Glenorchy Capital

Crunch time perhaps? We are coming to a critical juncture in US financial markets and as strange as it may seem it appears that equity markets are leading the way. Equities, as per the Vanguard Total Market Index at least, are in a perfect up trend. In fact small caps as per the Russell 2000 are now trading at multi-week highs. This typically is not what you would expect if this was a false rally in equity markets.

We are still of the feeling that there are few genuine bulls of the equity market, let us not forget the total “stop-out” of bullish commentary in early – mid February! If you put a gun to investors heads and asked them if they thought equity markets would close the year 20% higher or 20% lower from current levels, the vast majority would say 20% lower (remember if they sit on the fence the trigger gets pulled). OK that is rather drastic but I hope you get the point – this still remains one of the most hated rallies in modern history…..perhaps that is why equities have advanced the degree to which they have over the last 18 months and why they are likely to continue to rally over the course of this year. Not until there is a general complacency towards risk or a universal belief in a bull market in equities will the rally run into genuine problems.

We think where equities go, so too will commodities. Yes commodities remain about 10% away from their highs reached at the start of the year but to expect the CRB to be at or close to multi-week highs given the recent strength of the USD Index is somewhat unreasonable. Perhaps the king-pin to commodity prices is US Treasuries (TLT). A breakdown in the US Treasury markets is liable to propel commodities higher to multi-week highs. One reason which few realise is that a rise in treasury yields would increase the carry costs of holding commodities for physical delivery and thereby dramatically reduce the contango condition of many commodity markets which have been effectively held down the near dated contracts (on which many ETFs are based). Whether or not a breakdown in US Treasuries pulls down the USD Index remains to be seen, but with record short positions against the Euro (long the USD) we don’t think that it would take much to trip the USD Index.

While everyone is transfixed on the impending “default” by the Greeks and problems of the Portuguese, has anyone noticed that Credit Default Swaps on the PIGS government bonds (and Greece in particular) are lower than were they were trading at on the 1^st of February? Could we go so far as to say that the European CDS market for sovereign debt is suggesting that the EU Debt Storm (call it what you will) is passing?

And what if the Credit Default Swaps on the Greek and Portuguese debt continue to move down? Well we can only think that the worst position to have in the world would be shorts on the Euro!

It is all too easy these days to get caught up with the short term emotion of the market, perhaps this is still the hangover of the big crash of 2008. We always take time out at the start of each week to ask ourselves the all important question; has there been any fundamental change in long term trends within each asset class?

In essence we see little reason to doubt the health of the trends in equities, commodities, treasuries, and real estate that had their origins in October/November 2008. Any pull back in equities, commodities and real estate has, so far at least, been met with a deluge of bearish opinion/sentiment which has effectively limited any downside. The opposite applies to US Treasuries.

Now what about currencies? After all the USD Index has risen dramatically over the last 4 months! We would like punters to look beneath the scenes. Yes on the face of it the USD (as per the USD Index) does look strong but if you strip out the effect of the Euro things looks somewhat different. Take a look at the behaviour of the CAD, AUD, and emerging market currencies (using the ETF CEW as a proxy). Have these currencies broken down against the USD? Granted they are not exactly making new highs and have not done so for a few months now but all the same these currencies are not exactly trading at multi-week lows which would typically suggest a change in long term trend. We think the rise in the USD Index is a false move and we all know what is likely to happen to equities, commodities and US Treasuries when (as opposed to “if”) the USD Index falls!

We have updated our Earnslaw portfolio and members should login to view the details.

Since inception in February 2009, our Earsnlaw portfolio has returned 39%.

Also, in making some behind the scenes changes to the site I accidentally restricted access to some posts. whoops!. Sorry about that. All posts are now able to be read by everyone. Only the portfolio pages require membership.

All the best
Emilio Niederhoffer

When it comes to investing and market timing the immortal words of John Templeton ring loudly in our ears;

“The best time to invest is at the point of maximum pessimism”

Just where in the world would the ordinary average investor dare not tread with respect to equity markets? We think that place would be the Greek stock market. Yes it would be a brave man to even contemplate “walking on to the floor” of the Athens stock exchange and announcing “I am a buyer”. But if you want to find deep value then look no further. The price to book value of the average stock listed on the Athens exchange is a mere 0.890! One could argue all they like about the level of growth and earnings but when we see a nation’s stock market trading well below book value we see value!

Apart from futures on the FTSE/Athens 20 Future the best way to get access to the Athens stock exchange is via the Lyxor MSCI Greece ETF that trades on Euronext (code GRE)

If the US economy was contracting wouldn’t there be an increasing number of junk grade bonds entering a distressed condition? Yes that would be a reasonably logical assumption. Then why has there been no increase the level of distressed debt (junk grade issues trading in excess of 1000 basis pts over US treasuries) over the last month or so? In addition why has there been no material movement in junk grade CDS premiums, at least nothing out of the ordinary?

TRACE Distressed Debt Index

MARKIT High Yield CDS Index

We think that the two indices above are not so subject to speculative activity that the equity market is and accordingly the behaviour of the indices above give a more true representation of the mood of the market. In short equity markets are not genuinely bearish. The weakness we are currently experiencing appears to be entirely due to the crowds panic reaction to the excessive spending habits of a couple of Mediterranean nations, which have little or nothing to do with the earnings prospects of US Industrial heavy weights (aka DOW members).

Just how oversold is the equity market? One of the most reliable indicators we have found is the NYSE 50 day moving average ratio. In essence it is the ratio of stocks trading above their 50 day moving average to below. A ratio below 25% we consider oversold and above 75% overbought. Currently the ratio is 24%.

Of course just because the market is in an oversold condition does not mean that it is going to get even more oversold over the coming days/weeks. But we would just like to point out that if the S&P 500 were to fall to support at 1030 the 50 day moving average ratio would quite likely fall to 10, that is, the market would become as oversold as it was in early March last year.

OK now to take a stand! We consider the current weakness in US equity markets as a buying opportunity. Odds suggest that if you want to get bearish you are a few weeks too late!

Complete mayhem! These two words were the best we could come up with to describe the market’s behaviour last week. Over the last 10 days, especially the last few, we have been watching with interest the rapidly growing bearish consensus with the stock and commodity market and the Euro.

From our years of experience in the markets we have found that when a crowd becomes “unanimous” in its belief that a bear market has taken hold it coincides with the major market indices having already registered multi-week lows. Given the level bearish tone coming through in the popular press one could be forgiven for thinking that the S&P and Dow were trading well below the levels they were trading at in September/October. However, both indices are merely trading at mid November levels and still well above levels that would present “technical” breakdowns (1030 on the S&P). OK to cut a long story short – the crowd is too bearish. Major downside generally only occurs when there is complacency towards risk. Given how quick the “risk” trade has been thrown out the window over the last 10 days we think that the crowd is now far from being complacent towards risk.

It does seem like a repeat of late 2008/early 2009 but on closer inspection there are some notable differences. US treasuries have barely moved over the last three weeks or so. In fact they are only trading at mid December levels!

There is no question that the commodity market has been “crushed” over the last three weeks, but has it? Yes in USD terms it has (although no technical support level has been broken), but in Euro, GBP and AUD terms the CRB is only trading at November/early December levels. Until we see commodities registering multi-week lows in both USD and non USD terms we have trouble concluding that the rally in commodities is over.

There has been no material downside in real estate stocks to suggest a change in trend, yet we still find few believers in the prospects of the real estate sector. Markets follow the path of least resistance!

There can be no question that the USD Index is looking bullish and any technical analyst would tell you that this chart is going higher. Well higher it may go, but hear this for the week ended Tuesday, the CFTC said the net spec short position in the Euro (this translates to bullish positions on the USD) reached a record high dating back to its introduction in 1999. Given that the Euro has sold off dramatically since Tuesday it would be safe to presume that a new record has been set for bearish positions on the Euro.

If you want to get bearish on the Euro now odds firmly suggest it is too late…….which also suggests that being short the equity and commodity market and long “safe haven” markets/securities is a high risk proposition! Big call but someone has to make it!

We have always maintained that the best way to understand the mood of any stock market is to look at the behaviour of small caps. Small caps have a wonderful tendency to trend with relatively little volatility which makes depicting the true trend of the market considerably easier. Furthermore, due to their relative lack of liquidity their action forewarns or leads the behaviour of large cap indices.

We would like to draw your attention to one of the hottest equity markets in the world, Moscow! Look at the behaviour of the MICEX Small Cap index. It is at a multi-week high and gives every indication that it wants to move higher. Of course it is somewhat difficult to invest in Russian small caps themselves but for the average investor the ETF RSX will suffice.

If the market was “seriously” bearish then shouldn’t more junk rated bonds be entering a stressed condition? Well yes that would be a logical conclusion but it appears that there is no material increase in the number of junk rated bonds trading at more than 1000 basis points above the yield of US treasuries as the Bloomberg TRACE index below depicts.

Perhaps the graph above suggests that the US Economy is not in trouble as the recent behaviour of equity and commodity markets suggests.