Stock Market Troubles

Market Notes

Source: Short Side Of Long

• Industrial sector (XLI) within the S&P 500 tends to correlate with the main index the best. When we overlap the two, they seem almost identical at times and therefore this sector holds a strong "tell" on the overall market. Having failed at the 37 resistance three times over the last 16 months, the Industrial sector looks very vulnerable, especially because it tends to lead the S&P 500 at major turning points. Furthermore, the relative strength of Industrials is giving us a warning signal that the sector is losing its uptrend leadership role and may be ready for a break down. Disclosure: I have sold short the Industrial sector.

Source: Nordea Newsletter

• Euro currency skew risk, which is commonly used to derive the difference in price between Puts and Calls, is showing that complacency has once again returned to the currency options market. For what it's worth, the current market conditions are showing extremely cheap Put prices relative to the same strike / expiry Calls. Historically, this has indicated that the Euro is much closer to a top than a bottom. Furthermore, over the last few months Super Mario has managed to squeeze more than three quarters of all Euro bears that held short positions against the currency. Recommending to "short the Euro" is far from a consensus trade these days.

Source: Short Side Of Long

• The Australian economy has not suffered a recession in over 21 years. Unemployment rate has not risen meaningfully for a whole generation. Housing prices are some of the most overvalued in the Developed World largely due to incredible leveraging stemming from the country not experiencing a single day of hardship for more than two decades. Australians have now become the wealthiest individuals in the world. Too good to be true? That is because it is. The recent book published nationally was titled "The Australian Moment", describing how the fortunes of the "lucky country" will continue for a long time into the future. It was a fantastic read... for a contrarian. I am skeptic, with a view that the economy is on the edge of a rescission (finally) and that the currency is on the edge of a bear market.

Source: Merrill Lynch Newsletter

• Despite strong evidence supporting the fact that there is a very high probability of a global synchronised recession, the consensus outlook remains upbeat. Reading the recent Merrill Lynch newsletter, amongst others, it is becoming very clear that the consensus outlook is for a growth recovery in early 2013. As seen in the chart above, the main forecast is an Eurozone rescission to trough in early parts of 2013 and to regain growth by the third quarter, while the outlook for the United States is to miss a recession and continue to "muddle through". If you believe ML and many other investment banks, you have nothing to worry about in the coming 12 to 18 months. Once again, I am skeptic, with a view that: a) Chinese real estate will experience a hard landing; b) the Eurozone recession will intensify; c) EU Debt Crisis is heading for a final climax with an overdue default out of Greece and;  d) the US will once again enter a recession. 

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If you have been a following the blog since late July and early August, you would have noticed a critical change in my outlook on risk assets and the the global economy. It was around that time, that I started to make it clear that the fundamental conditions were deteriorating rapidly and that the stock market was most likely on its last leg of the advance. 

Source: BarChart / Short Side Of Long

This advance, out of the June lows was mainly driven by central bank stimulus and had nothing to do with fundamentals. Some of the broadest measures of the stock market price, like the NYSE Composite (chart above) or the MSCI World Index, actually experienced an orthodox top in May 2011, as recent rallies have failed to push prices to new bull market highs. Fast forward to today, I still hold a view that post US elections, the world will be facing a terrible 2013 and/or 2014.

Source: BarChart

Up to this point, stocks have been bullet proof as investors took refuge in US denominated assets for the whole of 2012. Indices like the Nasdaq 100, which tend to be stock market leaders, experienced huge gains year to date. Interestingly enough, today the Nasdaq 100 is still below its March high. But unlike March highs, retail investor greed and bullish sentiment during the August & September recovery has been quite remarkable to watch. These are some of the "real comments" dated back to only the September of 2012 from various blogs and forums:

• "Major Breakouts this week on $NYA, QQQ, $RUT, $SPX, $MID. A continuation of this could get people rotating out of bonds into stocks in a hurry!"

• "This indicator has done great work for years, so if we see no new highs in the coming weeks, I would be very surprised."

• "My look at "SPY:TLT" has bullish MAs alignment which clearly says PRO-RISK."

• "My probability calcs support the breakout, and if we can breakout [above March highs] into clear air, then the gains should be significant: a melt up, an overthrow should occur."

• "I’ve taken a small DOW long position this morning...with a pile of investor cash sitting on the sidelines."

• "In real terms, bearish arguments make a ton of sense, and are mostly accurate, but those beautifully-reasoned puts can take you for a ride all the way to zero."

• "S&P 500 10% higher from its current level, which would take us back to the all time nominal high, or 10% lower, which would take us back to the end of May of this year? Absolutely easier to see it 10% higher."

• "Short term overbought, if you are nimble can play the downside for a week or so, BUT remember trend is up, so best bet is buy the dips."

• "I don’t see price at this point looking toppy."

• "The Nas and the SP500 both broke out a week ago, then pulled back to the breakout, made a successful retest and then advanced again. That’s usually a pretty bullish formula."

Source: Short Side Of Long

Now, I could have included a million and one comments, but you get the point. It was only at the end of September that I was asking where are all the bears? Well, they are still no where to be seen. According to Dumb Money fund flows, bullish sentiment is not really pulling back, but actually intensifying. The retail crowd is still very happy "to buy the dip" and jump both hands and feet into the stock market. So... with such an optimistic outlook from so many market participants, I ask myself why is the Nasdaq 100 breaking down?

Source: BarChart / Short Side Of Long

We have just witnessed a classic bull trap or a false break (2B pattern) out at resistance around 2,800 on the Nasdaq 100. Technically, whenever an assets break a major support or resistance zone and then reverses in a fake out, the movement in the opposite direction tends to be quite powerful. Now correct me if I am wrong but with the abundance of optimism around, isn't the tech sector meant to be leading the advance higher? So why is it selling off and under-performing broad averages so rapidly? Furthermore, a keen market obscurer would have noticed that major bull market leaders like Apple (amongst others) are now reversing their breakouts and instead are breaking down. From my experience, that usually tends to be one of the warnings of a major top at hand.

Source: Short Side Of Long

Remaining on the topic of weakening sectors, one of the best ways to gauge the health of the market is through breadth participation readings. As we can see in the chart above, I find it astonishing that the S&P 500 is only 2 to 3 percent away from its 52 week high and yet less than two thirds of its components are above the 200 day moving average. What is even more alarming, is the very narrow participation of early cyclical leading sectors like Semiconductors and Technology, which currently show 12.5% and 37.5% of stocks above their 200 MA respectively. The industrial sector, which I shorted recently, has now started to break down too. There is now a rather large bearish divergence in progress between higher highs in prices and lower highs in the breadth participation.

Source: Short Side Of Long

And while some indicators are showing narrow participation and weakening breadth, other more smoothed measures are showing extreme overbought readings that signal a correction or even a top is close at hand. Consider the chart above, which shows the NYSE 52 Week High Low Ratio averaged over 21 days or one trading month, with overbought readings at 90% or higher. Over the last 7 years, there have been only 9 extreme overbought readings, including the current one. 

1. In Nov 06 - stocks rallied a few percent more before giving it all back in a correction
2. In Feb 07 - stocks corrected almost immediately with a sharp correction following
3. In Mar 07 - stocks rallied a few percent more, then the cyclical bull market topped
4. In Oct 09 - stocks corrected almost immediately with a sharp correction following
5. In Jan 10 - stock corrected almost immediately with a sharp correction following
6. In Mar 10 - stocks rallied a few percent more before giving it all back in a "Flash Crash"
7. In Feb 11 - stocks corrected immediately and later experienced a crash in August
8. In Mar 12 - stocks rallied a few percent more before giving it all back in a correction
9. In Oct 12 - stocks...

Will stocks rally higher before correcting? Or will they correct almost immediately? Are we going to experience another flash crash? Or maybe we are now topping in a similar pattern to 2007 and 2011, before a major sell off sometime in 2013? Or maybe stocks will just keep powering higher? Which one will it be?

Source: Short Side Of Long

Another reason why stocks are most likely breaking down is the fact that the "inflation trade" or the "risk on trade" has become well advertised. The Ben & Mario two punch combo (Street Fighter anyone?) has most likely been discounted by the market's powerful rally out of June lows. In the chart above, we can see that since the Global Financial Crisis started in 2007, every time 10 Year Break Evens reached extreme levels of consensus, the stock market as well as other risk assets, experienced a significant correction. Currently, the inflation expectations and euphoria surrounding inflationary stimulus measures is very much baked in and overcooked. Every man, his father, his mother, his daughter, his son, their cousins, pets and the next door neighbour all know about QE infinity.

Let us assume for the sake of this argument that the inflation trade, also known as the risk on trade, has becomes consensus. What should we expect going forward? Common sense would state the opposite, which is for the deflation trade to return. 

Source: Short Side Of Long

What I find to support this argument is the fact that while the stock market has railed rather powerfully out of the June 2012 lows, Bond prices have not sold off and have just moved sideways instead. As we can see in the chart above, this pattern has occurred before into early 2007, into early 2010, into early 2012 and now into late 2012. Every time stocks rallied and yet Bonds failed to sell off meaningfully, the non-confirmation usually resulted in Bonds making a new higher high and stocks correcting meaningfully. With the inflation trade overheating and overly bullish sentiment currently present on almost all risk assets, I think we are in for higher Bond prices largely due to the fact that money has no alternative, despite the Treasury Bull Market resembling an overvalued bubble.

When I look at the current condition of US stocks, it definitely reminds me of previous cyclical bull market tops just as the business cycle expansion was coming to an end. Be it overbought prices, narrowing breadth participation, tightening credit spreads, extremely prolonged complacent volatility,  overly bullish sentiment readings without a bear in sight or the fact that the Long Bond refuses to sell off - it all links to the economic fundamentals deteriorating rather rapidly. All of these signals make for quite a dangerous cocktail mix going forward (link here). Once again, I advise caution ahead into 2013.

Trading Diary (Last update 09th of October 12)

• Outlook: The Global economy continues to slow rapidly towards a recession. The United States GDP has grown below 2% for 5 out of the last 6 quarters. German GDP is also at stall speed, while China & India are slowing meaningfully with an increasing risk of a hard landing. US corporate earnings and gross profit margins are at record highs, so mean reversion is likely. Corporate revenue growth is already slowing. 

• Important Indicators: Cash levels within mutual funds, retail investors, hedge funds and money market funds are at extreme lows, volatility is at very complacent levels and credit spreads are very narrow relative to fundamentals.

• Long Positioning: Long focus is towards the secular commodity bull market, with positions in Precious Metals, especially Silver, and Agriculture, with Sugar recently added. NAV long exposure is about 100%.

• Short Positioning: Short focus is towards the secular equity bear market. Short exposure is held in Dow Transports, Technology, Discretionary and Industrial sectors. Apple and Amazon have been shorted with long dated OTM puts. Pound and the Loonie (long USD) have been shorted with long dated OTM puts. Junk Bonds are also shorted. NAV short exposure is about 80%.

• Watch-list: A major short in due time will be US Treasury long bonds, as they are extremely overbought and in the midst of a huge bubble. While Grains have exploded, Softs present amazing value for investors. Japanese equities are down about 80% from their all time high over two decades ago and offer great value.

What I Am Watching