Checking The Pulse Of Mr Market

Market Notes

• As I write this, there is a major battle taking place between bulls and bears in the marketplace. Physiological resistance levels of the Dow @ 13,000 and S&P @ 1,400 are now critical areas of play. Both indices have failed to close above these important levels two times already, so the question is whether or not bulls can push higher for a third time or are we in for a bull trap?

• As the Dow Theory continues to diverge, yesterday we saw critical Transportation components break down (FedEx & UPS). Industrial stocks continue to outperform as the US remains a safe haven. On the other hand, Transportation stocks are suffering as the global economy weakens and earnings disappoint. Dow Transports is now approaching a technical make or break decision.

• A recent Bloomberg chart of the day portrayed the credit markets in relative calmness. The chart explains that "measures showing US financial market conditions have improved". A similar occurrence was seen last year, during the summer break, until credit risk started rising due to the European Crisis intensifying. With nothing solved in Europe, is this time different?

• The Australian Dollar, a great risk barometer and a Chinese proxy, finds itself at a six week low. Fundamentally, we should all know the story of a weakening Chinese economy and the falling demand in industrial metals, including Iron Ore. Technically, the Aussie is now below the 200 day moving average as it just printed the second lower high in a row.

• To say that industrial metals have been under-performing lately would be an understatement. The fact is that the majority of these economically sensitive commodities have been selling off as the  Chinese economy slows meaningfully. There is only one industrial metal that still holds its support, as it gets ready for a technical make or break decision, and that is Dr Copper. Keep your eye on this one!

Big Picture

A lot more of the same as major global assets remain in consolidation patterns. Industrial economic barometers like Copper and Crude Oil are failing to rise above their 200 day MA and more importantly are not confirming the S&P 500's new highs in 2012. The Emerging Markets, saviour of global growth in the post Lehman recovery, also continue to lag other equity indices indicating that not all is well with the BRICs (GEMs also below 200 MA). Finally, Gold, Silver and Platinum have technically broken out to the upside, but the real test will come as volatility of global risk assets rise and if the US Dollar starts to rally again.

Leading Indicators

Due to a short week, I'll be updating majority of economic data on the weekend, including the Global Manufacturing PMIs making headlines in recent days.

Featured Article

Happy Labour Day to all of the US readers. It has been a long weekend for most of us around the world, even if we do not live in the States (perfect excuse). Coming back from the break, I thought it was a great idea to revisit the overall market sentiment and contrarian themes with the post today. This will be followed by an in-depth global economic update post later in the week. So lets get straight into it.

This week's Barron's magazine cover featured an invincible bull, which could not even be stopped by a canon ball shot. Tough stuff, as Barron's described it. I like using magazine covers to gauge the sentiment of the investment community for the simple reason that markets tend to be a discount mechanism majority of the time. Therefore, by the time asset success or failure reaches the cover page of a major publication, the asset is so well advertised (in a good or bad fashion), that the trend is almost completely priced in. The chart below shows MSCI World Equity Index together with five Barron's magazine covers I've chosen at critical moments.

The first one came out on the day of the stock market bottom in early March 2009 with a very bearish theme. The second one, came in late March 2010 with a bullish theme, approximately one month prior to the flash crash. The third one with a bullish theme, came out in late April 2011, about one week before the recent top in the MSCI World Index (unlike the US equities, global equities have topped in 2011). In February 2012, we were treated to a rather bullish Barron's magazine cover, signalling that the Dow will reach 15,000. What followed afterwards was an MSCI World Index intermediate top. Finally, the invincible bull which came out last week, could very well be another contrarian indicator to sell rather than buy stocks.

Last Thursday we also found out that according to the National Association of Active Investment Managers (NAAIM), fund managers are now exposed 82% net long. This is more than one and half standard deviations away from the mean, which from a contrarian point of view, is considered very negative for stock prices going forward. More importantly, the survey also showed that fund managers hold extremely bullish belief or high exposure intensity. What does this mean? We try and measure the relative exposure between bearish and bullish managers. The survey results showed that most bearish managers were actually neutral with very limited short exposure, while the most bullish managers were dangerously leveraged towards the upside. As we can see in the chart below, this is not a one week phenomena either.

Quite to the contrary, this has been a theme for the majority of the year and even a 10% correction in May failed to turn managers fearful or bearish. Since the Global Financial Crisis begin in late 2007, we have seen sentiment periods like these five times, as we can see in the chart above. Four out of the five resulted in lower equity prices in the coming months, while one resulted in a further rally followed by a major correction (one year later stocks achieved no gains). While this indicator signals that managers see no need to worry about downside risks, it is not the only one. Over the last few weeks, we have seen indicators like the Volatility Index and the Investor Intelligence Bears confirm complacency as well.

Moving towards the currency markets, I would like to focus your attention on the sentiment of risk currencies like the Canadian Dollar, seen in the chart above thanks to the SentimenTrader website. The current reading of 82% bulls is on the extreme side, which we've only seen a handful of times over the last five years. Interestingly, from a contrarian point of view, all of them marked a major top in the currency and a great selling / shorting opportunity. The Commitment of Traders report also confirmed that net long exposure towards commodity currencies in general was extremely bullish. Furthermore, since the Canadian Dollar tends to be a poster boy of risk appetite in the marketplace, Crude Oil and equity prices tend to correlate closely and could also follow lower.

And since we are on the topic of Crude Oil, it was interesting to see the Commitment of Traders on Friday report that hedge funds and other speculators now hold close to record bullish bets (chart below). This always makes me nervous, as I prefer buying assets when they are hated, not loved. The previous two instances where a similar amount of net long contracts was reported, an intermediate top was triggered almost immediately. Do keep in mind that from a fundamental side, there always seems to be a "hook" which attracts the herd of trend followers into buying an asset precisely at the wrong time.

The first instance was in March 2011 at $114 per barrel and the hook was the Libyan supply drop during Arab Spring. The second instance was in February 2012 at $110 per barrel and the hook was a escalation of the Israel-Iran geopolitical tensions linking to a full blown out war. This time around, hedge funds are getting "hooked" again, due to the promise of further monetary stimulus by both the Fed and the ECB. I've actually heard one analyst on CNBC state that with unlimited bond buying coming from the Fed and ECB, Oil could go to $150 a barrel very quickly. In my opinion, this is highly unlikely for now. Also consider the fact that Crude Oil is in a weaker technical position this time around, as it seems to be struggling to move above its 200 day MA. From a contrarian point of view, I'd expect long positions to unwind sooner rather than later.

Finally, let us finish off with Precious Metals, as they seem to be getting a lot of attention in recent weeks. Since my recent blog posts have appeared on various internet sites, I have received a few emails by investors asking me why do I bother holding investments in Precious Metals like Silver when I am so bearish on the global economy and risk assets in general.

I prefer not to get into the fundamental side of things right now as this is a technical sentiment post, but I will say that the worse the economy gets, the more bond buying central banks will administer as a cure regardless of whether or not the patient is improving. On the other hand, from the sentiment point of view, we can see in the chart above that in recent weeks investors became overly bearish on precious metal ETFs like GLD and SLV. Short interest ratios reached levels not seen since at least the 2008 lows, which in my opinion created a perfect buying opportunity. For those that follow the blog regularly, you'd remember that a large purchase was made in late June and a smaller purchase was also made in the third week of August (on the technical break out).

Trading Diary (Last update 05th of September 12)

• Outlook: I am of the opinion that the risk asset bear market is upon us and that the global economy continues to slow rapidly into a recession. United States GDP has grown 5 out of the last 6 quarters below 2%, which tends to be stall speed. German GDP is also at stall speed, similar to 2008. China and India are slowing meaningfully and could experience a serious hard landing. At the same time US corporate earnings and gross profit margins are at record highs, so I expect a mean reversion unlike so many stock analysts. More importantly, corporate revenue growth is already slowing. Cash levels with mutual funds, retail investors and money market funds are at extreme lows, financial stress is starting to rise, volatility is at very complacent levels and credit spreads are very narrow relative to fundamentals. I expect a risk off scenario!

• Long Positioning: Long focus is towards the secular commodity bull market, with positions in Precious Metals and Agriculture. The largest commodity position is held in Silver, with central banks gearing to print money, as the global economic activity deteriorates. Since Silver has broken out recently, hedges have been removed and a full position is held. If a negative reversal occurs, as global risk asset volatility rises, reducing positions will be appropriate. NAV long exposure is about 100%.

• Short Positioning: Short focus is towards the secular equity bear market, with cyclical sectors and credit offering best selling opportunities due to deteriorating global economic activity. Mild to modest exposure is held short in Junk Bonds, Technology, Discretionary and Dow Transportation (all economically sensitive). Tech stocks like the Apple parabolic and Amazon have been shorted with long dated OTM puts. Put options have also been purchased on the Pound and the Loonie (long USD). NAV short exposure is about 70%.

• Watch-list: A major short in due time will be US Treasury long bonds, as they are extremely overbought and in a mist of a huge bubble mania, but first we have to wait for the Eurozone dust to settle. Finally, while Grains have exploded up, Softs still present amazing value for long term investors, with Sugar being my second favourite commodity (after Silver). Japanese equities are down about 80% from its all time high over two decades ago and offer some great value.

What I Am Watching