepared to see further easing by global central banks. On the other hand, if you think there won't be a severe recession globally and central banks have done enough for growth to become self sustainable, you should short the Dollar first thing monday morning.

Commodity Markets

Another development I have found very interesting in recent days and weeks, is the retail investor actions in the Precious Metals ETF space. The chart above shows number of Gold tonnes held in GLD ETF, as reported by SPDR iShares Trust, compared to the actual price of GLD itself. What usually occurs that the bottoms, is retail investor paid selling as we can see in June 2011, October 2011 and December 2011. Furthermore, we can notice that in recent weeks retail investors have withdrawn about 50 tonnes of Gold out of the GLD vault and yet the price of Gold seems to be forming a base from which it is breaking out on the upside. Do keep in mind that PMs are now entering a period of strong seasonality and that recent sentiment readings have been extremely negative.

Credit Markets

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

Trading Diary

• Outlook: I believe that we in a bear market as the global economy starts slowing down meaningfully. US GDP has grown 6 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 the secular commodity bull market and especially in Silver (SLV, PSLV, SIVR) for awhile now. I 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. I have also shorted various US stock sectors, including Technology (XLK) and Dow Transportation (IYT), former because the sector is much loved by the global fund managers and the latter because I believe economically sensitive stocks will suffer during a recession. Finally, I have recently hedged 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 and most likely buy more.

• Watch-list: A major short in due time will be US Treasury long bonds (TLT), as they are extremely overbought and in a mist of a huge bubble mania. Other than that, not too much is on my watch list right now.

What I Am Watching