Markets; Walking on Ice

You certainty do.....

An opportune time for a distraction into markets which despite looking firm optically are a lot more fragile and shaky beneath.

A poor start to the week then with the G20 joining the IMF and BIS with bubble warnings and of course TSCO which says it has uncovered a “serious” issue, is investigating and has suspended a number of staff; "Principally due to the accelerated recognition of commercial income and delayed accrual of costs". Yep, £250m is serious all right. Something the now suspended UK CEO can reflect on. The fact that small chocolate supplier Moo Free Chocolate had to threaten the firm with a winding up order to receive a payment more than three months overdue is a tell on the internal culture. Tesco is many things but from a market point of view its like a bank, you simply don’t know what is in there because clearly the management don’t. Today’s announcement does though, come after a long period of shall we say financial flair during which return on capital employed deteriorated while EPS increased. Terry Smiths article in the FT earlier this month gave a good précis.

 The Alibaba IPO came and went. Its market cap of $168bn at the offering price made it the 36th most valuable company in the world which clearly wasn’t enough for the market which pushed it up another 50%. Buyers don’t of course get shares in the company. Instead they receive units in a Cayman Islands holding company. It makes most of its money in China, lacks transparency and there is no lock up period for the $8bn worth of units that can be sold. Think I’ve heard enough.

Taper will begin to have a deleterious impact on markets; it has to. In effect, the Fed is draining liquidity with its massive position in securities issued by corporations and government. As issues mature and coupons are due, money will flow to the Fed from the issuers withdrawing money from the economy. It’s tightening in all but name and its not a great time for that to happen. The Fed delayed a cathartic clean out with QE but having kicked the can down the road we’re arriving at the spot where it landed. Velocity of money slowing and tighter lending are not what equities like to hear.

Hindenburg Omen back again to cheer us up

Market participants should be braced for more negative headlines and by now be positioned defensively. The market is in a fragile and precarious place. Thursdays first Hindenburg signal was confirmed with another on Friday. That means that we have a 25% probability of a crash in the next four months. In itself that’s something we can manage but with the timing coinciding with the negative divergence in the NYSE cumulative advance/decline line and the 23 year maturing Jaws of Death Megaphone Top pattern we have a confluence of indicators bearing down which ought to make us sit up and take notice.

On Friday, New Highs were 128 and New Lows 102, the lower being 3.14% above the 2.20% threshold. New highs were not more than twice new lows, the McClellan Oscillator was negative and the 50 day moving average was higher than it was 10 weeks ago. With the exception of the mini crash of summer 2011, a HO has been present in every crash for the past 27 years but there hasn’t been a crash every time a HO signal has appeared.

 The divergence in the NYSE Cumulative Advance Decline Line started at the beginning of the month and is moving rapidly. The depth is similar to that last seen in 2007.  We also see negative divergence in the Russell and NASDAQ 10 day moving average Advance/Decline Line.

 Despite the record high close in the Dow on Friday decliners outnumbered advancers with a ratio of 1.4:1. As we discussed last week, many parts of the stock market hit highs months and months ago and have been in decline since. Yet we continue to see headlines typical of euphoric phases such as those alluding to luxury goods, residential and commercial property, art and tech. That the Russell 2000 is at a 22 month low ought to be a concern for investors. UK small caps are in a better place but for how long I wouldn’t like to speculate.

The original expectation of a 5-10% correction is still good but these other developments are telling us that while equities may look good optically, in fact market psychology beneath the surface is quickly turning negative. The expected correction could surprise to the downside.

The SKEW Index which we discussed on Friday closed at 146.08; that’s the highest reading since 1989. This index indicates that option traders are pricing in a near record probability of a large move in the next month.

European equities will also reverse this week. Quite simply, take nothing at face value; equities are displaying multiple exhaustion signs and are walking on ice.

Commodities meanwhile are not making life easy for anyone. On the one hand, multiple commodities are at multiyear support points; on the other the broad based commodity indexes are not a picture of health and vitality. At some point liquidity will flow from equities into the commodity complex but right now they are signalling deflation. If these already oversold assets are hit hard again there is a pretty simple message for equities there.

Gold, silver, Euro and Sfr all on support lines going back to the early 2000’s.

…. And the converse of those is the USD which is back at long term resistance and where bullish sentiment is plentiful.

Crude is back to 5 year support which really needs to hold.  It could drop rather a long way if it fails. Oil is probably waiting for the dollar to top but the rest of the commodity complex is unlikely to get a lift unless oil is leading.

Gold bulls need to be prepared. If they're not yet in the bunker they should be.

This week could be a bad one for precious metals. Fasten seat belts and cross check. Gold is sinking into its capitulation phase. It’s taken a while. I first decribed this in a piece called “Panic and Opportunity,” back in April. “A failure there, ($1280), will demoralise gold bulls but it will portend a more significant fall to the Dec low at $1180 with a possibility of the $1050’s beyond. A collapse to those levels would obliterate sentiment, create forced sellers and create the conditionality required for a final bear market cathartic cleansing thereby forming a firm base from which to move into a multi year bull market. That point of maximum pain will be the point of maximum opportunity but it will feel gut wrenching to pull the trigger when everyone else is racing round with their pants on their head.” Not much to add to that.

We can expect a reasonable bounce from daily cycle lows in the precious metals but most rallies will be met with more selling. We need to get through the cathartic washout to create the foundation for a long term rally.

In summary then, we’re about to see the kind of volatility usually associated with  the second half of September. Nothing unusual there but given the fragility of markets which has been largely ignored by the media surprise moves, and risk, therefore lie to the downside.

QE2, Lower Gold and a Higher Dollar......?

In the next in a series of guest financial pieces, Mark Tinker from Axa-Framlington discusses the anticipated next round of quantative easing in the US and how the outcome might not fit most current market expectations.



Many people have been scratching their heads about the wisdom behind QE2, seen now as almost a certainty by markets. We know that you need to trade on the basis of what you think will happen, rather than what you think should happen, but even so the logic seems very flawed. To recap, QE1 was effectively the US authorities stepping in to prevent meltdown in the US financial system in 2008. In effect the Fed had to undo the damage caused by the Treasury and the regulators, who in their wisdom had managed to paralyse an entire section of the shadow banking system. By insisting that everyone had to sell so called toxic assets while not allowing anybody to buy them, the politicians created a need for a buyer of last resort. Step forward the Fed. Thus the job of QE1 was effectively to supply liquidity to undervalued but almost totally illiquid assets and the Fed balance sheet expanded by $1.3trillion, almost all of which was mortgage backed securities

QE2 however seems aimed at doing something completely different; buying the most liquid and expensive (as opposed to the least liquid and cheapest) assets in the world; US treasuries. The apparent thinking here is that by reducing the cost of capital (yet) further, the Fed can stimulate growth in the US economy. Now this is dubious on a number of levels. First, for all the politicians Banker bashing, these policies are doing nothing to improve the supply of credit. Credit is what small businesses need to survive and prosper and it comes from the banking system (shadow or otherwise). Making it very cheap to raise money in capital markets is good for large businesses, but they are not the ones that drive employment growth, indeed they continue to shed labour. Equally, making it cheap for banks to borrow at the short end and then encourage them via your “Risk” policies to buy government bonds simply sucks investment capital away from the productive economy.

In reality, all that has happened so far is that as the MBSs run off, largely because they were not at all toxic and have been redeemed at par, but also because the very policy of driving down long rates encouraged refinancing and pre-payment, the Fed has simply rolled that liquidity into other fixed income products (mainly Treasuries) so as not to tighten policy. Somehow, this has been whipped into an hysterical bandwagon (encouraged by uber-keynesians like Krugman) that the Fed should spend $1trilion, $2 trillion or even $3 trillion on buying US Treasuries in order to stimulate the US economy. Never mind that the Leading Indicators are turning positive, never mind that employment is a lagging indicator (which incidentally your own policies are making even more lagging), hurry up and get employment going, encourage inflation, push up asset prices and everybody will be happy!

Now this all seems very strange, not only because it seems to be a repeat of the very asset bubble issues  that we swore not to repeat, but because the unintended consequences (if that indeed is what they are) are clearly evident already. Most notably the liquidity is flooding out of the $ and into real assets, notably commodities and emerging markets. The huge binary allocation of expensive bonds (buy with leverage because the Fed will buy them off you at a profit) and expensive emerging market equities (buy with $’s because not only is this where the growth is but the currency is only going one way) had, until recently left the rest of the equity markets looking ridiculously cheap with almost all large cap stocks trading at a dividend yield above their own corporate bond yield. Thus even the talk of QE2 has produced a dramatically weaker $ and risks of a bubble in commodity prices, treasuries and emerging market equities and no discernable effect on employment.

Now generally I prefer cock-up to conspiracy, but for once, let’s give the US authorities a bit of credit. Say you wanted the Chinese to revalue their currency, or even scrap the peg (now we know this is not the reason for the deficit, but we have seen this movie before with the Japanese), suggesting that you will dramatically lower the cost of capital and thus drive their monetary policy is a very credible threat, for as we know from 2007, the liquidity goes straight to Asia via the peg – a smart bomb straight into the heart of Chinese economic policy. Say too that you know from 2007 that a key vehicle for this transmission is the $ itself, a weak $ correlates to high commodity prices and we know that the Chinese are far more sensitive to imported food and energy prices than the US is. But of course this is not one sided, the Chinese have moved to tighten policy and also they can try and offset the weak dollar impact on their export economy by buying Yen and Euro, and then allowing a Yuan appreciation. To do this of course they effectively sell down the $ as well. Now they are not the only players in markets, momentum traders in $ are shorting and shouting, about debauching the currency and the  $ as a one way bet. Their equivalents in the commodity markets are also shorting $ to buy oil and metals, particularly gold. Other emerging economies are really struggling with capital inflows and instability is rising everywhere from Indonesia to Brazil.

So maybe these unintended consequences are actually intended. Now that the Yuan has revalued (at least somewhat), maybe the US backs off? Tim Geithner has started to make comments about wanting a stronger $ (something China’s EM competitors would also like) and, interestingly, a number of Fed Chairman from around the country are making increasingly hawkish (ie sensible) noises on QE2, not least concerned with the reality that higher energy prices in the US are a deflationary thing – as essentials they crowd out other disposable income. Come November the 3rd of course, the Fed oversight committee will likely be chaired by a republican $ hawk. But, and here is the final twist, how about Bernanke simply muses that the US might consider selling some of its physical gold reserves?  Gold would drop like the proverbial, almost certainly taking other commodities with it, meanwhile the $ would soar, reducing all those unpleasant emerging market tensions and reducing the price of gasoline to boot. Oh and John Paulson would get hosed (which would be nice)

Go on Tim, tell me it’s a plan.