If one was to take today’s newspapers, television, and financial websites/blogs at face value one could be forgiven for thinking that the end has arrived for Greece and perhaps the end is near for the Eurozone. The media relaying popular opinion would also have us believe that global equity markets, commodities and high yielding currencies are about to fall into the abyss.
If there is one thing that we have learned over the past 20 odd years of investing it would be that forecasting is essentially a fruitless exercise. So if we are unable to determine what lies in the future what do we do? Well we know that markets move in broad based trends, that there are underlying themes driving the returns of stocks, commodities, currencies etc. We know that once in motion these trends tend to last for considerable lengths of time. So we attempt to identify the underlying theme or mood of the market and ride with it.
What theme is currently running through world financial markets? Well believe it or not it remains yield seeking. There are a number of ways to identify this theme. Below we present two ways. The first chart is the spread between yields of emerging markets and US treasuries. If the market is in a yield seeking condition it will seek out the relative high yields of emerging market debt and accordingly one will observe a tightening of the spread. This is currently what is happening. Glance your eye over the chart below, is it exhibiting behavior out of the ordinary? Yes you will observe that the spread did widen yesterday, but that is not enough to draw into question the overall trend
JP Morgan EMBI Sovereign Spread. 
We can also approach the whole yield seeking puzzle by the cost of insuring junk grade bonds from default vs. Investment grade bonds. The Chart below is one we developed ourselves which in essence looks at the US junk grade CDS index / the US investment grade CDS Index(note the scale is going from negative to positive). In essence if the index is advancing it is saying that the crowd is willing to pay less of a premium to insure junk grade bonds from defaulting relative to investment grade bonds. I guess the big driver of the chart below is expectations of future cashflows. Higher cashflows suggest that there is less of a chance of default. The chart below continues to look bullish to us. Yes momentum has waned over the last 8 months but then what do you expect given it came from the depths of despair some 18-12 months ago!
Proprietary Chart of Spread between Junk and Investment grade CDS
One should only judge a market by its actions not the words of the crowd (newspapers and magazines). At this stage the market remains positioned in a risk taking condition. How long will this condition last? One could speculate that given the market (world equities) has managed to withstand the barrage of negative news/panic from the PIIGs “fiasco”, if it hasn’t moved to a risk aversion yet it probably has someway to go. That is, don’t be surprised to see continued strength in world equity markets over the coming months. We continue to see any weakness in world equity markets as a buying opportunity. Judge us by our actions not words!
The Underlying Theme in World Equity Markets Remains Bullish $VTI $EFA $SPY
Inflationary Forces Continue to Mass $DBC $TIP $IEF $TLT $TBT $GLD
Could it be that “inflationists”, fed up with the big commodity indices (CRB, Rogers, GSCI, & DJ) and US treasuries (10 & 30yr), having more or less gone sideways since June last year, are finally beginning to throw in the towel?
To us it seems that way. Perhaps this article from Bloomberg neatly encompasses what we are trying to say, the headline says it all: Bond Traders Declare Inflation Dead After Yields Fall.
But if inflation is dead then:
- Why is the real world market for commodities only a “few good weeks” away from all time highs?
- Why is it that TIPs are also a whisker away from breaking to a multi-week high against non inflation protected treasuries?
- Why is it that metals are preferred over US treasuries, JGBs, and Bunds?
- And why is there this persistent strength in gold in multi-currency terms?
Are these four indicators not clinical definitions of rising inflationary expectations by the market? If seems to us that the general trend of the graphs below is up!
Journal of Commerce Industrial Commodity Index
US 10yr Breakeven
Gold vs. US 7 & 10yr
Gold vs. International Bonds (JGBs Bunds etc)
Gold in JPY
There is a Titanic struggle going between inflationists and deflationists, but we think the inflationists will win and the chart below will break to the upside over the coming days/weeks! And then watch the inflationary storm hit with full force!
Commodities vs. Treasuries (CRB vs. TLT)
Smart Money is Beginning to Position for a Bullish Breakout in the Euro $FXE
While the press of popular opinion would have us believe that the Euro is going materially lower, the behaviour of the option market suggests that the Euro may well have already bottomed. Risk reversals have begun to diverge from the behaviour in the price of the Euro.
EURUSD 25 Delta 3 Month Risk Reversal (intraday)
EUR Spot (intraday)
What is a risk reversal? Well in essence it is the difference in price of like for like (same strike and exp) calls and puts. Generally it is expressed as the difference between 25 delta (OTM) 3 months to expiry calls and puts (see here for a more detailed explanation).
Over the years we have generally found that “smart” or “informed” money tends to show up first in the options market which is why we tend to scrutinize the behaviour of risk reversals. Sure no system is fool proof but little things like risk reversals can give you that vital edge, which in the competitive world of currency trading, is vital.
But what about the behaviour of the CDS market for PIG nation’s debt? Yes the behaviour of the option market for the Euro and the bonds/CDS market for PIGs nations is diametrically opposed. On the one hand the CDS market is suggesting that a solution will not be found to Greece’s problems (and perhaps PIGs as a group), on the other hand the options market for the Euro is suggesting that either; it will be no big deal if Greece does default or that a deal will be acted on (as opposed to agreed) to save Greece from defaulting.
At the end of the day a trader has got to make a call, and that is exactly what we are doing, buying OTM calls on the Euro 3 months to exp. Within the next 3 months the Eurozone would have either blown apart (and if it does goodness knows how much the Euro will fall), or a solution will be found and acted upon, the Eurozone will be saved, and the Euro will be trading materially above 1.40. Why not buy puts as well? Because as the risk reversal suggests, calls are very cheap relative to puts, and given the record level of short selling in the Euro it won’t take much to cause a short covering rally propelling the Euro significantly higher. Furthermore, the level of short selling suggests that anyone who could get short the Euro (long USDs) has already done so……..and making a habit of being long the world’s most crowded trades is the quickest way to the poor house! Of course we could be wrong in which case we will be limited to the cost of the short dated calls…..and we are certainly not betting the house on the resolve of the Germans to keep the Euro together!
Where in the World Would John Templeton Be Looking For Value $GRE
It we had to identify our investment style with an investment great it would be John Templeton. While Soros and Buffett continue to steal the limelight and many try to model themselves on what they did or at least are currently doing, few realise that it is exceptionally difficult for the average investor with limited means to replicate what they did. However, few pay attention to the investment style or process of John Templeton. A process which, with diligence and perseverance, can be repeated by the average investor…..provided of course they do not act like the average investor.
Templeton’s investing style can be summed up as looking for value investments, what he called “bargain hunting, “by searching out such targets in many countries instead of just one. Templeton’s investing mantra was “search for companies around the world that offered low prices and an excellent long-term outlook.”
As a value-contrarian investor, Templeton believed that the best bargains were in stocks that were completely neglected – those that other investors were not even studying. Perhaps the two quotes emanating from Templeton which act as the basis for our investment process are:
“Invest at the point of maximum pessimism.”
“If you want to have a better performance than the crowd, you must do things differently from the crowd.”
Well enough with guiding philosophy, now down to business – where in the world would Templeton be looking for bargains? Well geographically where is the point of maximum pessimism? Well you certainly don’t have to be anyone special to work that one out – we would say that it is the Greek stock market. With a median price to book ratio for the largest 100 stocks being a mere 0.65x it is a dead giveaway that stocks listed on the Athens stock exchange are the world stock market’s unwanted children. Sure Greece has its problems but you cannot tell us that every Greek stock is toxic waste as the market would have us believe. Furthermore, with such cheap fundamental values one cannot tell us that the crisis isn’t already priced into Greek stocks perhaps twice over!
It seems that the whole Greek stock market is priced for bankruptcy. Granted there will be casualties but those stocks that have low gearing levels and generate considerable cashflows from exports are likely to not only survive but thrive in the years to come as Greece gradually gets it finances in order. Don’t write the Greeks off, a crisis is a necessary ingredient for fundamental change.
The FTSE/ASE 20 Index
For the average investor identifying individual bargains may well be beyond reasonable expectations, but fear not. There is an ETF that trades on the Paris bourse which tracks the Athens Composite, its code is GRE. Buffet wasn’t joking when he said that the average investor should put their money into an index fund i.e. they should forget about being stock pickers!
Two Big Charts Depicting a Pickup in World Trade $SEA
We would like to present two big charts that are rather suggesting for a bullish outlook on global trade and shipping stocks. These charts centre on the costs of shipping cargo and hiring ships. Most people focus on the “infamous” Baltic Dry Index as a means of gauging what is happening on the high seas. However, as we have pointed out in the past, the Baltic Dry Index is heavily influenced by the erratic behaviour of the Capesize Index. We prefer to use the index of the smallest size bulk carriers, the Handysize, because its behaviour is significantly less volatile than the Baltic Dry Index and therefore long term trends are easier to depict. It is important to note that the Baltic Dry indices are based on how much it costs the shipper to ship bulk cargo.
There is another index which is widely overlooked, and in fact virtually unknown to the investment “community” let alone the general public. While Baltic Dry indices are based on the cost of shipping cargo in bulk carriers, the Contex Containership indices focus on the cost of chartering containerships. An analogy would be the cost of a taxi fare vs. how much to hire a taxi for a day. To be more precise the ConTex is a:
Container Ship Time Charter Assessment Index. It is a company-independent index which is calculated as an equivalent weight of percentage change from three ConTex assessments, which are for the classes of Type 1100 TEU, Type 1700 TEU and Type 2500 TEU. The index starting point is 1000. ConTex is compiled by a group of international operating brokers and is updated twice a week. The data source is Vereinigung Hamburger Schiffsmakler und Schiffsagenten e.V. (VHSS), the Hamburg Shipbroker’s Association.
The behaviour of the ConTex Index below is very encouraging, you don’t ship iron ore or coal inside containers…………you tend to send finished goods such as textiles and electronics.
Considering that you don’t tend to import or export finished goods unless there is demand from end users and the more demand for container space results in higher demand for ships to carry containers, does the chart above suggest that we can now expect inflationary forces to take hold? That would be a rather logical conclusion but either which way, it does suggest that the outlook for shipping stocks are about to improve dramatically!
And for those of you who are worried about the “overhang” of ships, well scrapping is a function of the level of commodity prices in general and scrap steel prices in particular. Just look at the two charts below, they depict the scrapping rates for bulk carriers and containerships. It does not take a rocket scientist to work out that we may well be looking at a shortage of ships over the coming months!
From a valuation perspective shipping stocks remain very cheap. The average book value of the top 20 shipping stocks in the world is approximately 1x, dividend yield of 5%, and price to cash flow of 7x – even after all the earnings and cash flow dramas they have been subject to over the last 18 months! Yes this is a simplistic way of looking at things but think about it. Within the next three years we are confident enough to say that the price to book value of shipping stocks will be materially higher than 1x! Our preferred entry to this market is via the ETF SEA.
Something Bullish is Building in Utility Stocks $XLU
On first appearances it would appear that Utility stocks (as per the S&P 500 Utility sector and the ETF “XLU”), are dull, boring, unromantic and all those descriptive things! They have gone absolutely no where since October 2008! Talk about a complete waste of time, actually if you compare the performance to the S&P 500 there has been a huge opportunity cost in being long Utilities!
So does one throw in the proverbial towel now, stick at it, or if one did not have any exposure, would now be a good time to take a long term stake? Let us start from a valuation perspective first, if there is no obvious value then let us not take this analysis any further. Take a quick glance at the table below it gives the key valuation metrics from the ETF XLU:
From a simplistic perspective valuations do not appear to be demanding by any stretch of the reasonable investor’s imagination. Sure I have seen lower P/E ratios in my time but with earnings being depressed as of late we are not taking this too seriously we place more emphasis on how much it costs to buy the assets of utility companies and with a price to book ratio of a mere 1.46x, asset prices are very reasonably priced.
We have often said that if you want to know what large caps are going to do look at what is happening to mid and small caps. To us mid and small caps are the proverbial “canary in the coal mine”. They are the first to show signs of weakness when economic conditions contract and, more often than not, the first to show strength when there is economic expansion or growth. Take a look at the behaviour of the S&P 400 and 600 Utility indices below. Both these indices look ever so strong, and if the last 6 months is anything to go by they are likely to trade at new highs before year end. So if you want to know what the S&P 500 Utility index is going to look like look no further than the charts below. Yes you are forgiven for thinking that this is a rather simplistic investment “analysis”…….but it goes something like this, something is driving mid cap and small cap equities higher and given the strength of the trend it suggests something a little more than the gods of chance are at play. There are four times more individual companies that make up these two indices relative to the S&P 500 Utility index – as far as we are concerned, majority rules!
There is something else that one should consider. Implied volatility on the ETF XLU has come crashing down over the course of the last few months and is back to the lower bounds of its historical trading range.
It does not take a rocket scientist to work out that a few dollars invested in deep out of the money LEAPs (Jan12 exp) calls on XLU could do dramatic things over the next two years.
The Carry Trade is in a Long Term Bull Trend $DBV $PCY $EMB $CEW
Just how “sustainable” is the rally in stocks, commodities (particularly crude), and the breakdown in US treasuries…..and where is gold going……and when? For an answer to that let us look at the currency market. More often than not the behaviour of currency markets precedes that of other asset classes. This behavioural “trait” of world financial markets has become even more pronounced over the last few years with the behaviour of the “yield” or “carry” trade leading commodity, equity and treasury markets.
By just looking at the behaviour of high yield currencies relative to that of low yield one can gain a detailed understanding of the likely direction of other asset classes. Why is this so? Well just look at who the high yielding currencies are……….in essence they are the currencies of commodity producing countries and/or emerging markets. In practical terms the behaviour of these currencies are barometers of world economic growth or the crowd’s appetite for “risk”, or something of that nature.
So what is happening on the carry trade front? Well popular opinion would have it that the yield trade is going nowhere. The ETF DBV ( a popular proxy for the carry trade) has essentially gone nowhere since mid October last year (some 6 months) perhaps little wonder why the CRB Index and the US 30 year have also tracked sideways in this time. Does this suggest that a top in the carry trade is imminent? Well to find the answer we will dig a little deeper.
If we expand our universe for the carry trade to the G24 instead of the G10 (on which DBV is based) we discover something rather interesting. The “carry trade” is actually at a multi-week high already. Below is the UBS V24 Carry Trade Index:
The same macro force that is pushing the UBS V24 Carry Trade Index higher is also pulling the spread between yields on emerging market sovereign debt and US Treasuries lower. Note the JP Morgan EMBI Spread Index (below) traded at a multi-week low last week.
Yes the carry trade is alive, well, and kicking. Prepare for a breakdown in US Treasuries and material upside in commodities, and prepare for it sooner rather than later. And if you have to hold currencies of the paper variety put them into a basket of emerging market currencies.
Crude Oil Breaks Out and With it the Inflation Trade $USO $FXA $FXC $FXY $TIP $IEF $TLT
Crude oil closed at a multi-week high in USD, Euro, Yen, and Emerging market currency terms. It also came close to closing at a multi-week high against both the Aussie and Loonie. Something is going on and it seems a lot deeper than just strength in crude oil. Many commodities also closed at multi-week highs in USD and non-USD terms. Furthermore, gold is only a few percent away from breaking out of its trading range.
In support of the bullish behaviour in commodities is the breakdown of US Treasury markets. On Friday the US 30yr future broke below “support” at the 115 level, propelling the 30 yr yield to a multi-week high. We also see strength coming through in inflation protected treasuries relative to conventional treasuries (i.e. breakevens are moving higher). And perhaps above all we have the Loonie trading at a multi-week high relative to the Yen.
We would not take the behaviour of crude oil very seriously if there was no confirmation in the behaviour of other commodity markets, inflationary sensitive treasuries and currency markets. As you can see from the charts below there is confirmation……yes the inflation trade is alive and well and ready to begin its next “leg” up. It looks like James Grant is going to win the great inflation debate…….I wonder if Rosenberg is long US Treasuries and short crude oil?
We think the best way in which to gain exposure to the inflation trade is via Jan12 exp, deep out of the money calls on the ETFs; DBC, TBT, XLE, and XLB.
The CADJPY Suggests that Commodities and Treasuries Will Breakout $FXC $FXY $DBC TLT $TBT
While the plight of the Euro is attracting everyone’s attention as of late you might be missing developments in the so called commodity currencies relative to the Yen. We have found in the past that the CADJPY and AUDJPY more often than not lead the behaviour of the CRB Index (the commodity market) and we see little reason to doubt that this time around this relationship will be any different. Note how long the CADJPY moved in a sideways direction, from early June last year in fact. Also note how long the CRB has also been tracking in a sideways direction. And perhaps it goes without mentioning that the US 30yr yield has also gone nowhere since early June 2009. Now, low and behold, the CADJPY is breaking out. We think that digging deep into our pockets to find cash to buy deep out of the money LEAPs calls on DBC and TBT (Jan12 exp) will be “dramatically” rewarding! If you are looking for a “black swan” trade this is it!
CADJPY Spot Rate
CRB Commodity Futures Index
US 30yr Yield
Five Charts to Rule Them All $VTI $DBC $IYR $UUP $TLT
The five charts below depict more or less all that one needs to know about the behaviour of the five big asset classes. We have a strong upward trend in equities and real estate, inconclusive action in commodity and treasury markets and what appears to be a change in trend (from bullish to bearish) in the USD Index. Again to a large extent the fate of commodity and US treasury markets lies with the behaviour of the USD Index. Bearish sentiment against the Euro and GBP (heavy weights in the USD Index) is at “unprecedented” levels and we believe that this will act as a ceiling to the USD Index’s advance. We would not be surprised to see the Euro trade at above the 1.38 level over the coming days and once it does that it will likely spark a powerful short covering rally taking it way past the 1.4 level. Of course it does not take a rocket scientist to figure out that if this happens the big heavy weight commodities (namely gold and crude) break to multi-week highs and in so doing drag the CRB Index and components along with it. Yes there are a number of commentators out there who believe that the inflation trade is history, but perhaps this “school of thought” merely reflects the fact that US treasuries and commodities have seemingly gone nowhere for the last 6-8 months. Ultimately the dramatic increase in government debt will weigh heavily on treasury prices and the perceived value of paper currencies.
